Borders 10K Report

I still don't get it. Borders appears to have mortgaged its immediate future with a short term loan that on the surface appears questionable. The company had cash on hand at the end of 2007 of $61mm versus $108.6mm in 2006; however, they also spent $123mm (versus $153.8mm in the prior period) in capital expenditures, technology improvements and new stores. Any of this could have been slowed to under $100mm if they believed they had a brewing problem. The company has announced for 2008 they will hold cap ex under $100mm and have also suspended their quarterly dividend (approx. $20mm). Importantly, the company has managed to effectively manage inventory and payables which has had a material impact in bridging the operating income stortfall to free cash. On inventory it looks like they have gained almost $120mm in cash from 2005-2007. A decent amount of good news. (Borders10k)

To the extent the company has operating issues they appear to have managed their way into them. The high costs of the Borders rewards program and the increasing costs of store occupancy costs are having a significant impact. Again, however the negative result of both of these items derive from management decisions on strategy. Pulling back on the promotions would enable the company to improve gross margin. Occupancy is a little more complicated and I suspect this is the real nub of the company's problem. The company has lost $113mm in gross margin between 2006-2008 (3%pts). In retail that is a lot to give up. Difficult to understand is whether the cost of the added bonus program has been covered in revenue growth. Revenues have gone up but the report doesn't tie one to the other directly.

Occupancy costs are also included in gross margin and the company has many long term lease obligations. It is likely that revenues are not growing fast enough to cover the rent escalations and this situation will grow worse over time. Borders has 435/509 store leases with terms that expire after 2014. If Borders can't aggressively grow top line revenues faster than these fixed occupancy costs they will continue to erode gross margin. Walden is in slightly better position with the majority of store leases expiring within 10 years. Borders can and is closing Walden stores because the leases are coming due.

The short and long of this evolving story is that we will know the fate of Borders by year end.

Here are some other highlights from the 10K:

• Opened 18 new stores in 2007
• $228/avg sales per sq ft
• Avg sales per superstore $8.6mm
• 541 Superstores (US-509, Oz-22, NZ-5, PR-3, Sing-1)
• 490 Walden stores
• 112 Paperchase stores
• Avg store sq ft is 7% less than their existing average (no explanation)
• Plan 14 concept stores in 2008
• Walden Avg sales/sq.ft: $299
• Walden avg sales/store: $1.1mm
• International: avg sales/sqft $381
• International: sales/store $8.3mm
• Closing 1 of 3 distribution locations in TN and expanding OH
• Interest expense up $13.2mm to $42.9mm in 2007
• Consolidated sales up $8.1mm due to new openings. Comp stores sales down 2.2% due to book sales decline
• Walden comp down 7.1%
• International comp up 0.1%
• Net cash from continuing operations 2007-$101.5mm, 2006-$38.7mm, 2005-$161.2
• Net cash used for investing: 2007-$123.1, 2006-$153.8mm, 2005-$57mm
• Borders retains some off balance sheet items related to leases for their sold UK store operation
• L/T liabilities to $350mm from $313.2mm