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Why We Doubled Our Position in Borders

by: Whitney Tilson April 18, 2008 | about stocks: BGP    

Whitney Tilson

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Excerpted with permission from the monthly letter to investors in Mr. Tilson's T2 Partners Fund:

Borders Group has been a terrible investment so far, as the stock has suffered from a weak macro environment, negative investor sentiment and numerous management missteps. Things got so bad recently that the company faced a liquidity crunch and was forced to do a dilutive emergency financing with its largest shareholder, Pershing Square Capital Management.

The pain of seeing an investment go so sour so quickly is only somewhat tempered by the fact that we’ve been through it before: over the years, we’ve owned a number stocks that have declined significantly from our initial purchase price. We of course try to learn from our mistakes and minimize their number, but investing is a probabilistic business, so the occasional misstep comes with the territory.

Dealing with a decline of some sort is almost inevitable in nearly every stock we buy, as we rarely precisely bottom-tick a stock and it immediately goes up after we purchase it. Thus, the key to long-term investment success is less being extremely clever in bottom-ticking stocks and more how one deals with the situation once a stock has declined from its initial purchase price. Making the right decision at that time to either sell, hold or buy more is often more important than the initial buy decision.

In the case of Borders, we have been closely following the unfolding situation and, after careful consideration, more than doubled our position recently when the stock tumbled below $5/share (it closed Friday at $6.17). This might strike some as pouring good money after bad, but while we don’t think Borders is a great business, we’re confident that it’s much more valuable than the market is giving it credit for.

Borders operates in three major segments. First, it operates over 500 book superstores in the United States that generated approximately $2.8 billion in revenues last year. Second, it operates over 500 mall-based stores, most of which are branded under the Waldenbooks name. Finally, the company has international operations, including 20 superstores in Australia, four in New Zealand, assorted small operations in several other regions and Paperchase, a UK-based designer and retailer of stationery, cards and gifts.

What are the different business lines worth? The largest pocket of value is in the superstores, which until recently were generating approximately $250 million of EBITDA (earnings before interest, taxes, depreciation and amortization). Subtracting $30 million for unallocated overhead to the superstores and using a 6x EBITDA multiple – which any number of financial buyers would likely pay – this business is worth around $1.3 billion.

The mall-based bookstores are struggling, as mall traffic continues to decline and the company appears unable to generate an attractive return on capital with this concept. Fortunately, the inventory can either be redeployed into Borders’ superstores or can be returned to publishers for full credit. At a minimum, this segment should be worth its estimated $80 million in working capital.

Finally, Borders is in the process of selling off its international operations, for which it could receive more than $200 million, but at the very least it has the right to sell them to Pershing Square at any time prior to January 15, 2009 for $125 million.

Add up the value of the businesses, subtract $550 million in debt and add $100 million that Pershing Square will pay to exercise its 14.7 million warrants with a strike price of $7, and the resulting value to Borders’ stockholders would be about $1.05 billion, equal to $14 per share, based on 75 million fully diluted shares.

Keep in mind that this is what a financial buyer would likely pay. We think Borders is worth even more to a strategic buyer such as Barnes & Noble (a stock we also own), which could tap significant cost savings and make great strides toward increasing Borders’ productivity to Barnes & Noble’s levels.

Borders has now hired a banker and put itself up for sale. We believe the most likely outcome of this process is that the company is sold this year for at least double its current share price, so we were delighted when the recent turmoil gave us the opportunity to buy it below $5.

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This article has 12 comments:

  •  
    Apr 18 04:15 AM
    good luck but i cannot resist the feeling that you still rely on some "greater fool" who buys bgp and thereby bails you out. bgp might be worth 14$, fine. If nobody wants to pay that and BN, for instance, doesn't see enough value for itself to spend money on borders than you may be sitting with your shares for another couple years while the business continues to erode. after all, didn't you acknowledge that "you don't like Borders' bussiness"?
    unlike distress investing in bond insurers like mbi where at least time is on your side, here it is quite the opposite.
    i held borders myself but immediately exited after their january quarterly report with a small profit. i do not like the prospect of ownong a bad business that erodes day by day - even id i pay 50ct on the dollar as this dollar may soon come down to 50cts
    Reply
  •  
    Apr 18 07:29 AM
    I'm no expert, and I agree with everything Mr. Tilson says, but I have only one caveat and question. Everything I read on the subject of BGP leads me to believe the Barnes & Noble does not want to buy BGP because of cross-over in stores. BGP would be much better off allowing BGP to file bankruptcy and then cherry-picking the stores it wants at fire-sale prices. And I don't know why any other company (such as private equity) would buy BGP. Maybe I'm wrong, but I'm afraid of bankruptcy, and that's the only reason I don't buy it. Am I right or wrong?
    Reply
  •  
    Apr 18 08:57 AM
    Where was the margin of safety at much higher levels, BGP has no asset backstop and just a bunch of leases in many second tier locations. It appears the only MOS was the presence of Ackman at higher levels. The idea that BKS would buy BGP sounds idiotic, why wouldn't they just wait for BGP locations to struggle and kick out and then go directly to the lessor to assume the leases and flat out push BGP out?

    BGP could be renting from Vornado for example and not be meeting its rent payments. BKS can just go to Vornado and say they'll assume the lease and then just boot BGP out for much cheaper than buying BGP. Also, with the current situation in commercial real estate and retail, why would BKS want to "expand" via an acquisition of BGP when nearly every retailer is pulling back? I don't think the BGP locations are all that unique or have little overlap relative to where BKS is, do they really need to BGP site 1-2 miles down the road from them?

    No LBO shop would touch BGP and no bank would refinance that on an EBITDAR basis. Also, why do you even mention EBITDA for a retailer that leases all of its stores? If you want to find what BGP would be financed for and more important what it's really valued at, used EBITDAR and gross up the leases for the enterprise value. Then step back and think if a bank would actually refinance that for a take private. I'm sorry but to be a professional fund manager and miss this is a considerably oversight IMO.

    I've been an admirer of Tilson's previous writings from the Fool and also his behavioral finance stuff but over time I've really been disillusioned with what he writes relative to what he does. If you're a Buffett disciple as you claim to be and manage $200MM in T2 I find it odd that your largest ideas are Ackman tagalongs in TGT and BGP. At least Ackman duped investors into being in a separate fund that doesn't impact this main fund's returns, yet in T2 you have calls and common TGT and are paying a tough price for it. Then to also own BKS and BGP? Not to mention prior investments in MCD and WEN/THI?

    I honestly can't see why an investor gets charged fees to be in a portfolio that is a mini Pershing Square to some extent. With $200MM you can invest in the most inefficient areas of the market and your recent coverage in Business Week regarding broken IPOs would make people think you are combing these pockets of inefficiency yet you plow a lot of your fund's capital into broadly followed stocks.
    Reply
  •  
    Apr 18 09:23 AM
    Why did you ever buy it? Amazon.com is the leader? Why buy the worst when you can buy the best?
    Reply
  •  
    Apr 18 11:37 AM
    Borders is toast. I know some of the insiders and they are real morons.

    This is a company that loses money every month except for Christmas. An LBO is entirely out of the question when the business is in a tailspin.

    Bankruptcy is about a 90% certainty in my mind.
    Reply
  •  
    Apr 18 01:15 PM
    The comments in this article are superficial at best and show a real lack of understanding about Borders. The reason that B&N is succeeding and Borders is not reflects several things: B&N has a superior inventory system while Borders is 1980s stuff, B&N has superior logistics while Borders struggles, In most markets B&N has superior locations. Both chains fail to give their stores a local feel and in books that is important. There are high costs associated in returning merchandise--yes the chain gets almost full credit but it pays the shipping both ways.

    Borders brought in George Jones to set a new strategic plan and turn things around, but now he is blaming the economy for Borders failures. I worked for Borders recently and have worked for other chains and independents and Borders has the weakest merchandising I have ever experienced. Their idea of a concept store is interesting but they promise high customer service yet have cut positions and payroll in their stores.

    I can see no scenario that rescues Borders except that bookselling is a sexy business and may attract an MMTB investor (more money than brains). Where are B Dalton, Brentanos, Crown Books, Scribners, Doubleday now?
    Reply
  •  
    Apr 18 07:02 PM
    Catching a falling knife is a dangerous game. Borders is in the same position as Circuit City--both have a strong number 1 to compete with, but that number 1 has benefited from industry consolidation (for Best Buy the demise of Circuit City; for Barnes & Noble the demise of so many small chains and independents). The number 1 chains have issues as more chains take a "bite" out of Best Buy and Amazon is taking a whole hunk out of Borders. I am a heavy user book buyer/reader--80 per year; and I stopped bothering with Borders years ago (I rarely shop at Barnes & Noble, but do sometimes). Amazon is the place--and for the future too. Good luck with the dropping knife....
    Reply
  •  
    Apr 19 04:58 PM
    According to the annual report the superstores generated $30.6 million in operating income for 07. How do you get to $250 million EBITDA? Seems a bit of a stretch and would explain why the market is valuing Borders at $360 million and not at $1.3 billion
    Reply
  •  
    Apr 20 05:15 PM
    Ackman is offering to buy BGP's international operation for 135 million, although the price could go as high as 200 million, as Mr Tilson states. That would give a value of aprox 4 million dollars for each of BGP international superstores. If you give the same valuation to the 509 superstores BGP has in the US, that would give a total of 2 billion dollars plus the 135 million of international operations would total 2.14 billion minus 550 million in debt would give a valuation of 1.59 billion, divided by aprox 60 million shares outstanding would be around 26 dollars per share. That is without counting the value of Waldenbooks. Of course there are the shortys who say that BGP is on the verge of bankruptcy. They are the same who 8 years ago when the stock price went down to 11, said that BGP was going out of business beacause everybody was going to purchase books only via internet. It never happened and BGP has grown in tha past 8 years and will continue to grow. With Ackman owning almost 20 percent of the company you can be sure he will do everything on his power to make sure his investment is profitable. He made the bulk of his purchases at 12-13, so he needs the price of BGP to go above this level to make money. For me the fact that Ackman and other fund managers like Tilson own big chunks of the company is a gaurantee that BGP's price can easily double fron current prices. I'm a buyer and actually own 34,000 shares.
    Reply
  •  
    Apr 27 01:59 AM
    It's as ridiculous to claim that this is a $26 stock (at the moment, at least) as it is to say the company is on the bankruptcy. People, how about some moderation in your projections? The company brings in billions in revenue, the folks who are only or mostly going to buy via Internet are already factored in to the brick-and-mortar customer base, and with a little tweaking and a little luck Borders Group can once again reach the mid-teens (to hit the twenties would, I think, require a stronger economy, or at least that the market anticipate a stronger economy). Let's be honest: the stores are not worth $4 million each, but in Beantown (Boston), for example, the downtown Borders is thriving and the Barnes & Noble vacated its prime location years ago. Is there something so unique about the way B & N conducts its business that Borders can't learn from it? Imitation is the sincerely form of flattery, perhaps; and perhaps is the shortest road to attaining your closest competitor's profits, too. So let's be conservative, taking into account an iffy economy, and value Borders, at least for the near-term (3 to 6 months), at $16-$18 a share. My feeling is, people may put off buying a new car for a year or two, but a lot of the customers at these big box bookstores are educated, upper middle class, and looking for a relatively cheap place to spend a few hours relaxing and destressing. While at the bookstore, an impulse purchase of a book or magazine -- well, assuming Borders continues getting its inventory act together (which is already starting to bear fruit: just visit your local Border and take a look at the shelves these days) -- is not as subject to the fickleness of the economy as is, say, the purchase of a new piece of furniture, or remodeling a home. A bookstore may be a specialty retailer, but it's not subject to quite the same ill winds of a decline in consumer confidence (and purchasing power) as is a bix box home improvement store.

    The stock may bob and weave, but this stock is a screaming "buy" at any price under $10.
    Reply
  •  
    Apr 27 05:05 PM
    IMO, Mr. Tilson got it wrong.
    First, who wants to pay 6X multiple for a business that hasn't been profitable for the past two years?

    Second, why didn't Mr. Tilson factor in Capex in his valuation -- Capex averaged $160MM for the past three years.

    Think about it, it's a money losing business AND it requires $160MM, on average, for Capex needs. Based on these observations, Mr. Tilson believes it is worth $14 a share.
    Reply
  •  
    May 20 10:00 PM


    Barnes & Noble Inc., the nation's largest book chain by sales, has assembled a team of executives and advisers to study the possibility of acquiring No. 2 chain Borders Group Inc., according to a person familiar with the situation.
    Reply
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