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Executives

George Jones – President & CEO

Edward Wilhelm – EVP & CFO

Analysts

Matthew Fassler - Goldman Sachs

David Weiner - Deutsche Bank

Borders Group, Inc. (BGP) Q3 2008 Earnings Call November 26, 2008 8:00 AM ET

Operator

Good morning and welcome to the Borders Group Inc. third quarter 2008 financial results conference call. (Operator Instructions) I would like to turn the call over to Borders' management. Sir, you may begin.

Edward Wilhelm

Good morning, everyone. This is Edward Wilhelm, CFO of Borders Group and I am here this morning with our CEO, George Jones. Thanks for being with us on the call today.

Before we begin, I need to point out that this conference call includes forward-looking statements. These statements, among others, include sales and earnings expectations and information related to corporate initiatives.

Please refer to the news release issued last evening and our most recently filed 10-K for information relating to forward-looking statements, including factors that could cause actual results and plans to differ.

I will now turn it over to George who will get started with today’s call.

George Jones

Good morning everyone. As all of you know the focus at Borders Group since the beginning of this year has been on strengthening our balance sheet. With that as our top priority we detailed several months ago our efforts to significantly reduce debt, improve cash flow, reduce expenses, and improve the productivity of our inventory.

We have attacked each of these objectives with specific and highly focused effort designed to drive substantial results quickly. I am pleased to report again this quarter that we’ve made great strides even in the midst of this most challenging economic environment.

In the third quarter we reduced debt year-over-year by over $273 million, that’s a 34.2% reduction in debt compared to the same period last year.

Operating cash flow from continuing operations improved by $110 million as we moved from a fiscal year-to-date cash use of $100.6 million a year ago to positive cash flow of $9.4 million year-to-date this year.

We significantly improved inventory productivity due in large part to the work we are doing in conjunction with our vendors. We reduced inventory at cost by $304.2 million or 19.5% of reductions at the end of the third quarter compared to the end of the third quarter a year ago.

Our intense focus on inventory management called for us to collaborate more closely with vendors on opportunities such as [sage] product flow, accelerated returns, assortment management, and other efforts, some of which are standard practice in many industries that have been long overdue in the book-selling business.

I’ve been outspoken about the need for these types of industry-wide changes since I joined Borders as CEO almost two-and-a-half years ago. While our need to improve cash flow and reduce debt as well as the difficult overall economic environment really accelerated these efforts, make no mistake that this is a much more intelligent way to run our business overall.

And when the dust settles we will emerge as the better run and more profitable company because of these efforts. I am extremely pleased with the strong partnership and support we are now getting on this from our key vendors.

At the same time we realize that these inventory initiatives have had at least some degree of negative impact on our sales. With a program as aggressive and multifaceted as the one we have implemented the cuts were not always as surgical as we would have liked. But we are now in the process of doing a store-by-store deep dive into our inventory, returning what is not selling and adding back in where we may have cut too deeply at specific store locations. We are fine-tuning.

Expense reduction has also been a special focus this year. About six months ago we announced that we would reduce annual operating expenses by $120 million beginning in 2009 and would achieve half of that target or $60 million in savings this year.

We have successfully implemented a comprehensive expense reduction effort that has touched every part of our business and I’m pleased to tell you that we are now on track to exceed the original target. We now plan to reduce annual operating expenses by $140 million in 2009, with at least $70 million in savings this year.

I am very proud of the tremendous progress our team has made at reducing expenses and enhancing the inventory productivity this year and now, we are beginning to embark with the same intensity on another high focus special project, that’s gross margin improvement.

We have brought in an external consultant as we did with the previous successful special projects to help with this initiative and we feel there is a major opportunity for us to make improvements that will increase both gross margin rates and total gross margin dollars, with an emphasis on that, total gross margin dollars. We are focusing on improving our gross margin dollars.

As we stated in our release our third quarter earnings on an operating basis were essentially flat versus the same period last year. We certainly had originally planned for much stronger earnings but that was before we encountered the current retail climate, which is by far the most [pervasively] difficult I’ve ever seen during my 36-year retail career.

We got in front of this storm however as early this year we revised our planned sales to very conservative levels and took the necessary steps to reduce inventory and expenses. So even though customer traffic has declined during this period, sales have been tough, we have still managed our business well and the result is that we have still been able to make major progress on improving our balance sheet.

I also want to point out that Borders actually turned out to be one of the very few retailers that did not report significantly decreased operating earnings for the quarter. As I said, our operating loss from continued operations was essentially flat versus last year.

On the sales line, same store sales at Borders superstores decreased for the quarter by 12.8%. Factoring out the music category superstore comps declined by 10.6% and Waldenbooks had a 7.7% same store sales decline.

We experienced the same problems as almost every other retailer as our negative comps were primarily a traffic issue and the traffic drop was especially pronounced in September and October. Also, as I previously mentioned our inventory efforts are likely responsible for at least some of the same store sales decline and as I noted we are taking aggressive measures to identify where we may have reduced inventory too deeply in certain stores and are carefully adding back inventory on a store-by-store basis.

We did see positive performance in some categories including children’s where the Stephanie Meyer Twilight Saga [inaudible] drove really strong results and in addition we continue to see good results out of our Paperchase gifts and stationary category which also had positive comps this quarter.

With regard to borders.com as our news release stated, we had sales in the third quarter of $11.9 million, a lower then expected result that was driven by overall economic conditions which slowed online traffic as well.

In addition we delayed the public grand opening of the site until the last two weeks of July this year before we got it open, so the ramp up of borders.com got a late start. Due to the sales shortfall we do not expect, as originally predicted, to break-even with the site this year.

However we continue to be very pleased with the site itself and the overall customer response to it. We have just completed the rollout of borders.com to select kiosks in each of our Borders stores giving customers the ability to order using borders.com while in our stores.

We look forward to the cross-channel opportunities this can drive going forward.

We continue to market directly to our now nearly 30 million Borders Rewards loyalty program efforts. Membership continues to grow by over 127,000 new members weekly who receive our weekly shortlist emails.

As [inaudible] our stores are stocked and ready for the holidays. We expect to see strength in titles such as Malcolm Gladwell’s Outliers, James Patterson’s Cross Country, and Ina Garten’s newest, Barefoot Contessa Back to Basics.

Building on the success of the Stephanie Meyer books and the recently released Twilight film we have taken an industry-leading position in our stores with dedicated tables featuring the Twilight Saga books as well as a tremendous assortment of other items related to the film, some of those which are exclusive to Borders that are popular with tweens and teens.

In addition we are thrilled to have a retail exclusive on Aretha Franklin’s first ever Christmas CD titled This Christmas. She was just named the greatest singer of all time by Rolling Stone Magazine and this CD is getting an incredible amount of attention in the major media. We truly believe that our stores are the place where shoppers can get something for virtually everyone on their shopping list and at a price point that are attractive, especially this year.

Before I turn it over to Edward, I want to address the update we provided regarding the strategic alternatives process. As reported in our press release with respect to the sale of the company we are no longer contemplating a transaction.

Regarding Paperchase we retained the right to exercise the put option to sell Paperchase to Pershing Square Capital Management for $65 million and we are also in discussions with Pershing Square regarding an alternative financing transaction.

Of course no assurance can be given as to whether an alternative financing transaction will be entered into or contemplated. The process we undertook was very comprehensive however it has also been a notable distraction. We are pleased to have it behind us. We are now moving forward and I’m very pleased with and quite encouraged by the important progress we continue to make on our balance sheet.

With that, I’ll turn it over to Edward.

Edward Wilhelm

Thanks George, I want to provide a little more color primarily on the key initiatives that are driving cash flow, debt reduction, profitability improvement, as well as the non-cash, non-operating charges we took in the quarter.

We continue to have a clear focus on maximizing our cash flow and are exploring any and all alternatives to do so. Primary drivers of maximizing cash flow and profitability include reducing our working capital needs and improving inventory productivity, reducing our capital spending, and reducing expenses and improving our gross margins.

Our results so far in 2008 show the significant progress we have made. As it relates to the inventory reduction, one of the drivers has been the reduction in music inventory which was decreased by 30% compared to last year.

We have reduced floor space dedicated to music in all of our stores by about a third on average. Music now occupies about 7% of our total floor space. The space previously occupied by music was reallocated to growth categories such as children’s books and bargain books.

In addition we’ve reduced weeks of supply and book inventory and DVD inventory as well. As Georges said we are working closely with our vendors to execute this inventory productivity initiative. Together with our vendors we are analyzing sales potential but being prudent in our assessment.

We are also leveraging our distribution network to a greater degree and creating a more just-in-time inventory model. Borders.com has been rolled out to all of our stores for this holiday season and will not only help drive special order sales but will also help drive inventory productivity.

There continues to be a lot of opportunity in this area and it will remain a key driver of cash flow for us going forward.

Related to capital spending we remain on track to spend approximately $80 million in capital expenditures this year including approximately $10 million to support Paperchase overseas. That compares to a total capital spend of $143 million in 2007.

The CapEx reduction will be another key driver of cash flow improvement for us in 2008 and going forward.

We continue to diligently review all discretionary capital projects and are spending capital only where significant financial returns are assured. We are spending capital where necessary to maintain stores, distribution centers, and critical IT systems.

Next, I want to update you on the status of improving the profitability of our business. The key drivers of profit improvement include operating expense reductions, gross margin improvement including lower DVD and shrink and café waste, and lower interest expense driven by positive cash flow and lower overall debt levels.

Regarding our operating expense reduction initiative we continue to critically review the cost structure of or entire business. Earlier this year we began taking significant steps to reduce expenses. As George noted we are on track to now realize approximately $70 million of expense savings in 2008 and expect to be operating at a level to realize $140 million in annualized expense savings at the beginning of fiscal 2009.

The incremental expense savings are across the board with store expense and facilities maintenance being the largest individual areas.

We are very confident in our ability to deliver these expense savings and have made good progress as demonstrated by the reduction in absolute SG&A dollars of over $22 million realized in the third quarter of this year compared to the prior year.

Next related to gross margin improvement we made progress again in the third quarter. Absent the negative impact of deleveraging occupancy costs, our gross margins improved by 30 basis points compared to last year.

The major items contributing to this improvement include a favorable sales mix and lower shrink. Sales mix was favorable as the higher margin categories such as gifts and stationary and bargain books continued to show a comp sales performance that outpaced the total store while music, a low margin category continued to show a significant decline in comp sales.

Related to DVD shrink and café waste, given the control actions implemented late last year our cycle inventory results continue to show improvement over the prior year. In the third quarter shrink improved in the Borders superstore segment by about $4 million or 70 basis points over last year bringing our year-to-date shrink improvement to $6.5 million over last year.

We continue to work diligently to reduce our shrink costs. In the third quarter we incurred significant non-operating charges related to asset impairments and other items. These charges totaled $133 million after-tax and were non-cash.

The most significant charge related to write-downs of deferred tax assets which totaled $107 million. In addition we were required by accounting rules to test store assets for impairment and as a result recorded an after-tax charge totaling $31 million.

This test had typically been done in the fourth quarter in previous years, however certain impairment indicators required that the test be done in the third quarter this year.

There were other miscellaneous items as detailed in our press release which on a combined basis totaled about $5 million in after-tax income, again, these non-operating charges while significant and required by GAAP were non-cash.

To conclude, we as a management team remain keenly focused on maximizing cash flow and improving the profitability of our business even in the face of a weak consumer environment.

That’s it today for our prepared comments, we’ll now open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Matthew Fassler - Goldman Sachs

Matthew Fassler - Goldman Sachs

If we could focus first on gross margin there are two elements to the question. I believe that your year-on-year improvement excluding the impact of occupancy had been 90 basis points in the second quarter, its down to 30 basis points in the third quarter. Obviously the environment was no help to you this quarter. Any sense as to what might have held up the momentum there. What the change was from a year-on-year improvement perspective.

Edward Wilhelm

In the second quarter we were cycling against Harry Potter in the prior year. That was the biggest driver. As we mentioned gross margin has been a focus of ours. George talked about the efforts we are now organizing here internally to drive further gross margin improvement and it will be a combination of the factors we talked about; mix and shrink improvement which have been working for us and also focusing on the promotional spend.

George Jones

The fact first off that we did manage to improve our margins somewhat in still a very, very competitive and tough retail environment out there, we were pleased. But I also want to note that this gross margin improvement effort that we’re having and bringing in the outside help, the same type of focus that we put on expense reduction and inventory management I think we’ve really proven that we can get behind something like this and make it work.

We just now really started on the same thing as far as on gross margin. We are analyzing discounting and we’re analyzing use for our promotional dollars and promotional effectiveness for ad, really getting a really deep dive into this and we think we have a nice opportunity here.

Matthew Fassler - Goldman Sachs

The Potter answer makes a lot of sense. Also on gross margin I believe that your occupancy deleverage stayed about the same, and correct me if I’m wrong in that, even though your comp decline was somewhat deeper and seasonally this is a lower volume quarter I would have thought it would have hurt you more. Any color on that?

Edward Wilhelm

I think the occupancy deleverage in the quarter is a little worse then what we experienced in the second quarter but not much to your point and certainly not in relation to the sales differences between the quarters.

The expense reduction initiative that we’re undertaking is all encompassing and it includes occupancy going after occupancy reductions, and we’re in discussions with landlords on many, many of our store leases and with efforts to get reductions where we can, to get buyouts that are satisfactory to us and to landlords so there’s again a part of our overall expense reduction initiative does include going after occupancy and we’ve have had some success to date there.

Matthew Fassler - Goldman Sachs

If you could give us a little more itemization on the non-operating charges, it would be very helpful. For example what did that deferred tax asset relate to and then just some of the other, other then the impairments, if you could try to give us some sense as to relative size of the different pieces because I know some of these realistically have recurred from time to time.

Edward Wilhelm

I’ll start with the deferred asset impairment because it was the most significant, the accounting rules required test of realized ability of those assets on a regular basis and the accounting test that we did in this third quarter showed that it required a write-down of those assets and it doesn’t mean these deferred tax assets are going away, what it means is that in order to realize them in the future we need to generate future income.

So what that means is we generate income in the future, effectively we’ll have minimal, or no tax provision against those earnings because we’ll restore those deferred tax assets.

The rest of the impairment charges and non-operating charges relate to either store impairments or the warrant liability re-measurement for the Pershing warrants and then we also had a meaningful benefit, about a $5 million after-tax benefit from sale of a store lease, underperforming store lease.

Operator

Your next question comes from the line of David Weiner - Deutsche Bank

David Weiner - Deutsche Bank

On the internet business, you’ve had that under your belt now for a couple of quarters, and given your comments in the press release what strategic changes do you think you need to make to try to draw more traffic to the site?

George Jones

Actually our issue is I think its just been that we’ve really had a slower time ramping this up then we had anticipated or hoped for and we’ve seen actually, its ramping up nicely now. We’re pleased with the ramp on it. We got a late start on it, frankly it seems like we had one sort of technical snafu after another and just a lot of odd things and we finally got now just over the last several weeks we’ve really got things stabilized nicely and we’ve been reluctant to fully turn on the full blast on marketing until we’ve made sure that we had the service element there really right for the customers.

We didn’t want to bite off something that we couldn’t really handle in terms of the customer service part of it. So what I’m saying is basically that we were disappointed in the sales in this for the quarter but also realizing we’re not running it full gallop so to speak. If you remember we said originally we were planning on launching this site by the end of the first quarter and then we said it would be the first part of the second quarter and it didn’t really get up until the end of May which is at the end of the first month of the first quarter.

And then where we planned on a couple of weeks of soft opening and being able to start really going marketing in June, we really didn’t start marketing it at all until the last two weeks of the quarter, the last two weeks of July. And since then its been sort of stop and go from the standpoint of some of the system things and other things we’ve had. But we’ve brought in outside people, we’ve got the help on it, we’ve got the site really stabilized.

As a result of that we delayed the rollout of our in-store kiosk which accesses the online business within our stores which originally we planned much earlier. We just got those finished up actually last week. We got these up for the holiday season. We think that will be positive for us. So this has been something that frankly we’ve been cautious in terms of pushing it too hard until we made sure we got the stability in the system. I wish it had been something that had gone smoother then it has but we feel like we’ve got our arms around it now.

David Weiner - Deutsche Bank

Also you mentioned earlier in your opening remarks I think you emphasized that the, on the gross margin side that the goal is gross profit dollars. I think you were trying to make that distinction. So are you trying to say that maybe longer term the idea is more that you want to turn the sales more quickly and perhaps at a lower gross margin, is that correct?

George Jones

Not necessarily at all, as a matter of fact if you look at what we’re doing with our mix, and the changes we’re having in our mix, its actually giving us a higher margin on the mix and we’re also really aggressively analyzing our promotional effectiveness thinking we’d be more effective there as well. So I definitely don’t mean that it means we think we’re going to be at a lower gross margin rate.

However I found that you have to keep an organization focused on gross margin dollars, that’s what you pay your bills with on the bottom line. We are looking to improve our inventory turns and frankly we’re making nice progress on that. But it has nothing to do with lowering the margin rate. Its basically, that goes in the better inventory management, working with our vendors, etc.

The answer to that is no, we clearly expect for our gross margin rates to increase.

David Weiner - Deutsche Bank

You touched on the inventories and how selectively at some stores you might have to restock some of the stores to try to drive sales, but net net it sounds like inventories still have room to come down especially when you layer in your exposure to music.

George Jones

First off I think any retailer, if you’re really doing it effectively you’ve got opportunity through inventory to write some down. You grow operating between orders in and our specialty doors [inaudible] up here, and you know frankly we’re making improvements in our systems but they’re still not really state of the art yet. We’ve just put in our merchandise planning and replenishment organization, got it in place in May. I think we’re doing really nice work on there in this.

But the answer to that is you still can see some imbalances, the stores will sometimes order too much on a quantity of something because you over project sales on something you thought was going to be a hot seller and it doesn’t materialize and on the other hand you may need other things that sell faster then you thought.

The cause of the broad base of titles that we carry in our store, we carry literally 100,000 plus titles in a store between all the categories, that’s a lot and any time you’re never going to have it to perfection. But I think we did, as we moved we really got aggressive about reducing our inventories and getting more productive.

We did it as surgically as we could based on the fact that we were really trying to aggressively do this. But invariably you’re going to miss some and so what we’re trying to do now is fine-tune it and go back in and look at it on a by-store basis.

We regularly monitor our customer service ratings however and one of the things we monitor is how they feel as far as our in-stocks and in our superstores we’re still getting good marks on that. Our specialty stores I think have been a little more challenged on it. I think we’ve got some cases there where we pulled too much and we’re really aggressively trying to get back in on some of those.

So again its not a perfect science on it, I think net net what we’ve done though, our inventory levels are down 19.5% and in doing that we freed up a lot of cash, we’ve been able to pay down our debt but did it hurt us on some of our sales? Yes, it certainly did. I don’t know if its 2% comp that hurt us or 3%, or 4% but its not zero and its not 12. But I still contend that if you look at that and you looked at the two, or three or what percentage may have hurt us in sales, would you say would you put back in 20% plus more inventory if you invert that [inaudible] number and be able to get two or three percent more sales, you’d say that would not be a very smart move.

Operator

Your next question is a follow-up from the line of Matthew Fassler - Goldman Sachs

Matthew Fassler - Goldman Sachs

Related to the other deal you’re looking at with Pershing you talked about retaining the put on Paperchase but you said you’re looking at an alternative strategic transaction to the extent and if you’re free to shed any light on what kind of transaction that might be we’d be interested.

Edward Wilhelm

We do have, we have retained the rights to the put, and the disclosure in the release was an alternative financing transaction. And we can’t comment any further then what was in the release.

Matthew Fassler - Goldman Sachs

Would that be presumably a more comprehensive transaction that goes beyond Paperchase?

Edward Wilhelm

We really can’t comment any further.

George Jones

The key thing to note though is we still have the right to the put so anything we do is obviously going to be favorable for the company.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

George Jones

Thanks everyone, thanks for talking with us today. Our next press release will be a post holiday sales update that will be released to you in mid-January. I want to wish each of you and your families a very happy Thanksgiving and have a good day.

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Source: Borders Group, Inc. Q3 2008 (Qtr End 11/01/08) Earnings Call Transcript
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