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Executives

Glen Tomaszewski – Interim CFO

Mike Edwards – President and CEO

Analysts

David McFadgen – Cormark Securities

Borders Group, Inc. (BGP) Q2 2010 Earnings Call Transcript September 1, 2010 10:00 AM ET

Operator

Good morning and welcome to the Borders Group, Inc. second quarter 2010 financial results conference call. Participants will be able to listen only until the question-and-answer portion of the call. (Operator Instructions). Today's conference call is being recorded. If you have any objections, you may disconnect at this time.

Now, I would like to turn the call over to Mr. Glen Tomaszewski, Borders Group Interim Chief Financial Officer. Sir, you may begin.

Glen Tomaszewski

Good morning, everyone. I am here today with Mike Edwards, President and Chief Executive Officer of Borders Inc. Thank you for joining both of us on the call this morning.

As always, I need to point out that today’s discussion may include forward-looking statements. These statements, among others, may include sales and earnings expectations and information related to corporate initiatives. Please refer to the news release issued earlier this morning 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.

With that, let me start by discussing the continued progress we have made in strengthening our balance sheet. As noted in our July 13th news release, we sold Paperchase, our U.K. based retailer of stationery, cards, and gifts to Primary Capital Limited, a private equity firm. We received $31.2 million from the transaction and used $25 million of the proceeds to reduce the principal of our $90 million term loan. This transaction, as well as the debt refinancing in the $25 million equity investment that occurred earlier in the year further improves the company's capital position.

We will continue to focus on strengthening the balance sheet and on improving the bottom line for the remainder of 2010. I would like to highlight two important financial initiatives currently underway.

First, addressing the profitability of our existing stores remains a key priority in 2010. We continue to pursue lease buyouts on stores which are dilutive to our EBITDA. Fiscal year-to-date, we have terminated seven store leases before the end of their terms and we will continue to opportunistically exit additional store leases. This will benefit not only our bottom line in the future, but it will also improve working capital.

Second, we continue to focus on increasing the efficiency of our supply chain. We are actively reengineering all aspects of our supply chain, a process that will continue into fiscal 2011. We anticipate both working capital benefits, as well as a lower operating cost structure through smarter ordering, lead time reductions, and lower inventory levels. We intend to achieve these goals without impacting the customer experience.

Mike will provide updates about all our strategic initiatives in a minute. But before I turn it over to him, I will cover key aspects of our second quarter performance. During the quarter, we continued to have challenges on the top line. Specifically, in the second quarter, our bookstores generated negative comp store sales of 6.8%, which was largely due to the performance of our trade book category. Our bargain and café categories outperformed the rest of the store however and generated positive comps.

Transaction comps were down 3.7% and the average ticket was down 3.2%, driven by a decline in price per unit, as well as decreases – as the decrease in units per transaction of 1%. Borders.com sales continued to exhibit strong growth, increasing 56% or $5.6 million in the second quarter.

Specific to gross margin, promotional spending was 240 basis points higher than a year ago, as we increased our investment in programs designed to drive traffic and we continued to shift our promotional focus from in-store discounts to those designed to bring customers into our stores.

Occupancy costs were higher by 110 basis points due to cost de-leverage, and freight and other costs increased by approximately 70 basis points. Shrink improved, however, by 50 basis points over the last year as we began to see results from our efforts to improve store-level execution and compliance.

With regard to SG&A costs, our continued efforts to simplify and streamline our business decreased SG&A compared to the prior year, both in absolute dollars and as a percentage of sales. Our reduced store count also played a role and overall, we were able to reduce SG&A expense by 14% versus last year.

Interest costs were up over the prior year, given the higher cost of capital required by our recently completed financing arrangements. In terms of capital expenditures, most of our $7.7 million of spending during the quarter was invested in two important sales driving initiatives, the development of our eBook store powered by Kobo, which opened during the second quarter; and our Area-e digital shops.

That's it for my comments. Now, I will turn it over to Mike who will talk about our strategic path forward.

Mike Edwards

Thanks, Glen and good morning, everyone. We are in the process of rolling out several programs that we believe will drive improved sales and increased profitability and market share going into the important second half of the year.

First, our Digital, Online, and Social Media strategy. The first of these programs I want to tell you about is our Digital initiative. In a short period of time, we have emerged as an industry authority for digital content and devices. We are leveraging our strong brand recognition to position Borders as a destination for eReading. We are now offering six eReaders in addition to – our assortment includes the Kobo eReader, Aluratek, Velocity Micro Cruz Reader Tablet, as well as two Sony devices. The sales of the Kobo have been well ahead of our expectations on our pre-orders and our Aluratek and Velocity Micro devices have also exceeded our expectation.

To make eReading accessible for everyone, we have lowered the price on our Kobo device to $129 and our Aluratek device to $99, which is among the most aggressive priced eReaders in the market. We expect to continue to seek out opportunities to price eReaders in such a way that our customers will think of Borders as the first place to go for their device needs.

I am happy to tell you that we have gotten great customer response to our recently launched eBook store, powered by Kobo and we expect the number of eBook downloads to continue to increase as we grow awareness of our digital offerings. We believe the success we are seeing with our eBook store together with our extensive device offering puts us in a strong position as the digital landscape continues to evolve and expand.

In relation to our digital strategy, these special areas will feature a selection of eReaders, as well as an array of accessories. In preparation for the launch, our sales associates have undergone an Area-e training program and received certification on our devices. They will continue to receive training on devices as we add them to our selection so they can answer questions, provide demonstrations, and educate our customers.

Now, I would like to briefly touch on our Borders.com business. We are currently executing programs to increase conversion rates and drive increased traffic to our site. The newly launched Borders Textbook Marketplace, which features more than 1.4 million titles and a textbook buyback option, is exceeding our expectation. We are also expanding our merchandise mix online to include high growth and higher-margin products and we will continue to grow our offerings in the upcoming months.

Before I leave the digital update, I want to tell you we have recently enhanced our social media footprint as the first in the industry to introduce Facebook Like, a feature on all detailed pages, allowing customers to share their favorite books and other products with friends on Facebook. We have also revamped our Facebook page around pop culture, book, and entertainment topics important to Borders' customers. In just one week after the launch of the new page, the company grew its fan base by over 100,000 members. We will continue to leverage social media as a critical customer engagement tool.

The in-store experience and brand. Transforming the retail experience to strengthen our top line is a key focus leading into the fall critical shopping season. I said before that a compelling in-store environment plays a key role in connecting with our customers.

Again, through research we have learned that our customers come to Borders to escape the everyday pressures of life. Over time, we will create an oasis-type of environment and the first set of improvements we are making to the look and feel of our stores will begin at the end of September. Our stores will feature inspiring new signs to enhance both shopability and navigation, while communicating value messages, as well as important author releases and book content.

We plan to make additional enhancements over the upcoming month as we go into the critical holiday season, so you will notice a very significant difference in our merchandising, product layout, and in-store signage going into the critical fourth quarter of this year.

As the bookselling landscape continues to evolve, we recognize we must shift our product offerings to include a mix of non-book product that complements our brand and increases our average ticket and improves our margins. We are starting with our children's department as it represents a significant growth opportunity for the company.

Our goal is to create a compelling retail experience for both kids and their families. To that end, we are in the process of increasing our selection of educational toys and games. We have also launched a partnership with Build-A-Bear Workshop that will include additional several Build-A-Bear make and play craft kits to our children's assortment, as well we will have a very comprehensive combined marketing program to enhance the children's experience.

We intend to grow this compelling mix of product, not just book related, now and into the future. I also want to mention that we are increasing our assortment in the high-end stationary and gift items and expanding other productive non-book categories such as adult games and puzzles, which were a runaway success last holiday.

Rewards. I am excited to tell you we have launched our New Paid Borders Rewards Plus Loyalty Program, which can be purchased for $20 a year, as well as our enhanced free Borders Rewards program for our best customers.

We are the only major book reseller to offer both a paid and free option, and our program is one of the largest in specialty retail. Nearly 40 million people have signed up year-to-date. This is a significant competitive advantage in terms of segmentation and competing effectively in the digital world. We have spent the last several months conducting customer research, which helped shape the reinvention of the Borders Rewards program from a one-size-fits-all model to one that employs segmentation, personalization, and has the ability to drive increased traffic and sales through all channels of the Borders experience.

No longer will Borders Rewards members receive weekly discounts. We now have the ability to provide targeted offers, which help manage our discounting. In addition, it will drive a high level of customer engagement. Our Rewards e-mails will also include personalized content such as title recommendations and local events.

To conclude, as the physical bookstore landscape is rapidly changing, we must work fast to transform the retail experience and redefine our brands so we can differentiate ourselves in the marketplace. You have heard we mention the customer research we have conducted. We will use those findings to make sure our plans for transforming our brand is on what truly matters most to our customers.

Our research clearly is telling us that we have a predominantly female customer, and we are a family and community-based destination. That is a significant difference relative to our competitive landscape. This insight, as well as other findings we have gleaned, will not only support our efforts to redefine our brand, but they also inform our decisions around our in-store experience, product mix, and strategic partnerships moving forward.

That is the summary of where we are headed strategically. I want to close by telling you that we have recently strengthened our executive leadership team with the appointment of Michele Cloutier as our new Chief Merchant. Michele is a retail veteran with 22 years of experience and spent much of it driving female-focused brand improvement and turnarounds, as well as lifestyle categories. I am pleased to have her on our team.

We will now take your questions. Operator, will you take the first question, please?

Question-and-Answer Session

Operator

(Operator Instructions). You have a question from the line of David McFadgen of Cormark Securities.

David McFadgen – Cormark Securities

Yes, a couple of questions. First of all, just on the digital front, can – on the eReaders that you have for sale, can you confirm that they are all powered by Kobo?

Mike Edwards

All of them are powered by Kobo with the exception of the Sony product.

David McFadgen – Cormark Securities

Okay.

Mike Edwards

But the Sony is able to access the Kobo eReader store.

David McFadgen – Cormark Securities

Okay. But would a user have to go and download the Kobo app or it's pretty easy to get to it?

Mike Edwards

On the Sony product, they would have to download the Kobo app. The other readers we are carrying are preloaded with Kobo.

David McFadgen – Cormark Securities

Okay. And when you look at the Borders.com revenue growth, it's obviously quite high. I would imagine that that is being fueled initially by the eReader sales. Is that true or is it also the eBook sales?

Mike Edwards

The eReader sales are a very small portion of our online growth. Our online growth is coming in our traditional categories, such as adult trade and children.

David McFadgen – Cormark Securities

So that's –

Mike Edwards

But the majority of our eReader sales are at retail.

David McFadgen – Cormark Securities

Oh, okay. So the 50-some-odd percent growth, that's just your – kind of what the base business is, right?

Mike Edwards

We are growing our market share online.

David McFadgen – Cormark Securities

Oh, okay. And then just on the Kobo volumes, you said they significantly exceed your expectations. Can you give us any idea of what those volumes are?

Mike Edwards

I can't really quote the numbers around it, but we have had to go back and place additional reorders to support the pre-launch, as well as when we have just recently gone retail with the product.

David McFadgen – Cormark Securities

So, do you have inventory for sale now that people can purchase or are they still waiting?

Mike Edwards

Both the Kobo and Aluratek product is in our stores today.

David McFadgen – Cormark Securities

Okay. And then how many, lastly – sorry, just one last question. How many stores do you have right now that have Area-e in them?

Mike Edwards

They all will have a portion of Area-e, but it's tiered based on the size, capital investment, and product categories. But – there is over 150 stores that will have the full center in it, and then it tiers off from that throughout the chain.

David McFadgen – Cormark Securities

Okay. Okay, thank you.

Mike Edwards

Welcome.

Operator

(Operator Instructions). There are no further questions at this time. Presenters, do you have any closing remarks?

Mike Edwards

I would just like to close by thanking everyone that has supported our company, our associates, our publishers, our bankers. Thank you for working with us, supporting us, and helping us through the transformation.

Operator

This concludes today's conference call. You may now disconnect.

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