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Executives

Edward W. Wilhelm - Chief Financial Officer, Executive Vice President

George L. Jones - President, Chief Executive Officer, Director

Analysts

Matthew Fassler - Goldman Sachs

Danielle Fox - Merrill Lynch

David Schick - Stifel Nicolaus

Fred Speese

Charles Grom - J.P. Morgan

David Weiner - Deutsche Bank

Gary Balter - Credit Suisse

Borders Group, Inc. (BGP) F4Q07 Earnings Call March 20, 2008 11:00 AM ET

Operator

Good morning and welcome to the Borders Group fourth quarter full year 2007 financial results conference call. (Operator Instructions) I would like to turn the call over to Borders' management. Sir, you may begin.

Edward W. Wilhelm

Good morning, everyone. Thanks for joining us today. This is Ed Wilhelm, the Chief Financial Officer of Borders Group and I am here today with our CEO, George Jones. Before we begin today, 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 our news release and the most recently filed 10-K for information relating to forward-looking statements, including factors that could cause actual results and plans to differ. At this time, I’ll turn it over to George.

George L. Jones

Good morning. Borders Group, like nearly all retailers today, is operating in a difficult economic environment that doesn’t show signs of improving as we move forward into the year. With this backdrop, we believe it’s critically important for us to retain the financial flexibility that we need to success to maximize shareholder value and build a stronger company. That is why we are pleased to have a $125 million financing commitment with Pershing Square, our largest shareholder, who has demonstrated their confidence and support of our company by agreeing to provide this funding commitment to address our shorter term needs. It also gives us adequate opportunity to pursue a full range of longer term solutions through the exploration of strategic alternatives, which will include a broad range of possibilities, including the sale of parts of the company, including Paperchase and our international businesses, or the sale of the entire company. We view this as a positive development as we move forward to implement our key strategic initiatives.

We’ve demonstrated the success of our initiatives to drive sales even within this difficult economic environment. For the third consecutive quarter, our same-store sales have increased across all of our business segments, a significant improvement over prior trends. At Borders superstores, we generated a 2.1% comp store sales increase and increased the transactions by 1% in the fourth quarter. At Walden Books, we generated a 1.2% comp store sales increase in the fourth quarter and a 2.2% comp store sales increase for the full year, which compares to a negative 7.5% sales comp for the full year 2006.

International segment same-store sales were up by 9.3% in the fourth quarter and 7.9% for the full year. These sales results helped us on an operating basis to reach fourth quarter consolidated operating earnings per share of $1.44 compared to $1.45 for the same period in 2006.

We came into the fourth quarter thinking that sales would be even better and we would drive the CPS even higher, but we ended the period in line with expectations, as we knew 2007 was primarily a year of investment.

I cannot overemphasize the importance for any retailer, especially during tough times, to keep bringing customers into the store, to motivate them to visit and spend their limited discretionary dollars with us versus the many other places and activities where they could put those dollars.

We are pleased with the rollout of now more than 25 million member Borders Rewards loyalty program has played in driving customers to our stores and we are doing better once they are there at increasing their purchases.

We’ve been competing in a highly promotional environment, however, and discounting has been necessary to drive those customer footsteps. That’s resulted in gross margin pressures. Therefore, our top priority in 2008 is to leverage our successful top line efforts while also increasing profit through cost management and gross margin improvements. This is our main focus as we work to reduce capital spending, manage costs prudently, address fixable issues that have impacted our margin, and launch key profit driving initiatives, such as our upcoming borders.com site, that have thus far required an investment that we really haven’t got a pay-back on yet. We’ll start to get that and we will soon be able to provide a return.

We plan to improve our profitability and cash flow in 2008, although within the current economic environment, we do not feel it remains realistic to improve these measures to the degree we originally had hoped and therefore, achieving the financial goals we originally set for 2009 does not appear to be feasible by that time.

Don’t get me wrong -- we believe we will reach our previously stated goals but within this economic environment, it will realistically take us longer to achieve them than we originally projected.

Clearly to reach our long-term goals, we need to generate cash to sustain our initiatives. Some of it will come as we complete the strategic alternatives process for our successful Australian/New Zealand operations, and additional cash will come from our continued efforts to improve inventory turnover, an effort where we are showing good progress and as a result of our intense focus on this critical aspect of our business, we are on track.

However, we still need to obtain additional financing to make our goals a reality and that is why we are pleased to have the financing commitment with Pershing Square and why our company is pursuing this strategic alternative.

I should also mention here that our board has also determined to suspend the dividend program, as noted in our press release.

Before I turn it over to Ed for a review of Q4 and full year results, I want to take a few minutes to give you a progress report on where we stand with implementation of the strategic plan that launched almost exactly one year ago today. We’ve made solid progress on our plan and putting it into action. Just as a reminder, the overarching direction of the plan was to focus on the core domestic superstore business and improving its results.

We talked in the plan about the need to get better retail basics in our superstores, with more effective use of key items, impulse items, end caps in the queue line to sell more, and to that end we have improved the effectiveness of our merchandise presentation and increased our focus on driving items while also improving consistency of execution across our stores.

Our comp store sales results and increase in traffic and average ticket at borders demonstrate that these efforts are helping us make progress.

One of the biggest initiatives of our plan to improve our domestic superstore results was the development of a concept store prototype, bringing together technology and experiential elements, as well as key destination businesses to dramatically enhance the shopping experience and drive improved sales results. And this is a key part of our long-term plan.

Last month, we launched our first concept store in Ann Arbor and the response has been incredibly positive. The store has really captivated customers from all over and they tell us they love it. This new store made national news headlines and generated real excitement because it truly offers an experience that is not available anywhere else in retailing.

We are opening an additional 13 of these concept stores around the country this year and we will look for ways to integrate the most successful elements of it into our existing store base.

As you know, we also plan to launch the new borders.com site by the end of our current fiscal quarter, which ends May 3rd, and we are on track for this launch. We are excited now to be close to the debut of this site, which has been in the works since the fall of 2006, because it will be the centerpiece of delivering our company’s cross channel strategy. This strategy offers the customers a consistent brand experience with Borders across all channels and integrates the in-store and online experiences to deliver a uniquely satisfying customer experience.

Most importantly, once the site is ready it will begin rolling out to our physical stores over the coming months on the current Borders search computer kiosks that are already in our stores. This move will greatly expand the title base selection in our stores and better serve customers inside and outside of our stores.

As I said earlier, our strategic plan calls for a focus on the core domestic superstore business and therefore, we announced with that plan that we would seek strategic alternatives for the majority of our international operations when we put the plan out a year ago.

Last fall, we completed the sale of our U.K. and Ireland businesses to Risk Capital Partners and we are now continuing with the process of selling our successful Australian/New Zealand businesses, and we are confident that we can ultimately negotiated a commitment that meets our business objectives.

Our plan also called for us to aggressively right-size the Walden Books chain by closing underperforming locations and in 2000, we closed 75 of these stores and we’ll continue to aggressively close underperforming locations.

Importantly, we retained the Walden store locations that met our financial return objectives and worked hard in 2007 to improve results in these stores by changing the mix in presentation and as I said earlier, we drove a dramatic turnaround in comp store sales within that Walden segment.

Overall, we are pleased with achieving what we have on our multiple strategic initiatives in the span of just one year. We look forward to the potential that this plan continues to hold to deliver for our long range results and as I said earlier, in this economic environment the results may be slower to come but we still believe that we are on the right track and our plan is the right one to get us there and now we have the financial flexibility necessary to get us where we need to be.

Now I’ll turn it over to Ed.

Edward W. Wilhelm

Thanks, George. Very early this morning, we announced a full review of strategic alternatives and also a critically important financing transaction for Borders Group. This financing commitment with Pershing Square was successfully completed in one of the most challenging financial markets, certainly that I’ve ever experienced. Under the terms of the commitment, Pershing Square will lend $42.5 million to the company and offered to purchase at the company’s discretion certain of our international businesses pursuant to $125 million back-stop purchase commitment.

This financing was compared to various financing options that we have available. The current credit environment has made many of these alternatives prohibitively expensive or entirely unavailable to us.

The financing with Pershing Square provides us with certainly the certainty that we were looking for and was completed quickly. In addition, we have the right to determine before April 4th if more favorable financing alternatives exist. If they do, we can move forward with the alternative financing and terminate the Pershing Square financing commitment with no break-up fee.

With this financing commitment in place, we will immediately begin the process to explore strategic alternatives. In this regard, we’ve retained J.P. Morgan and Merrill Lynch as financial advisors to assist in the process. A review process will include the investigation of a wide range of alternatives, including the sale of the company and/or certain divisions of the company, including Paperchase and our Australian/New Zealand businesses, all for the purpose of maximizing shareholder value.

We will manage our business in this challenging environment by focusing on maximizing cash flow and profitability. We will reduce our capital spending and focus our CapEx on projects with short pay-backs and high returns. We will also review all of our cost structures with the objective of reducing expenses to improve profitability. We will continue to reduce working capital needs of the business and drive inventory productivity, thus improving cash flow and lowering supply chain costs. Reducing our DVD shrink and café waste will remain a focal point to improved profitability as well.

All in all, there’s a significant opportunity to improve the profitability of our business and to generate more cash from operations even in the face of a weak consumer environment. Lastly, we look forward to working with our advisors to explore any and all alternatives that will enhance shareholder value.

With that, we will now open it up for questions. Laurel, will you take the first question please?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Matthew Fassler. Your line is open and please state your company name.

Matthew Fassler - Goldman Sachs

I guess my first question is looking at your balance sheet, where is the urgency on the fundraising side? What did you see happening over the course of this year that led you to think that liquidity would be a significant barrier? Is it the tone of business today? Is it your working capital needs going forward because you didn’t get there this past year and looking at the fixed charge coverage numbers, et cetera, that are part of your line, it looks like it’s close but not over the line. So what is it that had you as concerned as you apparently were that you needed to make the moves you made today?

George L. Jones

Okay, well listen -- I’ll go back a little history on this, I guess. I came here about a year and eight months ago and the company had a lot of debt at that point in time, so we knew that we really needed to something financially to address that and we started last year with a -- we first put out the announcement of doing a convertible and we had adverse reactions from shareholders on that, so we said okay. We go down the road of a term loan. Went down the road of a term loan and that was in July and the week that we were going to close on that is when the bottom of the market dropped out on the credit market, so our need for financing really didn’t go away, so to speak, but we worked through it.

Our sales were better than we thought they would be and we controlled our inventories well and we made it through within our existing availability on that too. And our sales were trending pretty well and we were feeling pretty good about things all the way through. As a matter of fact, even coming into the fourth quarter, as we looked at the early part of the fourth quarter, our sales were quite robust. We were running well above plan and looking quite good and frankly, when we hit into the fourth quarter, we hit December, as they did I think for a lot of other retailers, it’s like a faucet they sort of cut off. Now, we still ended up with a positive comp for the fourth quarter, as you saw, 2%, but frankly that isn’t as much as we expected. And we were expecting to do better than that and we thought that the things we were doing were getting results and we’re still pleased with a lot of things that are happening.

But what it did is we started looking at where we were planned in the first quarter, as we got finishing up after Christmas and getting finishing up in the fourth quarter, we said are we really realistic planning this at the levels, even though our trend had supported that from where we’d been previously. And are we really realistic planning an increase here in our business going forward with the type of economic environment we’re in? Because if we are wrong on that, you know, that’s -- there could be consequences on it.

So basically we took our plan down to a much more conservative level and really were looking at that.

Now, everything was still pretty well on track because we were also way, way on track in terms of he sale of Australian and New Zealand and we got right down to the altar on that, literally, and the deal didn’t happen. And so fortunately, we had back-up offers and people that were there that were interested, so we were able to restart negotiations on that and move forward, and we started looking at other financial options that we have, still having the issue that we have too much debt and having debt like we have is even a bigger problem in the type of environment that we are in right now. I think most people would agree with that. This is not a time when you want to have a lot of debt and have this tightness.

And now as we lowered our projections down, we realized really that we needed to address this. We were taking steps already, measures to be able to free up cash, our inventory, our reduction program is well on track. And by the way, we think that’s a case where less will be more. We think that as we take the inventory out of the stores and free up space for more face-outs, that’s something we wanted to do anyway and that’s going to help us and it frees up cash.

But you know, the key thing I think we have to be in an environment we are in right now, is we have to be really, really prudent. We don’t want to put ourselves in a situation where we’d have any kind of financial jeopardy. The reason we were doing this is because we were trying to be very, very prudent. And as we look at all the options that were there and we started approaching this time, we realized that with Australian/New Zealand, even though we made progress on it, that deal wasn’t going to close before we had to announce year-end results and also, frankly, even though we were looking at other options that we might have in terms of financing, those weren’t going to happen anyway. Nothing was going to happen that quickly in terms of before we had to announce the year-end results.

And so then we’d have to face the possibility of facing out there with uncertainty, as far as even though we’ve got options and things we’re doing, we’d have to put uncertainty out there in terms of -- well, we think this will be fine but we are doing these things but we need to get this done, we need to get this done, et cetera. And frankly the environment we’re in right now, we didn’t think that our vendors, that that would work. And I feel based on my experience, I feel absolutely confident that we could have been in a situation where we could have had problems with the vendors if we put that level of uncertainty out there.

And then, as you know, we deal with a lot of vendor credit. If the vendor credit starts moving, the you would be in a situation you could have a serious problem. We could not -- it was absolutely not prudent on our responsibility as management or directors to let that happen, so we had to look at what the alternatives were. And as we looked at that, fortunately Pershing Square came and gave us a good alternative, a really good alternative here that would allow us to be able to take care of our financial flexibility, give us the financial flexibility we needed so that our vendors and creditors could be absolutely certain, absolutely certain that we are going to be in good shape in the immediate future and it gives us time for a longer term basis to be able to put, take measures, looking at strategic alternatives, the other things we need to do that will allow us to have the financial position we need to be able to pursue our initiatives and move forward.

Matthew Fassler - Goldman Sachs

So just to put that in sort of some concrete financial terms, it sounds like you are concerned that with the earnings expectations coming down, you would have reached the limits of your credit line when you had peak working capital needs?

Edward W. Wilhelm

Matt, I would say certainly the outlook that -- the current consumer environment that we are in is very difficult. That’s not surprising anyone. The outlook through the rest of this year, anyway, is for that to continue. Capital markets are in disarray. There’s minimal opportunities or options available to us, so what this financing provided us was the certainty and put us in a much stronger position to move forward in 2008 to not only execute the plan but to focus on maximizing cash flow and profitability, but also to move forward in a stronger position with a strategic alternative process.

Matthew Fassler - Goldman Sachs

One very quick follow-up; I’ve heard you talk a lot about sales and the success that you had with sales earlier in the year. Looking at your sales per Borders store over the past three or four years, they are down very nominally but the operating margin is down quite substantially. So can you give us a little more color on the cost cutting and profit driving initiatives that you’ve got? Because it sounds like sales probably hasn’t really been the problem and might not be the answer, at least in the short run.

George L. Jones

Well, I think the real issues that we have, if you look at the sales, obviously sales -- we’ve been more effective in terms of driving sales than we have on the margin side, and on the cost side, we actually increased costs last year. And part of that, as we said, we made some strategic investment. You know, we’re going to get some benefit, we think a good benefit, out of borders.com, but we had to start from zero and put in infrastructure and investment to be able to do that and you know, you don’t just get to first quarter this year and flip a switch and everything is going. So we carried that last year and we had investments in that, and we had investments in other things.

We’ve invested in systems that -- and a lot of investment in that that we won’t reap the benefit of it and the concept store, and things that we don’t reap the benefit of it until this year. And with all those things, we are feeling really good about that, so -- but now, basically, we’ve got a point right now that we’ve got a lot of these development things really behind us. We’ve still got some more systems work to do but not to the level of what we had. We’re finishing up on that. We’ve got the e-commerce thing behind us, et cetera and we are taking steps already.

Like, we’ve cut our capital down substantially now. If you look at our capital, it had been around the $200 million level the year before last. We already had a lot of commitments for last year and stores already on dock and everything too, but we still cut it. Last year our spend was about $140-something million, which was less than what we stated and budgeted, 170. And now this year, we’ve got it down even more substantially, quite substantially. We’ve cut capital down now which basically is still following up on the stores that were already committed, where we had those under construction. But really frankly now, we’ve been able to take the capital down further and also, we’re looking at expenses and saying right now, we’ve invested already. Now’s the time to start trying to reap rewards from some of these investments, so we are taking cost out of the business.

Matthew Fassler - Goldman Sachs

Thank you.

Operator

Our next question comes from Danielle Fox. Your line is open and please state your company name.

Danielle Fox - Merrill Lynch

First, you talked about moving out your 2009 EBIT margin target, but you said that you expected to make continued progress. Does that mean that you actually expect earnings for the full year to be up this year? I’m trying to get a sense of what the financial situation will be like.

Edward W. Wilhelm

Of course, we’re not giving specific guidance but we are driving -- there are ways that we can improve the profitability of the business, even in the face of a weaker consumer environment. So as I mentioned, we’re going to work with our financial advisors. We’re going to identify opportunities to reduce our costs, both -- all around, in headquarters, in the supply chain area, and in the stores. And as we do that, there’s also opportunities to improve cash flow through better working capital management by reducing our capital expenditures.

So I think there are many opportunities available to us to improve the profitability of the business, Danielle, even with the consumer environment we are facing.

George L. Jones

Yeah, we still feel even in this environment, we feel like we can still have the opportunity to increase our profitability. The problem is basically getting it to where we needed to be. In 2009, if you look at just the stair stepping and because we did take the stair step we had planned in it for this year didn’t appear realistic after we hit this economic environment.

So we think we’re still going to get there. We’re just not going to be able to do it as quickly.

Edward W. Wilhelm

If you look at our business segments, Walden continues to show improvement as we pare back the underperforming stores there, and then our international business continues to perform very well there and who profit improvement through the growth initiatives in both Paperchase and in Australian/New Zealand. And of course, they are benefiting from the weak dollar and getting a currency benefit there as well, but they continue to perform well for us, our international businesses.

Danielle Fox - Merrill Lynch

Okay, and is it important to continue to comp positively if it comes at the expense of gross margin, or at a certain point do you say you know, it’s more important to protect the access to liquidity and the cash flows than it is to make incremental progress on the top line part of the turnaround?

George L. Jones

By the way, that’s one of the reasons frankly that we took a more conservative sales approach, instead of just swinging for the fence or whatever too, that we did want to make sure that we were conservative as we looked at how we are managing our cash and everything else on it too.

Frankly though, I do think that it’s important to still make progress and not have your sales drop dramatically. We’ve taken it down now to much more conservative situation as far as our sales forecast for this year because of the environment but we still need to retain customers, we still need people coming in our stores, we still want to be able to try to keep the transactions up, et cetera. And frankly, we still want to be able to keep our market share in a situation like this.

But we are not doing it -- we are absolutely paying attention to margin and when you talk about -- you know, Matt asked earlier about the issues as far as costs and margins and I talked about the measures we are doing as far as in our cost initiatives and this stuff, cost-cutting initiatives and this type of thing we are doing. You know, we are also absolutely working on our margins as well, too.

We have some favorable things that are happening in our mix because of some of the areas that are growing in terms of our -- like our bargain business and our café and Paperchase. They are really getting this outsized growth. We are getting big drops out of music. Well, music’s the lowest margin component of our business and the others are right at the highest. They are very high margin businesses, so that’s going to help us.

The big thing we’re finding is we are still playing with the promotional situation and we are still finding that frankly, it’s very promotional out there and we are finding that when you try to let off the promotional pedal very much, you know, you do get a hit on the sales. However, I can tell you even in recent weeks, we are finding that we are making some progress on that.

So we are going to keep working on that too. We clearly feel like we have an opportunity to improve our margin this year, even in spite of whatever the situation is. We clearly feel like we should improve our margin this year and we are on track to really do that and I think that’s part of our solution as well.

Danielle Fox - Merrill Lynch

Okay, and then just one last question; how much EBITDA is associated with the Paperchase, Australia, New Zealand, and Singapore businesses that are covered under this $125 million back-stop offer?

Edward W. Wilhelm

The Paperchase and Australia/New Zealand is substantially all of our international operations.

Danielle Fox - Merrill Lynch

So it’s about $30 million in EBITDA?

Edward W. Wilhelm

Yes.

Danielle Fox - Merrill Lynch

Okay. Thank you.

Operator

(Operator Instructions) Our next question comes from David Schick. Your line is open and please state your company name.

David Schick - Stifel Nicolaus

I don’t know if I somehow missed it, but I know George, you spoke about how much different late in the quarter and into this year the consumer is acting. Could you give some detail on how much deceleration occurred and how -- just some math behind the front of the quarter versus the back of the quarter?

George L. Jones

I’ll tell you this -- that we were running, in the early part of the quarter -- I think I can say that. In the early part of our quarter, our sales were running in the higher single digit range comps and basically as the quarter went on, it leveled out more. It wasn’t like we had these huge negatives or anything but it’s leveled out more, it got more in the flattish range. And as a result, this is where we came out, the 2% increase. So it isn’t like that there were big plunging negatives here but it’s basically we just decided that where we’d been planning, looking into the year moderate positive comps, we decided that was a bit too aggressive based on the situation. And we’re not looking to have big drops in sales, don’t get me wrong. But frankly, we also don’t think it’s prudent that we are going to have big increases in sales in the environment, and in spite of the fact that we think we are doing a lot of really good things.

David Schick - Stifel Nicolaus

Right. So all things -- so if you are running up or singles, it sounds like, and you closed out with a 2, is it fair to say -- we can do the math on the back-end of the quarter and that’s the kind of assumption you’re making then on a comp basis for the year?

George L. Jones

Basically what you saw was that we were running at a higher level and as the business slowed down, like it did for a lot of other retailers, like a faucet, it happened in December. It was cut off in December. We said we need to reevaluate it. It’s a different situation right now and it just wouldn’t be prudent for us as we are trying to manage a company with not unlimited money here, it wouldn’t be prudent of us to keep on those same assumptions.

David Schick - Stifel Nicolaus

Right, but to get to a 2, it’s got to be a negative comp for January and then the assumption is it’s continued. Is that fair?

George L. Jones

Not necessarily. [You’re pretty heavily weighted] in the first part of the quarter, but anyway, without breaking it down too much on that too, I still want to say it really more flattened out. It wasn’t like we were in some kind of a big negative drop.

David Schick - Stifel Nicolaus

Okay. Thanks.

Operator

Our next question comes from Fred [Speese]. Your line is open and please state your company name.

Fred Speese

This is a big surprise, the financial urgency and this is a heck of a deal, 12% plus coupon and an option on the shares. I am still confused of how this urgency came about and maybe you can help us with the CapEx going forward and D&A to see why the [squeezed] accept such a costly financing deal?

George L. Jones

Well, as I said earlier when Matt was there, as far as the urgency that came about came from the standpoint of the business which was trending at a higher rate in terms of comp sales going in early in the fourth quarter, as it did for just about everybody out there, really leveled out. And as a result, it changed our financial projections going forward as far as sales. And that combined with the fact that we’d also were way down the road on the Australia/New Zealand transaction to the point of right at closing and it changed it. And even though we still have options in terms of doing that, that wasn’t something that could happen very quickly.

And so we started looking at various financial options but then we also had the obligation, even legally as far as putting this call out there, that we’d have to put out concerns because we didn’t have those transactions done. And when you look at those concerns, we didn’t feel like frankly that that was something that’s for the good of the company to be able to do that.

We needed stability and we needed to be able to have our vendors and creditors to have confidence that we weren’t going to have financial problems, and that’s the reason we did it. So now we are in a position that we are funded and we don’t have to face those financial issues.

Fred Speese

Is Pershing technically considered an insider?

Edward W. Wilhelm

Pershing -- a representative of Pershing Square, Mick McGuires, is on our board, Fred. And I would say that we are looking hard at capital spending. We are looking hard at expenses, as I mentioned earlier. And with respect to the arrangement with the purchase commitment from Pershing Square, the financing commitment, there is a two-week period of time here that we are going to take to shop around and see if there’s a better financing alternative out there. And if there is, then we have full rights to go with that other financing alternative.

But most importantly, Fred, it just puts us in a position where we’ve certainty and we’ve got the financial flexibility that we need to move into 2008, to run the business, continue to execute the plan, and to go through a full-scale strategic alternative process.

George L. Jones

One more thing I’m going to say about as far as if you talk about this versus other financing options at this time, after we determined that we had this need, I will say this -- this wasn’t really Ed and I sitting in a room and we get some solution from Pershing and that’s all we considered, et cetera.

We looked at the options that were out there. We had expert financial advice. We had -- you know, J.P. Morgan was involved, we’ve had Merrill Lynch involved, our board of directors involved, and all of us considered and frankly, we all felt that this was absolutely clearly the best option we had.

Fred Speese

Thank you.

Operator

Our next question comes from Charles Grom. Your line is open and please state your company name.

Charles Grom - J.P. Morgan

Just wondering -- you alluded to when you pulled back on promotions that your sales get a little bit of a hit. I’m just wondering when you look out over the next four quarters, could you just give us a little bit of sense for how your promotional cadence will be relative to a year ago? And what sort of metrics can you use to kind of measure the benefit from that promotional activity?

George L. Jones

Well, let me say this -- it’s still a really promotional environment. We still feel real confident that we can be -- we don’t have to be more promotional than we were a year ago in terms of the overall promotional spend to be able to get where we need to go. And the reason for that is we do have methods now that we didn’t -- increasingly we have methods that we can be more efficient with our promotional spend.

For example, in our Borders Rewards program, which is now at 25 million members and as that continues to grow, and one of the reasons we did this is because we keep getting data, et cetera and we now have the ability we can segment it into different customer types in terms of how they spend and even more than that, even their specific interests. So it’s going to allow us to be more category specific on promotional offers, which we think that will be more effective for us going forward. And we have other methods.

We’re getting more capabilities and sophistication in terms of how we can do this so I do not expect that the promotional environment is going to all of a sudden just miraculously change. What I do think is I think we can make some improvement on it because of the steps we’ve been taking and what we are going to be capable of doing. And as we’ve already been experimenting with these things, we’re learning some things and we think we’re going to be better at it.

Edward W. Wilhelm

The thing I would add to that is we faced in 2007 pretty significant growth in the membership base year over year, so we don’t anticipate -- we’re over 25 million members today. We don’t anticipate a lot of growth, certainly to the levels that we saw in 2007. So that’s going to help in terms of gross margin comparisons.

And then, as we mentioned, we continue to see improved mix of our sales, so as Paperchase, Seattle’s Best, and our bargain book categories, which are all the highest gross margin categories in the store, continue to perform double-digit comp, that will help our mix. And music continues to decline and that’s our lowest gross margin category. And then the last component that’s going to help us in ’08 on the margin side is getting the shrink levels down for DVD and café waste. And we started to see improvement in that. We just need to continue to focus on that, work hard on that and reduce those shrink levels.

George L. Jones

To understand -- I mean, the magnitude of this DVD shrink, this is not an insignificant issue. We’re talking $20 million last year that this really cost us in excess shrink, and [inaudible] -- that came up from a decision that had been made back some time ago in terms of changing the way we secured DVDs, and also changed the Seattle’s Best on the waste issue and things in there. We talked about that some too.

But those are fixable things and we are taking measures already that we think that will improve it.

Charles Grom - J.P. Morgan

Okay, and then just a follow-up for -- just to look at the fourth quarter, can you just give us the breakdown of the 90 basis point decline in GPM between the increase in promos and shrink? Question one. Question two would be of the 40 bps drop in SG&A, you talked about improving cost measures. Can you elaborate? And then three, the $13 million after-tax non-operating charge. That was a big step up from the past couple of quarters. Can you just elaborate on why such a big increase? Thanks.

Edward W. Wilhelm

Let me take those in reverse order. Non-operating charges in the fourth quarter of this year, two primary components. We had a handful of Borders stores that we closed in the fourth quarter and to relocate in some areas, in a couple of instances and then just outright close to improve profitability. And there were some charges associated with that.

We also had some write-downs that we took in regard to our music space reduction in our stores, where we reduced music inventory and the investment in music space in our stores and have reallocated that to higher margin categories that have higher growth potential, so that reallocation of space also resulted in some costs that were out of the normal course of operations that were included in that non-operating bucket.

The reduction in SG&A really across the board, there were some savings mostly in the stores, particularly as we started to see the sales slow down, as George talked about, towards the end of the quarter. There were some -- we pulled back on expenses and prudently managed those expenses and also here in the headquarters as well, so those were the big drivers of the SG&A reduction.

And then the 90 basis point reduction in gross margin, the biggest -- there’s a couple of components of it. The shrink component and the promotional component is about half of the reduction combined, and then the remaining half relates to a non-cash inventory charge that we took, which is an accounting convention that we do at the end of every year. We capitalize costs, put it into inventory and when inventories decline, like they have for us, there is a charge that needs to be taken for that capitalized cost piece. So those are the -- and again, I’ll stress that that was a non-cash charge.

So those were the components of the gross margin reduction from LY.

Charles Grom - J.P. Morgan

Great. Thanks for the color.

Operator

Our final question comes from Matthew Fassler. Your line is open and please state your company name.

Matthew Fassler - Goldman Sachs

Two quick follow-ups; first of all, can you give us some detail on working capital, just as we try to get the apples-to-apples inventory position, particularly for the Borders superstores?

Edward W. Wilhelm

So specifically, Matt, the average working capital in an average working -- in an average Borders store, is that what you are after?

Matthew Fassler - Goldman Sachs

Well, I guess just if we were to look at the inventory change year to year, if we could figure out how much of that related to the core Borders business.

Edward W. Wilhelm

So the reduction in inventories was mostly the Borders superstores but there were also some reductions in Walden as well, both a combination of store reductions because we closed a number of stores in January plus just reductions in the average holding that a Walden store would have, but the majority of the reduction just came in the average inventory in a superstore.

So as George mentioned, it’s a priority for us and has been to improve the inventory turns, to bring down our average inventory levels, and that working capital management will help improve cash flows going forward and will also help operating efficiencies.

George L. Jones

We’ve been talking about, ever since I arrived here, about the need to improve our inventory turns. It was a part of our strategic plan, very specifically and we feel like we are finally starting to make some progress on that front.

Matthew Fassler - Goldman Sachs

And just to clarify -- your year-ago balance sheet excludes the businesses that you sold?

Edward W. Wilhelm

It excludes the U.K.

Matthew Fassler - Goldman Sachs

Okay. And my follow-up relates to the strategic alternatives question; in a sense, you’ve given yourselves it seems like significant financial flexibility, at least for the next year or so, through your deal with Pershing. You have the loan, you have the back-stop on the sale of the international businesses, which would give you some more permanent capital. Yet you are still -- so that would in a sense equip you to pursue your strategic plan, yet you are still pursuing strategic alternatives, or at least considering them.

So what is your preferred course here? Would you like to stay independent, funded as you are today and execute that plan? Or is it a question of that’s plan B relative to strategic alternatives that you are pursuing?

Edward W. Wilhelm

I would say the course is whatever is going to maximize value for shareholders. So we are -- we believe that the plan we are operating is the right plan to maximize shareholder value in the long-term, but starting immediately we are working with our advisors to explore any other alternative, selling parts of the business or selling the company as a whole that may be more beneficial to shareholders. So we’ll evaluate both, which is why we hired the advisors that we did and we’ll work closely with them to help us and the board make that determination.

George L. Jones

One of the key things to note again is the commitment we have from Pershing, and particularly this is where that back-stop comes in, really gives us the time and the flexibility. It takes care of our near-term needs, where we are really well funded near-term and it allows us to have the time and flexibility just to literally what we said there is true, to explore the options.

Matthew Fassler - Goldman Sachs

And is the reason you went to Pershing as an intermediate step that from the time you realized that you had liquidity issues, it just would have been too brief a time to get the -- to get a full exploration process done?

Edward W. Wilhelm

Yeah and I would say -- you know the status of the financial markets. I mean, they are extremely challenging. Alternatives were limited and those that were available to us were just extremely expensive, so we moved quickly with Pershing. It certainly allowed us speed of execution, provided us the certainty that we were looking for and again, we do have the ability to shop this over the next couple of weeks and if there is a better deal out there, we will certainly do it but most importantly, as you said, provides us the runway to allow us to operate the plan and to at the same time work with our advisors to identify any and all opportunities to maximize shareholder value.

George L. Jones

I wanted to again stress too the main thing that this Pershing deal did for us, much better than any other alternative, is the only alternative out there that really provided a degree of certainty that we really thought was necessary.

Matthew Fassler - Goldman Sachs

Okay. Thanks so much.

Operator

And we do have one more final question David Weiner. One moment, please. Your line is open and please state your company name.

David Weiner - Deutsche Bank

A lot of my questions -- pretty much all of my questions have been asked but I’ll ask one other here. Could you give -- George, you talked a little bit about this but could you give a little bit more color on why your talks on the sale of the New Zealand and Australia businesses kind of were left at the altar, if you will, to use your words?

Edward W. Wilhelm

I can comment on that. Again, I’ll point to the credit markets. You know, LBO transactions, they are non-existent these days and just money is not available in many cases to finance transactions. So that certainly has had an impact but there was a lot of interest in that business and the good news is there are others. If one preferred buyer, preferred deal doesn’t work out, as it didn’t, then there are alternatives and we are in active pursuit with alternative buyers there.

David Weiner - Deutsche Bank

Okay. Thanks a lot.

Operator

One moment. We do have a question from Gary Balter. Your line is open and please state your company name.

Gary Balter - Credit Suisse

I just wanted to follow-up on Matt’s question, just get a little bit of an understanding on -- it seemed like this was somewhat of a hurried event. Was there a sense from certain vendors that had you not gotten more capital, that they were going to stop shipping?

Edward W. Wilhelm

No, but what we did was we looked at the business environment that we are in. We looked prudently at the projections for the rest of the year and against the availability, capacity availability that we had and just felt it was prudent and necessary in our situation to get a commitment for some committed financing to again allow us to continue to execute the plan, as well as explore strategic alternatives. So it was really the combination of the outlook that we had for the business, as well as limited options available.

George L. Jones

Understand too, as a company we’ve been carrying a lot of debt. You know, we’re not like unnoticed out here by vendors. They watch us very, very closely and we just had great concerns that unless we had that degree of certainty there, that it would have caused us some serious problems.

Gary Balter - Credit Suisse

No, it seems prudent. Could you also talk -- you may have covered this but your competitor on their conference call talked about the competitive environment still staying very aggressive, and the pricing environment. Could you comment on that?

George L. Jones

Yeah. It’s really as I said before; frankly, we went through this holiday season -- and again, I’m new to the book business. I mean, I’ve been here now a year-and-a-half or so, but for people that had been here a long time and really watched it very closely, they said they’ve never seen it be as competitive as it was this year. And I don’t think it’s just the book business. I think it’s out there just in general. You know, people were really just -- people start -- if it’s a tough time and people start struggling for sales, they get aggressive and that was the environment that was really out there. And I do not see that easing off this year. If it does, that will be great but I just don’t see it easing off. We’re not trying to be out there, you know, driving it too. We’re looking for ways, frankly, that we can be more efficient with our promotional dollars, but that’s what I’d say.

One thing to understand we’re doing -- we’re running tests, we’re doing all kinds of things. And now we have the ability to be able to do this, where we can take different markets, take different things, run different offers, et cetera, to try to -- and it helps us really gauge the price sensitivity of different things. And what we are seeing is not just gee, we think this will be the case but we’ve got pretty substantive evidence here that doesn’t allow us to really pull a whole lot less competitive than we were.

The thing that it will allow us to do as we learn these things too is to be able to use our offers more effectively, and by doing that we think we are going to get some margin benefit, besides the fact of the shrink issues, which we think will be improved, as well as some of the other things we talked about.

Gary Balter - Credit Suisse

Okay, that’s helpful. Thank you very much and good luck in the next year.

Operator

That does conclude today’s Q&A session.

George L. Jones

Okay. Thank you, everyone, for being with us today. Our next planned conference call will be May 28th when we’ll discuss our first quarter results. Thank you very much.

Operator

That does conclude today’s conference call. Thank you all for participating.

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Source: Borders F4Q07 (Qtr End 2/2/08) Earnings Call Transcript
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