Excerpted with permission from the monthly letter to investors in Mr. Tilson's T2 Partners Fund:
Borders Group has been a terrible investment so far, as the stock has suffered from a weak macro environment, negative investor sentiment and numerous management missteps. Things got so bad recently that the company faced a liquidity crunch and was forced to do a dilutive emergency financing with its largest shareholder, Pershing Square Capital Management.
The pain of seeing an investment go so sour so quickly is only somewhat tempered by the fact that we’ve been through it before: over the years, we’ve owned a number stocks that have declined significantly from our initial purchase price. We of course try to learn from our mistakes and minimize their number, but investing is a probabilistic business, so the occasional misstep comes with the territory.
Dealing with a decline of some sort is almost inevitable in nearly every stock we buy, as we rarely precisely bottom-tick a stock and it immediately goes up after we purchase it. Thus, the key to long-term investment success is less being extremely clever in bottom-ticking stocks and more how one deals with the situation once a stock has declined from its initial purchase price. Making the right decision at that time to either sell, hold or buy more is often more important than the initial buy decision.
In the case of Borders, we have been closely following the unfolding situation and, after careful consideration, more than doubled our position recently when the stock tumbled below $5/share (it closed Friday at $6.17). This might strike some as pouring good money after bad, but while we don’t think Borders is a great business, we’re confident that it’s much more valuable than the market is giving it credit for.Borders operates in three major segments. First, it operates over 500 book superstores in the United States that generated approximately $2.8 billion in revenues last year. Second, it operates over 500 mall-based stores, most of which are branded under the Waldenbooks name. Finally, the company has international operations, including 20 superstores in Australia, four in New Zealand, assorted small operations in several other regions and Paperchase, a UK-based designer and retailer of stationery, cards and gifts.
What are the different business lines worth? The largest pocket of value is in the superstores, which until recently were generating approximately $250 million of EBITDA (earnings before interest, taxes, depreciation and amortization). Subtracting $30 million for unallocated overhead to the superstores and using a 6x EBITDA multiple – which any number of financial buyers would likely pay – this business is worth around $1.3 billion.
The mall-based bookstores are struggling, as mall traffic continues to decline and the company appears unable to generate an attractive return on capital with this concept. Fortunately, the inventory can either be redeployed into Borders’ superstores or can be returned to publishers for full credit. At a minimum, this segment should be worth its estimated $80 million in working capital.
Finally, Borders is in the process of selling off its international operations, for which it could receive more than $200 million, but at the very least it has the right to sell them to Pershing Square at any time prior to January 15, 2009 for $125 million.
Add up the value of the businesses, subtract $550 million in debt and add $100 million that Pershing Square will pay to exercise its 14.7 million warrants with a strike price of $7, and the resulting value to Borders’ stockholders would be about $1.05 billion, equal to $14 per share, based on 75 million fully diluted shares.
Keep in mind that this is what a financial buyer would likely pay. We think Borders is worth even more to a strategic buyer such as Barnes & Noble (a stock we also own), which could tap significant cost savings and make great strides toward increasing Borders’ productivity to Barnes & Noble’s levels.
Borders has now hired a banker and put itself up for sale. We believe the most likely outcome of this process is that the company is sold this year for at least double its current share price, so we were delighted when the recent turmoil gave us the opportunity to buy it below $5.