Borders F2Q08 (Qtr End 8/2/08) Earnings Call Transcript

Aug.27.08 | About: Borders Group, (BGPIQ)

Borders Group, Inc. (BGP) F2Q08 Earnings Call August 27, 2008 8:00 AM ET

Executives

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

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

Analysts

Matthew Fassler - Goldman Sachs

Aaron Stein - J.P. Morgan

David Schick - Stifel Nicolaus

David Weiner - Deutsche Bank

Operator

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

Edward W. Wilhelm

Good morning, everyone. This is Ed Wilhelm, the CFO of Borders Group. I am here with our CEO, George Jones. Thank you for joining us today. Before we begin, I should 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.

With that, I’ll turn it over to George to discuss the second quarter.

George L. Jones

Good morning, everyone. I am pleased with the progress we made in the second quarter in improving the bottom line and strengthening our company’s balance sheet. Building on our first quarter efforts, we were able in the second quarter to demonstrate that we continue to have the focus and the discipline in place to drive substantial improvements, even in the midst of a very challenging consumer environment.

Our progress is impressive when you consider the environment and take a close look at what we’ve been able to accomplish. We improved profitability substantially compared to last year and beat analyst expectations by $0.10 per share. We ended the second quarter with a loss from continuing operations of $11.3 million, or $0.19 per share, versus last year’s loss of over $18 million, or $0.31 per share. On an EPS basis, that’s a 38.7% improvement.

Obviously we are not satisfied with posting a loss but we clearly have this going in the right direction and are making significant progress towards our profit goals. At the beginning of this year, we stated that reducing debt is a primary focus for us. By the end of the second quarter, we decreased debt by over $272 million compared to the same period last year. That is a 37% reduction in debt from where we were at this time a year ago, which represents a significant improvement.

We drove this improvement through tighter management of inventory, lower capital expenditures and proceeds from the sale of our Australia/New Zealand/Singapore businesses.

In the first half of this year, cash flow from continuing operations improved by $195.7 million compared to a year ago, and that’s attributable in large part to the work we have done to reduce inventory, which decreased in the second quarter by over $181 million and that’s 14% less inventory than last year.

SG&A dollar expenses from continuing operations were $16.7 million lower than last year, as a result of disciplined expense reductions. We continue to stay highly focused on reducing expenses and are on track with our stated plan to reduce annual expenses by $120 million. With this effort, we are creating a new base operating model for our company and this is one that positions us well for a long-term future.

As we have said, and virtually everyone agrees, the current retail environment is very difficult yet when sales rebound, and eventually they will, we will continue to hold down our operating expenses and the result will be a dramatic improvement in our profitability.

Gross margin also saw signs of improvement. This was masked somewhat by the deleveraging of occupancy costs, which offset the progress we made in lowering promotional discounts and driving more favorable sales mix. Excluding occupancy, gross margin increased by 90 basis points compared to a year ago.

I am pleased with how far we have come on these important measures in a relatively brief period of time, all the while operating in the midst of one of the most challenging times I’ve experienced in my retail career. We will continue to manage our business prudently and build upon the progress we are making going forward.

Obviously it remains our challenge to better balance the top line with the progress we are making on the bottom line. Our industry remains highly competitive and that is why our focus continues to be on leveraging our now more than 28 million Borders rewards loyalty program members. This program continues to attract new members at a rapid pace. We are still averaging over 131,000 new members a week. These are our best customers and we will continue to expand our efforts to more highly segment and target the market for these customers, increasing the effectiveness of our promotions.

As far as comp store sales, our performance at both Borders and Walden Books was impacted by comparisons to last year’s Harry Potter release and at Borders, the music category also negatively impacted same-store sales results significantly. Sales continue to be challenging but frankly with all that we have done during the first half of the year to significantly reduce inventories and reduce our cost structure, it would really be naïve of us to think that we were so surgically precise with these cuts that we could avoid a negative impact on sales, at least to some extent. Still, we absolutely believe that our actions were necessary and good for our business in the long-term.

Having more space in our stores due to inventory reduction allows us to focus on driving profitable sales by better using that space to expand growing categories, such as children’s and bargain, as well as to face out more books and make some merchandising improvements.

We are seeing these strategies work in our new concept stores and our concept stores, we’re really pleased. They are performing very well on the whole and we will be applying them in all of our stores.

I am also pleased to say that Borders.com is up and running and I am proud of the site we’ve created with its innovative features. We have planned a soft launch period for the site to get any kinks or bugs out before we began actually marketing the site and frankly, this process took us longer than we originally planned, so it was actually mid-July when we finally kicked off the site’s grand opening marketing campaign. Obviously having our own site will not only contribute to revenues and ultimately to profit but it also allows us expanded opportunities to strengthen our brand and better serve our customers.

As we said in our release, our international segment has changed substantially with the sale of our Australia, New Zealand and Singapore operations and the earlier sale of our U.K. and Ireland business. As far as the previously announced strategic alternatives process for the company and Paperchase, the process continues as we evaluate our alternatives.

I think you can see that this process has not stopped us from aggressively pursuing what needs to happen within our organization. We continue to do the right things for our business and as I’ve said earlier, we are making significant progress that we will build upon to position Borders Group well for the long-term future.

With that, I will turn it over to Ed.

Edward W. Wilhelm

Thanks, George. I want to provide a little more color, primarily on the key initiatives that are driving cash flow and debt reduction, as well as profitability improvement for our company. We have a clear focus on maximizing our cash flow and improving the profitability of our business. I am pleased to report that we made excellent progress on both fronts.

The key drivers of maximizing cash flow include reducing our working capital needs and improving our inventory productivity, reducing our capital spending, and monetizing international assets through the strategic alternatives process. Our results for the second quarter and first half of 2008 show tangible signs of the progress we’ve made on inventory productivity and reducing capital spending.

Also, as previously reported, the sale of our Australia, New Zealand, and Singapore businesses was completed in the second quarter and was a critical component of our debt reduction efforts.

As it relates to inventory reduction, a big driver was the reduction in music inventory, which declined over 30% from last year. We have also reduced floor space dedicated to music in all of our stores by about a third, on average. Music now occupies approximately 7% of our total store floor space. The space previously occupied by music was reallocated to growth categories, such as children’s and bargain books. In addition, we reduced weeks of supply in book inventory and DVD inventory as well.

We have restructured our merchandising group and created a merchandising planning and allocation organization with dedicated resources and the focus to drive inventory productivity.

In addition, we continue to make enhancements to our merchandising systems and as a result, improved functionality is being delivered to the merchandising organization to assist with inventory management.

We also expect to be rolling out borders.com to our stores later this year, and this will not only help drive special order sales but it will also drive inventory productivity improvement. 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 our Paperchase operations. 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.

In the current year plan of $80 million, we will invest capital to open 14 new domestic border stores, including two relocations. This opening program is substantially completed for the year, with all but one of these stores currently open. All 14 are new concept stores and the capital for these openings represent almost 40% of the total planned CapEx spend for the year.

We continue to be very pleased with the performance of our new concept stores and we will be applying what we learn from these to the rest of the chain as appropriate.

Next I want to update you on the status of improving the profitability of our business. We have previously indicated that there was an opportunity to improve our profitability even if the overall sales environment remained challenging, which of course it has. Key drivers of profit improvement include operating expense reductions, gross margin improvement, including lower DVD 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 have critically reviewed the cost structure of our entire business and have taken significant steps to reduce expenses on an annual basis by $120 million, including eliminating approximately 20% of the company’s corporate positions as previously announced in early June.

Approximately half of the $120 million in savings is related to corporate office expense reductions and the other half is reductions in store and distribution expenses. Most of the actions necessary to realize these savings have been taken. We are on track to realize approximately half of the expense savings, or about $60 million in 2008 and expect to be operating at a level to realize $120 million in annualized expense savings at the beginning of fiscal 2009.

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 dollar expenses realized in the second quarter.

Next, related to gross margin improvement, we made progress in the second quarter with our focus on driving profitable sales. Absent the negative impact of deleveraging occupancy costs, our gross margins improved by 90 basis points compared to last year. The major items contributing to this improvement include a favorable sales mix, lower promotional discounts, and lower shrink. Sales mix was favorable as the higher margin categories, such as bargain books and gifts and stationary, continue to show comp sales growth that outpaces the total store while music, a low margin category, continues to show a significant decline in comp sales. In addition, promotional discounts were below last year, due in part to the Harry Potter comparisons.

Finally, 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 and we expect this favorable impact to increase for the remainder of the year as subsequent cycle inventories are taken and recorded.

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

That concludes our prepared remarks. We will now open it up for questions. Candy, will you take the first question, please?

Question-and-Answer Session

Operator

(Operator Instructions) We have our first question from Matt Fassler, Goldman Sachs.

Matthew Fassler - Goldman Sachs

Thanks a lot and good morning. A couple of questions, if I could. First of all on the P&L, as I look at the operating and non-operating items, there were some non-operating items related to interest expense and then I think that the tax rate also changed a bit when the non-operating items were contemplated, specifically there was I guess a $6.4 million income item booked against your interest expense in the quarter and then the tax rate I guess just is what it is. So if you could shed some light on each of those, that would be great.

Edward W. Wilhelm

On the non-operating side, Matt, the pretax items -- actually the EBIT items, so before interest, relate primarily to severance costs and costs related to the strategic alternatives process. Then you go down to the interest line and on the interest line, we had to do a mark-to-market of the warrants for the Pershing Square financing transaction that occurred earlier this year and the accounting for that goes through the interest line, just the way that the accounting worked for that. So that income item gets reflected as an interest income.

On the tax rate side, that income related to the mark-to-market on the warrants is not tax affected because for tax purposes, it’s treated as a capital item. So we get a benefit there, and then there were some other pluses and minuses that came through on the tax line but largely related to just not providing taxes on the warrant income.

Matthew Fassler - Goldman Sachs

And just a really basic question on the Pershing warrants, the benefit to you is a result of what specifically be --

Edward W. Wilhelm

Well, the warrants again have a strike price of $7, the stock being under $7 results in a downward adjustment, an income item. If things were to go the other way, it would be a -- obviously an expense item if things were to, if the stock were to be over $7. And again, this is all non-cash too.

Matthew Fassler - Goldman Sachs

And as it moves closer to or further away from $7, you take -- you book something there?

Edward W. Wilhelm

That’s right. And again, non-cash item.

Matthew Fassler - Goldman Sachs

The next question relates to your cost cutting program. If you could just tell us, is the $60 million that you expect to book this year a run-rate that you would expect to achieve by year-end?

George L. Jones

-- expect to the book this year. The run-rate by year-end, by the time we come into the first of next year, the run-rate is going to be at $120 million.

Matthew Fassler - Goldman Sachs

And how much would you say of that 60 you were able to achieve related to the program? I know it’s hard to unscramble the egg and identify precisely where those [inaudible] come from. How much came from the program, if you could identify it?

Edward W. Wilhelm

I think about a third of it in the quarter, a third of the $60 million, Matt, best I can tell you. It’s a little bit of scrambled eggs but about a third of it came through this quarter.

Matthew Fassler - Goldman Sachs

Which would mean that you are at the run-rate -- you are already at the run-rate of getting 60 for the year --

Edward W. Wilhelm

Yes, very confident -- very confident that we are going to get 60 for the year and by the time we end this year in January, we’ll be at a run-rate of $120 million lower --

George L. Jones

This is definitely well on track. These aren’t cuts that we are thinking we might do or hope we can do, et cetera. We are well focused in on this.

Matthew Fassler - Goldman Sachs

The last question -- as you think about, and Potter distorts your numbers a little bit in that you had I guess the [inaudible] leverage works more against you in the absence of the Potter revenue but Potter probably depressed your margins last year, so focusing on the gross margin line, how much would you say that Potter detracted from your margin this year so if you look at the 90 bps of I guess it’s merchandise or at least gross margin ex occupancy, how much of that is from the Potter compare?

Edward W. Wilhelm

Are you talking about on the discount line, Matt?

Matthew Fassler - Goldman Sachs

Presumably. Just whatever --

Edward W. Wilhelm

Yeah, I mean --

Matthew Fassler - Goldman Sachs

-- Potter at a very low margin would have had on your gross.

Edward W. Wilhelm

I would say on the Borders side, the improvement that we saw was largely attributable to the Harry Potter effect. Walden, partially attributable to the Harry Potter effect.

Matthew Fassler - Goldman Sachs

So if you back out Potter and you look at the company’s gross margin overall, year to year you’ve probably gotten to the point where you are about flat right now, ex occupancy as well, just merchandise and --

Edward W. Wilhelm

No, I would say we’re better than flat because again, I was just explaining the discount line. We continue to see our initial margin improve as the mix of sales continues to get better for us. Music is now down under 7% of total store sales and of course, that’s our lowest margin category. And then the other benefit that is coming through for us that will continue is shrink improvement, so we have seen shrink improvement this year as a result of the cycle inventories we’ve taken to date.

Matthew Fassler - Goldman Sachs

Understood. Thanks so much.

Operator

Next, Aaron Stein, J.P. Morgan.

Aaron Stein - J.P. Morgan

Thank you. First of all, could you give us a little color on how the comp trended through the quarter?

Edward W. Wilhelm

It was about -- absent the Harry Potter effect, it was about the same. It ran pretty equal throughout the quarter, again absent the July impact of Harry Potter.

Aaron Stein - J.P. Morgan

Can you talk to August at all and maybe your second half expectations for that?

Edward W. Wilhelm

We’re not giving guidance, of course, in terms of expectations but the early part of August is affected by the Olympics and as everyone knows, I mean, our business is impacted sales wise by the Olympics so a little softer early August trend than what we saw coming out of Q2 but all of that was expected, so none of it -- it wasn’t any worse than what we had thought and we saw most of the softness occur in the evening hours.

George L. Jones

Just to tell you as far as why we aren’t giving guidance, I will tell you that we are planning our business from a sales and traffic standpoint very conservatively going forward and we will continue to control our inventories well and manage our expenses well, so we expect to still be able to deliver the improved results going forward, in spite of the fact that we don’t see an up-tick in the economy or anything.

Aaron Stein - J.P. Morgan

Okay, great.

George L. Jones

And if it does happen -- we aren’t economists -- if it does happen, that’s great but we’re not really counting on that.

Aaron Stein - J.P. Morgan

And then in regard to the $60 million, I think you broke it out -- or I’m sorry, the 120 total bucket, you broke it out 60 for corporate expense savings and 60 in the store DC. Could you just elaborate a little bit more on the 60 from the store DC side? Where do you see those cuts coming?

Edward W. Wilhelm

They are both payroll and non-payroll and just again, some of the things that we’ve done in the stores are adjust the payroll hours through better scheduling to reflect more with sales trends. We’ve also taken a critical look at all of our stores and adjusted hours of operations and that’s helped create some savings for us in the stores.

We’ve re-bid supply contracts and energy management contracts and through energy management systems helped reduce our utility costs. In the DCs, we’ve adjusted indirect labor and reduced our indirect labor in a lot of the distribution centers and those were some of the areas where we went and adjusted expenses downward.

George L. Jones

One thing to note in this expense initiative, this is something we started last year looking at and had some outside help, even beginning last year, looking at the fact that we really needed lower overhead and we thought there was an opportunity to [do there]. Obviously we stepped this up quite a bit in the first of the year as we saw sales softening and what was happening with the economy and brought in some additional outside help, which really helped us focus on it at the beginning of the year. And as we put this in in second quarter, this was something that we did quite surgically with a lot of focus and literally, it was a process that was not just concentrated on let’s eliminate some jobs or do this, et cetera, which all that happened but we really literally turned over every possible stone within the company in every area and that’s the reason we are so confident that we can deliver more than the $120 million in expense reductions. And we’re still finding things.

Aaron Stein - J.P. Morgan

Great. And then just a quick final question -- we noticed through the quarter you switched your promotional cadence to offer a 40% off on bestsellers all the time. I was hoping you could give us a little color on your decision and what impact that’s had to your business and trends in that category.

George L. Jones

It’s something -- you know, we looked at it and basically it was something that we saw, it was something that we felt like we might need to do to be competitive with what was going on out there and as we were seeing that kind of discounts at competitors. And we tested this very thoroughly before we did it because -- but frankly, we test a number of thing. We test a lot of things on pricing, et cetera. This is when it conclusively came back that it was beneficial and actually was beneficial for us to do this. So as we did it, it was well-tested. We’ve been pleased with the results since we’ve done it.

Edward W. Wilhelm

Aaron, I would just add that when we did that, we also pulled back on some other promotions that we were doing, so we pulled back on things like our bounce back coupons, some of our front of store table promotions, some of our buy one get one promotions as well. So again, we are really focused on balancing the whole promotional discounts with driving profitable sales.

George L. Jones

That’s an important part. This wasn’t just something we said okay, let’s do this and just step up the discounting. I mean, we are trying to really manage our gross margin and in doing this, we saw some other programs that we though would not give us as much bump as the 40% did so we, as Ed said, we pulled back on some other things.

Aaron Stein - J.P. Morgan

Great. Thank you very much.

Operator

Next, David Schick, Stifel Nicolaus.

David Schick - Stifel Nicolaus

Good morning. Just to sort of drill back into that SG&A issue, the pace of SG&A that you are taking out of the store, is it fair -- forgetting the buckets that you’ve drawn into, is it fair to say as you watch the whole quarter play out that that’s the pace we can expect and is there any indication that as you go into ’09 or as business stabilizes, the SG&A per foot would have to come back up to run the business? Or how do you think about how it will impact the longer term?

Edward W. Wilhelm

I would say definitely not. The cost that we’ve taken out, as George said, were very carefully looked at, planned, analyzed, and is being executed. If anything, I think there’s -- as we look to ’09, there’s probably more upside potential in SG&A reductions. Our internal plans, for example, are to take out more than $120 million of annual expenses. So we’ve got internal plans that are adding up to more that we are driving towards and we really think we can achieve, yet we are confident in saying we can deliver at least $120 million of annual expenses.

So I would just say that we see as we look to ’09, there’s more upside in that than not.

George L. Jones

I want to second that and you know, it’s interesting. Yes, it’s true and any retailer knows this -- as sales flex up, you know that you do have some increase in expenses that goes up as it flexes up. However, that will not flex up nearly at the same rate and we feel really confident that now that we’ve taken this, and we’ve gone through a whole lot to get these expenses down here and it’s some painful things, as you lay off some people and you do some things that we felt like we just needed to do. But now that we’ve got these expenses down at this level, we are not going to let them go back up. And I think that’s the important thing because we know as we put the volume back on and things open back up, it’s going to change our profitability formula dramatically.

David Schick - Stifel Nicolaus

George, I think you mentioned in an answer to a previous question that you tried some things that you actually reversed or abandoned, so you keep kind of tweaking it. Can you talk about something that you felt you cut too far or that wasn’t appropriate and you brought back on the expense side? I might have heard that answer wrong.

Edward W. Wilhelm

Yeah, it was more on the inventory side, I think.

George L. Jones

Yeah, really the expense side, frankly we think we’ve done this pretty well. Is it perfect? But frankly, I think we’ve done a job in our stores, as Ed said, we probably do a lot of it in terms of getting the right hours in the right places within our stores and some things like that.

I think the place where we probably did cost ourselves some sales, honestly, is we’ve taken our inventory levels down over 14% and that’s a lot. And we’ve done it, frankly, we haven’t had a -- while we were making improvements on our systems, our systems aren’t really state-of-the-art in that area. I’ve been honest about that before. We have done some really good things. We put in a merchandise planning and allocation organization but we just got that put in place really the first part of this quarter and we think that helps us going forward and are getting our systems better. But frankly, as we took these inventory levels down, we did this as best we could but frankly to think that we did this with enough surgical precision that we took our inventories down over 14% and didn’t affect sales at least to some degree I think would be pretty naïve on our part. It’s hard to quantify it and frankly we see, as we look at our business right now, we see that our -- you know, we get things like Book Scan and Sound Scan, et cetera -- we see our market shares holding up really, really well on bestsellers, new releases, et cetera but we probably hit some on the backlist.

You know, as we took the cuts out of the inventory, we really made this primarily in SKUs that sell less than one copy per year per store, so you think well, that’s pretty easy. You start taking out books that sell less than one copy per store per year, but you know, it’s like the long tail. Collectively, this could still add up to a meaningful business and so you have to do this carefully.

And you know, we did it. It made sense. I guess the way I would look at it, Dave, if you look at it this way -- we took out 14.5% of inventory. So if you took the inverse of that and you said would you put that back in, which would be about 16.2%, 16.3% of inventory, would you be willing to invest that to tick up a couple of points in sales? You’d say well no, that’s a bad investment. And so that’s -- I mean, I think we’ve done the right thing here but frankly we are still fine-tuning this and I think we will be able to run our inventory levels at this level but still do it better as we fine-tune this more.

David Schick - Stifel Nicolaus

Great. Thanks a lot.

Operator

Next question, David Weiner, Deutsche Bank.

David Weiner - Deutsche Bank

Quite a few of my questions have been asked but I’ll start with this one -- on the Internet business, can you talk a little bit about how you are strategizing to grow that? Obviously a competitive part of the business as well. How are you going to be able to lever your millions of members? What’s the strategy there?

George L. Jones

Sure. First off I’ll just say we’re really happy to get this up and running. You know, this is something we made the decision to take back the Internet business and get out of the Amazon deal basically almost immediately after I got there and we’ve put in almost two years in prepping for this and investing in it, et cetera. And we finally got it up and running this quarter. It’s been a slower start than we thought, not in terms of the response to the site but just in terms of getting the bugs out of it and everything too. So it was really, as we said, mid-July before we really even started marketing this. So we only got a couple of weeks of really marketed sales in this quarter.

The good news is that customers are responding to this very, very well and we’ve seen as we began marketing on it, we’re getting a really strong response to it and people really like the site.

As far as marketing it, one of the great tools we have and this is one of the reasons that we’ve started planning to do this two years because a couple of years ago is when we also put in the rewards programs, and we built this from scratch. That’s over $28 million members now. And we have the ability with that -- you know, we send out the weekly e-mail, the short list, and we get a great response and a great open rate from that.

Well now we have the ability that we can put in buy now features on it, where you can click and buy on it. It drives traffic to the site, so it’s more than just saying okay, we put out an e-commerce site out there and if you want to buy from us, come to the site, et cetera.

You know, we’ve got a lot of things. We’ve created content, we’ve seen stickiness from that with everything we’re doing with Borders Media and this is a very -- I think a very exciting site and customers are responding. We’re seeing on the stay times on the site, we’re seeing it at the buys. So we think that frankly we’ve got great internal marketing ability to be able to do that.

The other thing is, and this is something that we will be rolling out to all of our Borders superstores later this year, is that we are going to put interactive kiosks in the stores where basically you can access that from inside the store too.

You know, we’re approaching this, and I’ve said this from the start really, that we want to be a true cross channel retailer and you see a lot of retailers out there that they have their in-store business, bricks and mortar, and they’ve got separately out here, they’ve got their dot.com and it is sort of like those two almost like compete for business and there’s not a lot of synergy between the two.

We’ve designed this from the start, that we want to let one drive the other. We’re glad to take that business anywhere we can get it, between in-store or online, either way, and we want one to feed the other.

So we feel like we’ve got a good plan for this. We are really pleased with the response we are getting early on and we are very optimistic about this.

David Weiner - Deutsche Bank

Okay, and then just as a follow-up to that -- have you done any kind of measurement or kind of any analysis on whether your rewards customers, by what degree they are your best customers? I mean, how much more incrementally doe they spend than the average customer? Any color on that front you can share?

George L. Jones

We’ve got a whole lot on it. I don’t know how much of it I really want to share on it but I can tell you, they are very clearly our best customers and it’s disproportionate in terms of the amount, the customers in terms of the number of customers versus their spend. Their average spend is higher, their frequency in shopping is higher, and the key thing about it right now is now that we do this, we are able to tell not only how much they are spending, we can tell what they are spending it on and we can tell more and more about them.

So what we are testing right now in using this, Dave, and we refer to this a little bit as segmentation. So if you look at our promotions, what we are doing, we are promoting differently to different people. So the promotions you’d be receiving from us are going to be different than your next door neighbor who may have different interests in different things in terms of the type of things we’re promoting, the frequency we promote to you, the level of the promotion in terms of the level of discounts. It all depends on your frequency and what you buy and that’s where we really get the benefit from this. It’s not just building a mailing list, so to speak. It’s really getting a lot of really valuable information.

David Weiner - Deutsche Bank

Okay, and then just one final separate question and I’ll pass it on -- if you can just remind me what the implications are of not selling the Paperchase business within your agreement with Pershing? Are there kind of certain levers that happen, if I remember the Paperchase business doesn’t get sold to an outside party by the fourth quarter?

Edward W. Wilhelm

No, there are no implications of that, and just to be clear, the put that we have available that remains for our ability to put the Paperchase business back to Pershing Square remains in effect. We haven’t exercise the put and we obviously haven’t sold the Paperchase business either. And I would just say that as we sit here today, we’ve got plenty of available capacity to get through the peak debt season for this year and we can sit here even without the sale of Paperchase or the exercising of that put and we can say that with a high degree of confidence because that peak debt occurs early next month. So we are sitting in a very comfortable position, again even without the sale of Paperchase as we look out through the remainder of this year and again, there are no implications of not exercising that put.

George L. Jones

The Pershing put was really a back-stop for us to give people confidence that we had the wherewithal going forward, et cetera. That’s why it was done. It was never necessarily our intent that we would exercise it but it was there if we needed it. It was a safety net, so to speak.

Since that happened, I mean, we’ve dramatically improved the financial strength of this company and the balance sheet, as evidenced by the debt and our improvement in cash flow and everything that we have reported here. We feel really, really good about that and the expense reductions, everything we’ve got. So we’re just in a much, much stronger position financially than we were.

David Weiner - Deutsche Bank

Okay. Thanks for the color.

Operator

Next, Aaron Stein, J.P. Morgan.

Aaron Stein - J.P. Morgan

Two quick follow-up questions, just to clarify -- the Internet sales, the $7 million in borders.com Internet sales, is that included in your comp?

Edward W. Wilhelm

No, it’s not, Aaron.

Aaron Stein - J.P. Morgan

Okay, and then of the $120 million of annual savings, can you break out how much of that you think comes from either store closures or business spin-outs, so on and so forth versus existing operational savings?

Edward W. Wilhelm

None. It’s all from existing operational savings.

Aaron Stein - J.P. Morgan

Okay, perfect. Thanks again.

Operator

(Operator Instructions) Thank you. At this time, we’re showing no questions.

George L. Jones

Okay. Thank you all for talking with us today. Our third quarter news release is scheduled for November 25th with the conference call to follow at 8:00 a.m. November 26th, and have a great day.

Operator

Thank you. That does end today’s conference. You may disconnect.

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