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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10 - Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended October 26, 2003

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from          to         

Commission file number 1-13740

BORDERS GROUP, INC.

(Exact name of registrant as specified in its charter)

100 Phoenix Drive, Ann Arbor, Michigan 48108
(Address of principal executive offices with zip code)

(734) 477-1100
(Registrant's telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes   X            No     

BORDERS GROUP, INC.

INDEX

ii

BORDERS GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN MILLIONS EXCEPT PER SHARE DATA)
(UNAUDITED)

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

1

BORDERS GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN MILLIONS EXCEPT PER SHARE DATA)
(UNAUDITED)

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

2

BORDERS GROUP, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN MILLIONS)
(UNAUDITED)

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

3

BORDERS GROUP, INC.
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
FOR THE 39 WEEKS ENDED OCTOBER 26, 2003
(DOLLARS IN MILLIONS)
(UNAUDITED)

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

4

BORDERS GROUP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
(UNAUDITED)

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

5

BORDERS GROUP, INC.
NOTES TO UNAUDITED CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in millions except per common share data)

NOTE 1 - BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Borders Group, Inc. (the Company) have been prepared in accordance with Rule 10-01 of Regulation S-X and do not include all the information and notes required by accounting principles generally accepted in the United States for complete financial statements. All adjustments, consisting only of normal recurring adjustments, have been made which, in the opinion of management, are necessary for a fair presentation of the results of the interim periods. The results of operations for such interim periods are not necessarily indicative of results of operations for a full year. The unaudited condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and notes thereto for the fiscal year ended January 26, 2003.

The Company’s fiscal year ends on the Sunday immediately preceding the last Wednesday in January. At October 26, 2003, the Company operated 473 superstores primarily under the Borders name, including 24 in the United Kingdom, nine in Australia, two in Puerto Rico, and one each in Singapore and New Zealand. The Company also operated 750 mall-based and other bookstores primarily under the Waldenbooks name, and 36 bookstores under the Books etc. name in the United Kingdom.

NOTE 2 - COMMITMENTS AND CONTINGENCIES

Litigation. In August 1998, The Intimate Bookshop, Inc. (Intimate) and its owner, Wallace Kuralt, filed a lawsuit in the United States District Court for the Southern District of New York against the Company, Barnes & Noble, Inc., and others alleging violation of the Robinson-Patman Act and other federal laws, New York statutes governing trade practices and common law. In response to Defendants' Motion to Dismiss the Complaint, plaintiff Kuralt withdrew his claims and plaintiff Intimate voluntarily dismissed all but its Robinson-Patman claims. Intimate filed a Second Amended Complaint limited to allegations of violations of the Robinson-Patman Act. The Second Amended Complaint alleges that Intimate has suffered $11.3 or more in damages and requests treble damages, injunctive and declaratory relief, interest, costs, attorneys' fees and other unspecified relief. On September 30, 2003, the Court granted the defendants' Motion For Summary Judgment and dismissed the case. Intimate has filed a Notice of Appeal.

Two former employees, individually and on behalf of a purported class consisting of all current and former employees who worked as assistant managers in Borders stores in the state of California at any time between April 10, 1996, and the present, have filed an action against the Company in the Superior Court of California for the County of San Francisco. The action alleges that the individual plaintiffs and the purported class members worked hours for which they were entitled to receive, but did not receive, overtime compensation under California law, and that they were classified as exempt store management employees but were forced to work more than 50% of their time in non-exempt tasks. The Amended Complaint, which names two additional plaintiffs, alleges violations of the California Labor Code and the California Business and Professions Code. The relief sought includes compensatory and punitive damages, penalties, preliminary and permanent injunctions requiring Borders to pay overtime compensation as required under California and Federal law, prejudgment interest, costs, and attorneys’ fees and such other relief as the court deems proper. On July 29, 2002, the Superior Court of California granted the plaintiffs’ motion for class certification in the action. The class certified consists of all individuals who worked as Assistant Managers in a Borders superstore in California at any time between April 10, 1996 and March 18, 2001. The class was further certified by the Court into the following subclasses: Assistant Manager-Merchandising; Assistant Manager-Inventory; Assistant Manager-Human Resources; Assistant Manager-Music; Assistant Manager-Training; Assistant Manager-Cafe. The Company’s request for an immediate appeal of the class certification ruling has been denied. Mediation did not result in a resolution of the matter, and the Company will continue to vigorously defend the action. Given current factual and legal uncertainties, the Company is not in a position to reasonably estimate the amount of the loss, if any. The trial is scheduled for March 15, 2004.

On October 29, 2002, Gary Gerlinger, individually and on behalf of all other similarly situated consumers in the United States who, during the period from August 1, 2001 to the present, purchased books online from either Amazon.com, Inc. (“Amazon) or the Company, instituted an action against the Company and Amazon in the United States District Court for the Northern District of California. The Complaint alleges that the agreement pursuant to which an affiliate of Amazon operates Borders.com as a co-branded site violates federal anti-trust laws, California statutory law and the common law of unjust enrichment. The Complaint seeks injunctive relief, damages, including treble damages or statutory damages where applicable, attorneys fees, costs and disbursements,

6

BORDERS GROUP, INC.
NOTES TO UNAUDITED CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in millions except per common share data)

disgorgement of all sums obtained by allegedly wrongful acts, interest and declaratory relief. The Company has filed an answer denying any liability and intends to vigorously defend the action.

The Company has not included any liability in its consolidated financial statements in connection with the lawsuits described above and has expensed as incurred all legal costs to date. Although an adverse resolution of these lawsuits could have a material adverse effect on the result of the operations of the Company for the applicable period or periods, the Company does not believe that any such litigation will have a material effect on its liquidity or financial position.

Certain states and private litigants have sought to impose sales or other tax collection efforts on out-of-jurisdiction companies that engage in e-commerce. The Company currently is disputing a claim by the state of California relating to sales taxes that the state alleges should have been collected on certain Borders.com sales in California prior to implementation of the Company’s Mirror Site Agreement with Amazon. Also, the Company and Amazon have been named as defendants in actions filed by a private litigant on behalf of the States of Tennessee, Nevada and Illinois under the applicable state’s False Claims Act relating to the failure to collect use taxes on Internet sales in Tennessee, Nevada and Illinois for periods both before and after the implementation of the Mirror Site Agreement. The Complaints seek judgments, jointly and severally, against the defendants for, among other things, injunctive relief, treble the amount of damages suffered by the States of Tennessee, Nevada and Illinois as a result of the alleged violations of the defendants, penalties, costs and expenses, including legal fees. The Tennessee action has been dismissed, but the appeal period has not yet expired.

The Company does not believe that it should be liable under existing laws and regulations for any failure by it or Amazon to collect sales or other taxes relating to Internet sales. Although an adverse resolution of claims relating to the failure to collect sales or other taxes on online sales could have a material effect on the results of the operations of the Company for the applicable period or periods, the Company does not believe that any such claims will have a material adverse effect on its liquidity or financial position.

In addition to the matters described above, the Company is, from time to time, involved in or affected by other litigation incidental to the conduct of its businesses.

Relationship with Kmart - -- General. Prior to its initial public offering in May 1995, the Company was a subsidiary of Kmart Corporation (Kmart); Kmart currently owns no shares of common stock of the Company. In January 2002, Kmart filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code. Such filing has not affected the operations of the Company.

Kmart and the Company continue to have the following contractual relationships.

Tax Allocation and Indemnification Agreement. Prior to the completion of its initial public offering (IPO), the Company was included in the consolidated federal income tax returns of Kmart and filed on a combined basis with Kmart in certain states. Pursuant to a tax allocation and indemnification agreement between the Company and Kmart (Tax Allocation Agreement) the Company will remain obligated to pay to Kmart any income taxes the Company would have had to pay if it had filed separate tax returns for the tax period beginning on January 26, 1995, and ending on June 1, 1995, the date of the consummation of the IPO (to the extent that it has not previously paid such amounts to Kmart). In addition, if the tax liability attributable to the Company for any previous tax period during which the Company was included in a consolidated federal income tax return filed by Kmart or a combined state return is adjusted as a result of an action of a taxing authority or a court, then the Company will pay to Kmart the amount of any increase in such liability and Kmart has agreed to pay to the Company the amount of any decrease in such liability (in either case together with interest and penalties). The Company’s tax liability for previous years will not be affected by any increase or decrease in Kmart’s tax liability if such increase or decrease is not directly attributable to the Company. After completion of the IPO, the Company continued to be subject under existing federal regulations to several liability for the consolidated federal income taxes for any tax year in which it was a member of any consolidated group of which Kmart was the common parent. Pursuant to the Tax Allocation Agreement, however, Kmart agreed to indemnify the Company for any federal income tax liability of Kmart or any of its subsidiaries (other than that which is attributable to the Company) that the Company could be required to pay and the Company agreed to indemnify Kmart for any of the Company’s separate company taxes.

7

BORDERS GROUP, INC.
NOTES TO UNAUDITED CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in millions except per common share data)

Lease Guaranty Agreement. Borders’ leases for 13 of its retail stores and its distribution center in Harrisburg, Pennsylvania have been guaranteed by Kmart. Under the terms of a lease guaranty, indemnification and reimbursement agreement entered into uponcompletion of the IPO, as amended, (Lease Guaranty Agreement), the underlying leases will be transferable by Borders, subject to a right of first refusal in favor of Kmart with respect to sites within a three-mile radius of a Kmart store and, with respect to all other sites, a right of first offer in favor of Kmart. The Company and Borders are required to indemnify Kmart with respect to (i) any liabilities Kmart may incur under the lease guarantees, except those liabilities arising from the gross negligence or willful misconduct of Kmart, and (ii) any losses incurred by Kmart after taking possession of any particular premises, except to the extent such losses arise solely from the acts or omissions of Kmart. Under the terms of the Lease Guaranty Agreement, in the event of (i) the Company’s or Borders’ failure to provide any required indemnity, (ii) a knowing and material violation of the limitations on transfers of guaranteed leases set forth in the agreement, or (iii) certain events of bankruptcy, Kmart will have the right to assume any or all of the guaranteed leases and to take possession of all of the premises underlying such guaranteed leases; provided, that in the event of a failure or failures to provide required indemnities, the remedy of taking possession of all of the premises underlying the guaranteed leases may be exercised only if such failures relate to an aggregate liability of $10.0 or more and only if Kmart has provided 100 days’ prior written notice. In the event of a failure to provide required indemnities resulting in losses of more than the equivalent of two months rent under a particular lease but less than $10.0, Kmart may exercise such remedy of possession as to the premises underlying the guaranteed lease or leases to which the failure to provide the indemnity relates and one additional premise for each such premises to which the failure relates, up to a maximum, in any event, of five additional premises, and thereafter, with respect to such additional premises, Kmart remedies and indemnification rights shall terminate. In the event of a failure to provide required indemnities resulting in liabilities of less than the equivalent of two months rent under a particular lease, Kmart may exercise such remedy of possession only as to the premises underlying the guaranteed lease or leases to which the failure to provide the indemnity relates. The Lease Guaranty Agreement will remain in effect until the expiration of all lease guarantees, which the Company believes will be in January 2020.

NOTE 3 - FINANCING

Credit Facility. The Company has a Multicurrency Revolving Credit Agreement (the “Credit Agreement”), which will expire in June 2005. The Credit Agreement provides for borrowings of up to $450.0. Borrowings under the Credit Agreement bear interest at a variable base rate plus an increment or LIBOR plus an increment at the Company’s option. The Credit Agreement contains covenants which limit, among other things, the Company’s ability to incur indebtedness, grant liens, make investments, consolidate or merge, declare dividends, dispose of assets, repurchase its common stock in excess of $225.0 over the term of the Agreement (plus any proceeds and tax benefits resulting from stock option exercises and tax benefits resulting from restricted shares purchased by employees from the Company), and requires the Company to meet certain financial measures regarding fixed coverage, leverage, tangible net worth and capital expenditures. The Company had borrowings outstanding under the Credit Agreement (or a prior agreement) of $136.9 at October 26, 2003, $170.5 at October 27, 2002 and $112.1 at January 26, 2003.

Term Loan. On July 30, 2002, the Company issued $50.0 of senior guaranteed notes (the “Notes”) due July 30, 2006 and bearing interest at 6.31% (payable semi-annually). The proceeds of the sale of the Notes are being used to refinance existing indebtedness of the Company and its subsidiaries and for general corporate purposes. The note purchase agreement relating to the Notes contains covenants which limit, among other things, the Company’s ability to incur indebtedness, grant liens, make investments, engage in any merger or consolidation, dispose of assets or change the nature of its business, and requires the Company to meet certain financial measures regarding net worth, total debt coverage and fixed charge coverage.

In August 2003, the Company entered into an interest rate swap, which effectively converted the fixed interest rate on the Company’s Notes to a variable rate based on LIBOR. In accordance with the provisions of FAS 133, the Company has designated this swap agreement as a fair market value hedge. The notional amount of the swap agreement is $50.0, and it expires concurrently with the due date of the Notes.

Lease Financing Facilities. The Company has two lease financing facilities (collectively, the “Lease Financing Facilities”), which were amended in May 2003, to finance new stores and other property owned by unaffiliated entities and leased to the Company or its subsidiaries. The original facility (the “Original Lease Facility”) will expire in June 2004 (2005 if certain conditions are satisfied). In June of 2002, the Company established a new facility (the “New Lease Facility”), which will expire in 2007. The aggregate amount

8

BORDERS GROUP, INC.
NOTES TO UNAUDITED CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in millions except per common share data)

available under the Lease Financing Facilities is $25.0. Properties to be financed after the effective date of the New Lease Facility will be financed under that Facility, and no additional properties will be financed under the Original Lease Facility. The Lease Financing Facilities provide financing to lessors of properties leased to the Company or its subsidiaries through loans from lenders for up to 95% of a project’s cost. Additionally, under the New Lease Facility, the unaffiliated lessor will make equity contributions approximating 5% of the cost of each project. The lessors under the Original Lease Facility have made similar contributions.

Independent of the Company’s obligations relating to the leases, the Company and certain of its subsidiaries guarantee payment when due of all amounts required to be paid to the third-party lenders. The principal amount guaranteed is limited to approximately 89% of the original cost of a project so long as the Company is not in default under the lease relating to such project. The agreements relating to both of the Lease Financing Facilities contain covenants and events of default that are similar to those contained in the Credit Agreement described above. Security interests in the properties underlying the leases and in the Company’s interests in the leases have been given to the lenders. The Lease Financing Facilities contain cross default provisions with respect to the obligations of the Company under the Credit Agreement and certain other agreements to which the Company is a party. There also are cross default provisions with respect to the obligations relating to the Lease Financing Facilities of Wilmington Trust Company, as owner trustee of a grantor trust formed for the Lease Financing Facilities, and the unaffiliated beneficial owner of the grantor trust.

There were 2, 21 and 7 properties financed through the Original Lease Facility at October 26, 2003, October 27, 2002 and January 26, 2003, respectively, with financed values of $13.8, $93.8 and $36.3. The Company has recorded $12.9, $48.7 and $19.0 of the amounts under the Original Lease Facility as capitalized leases under “Other assets” (for the capital lease assets) and “Long-term capital lease and financing obligations” (for the capital lease liabilities) on the consolidated balance sheets at October 26, 2003, October 27, 2002 and January 26, 2003, respectively. These amounts have been treated as non-cash items on the consolidated statements of cash flows. There were no borrowings under the New Lease Facility as of October 26, 2003. In the third quarter of 2003, the Company permanently financed, through long-term leases, two properties that had been financed through the Original Lease Facility with a total value of approximately $6.1, which had been capitalized.

As of October 26, 2003 the Company was in compliance with all debt covenants contained within the Credit Agreement, Notes and Lease Financing Facilities described above.

NOTE 4 - STOCK-BASED BENEFIT PLANS

The Company accounts for equity-based compensation under the guidance of APB No. 25. As permitted, the Company has adopted the disclosure-only option of Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based Compensation” (FAS 123). The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation:

9

BORDERS GROUP, INC.
NOTES TO UNAUDITED CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in millions except per common share data)

NOTE 5 - SEGMENT INFORMATION

The Company is organized based upon the following operating segments: domestic Borders stores, International Borders and Books etc. stores, Walden stores, and Corporate (consisting of the unallocated portion of interest expense and certain corporate governance costs).

Segment data includes charges allocating certain corporate headquarters costs to each segment. Transactions between segments, consisting principally of inventory transfers, are recorded at cost. The Company evaluates the performance of its segments and allocates resources to them based on anticipated future contribution.

Total assets for the Corporate segment include certain corporate headquarters property and equipment, net of accumulated depreciation, of $72.2 and $74.1 at October 26, 2003 and October 27, 2002, respectively, whose related depreciation expense has been allocated to the Borders and Waldenbooks segments. Depreciation expense allocated to the Borders segment totaled $2.8 and $2.5 for the 13 weeks ended October 26, 2003 and October 27, 2002, respectively, and $8.6 and $7.1 for the 39 weeks ended October 26, 2003 and October 27, 2002, respectively. Depreciation expense allocated to the Waldenbooks segment totaled $1.4 and $1.3 for the 13 weeks ended October 26, 2003 and October 27, 2002, respectively, and $4.4 and $3.9 for the 39 weeks ended October 26, 2003 and October 27, 2002, respectively.

NOTE 6 – NEW ACCOUNTING GUIDANCE

In November 2002, the Emerging Issues Task Force issued Consensus No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor” (EITF 02-16), which is effective prospectively for all vendor arrangements entered into after December 31, 2002. The Consensus requires that consideration received from a vendor be considered a reduction of the prices of vendor’s products and shown as a reduction of cost of sales in the income statement of the customer. If the consideration represents a reimbursement of specific incremental identifiable costs incurred, these amounts should be offset against the related costs with any excess consideration recorded in cost of sales. In fiscal 2003, the Company has reclassified the prior year’s vendor

10

BORDERS GROUP, INC.
NOTES TO UNAUDITED CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in millions except per common share data)

consideration to conform to current year presentation and EITF 02-16. Additionally, the Company recorded $0.3 of excess vendor consideration as a reduction to its inventory balance in the first quarter of 2003.

In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46). FIN 46 requires the consolidation of variable interest entities in which an enterprise absorbs a majority of the entity’s expected losses, receives a majority of the entity’s expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Currently, entities are generally consolidated by an enterprise that has a controlling financial interest through ownership of a majority voting interest in the entity.

The Company leases two properties from unconsolidated variable interest entities (VIEs) that had borrowings outstanding under the Original Lease Facility at October 26, 2003. Third parties have invested capital at risk equal to or in excess of 5% of the assets of the VIEs, with the remainder being financed through borrowings under the Original Lease Facility. This, and certain other criteria, allow the Company not to consolidate the VIEs in the Company’s financial statements at October 26, 2003. Rather, the Company accounts for these arrangements as capital leases. Accordingly, the capitalizable portion of the leased facilities and the related borrowings are reported in the Company’s accompanying balance sheets. Independent of the Company’s obligations relating to these leases, the Company and certain of its subsidiaries guarantee payment when due of all amounts required to be paid to the third-party lenders. At October 26, 2003, the maximum loss that the Company could incur under these guarantees approximated $13.8.

The Company also leases two properties from unconsolidated VIEs that had borrowings outstanding under the Original Lease Facility at January 26, 2003, but whose borrowings had been permanently financed by the VIE through long-term leases during the first quarter of 2003. Third parties have invested capital at risk equal to 5% of the assets of the VIEs, with the remainder being financed through borrowings unrelated to the Lease Financing Facilities. This, and certain other criteria, allow the Company not to consolidate the VIEs in the Company’s financial statements at October 26, 2003. Rather, the Company accounts for these arrangements as operating leases. Accordingly, neither the leased facilities nor the related debt is reported in the Company’s accompanying balance sheets. Independent of the Company’s obligations relating to these leases, the Company and certain of its subsidiaries guarantee payment when due of all amounts required to be paid to the third-party lenders. At October 26, 2003, the maximum loss that the Company could incur under these guarantees approximated $6.0.

The Company expects to begin consolidating the four VIEs mentioned above in the quarter ending January 25, 2004, because it believes it is the VIEs’ primary beneficiary under FIN 46‘s requirements. At January 25, 2004, consolidation of these VIEs would have the effect of increasing property and equipment by $7.0, net of accumulated depreciation of $1.6, and increasing long-term capital lease and financing obligations by $6.9. Minority interests of $1.7 would also be reported, and the Company would record a charge of $1.0, net of tax, as a cumulative effect of change in accounting principle.

In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (FAS 149). In general, this statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities”. This statement is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The adoption of FAS 149 is not expected to have an impact on the Company’s consolidated financial position or disclosures.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (FAS 150). This statement affects the classification, measurement and disclosure requirements of the following three types of freestanding financial instruments: 1) manditorily redeemable shares, which the issuing company is obligated to buy back with cash or other assets; 2) instruments that do or may require the issuer to buy back some of its shares in exchange for cash or other assets, which includes put options and forward purchase contracts; and 3) obligations that can be settled with shares, the monetary value of which is fixed, tied solely or predominantly to a variable such as a market index, or varies inversely with the value of the issuers’ shares. In general, FAS 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of FAS 150 is not expected to have an impact on the Company’s consolidated financial position or disclosures.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

Borders Group, Inc., through its subsidiaries, Borders, Inc. (Borders), Walden Book Company, Inc. (Waldenbooks), Borders U.K. Limited, Borders Australia Pty Limited and others (individually and collectively, “the Company”), is the second largest operator of book, music and movie superstores and the largest operator of mall-based bookstores in the world based upon both sales and number of stores. At October 26, 2003, the Company operated 473 superstores primarily under the Borders name, including 24 in the United Kingdom, nine in Australia, two in Puerto Rico, and one each in Singapore and New Zealand. The Company also operated 750 mall-based and other bookstores primarily under the Waldenbooks name, and 36 bookstores under the Books etc. name in the United Kingdom.

The Company’s business strategy is to continue its growth and increase its profitability through (i) expanding and refining its core domestic superstore business, (ii) driving international growth by expanding established markets and leveraging infrastructure investments, (iii) leveraging strategic alliances and in-store web-based commerce technologies which enhance the customer experience, and (iv) maximizing cash flow at Waldenbooks by containing costs. Specifically, the Company opened 32 domestic Borders stores in 2003 and expects to open a reduced number in 2004. International store growth over the next several years will focus on existing markets, primarily in the United Kingdom and Australia, with approximately six to eight international store openings annually. Full year profitability is expected to be achieved by the International segment in 2004. The Waldenbooks segment has experienced decreased comparable sales percentages for the past several years primarily due to the overall decrease in mall traffic and the impact of superstore openings. As a result, the Company is continuing to implement its plan for the optimization of the Waldenbooks’ store base in order to improve sales, net income and free cash flow. This plan could result in further store closing costs or asset impairments over the next few years. The Company’s objectives with respect to these initiatives are to continue to grow consolidated sales and earnings in 2003. In addition, the Company plans to provide returns to shareholders through dividends (recently announced) and share repurchases by utilizing free cash flow generation by the business. In May 2003, the Board of Directors authorized an increase in the amount of share repurchases to $150 million (plus any proceeds and tax benefits resulting from stock option exercises and tax benefits resulting from restricted shares purchased by employees from the Company). In November 2003, the Board of Directors declared a quarterly dividend of $0.08 per share on the Company’s common stock, payable January 28, 2004 to shareholders of record at the close of business January 7, 2004. The Company intends to pay regular quarterly dividends, subject to Board approval, going forward.

From May 1998 to August 2001, the Company operated an Internet commerce site, Borders.com. In 2001, the Company entered into an agreement with an affiliate of Amazon.com, Inc. (“Amazon”) for Amazon to develop and operate a web site utilizing the Borders.com URL (the “Mirror Site”). Operation of the Mirror Site began August 1, 2001. As of that date, the Company stopped selling merchandise via its Company-owned and -operated Borders.com web site (and the Internet). In 2002, the Company entered into an additional agreement with Amazon for Amazon to develop and operate a web site utilizing the Waldenbooks.com URL (the “Second Mirror Site”). Operation of the Second Mirror Site began November 11, 2002.

Under these agreements, Amazon is the merchant of record for all sales made through the Mirror Sites, and determines all prices and other terms and conditions applicable to such sales. Amazon is responsible for the fulfillment of all products sold through the Mirror Sites and retains all payments from customers. The Company receives referral fees for products purchased through the Mirror Sites. The agreements contain mutual indemnification provisions, including provisions that essentially allocate between the parties responsibilities with respect to any liabilities for sales, use and similar taxes, including penalties and interest, associated with products sold on the Mirror Sites. Currently, taxes are not collected with respect to products sold on the Mirror Sites except in certain states.

Amounts relating to the Company-owned and -operated Borders.com web site prior to August 2001, other than intercompany interest expense (net of related taxes), have been classified in the Borders segment for all periods presented. Intercompany interest charges (net of related taxes) relating to Borders.com have been included in the Corporate segment.

Also in 2002, Borders entered into an agreement with Amazon to allow customers ordering certain book, music and movie products through certain of Amazon’s web sites to purchase and pick up their merchandise at Borders stores in the United States (“Express In-Store Pick Up”). Under this agreement, the Company is the merchant of record for all sales made through this service, and determines all prices and other terms and conditions applicable to such sales. The Company fulfills all products sold through Express In-Store Pick Up. In addition, the Company assumes all risk, cost and responsibility related to the sale and fulfillment of all products sold. The

12

Company recognizes revenue upon customers’ pick up of the merchandise at the store, and classifies this revenue as a component of “Sales” in the Company’s consolidated statements of operations. The Company also pays referral fees to Amazon pursuant to this agreement. This service was offered to customers beginning November 27, 2002.

In November of 2003, the Company announced a multi-year extension of the Mirror Sites and Express In-Store Pick Up agreements with Amazon.

In August of 2003, the Company entered into an agreement with FAO, Inc. (FAO), a specialty retailer of toys and juvenile products in the United States, by which Borders would provide certain books, music and movies to FAO for sale in its FAO Schwarz, Zany Brainy and The Right Start stores. FAO in turn would provide certain products from its assortment for sale within Borders superstores. Borders shipped merchandise related to this agreement to FAO in late October 2003. In early December 2003, FAO filed voluntary petitions under Chapter 11 of the Bankruptcy Code for itself and its operating subsidiaries ZB Company, Inc. and FAO Schwarz, Inc. FAO disclosed that, at the request of its lenders, it had engaged liquidators to sell inventory of all three of its brands pending the outcome of its efforts to find buyers for the FAO Schwarz and The Right Start businesses. As result, the Company may be required to write-off a net receivable, totaling $1.4 million net of tax, for the merchandise shipped to FAO.

The Company’s third quarters of 2003 and 2002 consisted of the 13 weeks ended October 26, 2003 and October 27, 2002, respectively.

Results of Operations

The following table presents the Company’s consolidated statement of operations data, as a percentage of sales, for the periods indicated.

Consolidated Results -- Comparison of the 13 weeks ended October 26, 2003 to the 13 weeks ended October 27, 2002

13

14

Consolidated Results -- Comparison of the 39 weeks ended October 26, 2003 to the 39 weeks ended October 27, 2002

15

Segment Results

The Company is organized based upon the following operating segments: Borders stores, Waldenbooks stores, International stores, and Corporate (consisting of interest expense, certain corporate governance costs, and corporate incentive costs). Intercompany interest charges (net of related taxes) relating to the former Company-owned and - -operated Borders.com web site have been included in the Corporate segment. See “Note 5 -- Segment Information” in the notes to consolidated financial statements for further information relating to these segments.

Segment data includes charges allocating all corporate support costs to each segment. Interest income and expense are allocated to segments based upon the funding required to meet the operational needs of those segments. The Company utilizes fixed interest rates, approximating the Company’s medium-term borrowing and investing rates, in calculating segment interest income and expense.

Comparison of the 13 weeks ended October 26, 2003 to the 13 weeks ended October 27, 2002

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Comparison of the 39 weeks ended October 26, 2003 to the 39 weeks ended October 27, 2002

17

18

Comparison of the 13 weeks ended October 26, 2003 to the 13 weeks ended October 27, 2002

19

Comparison of the 39 weeks ended October 26, 2003 to the 39 weeks ended October 27, 2002

20

Comparison of the 13 weeks ended October 26, 2003 to the 13 weeks ended October 27, 2002

21

Comparison of the 39 weeks ended October 26, 2003 to the 39 weeks ended October 27, 2002

Comparison of the 13 weeks ended October 26, 2003 to the 13 weeks ended October 27, 2002

Comparison of the 39 weeks ended October 26, 2003 to the 39 weeks ended October 27, 2002

22

Liquidity and Capital Resources

The Company’s principal capital requirements are to fund the opening of new stores, the refurbishment and expansion of existing stores, continued expansion of in-store web-based commerce technologies, and corporate information technology spending.

Net cash used for operations was $84.3 million and $117.8 million for the 39 weeks ended October 26, 2003 and October 27, 2002, respectively. Operating cash inflows for the period primarily reflects operating results net of non-cash depreciation, as well as an increase in accounts payable and a decrease in accounts receivable. Operating cash outflows for the period primarily resulted from increases in inventory and prepaid expenses, as well as decreases in expenses payable, accrued liabilities, other long-term assets and liabilities and taxes payable during the period.

Net cash used for investing was $79.5 million and $85.7 million for the 39 weeks ended October 26, 2003 and October 27, 2002, respectively, which primarily funded capital expenditures for new stores, the refurbishment of existing stores and technology investments.