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FORM 10-K

For the fiscal year ended January 27, 2002

OR

For the transition period from                to                .

Commission File Number 1-13740

BORDERS GROUP, INC.

(734) 477-1100

Securities registered pursuant to section 12(g) of the act:

Securities registered pursuant to Section 12(b) of the act:

None

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 o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

The aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $1,903,653,086 based upon the closing market price of $23.91 per share of Common Stock on the New York Stock Exchange as of March 28, 2002.

Number of shares of Common Stock outstanding as of March 28, 2002: 81,635,509

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the Registrant’s Proxy Statement for the May 23, 2002 Annual Meeting of Stockholders are incorporated by reference into Part III.

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BORDERS GROUP, INC.

INDEX

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General

      Borders Group, Inc. (the Company), through its subsidiaries, Borders, Inc. (Borders), Walden Book Company, Inc. (Waldenbooks), Borders U.K. Limited, Borders Australia PTY Limited and others, is the second largest operator of book superstores and the largest operator of mall-based bookstores in the world based upon both sales and number of stores. At January 27, 2002, the Company operated 385 superstores primarily under the Borders name, including 12 in the United Kingdom, six in Australia, two in Puerto Rico, and one each in Singapore and New Zealand. The Company also operated 827 mall-based and other bookstores primarily under the Waldenbooks name and 36 bookstores under the Books etc. name in the United Kingdom.

Borders

      Borders is a premier operator of book and music superstores, offering customers selection and service that the Company believes to be superior to other book superstore operators. A key element of the Company’s strategy is to continue its growth and increase its profitability through the ongoing expansion and refinement of its Borders book and music superstore operations. In 2001, the Company opened 29 new Borders book and music superstores. Borders superstore operations achieved annual growth in net sales and net income for the year ended January 27, 2002 of 6.0% and 27.6% respectively. Borders superstores also achieved average sales per square foot of $245 and average sales per superstore of $6.4 million in 2001. The Company believes its average sales per superstore to be higher than the comparable figure of any publicly reporting book superstore operator. Borders superstores achieved compound annual growth in net sales for the three years ended January 27, 2002 and January 28, 2001 of 13.6% and 18.5%, respectively.

      Each Borders superstore offers customers a vast assortment of books, superior customer service, value pricing and an inviting and comfortable environment designed to encourage browsing. Borders superstores carry an average of 116,000 book titles, ranging from 73,000 titles to 204,000 titles, across numerous categories, including many hard-to-find titles. As of January 27, 2002, 349 of the 363 domestic Borders superstores were in a book and music format, which also feature an extensive selection of pre-recorded music, with an emphasis on hard-to-find recordings and categories such as jazz, classical and foreign music, and a broad assortment of pre-recorded videotapes and digital video discs, focusing primarily on classic movies and hard-to-find titles. Each book and music superstore carries approximately 34,000 titles of music and over 6,000 titles of videotapes and digital video discs.

      Borders superstores average 26,200 square feet in size, including approximately 5,000 square feet devoted to music, approximately 600 square feet devoted to videos and digital video discs and approximately 1,400 square feet devoted to a café. Stores opened in fiscal 2001 averaged 24,600 square feet. Each store is distinctive in appearance and architecture and is designed to complement its local surroundings, although Borders utilizes certain standardized specifications to increase the speed and lower the cost of new store openings.

      Borders has entered into an agreement with an affiliate of Amazon.com under which customers will be able to order certain book, music and video products on Borders.com or Amazon.com for pick up in Borders stores. This service is expected to be available for the 2002 holiday season.

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      The number of Borders domestic stores located in each state and the District of Columbia as of January 27, 2002 are listed below:

Waldenbooks

      Waldenbooks is the leading operator of mall-based bookstores in terms of sales and number of stores, offering customers a convenient source for new releases, hardcover and paperback bestsellers, periodicals, and a standard selection of other titles. Waldenbooks generates cash flow that the Company uses to finance the Company’s growth initiatives. Waldenbooks achieved average sales per square foot of $266 and average sales per store of $1.1 million for 2001, both of which the company believes are higher than its closest competitor. Waldenbooks stores average approximately 3,500 square feet in size and typically carry between 15,000 and 40,000 titles.

      Waldenbooks operates one of the longest-running customer loyalty programs in the nation, the Preferred Reader Program. The lessons learned via this program are helping the Company in considering the development of customer loyalty programs across its other business channels.

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      The number of Waldenbooks stores located in each state and the District of Columbia as of January 27, 2002 are listed below:

International

      The Company’s international initiative began in 1997 with the acquisition of Books etc. in the United Kingdom and the opening of a superstore in Singapore. Since then, Borders has expanded its international operations to establish a presence on four continents. The Company opened eight international superstores in 2001, and as of January 27, 2002, operated 12 superstores in the United Kingdom, six in Australia, two in Puerto Rico, and one each in Singapore and New Zealand.

      International superstores range between 16,000 and 43,000 square feet in size, and tend to be multi-level facilities located in older buildings in urban locations. The Company believes it has a competitive advantage due to the depth of Borders’ system-driven assortment and level of service. In 2001, international sales increased 14.8% to $251.7 million. Currently, four of the ten highest volume Borders superstores are international stores.

      Borders U.K. Limited also operated 36 stores under the Books etc. name in the United Kingdom as of January 27, 2002, all of which are small-format stores located primarily in central London or in various airports in the United Kingdom. These stores generally range from 2,000 to 5,000 square feet in size, with the largest being 8,000 square feet, and the smallest being 650 square feet.

Borders.com and Waldenbooks.com

      From May 1998 to August 2001, the Company operated an Internet commerce site, Borders.com. In August 2001, the Company re-launched Borders.com as a co-branded Web site powered by Amazon.com’s e-commerce platform. Amazon.com became the seller of record, providing inventory, fulfillment, site content and

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      In the consolidated financial statements, amounts relating to Borders.com, other than intercompany interest expense (net of related taxes), have been reclassified from prior years into the Borders segment. Intercompany interest charges (net of related taxes) relating to Borders.com have been included in the Other segment.

Discontinued Operations

      In January 2001, the Company adopted a plan to discontinue operations of All Wound Up, a seasonal retailer of interactive toys and novelty merchandise the Company had acquired in March 1999. Accordingly, the operating results of AWU have been segregated from continuing operations.

Segment Information

      The Company is organized based upon the following operating segments: domestic Borders stores, Waldenbooks stores, international Borders and Books etc. stores, and other. For financial information about segments, see “Note 15 — Segment Information” in the notes to consolidated financial statements.

Distribution

      The Company believes that its centralized distribution system, consisting of 13 distribution facilities worldwide, combined with Borders’ use of its proprietary “expert” system to manage inventory, significantly enhances its ability to manage inventory on a store-by-store basis. Inventory is shipped from vendors to one of the Company’s distribution centers. Approximately 95% and 70% of the books carried by Borders and Waldenbooks, respectively, are processed through the Company’s distribution facilities. Approximately 85% of the inventory that arrives from publishers is processed within 48 hours for shipment to the stores. Newly released titles and rush orders are processed within 24 hours. Borders purchases substantially all of its music merchandise directly from manufacturers and utilizes the Company’s own distribution center to ship approximately 99% of its music inventory to its stores.

      The Company utilizes distribution centers located in Harrisburg, Pennsylvania; Indianapolis, Indiana; Columbus, Ohio; Mira Loma, California and Nashville, Tennessee that provide exclusive service to Borders’ stores. The Company also utilized a distribution center in Columbus that serviced the All Wound Up seasonal kiosk operations in fiscal 2000. The distribution center in Columbus closed in 2001 due to the discontinuance of operations of All Wound Up. In addition, the Company has distribution facilities in Mira Loma, California and Nashville, Tennessee that service Waldenbooks and provide central overstock for Borders’ stores. Distribution centers located in the United Kingdom, Australia, Puerto Rico and Singapore support the Company’s growing international business.

      The Company has a 200,000 square-foot fulfillment center in La Vergne, Tennessee that supported Borders.com prior to August 2001. Pursuant to the agreement with Amazon.com as discussed above, Amazon.com assumed the fulfillment of online orders upon the transition to a co-branded site in August 2001. This fulfillment center also distributed the Company’s special order merchandise to Borders and Waldenbooks stores. Pursuant to the March 15, 2001 agreement, Ingram Book Group became the primary provider of book fulfillment services for Borders Group’s special order sales. The transaction included the sale to Ingram of a large percentage of the book inventory housed in this fulfillment center. The Company has converted the La Vergne facility to support other products and retail store growth.

      In general, books can be returned to their publishers at cost. Borders and Waldenbooks stores return books to the Company’s centralized returns center in Nashville, Tennessee to be processed for return to the publishers. In general, Borders can return music and videos to its vendors at cost plus an additional fee to cover handling and processing costs.

Competition

      The retail book business is highly competitive. Competition within the retail book industry is fragmented with Borders facing direct competition from other superstores, such as Barnes & Noble, Inc., as well as regional chains

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      The music and video businesses are also highly competitive and Borders faces competition from large established music chains, such as Tower Records and the Musicland and Media Play divisions of Musicland Stores Corporation (which also sell videos), established video chains, such as Blockbuster and Suncoast Motion Picture Company (a division of Musicland Stores Corporation), as well as specialty retail stores, video rental stores, discount stores, warehouse clubs and mass merchandisers. In addition, consumers receive television and mail order offers and have access to mail order clubs. The largest mail order clubs are affiliated with major manufacturers of pre-recorded music and may have advantageous marketing relationships with their affiliates.

      The Internet has emerged as a significant channel for retailing in all media categories that the Company carries. In particular, the retailing of books and music over the Internet is highly competitive. Competitors on the Internet include Amazon.com, barnesandnoble.com, and others. In addition, the Company faces competition from companies engaged in the business of selling books and music products via electronic means.

Employees

      As of January 27, 2002, the Company had a total of approximately 15,000 full-time employees and approximately 17,000 part-time employees. When hiring new employees, the Company considers a number of factors, including education and experience, personality and orientation towards customer service. All new store employees participate in a training program that provides up to two weeks of in-store training in all aspects of customer service and selling, including title searches for in-stock and in-print merchandise, merchandising, sorting, operation of point of sale terminals and store policies and procedures. The Company believes that its relations with its employees are generally excellent. None of the employees of the Company are represented by unions.

Trademarks and Service Marks

      Borders®, Borders Book Shop®, and Borders Books & Music®, among other marks, are all registered trademarks and service marks used by Borders. Brentano’s®, Coopersmith’s®, Longmeadow Press®, Waldenbooks®, Waldenbooks Preferred Reader®, Waldenkids® and Waldensoftware®, among other marks, are all registered trademarks and service marks used by Waldenbooks. Books etc.® is a registered trademark and service mark used by Borders U.K. Limited, Borders.com® is a registered trademark and service mark used by Borders Online, Inc. The Borders, Walden, Books etc. and Borders.com service marks are used as trade names in connection with their business operations.

Seasonality

      The Company’s business is highly seasonal, with sales generally highest in the fourth quarter and lowest in the first quarter. During 2001, 35.6% of the Company’s sales and 96.1% of the Company’s operating income were generated in the fourth quarter. The Company’s results of operations depend significantly upon the holiday selling season in the fourth quarter; less than satisfactory net sales for such period could have a material adverse effect on the Company’s financial condition or results of operations for the year and may not be sufficient to cover any losses which may be incurred in the first three quarters of the year. The Company’s expansion program generally is weighted with store openings in the second half of the fiscal year. In the future, changes in the number and timing of store openings, or other factors, may result in different seasonality trends. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Seasonality”.

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 Corporation filed for reorganization under Chapter 11 of the US Bankruptcy Code. Such filing has not affected the operations of the Company.

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      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 will 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.

      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 upon completion 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 aggregate liability of $10.0 million 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 million, 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.

Forward-Looking Statements

      This Annual Report on Form 10-K contains forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Forward-looking statements reflect management’s current expectations and are inherently uncertain. The Company’s actual results may differ significantly from management’s expectations. Exhibit 99.1, “Cautionary Statement Under the Private Securities Litigation Reform Act of 1995”, filed with this

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      Borders leases all of its stores. Borders’ store leases have an average initial term of 15 to 20 years with multiple three- to five-year renewal options. At January 27, 2002, the average unexpired term under Borders’ existing store leases was 13 years prior to the exercise of any options.

      Waldenbooks leases all of its stores. Waldenbooks’ store leases generally have an initial term of ten years. At present, the average unexpired term under Waldenbooks’ existing store leases is approximately 3.5 years. The expiration of Waldenbooks’ mall-based bookstore leases for its bookstores open as of January 27, 2002 expire as follows:

      Books etc. operated 36 stores in the United Kingdom as of January 27, 2002. Books etc. generally leases its stores under operating leases with terms ranging from 5 to 25 years. The average remaining lease term for Books etc. stores is 11.8 years.

      The Company has leased a portion of its corporate headquarters in Ann Arbor, Michigan and owns the remaining building and improvements. The Company leases all distribution centers.

      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 has 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 million or more in damages and requests treble damages, injunctive and declaratory relief, interest, costs, attorneys’ fees and other unspecified relief. The Company intends to vigorously defend the action.

      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

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      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. The Company does not believe that any such other litigation will have a material adverse effect on its liquidity, financial position or results of operations.

      Not applicable.

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      The following table sets forth, for the fiscal quarters indicated, the high and low closing market prices for the Common Stock on the New York Stock Exchange.

      The Common Stock is traded on the New York Stock Exchange.

      As of March 28, 2002, the Common Stock was held by 3,845 holders of record.

      The Company has not declared any cash dividends and intends to retain its earnings to finance future growth. Therefore, the Company does not anticipate paying any cash dividends in the foreseeable future. The declaration and payment of dividends, if any, is subject to the discretion of the Board and to certain limitations under the Michigan Business Corporation Act. In addition, the Company’s ability to pay dividends is restricted by certain agreements to which the Company is a party. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources”.

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SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA

      The information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Company’s consolidated financial statements and the notes thereto.

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General

      Borders Group, Inc. (the Company), through its subsidiaries, is the second largest operator of book and music superstores and the largest operator of mall-based bookstores in the world based upon both sales and number of stores. As of January 27, 2002, the Company operated 385 superstores primarily under the Borders name, including 12 in the United Kingdom, six in Australia, two in Puerto Rico, and one each in Singapore and New Zealand. The Company also operated 827 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 superstore business, (ii) driving international growth by leveraging infrastructure investments and expanding established markets, (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 expects to open an average of 40 domestic Borders stores annually over the next several years. International store growth over the next several years will focus on existing markets, primarily in the United Kingdom and Australia, with approximately eight to ten international store openings annually. Full year profitability is expected to be achieved by the International segment in 2003. The Waldenbooks segment has experienced decreased comparable sales percentages for the past few years primarily due to the overall decrease in mall traffic and the impact of superstore openings. As a result, the Company has developed a plan for the optimization of its store base in order to improve net income and free cash flow. This plan could result in further store closing costs or asset impairments over the next few years. Overall, the Company expects these initiatives to support consolidated annual sales growth of 8% to 10% and consolidated annual earnings growth of 13% to 15%.

      In August 2001, the Company entered into an agreement with Amazon.com, Inc. to re-launch Borders.com as a co-branded Web site powered by Amazon.com’s e-commerce platform. Amazon.com is the seller of record, providing inventory, fulfillment, site content, and customer service for the co-branded site.

      The Company’s fiscal year ends on the Sunday immediately preceding the last Wednesday in January. Fiscal 2001 consisted of 52 weeks and ended January 27, 2002. Fiscal 2000 consisted of 53 weeks and ended January 28, 2001. Fiscal 1999 consisted of 52 weeks and ended January 23, 2000. References herein to years are to the Company’s fiscal years.

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Results of Operations

      The following table presents the Company’s consolidated statements of operations data, as a percentage of sales, for the three most recent fiscal years.

Consolidated Results

Sales

      Consolidated sales increases in fiscal 2001 and 2000 resulted primarily from the opening of new Borders superstores and increases in comparable store sales for Borders superstores of 2.0% and 2.3%, respectively.

Gross margin

      Consolidated gross margin decreased as a percentage of sales in both 2001 and 2000. The decrease in 2001 primarily resulted from an $8.7 million pre-tax charge for the writedown of inventory affected by the Company’s agreement with Ingram Book Company (Ingram). On March 15, 2001, the Company announced an agreement with Ingram, a wholesaler of books, spoken audio and magazines, pursuant to which Ingram provides fulfillment services for the Company’s special order book sales. The agreement included the sale to Ingram of a large percentage of the book inventory housed in the Company’s fulfillment center in LaVergne, Tennessee, which handled the function assumed by Ingram. The decrease in 2000 gross margin was driven by lower gross margin percentages for both the Borders and Waldenbooks segments. Among the reasons for the decrease in gross margin percentage of Borders was a change in sales mix to lower margin items. The decrease in gross margin percentage of Waldenbooks was due to its fixed expenses being spread over a smaller store base, as well as lower sales volume in 2000 compared to 1999.

Selling, general and administrative expenses

      Consolidated selling, general and administrative expenses as a percentage of sales decreased in 2001 due to a reduction in Borders.com operating expenses in conjunction with the agreement with Amazon.com, a decrease in Borders payroll costs resulting from the restructuring of Borders store personnel, and strong expense control of Borders advertising costs, partially offset by continued spending on the Company’s international expansion. The

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Legal settlement expense

      In March 1998, the American Booksellers Association (ABA) and 26 independent bookstores filed a lawsuit in the United States District Court for the Northern District of California against the Company and Barnes & Noble, Inc. alleging violations of the Robinson-Patman Act, the California Unfair Trade Practice Act, and the California Unfair Competition Act. On April 19, 2001, the Company announced that a settlement had been reached in this action. The Company paid $2.4 million under the agreement.

Goodwill amortization

      The Company uses the straight-line method for goodwill amortization, which was flat in fiscal 2001 and 2000. In the first quarter of fiscal 2002, the Company will adopt Statement of Financial Accounting Standards No. 142. Adoption will have the impact of eliminating the Company’s goodwill amortization and increasing net income by approximately $2.8 million annually. The Company does not expect that adoption will result in an impairment of goodwill.

Asset impairments and other writedowns

      In fiscal 2001, the Company recorded a $25.4 million pre-tax charge for asset impairments and other writedowns. The aforementioned agreement with Ingram in March 2001 resulted in a first quarter pre-tax charge of approximately $16.0 million primarily related to the writedown of assets used by the Company-owned facility to fulfill special order sales, including warehouse equipment, hardware, and software. The Company also took a fourth quarter pre-tax charge of $6.9 million primarily related to the impairment of the leasehold improvements and furniture and fixtures of 97 underperforming Waldenbooks stores. In addition, the Company adopted a plan to close certain underperforming Waldenbooks stores and recorded a fourth quarter $2.5 million pre-tax charge for the closing costs of those stores.

      In fiscal 2000, the Company took a pre-tax charge of $36.2 million related to the impairment of certain long-lived assets and other writedowns. The charge taken in 2000 primarily consisted of $17.7 million for computer hardware and software of Borders.com and $12.5 million for leasehold improvements and furniture and fixtures primarily related to 103 underperforming Waldenbooks stores. The remainder of the charge related to employee severance, the costs of certain lease obligations for redundant headquarter buildings, and the writeoff of certain equity investments.

Interest expense

      Despite the decrease in the weighted average interest rate from 6.8% in 2000 to 4.1% in 2001, interest expense as a percentage of sales was flat in 2001 primarily due to the Company’s interest rate swaps, which converted a portion of its variable rates to fixed rates. Interest expense as a percentage of sales decreased in 2000 as a result of lower consolidated borrowing levels.

Taxes

      The effective tax rate for the years presented differed from the federal statutory rate primarily as a result of state income taxes. The Company’s effective tax rate was 38.7% in 2001 compared to 39.4% in 2000. The decrease is primarily due to changes in the mix of income subject to tax in the various taxing jurisdictions. In 1999, the effective tax rate was 39.1%.

Discontinued operations

      In January 2001, the Company adopted a plan to discontinue operations of All Wound Up, a seasonal retailer of interactive toys and novelty merchandise the Company had acquired in March 1999. The discontinuance and closure of All Wound Up resulted in an after-tax charge of $19.4 million in the fourth quarter of fiscal 2000 and is reflected

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Effect of terrorist attacks on September 11, 2001

      As a result of the terrorist attacks on September 11, 2001, a Borders store that operated in the World Trade Center in New York City was destroyed. The loss of that store’s sales and net income was not material to the Company’s consolidated fiscal 2001 results.

      The Company was insured for the replacement value of the assets destroyed at the store and up to 24 months of lost income from business interruption coverage and has recognized a total recovery of $13.0 million to date. Net asset values of $8.0 million (net of straight-line rent reserves of $2.0 million) were written off against the allocated property insurance proceeds of $11.0 million. Gains were categorized in the consolidated statements of operations as follows: $1.0 million in “Selling, general and administrative” and $2.0 million in “Cost of merchandise sold.” In addition, $2.0 million of business interruption proceeds were recorded in “Cost of merchandise sold” to offset otherwise lost profits from the store.

      The Company expects to recover additional insurance amounts, which will be recognized when collection of such additional recoveries is assured.

Segment Results

      The Company is organized based upon the following operating segments: domestic Borders stores, Waldenbooks stores, international Borders and Books etc. stores, and other (consisting of interest expense and certain corporate governance costs). Amounts relating to Borders.com, other than intercompany interest expense (net of related taxes), have been reclassified from prior years into the Borders segment. Intercompany interest charges (net of related taxes) relating to Borders.com have been included in the other segment. See Note 15 in the notes to consolidated financial statements for further information relating to these segments.

      The increases in Borders sales for 2001 and 2000 are primarily the result of new store openings and comparable store sales increases. Borders opened 29 and 44 new stores in 2001 and 2000, respectively, and experienced comparable store sales increases of 2.0% and 2.3% in 2001 and 2000, respectively.

      Net income for 2001 increased primarily due to the larger store base, partially offset by $14.7 million of after-tax asset and inventory writedowns, which resulted from the March 2001 agreement with Ingram. Net income for 2000 decreased from 1999 primarily as a result of an $11.3 million after-tax asset impairment charge related to the computer hardware and software of Borders.com taken in 2000, partially offset by net income generated by the larger store base. The increase in net income as a percentage of sales in 2001, exclusive of asset and inventory writedowns in 2001 and 2000, was the result of a reduction in Borders.com operating expenses in conjunction with the agreement with Amazon.com. Lower store payroll expenses as a percentage of sales due to the restructuring of store personnel also contributed to the improvement. Net income as a percentage of sales was flat in 2000 (exclusive of asset writedowns) despite a decrease in gross margin percentage and an increase in non-payroll store expenses as a percentage of sales. The decrease in gross margin as a percentage of sales was due to a change in sales mix to DVDs and new-release music, a slight increase in promotional costs, and less leverage of store occupancy costs resulting from lower comparable store sales. Non-payroll store expenses as a percentage of sales

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      Depreciation and amortization expense increased in 2001 and 2000 as a result of the depreciation expense recognized on new stores’ capital expenditures.

      Interest expense decreased in 2001 and 2000 due to lower average borrowing levels at fixed internal interest rates.

      The decreases in Waldenbooks sales in 2001 and 2000 are primarily the result of the decrease in store count during each year coupled with comparable store sales decreases of 1.6% and 2.9%, respectively, due to decreased mall traffic.

      In 2001, net income decreased primarily as a result of a smaller sales and store base, along with a $4.3 million after-tax asset impairment charge related to 97 underperforming stores and a $2.4 million after-tax charge for store closing costs. Net income decreased in 2000 primarily as a result of decreased sales and a $7.8 million after-tax asset impairment charge primarily related to 103 underperforming stores. As a percentage of sales, net income for 2001 was flat, exclusive of asset impairments and the store closing charge. In 2000, net income as a percentage of sales decreased primarily due to the asset impairment charge and a decrease in gross margin percentage. The gross margin decrease was due to increased promotional costs as a percentage of sales and higher distribution and store occupancy costs as a percentage of sales resulting from the smaller store base and lower sales volume.

      Depreciation expense decreased in 2001 as a result of a lower fixed asset base due to asset impairments, while it increased in 2000 as a result of the depreciation expense recognized on new stores’ and refurbished stores’ fixed assets.

      Interest income increased in 2001 and 2000 as a result of Waldenbooks continued positive cash flow at fixed internal interest rates.

      The increases in International sales for 2001 and 2000 are primarily the result of new superstore openings and comparable store sales increases. In 2001, the Company opened three stores in the United Kingdom, four stores in Australia, and the Company’s second store in Puerto Rico. In 2000, the Company opened three stores in the United Kingdom, one store in Australia, and the Company’s first store in Puerto Rico.

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      The net loss in 2001 decreased from 2000 as a result of higher operating income generated from the maturation of the store base. Net loss as a percentage of sales for 2001 is lower than the prior year due to the leveraging of distribution center and overhead infrastructure, primarily in the United Kingdom and Australia, over a larger store base. Net loss for 2000 increased as a result of higher depreciation and interest expense, partially offset by increased operating income generated from the maturation of the prior year’s store base. Net loss as a percentage of sales for 2000 remained flat from the prior year.

      Depreciation and amortization expense increased in 2001 and 2000 as a result of the depreciation expense recognized on new stores’ capital expenditures.

      Interest expense increased in 2001 and 2000 due to higher average borrowing levels necessary to finance investments in new stores at fixed internal interest rates.

      Foreign currency transaction gains (losses) were $0.3 million, $(0.8) million, and $0.2 million in 2001, 2000, and 1999, respectively.

      Net loss consists of various corporate governance costs and interest. The net loss in 2001 increased from 2000 as a result of an increase in the amount of annual incentive compensation and interest expense. Interest expense represents corporate-level interest costs not charged to the Company’s operating segments.

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 streamlining.

      Net cash provided by continuing operations was $265.0 million, $152.8 million, and $181.3 million in 2001, 2000, and 1999, respectively. The current year activity primarily reflects income before non-cash charges for depreciation and amortization. Fiscal 2000 and 1999 activity primarily reflected income before non-cash charges for depreciation and amortization offset by cash used for inventories as a result of store expansion at Borders. Fiscal 2001 inventory net of accounts payable decreased primarily due to supply chain improvements and strong inventory management, while fiscal 2000 and 1999 inventory net of accounts payable increased primarily due to 49 and 50 new Borders stores, respectively.

      Net cash used by discontinued operations represents the cash needed for the operations of All Wound Up in fiscal 2001, 2000, and 1999.

      Net cash used for investing in 2001 was $90.7 million, which primarily funded capital expenditures for new stores and the refurbishment of existing stores. Capital expenditures in 2001 reflect the opening of 37 new superstores and 11 new Waldenbooks stores. Capital expenditures of $141.1 million in 2000 primarily reflect the opening of 49 new superstores and 11 new Waldenbooks stores. Additional capital spending in 2001 and 2000 reflected the development and installation of in-store Web-based technology and spending on corporate information technology streamlining. Capital expenditures of $159.2 million in 1999 reflect the opening of 50 new superstores and 39 new Waldenbooks stores.

      Net cash used for financing in 2001 was $41.1 million, resulting primarily from the paydown of the Company’s Credit Facility of $58.2 million and the repurchase of common stock of $17.7 million, partially offset by $34.9 million received from the issuance of common stock under the Company’s employee benefit plans. Net cash provided by financing in 2000 was $19.5 million, resulting primarily from net borrowings under the Credit Facility and the issuance of common stock under the Company’s employee benefit plans. Net cash used for financing in 1999 was $15.0 million, resulting primarily from the repurchase of common stock of $25.4 million, partially offset by the issuance of common stock under the Company’s employee benefit plans.

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      The Company expects capital expenditures to increase to approximately $120.0 million in 2002, resulting primarily from domestic store openings. In addition, capital expenditures will result from international store openings, refurbishment of a number of existing stores, and investment in information technology streamlining. The Company currently plans to open approximately 40 domestic Borders superstores and eight international stores in 2002. Average cash requirements for the opening of a domestic prototype Borders Books and Music superstore are $2.4 million, representing capital expenditures of $1.1 million, inventory requirements (net of related accounts payable) of $1.1 million, and $0.2 million of pre-opening costs. Average cash requirements to open a new or expanded Waldenbooks store range from $0.4 million to $0.7 million, depending on the size and format of the store. The Company plans to lease new store locations predominantly under operating leases.

      The Company plans to execute its expansion plans for Borders superstores and other strategic initiatives principally with funds generated from operations and financing through the Lease and Credit Facilities. The Company believes funds generated from operations, borrowings under the Credit Facility, and financing through the Lease Facility will be sufficient to fund its anticipated capital requirements for the next several years. As discussed below, the Credit and Lease Facilities expire in October 2002, but the Company expects to be able to successfully renew the Facilities in the second quarter of 2002. The Company believes that its borrowing rate may increase upon renewal of the Facilities if financial market conditions remain unchanged.

      The Company currently has a share repurchase program in place with remaining authorization to repurchase approximately $86.5 million. During 2001, 2000, and 1999, $17.7 million, $9.2 million, and $25.4 million of common stock was repurchased, respectively. The Company plans to continue the repurchase of its common stock throughout fiscal 2002, subject to the Company’s share price and capital needs.

      The Company has a $472.8 million multicurrency credit agreement (the Credit Facility) which expires in October 2002. Borrowings under the Credit Facility bear interest at a base rate or an increment over LIBOR at the Company’s option. The Credit Facility contains covenants which limit, among other things, the Company’s ability to incur indebtedness, grant liens, make acquisitions, merge, declare dividends, dispose of assets, issue or repurchase its common stock in excess of $100.0 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), and require the Company to meet certain financial measures regarding fixed charge coverage, leverage, and tangible net worth. The Company is prohibited under the Credit Facility from paying cash dividends on common shares.

      The Company has a $175.0 million lease financing facility (the Lease Facility) to finance new stores and other property through operating leases which expires in October 2002. The Lease Facility provides financing to lessors through loans from a third-party lender for up to 95% of a project’s cost. It is expected that lessors will make equity contributions approximating 5% of each project. Independent of its obligations as lessee, the Company guarantees payment when due of all amounts required to be paid to the third-party lender. The principal amount guaranteed will be 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 Lease Facility contains covenants and events of default that are similar to those contained in the Credit Facility described above.

      To date, the Company has not been required to perform under the guarantees described above. In the event that the Company should be required to perform, borrowings under the Credit Facility would be sufficient to meet its obligations.

      Management believes that the rental payments for properties financed through the Lease Facility may be lower than those which the Company could obtain elsewhere due to, among other factors, (i) the lower borrowing rates available to the Company’s landlords under the facility and (ii) the fact that rental payments for properties financed through the facility do not include amortization of the principal amounts of the landlords’ indebtedness related to the properties. Rental payments relating to such properties will be adjusted when permanent financing is obtained to reflect the interest rates available at the time of the refinancing and the amortization of principal.

      There were 31 properties financed through the Lease Facility, with a financed value of $121.8 million, at January 27, 2002. Of this amount, the Company has recorded $49.7 million as capital leases on the consolidated balance sheets. The Company expects that the properties financed under the Lease Facility will either be transferred to a new facility currently under negotiation or be permanently financed.

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      During 1994, the Company entered into agreements in which leases with respect to four Borders locations served as collateral for certain mortgage pass-through certificates. These mortgage pass-through certificates included a provision requiring the Company to repurchase the underlying mortgage notes in certain events. In the fourth quarter of fiscal 2001, the Company was obligated to purchase the notes for $33.5 million. As a result, the Company has categorized this prepaid rent amount as part of “Other assets” in the consolidated balance sheets with a corresponding amount in “Accrued payroll and other liabilities,” since the payment did not occur until after the Company’s fiscal year end. The prepaid amount will be amortized over each property’s remaining lease term.

      The following table summarizes the Company’s significant financing and lease obligations:

      The Company is subject to risk resulting from interest rate fluctuations since interest on the Company’s borrowings is principally based on variable rates. The Company’s objective in managing its exposure to interest rate fluctuations is to limit the impact of interest rate changes on earnings and cash flows and to lower its overall borrowing costs. The Company primarily utilizes interest rate swaps to achieve this objective, effectively converting a portion of its variable rate exposures to fixed interest rates.

      LIBOR is the rate upon which the Company’s variable rate debt and its payments under the Lease Facility are principally based. If LIBOR were to increase 1% for the full year in 2002 as compared to the end of 2001, the Company’s after-tax earnings, after considering the effects of its existing interest rate swap agreements, would decrease $1.2 million based on the Company’s expected average outstanding debt, including its indirect borrowings under the Lease Facility, as of January 27, 2002.

      A portion of the Company’s operations takes place in foreign jurisdictions, primarily the United Kingdom, Australia, New Zealand and Singapore. As a result, the Company’s financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which the Company operates. The Company has generally not used derivative instruments to manage this risk.

Seasonality

      The Company’s business is highly seasonal, with sales significantly higher and substantially all operating income realized during the fourth quarter, which includes the holiday selling season. The information below excludes discontinued operations, fulfillment center and other inventory writedowns, legal settlement expense, and asset impairments and other writedowns.

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Critical Accounting Estimates

      In the ordinary course of business, the Company has made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of its financial statements in conformity with accounting principles generally accepted in the United States. Actual results could differ from those estimates under different assumptions and conditions. The Company believes that the following discussion addresses the Company’s most critical accounting estimates.

Asset Impairments

      The carrying value of long-lived assets is evaluated whenever changes in circumstances indicate the carrying amount of such assets may not be recoverable. In performing such reviews for recoverability, the Company compares the expected cash flows to the carrying value of long-lived assets for each of its stores. If the expected future cash flows are less than the carrying amount of such assets, the Company recognizes an impairment loss for the difference between the carrying amount and its estimated fair value. Fair value is estimated using expected discounted future cash flows. To the extent that there is a significant deterioration in the performance of the Company’s stores, significant asset impairments may result.

Inventory

      The Company records reserves for shrinkage and non-returnable inventory based on actual historical rates. If future experience differs from these historical rates, the recorded amounts for inventory and cost of sales will be impacted.

      The Company includes certain distribution and other expenses in its inventory costs, particularly freight, distribution payroll, and certain occupancy expenses. In addition, certain selling, general and administrative expenses are included in inventory costs. These amounts approximate 2% of total inventory. The extent to which these costs are included in inventory is based on certain estimates of space and labor allocation.

New Accounting Guidance

      In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, “Business Combinations,” and No. 142, “Goodwill and Other Intangible Assets,” effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and intangible assets deemed to have indefinite lives are no longer amortized but are subject to annual impairment tests in accordance with the Statements. Other intangible assets continue to be amortized over their useful lives.

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      The Company will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of 2002. Adoption of the provisions of the Statements will have the impact of eliminating the Company’s goodwill amortization and increasing net income by approximately $2.8 million annually. The Company does not expect that adoption will result in an impairment of goodwill.

      In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long Lived Assets” (FAS 144), which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. FAS 144 is effective for fiscal years beginning after December 15, 2001.

      The Company expects to adopt FAS 144 beginning in the first quarter of fiscal 2002, and it does not expect that the adoption of the Statement will have a significant impact on the Company’s financial position and results of operations.

Related Party Transactions

      The Company has not engaged in any related party transactions which would have had a material effect on the Company’s financial position, cash flows, or results of operations.

      See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

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INDEX TO FINANCIAL STATEMENTS

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CONSOLIDATED STATEMENTS OF OPERATIONS