Borders (BGP) now sees a loss per share from 28 cents to 32 cents, versus an earlier projection for a loss in the range from 10 cents to 20 cents. The updated guidance includes nonoperating charges related to a facility closure and the retirement of the company's CEO. While Borders is revamping stores through extensive remodeling, the benefits accrued are being eclipsed by a soft book sector and an eroding macro milieu.
We believe further operational difficulties at Borders will drive interest in a possible Barnes/Borders merger or private equity deal. Both stocks have underperformed thus far in 06, with Barnes down 18% and Borders' down over 30%. A deal would return nominal value to investors, close the staggering valuation gap between the two stocks (BGP trades at 14 x whereas Barnes floats at 17 x), and achieve further economies of scale. The deal would ultimately resemble, we think, that struck between #1 and #2 video game retailers Gamestop (NYSE:GME) and Electronics Boutique a couple of years ago: the buyer sees its sales double overnight (to $10B, in this case) while the acquisition target returns long-sought return on capital to beleaguered investors.
We're not buyers of book stocks in general. The book space is a mature industry with flat sales; companies spend heavily on luring customers away from each other and profitability is low. Borders' numbers, quite frankly, do little to excite us: debt/equity is at 50%, insiders own less than 1% of the stock, and a price/sales ratio of .3 x reflects industry sluggishness and unattractiveness. Borders' 4% operating margins, 200 bps lower than Barnes and Nobles', indicate how pervasive the fight to breakeven is in this category.
Barnes and Noble (NYSE:BKS) looks like the smarter play here. The NY-based firm grew its EPS 20% last year, trades at a deep discount to the industry on a price/cash fow basis, and is debt free. We take comfort in the insiders owning 22% of the shares outstanding. Furthermore, Barnes/Nobles' operating margin picture (5-6%) is healthier. Lastly, we believe that Barnes and Noble is better attuned to consumer trends and/or consumption patterns. One reason investors are giving Barnes and Noble a higher valuation is because, unlike Borders, Barnes and Noble is not overexposed to music. The rapid proliferation of digitally-driven music and MP3 portables has had a detrimental effect on both stores, we think.
We suggest investors keep an eye on both stocks, especially if Borders' stock price continues to languish: BGP shareholders may have their day in the sun sooner than they think. If Barnes and Noble decides snapping up Borders would be a poor cap ex decision -- or the deal gets blocked for antitrust reasons (quite possible) -- private equity could presumably come to the rescue: PE has already developed a penchant for swooping in and taking over troubled retailers, as any Petco (PETC) investor will tell you.
BGP 1-yr chart: