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 (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 (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: