Why Barnes & Noble Is Thumping Borders

| About: Borders Group, (BGPIQ)

Some corporate battles go on for years, with titans vying for dominance in endurance races where the lead can routinely change hands: Apple (NASDAQ:AAPL) versus Microsoft (NASDAQ:MSFT). Dell (NASDAQ:DELL) versus HP (NYSE:HPQ). Boeing (NYSE:BA) versus Airbus.

But other battles are more like a war of attrition, an all-or-nothing fight with the spoils going to the last man standing. That may be the kind of struggle that Borders Group (BGP) and its main rival, Barnes & Noble (NYSE:BKS), are locked into. The book business, of course, is rapidly changing, thanks to the same digital technology that has transformed the music, news, travel, and entertainment industries. That has left the big, traditional booksellers fighting to stay in business—with Barnes and Noble now starting to look like a lone survivor. Both big retail chains struggled during the recession, closing stores, revamping their strategies, and enhancing their digital offerings. Barnes and Noble now seems to be rebounding, with a surge in retail and online sales during the December holiday season. December 23, in fact, was the biggest sales day ever for the nation's largest bookstore chain.

Borders, however, is starting to look like the next casualty of the digital revolution. The chain didn't report holiday results, but a long slide in sales has forced Borders to delay payments to the publishers that supply its books, and the company has warned that it may face a "liquidity shortfall" within a couple months if it can't restructure its debt and get some relief from lenders. The departure of several top executives in recent months has added to the turmoil. Borders insists that it's focused on refinancing, not bankruptcy, but analysts are already gaming out a Chapter 11 scenario. "There's a decent chance of a Chapter 11 filing," says John Pottow, a law professor and bankruptcy expert at the University of Michigan Law School. "As for Borders remaining a standalone company, I'd bet against that."

If it happens, Borders stores won't necessarily go away, and the chain will likely continue to honor gift cards and other obligations to customers. Many retail chains—including Blockbuster (OTC:BLOKA), Loehmann's, A&P, Uno Restaurant Holdings, and Jennifer Convertibles—have declared bankruptcy over the last 12 months, and continued to operate more or less normally while reorganizing their finances. If Borders files, it could be a chance to shed debt, shrink to a more manageable size, and start over. Or, Borders could end up merging with Barnes & Noble, a possibility its management has publicly expressed interest in. Customers might not even notice a difference. "A Chapter 11 reorganization should have no major impact on consumers," says Pottow. "It's not like people stopped buying General Motors (NYSE:GM) or Chrysler cars when they declared bankruptcy, or stopped flying on United or U.S. Airways (NYSE:UAL)."

Still, Borders' precarious position is yet another example of the wrenching change that has wracked the economy and upended entire industries over the last few years. Here's how Borders got into trouble:

It opened too many stores. Borders, the No. 2 book chain behind B&N, has closed more than 200 stores since 2008, most of them under its Waldenbooks brand. That leaves Borders with 508 superstores and about 175 smaller outlets. Yet with consumers buying more and more books online, some analysts think the top two chains still have too much real estate. That's one reason Borders mounted an effort late last year to buy Barnes & Noble and combine operations, an initiative that drew skepticism from analysts. "We struggle to see the value of combining two over-stored retailers, as that will not solve the over-stored problem," wrote analyst Gary Balter of CreditSuisse. "It will just compound their problems."

B&N has been closing stores too, including the complete wind-down of its B. Dalton chain. But with a bigger footprint, sounder finances, and rebounding sales, Barnes & Noble is in a better position to streamline. And if a merger of the two chains would lead to a significant consolidation of overlapping stores, that might produce a single healthy bookseller. Balter now sees B&N as a beneficiary of Borders' woes, since it's in a position to gain business from its struggling rival. And if Borders were to declare bankruptcy, Balter thinks B&N could buy some of its stores at a discount and score 20 to 50 percent of Borders' business. That's one reason he upgraded the outlook for B&N's stock in early January.

Borders went digital too late. Both chains fell way behind Amazon, which started selling books online more than a decade before either retailer mounted a significant website of its own. But Barnes & Noble has made an impressive effort to catch up, offering its own Nook E-reader in 2009 to compete with Amazon's Kindle and other similar devices. That was a big factor in strong holiday sales. And Barnes & Noble's website offers a whole range of periodicals and other products, making it one of the largest digital newsstands on the Web.

Borders has ramped up its digital offerings too, but instead of investing in its own E-reader, it has relied on devices like the Kobo and Cruz that are less popular than the Nook or Kindle. And Borders has put more emphasis on fixing its finances and improving the in-store experience for shoppers than on becoming a premiere digital destination. That puts Borders in a position similar to Blockbuster, which relied too heavily on expensive retail outlets, failed to keep up with competitors like Netflix (NASDAQ:NFLX) and Redbox, and declared bankruptcy last year. Blockbuster is attempting a comeback, but it's now way behind Netflix in a business that requires constant innovation and ruthless cost-cutting. Like Blockbuster, Borders risks becoming a digital also-ran known more for copying competitors' moves than for developing its own cutting-edge offerings.

It fell behind on debt. Many companies carrying debt got into a bind during the recession as plunging sales generated a cash-flow shortage that left them unable to make scheduled payments to lenders. Borders has already restructured its finances twice since 2008, and sold some of its assets to pay down about $350 million in debt. Yet the company has lost money for four straight years, and 2011 isn't looking any better. Standard and Poor's predicts that Borders' results in the current fiscal year will be even worse than in 2010, and current efforts to refinance debt might intensify financial pressure on the company. "We expect terms to be onerous if the refinancing is successful," wrote S&P analyst Michael Souers in a recent research note. "Longer term, we foresee an ultra-competitive landscape offering razor-thin margins."

It might all sound grim to book lovers who revel in the thousands of titles piled high and low in their favorite superstore. But books have survived every retail transformation so far, and they'll still line the shelves somewhere once Borders' future becomes clearer. And if a digital shelf is unsatisfying, there's always the library.

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