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By Henry Hoffman

Foremost, it must be acknowledged that the downside in purchasing the equity of bankrupt Borders, listed on the pink sheets under the ticker (OTC:BGPIQ), is noticeably 100% of your investment if shares are cancelled. This is a very real probability and is the end result in better than 90% of bankruptcies. The upside, however, is what is so intriguing.

Why is Borders in Bankruptcy?

Predominantly, the company operates in a highly competitive environment [Barnes & Noble (NYSE:BKS), Amazon (NASDAQ:AMZN), Wal-Mart, (NYSE:WMT) etc.], which has experienced huge technological disruptions and is one of the many victims of the tough macro retail environment. Borders’ other more idiosyncratic and self-caused problems include an overly aggressive expansion pre-crisis, remarkably high long-term rents, turnover of management, an outsourced website and, of course, the company’s late adoption of the e-reader.

Bankruptcies are typically very bad for equity holders. Why? First, bankruptcies are expensive. Lawyers, accountants, bankers, and management love to bleed the debtor until the creditors force liquidation. Lawyers and accountants charge a lot, and the longer a company stays in bankruptcy, the more these guys make, thus incentivizing them to drag out the process. Second, management is typically at odds with shareholders. Managers want to please creditors, cash out on good terms, or just keep their jobs. Even in the case where the company survives, management wants to reset the share price as low as possible upon re-emergence. Third, debt holders are incented to make the case that the company is worth just enough to make them whole while leaving nothing for those junior to them in the capital structure (equity holders). This allows debt holders to capture all of the upside if the company reorganizes.

Compounding the challenges faced by equity holders, there are typically no substantial shareholders of a bankrupt company. Institutional owners have usually sold as bankruptcy approaches and are often prohibited from owning equity in bankrupt companies. Thus, with virtually every stakeholder’s interests opposite those of the equity holder, there is no one left with the resources to fight for shareholders.

Why is Borders’ bankruptcy different? First, management is aligned with shareholders, as Bennett LeBow, Borders’ CEO and Chairman, is the largest shareholder and is Borders Inc’s President and CEO Mike Edwards’s boss. Likewise, Pershing Square’s Bill Ackman, Borders’ next largest shareholder, has, and continues to have, considerable influence over the management and operations of the company. Second, Borders has practically no debt and substantial tax assets not appearing on its balance sheet. Further solidifying the company’s balance sheet, inventory was marked down last year for possible liquidation sales and will likely not be written down farther since it can still be liquidated or returned to publishers at values close to those listed on the balance sheet. Third, due to bankruptcy law, the company can cheaply exit unfavorable long-term liabilities, chiefly leases, substantially improving its profitability upon reemergence. Finally, Liberty Media, which just made an offer for Barnes and Noble, is known for realizing tax assets and unlocking value in struggling companies, making it a potential strategic buyer for Borders.

Trading at a market capitalization of only $16 million currently, the equity of Borders may be completely overlooked. As a company in bankruptcy, many professionals are restricted from trading it. Additionally, there is no sell side coverage, and even if a professional investor wanted to take a sizeable position, they would not be able to without changing the price dramatically. Lastly, anyone acquiring more than 5% of the shares ($750,000 at current prices) would have to file as a substantial owner but would likely not be able to participate as an activist investor because of the size of Ackman's and LeBow’s positions.

Borders’ net operating losses (NOLs) are a significant asset if the company emerges successfully or is acquired. As a profitable going concern, NOLs are taken at face value. However, a company in bankruptcy cannot list these assets on the balance sheet as they are considered to have only a remote chance of being realized. For those betting on a successful reorganization or sale, these NOLs are both real and valuable, and in this case, total $876.7 million. From page 56 of the 10-K:

“We have a federal gross net operating loss (“NOL”) carryforward of $319.2, of which $152.8 can be carried forward through 2029 and $166.4 can be carried forward through 2030, state apportioned NOL carryforwards of $321.2, which can be carried forward from 1 to 20 years depending on the taxing jurisdiction, and a federal gross capital loss carryforward of $53.6, which can be carried forward through 2012. We also have gross foreign tax NOL carryforwards from continuing operations in Puerto Rico totaling $9.5 as of January 29, 2011, $7.3 as of January 30, 2010, and $6.8 as of January 31, 2009, which have a carryforward period of 7 years. We have recorded a full valuation allowance against the tax effect of both our domestic and foreign carryforwards and net deferred tax assets, as it is more-likely-than-not that a future benefit from these assets will not be realized.”

Thus, Borders’ NOLs are worth $305 million to a profitable business going forward, but listed as only $25.8 million on the balance sheet - making them very important when analyzing the solvency of the company in an upside scenario. Additionally, Borders has racked up another $184.8 million in NOLs in February, March, and April, according to monthly operating reports. Assuming a 35% tax rate, this adds another 64.7M to the company's potential tax assets. Therefore, in the case that Borders does not liquidate, the company has an asset worth $343.9M that is currently not being seen on the balance sheet. This number is important, because as of the end of April, Borders showed total assets of $736.7 million and liabilities of $1,075.1 million, presenting them as insolvent by $338.4 million. However, if you believe in the successful scenario for Borders, the company is actually solvent by $5.5M. That being said, Borders still has not realized all of its losses coming from breaking leases, but these can be easily calculated.

Bankruptcy law lets retailers break leases with minimal punitive effect. In order to help more retail outlets survive the law allows retailers to reject existing leases while paying only the maximum of 1-year's rent or 15% of the obligation remaining on the lease. In 2010, Borders’ rental expenses were $287 million. As of the end of January, Borders operated 489 superstores (24,500 sq ft), 126 small format stores (~3,600 sq ft) and 27 borders-branded airport stores. With rent at roughly $22.90 per square foot, and the company intending to close 226 superstores, a likely financial cost (conservatively) assuming an average lease has 10 years remaining (vs a reported average 7.4 years for all stores) of $190.2 million would be taken immediately. [This calculation can be sanity checked by taking the $988 million of future minimum lease payments provided in the 10-K for 2010 (page 61) on rejected leases and taking the 15% of those obligations to yield a total cost of $148 million]. Already, in my estimation, monthly operating reports suggest that Borders has already taken around $90 million of costs for writing down leases (this is not broken out and is a guess). Assuming Borders needs to take another $100 million of costs to break leases, in the upside scenario (where the company is profitable), this would be discounted at 1 minus the corporate tax rate, netting $65 million from the balance sheet.

In this hopeful case, where Borders emerges successfully with equity holders intact or the company is acquired, the balance sheet would show an equity value of -$60 million.

So, in this case, what is the company worth as a going concern now that it has only profitable stores remaining and has been able to negotiate additional concessions for these stores? In a very simplistic analysis, in April, Borders Group stated that it expects $1.5 billion in revenues upon emergence from bankruptcy. As the company cherry picked the most profitable stores to provide these sales going forward it seems reasonable to assume after-tax profit margins of 3% (ignoring NOL benefits, which have already been included in the balance sheet calculation) – in line with grocery store type retailers selling commodity goods. This may be conservative as it is sensible to believe that a superstore concept with better terms from landlords and publishers could yield a better margin than a grocery store. However, in staying conservative, a below market multiple of 10x earnings would result in a value of $450 million.

In a simplistic scenario, assume that new capital is injected in the form of debt to make creditors whole and the company is purchased out of bankruptcy for $450 million. In such a purchase, equity holders would receive $390 million. As of April 15th, 2011, Borders had 72.0 million shares outstanding. Additionally, Pershing Square held 25.9 million options at a strike of $0.65/share and Bennett LeBow has 11.1 million at strike of $2.25/share. This yields a share price of $3.96 which can be calculated by taking equity value plus proceeds from the exercise of LeBow’s options plus proceeds from the exercise of Ackman’s options all divided by the fully diluted share count [($390+$25+$16.9)/109.1]. That’s a 1786% return and an even higher IRR considering the speed at which this outcome may occur.

The above optimistic scenario also does not include the value to be realized in the synergies and competitive advantage gains from a merger with Barnes and Noble. Simply, too many superstore bookstores exist. For both Borders and/or Barnes & Noble to survive longer term they need to dramatically reduce store count, reduce pricing pressure, and move away from a books only store. They need to merge. Borders’ bankruptcy has helped accomplish exactly this. Following a reemergence and merger with B&N, a superstore concept could work and be competitive while realizing all of the many synergies and reducing the enormous cash strain from developing independent e-reader technologies.

The immediate catalyst for a B&N and Borders combination comes from John Malone’s Liberty Media Holdings purchase of B&N. This deal appears likely to get done as Liberty’s purchase of Barnes and Noble resembles a management buyout deal (MBO) as Len Riggio will retain a 30% equity stake in B&N after the deal’s completion. Furthermore, the deal would allow Ron Burkle’s Yucaipa an opportunity to cash out of his 19% stake following his unsuccessful efforts to overturn B&N’s poison pill and resulting public cry for B&N to sell itself.

The acquisition of B&N by Liberty Media seems opportunistic from a financial perspective but lacks major synergies from its disparate business lines. For B&N, Liberty offers deep pockets and alleviates cash flow concerns for continuing to invest in its NOOK e-reader. However, Liberty could pick up more assets cheaply and also realize substantial synergies and eliminate B&N’s major competitor by wrapping it with Borders Group. In such a scenario, Borders would offer John Malone and Len Riggio a cheap way to acquire an additional 263 profitable superstores that now have more flexible terms. Plus Malone and Riggio get another 153 profitable small format stores with short term leases of only 1 to 1.5 years.

Additionally, Liberty is unlikely to overlook the substantial NOLs Borders offers. John Malone is familiar with realizing the value of tax assets as demonstrated by his long acquisition history and has undoubtedly considered wrapping Borders into this acquisition of B&N. A merger with rival Barnes and Noble would offer the most value to all parties and therefore should garner a significantly higher price than suggested by analysis of Borders as a stand-alone going forward (as presented above). Liberty also has plenty of firing power left. It is only putting in $500M in cash for the deal to acquire B&N for $1 billion as Len Riggio puts in $300M of equity, and Liberty will finance the deal with $200M in additional debt.

Finally, a lot of the reorganization work is already behind Borders. Unprofitable leases have already been rejected and much progress has been made renegotiating the terms of the remaining leases. Borders is ostensibly just waiting on the publishers to sign on to its plan of reorganization, returning it to normal trading terms. However, a merger now with Liberty Media’s B&N would supersede this and the publishers would be forced to fall in line given the power of the consolidated entity.

How things will unfold remains quite uncertain, but the option of the payoff is so extreme that it is worth a bet even if one thinks there is only a remote chance that an optimal scenario occurs. I do believe that the expected value of a purchase of shares of BGPIQ.PK at $0.21 here is very much positive.

A bonus: An unseen, but real, value to Pershing Square. In addition to the obvious payoff related to Pershing’s Borders holdings, there is a less obvious reputational benefit to salvaging Borders’ equity value. Pershing Square has had control over Borders as an activist and has wiped out shareholder value. If equity holders can regain even a modicum of past value, the question must be asked: What is a semi-success story worth for a $10 billion activist hedge fund that relies on other shareholders and managements to follow its lead and advice. Given that the fund in question charges 2/20 (2% of assets and 20% profits), I’d guess it’s a BIG number, and this value accrues to Pershing Square directly (versus its investors). In other words, Bill Ackman has much more at stake in reputational capital than dollars and, therefore, is more motivated to find a successful solution than a quick glance at his financial investment would suggest. Ackman himself has described Borders as his “worst investment” (although Target (NYSE:TGT) options in Pershing Square IV (PSIV) lost investors far more money), and I think he really wants to make good. He did offer a billion dollars in debt to finance a B&N transaction in late 2010. Why not take a few hundred million in senior debt to make all creditors whole and keep the equity intact?

Disclosure: I am long OTC:BGPIQ.

Source: Borders: Interesting Risk/Return for the Optimist