Borders' Big Markdown

Facing a cash shortage, the bookstore chain might put itself up for sale. Could rival Barnes & Noble snap it up from the remainder pile?
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Struggling bookstore chain Borders (BGP) may put itself up for sale, giving rival Barnes & Noble (BKS) a chance to buy its main bricks-and-mortar competitor.

Borders executives, one year into a plan to turn around the bookseller, revealed on Mar. 20 they were considering selling all or part of the company after being hit hard by the tough retail environment and the difficult credit markets.

Running out of cash, Borders says it secured expensive financing from Pershing Square Capital Management, a major shareholder. It also suspended its dividend and reported mediocre quarterly earnings on Mar. 20, the same day Barnes & Noble also posted results.

Barnes & Noble shares traded 8.1% higher on Mar. 20 to close at 30.27. Borders shares hit a 52-week low below $4 per share at one point on Mar. 20 before ending the day at 5.07, down 29%. That gave Borders a total stock market value of $298 million.

Though some analysts expressed doubts about a Barnes & Noble purchase of Borders -- which would need the approval of anti-trust regulators -- Barnes & Noble executives told analysts they were open to the idea.

Borders has hired JPMorgan (JPM) and Merrill Lynch (MER) to look into a possible sale.

"We haven't been approached by Borders' investment bankers," Barnes & Noble chief financial executive Joseph Lombardi told analysts Mar. 20. "If we are, we'll certainly take a close look at the company and put it under review."

Barnes & Noble reported earnings of $1.79 per share, vs. $1.83 a year ago as revenue rose 1.7%. The firm raised its quarterly dividend from 15 to 25 cents per share.

Those results looked good compared to the shaky conditions at Borders.

The book-selling business is already ferociously competitive, with Internet retailer (AMZN) giving both chains a tough battle. But Borders president and chief executive George L. Jones says sales figures looked good until December, when many other retailers also reported a significant drop-off in consumer spending. "It's like a faucet [was] cut off," Jones told analysts.

Borders posted earnings of $1.44 per share, vs. $1.45 per share, and sales rose 2.8%. But the main concern is over Borders' future.

While the company was already heavily in debt when Jones took over in 2006, he says flagging sales raised worries about Border's cash flow this year. "We have too much debt," Jones said. That "is an even bigger problem in the kind of environment we have."

The difficult credit markets have made Borders' situation worse.

The chain had planned to sell its profitable Australia and New Zealand stores, but Borders execs say one deal fell through due to the credit crunch, which has made it difficult for private equity buyers to arrange financing for leverage buyouts.

Hit by a possible cash shortage, Borders went out to get financing of its own but found "one of the most challenging financing environments that I've ever experienced," chief financial officer Edward W. Wilhelm said.

Pershing Square will lend Borders $42.5 million through next January at an interest rate of 12.5%, expensive terms that, Wilhelm said, were nonetheless the best Borders could find.

Jones touted the virtues of the Pershing deal. "It allows us to have the time and flexibility to explore the options," Jones said.

Because of the credit crunch, private equity buyers might have difficulty making an offer for Borders.

Goldman Sachs (GS) analyst Matthew J. Fassler said Barnes & Noble is the "most likely strategic buyer."

A combination would unite the world's largest seller of books and other media, Barnes & Noble, with its second largest, Borders. Barnes & Nobles also owns the B. Dalton chain, while Borders owns Waldenbooks.

Credit Suisse (CS) analyst Gary Balter praises Jones' efforts to turn around Borders, saying the chain "finally found a CEO that can improve merchandising." But the fierce competition in the book-selling business has left Jones little breathing room.

"The book stores seem to be in the midst of an escalating price war," Balter wrote, "with Barnes in particular seemingly intent to hurt its own [profit] margins to keep Borders' [profits] down and maintain its [market] share."

Borders' "financial distress" lowers the threat that antitrust regulators will try to block a Barnes & Noble acquisition because it would unfairly restrict competition, Fassler wrote Mar. 20. However, Barnes & Noble would benefit most if it were to buy Borders while it was in bankruptcy, he added. That way, Borders could more easily break long-term leases on stores, enabling Barnes & Noble to close down locations that compete with its own stores nearby.

The sharp drop in Borders shares may reflect pessimism about an acquisition. "We see little opportunity in the near term for Borders to be sold," Balter wrote.

Hope for Borders might be found in Jones' turnaround initiatives, which include a new effort to sell books online. But the success of those ventures will depend on whether consumers keep buying books. With the price of gas up 30% in the past year, that's an open question.

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