Borders in Need of Doctor
Watch List member Borders Group (BGP) revised its second-quarter earnings guidance to a loss of $0.28-$0.32 from the prior expectations of $0.10-0.20. According to their press release:
The updated guidance reflects non-operating charges, including a pre-tax charge of $2.7 million associated with the retirement of Chief Executive Officer Greg Josefowicz (see related news release issued today), and a pre-tax charge of $2.3 million related to the closure of a distribution facility, which was completed earlier than initially planned. As a result, non-operating adjustments, which were originally estimated to be an after-tax charge of $0.00 to $0.02 per share are now expected to be $0.06 to $0.07 per share. In addition to these non-operating charges, the company is also experiencing second quarter sales trends that are below expectations, which also contributed to management’s decision to revise second quarter earnings per share guidance.
Due to these trends, Borders Group also updated second quarter comparable store sales estimates, which include the cycling against the Harry Potter book from last year.
They knew there was no Harry Potter book this year, so that can hardly be trotted out now as an excuse for the incremental $0.10 earnings shortfall not accounted for by one-time charges.
Shares fell as low as $15.10 in after-hours trading, marking new 3+ year lows.
The company also announced that George Jones, 55, who headed Saks’ department store group before leaving in September, will replace Greg Josefowicz, who said in January he would retire within the next two years. While it looks like Jones will have his work cut out for him, by starting at such a low point it might not take much to get the shares moving in the right direction.
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We believe further operational difficulties at Borders will drive interest in a possible Barnes/Borders merger. Both stocks have underperformed thus far in 06, with Barnes down 18% and Border’s 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. Border’s 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. Barnes/Nobles’ operating margin picture (5-6%) is healthier, furthermore. Lastly, we believe 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 Border’s stock price continues to languish: BGP shareholders may have their day in the sun sooner than they think.