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Booksellers Need to Find a New Story

Marc Lichtenfeld

When investing, it often makes sense to be a contrarian and go against the crowd. But sometimes the crowd is right.

Such is the case with the big book chains Borders Group (BGP Quote) and Barnes & Noble(BKS Quote), which each reported weaker-than-expected fourth-quarter results Thursday.

Just three of nine analysts rate Barnes & Noble a buy, while only one analyst likes Borders of the 10 who cover the company. Given the tough retail environment and few signs of improvement ahead, Wall Street's current cautious stance on the retailers is prudent.

Borders Looks to Turn the Page

Borders earned $1.61 a share in the fourth quarter, with $1.5 billion in revenue. The results missed analysts' estimates by 2 cents on the bottom line, though they were a tad above Wall Street's forecast on the top line. Same-store sales slid 2.2% at Borders Superstores for the fiscal year.

Borders' operating results, however, were overshadowed by the company's announcement of a plan to improve its performance.

The retail environment for books is extremely difficult. Book stores can only compete on price and customer experience. However, with the price competition from Amazon.com (AMZN Quote) and eBay (EBAY Quote), not to mention discounted tomes at Wal-Mart (WMT Quote), Target (TGT Quote) and Costco (COST Quote), books have become commoditized. Shoppers often look for the lowest price, rather than pledge loyalty to their favorite retailer.

In an attempt to bolster results amid these issues, Borders will close roughly 300 of its Waldenbooks stores, possibly sell much of its international business and build its own online presence.

Borders currently is partnered with Amazon. The new online business is expected to be close to break even in the first year and profitable by the second. Borders plans on launching it early next year.

The company hopes to increase earnings before interest and taxes margin to the 5% to 6% range by 2009 from the current 1.8%. Along with the new online venture, management expects to achieve this by focusing on the Borders Superstores.

Part of that effort will entail changing the corporate culture so that executives' compensation is tied more to their group's performance rather than that of the overall company. On Borders' earnings conference call, CEO George Jones discussed the need to do more basic "blocking and tackling" when it comes to merchandising and retailing and less remodeling of stores.

Borders is known for carrying more titles than most book retailers. The company hopes to turn inventory over more quickly by moving some of those slow-moving titles off the shelves, but still making them readily available through in-store technology, where customers will be able to order the books.

Whether these initiatives will work remains to be seen, but it appears at least that Borders is taking steps in the right direction. Barnes & Noble, on the other hand, seems to be doing very little to stop the bleeding.

Few Answers from Barnes & Noble

Barnes & Noble, the larger of the two chains, earned $1.84 a share in the fourth quarter, missing the consensus by 4 cents.

For the first quarter, the company forecast results ranging from a loss of a penny a share to profits of 5 cents, excluding charges. According to Thomson Financial, analysts currently expect earnings of 1 cent per share. Barnes & Noble also reiterated full-year guidance of $1.65 to $1.80 a share, excluding items.

Same-store sales fell 0.3% for the year and were down 1.1% at Barnes & Noble.com.

One of the few positives in the earnings report was an improvement in gross margin. However, on the conference call CEO Stephen Riggio acknowledged that a major factor in the higher gross margin was "historically low shrinkage" -- meaning less stuff got stolen. So not only are customers avoiding the stores, so are the thieves.

It will be tough to improve margins unless costs can be cut, as there is no pricing power in the industry. In fact, it's quite the opposite. Booksellers need to discount, especially to their best customers, to keep them active in their loyalty programs.

The performance of Barnes & Noble's Internet business is disappointing. Considering the company's leading brand name, it's surprising that Internet sales comprised only 9.6% of total sales and that same-store sales were down for the year.

On the call, Riggio said the U.S. Census Bureau stated that e-commerce was up 6% in 2006. Barnes & Noble's online business was up a little over 5%. Considering books are the perfect product to buy online (no need to feel it, try it on, see it, etc.), you'd like to see the company's dot-com business performing a lot better.

But what was especially disconcerting was that management had no answers. They blamed the results on a lack of titles that garnered media attention and on discounts to members in the loyalty program for the results.

On the asset side of the ledger, Riggio pointed to its leading brand and strong real estate. Those are true, but not enough to convince me anything is going to change for the better.

Close the Book

Both of these companies are profitable, produce cash flow and have impressive real estate holdings. Naturally, therefore, there has been much speculation regarding leveraged buyouts of either, both or perhaps a merger between the two. The CEOs of each company stated they had no intention of going private and planned to continue operating as a public company.

Of course, their denials mean nothing and considering that activist investor Bill Ackman of Pershing Square Capital owns a sizeable stake in both companies, it's quite possible that they will get sold. However, I don't think it's wise to buy or own stocks in the hopes that the companies get taken out, particularly when business is bad.

Since there are so many good stocks out there, it makes no sense to sit in these two dogs, waiting for a catalyst. I like Borders a slightly more than I like Barnes & Noble, simply because they are being proactive and trying to make some things happen. But that's like saying I like romance novels slightly more than pop-psych self-help books. I don't really want anything to do with either one.