The number of people going to bookstores these days is rapidly diminishing. Apparently this statement needs to be repeated because as bad as things have gotten in the bookseller arena, whispers of a potential merger between long-time rivals Barnes & Noble (BKS) and Borders Group (BGP) continue to grow louder.
Technological advancements first allowed for people to buy physical books on line and have them shipped to their homes. It was Amazon.com (AMZN) that originally cashed in on this market. Then, the birth of the e-book made it possible for individuals to buy an e-reader and download the book on to their “device”. Amazon was again a leader in this wave with its offering, the Kindle. Barnes and Borders both acknowledged this burgeoning business proposition, but initially stuck to their guns and remained in full brick-and-mortar mode. Yes, there will always be traditionalists who go to book stores, but more and more consumers are heading to the Internet to meet their purchasing needs. Moreover, teenagers and children being raised today have wholly bought into the new devices and society is unlikely to regress back to the “good old days”.
Most recently, Barnes has put itself up for sale and Borders filed for Chapter 11 bankruptcy protection. Originally, Borders had planned to avoid such a move and put its hand out to lenders to avoid a cash shortfall this year. Its prayers were answered when General Electric’s (GE - Free General Electric Stock Report) finance arm, GE Capital, came through with just over $500 million in financing that should allow Borders Group to maintain its operations through the court proceedings. Bankruptcy became the company’s only option after it was unable to persuade publishers from accepting interest-bearing debt instruments in exchange for current payments owed. Borders stopped paying its publishers late in 2010, and it has continued to withhold these funds in the early stages of this year.
Previously, one of Borders’ largest shareholders, William Ackman’s Pershing Square Capital Management, offered to pony up nearly $1 billion for a merger between the two struggling bookstores, however, Wall Street greeted this move with much disdain because of how much the companies’ store bases overlap. The general sentiment was that Barnes & Noble could just sit back and let Borders Group be the first to slide into bankruptcy. Then, Barnes could pick up whatever real estate assets it deemed worthwhile in a chapter 11 selloff. Still, some think a marriage of the two is a grand idea. We simply do not see the logic. Apparently, with Borders now indeed in the midst of bankruptcy, Mr. Ackman is still hoping for merger talks to pick up once a few hundred underperforming stores are shuttered and the company’s financial position improves somewhat.
The bottom line is that selling physical books is a shrinking business. And unfortunately, it is this vehicle that makes up the lion’s share of these two companies’ revenues. This point is highlighted by the fact that e-books sales are projected to triple within five years. This statistic bodes ill for both entities since, combined, they operate more than 1,200 facilities, with Barnes having over 700 and the other 500-plus properties belonging to Borders. Together, the chains account for 25% of the physical books sold in the United States. This asset-heavy model is a major disadvantage in a digital age.
The store bases are simply way too high. To its credit, Borders seems to be cognizant of this fact. Recently, its Waldenbooks chain was rapidly shuttered and underperforming store closings have increased in number over the last few quarters. Now that this entity is in Chapter 11, the pace of shutdowns may well pick up further, as the company will have more freedom in walking away from leases. We fear such moves will prove too little and too late when the dust is settled in the bookstore arena. Barnes & Noble, on the other hand, has been less aggressive in reducing its store base. We find management’s insistence on operating such a high number of branches to be particularly troubling.
Currently, Barnes & Noble is on much better footing than its primary rival. It jumped into the e-book and e-reader market ahead of Borders, who, for whatever reason, was bent on improving the in-store experience as the rest of the industry underwent this digital revolution. Barnes’ e-reader offering the Nook, posted adequate penetration numbers when it arrived on the scene, but did not approach the sales put up by Amazon’s Kindle. However, the newest color version of this device has some substantial upgrades that are catching the attention of the general public. Obviously, color makes the product more enjoyable for readers of newspapers, magazines, and books to use. Moreover, its ability to surf the web and listen to music put it more in line (though still staggeringly inferior) to the tablet computer that is currently flexing its muscle in this space, Apple’s (AAPL) iPad.
It is our view that neither of these bookstores, or Amazon for that matter, have the technological wherewithal to keep up with Apple, and it will be the iPad and similar tablet computers that cannibalize the majority of market share over the next couple of years. Techies only knock on the iPad is that the original version does not have a USB port. Industry message boards have been buzzing for some time though that this flaw will be remedied when the updated model is rolled out this spring. In sum, even in areas where it appears Barnes is making strides, in all likelihood its improved fortunes will not last, as it runs headfirst into tech behemoths like Apple.
With that said, we think a potential merger of Barnes and Borders is not a sound idea. The companies problems are very similar and the overlaps way too widespread to lead to significant improvements in a combined entity, in our opinion. Too, the deterioration of their primary market, coupled with the inability to compete with rivals on a technological front, would still render the post-merger company extremely vulnerable.
Borders Group has filed for bankruptcy, and rumors are swirling that up to five potential suitors for Barnes & Noble currently exist. We believe that each company should pen its future on an individual basis. And regardless of the near-term decisions, we are not certain both novels will have happy endings.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.