bankruptcy of Borders Group: implications for Barnes & Noble (BKS)

Borders’ bankruptcy

Last week BGP filed for a reorganization under Chapter 11 of the Bankruptcy Code and announced it had subsequently received new financing from GE Capital.

This wasn’t a big surprise, given that BGP had been reported for some time to be withholding payments to book publishers and to its landlords in order to conserve cash.  What would it be “conserving” this cash for?   –to pay salaries and keep the lights on in the bookstores and warehouses, for one thing  It’s also possible that some of its suppliers had noted Borders’ deteriorating financial condition and were asking for cash payment before shipping new merchandise.

Chapter 7 vs. Chapter 11

Bankruptcy in the US generally comes in two flavors:

–Chapter 7, or liquidation, where the debtor is considered defunct.  In this case, the bankruptcy action consists in selling the assets and distributing proceeds to creditors.

–Chapter 11, or reorganization with the debtor remaining in control. The main thrust is to put the enterprise into position to have a second chance at success.  The firm continues to operate while it restructures.  It may terminate or renegotiate contracts, including leases, under the supervision/assistance of the bankruptcy judge.  Typically, common shareholders and trade creditors are wiped out completely.   Debtholders exchange their obligations for stock in the revamped company that emerges from from the bankruptcy proceeding.

To some extent, bankruptcy can become a self-fulfilling prophecy.  Suppliers typically study the finances of their customers carefully.  They may reduce–or even stop completely–shipments at the first whiff of trouble.  Or they may ask for cash upfront instead of extending credit.  And why not, since their receivables are most likely a total loss once a customer files for bankruptcy.  The result, however, is that the store in question may no longer have the best merchandise, or the former large variety, in stock  …which means more customers stop coming.

reports of the Borders plan

Reports in the blogosphere and in newspapers suggest that book publishers want Borders to shrink its floorspace by about a third in its reorganization.

positive news for BKS?

The stock did go up about 10% last week, as the rumors of an imminent Chapter 11 filing by Borders swirled. So someone must think this is a big plus for BKS..

My guess, however, is that the demise of the current Borders will do little good for BKS.  Three reasons:

1.  Borders will continue to operate, although in about a one-third smaller form.

2.  In a case that I think is very similar to Borders/Barnes&Noble today, in 2009 consumer electronics retailer Circuit City went into liquidation.  How fast are the revenues of rival Best Buy growing today, without competition from Circuit City?  In the US, they’re not growing much  at all.  In fact, on a comparable store basis, they’re actually declining.

How so?  Circuit City’s customers didn’t all flock to Best Buy.  As I see it, the chain’s demise accelerated the trend of consumer electronics sales to a newer technology, the internet, and to the big discounters like Wal-Mart.

In the bookstore instance, the biggest effect of Borders’ shrinkage in size may well be a speeding up in the adoption rate for e-readers.   My feeling is that most of the new business will go to Amazon, not Barnes and Noble, although thee may be some shifting of Barnes and Noble’s bricks-and-mortar customers to the Nook.

3.  Another, somewhat older–but still pertinent, I think–pattern of industry development comes from toy retailing.  As I interpret the data, every year in the first half of the Nineties big discounters like WMT and TGT took market share from Toys R Us.  But every year, Toys R Us took market share away from small independent toy retailers, so it was relatively unaffected by the loss of customers was experiencing.  But then, sometime in the mid-Nineties, there were no more small independents left for Toys R Us to take market share from.  Toys had killed all the ones who were going to die.  The competitive situation had therefore been reduced to Toys R Us vs. the big discounters.  From that point on, TRU was in trouble.

I think that we may be seeing the same mid-Nineties situation emerging in the book industry, with BKS playing the role of Toys R Us, Borders and small independent bookstores the part of the small toy retailers, and Amazon and WMT being the equivalent of WMT/TGT.  If Borders and the small booksellers (who appear to be enjoying a resurgence, by the way) have no more market share to give up, then the new competitive dynamic is between BKS and AMZN.  Of course, AAPL may take some market share as well.

Given that different e-reader systems are mutually incompatible, would you feel more comfortable buying one from a company with a market cap of $84 billion (AMZN) or $1 billion (BKS); with $8 billion in net cash (i.e., after repaying all debt) on the balance sheet (AMZN) or a comparable number we won’t know for sure until reporting time, but which is probably going to be only mildly positive (BKS).  In this case, I think size will count for a lot.