The Book Burning Begins

Both Borders Group (NYSE: BGP  ) and Barnes & Noble (NYSE: BKS  ) have reported fourth-quarter results, but the reality that both have competitive challenges is overshadowed by the fact that Borders disclosed an alarming near miss.

Here are some highlights (or maybe lowlights is a better description):

  • Borders has embarked on a "review of strategic alternatives," so it's considering a sale, or at least selling pieces of itself. (Of course, some kind of merger or buyout has long been rumored as a possibility for Borders, so this wasn't really the surprising part.)
  • Borders is suspending its dividend to preserve capital for its ongoing plans. (Given its problems with profitability and free cash flow generation, did it ever make that much sense to have one?)
  • The bookseller secured a $42.5 million financing commitment from major shareholder Pershing Square Capital Management. In addition, there's a "backstop purchase commitment" that could require Pershing Square to buy some or all of Borders' international businesses for $125 million. Plus, the company issued $14.7 million of warrants through which Pershing Square can purchase Borders' stock at $7 per share over the next seven and a half years.

Borders said that given the current credit environment, financing was looking "prohibitively expensive or entirely unavailable," and had it not been able to get the loan, it may have faced liquidity issues within the next couple of months. Um, yeah ... scary times, anyone?

An industry under fire
Even before the current economic firestorm, Borders and Barnes & Noble had their work cut out for them. Peddling books is a tough business, relying on a relatively small number of best-sellers to grow sales (and competitive forces have forced a lot of margin-killing discounts).

Think about all the other places bookworms can get their fix. While shopping for household necessities, for instance, at Wal-Mart (NYSE: WMT  ) , Costco (Nasdaq: COST  ) , and Target (NYSE: TGT  ) , which offer books at discount prices.

Meanwhile, there's online retail powerhouse Amazon.com (Nasdaq: AMZN  ) . (Amazon is also trying to revolutionize the way books are consumed with its Kindle e-book reader.) Borders severed its agreement last year with Amazon for an online storefront, but whether its own online initiatives can compete adequately with Amazon is a very good question indeed.

Barnes & Noble hasn't had quite as difficult a time as Borders, although its fourth-quarter net income dipped 9.2% as the competitive climate led to lower margins. However, in contrast to Borders' tidings, Barnes & Noble was able to increase its dividend and said that it will be profitable in the first quarter, even though it's by no means indicating an easy year ahead. It's guiding for annual earnings about flat compared to 2007.

When debt's a drag
Granted, Borders managed a fourth-quarter profit, but it sounds as if its goal to attain a turnaround will be even slower (and many investors have already been waiting awhile). Furthermore, its debt-heavy balance sheet and the need to access additional capital for this year aren't comforting. Pershing negotiated a 12.5% interest rate on its capital infusion, but it has also given the bookseller until April 4 to find a better deal on financing. Still, with a times interest earned ratio of just 0.5 before the new debt, the company may have difficulties handling the additional liability regardless of the rate.

I think Borders' having dodged a bullet liquidity-wise underlines why it's Foolish to have a healthy skepticism for debt-laden companies. Shareholders still have good reason to question what the long term holds for this retailer.

My Foolish colleague Ryan Fuhrmann wrote an excellent article in 2006 called The Straight Dope on Debt, and I'm reminded of one quote in his analysis of the ins and outs of capital structure: "And if an extreme shock hits the economy or the financial ecosystem, debt can quickly cause a company to go the way of the dinosaur."

Tough times, of course, make for great investing opportunities as quality stocks get knocked down to bargain levels. But situations like Borders' current plot twist offer important lessons for investors on why they should choose their stocks very carefully.

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