Goldman Takes A Closer Look at Borders

• Posted by ToddSullivan
• on June 8th, 2009

Goldman Sachs (GS) last week released the following note on Borders Group (BGP). Not sure many of you have notice but Borders has jumped from $2.50 to $4.50 in less than a week.

Price jump aside, what is even more promising is that their reasoning backs what we have been talking about here for the better part of 6-8 months now. Borders is heading in the right direction in a simply brutal environment….

In a group that has moved, BGP stands out as an underappreciated turnaround situation with significant potential upside off a low base. We are raising our 12-month price target sharply, to $4.50 from $2.00, reflecting BGP’s solid 1Q performance relative to expectations, strong short-term cash flow dynamics, and the more generous multiples being rewarded to levered turnaround stories in the early stages of economic recovery. The firm’s new management team is driving financial discipline, with significant cost controls, and implementing merchandising improvements, i.e. driving the children’s business, gradually exiting music and video, and reducing cycle times with vendors. BGP faces structural and financial risks, but there is a price for every security, and its riskadjusted upside has become increasingly appealing as the firm emerges from financial distress, and EBITDA looks poised to stabilize off 2008 troughs.

Implications
We are raising our 2010/2011 EPS estimates to ($0.16)/($0.08) from ($0.60)/($0.40), respectively, reflecting the 1Q beat, as the company delivered a loss of ($0.31) per share, vs. our ($0.49) and last year’s ($0.53), reflecting both gross margin and expense upside. We are flowing additional margin improvement through to the year, and expense control to 2Q & 3Q, noting that the firm does cycle substantial expense cuts at 4Q. We are also introducing a 2011 estimate of ($0.07).

Valuation
Our new $4.50 target, up from $2.00, is derived using risk/reward EV/EBITDA analysis. Note that the stock appears quite inexpensive on FCF yield, but that cash flows are not sustainable at these levels given the depressed state of cap-ex relative to D&A.

So what happens to Borders? My friend on twitter @Dasan thinks the paper book biz is headed the way of the CD via amazon (AMZN). I disgaree. While an increasing number of folks will get digital books, children’s books will never be digitized and books, unlike a CD are a hands-on experience for most folks.

That being said, Borders and Barnes & Noble (BKS) need to merge. While they cannot compete separately with Amazon’s Kindle, Border’s deal with Sony’s Reader can enable them to compete combined. Further, rather than competing with each other on price, the combined entity would see margin improvement in the physical stores & give them more bargaining strength with suppliers. Anit-trust issues are minor as Wal-Mart is a huge book retailer and the combined entity would still be dwarfed by Amazon. There is store overlap but working off that excess is less of a concern that the benefit they would see from a merger.

Let’s not forget that it was just last year that BKS looked at BGP but declined to make an offer. Let’s also not forget this was last year at a time when credit markets were collapsing and BGP’s turnaround was in doubt by many. Now that both of those issues are far less urgent, do not be surprised to see BKS take another look at its brick and mortar rival.

Pershing Square ans Bill Ackman have become a 40% shareholder.

Patience is required on this one. This is a hold because selling now, to try and buy back in later could cost you. I can easily see a scenario in which we wake up one day and either BKS or another private equity firm make an offer for the company.

Disclosure (“none” means no position):Long BGP

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