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Borders’ Sickly Stock Price Shows – Why LBOs May Be Retailers’ Next Fad

By Katherine Hobson, Staff Reporter

What does a retailer like Borders have to do to catch a break on Wall Street these days?

Delivering good earnings growth won’t cut the mustard. Neither will steady revenue gains. Nor will setting up the all-important Internet unit. For all its efforts in those areas, Borders stock trades at about 15, just about 11 times next year’s earnings and 60% off its 1998 high. Borders threw up its hands last week, saying it hired Merrill Lynch to explore those ever-popular “strategic alternatives,” including a leveraged buyout. And if Borders goes the LBO route, it’s not likely to be alone among retailers, say observers. Cash Is King

“It’s highly possible,” says Amy Ryan, a retail analyst with Prudential Securities. “Some of these companies are at historically low levels, and they have the cash flow to support it.”

Wall Street hasn’t been the happiest place on earth for retailers lately. In part, it’s because investors have yanked their money from steady-as-she-goes sectors like banking and consumer products and poured it into the sexier tech and Internet companies. That’s left retailers feeling a lot like Bill Bradley, sitting on the sidelines watching John McCain reap all the media love.

Also weighing on retail stocks: Internet companies have been perceived as a massive threat to bricks-and-mortar players, particularly ones selling commodity products like books and CDs. “There’s a perception that online players are taking share,” says Derek Leckow, an analyst at Barrington Research who rates Borders a long-term buy, his second-highest rating. (His firm hasn’t done banking for Borders).

While Amazon.com is certainly becoming the bookseller of choice for a lot of people, Borders still managed to eke out $2.6 billion in sales last year, compared to Amazon’s $609 million. And this holiday season proved that even online, consumers like familiar brand names. Borders is still going to sell plenty of books and music. Investors are also scared that higher interest rates will eventually choke off consumer spending. And all this has combined to beat retailers to a pulp. The S&P Retail Index has fallen 18% so far this year. Even industry stars such as Wal-Mart have been hit. Battered stock makes for bad currency. It’s hard to make acquisitions and even harder to attract top executives without the lure of lucrative options.

The Power of Leverage

Under these circumstances, an LBO — that 1980s throwback — can sound pretty appealing. Freedom to spend for the long term. No more conference calls with analysts demanding guidance for the next quarter. No more watching the stock plummet if same-store sales miss by a percentage point. No more explaining your online strategy to some 12-year-old punk of an Internet analyst.

“You don’t have to open the kimono anymore,” says Paul Schaye, managing director at Chestnut Hill Partners, which advises LBO firms.

That’s why a lot of analysts expect Borders to seriously consider an LBO. “We think a leveraged recapitalization or buyout would be most likely,” wrote Danielle Fox, analyst with J.P. Morgan, in a research report Monday. (She rates Borders a market perform, and her firm hasn’t done recent underwriting for the company.) Borders wouldn’t comment further on its alternatives.

Moreover, others may follow Borders’ example. “We’re sure many out-of-favor retailers with good cash flows but not a lot of institutional interest in their stocks will be watching how Borders’ pursuit of strategic options unfolds, particularly Barnes & Noble,” wrote Fox. (A Barnes & Noble spokeswoman had no comment.) “There are a lot of undervalued, strong, sound companies out there,” says David Strasser, an analyst with Salomon Smith Barney. Some have already chosen the LBO route. TCBY Enterprises last month said it agreed to a $140 million buyout by Capricorn Investors III. Vestar Capital took apparel maker and retailer St. John’s Knits private last summer.

One money manager who wanted to remain anonymous says two of his holdings, Ames and ShopKo , could be LBOcandidates. “We didn’t buy these with the idea of them being takeouts, but at these levels, they make sense,” says the money manager. (Ames and ShopKo officials weren’t immediately available to comment.) Who’s in the Game

Most analysts declined to name other specific LBO candidates but said any beaten-up but profitable retailers with a solid business model, good cash flow and not a lot of debt may consider the option. Companies not relying on one season for all their sales are also more likely to consider an LBO, since their cash flow is spread out more evenly during the year. Management frustrated with languishing holdings may also be looking for an exit, so retailers with high insider ownership are more likely to choose an LBO.

The timing right now is also good for retail LBOs. “You never like to LBO into the Christmas season,” with the uncertainty surrounding all-important holiday sales, says Susan Jansen, an analyst in Lehman Brothers’ high-yield department.

To be sure, conditions aren’t entirely ideal for a LBO boom. The high-yield debt market — which is how LBOs are typically financed — isn’t as friendly these days. It will be more expensive to go private. “That’s a concern, but not a deal-stopper,” says Peter Wexler, an investment banker and managing director at Lehman Brothers. While the high-yield market isn’t great now, things change quickly in the debt world. And Wexler expects more deals to use bank debt or mezzanine financing, which is similar to high-yield debt but often involves equity. Still, things may not really pick up until the high-yield market improves.

There’s a big note of caution to all of this: Buying cheap stocks in the hopes that they’ll be bought out is never the safest investment strategy. And, as the raft of 1980s retail LBOs showed, it’s hard to take a company private, cut costs and still grow the business enough to please its new investors. But if Borders goes the LBO route and all ends well for it, current investors in some ailing but profitable retail stocks may finally get a tiny bit of relief this year. And the companies themselves get a much-needed respite from the Wall Street treadmill.