With shares of leading book retailers Borders (NYSE: BGP) and Barnes & Noble (NYSE: BKS) having tanked in recent months, some prominent investors are starting to wonder if there's value to be unlocked.

Pershing Square Capital Management, a very good activist hedge fund run by William Ackman, secured a spot on the Borders board of directors last week, and may seek to make changes.

But with sites like Amazon.com (NASDAQ: AMZN) and discounters like Wal-Mart (NYSE: WMT) offering books at a much better value than Borders can, the activists' traditional bag of tricks -- cost-cutting, buybacks, dividends, putting the company up for sale, etc -- may not be enough. For Borders, cost-cutting is the opposite of the solution. In order to remain relevant, the brick and mortar stores will have to provide a value-added experience to the consumer, and make it worth paying 30% more than you would on Amazon. Creating an environment like that costs money.

Running a small independent bookstore is a labor of love characterized by poor margins and cutthroat competition. The Wall Street Journal recently looked at one of the ways struggling retailers are looking to stay open (subscription required) -- essentially getting book-lovers to "invest" in the stores to keep them open, with the understanding that the investment is risk and has very little upside. Now that my friends is angel investing.

In the end, I think Ackman may be barking up the wrong tree. As Oren Teicher, the chief operating officer of the American Booksellers Association, told the Journal, "The margins are small, the competition is fierce, and you're selling a product that is the same no matter where you buy it."

Borders is already bleeding red ink and won't be able to differentiate itself without spending tons of money, probably exacerbating the problem. But in its current form, the company just can't make any money.

Bookseller Borders Group Inc. (NYSE: BGP) continues to bleed money even with the release of the latest Harry Potter volume. If anything, the losses, already substantial, are getting bigger. Despite the fact that consolidated sales as reported in 2Q 2007 results were up 10% to $945 million, the company still posted a net loss of $25 million, or $0.43 per share, a 25% bigger loss than Wall Street had anticipated. Things have gotten so bad that CEO George Jones remarked he was encouraged by flat sales at Waldenbooks. For the last 7 quarters, Waldenbooks' same-store sales have fallen.

Borders stores posted a total sales increase of 9.7%. Excluding Harry Potter, organic sales growth -- a misleading term in this instance -- was less than half of 1%. This is an expensive business model that is not working. In an effort to lure customers into stores, Harry Potter was sold at a large discount to match prices at discount chains. Administrative expenses increased a bit, but debt increased by almost $200 million, to $663 million. No wonder Borders is now negotiating to amend its credit agreement with its banks and considering the possibility of selling its Borders International segment, which still somehow posted a $10 million operating loss even while total sales increased 31% to $170 million.

Waldenbooks is in an even worse situation. Total sales declined 7.7% and operating losses were the same as one year ago, meaning the chain has made made no improvements to its bottom line situation. BGP shares began the year trading at $22.46, reached a high of $23.41 in late May and have been tanking ever since, closing at $14.66 on Thursday, down $0.28.

Book seller Barnes & Noble Inc. (NYSE: BKS) pulled a rabbit out of its own hat and posted diluted EPS of $0.26 in 2Q 2007 last week. But there is always a catch. $0.12 of those earnings derived from a tax benefit and $0.03 derived from lower than expected costs related to closing a huge distribution warehouse. Net earnings for the quarter were just over $18 million or $0.12 per share. Total sales increased 7.6% to $1.2 billion. In-store sales were up 4.4% while online sales were up 18%. Enjoy these increases while they last. Almost all of the good news is a result of the release of the last Harry Potter installment. Barnes & Noble sold just over 2 million copies of the title as of early August. Without Harry Potter, sales increased barely 1%.

Bricks and mortar book stores are a mature business. Possibilities for growth are very hard to come by. CEO Steve Riggio admits as much even while trying to sound upbeat about 3Q releases planned by former President Clinton, former Fed Chair Greenspan and musician Eric Clapton. No offense to these gentlemen, but Harry Potter they ain't. 3Q store sales are forecast to be flat with a loss per share of $0.06-$0.10. Barnes & Noble also posted losses in 1Q, so an increase in FY guidance to $1.69-$1.87 from $1.49-$1.67 is puzzling. Perhaps management is expecting a huge 4Q surge in book buying for the December holidays. Guess they missed the recent report stating 25% of adults surveyed in the U.S. read ZERO books the previous year.

The company is still buying back its shares, adding 500,000 repurchased shares in 2Q to the 750,000 shares repurchased in 1Q. Barnes & Noble has budgeted $400 million for stock buy backs. The stock is surprisingly volatile. It began the year trading at $40.29, hit $42.88 in May, but closed at $35.80 on 27 August. By all means, shop at Barnes & Noble, but spend investment dollars elsewhere.

Even with magic as strong as Harry Potter's, Publisher's Weekly reported today that bookstore sales continued to fall for the fifth consecutive month. According to the U.S. Census bureau, sales in May were down 4.3%, to $1.10 billion.

However, bookstore sales totaled $6.20 billion in the period between January and May. The retail segment in total saw sales up 5.6% in May, and were ahead 4.1% for the first five months of 2007.

How does that jibe with Harry Potter and the Deathly Hallows, the latest (and last) Potter tome selling an unprecedented nine million copies in the U.S. and Britain in its first 24 hours of release? Well it's all good, everyone agrees, compelling millions of kids to lay aside their Nintendo for the week and venture into bookstores. But as Sara Nelson, editor-in-chief of Publishers Weekly recently wrote, there are still some problems in the numbers.

"Take, for example, the retailers, big and small. The former have made the dubious choice to discount HPATDH so drastically that even they admit their revenue – on the most popular book in history! – will be down this year. The latter can't begin to compete with the economies of scale and some may bypass their distributors and buy direct – at nearly the same discount – from Amazon or Costco."

A piece on Bloomberg offers a similarly dark assessment, suggesting that Big-box retailers like Costco Wholesale Corp. (NASDAQ: COST) and Sam's Club (A division of Wal-Mart Stores, Inc. (NYSE: WMT) discount the book so deeply as to use it as more a customer draw then a revenue-booster. In the meantime, independent bookstores that can't afford to discount this most popular literary offering in history must resort to any tactic they can to draw customers in, including hosting Potter parties, and other community-building schemes.

I have another idea for keeping small booksellers and their particular brand of magic alive. Maybe every wealthy best-selling author (and Oprah, who's responsible for creating a few) could each sponsor an independent bookstore. Surely it's not too much to ask from someone who probably spent the better part of their youths perusing the musty stacks. Besides, what's J.K. Rowling got to do these days?

Gallery: Everybody loves Harry Potter

Shares of book retailer Borders Group Inc. (NYSE: BGP) traded down 4.72% today as the company reported less than stellar earnings. The company lost 61 cents per share, compared to 31 cents in the same quarter last year. Same-store sales at the flagship Borders superstores declined 1.9%.

As I wrote in March, I don't really understand the company's strategy. They slashed their customer rewards program, making their books even more overpriced compared to online bookstores like Amazon.com (NYSE: AMZN). That move has done little inspire customer loyalty, and it's actually hilarious going into a Borders stores and watching the hapless clerk try to explain to a confused customer how the new program really isn't that terrible -- even though it is:

I came in late on the Battle of the Brands and missed a chance to join in the fun, but I have been keeping my own list, for what it's worth:

Borders Group Inc. (NYSE: BGP) vs. Barnes & Noble, Inc. (NYSE: BKS) -- Borders. Better coffee, magazine selection, and easy chairs. If only they didn't waste so much store space on those bound-paper things; there are shelves and shelves of them getting in the way of the gift cards, games, and Will Ferrell DVDs.

Krispy Kreme Doughnuts (NYSE: KKD) vs. Dunkin' Donuts -- Krispy Kreme. Their trademark glazed ring is only 200 calories, while Dunkin' Donut's standard cake donut runs to 300. Stated in standard American consumption units, that would be 2,400 calories/dozen vs. 3,600.

Home Depot, Inc. (NYSE: HD) vs. Lowe's Companies, Inc. (NYSE: LOW) -- I choose Home Depot, for their attire. Every time I'm in a Lowe's, I find myself wondering why they can't wash their vests. Perhaps they should acquire Aramark.

Time Warner Inc.'s (NYSE: TWX) Time magazine vs. Washington Post Co.'s (NYSE: WPO) Newsweek -- Time. I found a couple of pages in the last issue of Newsweek where I actually had to read text. What's up with that?

Charmin, a product of Procter & Gamble (NYSE: PG), vs. Northern, a product of Koch Industries -- Charmin wipes out the competition. To paraphrase a CEO of BFI, their bottom line is my bottom line.

Jockeys vs. Boxers -- jockeys. They're holding a high pair.

Left turns vs. right -- Right. It's hard to hold the cell phone without spilling my coffee when turning left.

Babies vs. kittens -- They both start off cute, but evolve into creatures that lie around the house expecting to be pampered without bothering to show gratitude. A cat, however, won't expect you to send it to Yale, then blow off senior finals to go to the Burning Man Festival.

Baseball vs. waiting for a Twinkie to show signs of decay -- Baseball. They bring beer to you.