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Executives

William Lynch – Chief Executive Officer

Michael Huseby – Chief Financial Officer

Mitchell Klipper – Chief Executive Officer, Retail

Andy Milevoj – Vice President, Investor Relations

Analysts

Taylor LeBar (ph) – Stifel Nicolaus

Matthew Fassler – Goldman Sachs

Peter Wahlstrom – Morningstar Investment Research

Alan Rifkin – Barclays

John Tinker – Maxim Group

David Strasser – Janney Capital Markets

Marjorie Gochberg – Harvest Management

Rick Schottenfeld – Coyote Capital

Barnes & Noble Inc. (BKS) Q2 2013 Earnings Call November 29, 2012 10:00 AM ET

Operator

Good day ladies and gentlemen and welcome to the Barnes & Noble Second Quarter 2013 Earnings call. As a reminder, today’s call is being recorded. At this time, I would like to turn the call over to Mr. Andy Milevoj, Vice President of Investor Relations. Please go ahead, sir.

Andy Milevoj

Good morning and welcome to Barnes & Noble’s Fiscal 2013 Second Quarter Earnings conference call. Joining us today are our CEO, William Lynch; Mitch Klipper, CEO of retail; Michael Huseby, CFO; and Allen Lindstrom, Corporate Controller, as well as other members of our senior management team.

Before we begin, I would like to remind you that this call is covered by the Safe Harbor disclaimer contained in our press release and public documents and is the property of Barnes & Noble. It is not for rebroadcast or use by any other party without the prior written consent of Barnes & Noble.

During this call, we will be making forward-looking statements which are predictions, projections, or other statements about future events. These statements are based on current expectations and assumptions that are subject to risks and uncertainties, including those contained in our press release. The company disclaims any obligation to update any forward-looking statements that may be discussed during this call.

At this time, I’d like to turn the call over to William Lynch, CEO of Barnes & Noble.

William Lynch

Thank you, Andy. In Q2, our top line was essentially flat as compared to last year, while EBITDA increased 16% from a year ago to 65 million. We achieved these improved operating results while continuing to make the investments necessary to grow our digital content business in the consumer and education segments short, mid and long-term. Mike will get into the specifics of the Q2 financial performance in a moment, but I do want to address the important strategic advancements we made this quarter across the business. Most notably in Q2 and as we committed, we closed our Microsoft investment and completed the formation of our promising Nook Media subsidiary. This partnership with Microsoft brings a significant inflow of capital into the company while also providing access to millions of new customers for our Nook digital bookstore and Nook reading technologies.

Also in the quarter, we announced our two new breakthrough tablet products, the 7-inch Nook HD and 9-inch Nook HD Plus. As a result of our laser focus on providing our customers with the best reading and entertainment experience, you won’t find a better higher resolution display on a 7-inch device than Nook HD, and you won’t find a lighter, full HD tablet than Nook HD Plus. As we’ve stated publicly, preorders for these devices not only exceeded our expectations but were higher than any other Nook launch to date. Leading tech review site, Tech Crunch, called Nook HD the best reader you can buy, and New York Times reviewer, David Pogue said it trounces the competition, calling it fast, fluid and gorgeous. Nook HD and HD Plus began shipping after the close of our Q2; therefore, sales from the launch of those products will be reflected in the current fiscal third quarter and subsequent quarters.

Also in Q2, we signed deals with the major studios and content providers for the launch of our new Nook Video service, launched our Nook in the U.K. working with leading publishers and retailers there to offer our award-winning devices, and bringing our digital bookstore of over 2.5 million titles for sale to British customers. We also finalized our Nook for Windows application which in two short weeks became the highest rated reading and digital bookstore application in the Win8 store. Our new Nook app for Win8 is currently rated four out of five stars by Windows users with no other competing reading app receiving higher than a three-star rating.

All of these significant accomplishments by the team in Q2 – the close of the Microsoft partnership, launch of our two highly acclaimed new Nook HD products, launch of our Win8 app, introduction of our Nook U.K. bookstore, and launch of our Nook Video service – will help further fuel the growth of our digital content business in the future. In fact, we are maintaining our previous projection that the Nook business will scale in fiscal year 2013, reducing losses from last year as we continue to drive rapid digital content growth from these initiatives, maintain a healthy gross margin rate on content sales, and prudently manage expenses.

Turning to retail, we had a very strong quarter from a margin perspective, doubling our EBITDA from 14 million last year to 28 million this year. Our top line growth flattened, however, as we began to cycle the effect of the Borders store closings from Q2 of last year. The growth in EBITDA in the quarter came primarily from gross margin rate increases as our merchants have implemented effective product margin expansion strategies, and from capable and diligent expense management from our store operators and real estate team.

As we look towards our key holiday season at retail, our merchants and booksellers have done a tremendous job getting the stores ready for the tens of millions of gift-givers and families expected to visit a Barnes & Noble over the next few weeks. Our stores will be the only destination for customers to shop a large selection of printed media this holiday and we will offer the world’s best assortment of educational toys and games in our educational toy and game shops. Also, our newly expanded gift departments will have great affordable gifts that we expect will help grow our share of wallet with customers in non-book categories.

Lastly, at Barnes & Noble College Q2 sales, which included our big back-to-school rush period, were essentially flat as compared to last year. The business generated 88 million in EBITDA, a slight decrease versus last year due to a larger mix of textbook rentals leading to higher revenue deferral into future quarters. We are pleased the textbook rental business is the fastest growing part of the business and becoming a bigger part of the mix as we make more absolute margin dollars on rental than any other textbook format we offer, including new textbook sales.

Strategically, what we are seeing in the college business is an increase in the pipeline of RFPs from schools looking to outsource their physical and online campus bookstores. These schools see the growth in textbook rentals and recognize the pending growth of digital content, and are unable or unwilling to invest in managing the distribution of course materials in these formats themselves. Combining our physical on-campus bookstore capabilities with the technology platform in Nook Study, we are building for the management, merchandising and distribution of digital content. This gives Barnes & Noble College a one-stop suite of retail and digital services for schools and students, which is a valuable competitive advantage. As a result of this, we are forecasting account growth at Barnes & Noble College this year to be the highest we’ve seen in 10 years. Said differently, we will add more new schools into the college business than we have in a decade.

In closing, we are pleased with the improvement in our year-on-year financial performance in Q2 and in particular growing EBITDA 16% versus last year to $65 million. As we had committed, we closed the transformative Microsoft transaction in Q2, formed Nook Media, and launched a host of new digital initiatives, including two best-in-class entertainment tablets in Nook HD and HD Plus. As we execute Q3, very early holiday results are encouraging. Over the four-day Black Friday period, the unofficial start of the holiday season, we doubled our Nook unit sales versus last year driven in large part by additional promotional support stemming from our expanded relationships with Wal-Mart and Target. Our retail comps over the Black Friday weekend were in line with expectations. As we get into the peak holiday season, we look forward to servicing our millions of wonderful customers in our stores with the best gift shopping experience we’ve ever offered and encourage everyone to come in for a demonstration of Nook HD and HD Plus, the best products ever designed for reading and entertainment.

Now I’d like to turn the call over to Michael Huseby, our CFO, for more detailed financial commentary on our Q2.

Michael Huseby

Thank you, William, and good morning everyone. This morning before the market opened, we released our second quarter results for fiscal 2013, which ended on October 27. Consolidated sales were $1.9 billion for the quarter, a decrease of 0.4% as compared to the prior year. Retail sales, which include results for Barnes & Noble’s retail bookstore business and BN.com business, decreased 3% for the quarter to $996 million as flat comparable store sales were offset by store closures and lower online sales. The reversal in comp trends as compared to recent quarters was expected because the company began to cycle against the favorable impact of last year’s liquidation of the Borders bookstores.

Retail core comparable store sales, which exclude sales of Nook products, increased 1.8% over the last year during the quarter, led by comparable physical book sales which increased 1.2% and sales of toys and games, which increased 32%. Sales of Nook products in our bookstores declined during the quarter, resulting from a decline in both average selling price and units.

Second quarter college sales, which include the fall back-to-school rush season, increased 0.4% to $773 million, due primarily to new store growth. On a comparable basis, college sales decreased 0.5%. Sales were impacted by the continued growth and higher mix of textbook rentals. These rentals are lower priced than new or used books and a portion of rental revenues, as William mentioned, are deferred and recognized over the rental period.

Second quarter Nook sales, which include sales of devices, digital content and accessories, were $160 million for the quarter, increasing 6% as compared to last year. Second quarter digital content sales increased 38% over last year. Content revenue includes sales of digital books, digital newsstand, and our apps business. Conversely, device sales declined during the quarter primarily due to lower average selling prices which were approximately 18% lower than a year ago.

Consolidated gross margin increased 60 basis points for the quarter. Retail gross margin continued to benefit from a positive mix shift towards higher margin core products. College gross margin of 21.8% was flat with the year ago while gross margin for Nook increased 240 basis points to 16.4% for the quarter, as the company benefited from the increased mix of higher margin content sales somewhat offset by higher occupancy costs on increased office space in Palo Alto.

Selling and administrative expenses were flat both in dollars and rate as compared to a year ago. Retail’s SG&A rate improved 30 basis points as a result of the reversal of $4.7 million of accrued legal costs recorded in fiscal 2012 resulting from the final settlement of litigation on the company’s 2009 acquisition of Barnes & Noble College. College expenses increased over last year due to new store openings and continued investments in digital education. College expenses outpaced margins given the timing and higher volume of textbook rental revenue, which is deferred and amortized over future period. Nook expenses increased primarily to support the company’s digital expansion plans.

Interest expense was $8.1 million for the quarter as compared to $8.5 million a year ago. The company increased EBITDA by 16% to $65 million this quarter as compared to 56 million a year ago as a result of the factors just highlighted.

Consolidated second quarter net earnings attributable to Barnes & Noble improved to $2.2 million as compared to a loss of 6.6 million a year ago. Second quarter net losses attributable to Barnes & Noble were $0.04 per share, which includes the impact of the redeemable preferred shares as compared to a loss of $0.17 per share in the prior year. At quarter-end, the company had $471 million in cash and borrowings of $338 million against it’s credit facility.

On October 4, the company announced the completion of its strategic partnership with Microsoft, which invested $300 million in Nook Media LLC for an approximate 17.6% stake. The investment is classified as temporary equity in the mezzanine section of the balance sheet net of investment fees of $8 million. 17.6% of Nook Media’s earnings or loss is reflected in the income statement as a non-controlling interest.

As part of the commercial agreement, Microsoft is making certain advance payments to Nook Media, which will be accounted for as a financing arrangement. The cash flows from the Microsoft agreement benefit Nook Media from the outset as we’ve previously disclosed and discussed. The accounting treatment defers the income statement benefit of such advances commensurate with revenue performance. Revenues will be recognized under the partnership as earned.

Turning back to the quarter, consolidated CAPEX for the second quarter were $41 million. In the second quarter, we did not open or close any retail bookstores. College opened 11 new stores and closed four.

Our outlook for fiscal 2013 remains unchanged. We continue to expect retail comparable bookstore sales to decline on a percentage basis in the low to mid-single digits, college comparable store sales to be flat, and at Nook we expect EBITDA losses to decrease in fiscal 2013.

With that, we will open the call for questions. Operator, please provide instructions for those interested in asking a question.

Question and Answer Session

Operator

Thank you. [Operator instructions]

Our first question today comes from David Schick with Stifel Nicolaus.

Taylor LeBar – Stifel Nicolaus

Hi, thanks. This is actually Taylor LeBar on for Dave. I guess my question is when you look at Nook device sales, how can we think about the breakdown between sales to consumers who are upgrading or replacing an older device versus those who are adding maybe a second device, a tablet in addition to an e-ink reader, versus those who are just totally new to the platform? I guess another way to think about it would be device growth relative to account growth.

William Lynch

Thanks, Taylor. This is William Lynch. First of all, let me just make it clear that in the quarter Nook unit sales actually increased, so while Mike obviously was accurate in saying that they decreased at retail, what we’re seeing a share shift as we broaden distribution, and what we’ve seen is our third-party retail partners get really behind Nook units and Nook brand with expanded merchandising and footprints in their stores, so especially Wal-Mart and Target. So Nook units sales increased.

In terms of account growth, it’s the right question. The way we look at it is opening digital lockers and getting people in our ecosystem. The large, large majority of the digital content, new digital content users we added were new, meaning they weren’t upgraders; and what we’re seeing that as we expand distribution, as apps and non-device acquisition becomes a bigger part of the overall business and we’re less reliant, although the retail business—our store business is still a big part of our device sales, while we’re less reliant on that we’re seeing new account growth rather than upgraders as the lion’s share of the new device sales, and new users.

Taylor LeBar – Stifel Nicolaus

Great, thanks.

Operator

Again ladies and gentlemen, that is star, one for questions. We’ll hear next from Matthew Fassler with Goldman Sachs.

Matthew Fassler – Goldman Sachs

Thanks a lot, and good morning to you. First question – you indicated, I guess it was Michael, that the Microsoft payments were initially going to be considered finance arrangements and then recognized as income based on revenue. What revenue stream is going to determine the treatment of those payments and the recognition of income?

Michael Huseby

Well first off, I just want to say we’re happy that we got the economics and strategic relationship fostered by the Microsoft relationship, have closed it, and are starting to realize the benefits – initial payments have been received, other than the $300 million that was invested.

In terms of the accounting, the advance payments, the payments that we’ve described as $60 million advance payments for revenue share and $25 million to help support operations, are flowing through P&L over the five-year term of the agreement. The agreement—this is happening because all the agreements we entered into with Microsoft back in April and that we closed in October are viewed as a single arrangement; so the three primary elements of the commercial agreement, which are the revenue share advances, the operating cost advances, and then the revenue share payments that we make to Microsoft, are viewed as a single multiple-element arrangement and because of that, the advance payments are recorded as a liability when they are received and then the revenue share we pay to Microsoft over the term of the arrangement will be considered a repayment of the liability and broken down between retiring the liability and interest expense.

So the benefits to the P&L increase as the revenue from content sales, digital content sales ramps up over the term of the arrangement.

Matthew Fassler – Goldman Sachs

And is that, Michael, digital content sales across specific platforms that relate to Microsoft, for example, their tablets—

Michael Huseby

Yeah, the virtual agreement—yes—I’m sorry, go ahead.

Matthew Fassler – Goldman Sachs

Or just goes through the Windows 8 app, for instance.

Michael Huseby

Yeah, through the Windows 8 app, and also there are certain other within the Microsoft arrangement – for example, Windows Phone and other devices – that are Win8 devices, devices on which Win8 runs that Microsoft and we have agreed to in the agreements are the revenue sources.

Matthew Fassler – Goldman Sachs

Got it. That’s helpful. Second question for William, or I guess anyone else, just kind of a high level question on the interaction of the Nook business and the college business. Can you talk to us about how the stores, if at all, are enabling you to kind of achieve a franchise situation with universities as relates to their professors or their classes with digital content. Obviously you have the physical presence, and how are you actually using that to ensure that you have a prominent digital presence on campus?

William Lynch

Thanks Matt, this is William. First of all, digital education, the shift to digital from analog content in higher ed and digital education is just starting to happen, so there should be a recognition that we think we’re three years behind what we saw in the trade side. Having said that, our (inaudible) suggest we’re going to see digital education content growth over the next five years something approximating 50%.

So the way we’re going to approach that is we’ve made no secret we’re investing, starting to invest in the digital education platform and have been investing, and we’re going to use the 620-some odd schools and our relationships with schools and faculty to run pilots, as we have been doing, for the distribution of digital education materials. We service close to 5 million students in those schools. We have relationships with faculty and administrators, and so what we’re doing is – and rather quietly – trying to hone that platform and you’ll see us making some announcements in the future.

So at schools like Columbia, Penn, Harvard, Michigan – those are all Barnes & Noble College bookstores where we have those relationships, and so what we’re trying to do is get the product right and make some strategic moves to position us well as that market emerges again behind consumer trade.

Matthew Fassler – Goldman Sachs

Got it. And then one more question before I give the mic to someone else – the growth in digital content seems to be moderating, certainly for you – 38% is a very good number, you were 46% last quarter. The numbers for the marketplace are sort of tough to get to, but they also seem to be moderating a bit. What’s your take on the likely trajectory of growth in this market, given that we’re still fairly early in penetration? Is this a number for the market and for Barnes & Noble that if it continues to decelerate, is there a reason why it would pick back up?

William Lynch

Yeah, you’re right that growth in e-books in particular moderated in the quarter, and that was more broadly—if you talk to the publishers, and we speak to them all the time, if you look at the Killing Lincoln book versus Killing Kennedy last year as an example, I had a publisher CEO tell me it was the first time they had seen where e hadn’t gained on physical as a format year-on-year. So—and we think that’s an anomaly, but clearly e is going to continue to grow and be the fastest growing format.

But what you see is October is historically over the last three years the smallest growth month for e, and there are reasons for that. What you see is January is the fastest growth month for e, and there’s reasons for that. When you sell these digital devices that are connected to digital bookstores and you’ve got innovative products like Nook HD and HD Plus being opened by the millions on December 25, these people light them up—often new users to e, these people light up those screens and suddenly start ordering digital books and those first few months, we see are the biggest in terms of attach rate on the new cohort.

So October for anybody – the publishers, us, almost sure for Amazon – is likely the slowest growth month in e. January and Q1 is the fastest growth, and it’s because you’re just adding a whole lot of screens and digital bookstores into the equation. So hopefully that helps.

We feel like—we believe we’ve maintained, maybe even slightly grew share. Unlike the last few quarters, we don’t have confirmation that we grew share, but we certainly believe we’ve maintained our healthy 25 to 30% share this quarter in digital books.

Matthew Fassler – Goldman Sachs

Thank you very much.

Operator

Again, that is star, one if you’d like to ask any questions. We’ll move next to Peter Wahlstrom with Morningstar Investment Research.

Peter Wahlstrom – Morningstar Investment Research

Good morning. Thanks for taking my question. Can you talk a little bit about Nook traction in the U.K.? Basically the Simple Touch and GlowLight products have been in the market for about a month now, and maybe provide a quick assessment of the competitive environment in the U.K. to date and how the HD and HD Plus recent launches could potentially shift the balance.

William Lynch

Sure. This is William again. Amazon dominates in the U.K. I believe they have something north of 90% share in the U.K. in terms of e-book sales. We just entered and really started selling about two weeks ago in terms of devices. It’s too early to tell. We’re in the U.K. for the long haul. We feel like we’re going to be a strong number two there over time. We’ve gotten and lined up some great distribution partners. We’ve got a huge catalog of digital books – over 2.5 million digital books, and we’ll know a lot more when we talk next quarter. But two weeks of sell-through, it’s just not productive for me talk about. What I will say is we’re in there for the long haul and we’re committed to it. Obviously it’s going to be accretive to our growth and how much is the big question, so we’ll have more details on that next quarter.

Peter Wahlstrom – Morningstar Investment Research

Sure. And on the dip in the BN.com sales during the quarter, number one, can you quantify that for us and is that actually more related to the segment realignments, or you’ve see a bit more competition in the online environment?

William Lynch

It has nothing to do with the segment realignments. It’s the latter, and our view on managing that I would say more for profitability than growth than we have historically.

Peter Wahlstrom – Morningstar Investment Research

Okay. And then no major changes obviously to the global affiliate program, then?

William Lynch

Yeah, in some cases where it didn’t make economic sense, we’ve pulled back on affiliates, and that is specifically for physical goods – you know, shipped to home physical goods. That’s what you’re talking about, correct?

Peter Wahlstrom – Morningstar Investment Research

That’s correct, yes.

William Lynch

Yeah.

Peter Wahlstrom – Morningstar Investment Research

Okay. And one quick housekeeping – is there any change to your capital spending plan for fiscal 2013, still expecting $175 million? And any change to the allocation between the three business segments?

Michael Huseby

No, not at this point.

Peter Wahlstrom – Morningstar Investment Research

Okay, thank you very much.

Operator

Our next question comes from Alan Rifkin with Barclays.

Alan Rifkin – Barclays

Thank you very much. If you look at it with respect to the Nook, the EBITDA in the quarter was flat which was, relatively speaking, the best performance in some time, and I understand your commentary on the full year; but do you think that Q2 really marks a change in direction in terms of the relative contribution from the Nook?

William Lynch

Hey Alan. I think one thing that was notable is the gross margin—beyond the 38% digital content sales increase, really the gross margin increase year-on-year for Nook. We increased 240 basis points. Even within that, if you look at specifically gross margin associated with content, we grew that substantially year-on-year. I think there was some concern given DOJ and other activity earlier in the year that we would see eroding gross margins. We’ve said maintaining healthy gross margins on our content business is key, and so we saw that grow year-on-year and we felt good about that.

Here’s what I’ll say – the key to that Nook business is continuing to grow digital content sales and managing expenses, so by definition if we’re shrinking losses year-on-year, you can expect increased performance out of the Nook segment from the standpoint of EBITDA losses in subsequent quarters.

Alan Rifkin – Barclays

Okay, thank you. And one follow-up if I may – if you look at the continued investment in R&D going forward, not only for the remainder of this fiscal year but even longer term as it relates to the Nook, do you believe the Microsoft investment in and of itself will be enough to continue to help fund that development, or do you think that ultimately you may need additional capital infusion?

Michael Huseby

Well, based on our current plan, we have sufficient liquidity and going forward feel comfortable funding our current plans. Obviously we’ll look at anything that makes sense in the context of better leveraging our capabilities and cost structure to maximize or optimize cash flow when it’s traded off against the quality of the products that we can produce.

Alan Rifkin – Barclays

Okay. And one last one, if I may – now that we’ve just about anniversaried the Borders liquidation and the effects on you folks, in hindsight as you look back over the past 12 months, what do you think was the net benefit to both your revenue and profitability from Borders going away? Are you able to dissect that?

William Lynch

We haven’t specifically disclosed the number for this fiscal year. Previously we’d disclosed the number for last year, what we thought the sales lift would be, and we thought there would be additional lift this year, as we’d previously said.

Alan Rifkin – Barclays

Okay, thank you very much.

Operator

Thank you, and ladies and gentlemen, that’s star, one for questions. We’ll move to John Tinker with Maxim.

John Tinker – Maxim Group

Hi, thank you. Just following up on some of the costs questions, you’ve got a reasonably aggressive TV marketing campaign plus if I look at your boxes for the new tablets and the readers, I think they’re including Spanish, Italian, French and German, suggesting that you are pretty far along in your launch plans internationally. If you could also provide some kind of update on the costs there as well, potential costs, that would be great.

Michael Huseby

Well clearly we have incremental costs for international expansion, if that’s the gist of your question. As William said, we’re just early into the U.K. in terms of selling there. We just launched the app for Windows 8, which will help to facilitate our launch internationally of digital content sales in a big way, and we’re not planning yet to break out international costs. At the point in time where that scales to the point where it’s significant enough, I think, from a revenue and an expense perspective to break out, we’ll consider it at that point in time. But at this point, we’re not breaking out that level of detail for probably pretty obvious reasons competitively.

John Tinker – Maxim Group

And on a year-over-year comp on the cost of the TV marketing, that will be up as well or will be similar?

William Lynch

Hey John, this is William. The TV and ad spend will be up marginally and that’s a function of we’re trying to drive more traffic into our retail partners and our own stores obviously, because we feel so much better about how they’re set and how Nook looks at Target and Wal-Mart stores. So it’s up. It’s not up in any huge way. We think we’ve been smarter on our media buying. It’s up, but I would say it’s up marginally.

John Tinker – Maxim Group

So one quick final question – as you’re looking at the customer base expanding, is there any difference between the newer customers coming in in terms of, say, attachment rates or the kind of product they’re buying, so the mix between, say, traditional books versus magazines?

William Lynch

There are differences in those cohorts. Some of the early classes were some of our most—the early adopters were some of our most valuable, but we still add some of those heavy attach readers in the new classes as well. And then what we’re seeing is as we launch experiences like Nook HD and HD Plus, new content types like newsstand have a higher attach, but again those are very new products and so it’s too early to project how much those two products are going to fuel our newsstand business.

John Tinker – Maxim Group

Okay, thanks.

Operator

Our next question comes from David Strasser with Janney.

David Strasser – Janney Capital Markets

Thank you. Can you dig in a little bit more on the gross margins on the digital side, because quite frankly, I was fairly concerned when pricing went away with the DOJ or the pricing dynamics changed. Can you give a little bit more color how you’re able to maintain that or actually even increase those gross margins? I mean, what has happened to pricing, maybe another way to ask it, since that’s kind of gone into practice?

William Lynch

Well, most of our business was not affected by the DOJ, so let’s start there. The fastest growing part of our digital content sales are in self-published areas and in new content formats, like newsstand. So on the e-book side, we said we felt good that we would be able to negotiate agreements with publishers that align us with them and allow us preserve what are healthy margins in our digital content business, and so that’s what you’re seeing. We’ve always been aligned with publishers and we feel good that we’re going to manage a business that is both competitive in terms of consumer pricing – you’ll find that if you go and shop us, you know, the two leaders in selling digital books – and allows us to make an adequate return selling books. And so that’s what we’ve done, and I’m not going to get into specifics on how we’ve done that, but that’s what you saw in the gross margin rate.

David Strasser – Janney Capital Markets

No, that’s actually pretty helpful. And then another question – you continue more and more talk about the educational business inside the stores. It’s obviously becoming a bigger part of the business and appears to be pretty strong. Can you give a little bit of color about the size or where you think that could get to, or just a little bit of color about how much it’s actually helping the retail business?

William Lynch

Mitch, you want to take that?

Mitchell Klipper

This is Mitch Klipper. There’s no question the digital sales of devices, not only (inaudible) sales from chain-wide are clearly increasing the traffic in our stores. Not only do we have the best products out there but the products are being sold now in Targets and Wal-Marts, and these are new customers. These are areas that we didn’t necessarily would have served and many of these people are coming back into our stores for help on how to use the device, that come to our Nook classes. They come back and we sell them an accessory (inaudible), so this is clearly driving business into our stores. The mobile devices that we sell traffic is increasing in our stores. We’re very happy. The more devices we can sell, the more customers we can serve, even if they come in and have a cup of coffee. More people are coming through the doors now as we increase the number of devices.

David Strasser – Janney Capital Markets

I’m kind of thinking a bit more on the education side because that seems to be a growing and more powerful area of the store. You haven’t given much information on it, which I presume is not quite 10% of the business; but I’m just trying to get a sense of if you are comfortable getting any sort of sizing of that business or growth trajectory of that business, because it seems like it’s becoming more important. There are obviously a lot of things driving traffic into the store, but that one seems to be one you talk a fair amount about.

William Lynch

You’re talking about educational toys and games?

David Strasser – Janney Capital Markets

Oh, I’m sorry. Yes, I apologize – yeah, the educational toys and games business.

Mitchell Klipper

Oh. Well that business, as we said last year, we got into it two years ago. We tested it, we rolled it out last year. It is clearly driving people into our stores. This will be our second holiday that the American public knows that Barnes & Noble is in the educational toy and game business, and nobody does it better than we can. Again, we have great product, hand-selected. Inventory levels are at an all-time high level, so we’re ready to take on the holiday season. But this will be the second year that will actually put us into that toy business in a much bigger way, and it’s just complements the stores and everything we do. So yes, that too is a driver into the stores.

You know, one of the fastest growing areas in the store outside of Nook is our children’s area, so this is just another complement for the children’s area of educational toys and games, and we will become a regular for our customers to shop now for their toy purchases for the holiday season. We’re into that program.

David Strasser – Janney Capital Markets

And at the risk of—it seems like it’s such a defensible business for you and a potential growth business. That’s why I’m trying to frame sort of the relative size of the business or any sort of growth trajectory around it, because it does feel like no matter what happens over time, this becomes more and more defensible to you guys. That’s why I’m trying to get some numbers around it.

William Lynch

Well here’s the number we’ll give you. Last quarter, we said it grew 32%. As Mitch said, we’ve reinvested more from an inventory and merchandise standpoint. It’s our second holiday with significant floor space that Mitch and the team have dedicated to it, and so that should tell you directionally that we think (a) it could be big for us, and we feel it will continue to be a growth business for us.

David Strasser – Janney Capital Markets

Fair enough. Thank you.

Operator

Our next question comes from Matthew Fassler, Goldman Sachs.

Matthew Fassler – Goldman Sachs

Thanks a lot. Since there’s time, I wanted to ask a follow-up or two. First of all, you talked about the promotions that you held with some of the discounters over Black Friday, and clearly the unit sell-through benefited. Who funded the discounts that saw some of those deals? They were pretty compelling. Is that cost borne by Barnes & Noble, borne by the discounters, or is it shared?

William Lynch

They’re shared. Black Friday has been a big traffic driving area. First of all, you’ve got to be deemed and coronated as one of the products worthy of getting in the circulars; and Target, as an example, Matthew, that was—we had Simple Touch, which is the highest rated e-reader ever on the cover of the Target circular at, as you say, a compelling deal. So those retailers are very invested in offering those kind of values during Black Friday. It’s become the game – sort of great products at good deals is the sport of it, and to some extent they are shared.

Matthew Fassler – Goldman Sachs

Okay. Second question – you’ve been asked about this a bit over the course of the call. Obviously the DOJ settlement had the potential to change the competitive dynamic in the e-book business. If you look at sort of what the speculation was about how it would play out, what changes in competitive behavior have you seen since some of the rules and pricing structures started to change?

William Lynch

Well, you may have seen that article on elasticity on digital books. I forget what the source was, but we can send it to you, Matthew. What we saw was Harper Collins was the first to implement the consent decree with the DOJ and allow discounting off of agency, and what they saw was Harper Collins, as we and Amazon started discounting, did not see a material lift in the velocity of their books and their share gains vis-à-vis other publishers. So that was a big epiphany, and that’s certainly what we saw. I know that was true for our largest competitor, and so that was an interesting dynamic that there wasn’t much elasticity. If someone wants to buy a John Grisham book in electronic format, they’re going to pay $11.99 or they’re going to pay $10.99, and there’s not as much elasticity as you may have guessed there.

So was that helpful?

Matthew Fassler – Goldman Sachs

It does help. And then one final question – your retail guidance for the year implies some further deceleration, and obviously we have sort of, I guess, a fuller impact of Borders so that toughens up the compare. It would imply – just correct me if I’m wrong – that the retail comp dips into negative territory in the second half of your fiscal year. I just want to make sure that we read that right.

Michael Huseby

Yeah, well if you look at the results for the first quarter and this quarter and you do the math relative to the guidance, it’s a pretty easy conclusion to come to, I think; or it’s a reasonable conclusion to come to, I should say.

Matthew Fassler – Goldman Sachs

And is that a function basically of the Borders compare getting tougher, maybe some of the seasonal product getting a little less important as you exit the holiday?

Michael Huseby

Well, it’s certainly a function of the Borders liquidation cycling off, as well as just the overall trend in terms of some market share shift to e-books.

Matthew Fassler – Goldman Sachs

Got it. Thank you, guys. I appreciate it.

Operator

Thank you. Our next question today comes from Marjorie Gochberg with Harvest Management.

Marjorie Gochberg – Harvest Management

Hi. I had two questions The first one was you talked about college revenues being down slightly because of the shift from purchase to rental. Can you tell what the impact is for the quarter? Will that smooth out since rental is recognized as it goes, as opposed to a purchase which is up front? Can you tell what the magnitude of that would be?

Michael Huseby

Well, we’re not forecasting the magnitude. The other thing to keep in mind is that because of the trend towards higher market share to rental versus purchase, you’re going to continue to have a higher percentage of your sales, so to speak, go to rental each quarter, so it makes it—you know, forecasting isn’t something that we’re going to do in terms of specifics. I think the trend is an important one to recognize because it does affect revenue year-over-year and will continue to affect the percentage change year-over-year as this trend continues for the foreseeable future. But the good news is at the margin line, it helps you.

Marjorie Gochberg – Harvest Management

Got it. And have you quantified at all what you expect the spending to be on digital education?

William Lynch

You mean the market size?

Marjorie Gochberg – Harvest Management

Yes.

William Lynch

Yes, and I do—well, in what year?

Marjorie Gochberg – Harvest Management

Well, I guess next year would be great but last year is fine.

William Lynch

I believe last year in the U.S., higher ed, it was something close to 500 to 600 million if what we’ve said—

Marjorie Gochberg – Harvest Management

Okay.

William Lynch

--and we see that going to over 3 billion in the next three to four years.

Marjorie Gochberg – Harvest Management

Okay, thank you.

Operator

And our next question comes from Rick Schottenfeld with Coyote Capital.

Rick Schottenfeld – Coyote Capital

Yeah, hi guys. I ask this question every call, but I’m going to try to ask it a little different way. You have two businesses that have different goals that are now separated. You have a significantly profitable bookstore business. You have a growth-y Nook business that requires capital investment. They appeal to different investor sets. You’re clearly getting penalized for the fact that they live together. Can you tell me the sort of thoughts process that you’re working on in terms of how to ultimately separate these businesses, what your calculations are in terms of how you think about it, and when also you might consider breaking out what the reported earnings per share on the bookstores would be were they standalone so that we can get a better feel for the value of the two separate businesses?

Michael Huseby

Yeah, I think we’ve consistently disclosed that we are looking at strategic alternatives and will continue to do that, but we don’t have anything further to announce at this time. The formation of the partnership with Microsoft, which just closed on October 4, where we ring-fenced the digital and college businesses into a separate entity is a very significant event in the context of getting and isolating the value and really promoting those business plans with not separate capital structures but almost separate capital structures at this point in time. And that subsidiary, Nook Media, is still over 82% owned by Barnes & Noble and because of that and the integration with the retail stores, there’s really nothing to announce at this point in time. But I will tell you that there’s constant thought given to how we can optimize the cash flow from those assets, both the retail asset and Nook Media.

Rick Schottenfeld – Coyote Capital

Have you thought about providing some sort of non-GAAP supplemental data to investors so that they could see what the profitability of the bookstore business would be as a standalone?

Michael Huseby

Well, I think that would be appropriate at such time as we actually made a decision to do something where it looked like it was going to be a standalone entity. Right now, we haven’t made any such decisions.

Rick Schottenfeld – Coyote Capital

Okay, thanks.

Operator

There are no further questions at this time. I would like to turn the call back over to the speakers for any additional remarks.

Andy Milevoj

Great. Thank you everyone for joining us on today’s call. Please note that our next release will be our holiday sales release on or about January 3, 2013; and with that, I’d like to wish you all a good day.

Operator

Thank you, ladies and gentlemen. That will conclude today’s presentation.

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