Barnes & Noble (BKS) first caught my attention in February of 2011 when Borders Group filed for chapter 11 bankruptcy. Immediately after the news, Barnes & Noble saw its stock price cut in half. At the time many considered it to be a great opportunity to buy; if Barnes & Noble's business was healthy, then reduced competition should only benefit the business. Ultimately, many decided not to buy because the retail book industry was under intense pressure, and it was still too soon to tell how the NOOK would compete against Amazon's (AMZN) Kindle, Apple's (AAPL) iPad, and other soon to be released tablets, such as Google's (GOOG) Nexus. Since then, the stock has seen its fair share of ups and downs.
The most recent high came on news of Microsoft investing $300M into the NOOK business and rumors of Barnes & Noble spinning off the digital e-book business. Then in September, WalMart (WMT) announced it would no longer sell the Kindle e-readers. These two pieces of news got me thinking it might be time to review the company again.
Barnes & Noble is composed of three segments: Retail, College, and Nook. In the most recent quarter, the company had Revenue, Gross Profit and Earnings before Interest, Depreciation and Amortization (EBITDA) for the three segments of:
It might come as a shocker to many, but the Barnes & Noble retail business is relatively healthy, all things considered. Yes, it saw its revenue decline 3%, and we can probably expect that to continue with time as virtual content gradually replaces printed, but Retail was able to double its EBITDA! The real drag on the company's financials is funding the market share expansion of NOOK, which lost the company $54M. If we removed the NOOK entirely from Barnes & Noble's income statement, and assumed the entire $66M in Depreciation, Amortization, and Interest Expense, was from the Retail and College Business, the company would have had net income of approximately $50M or $0.87 per share before taxes and preferred dividend payments. Instead, Barnes & Noble reported a net loss of $2.2M, or $0.04 per share; however the loss was down significantly compared to the net loss of $10M or $0.17 per share in Q2 2011.
The Big Risk: Competing Strategies
Without further debt financing, Barnes & Noble will fund its NOOK expansion with Retail/College earnings, essentially asking shareholders to forgo positive earnings (without even a dividend to sit and wait on) in the short term while the company positions itself for long term growth. The biggest risk I see in this strategy is the dichotomy within the business. If we think about NOOK, it is essentially a platform by which to deliver online content, so essentially you have Online vs. Retail (brick and mortar) within the same company.
There are certainly pros and cons to both business models. Online retailers like Amazon have low cost structures and can maintain larger inventories making it difficult for brick and mortar retailers like WalMart to compete on price and product selection. On the other hand, brick and mortar retailers offer real people to talk to, don't require credit cards, and can provide unique services that require the consumer to be in the store. Take GameStop (GME) for example, which interestingly enough, was sold off by Barnes & Noble in 2004. GameStop purchases used games in exchange for in-store credit; one reason this service can't be completed online is because the purchaser has to confirm the game works before payment.
The struggle for Barnes & Noble is that the Retail/College segment is funding the NOOK market share expansion and doesn't have a unique in store offering to keep the business healthy (like GameStop does with trade-ins). Essentially, NOOK and other e-readers/tablets will continue to cannibalize the Barnes & Noble Retail/College revenue that is feeding its expansion. While Barnes & Noble has to have some reaction to this new trend, this one is quite like biting the hand that is feeding you. This will ultimately end up creating a lot of tension within the business.
Back of Napkin Valuation:
Microsoft's investment of $300M for a 17.6% stake in the NOOK business implies a value of $1.7B for the business. The remaining 82.4% within Barnes & Noble would then be worth $1.4B. Even if we assume Microsoft paid a premium of 40%, the intrinsic value still within Barnes & Noble would be about $840M, or approximately $14.5 per share. With BKS currently trading in the $15-16 range, you are essentially buying the Nook business and getting the Retail/College divisions for free.
The situation at Barnes & Noble has certainly been improving. Many were concerned that when Borders Group declared bankruptcy Barnes & Noble would follow. In reality, however, the Retail business has actually been doing quite well since Borders went out of business and the NOOK seems to be benefiting from anti-Amazon moves by brick and mortar retailers. The back of napkin calculation shows pretty clearly that the stock appears undervalued, but those thinking about investing should consider the risk described above.
The businesses within Barnes & Noble are fundamentally different and don't appear to have much synergy. The Retail and College divisions don't appear to have any unique advantage and will continue to decline with time as the market reaches equilibrium between printed book loyalists and virtual readers. The one move that I could see benefiting investors is to divide the companies into two separate entities, so both can compete freely. This will also enable investors to decide which segment of the business they'd rather invest in.