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Executives

Andy Milevoj - Vice President of Investor Relations

William J. Lynch - Chief Executive Officer, President and Director

Michael P. Huseby - Chief Financial Officer

Mitchell S. Klipper - Chief Executive officer-Barnes & Noble Retail

Eugene V. DeFelice - Vice President, General Counsel and Corporate Secretary

Analysts

David S. Strasser - Janney Montgomery Scott LLC, Research Division

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Peter Wahlstrom - Morningstar Inc., Research Division

John Tinker - Maxim Group LLC, Research Division

Alan M. Rifkin - Barclays Capital, Research Division

Richard Shottenfeld

Bill Kavaler

Barnes & Noble (BKS) Q3 2013 Earnings Call February 28, 2013 10:00 AM ET

Operator

Good day, everyone, and welcome to the Barnes & Noble Third Quarter Earnings Conference Call. Today's conference is being recorded. At this time, I am pleased to turn the conference over to Mr. Andy Milevoj. Please go ahead, sir.

Andy Milevoj

Good morning, and thank you for joining us on Barnes & Noble's 2013 Third Quarter Earnings 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'll turn the call over to William Lynch, CEO of Barnes & Noble.

William J. Lynch

Thanks, Andy. As we announced several weeks ago, Q3 revenue and earnings shortfall across the company was almost entirely a function of our missing sales targets for our 2 new NOOK tablet devices. Despite generating very strong reviews and the highest preorder volume we received on any NOOK launch to date, sales of those products didn't materialize at the rate we expected through holiday, as heavy competition in the tablet market negatively impacted our sell-through.

In many ways, we helped create the portable tablet category by launching the first-ever 7-inch Media tablet with NOOK Color almost 3 years ago. Since that time, several large technology brands have entered the tablet market, making it more difficult to break through with our award-winning products. We've analyzed what happened during the holiday and have started to quickly make adjustments to our digital strategy, which I will touch on in my remarks in just a moment.

Turning to Retail, core sales in our stores actually exceeded our expectation in Q3 and helped contribute to a 7% year-on-year growth in EBITDA for our Retail segment in the quarter. Based on all the publisher data we have, it appears that the eBook market growth has slowed and digital cannibalization of physical book sales has slowed as well.

After the hyper-growth in eBooks over the last few years, consumers have settled into their book formats of choice. And while eBooks will continue to drive growth in the book category in the future, physical book sales will have a longer tail than previously anticipated. As the country's only remaining national bookseller, our Retail stores will benefit from this flattening of the slope of the physical book decline.

Mike will get into the specifics of the company's Q3 financial performance in a moment, but I do want to address a few big strategic developments the company has announced recently. Specifically, that we are evaluating a sale of Retail and we are making adjustments to our NOOK Media strategy and cutting costs. First, let me say we have 2 valuable businesses in Barnes & Noble Retail and NOOK Media. We can't comment further on Len Riggio's plan to make a proposal to purchase the Retail business other than to confirm ongoing discussions between Len and the Strategic Committee of the board.

In terms of NOOK Media, the subsidiary has been financing itself since October, with investments from new partners, Microsoft and Pearson, as well as positive cash -- with positive cash flow from the College business. NOOK Media currently has approximately $240 million in cash with no debt. Our plan is to have NOOK Media self-finance, and we will do that by carefully managing our costs, converting existing NOOK device inventory into cash and generating cash flow in the Barnes & Noble College business.

As it relates to NOOK Media strategy going forward, as we've announced today, we've taken steps to significantly reduce the costs and overhead in the digital consumer business with the objective of operating the NOOK Media business at a positive EBITDA within a reasonable time frame.

Since we launched the digital business in 2009, we've ramped expenses and capital quickly to build out the platform and fuel the growth. The results of this investment is that we've built one of world's most valuable catalogs of digital copyright content for books, magazines and educational materials, as well as a digital bookstore service that contains approximately a 25% share of the eBook market and an over 35% share of digital subscription market in the U.S. We are working to complete the global expansion of the NOOK digital content and retailing service in approximately 10 countries, selling it over 10 languages by this summer.

Now that we've built this global asset, we are actively in discussions to leverage our valuable technology and content platform to sell digital content through partnerships, similar to the partnership we struck with Microsoft on Windows 8. Partnerships are one of the key strategy for growth for our NOOK digital content business, and we are encouraged by the status and breadth of discussions we're in the midst of.

Even with the decline in NOOK unit sales in Q3, we grew digital content sales 7%. So we've demonstrated we can grow our content business without having to grow hardware sales.

At the same time, I want to be clear about the fact that we continue to remain committed to the eReader and tablet business going forward. We're extremely proud of the award-winning line of products we've created. In fact, we're proud of all the products we ship, including our mobile apps for iOS and Android, which are the highest-rated reading apps in both iTunes and Google Play.

From a marketing and sales standpoint, regardless of what happens with our bookstores and -- regardless of what happens, our bookstores and NOOK will continue to have a close relationship for the foreseeable future. Our bookstores have made a significant contribution in NOOK's success over the past 3 years. And in turn, our award-winning line of NOOK products has proven to be a strong driver of traffic to our stores.

In terms of the device hardware investments going forward, we will adjust our approach to better mitigate our investment risk, while pursuing models that better position NOOK for success. Some specific announcements detailing those plans will be forthcoming in the next few months.

Turning to education. Our Barnes & Noble College business contained within NOOK Media remains a very valuable and well-positioned business. In 2009, we bought Barnes & Noble College for $596 million. And since that time, the business has exceeded the internal projections in our first full 3 years since buying it. The core business of selling physical education materials and general merchandise through campus physical and online stores is steady and consistent. Additionally, we've added more new school contracts to Barnes & Noble College this year than we have in the last decade.

Beyond the healthy core business, we're extremely excited about the growth opportunity digital education presents for the company. As validated by Pearson, the world's leading education company, closing their investment of $89 million in NOOK Media this quarter.

With our partnerships, our global content and eCommerce platform, combined with our access to over 1/4 of the U.S. students through our 678 campus bookstores, we feel NOOK Media is in a unique position to lead in the fast emerging market for digital education content.

In closing, we were obviously disappointed that our NOOK tablets didn't perform better over the holidays. We put significant investment into creating those products and believe that because of the quality of the experience, favorable early reviews and preorders, they would have fared better. In response to that holiday data, over the last 60 days we've worked hard to take decisive actions in the NOOK Media business to better position it going forward for growth and profitability, including taking significant actions to begin to rightsize the cost structure of the NOOK segment.

We have also closed the Pearson investment and partnership, bringing in a great partner into NOOK Media and positioning ourselves to be the leader in the market for digital education content. The College core business is steady and consistent and our newly signed school contracts have added more new business this year than we have in the last decade. NOOK Media has sizable cash, no current debt and a good plan to unlock value for shareholders going forward by capitalizing on the opportunity in the growing global market for digital content in the consumer and education markets.

Lastly, the Strategic Committee of the board is currently evaluating the potential value that could be unlocked in the sale of the Retail business.

Thanks, and now I'd like to turn the call over to Mike Huseby, our CFO, for more detailed financial commentary on Q3.

Michael P. Huseby

Thank you, William, and good morning, everyone. This morning before the market opened, we released results for our fiscal 2013 third quarter, which ended on January 26. Consolidated sales were $2.2 billion for the quarter, a decrease of 8.8% as compared to the prior year. Retail sales, which include results for Barnes & Noble's Retail bookstores and BN.com businesses, decreased 10.3% for the quarter to $1.5 billion due to a 7.3% decline in comparable store sales, store closures and lower online sales.

As noted on our holiday sales release on January 3, sales of NOOK products by the Retail segment declined during the holiday period due to lower unit volume. Retail core comparable store sales, which excludes the sales of NOOK products, decreased 2.2% as compared to the prior year during the third quarter.

Third quarter College sales decreased 1.6% to $517 million. On a comparable basis, College sales decreased 5.2% as compared to the prior year, in part due to the spring back-to-school rush season extending 2 weeks beyond the close of the third quarter. Comparable sales for the third quarter, when adjusted to reflect results of those 2 additional rush weeks for year-over-year comparison purposes, decreased 2.1%.

Third quarter NOOK sales, which include sales of devices, digital content and accessories, were $316 million for the quarter, decreasing 26% as compared to last year. The sales decline was primarily driven by lower device unit volumes. In addition, to optimize future sales opportunities, the company took back $21 million of incremental channel partner returns during the quarter and recorded $15 million of promotional allowances. Both items were recorded as revenue reductions in the quarter. Despite the device sales shortfall, third quarter digital content sales increased 6.8% over last year.

Consolidated gross margin decreased 210 basis points for the quarter as compared to the prior year, driven by negative margins in the NOOK segment. The holiday sales shortfall caused higher than anticipated levels of finished and unfinished goods, resulting in $59 million of device markdowns, as well as the previously mentioned promotional allowances and product returns. Other drivers include device product mix and higher occupancy costs and increased office space in Palo Alto.

Conversely, Retail's gross margin improved 230 basis points as compared to the prior year, as the company continued to benefit from a positive mix shift towards higher margin core products. College's gross margin increased 90 basis points over the prior year on an increased mix of higher-margin textbook rentals.

As a percentage of sales, selling and administrative expenses increased 160 basis points over the prior year from 20.6% to 22.2%. Despite the sales decline at Retail, strong cost management kept the rate essentially flat as compared to a year ago at 19.2%. College expenses increased over last year due to new store openings and continued investments in digital education. As a percent of sales, College expenses outpaced margins, given the timing and higher volume of textbook rental revenue, which is deferred and amortized over future periods.

NOOK expenses increased primarily to support the company's international expansion plans, as well as increased advertising spend during the quarter.

Interest expense is $8.8 million for the quarter, which is flat as compared to a year ago. The company's EBITDA decreased to $55 million this quarter as compared to $150 million a year ago, as a result of the factors just discussed.

Consolidated third quarter net losses were $6 million as compared to net earnings of $52 million a year ago. Third quarter net losses were $0.18 per share as compared to $0.19 -- as compared to net earnings of $0.71 per share in the prior year.

At quarter end, the company had $214 million in cash on hand with no borrowings against its $1 billion credit facility as compared to net debt of approximately $74 million at the end of the third quarter of 2012.

On January 23, the company announced the completion of the strategic partnership with Pearson, which invested $89.5 million in NOOK Media LLC for preferred membership interest, representing a 5% equity stake. Following the closing of the transaction, Barnes & Noble now owns approximately 78.2% of the NOOK Media subsidiary and Microsoft, which also holds preferred membership interests, owns approximately 16.8%.

Inventories were $30 million below last year's level despite higher-than-anticipated NOOK device levels on higher-than-anticipated retail core sales trends and improved inventory management.

Consolidated CapEx for the third quarter were $44 million, bringing the year-to-date total to $111 million.

In the third quarter, the company opened 2 new Retail bookstores and closed 14. This is consistent with the amount of stores that we have closed during each of the last few years, as is the timing of the closings postholiday in the third quarter. College opened 4 stores during the quarter and closed none.

For fiscal 2013, the company continues to expect Retail comparable bookstore sales to decline on a percentage basis in the low to mid single digits. College comparable store sales are now expected to decline on a percentage basis in the low single digits. NOOK Media revenue, which includes the NOOK and College businesses, is expected to be approximately $2.5 billion for the year.

The company now expects fourth quarter NOOK segment EBITDA losses to be comparable to last year's fourth quarter loss of $77 million. Given the holiday device sales shortfall and the associated impact on subsequent digital content sales, coupled with the previously discussed product and component inventory markdowns totaling $74 million, the company now expects fiscal year '13 NOOK segment EBITDA losses of approximately $375 million.

As William discussed, management has taken steps and will take further action to reduce costs in the digital consumer business. We project that starting in fiscal year 2014, these actions will significantly reduce costs at NOOK.

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

Question-and-Answer Session

Operator

[Operator Instructions]

[Technical Difficulty]

David S. Strasser - Janney Montgomery Scott LLC, Research Division

[Audio Gap]

I just kind of -- you were talking about the commitment to the eReader and so on. I'm just trying understand like what you mean by that. Do you have more detail? It just seems like you're being a little bit defensive there about the category. And I guess, if you kind of just back into some valuation of what the Retail businesses were, what -- you could argue the bookstores were -- the College business work from an EBITDA standpoint, you can argue that there is a significant amount of negative value being attributed to this business. And is that in your thought process as well? It can be hundreds and millions of negative value there being attributed to that business. I mean, are there opportunities or thoughts about getting the hardware business or maybe licensing that out or getting rid of the hardware business? Or I'm just trying to understand the commitment and stuff in the context of sort of that whole valuation argument.

William J. Lynch

Thanks, David, it's William. We obviously, if you look at what we've done to date, we had been basically the innovation leader in what I'll call eReader and reading tablets, and that it fueled a lot of growth. What we saw in the holiday is the market has shifted to multifunction tablets. And that's where, if you read any of the analysts' reports, that's where the growth is coming from. We did a lot of work with the consumer postholiday to find out what happened, and what we're seeing is that the bigger brands, larger technology brands have more resonance in that multifunction tablet market than we do. And so we obviously have to adjust and change. And so when I say, we're going to -- we've got a commitment to the tablet and eReader market, we do. But we've also got a commitment to change the model, as I've said, and how we're approaching it, so that we mitigate the risk. We address maybe some of the perceived consumer shortfalls in our -- what I'll call our broader ecosystem, and there's a lot of ways we can do that. And so I mentioned in my remarks, we'll have announcements forthcoming. But yes, we are not going to continue doing what we're doing. We will adjust quickly, and that's what we've said and it's obviously the thing to do.

David S. Strasser - Janney Montgomery Scott LLC, Research Division

And just looking at it, when you -- the 7% or so growth in digital, was -- are you seeing that it's the core customers buying more? Are you seeing that number? Is it more, so to speak, ticket versus traffic or more -- the same customer is buying more and getting more engrossed in your ecosystem, more engrossed in the NOOK, in their library? Or is it more new people coming in?

William J. Lynch

Well, I'll answer the question. But first, let me say that, because we get this question a lot on did we gain share this year with the 7% -- or this quarter with the 7% content growth, we've gotten data now from 5 -- the 5 top publishers on what's happened since holiday. And with 2, we were flat; with 2, we were down 1; and with 2, we were up 1. Overall, it looks like we were flat in terms of market share, call it mid-20s. And so what that means is the eBook market greatly slowed from the trajectory we'd seen before, which benefits physical books, which is obviously good for our business. Where we saw the growth in eBooks, we saw it from 2 areas. One, we've added -- we continued to add net new digital content buyers to the franchise. And we do that in a lot of different ways. One, we've got fewer people attriting off of our existing devices at the rate we expected. We're seeing very strong retention. I think it talks to the quality of those devices. And then we continue to add new customers. Now obviously, the rate of growth of new customers slowed, and that was primarily due to the hardware unit sales. But we also, if you look, continue to grow the number of people reading on our apps, iOS and Android, and I mentioned those are the 2 highest rated reading apps in the iTunes store. Android, we launched our Win 8 app, which is getting -- which is the highest-rated reading app on Win 8. So it's a combination of existing customers staying on with us longer and then adding new customers albeit at a slower rate.

David S. Strasser - Janney Montgomery Scott LLC, Research Division

Okay. No, okay, I mean, actually I was going to follow up with the market share question. And just one quick housekeeping note. The long-term debt on the balance sheet disappeared. And I'm assuming that, that had to get paid out of the EBITDA related to Retail. Can you -- you were not able to -- it just went to 0 from $101 million a year ago, and I'm just assuming that, that came out of -- you couldn't use any of the cash that came in from either Microsoft or Pearson to pay that.

Michael P. Huseby

Well, first off the, as you know, NOOK Media is comprised of 2 businesses, one of which is College. College has seasonal borrowing needs and sometimes draws on debt, and will draw on debt in the future to fund its seasonal needs prior to rush. Retail has the same seasonality. So each of those, each of the 3 entities we have, Retail, College and NOOK, if they need to have access to the line of credit, okay, there's separate ABL borrowing basis established for College. So yes, it's -- the net isn't broken out by segment. But to answer your question, the debt has been repaid because none of the 3 segments require any at the end of the quarter.

Operator

And next, we'll hear from Matthew Fassler with Goldman Sachs.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

My first question is just to make sure we understand the impact of the NOOK business on Retail sales and profitability. You spoke about the decline in same-store sales, excluding the impact of the NOOK. Can you give us a sense of what the contribution to sales was in aggregate from NOOK-related products in the January quarter, a year ago versus this past January? And how much of the margin and profit improvement related to the mix of digital sales within Retail are beginning to moderate?

William J. Lynch

We don't break out, Matt, different product line economics within Retail -- our Retail store business. But I do want to take this opportunity, I know you didn't ask this, but I want to flip it Mitch. Because there was some coverage about our store closure rate and where our stores will be in 5 years. That created a mischaracterization. So I'm going to toss it to Mitch now on that issue.

Mitchell S. Klipper

Sure. I want to make something very clear, given the recent news reports that we may be accelerating our store closings. That is simply not the case. Let me repeat that. That is simply not the case. We have historically closed 12 to 20 stores each year over the last 10 years, averaging 15 stores a year. That will not change. Today, we have 677 Barnes & Nobles nationwide. When we close 15 to 20 over next year, that represents under 3% of our total stores. As you all know, any successful retailer closes unprofitable stores. They relocate existing stores to better locations, and that keeps the remaining stores financially sound. And we're happy to report over 95% of our stores are profitable with no plans to close any of these. 95% of our stores are profitable, and we have no plans to close any of these. In fact, we're looking at opening new store prototypes, and we're expecting to open 3 to 5 new stores next fiscal year. So let's make no mistake about it, folks. Our Barnes & Noble stores will be here to serve our customers and communities throughout the country for a long, long time to come.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Great. If I can move onto another question. If you look at the anticipated NOOK Media EBITDA results for the current fiscal year in aggregate, how would the cash flow number for that business compare to EBITDA? So could you talk about the capital expenditures associated with that business, any working capital? Sort of the -- because I'm trying to, obviously, understand what the annual cash needs of that business will be or cash production given different levels of earnings. What are the numbers that we need in addition to EBITDA to bridge our way to the cash flow number?

Michael P. Huseby

Well, Matt, this is Mike Huseby. There's a couple of pretty major factors that affect differences between EBITDA numbers we're reporting and cash flow and then obviously, it depends on what horizon you're looking at trying to project the cash flow. We're not going to sit here and project cash flow for anybody. But first off, the Microsoft agreement that we entered into on October 4, which provides us with substantial amount of cash, in addition to the $300 million that was invested on October 4. Under the terms of the agreement, we get about $85 million on an annualized basis to help support the operations as we expand internationally. Much of that is not counted as EBITDA in the current year or won't be next year. Because of the accounting, it's really treated as debt and interest expense. And that's an important thing to understand in terms of doing a reconciliation. In terms of CapEx, our CapEx are up a little bit in NOOK this year and next year versus what they will be, especially this year because of Palo Alto's consolidation of what were 6 or 7 disparate locations into one location and just the build-out, some of the leasehold and that type of thing. But that -- those are a couple of the main things. And there are other -- when it comes to taxes and looking at segments and that type of thing, it gets a little bit more complicated. But the other primary thing that is really driving what we're doing right now is converting the inventory that was built, as William described. The holiday sales results were below the rate we expected but there's a lot of inventory that's been built that we'll be selling into fiscal year and through fiscal year '14 that's already been paid for. And that's like -- that's the major, I guess, element to understand in terms of trying to look at NOOK Media cash flow apart from the normal cash flow in College, which is positive and the discretionary nature of some of the CapEx. Most of the College or a lot of the College CapEx relate to the opening of new stores. So they're revenue-led, and so you have to break it down between NOOK and College. So those are some of the major items. If you look at the balance sheet and once the 10-Q comes out, you look at the cash flow statement, it will become apparent to you how much cash we'll be able to generate to meet our sales plans in fiscal year '14 off the inventory that we've already paid for.

Operator

And next, we'll hear from Peter Wahlstrom with MorningStar Investment Research.

Peter Wahlstrom - Morningstar Inc., Research Division

Sticking with Retail and margins. I know you're reluctant to break out the source of the mix shift. Maybe could you talk about lease renewals and how much of a lift those might have contributed to margins or cost reductions over the last year?

Michael P. Huseby

Well, we're not going to break out the -- what exactly that brought us. But every year, we're renewing 125 leases. It's in the 10-K. Again, our development team is the same group -- crew that opened these stores. They're renewing the stores. Landlords do not want us to leave. We're great tenant for the center, a lot of cotenancies are tied into us. So they don't want us leaving. We're still bringing the right customer, richer mind, richer pocket. So we are continuing to improve our lease deals. Again, many of these deals we did the prior 2 years were short-term renewals. So you're not going to get anything on the second round with those landlords. But the team is still bringing in some reductions. Again, the -- let's say the low-hanging fruit was achieved early on, and we're still getting some savings. So that will continue for the next 2 to 3 years. And again, landlords are very happy with the use of the space. We're bringing in great customers, and they just want to know how fast can we start rolling out new stores for them.

Peter Wahlstrom - Morningstar Inc., Research Division

Okay. And you also mentioned lower online sales at Retail. Can you quantify this for us and talk a little bit about how the trends have been going over the last few quarters and how you see that framing out for the rest of the fiscal year?

William J. Lynch

We're not breaking out the online BN.com sales. Here's what I'll say, we're repositioning BN.com, our ship-to-home service. We've recently put that under Jaime Carey, who is our Chief Merchant and very capable guy. We're looking at the assortments, pricing, et cetera. And those plans are starting to be formulated now. But to answer the question, we're not breaking out the top line sales at BN.com.

Peter Wahlstrom - Morningstar Inc., Research Division

Okay. And one quick question about NOOK. Obviously, third-party channel is under a little bit of pressure. Is it fair to say that you also felt the same pressure in NOOK at the Barnes & Noble Retail stores and web-based? And then relates to that, is there a difference in the customer who purchases via channel and what their post-purchase digital content purchasing behavior acts like?

William J. Lynch

Well, to the first question, if you look at the decline, we obviously saw a sizable decline year-on-year in unit sales at our own Retail stores as well. So actually, we saw less in third party in terms of decline, Retail being the biggest percentage driver of NOOK unit sales. The -- our 2 biggest relationships are Walmart and Target. We continue to work closely with them. And if you look at, I guess, the dynamics, you asked about in terms of customers, we get more new customer acquisition -- when I say new, new to Barnes & Noble -- from those third-party channels. It's somewhat of an intuitive statistic but it's true. And then in terms of content purchasing, they purchase slightly less content than our core Barnes & Noble NOOK buyer. But that's -- you would imagine that as well, right? Selection buys, people in our stores are readers and hard-core readers. So those in Target, Walmart, Best Buy, maybe not as heavy buyers in the reading category but still drive quite a bit of our content sales.

Operator

And next, we'll hear from John Tinker with Maxim.

John Tinker - Maxim Group LLC, Research Division

As you -- without sort of quarterbacking, but as you look back to the -- a few months ago and you were launching the tablet, is there anything that, given the disappointing numbers, you would have done differently?

William J. Lynch

Yes, it's a fair question. Sure. In hindsight, you look at the numbers, and there are absolutely things we could have done differently. John, it's a fair question. I'm not going to go into what those are because I think they portend on some of the moves that we're currently in the process of evaluating. Here's what I think we did well. I think we innovated extremely well in the areas of reading and with magazines. We will continue to focus on our core. I think we're leading in experiences and delivering reading experiences around books, magazines and education content. I think the consumer ratings validate that. But we have to look at -- as the market goes to more multifunction tablets, we have to look at how we offer functionality differently, and so that's what we're focused on now.

Operator

And now we'll move on to a question from Alan Rifkin with Barclays.

Alan M. Rifkin - Barclays Capital, Research Division

William, you mentioned that the NOOK Media business is now self-financing. Can we infer from that then, that you really don't need any further injections of capital from either new investors or from any of the investors that have already invested in NOOK?

William J. Lynch

Alan, I don't think we gave projections on capital going forward. What we said is what we have currently, which is $240 million in cash and no debt and then Mike talked to some of the activities we've got in terms of cash generation. What we'll do in the future, we're not commenting on that today. And as we have any news or decide on that to share, we'll do so.

Alan M. Rifkin - Barclays Capital, Research Division

Okay. You said, obviously, the NOOK hardware business was under a lot of pressure despite the greater promotions. Can you maybe just shed a little bit more color on what the lag factor is when you sell a NOOK hardware device in any of its forms and when you see the digital follow-up thereafter?

William J. Lynch

Sure. It's when you get -- what will happen is when you sell the devices in December, and this is seasonal in the eReader business, you see January is the big month where you get a sense of how you're going to comp on the content sales. If you take the cohorts and look at it by month, the first month, you get, on our business, you get the -- is the largest month by far. In terms of ancillary content sales. So January was in the quarter. The numbers that you're seeing on digital content reflect the impact of the lower unit sales in December and on the January content sales.

Alan M. Rifkin - Barclays Capital, Research Division

And just a point of clarification, if I may. Did you say that you expected the NOOK Media business to be positive EBITDA within a reasonable amount of time?

Michael P. Huseby

That's our objective in the context of developing, adjusting the strategy, that was one of the key driving objectives.

Alan M. Rifkin - Barclays Capital, Research Division

I mean, but you lost $200 million in EBITDA in the last quarter. You've lost $300 million in EBITDA in the first 3 quarters. Can you just provide a little bit more color as to when and how you're going to get the NOOK Media to reverse itself and have positive EBITDA. If you could just expand, I'd appreciate it.

William J. Lynch

Yes. It's 3 things, Alan. It's from growing our contents. It's from the cost-cutting initiatives that we've engaged in, and we've said they're significant. Cutting cost does not replace the strategy, but we feel like we have a good strategy going forward. It's through scaling our digital content. Our digital content is a profitable business for us. We carry approximately 30% gross margins and obviously has no inventory associated with it. And so one of the keys we've said is growing that digital content business. And then remember, the numbers that you quoted include a massive reserve for inventory. And so this Q3 was definitely cleaning up and living with some of the significant sales miss in December. So while you're right on the EBITDA numbers, if you look at the inventory reserves, $21 million we took back from channel, $15 million in promotional, additional promotional dollars, $50 million -- close to $60 million in inventory reserves. All those numbers are baked into the numbers you quoted. So -- and then remember that the $85 million per year in terms of the Microsoft partnership that Mike cited, we put it into debt, as Mike says. But as we sell that content, it -- we actually put it into the P&L and it flows through the EBITDA line. So hopefully, that gives you some sense of why -- it's our objective to get EBITDA positive within a reasonable time frame.

Alan M. Rifkin - Barclays Capital, Research Division

Okay. You wouldn't be at liberty to say how much of the cash is left from the Microsoft investment? I mean, your cash was $213 million at the end of the quarter. They invested $380 million or so. I mean would you be at liberty to say how much -- if that has already been burned?

William J. Lynch

Well, first off, the investment that Microsoft has put into date is $300 million plus, not $380 million. That $85 million is an annual number. So we've gone through 2 quarters of that, just about half of what you're citing. And not all of that even is in through the end of January. So no, it's not -- we don't really look at it as Microsoft -- keep in mind, the $89.5 million has been invested by Pearson also in January, okay? Just to be complete. So the money that Microsoft invested is being used to help us funnel international expansion and also drive the overall NOOK Media business, which includes the sales of NOOK devices to drive content sales. It's -- we don't track Microsoft cash per se within NOOK Media, although we obviously report to them on -- as we're required to, as we want to do, on their investment and what it's doing. But cash is fungible, and we have a commitment to get them a return on that cash over time, and that's what we're going to do. It's -- this is the first quarter of the partnership.

Operator

We'll now take a question from Rick Shottenfeld with Coyote Capital.

Richard Shottenfeld

So with the separation largely complete and NOOK Media's cash being sufficient, I know you just said cash is fungible, but is it safe to assume that the Retail cash is now going to accumulate and that we won't be downstreaming anymore of that cash from Retail to NOOK Media? And if so, what options do we have for that cash in terms of the free cash flow direct -- at Retail? Can we -- are we considering returning some of that cash to shareholders through buybacks or dividends?

William J. Lynch

Well, it's true that Retail generates significant cash and it's true that we -- if you look at Q3, our EBITDA was up 7%. In terms of what we'll do with the cash, we have not said anything going forward. The -- obviously, the big news on Retail was Monday's announcement that the company's board has formed a Strategic Committee to evaluate the sale of the Retail business. So that's where we're focused on right now, and the strategic committee is focused on those ongoing discussions with Len. And we're tabling discussions on what to do in terms of dividends or proceeds with the cash that Retail generates.

Richard Shottenfeld

And speaking to that, in other situations where the Chairman has decided to pursue their own interest over that of shareholders, they've been forced to step down from their role. Best Buy comes to mind. And I was wondering why Len is continuing to serve as Chairman while he's pursuing his own interest over that of shareholders. And also maybe, you could help me with the rationale of why the company would be considering selling its working business to the Chairman while trying to keep shareholders holding the business that currently isn't working?

William J. Lynch

Well, first of all, I think the premise of your question is -- I know the premise of your question is inaccurate. Len is not trying to do anything that isn't in the interest of all shareholders. And obviously, we've got a very confident and independent board that will be evaluating anything within the lens of what's good for all shareholders. So remember, to the extent anything successful here, Len owns a significant portion of NOOK Media as well. So there is no notion of Len owns both, obviously, the Barnes & Noble shares. And within that, Barnes & Noble owning 78% of NOOK Media. So this is all about increasing shareholder value. But I'll turn it over to Gene, our General Counsel to answer the second part of it.

Eugene V. DeFelice

So I agree with everything William said, and particularly Len's interest in maximizing shareholder value. But more importantly, we have an independent committee formed, it's a Strategic Committee. It's advised by independent lawyers, independent financial advisers as we disclosed in the press release. And their independence is, frankly, a matter of public record. So they're going to take a good look at any proposed transaction, and the board and the Strategic Committee will consider what the best interests of the shareholders are to maximize shareholder value.

Richard Shottenfeld

Well then could you sort of speak maybe to then why would be in the interest of shareholders to get rid of a business that generates significant free cash flow to pursue one that has negative EBITDA and doesn't have a clearly defined business model?

Eugene V. DeFelice

Actually, the loaded question you're posing isn't really appropriate for us to discuss on this call. We don't -- I don't agree with the underlying premise of it, and we're not going to speculate on potential permutations and combinations of hypothetical transactions. It's up for the Strategic Committee to assess on an independent basis with their independent advisers the bona fide-ness of any offer, the value of any offer and how to maximize shareholder value. So they're going to do that.

Operator

Next, we'll take a follow-up from Matthew Fassler with Goldman Sachs.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

I want to dig just a little bit deeper into the game plan for NOOK Media, with really 2 angles. The first is understanding the degree to which some of your global growth efforts, which involve some start-up spending, might be contributing to the EBITDA losses and where they fit into sort of your next steps. And then secondly, your corporate priority for NOOK was to really grow the brand, grow the install base, with the understanding that, that would be expensive upfront and granted it's probably cost a bit more than you thought. As you re-prioritize cash flow and profitability within the digital business, do you feel like you can still grow in that context? And does it matter as much to grow as you thought it did when you launched the strategy?

William J. Lynch

Yes. We think growth is really key. And the 2 ways that Mike mentioned, digital education, increased spending in digital education in the College segment. That's certainly one way. We haven't made any announcements other than the Pearson strategic investment, as well as commercial deal there. But you can expect to see things from us. Education has not tipped the way the trade business has towards digital, but we expect that will happen within an abbreviated time frame and we plan to be leaders in it. In terms of the -- your first question on international, yes, we've been spending on international, and that spending has been reflected in the Q3 financials. So we have said we are -- we will be in 10 international markets by the summer with our digital bookstore selling e-books. We've been doing publisher deals. We've added to our content database. And all of that has costed money and will enable us to -- will enable that international expansion.

Michael P. Huseby

Matt, one of the things I mentioned earlier is you're talking the about incremental costs of international expansion, a lot of that, from a cash perspective, is getting funded by our Microsoft deal. It's not necessarily falling through the financials that way because of the accounting for the investment and also the, what we call, operating support payments as debt. So while there is an EBITDA hit, from a cash perspective, that those expansion efforts are completely aligned with Microsoft's objectives on Win 8 and are being funded by them.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

So your answer kind of anticipated my follow-up. So I guess the last -- to close loop on that, at what point does that debt sort of season its way into income, presumably -- or EBITDA, for the NOOK Media business?

Michael P. Huseby

It's a 5-year agreement, and it started on October 4. And because of the way the accounting works and the percentage of the payments that are interest expense and the way the revenue flows, it turns around over time, but it's front-end loaded out of EBITDA.

William J. Lynch

As we sell digital content, it starts to shift.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

And where on the balance sheet is that debt showing up right now because it's not considered long-term debt per se. So which line is that in right now?

Michael P. Huseby

It's in other long-term liabilities.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

And that's -- is that $20 million, $30 million at this point of that number?

Michael P. Huseby

Yes, that's about right.

Operator

We'll take a follow-up from David Strasser with Janney Capital Markets.

David S. Strasser - Janney Montgomery Scott LLC, Research Division

I wanted actually to go back to the Retail business for a second, more of an operational question. And then kind of related to what Matt was talking -- well, or at least as it relates to some of the changes on NOOK. How are you working with pricing? It seems that pricing is getting more aggressive on the eBook side. And how are you working with -- on that pricing so that -- at the physical book side? Is that -- are you seeing that -- the discrepancy in pricing expand? It seems like it is based on what we're -- on the price checks that we do. And how do you, long and medium term, sort of deal with that issue of the sort of price differential discrepancy there between, I guess, eBook pricing as well as -- versus physical?

William J. Lynch

Well, maybe I'll tackle this, and then we'll flip it over to Mitch too, to tackle it a little bit. We haven't substantially changed our physical book pricing strategy across formats, whether it's hardcover, trade, et cetera. We haven't significantly adjusted it. In terms of what's happened with eBooks, what you saw is when we launched in 2009, 2010, eBook pricing was actually lower than where it is today. We had agency pricing go into effect where the publishers set the price, and that brought many of the front-list books above kind of $9.99 pricing where you'd seen it. Recently, what we've seen is a bit of a dip but not a huge dip in eBook pricing, a lot of front lists still above $9.99 when they are published. And so we don't see an accelerating cannibalization of eBooks on physical books at all. In fact, as I mentioned, it's just the opposite. What we're seeing is, and this is true across the market, is slowing of eBook adoption and the physical book business holding up fairly well. So Mitch, I don't think we haven't done anything recently to...

Mitchell S. Klipper

No. I mean, the pricing in stores have stayed relatively consistent. Remember, Barnes & Noble does discount across the board through our membership program and every day discounts throughout the store. And as one of the last guys standing, all the independents out there, they're pretty much full price. So the public is still getting great value coming into the stores as compared to the alternatives out there in the physical space.

David S. Strasser - Janney Montgomery Scott LLC, Research Division

Is that part of what allows you to sort of remain kind of consistent with your guidance and your sales growth thoughts as it relates to the Retail stores?

William J. Lynch

Yes. We're picking up. We know we're picking up share in physical book business. And we also have strong publisher support, and that is a great business for us. We've added new merchandise categories that have done well. We've talked a lot about that in the past. So that's all part of it.

David S. Strasser - Janney Montgomery Scott LLC, Research Division

I mean, if I could just follow up with one more question along that. Is there -- do you think there's a part of a backlash coming from authors/publishers on some of that eBook pricing as they kind of still look -- continue to look backwards at iTunes and what happened there? And particularly authors. I mean, musicians, what's happened to their business. And here you can't even go on touring and something like that. Do you -- is that at some point you think there's a backlash against pricing really getting crushed online? Or maybe you're seeing it's not as -- and maybe there's some very few -- very conspicuous low prices but for the most part, it's not really coming down that much.

William J. Lynch

Well, we talked it's absolutely true that if you look at the value chain, let's say content creator/author, publisher and then distributor, those 3. The less money there is in the total pool, the worse it is for the 3 players in that pool. And so commoditization of that pricing, as you're suggesting, is very bad for the content creator over time. And publishers are acutely aware of this. And I can tell you from talking to the CEOs of all the houses regularly, it's something -- they've looked at the music business, and so there is value in that content and they're going to charge for it with various models. And that's all I'll say about it.

Operator

And now we will take a question from Bill Kavaler with Opus Trading.

Bill Kavaler

Going back to NOOK for a minute. You pretty much admitted that the eReader business is now fully penetrated. And so is part of your cost-cutting shift to improve the software and possibly extend that improved software across multiple platforms, such as the apps and -- for other platforms like Android and iTunes?

William J. Lynch

Yes.

Bill Kavaler

Is that really a significant savings? I know you poured a huge amount of money into a display that seems really not to matter a whole heck of a lot? Is that the sort of thing that you think is going to be able to help return -- or help create a profitable NOOK business?

William J. Lynch

Meaning, not investing as much in specific areas of hardware?

Bill Kavaler

Yes.

William J. Lynch

That's part of it. Although, you will see some innovation from us going forward. It's all the things we've mentioned. It's -- part of it is we've just scaled the platform and built it, invested it over time. And now we've got one of -- there's 2 companies that have, in my view, the most valuable repository of copyright content in the world, and that's us and Amazon in terms of books, magazines, et cetera. So we've been building that out. And you'll see us slow the rate of bending in those areas as we built it out. And then it's a lot of the other things Mike and I talked about on the call.

Bill Kavaler

What do you mean by copyright repository?

William J. Lynch

Our catalog. Our ability to -- we've got hundreds of thousands of publisher relationships, our ability to resell their copyright content, books, digital books magazines, newspapers.

Bill Kavaler

Okay. But is that proprietary? Or can somebody turn around and put it on iTunes tomorrow?

William J. Lynch

It takes 5 -- each one of those contracts, I will tell you, having done them over the last 5 years, has its own nuance. And this isn't flip the switch, go get them done. And remember, we've -- in a lot of cases, we were the -- those -- the biggest customer for those publishers on the physical side, which made negotiating those business development deals very easy. So this is hard yards, and there is no flip switching. It is a strategic asset that is valuable and hard to replicate and expensive.

Bill Kavaler

I got you. Okay, one last question. I'm still confused about how the Microsoft payments flow? I mean, you get $20 million a quarter roughly, and that comes in as debt. Is that correct? And then is there sort of a deferred revenue or something? I'm not really sure what happens. How does it get paid off?

Michael P. Huseby

Yes, it's -- well how does it get paid off?

Bill Kavaler

What's Microsoft --or what is -- you're getting -- you get $20 million in from Microsoft. What do you do with it?

Michael P. Huseby

Well, we record it as cash and as a deferred -- as a long-term liability. Because we have obligations to perform against that money that we receive.

Bill Kavaler

Okay. And so you do development work for Microsoft and then -- so you then spend the cash and you've then got just a liability, more long-term debt at NOOK Media, correct?

Michael P. Huseby

Well, it's not long-term debt per se on the books. It's another long-term liabilities. Long-term debt is a different classification. But the theory behind it is that if money comes into you, you have an obligation to perform in the future, you -- to generate a significant involvement in the generation of the revenues and the activity related to that money you're receiving, and there's an obligation to help that financing vehicle -- in this case, Microsoft -- perform. You have debt from an accounting perspective. You either have equity or you have debt. And this is debt because you have an obligation to perform in the future.

Bill Kavaler

Okay. But then you spend the cash, you do your thing and there is still that debt sitting at NOOK Media, correct?

Michael P. Huseby

Well, it gets drawn down eventually over time as you produce the revenue that's associated with the development activity. You repay it in the form of the revenue share. There's a 50% revenue share in general under the terms of the Microsoft agreement or there's a -- it varies depending upon the terms. But there is a revenue share with Microsoft. Just theoretically, let's just say theoretically, it was 50%. It's not the actual terms. But then you would split the payments and what you get in from that activity and repay to them their share and draw the debt down that they. And then a portion of it is interest expense.

Bill Kavaler

Okay. So as sales are made through Windows 8 -- through the Windows 8 portal, some of those sales are -- some of that revenue is -- goes against paying down the debt that was incurred earlier?

Michael P. Huseby

Yes. You can actually read the terms, the general terms of the agreement. They're on file in the 8-K that we filed back in April of -- or October and the initial term is spanning back in April of 2012. But it talks about what the obligations are for both parties in general terms.

Operator

And that does conclude our question-and-answer session for today. At this time, I would like to turn the conference back over to Mr. Andy Milevoj for any additional or closing remarks.

Andy Milevoj

Great. Thank you, everyone, for joining us on today's call. Please note that our next call will be our fiscal 2013 year end earnings release on or about June 18, 2013. Have a great day, everyone.

Operator

Thank you. That does conclude today's conference call. We do thank you all for your participation.

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