Nook Media has been on a tear lately.
Since my last Barnes & Noble (BKS) article on September 20, Barnes & Noble stock has skyrocketed 78%. This move has been driven primarily by Chairman Len Riggio's move to buy the retail side of Barnes & Noble, as well as a capital injection from Pearson, and general strength in the retail sector. Most recently, Barnes & Noble stock has surged on a buyout rumor of the Nook unit from Microsoft (MSFT).
BKS data by YCharts
I believe that the short-term upside from these developments is priced, and am anticipating a pullback or plateau in the stock price for the remainder of the year. However, Barnes & Noble remains one of my favorite companies. Two recent developments have reinforced my long-term view that the Nook Media division has multibagger growth potential over the next several years.
The recent debut of the Nook Press publishing platform and the addition of Google (GOOG) Play to the Nook HD and HD+ tablets demonstrate that Barnes & Noble CEO William Lynch understands the "Gorilla Game" and is making the proper plays to dominate the eBook market and profit from tablet sales in the long run.
The Gorilla Game
The term "gorilla" in the context of technology markets was coined by technologist Geoffrey Moore in his book The Gorilla Game. Moore's theory holds that technology markets will be dominated in the long run by companies that acquire proprietary control over the common standard architecture.
In a nutshell, the idea is that walled garden formats that dominate early technology markets will eventually lose market share to an open standard backed by multiple generic competitors. Long term winners - "gorillas"- must therefore find a way to do two seemingly incompatible things at the same time:
1. Gorillas must be "open." They must be fully compatible with the common standard so that they can easily poach customers from generic competitors.
2. Gorillas must also be "proprietary." They must find ways to lock in their own customers during market consolidations. Further, they must also acquire de facto control over the standard format that they use so that they are free to innovate as the market evolves.
Nook Press Solidifies Nook As The ePub Gorilla
Amazon's (AMZN) Kindle is the market leader in eBooks, but it is not a proper gorilla as most generic eBookstores and eReaders have opted for the standard ePub format instead of Amazon's mobipocket format.
The Nook has always been "open" in that it is fully compatible with the ePub format used by other eBookstores, and it is "proprietary" as it has found a way to lock in its own customers through digital rights management. But there is one thing missing: the ePub standard is set by the International Digital Publishing Forum (IDPF) and Barnes & Noble has not exercised much de facto control over the development of the format.
The new platform creates an ePub file from an uploaded Microsoft Word, html, or ePub file, or from text and images entered into a simple WYSIWYG online editor. I began by laying out the book using the editor directly, and found this process to be fairly painless. However, when the book was completed, I found that I wanted to use some advanced HTML editing to better control how images were displayed. As such, I downloaded the Nook press PDF and began making modifications.
What I found was that while the Nook press ePub file was viewable using non-Nook software, it did NOT pass when I ran it through the compatibility checker provided by the IDPF. Furthermore, I found that the Nook press editor did NOT always accept ePub versions of the book that I created using alternative software even when those files did pass the IDPF check. This was a minor headache for me as an author, but obviously I was able to figure it out and get the book published, and as an investor, I was impressed that I was able to pull this off.
Nook has effectively created its own definition of ePub, and it isn't afraid to differ from the IDPF definition when it suits its needs. And because Nook makes the most ePub eReaders, sells the most ePub books, and now makes the most popular ePub editing software, the Nook definition of ePub is the de facto standard to which authors and even competing manufacturers must adhere. That makes it the gorilla.
Barnes & Noble's partnership with Microsoft will further reinforce Nook's control over the format because most authors initially draft their manuscripts using Microsoft Word. If Microsoft adds a native ePub conversion function to Word, it will use the Nook definition of the format. This means that moving forward, Nook will have all the tools and influence it needs in order to innovate and implement new eBook features without losing the advantages of cross-compatibility.
Google Play Shows It Gets It
Let's be perfectly clear: Google owns Android and Google is the gorilla of that operating system. The Nook is not and will not be the Gorilla in this space. By adding Google Play to the Nook HD and HD+ tablet, Nook's management team has shown that they understand this.
But the fact that the Nook will not be the gorilla does not mean that it cannot make money as a tablet manufacturer or that its own app store is not a valuable asset. This move will help sell a lot of tablets.
But don't take my word for it; let's take a look at Google trends for Nook over the last year:
and compare that to Kindle over the same period:
We can see that interest in both eReaders is actually seeing a year-over-year decline, but the addition of Google Play has caused a visible spike in Nook interest. As such, the year-over-year search interest for the Nook has declined only 22%, while the year-over-year search interest for the Kindle has declined 25%.
An aspect of this story that has gone under the radar is that Nook made this move just two weeks after hitting the 10,000 app mark with their own app market. I know this only because I have been counting the number of apps in the Nook store every week when they are released on Thursday. Because of the timing, I believe Nook has been planning this move for a while and was simply holding out to incentivize developers to add their applications to the Nook market.
But what can Nook do to with all those applications? I believe it should discount them to drive hardware sales.
The razor-and-blade business model that Barnes & Noble and Amazon have been using to drive content sales for the last two years is now broken. The Department of Justice disrupted it by banning the agency model that ensured positive margins for content. Since regulations are now forcing digital media providers to compete on price, it now makes more sense to develop premium hardware and offer below cost content to drive sales.
But it is too late for Amazon and Google to switch strategies as they have already made all of the digital media they sell available on competing devices. Nook, on the other hand, never quite got around to developing a way to move the apps and video it sells to other devices. It can still use those categories as loss leaders. It is like everyone was running a marathon and somebody blew a whistle and pointed out the finish line was in the other direction.
Of course, the current lineup of Nooks is not priced at a markup. But Barnes & Noble has already taken a heavy inventory writedown on those devices, so it can record a profit if they sell well. Barnes & Noble has historically launched hardware twice a year, and it will soon be able to set a higher margin price point for its hardware. The recently leaked buyout plans show Barnes & Noble planning to phase out the Android tablets by 2014, but I'm not sure I believe that. In fact, I wouldn't be surprised to see Nook launching a color e-ink display soon!
In Spite of My Bullishness, I'm Taking Profits
The bulk of this article has been about developments that I view as positive for Nook Media in the long run. But I must now throw some cold water on my own arguments because the current stock price reflects a buyout expectation that I believe is unrealistic.
Is Riggio buying the retail business to leave Nook, or is Microsoft buying the Nook business? I don't think we'll see both, and if we do, I think shareholders will be underpaid.
If Riggio buys the retail business, I believe investors will get a fair price, but not an overly generous price. Two months ago, Alexander Paslawsky wrote an excellent article in which he values the proposed buyout at $20/ share or higher. My estimate, based on comments Len Riggio reportedly made two years ago during another rumored buyout, is that Riggio would offer around $18/ share. But that $18-$20/ share will probably not be paid out to investors in the form of a dividend. The purpose of the sale would be to finance further investment in Nook Media. I'm fine with this capital allocation, but I don't think the majority of the people who've bid the stock up to $18/ share are. I think there will be heavy short-term selling pressure on the stock price when the buyout details are announced or shortly after the buyout is completed.
The other option would be to take Microsoft's offer of $1 billion for the Nook. Quite frankly, I think this offer is too low given Nook's de facto control over the ePub standard. But my opinion won't stop the sale. Most people don't know how valuable this sort of control is to technology companies. To most value investors the offer seems generous and the Riggio brothers, who still own approximately 40% of the shares, don't want to own the Nook anymore.
Additionally, I can't ignore the fact that the chairman of the board has a direct financial interest in lowering the share price in the short term if he is still planning to make an offer himself. Management can talk the share price down a lot easier than they can talk it up.
As such, I have sold calls at $20/ share. I'm comfortable exiting at this point, and I don't believe it is wise to for anyone to buy at these levels to chase speculative buyouts.
But I'm sure looking forward to buying back in when some of this blows over.