March 18, 2010, promised to be a great day for William Lynch. It was a nice New York morning, 60 degrees, sunny, and the Board of Directors of Barnes & Noble (NYSE:BKS) were about to announce his appointment to CEO, replacing the founder of the company in this role -- Stephen Riggio -- who was going to be kicked upstairs into the largely ceremonial role of Vice-Chairman.
William had every reason to feel good about himself and the company. He had successfully led B & N's entry into the digital world through the DotCom Division; he had been instrumental in propelling their E-Reader entry, the Nook, into a strong competitive position against its only rival, the Kindle of Amazon; and there were really no major clouds on the horizon. Yes, the retail stores were having a tough time because of consumers migrating to the Internet, but this was after all taken care of by the Nook and the DotCom effort. Yes, Apple (NASDAQ:AAPL), the computer and cell phone company, had announced a few months earlier that it was about to release a new type of computer, the so-called iPad, but William did not see this as being very significant, at least as far as Barnes & Noble was concerned.
The E-Reader had been a recent product entry triggered by the realization that book consumers were drifting away from the brick-and-mortar stores to the Internet. What better way to ride this tiger than to give them a gizmo to provide access to any and all books they possibly would want -- a computer that was an electronic book store? Amazon (NASDAQ:AMZN) was the first to realize this and to do something about it. And so, late 2007, it launched the first electronic book -- the so called E-Reader -- and Barnes & Noble followed suit shortly thereafter.
This is how things went from there:
Launches Kindle Original 6" 250 MB
Launches Kindle 2 6" 2 GB
Barnes + Noble
Launches Nook 6"
First iPad on pre-order
First iPad shipped
Barnes + Noble
Launches Nook 6" Wi-Fi only
Launches Kindle DX 9.7" 4 GB
Launches Kindle 3 6" 4 GB
Barnes + Noble
Launches Nook Color 7"
Barnes + Noble
Launches Nook Simple Touch 6.5"
Launches Kindle Fire Tablet 8 GB 7"
Barnes + Noble
Launches Nook Tablet 16 GB 7"
Barnes + Noble
Launches Nook Tablet 8 GB 7"
What took everybody by surprise was exactly how strong the iPad and its various fellow travelers were going to be. The iPad went first on pre-order through the Apple website and the Apple stores on March 10, 2010, and was released for sale on April 3. On the first day, 300,000 pieces were sold. By June 22, this went to 3 million. And by March 2, 2011, eleven months after launch, the iPad had sold 15 million units -- fifty percent more than all E-Readers combined. .
And the iPad was from the word "go" real competition to all E-Readers because it offered an incredible choice of books you could read on the device. Five major publishers made their titles available on the iPad from the first day onwards. To quote the Newsobserver of 3/2/2010 -- "the iPad at first blush seems ideal for the book-reading role Steve Jobs introduced through the iBooks program, which will connect to Apple's online bookstore. The five publishers that have signed on -- Macmillan, HarperCollins, Penguin, Simon & Schuster and Hachette -- will be able to display their wares in full color on a medium that offers a reading experience closer to that of reading an actual book than any other e-book reader."
Nevertheless, E-Reader sales continued to do nicely throughout 2010 and 2011 and B & N continued to grow market share in the category. In addition, its brick-and-mortar business got a reprieve in 2011 when Borders, its largest competitor, went into bankruptcy, then liquidation in July that year. However, this did not stop the continuing erosion of B & N's store-based book business; it just slowed it down.
However, it became clear in late 2011 that the E-Reader roof was about to cave in and that a sharp decline in worldwide demand was unavoidable due to three major reasons. One was the fact that the E-Reader consumer group really never broke out of the Early Adopter mold into the majority, the second was that the follow-up products were never quite compelling enough to get existing consumers to upgrade to the next generation gizmo, and lastly that all new potential consumers went straight to the iPad and other tablets in preference over the E-Readers. This is how sales worldwide developed until 2012 and are expected to go from that day onwards:
Source: iSuppli News Reports (Dec '12)
All major competitors in the field suffered, and both Amazon and Barnes & Noble lost half their E-Reader sales in 2012:
Not including Tablets such as Kindle Fire or Nook HD
Source: Klosters Retailer Panel
Google Trends tell the story from a web traffic point of view:
To compensate, both Barnes & Noble and Amazon resorted to two strategies. One was to develop and launch their own version of tablets late in 2011, and the second was to broaden distribution of the Nook and the Kindle by going to mass retailers such as Wal-Mart (NYSE:WMT), Target (NYSE:TGT), Best Buy (NYSE:BBY) and Toys "R" Us (TOYS).
This is how the Nook and Kindle distribution looks today with the U.S. mass retailers:
Toys "R" Us
Barnes + Noble Nook
Nook HD 7" 8 GB
Nook HD 7" 16 GB
Nook HD 9" 8 GB
Nook HD 9" 16 GB
Nook HD 9" 32 GB
Kindle 6" 2GB
Kindle HR 6" 2 GB
Fire 7" 8 GB
Fire 7" 16 GB
Fire 7" 32 GB
Fire 8.9" 16 GB
Fire 8.9" 32 GB
Fire 8.9" 4G Lite 32 GB
Fire 8.9" 4G Lite 64 GB
Nevertheless, neither strategy did B & N any good, and the end effect was that sales of the company first stagnated and then began to decline:
** after Eliminations, assuming that these are all brick-and-mortar related
Worse than the disappointing sales performance, Nook also was and continues to be responsible for significant operating losses: $126.9 million in 2010, $229.6 million in 2011 and $286.3 million in 2012. Current projections are that 2013 will be no better -- in fact, the first three quarters' results for Nook suggest that losses will be nearly double those of 2012
To ensure the survival of B & N in the face of these and anticipated future losses, the board decided to do two things. One was to spin-off Nook into a separate legal entity, Nook Media LLC, on October 4, 2012. Nook Media includes Barnes & Noble's Nook devices, online bookstore, e-content publishing and college business
The second was to bring in more cash by giving Microsoft (NASDAQ:MSFT) equity participation in this new entity of about 17.6% in exchange for an injection of $300 million; and to also bring in Pearson Plc (NYSE:PSO) on December 28, 2012, as a 5% shareholder, in return for a payment of $89.5 million. Given the trajectory of losses incurred by Nook -- which presumably will in future be incurred by Nook Media LLC -- the total cash handed over by the two investors will be pretty much burned through within twelve months or so.
Given the problems besetting B & N from all sides -- loss making Nook business, decreasing brick-and-mortar sales, lack of innovation in terms of new products -- it is interesting to see that two parties are seeking to take over different parts of B & N's business.
The one party is Microsoft, already a 17.6% shareholder in Nook Media LLC, [with Pearson having another 5%], which has expressed an interest in acquiring the remaining 77.9%. This proposal is not without merit, given the fact that Microsoft would through the Nook gain a foothold in the E-Reader segment and that the company would become a factor, so far virtually non-existent, on college campuses by virtue of the B & N College Stores. It would also gain traction in mass retail for its two tablets, Surface and Surface RT. Microsoft is not doing too badly in that segment of its business -- it is reported to have sold 900,000 units of these two tablets in the first quarter of 2013, representing 1.8% of the worldwide tablet market. One problem is that it has not been able to get distribution in any of the major retailers, other than Best Buy, whereas the Kindle is already in Wal-Mart and Target.
There are apparently ongoing conversations between the B & N and the Microsoft managements, and the chances of them leading to a deal are considered pretty good. There would be a number of synergies for Microsoft, and such a transaction would also benefit B & N in that it would give it the cash necessary to survive into 2014 and possibly beyond.
The second is Stephen Riggio, the founder and now Chairman of the company, who appears bent on buying the brick-and-mortar part of B & N, its 689 stores, and to take it private. He is not interested in the Nook Media business, which includes the Nook, the 678 College Book Stores and the DotCom business. This could make eminent sense if we assume that the problems besetting B & N are not exclusively due to negative trends in consumer behavior and the technological landscape, but are also to a measurable degree caused by internal factors.
In order to assess whether a change in management could positively affect the outlook for the brick-and-mortar part, we need to look at the business in which the company finds itself -- the U.S. Book Market place:
Source: Galleycat Bookselling Sales Stats June 15, 2012, first quarter 2012
While declining, the U.S. printed books market is still formidable -- $5.5 billion in 2012.
The main categories are:
Mass Market Paperback
Source: Publishers Weekly 1/4/2013
The two main contenders in this market place are Barnes & Noble, which is still #1, and Amazon, which is a relatively close #2. Both compete in a declining market, but the odds are more stacked against one than the other -- and the disadvantaged is, in fact, Amazon. Two reasons: one is that Amazon's sales tax advantage is about to disappear if Washington passes the Marketplace Fairness Act, forcing the Amazons of this world to pay sales tax on Internet sales; the other is that Amazon needs to charge shipping, which now costs about $4 for two items shipped and which the brick-and-mortar retailers do not. This shipment charge is most onerous if applied to the less expensive books such as paperbacks [which represent two-thirds of all printed books bought].
To demonstrate the impact of pricing, B & N's and Amazon's rates are shown in the table below for the top 20 fiction books, as per the NY Times Best Sellers list of May 2013:
B & N $
B & N $
12th of Never
Best Kept Secret
Life After Life
Dance w Dragons
Sub Total *
*no freight or sales tax included for both companies
**printed books: freight for Amazon $2 per pc but no sales tax, sales tax 6% for Barnes + Noble but no freight
In short, B & N is clearly more expensive, both for printed books as well as their E-counterparts. While this is somewhat understandable in the case of the printed books sold in their retail stores given the running costs involved, it is not at all so in the case of the E-books, where a price differential of 56% is very difficult to justify. Remember, we are not talking about some abstruse tome that nobody else carries and very few highbrow scientists would want -- we are talking about the top twenty bestsellers according to the most influential newspaper in the nation.
If this pricing issue can be addressed, there is absolutely no reason why the B & N retail stores could not do well even though their core market is declining. They have a few things going for them. One is that they are now the only place where you can sit down, have a cup of coffee, read a magazine, browse the book shelves and then even make a purchase -- a book, a toy, whatever. The second is that they are inordinately large stores at an average of 56,000 square feet, which should allow incorporating a number of new high-growth product categories -- consumer electronics, robotics, sports products etc. And the third is that they have a very well motivated and talented group of store associates and store managers that can execute much better than some disembodied Amazon telephone voice.
In other words, I would not give up on Barnes & Noble just now.