Barnes & Noble (NYSE:BKS) is one of the world's largest booksellers. The firm's bottom line has been in a downward spiral since the introduction of its Nook Color devices. High R&D, even higher marketing expenses, all coupled with a fierce competitive landscape that makes the fight for market share particularly difficult have all contributed to the colossal drag on the bottom line that the Nook division has had on the firm's EBITDA profile. However, while I am positive on the firm's decision to (finally) scale back and more wisely allocate its Nook investments, I remain negative on the name as its core business is in very clear secular decline.
Just How Bad Was Nook?
Barnes & Noble's Nook division cost the firm $475M in net losses for the entirety of FY2013. To put this loss in perspective, the firm's entire market capitalization sits at a mere $978M. These types of losses were completely unsustainable, and the decision to exit this business was the right one. But the troubling question is why management attempted to attack this business in the first place?
See, the problem with being in the computing device business is that success largely requires massive scale as the devices themselves can be built by any reasonably well capitalized firm by using off-the-shelf commodity parts. So what device vendors need to do is to either attack the market with sheer economies of scale and perhaps an extremely favorable cost structure (as with Samsung, since this giant in-sources the majority of the components for these types of devices), or to try to differentiate on software. Barnes & Noble tried the software route.
Nook was essentially an Android tablet with a custom user interface layer on-top of the core OS. This means that on top of this commodity hardware, Barnes & Noble was spending considerable amounts of money developing a UI to differentiate the Nook device from the hordes of other Android devices available. Of course, as the company is now finding out, it likely makes much more sense to simply find partners for the Nook software platform within the broader tablet vendor ecosystem. This means that Barnes & Noble can profit from the content sales that the platform allows for, while leaving the hardware risk (and profit) to device vendors.
I would watch Barnes & Noble's announcements regarding Nook carefully and hope to see some sort of licensing/royalty model for the Nook-specific platform.
The Core Business Is Strong, But Showing Signs Of Secular Decline
It's no secret that Barnes & Noble's foray into the tablet/e-reader market was largely driven by the realization that digital content is here to stay, particularly as rival Amazon.com (NASDAQ:AMZN) has aggressively pushed its own Kindle e-Readers, tablets, and even software platforms for non-Amazon branded devices.
Despite the firm's core retail business generating significant amounts of EBITDA (retail + online did $374M (+16% Y/Y), college did $111.5M (-3.9% Y/Y)), and factoring out the Nook losses makes Barnes & Noble look quite cheap at these levels. Unfortunately, there are a few issues here:
- Retail EBITDA was up 16% Y/Y, but this was driven by a richer mix offsetting a 10% sales decline
- College EBITDA was down 3.9% but sales were up 1.1%, implying margin pressure
So the two profitable, core businesses are both problematic. Further, with the firm's guidance of high single digit sales decline for the core retail business and low single digit decline for college, the main fear is that the business - in light of the world moving towards digital content, and with Amazon leading the charge there - is in an unstoppable long term secular decline.
While Barnes & Noble may be able to more effectively monetize its Nook business and establish some sort of moat when it comes to digital content distribution, there will be continued fears about the long term view of the business.
At this point, ex-Nook, shares are pretty cheap on an EV/EBITDA basis (2.07x), but it is likely that during the restructuring of the Nook business that the full value of the core business will not be realized. Further, there are still long-term structural concerns over the long term viability of the business itself in light of the new digital content paradigm that has defined the book industry. While at this point, the short side of the trade is quite crowded, it is difficult to see a catalyst to drive upside in the near to medium term, which makes it tough to recommend shares, even in light of the recent correction.