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Barnes & Noble, Inc. (BKS)

Q2 2006 Earnings Conference Call

August 17, 2006 11:00 am ET

Executives

Joseph Lombardi - CFO

Steve Riggio - CEO

Marie Toulantis - Barnes & Noble.com CEO

Analysts

Mark Rowen - Prudential Equity

David Magee - Robinson Humphrey

Blaine Marder - Loeb Partners

David Weiner - Deutsche Bank

Presentation

Operator

Good day everyone and welcome to this Barnes & Noble second quarter 2006 earnings results conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the Chief Financial Officer, Mr. Joseph Lombardi. Please go ahead, sir.

Joseph Lombardi

Good morning and welcome to Barnes & Noble's second quarter 2006 conference call. Joining us today are Steve Riggio, Mitchell Klipper, Marie Toulantis and other members of the senior management team.

Before I begin, I would like to remind you that this call is covered by the Safe Harbor disclosure contained in our public documents and it is the property Barnes & Noble. It is not for rebroadcast or use by any other party without the prior written consent of Barnes & Noble.

This morning, before the market opened, we released our results for the second quarter ended July 29, 2006. Second quarter consolidated sales totaled $1.2 billion, a 1% decline from a year ago which included sales of Harry Potter and the Half-Blood Prince. Sales at Barnes & Noble stores were $1 billion, flat with a year ago. Comparable store sales decreased 2.6% for the quarter, in line with guidance, which called for a low-single-digit decrease.

Sales of hardcover bestsellers remain soft as was the case in the first quarter. Music sales worsened this quarter to a double-digit decline, some of which was offset by a double-digit increase in DVD sales.

In the first quarter, we opened four Barnes & Noble stores and closed one for a quarter end total store count of 687. Comparable store sales at B. Dalton decreased 9.1% for the quarter and now represent less than 2% of consolidated sales. We have closed one more B. Dalton store this quarter, resulting in a total B. Dalton store count of 112.

Sales at the Barnes & Noble.com are $83 million, representing a 14% decline from last year when we reported a 14% increase. The decline is primarily attributable to last year’s Harry Potter book, which resulted in a big boost in second quarter sales not only from the book itself, but also related Harry Potter merchandise as well as add-on sales. As expected, gross margins were higher than last year, which included the deep discounting of the Harry Potter book.

Our conversion and transition plan for the new distribution center continues on plan and is nearing completion. Redundant costs included in our results for the transition were only about $0.02 per share this quarter. We now expect an additional $0.01 to $0.02 per share of redundant costs in the third quarter of this year. As a result, full year redundant costs will be $0.06 to $0.07 this year compared to $0.09 as previously discussed.

Our selling and administrative expense rate was 60 basis points higher as a percentage of sales this year. Most of this increase relates to the adoption of SFAS 123 R and the related expense associated with stock compensation costs. The SG&A rate was deleveraged by the negative comparable store sales, but was mostly offset by lower legal costs than last year.

Earnings per share for the quarter were $0.24, within guidance. Stock compensation expenses amounted to $0.04 per share for the quarter. In the second quarter of 2006, the Company acquired 677,000 shares, or $26 million, under its share repurchase program at an average price of $38.15. The Company has $52 million remaining under the current program.

On August 3, the Company announced an amendment to its credit facility which extended the agreement another year to 2011 and reduced our borrowing rates and commitment fees. As of the end of the second quarter, we have borrowed $41 million against our capacity of $850 million.

Now for guidance for the third quarter. Our sales guidance range for the third quarter is for flat to a low single-digit comparable store sales increase. The Company expects a net loss per share for the third quarter between $0.04 and $0.08. This includes a $0.04 per share projected charge for stock compensation costs.

Full year guidance for sales and earnings per share remain unchanged. Third quarter guidance is based upon a basic share count of 65 million shares. Full year guidance is based upon a fully diluted share count of 69.5 million shares.

At this point, I'd like to turn the discussion over to our Chief Executive Officer, Steve Riggio.

Steve Riggio

Good morning. As Joe mentioned, second quarter results were right in line with our expectations. We plan for comparable store sales to be negative due to the much stronger line-up of titles from last year. There were no surprises. Since we expected sales to be soft, we were able to manage our expenses well; our gross margin, slightly better than plan, and inventory levels were right in line with plan.

We look back at the first half of this year as one of the softest periods in recent memory for the book industry in terms of hardcover new releases. There were simply very few new hardcover books that generated media buzz or sustained sales by word-of-mouth recommendations.

But I will note that, even in such a lackluster new release environment, our comparable store sales would have been slightly positive in the second quarter when factoring out the extraordinary sales of J.K. Rowling's Harry Potter and the Half-Blood Prince from last year. This fact underscores what we've said time and again: our business certainly benefits from blockbuster titles. We love to have new authors hitting our bestseller list. We love when books are generating lots of media buzz and traffic, but we have a very strong foundation. That foundation is our back list when publishers' lists are weak.

I will mention that there was one notable bright spot in the quarter and it's due to some extraordinary of steps we took to promote a single book. Kim Edwards' novel The Memory Keeper's Daughter is one of the fastest-selling trade paperbacks in our history. We supported this title very strongly on its publication. The book shows no sign of slowing down and it's fast becoming a favorite book group selection of readers everywhere. Those are my comment on the second quarter.

I'll give you our forecast for the third quarter and holiday season in terms of the releases. We think that the new release schedule for the second half of the year is stronger than the first half in both the fiction and non-fiction fronts.

In fiction, several authors with strong track records have new books, including Frederick Forsyth, Anna Quinlan, Robert Harris. We have Mitch Albom's next book, For One More Day. His last book was the second-largest selling fiction book in our history. We have the long-awaited second novel from Charles Frazier, the author of Cold Mountain. His new book 13 Moons is highly anticipated.

There will be new titles from brand-name writers, including David Baldacci, Janet Evanovich, Robert Parker. We have two works from the writers that are getting a lot of buzz: Diane Setterfield, The Thirteenth Tale and Jed Rubenfeld's The Interpretation of Murder. These are all September/October.

On the non-fiction side, books on current affairs, politics, and war will be abundant, including Faith and Politics by John Danforth, The Greatest Story Ever Told by Frank Rich, Never Again by John Ashcroft, The Confession by James McGreevey and a currently untitled book by Bob Woodward continuing his take on the Bush administration and the war.

Lots of biographies and memoirs are due. Bob Newhart, Sandy Weil, Carly Fiorina, Ellen Burstyn and the musician David Crosby. There's a major new biography on Andrew Carnegie and the definitive book on the rock-and-roll band U2, greatly anticipated by its fans, goes on sales September 26.

It looks like a very strong season for cookbooks, led off with the 75th edition of the Joy of Cooking, a new edition of the Bon Apetit cookbook and new titles from Paula Dean, Rachel Ray, Emeril Lagasse and the Barefoot Contessa.

Lastly, for the first time ever, a non-fiction book from John Grisham, The Innocent Man, will arrive in stores on October 10th. It's one of the most eagerly-awaited books we have seen in a very long time. It is already on BarnesandNoble.com's top 100 list. Thank you.

Joseph Lombardi

Before we take your questions, I wanted to address one additional item. As you may recall, on July 11th, we announced that a putative Barnes & Noble shareholder had filed a derivative complaint in New York State making certain allegations regarding the Company's issuance of stock options. The complaint named certain current and former executives of Barnes & Noble as well as certain members of the Board of Directors.

A second derivative complaint was recently filed in the same court containing very similar allegations. Subsequent to the filing of the initial complaint, we also received notice from the SEC that it is conducting an informal inquiry into the matter with which the Company is fully cooperating.

The Board has appointed a special committee consisting of Patricia Higgins to review the Company's stock option practices. The Company has retained independent legal counsel to assist with that review and that review is underway. Under all of these circumstances, we will have no further comment on these matters at this time.

At this point, we would like to turn it over to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mark Rowen - Prudential Equity.

Mark Rowen - Prudential Equity

Thanks. Good morning, guys. Joe, can you tell us what the comps would have been without Harry Potter? If I remember last year, did that increase your sales by 5%? Was that the number?

Joseph Lombardi

No, the comps without Harry Potter are slightly positive.

Mark Rowen - Prudential Equity

Slightly positive. I don't know if you've looked at it this way, but if you exclude Harry Potter, what did the comps look like as far as traffic versus ticket?

Joseph Lombardi

For the quarter, the comp store sales decline was largely due to traffic, obviously, with Harry Potter.

Mark Rowen - Prudential Equity

Right, but I mean adjusting for Harry Potter.

Joseph Lombardi

I'm getting there. If you exclude the month of July, May and June traffic was up a tick and ticket was down a tick, but essentially, traffic and ticket were flat.

Mark Rowen - Prudential Equity

On your third quarter guidance, the loss of $0.04 to $0.08, it looks like it's difficult to get to, particularly the bottom end of the range without a significant deterioration in gross margin or SG&A. What's causing that, and is it mostly SG&A or is it mostly gross margin?

Joseph Lombardi

It's a little of both, more so SG&A. Obviously with flat sales at the bottom of the range, we don't make a lot of money in the third quarter typically anyway.

Mark Rowen - Prudential Equity

What would cause a gross margin decline in the quarter year-over-year?

Joseph Lombardi

Just timing of promotions and items, nothing significant.

Mark Rowen - Prudential Equity

Marie, on the online sales for the third quarter, are you still expecting similar increases year-over-year to what your comp store guidance is, which is I think what you had said early in the year?

Marie Toulantis

Yes.

Mark Rowen - Prudential Equity

So flat to up single digits?

Marie Toulantis

Yes.

Mark Rowen - Prudential Equity

The fact that Amazon is growing their media business, and I know that's not just books, but their media business faster than that, is that still primarily a function that you're not spending as much on advertising, or are there competitive pressures on pricing there?

Marie Toulantis

Again, I think you said it. They're not comparable in terms of the way we report and in terms of what Amazon may or may not have included in that number. So I don't think that's really a good comparison.

Mark Rowen - Prudential Equity

Okay great. Thanks.

Operator

Our next question comes from David Magee - Robinson Humphrey.

David Magee - Robinson Humphrey

Good morning. Just a quick question on the same topic there. Given that Amazon seems to have become a little more aggressive with shipping costs and with the Prime shipping, are you all contemplating any changes with regard to how you're pricing your product or charging for shipping on the online side of the business?

Marie Toulantis

We're always reviewing those options and we'll continue to do so. So I don't really want to comment on whether we have any changes pending, but it's fair enough to say that we'll continue to review those items.

David Magee - Robinson Humphrey

Okay thank you.

Operator

(Operator Instructions) Our next question comes from Blaine Marder - Loeb Partners.

Blaine Marder - Loeb Partners

Hi, guys. Joe, it seems the working capital this year is running a bit heavy. Is that going to reverse itself the rest of the year? I think you originally threw out a $200 million cash flow number for the year. Is that still appropriate?

Joseph Lombardi

Yes, the working capital number is a little bit of a blip at quarter end. It's nothing material. Our free cash flow is still expected to be $200 million for the year.

Blaine Marder - Loeb Partners

You guys still have an appetite to buy in your own stock; when do you have a board meeting that you might increase the authorization?

Joseph Lombardi

Well, the Company has bought back its own stock pretty significantly over the last six quarters. The Company has a regular scheduled board meeting in September, but that doesn't necessarily equate with when we do authorizations. Actually, the last two authorizations I believe weren't even done around Board meetings.

Blaine Marder - Loeb Partners

Okay. Might you guys consider increasing the dividend?

Joseph Lombardi

We don't really have any comment at this point. We just reaffirmed that we're doing the dividend, the quarterly dividend, in today's release. We don't have any further comment at this time.

Blaine Marder - Loeb Partners

Alright.

Operator

Our next question comes from David Weiner - Deutsche Bank.

David Weiner - Deutsche Bank

Thanks. Quick question on the gross margin. On my model, it was up roughly 90 basis points. Besides cycling the Harry Potter from last year and the discounts, can you talk a little bit about what else drove that increase?

Joseph Lombardi

The most important piece of that was the Harry Potter discount and the lower bestseller markdowns in the quarter. The rest of it is just the ordinary, everyday stuff.

David Weiner - Deutsche Bank

Did the Sterling contribution increase relative to last quarter, the self-published, I guess I should say?

Joseph Lombardi

It's in line with where we expected it to be. So it's fine.

David Weiner - Deutsche Bank

Secondly, are you feeling any competitive pressures from -- obviously, you're always feeling competitive pressures from Borders, but with the ramp-up of their loyalty card, are you seeing anything there that's more so than you expected?

Joseph Lombardi

To date, we're not seeing much of an impact at this point.

David Weiner - Deutsche Bank

Thanks a lot.

Operator

At this time, we have no further questions coming in. I will turn the call back to our presenters for any final or closing comments.

Joseph Lombardi

Thank you for listening to our second quarter 2006 conference call. Please note that our next scheduled financial release will be our third quarter release on or about November 16.

Operator

That does conclude our conference. Thank you all for your participation. We hope you enjoy the rest of your day.

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