Amazon and Barnes & Noble: A Tale of Two Booksellers

A look at America’s largest book sellers will reveal some stark contrasts. On one hand, we have Barnes & Noble (BKS), the steady and familiar “brick and mortar” bookstore, and on the other there is Amazon (AMZN), the popular internet retailer. Looking at these two companies and their stock prices brings you back to the heady days of 1999, when companies were neatly divided into “old economy” and “new economy” companies and the latter were given absurd valuations in the stock market. Now, ten years later, Amazon’s stock price has reached new all-time highs and Barnes & Noble is trading near the low end of its range for 1999.

In reality, many things have changed in the last decade. Companies are no longer worth hundreds of millions — or even billions — of dollars by virtue of a dreamy business plan and references to the internet in their names. Amazon is one of a handful of companies that has lived up to its hype of the dot com boom. It has consistently grown revenues well in excess of 20% per year and has been profitable every year since 2003.

However, when comparing these two distant relatives, it seems that their valuations have drifted too far apart. Care to guess what the ratio of their market capitalizations to one another is? The answer is 56:1 in Amazon’s favor. That would be understandable if Barnes & Noble were in a situation like its smaller competitor, Borders Group, which is headed for a fourth straight year of losses and whose survival is in question. But that is not the case with B&N. Barnes & Noble has remained profitable throughout the downturn, although revenue and EPS in the last twelve months are off 7.5% and 41% from their respective peaks in 2007 and 2006. Considering that, the company’s trailing P/E ratio is around 13, the market consensus would indicate that the decline of Barnes & Noble is secular rather than just cyclical.

As for the digitization of books, this is by many perceived as an opportunity for Amazon and a threat to B&N. It is premature to declare a winner in this battle. E-books should cut into physical book sales at Amazon just as much as at B&N, and the latter is coming out with an eBook reader, nook, which is by many accounts superior to the Kindle from Amazon. This new reader is coming out just in time for the holiday season and will have the advantage of being on display in stores where shoppers can handle the product, as opposed to seeing a picture of the Kindle on Amazon’s web site.

Other potential positives for B&N include its purchase of Barnes & Noble College Booksellers (which was previously a separate privately-held company) at the end of September. While the acquisition will have a negative impact on earnings in fiscal 2010 (the fiscal year ends in April), the college bookstore business is stable with some growth potential. Additionally, if Borders Group were to go under, an event whose odds I am not in a position to estimate, B&N would most likely be the largest benefactor.

The Tyranny of high P/Es

If Amazon and B&N had similar valuation ratios, there would be no question that Amazon would be my preferred investment. However, the valuation ratios differ widely. To give its investors a satisfactory return on their investment, Amazon will have to keep growing rapidly for a long time.

As a little thought exercise, let’s assume Amazon earns 2 dollars per share in 2009 and grows sales 25% every year while maintaining a constant profit margin. Further let’s factor in a required rate of return of 11% per year (not a very high rate considering the risk). In 2019, annual sales will have grown to 238 billion dollars and earnings to 18.6 dollars per share. Amazon’s stock price will be 340 and after all this, the P/E ratio will still be over 18.

Let’s think about what this means. Amazon has been an incredible success story over the last fifteen years. It is now a household name and the largest online retailer. Is it likely that sales will grow from 22 billion to 238 billion in the next ten years? Given how Amazon is already beginning to butt heads with the likes of Wal-Mart and Target, the price wars are moving from books to DVDs, you can imagine how hard and successfully Amazon will have to fight to reach that level of sales. My example is simplistic for illustrative purposes. Amazon could for instance start paying dividends instead of reinvesting all its cash flow. But the fact is that Amazon is in a low margin business and unless it can grow sales to 200 billion or so by 2019, its current P/E of 70 is not justified.

It is dangerous to short stocks on valuations alone, as they can always go from unreasonable to more unreasonable, but it is worth remembering that ultimately prices are determined by fundamentals and not the other way around.

Disclosure: Long position in BKS and short position in AMZN.

Comments

[rrtzmd:]

...more like a tale of two managements...one is innovative, aggressive, and constantly prowling for new avenues of growth...the other has its head stuck up its brick and mortar butt and is slowly but surely traveling the path of the dinosaurs....

Nov 09 08:44 AM

[epeon:]

I have been thinking about this, too. AMZN is so highly valued that I see no way it can deliver a reasonable return to the investor. BKS, on the other hand, pays a reasonable dividend, has the cashflow to maintain it, and you can write covered calls against and make reasonable money. I kind of like BKS.

Nov 09 09:29 AM

[FranklinAZ:]

Yeah, the BKS div is typically in the high 4% to 5+ % range, so that and the fact that the nook (which is also an audiobook and mp3 player) apparently blows the kindle out of the water, makes BKS far more attractive. Actually, if B&N were to add a web browser to the nook, you'd start to look at a category killer, as it would be pretty much everything but a camera and cellphone.


On Nov 09 09:29 AM epeon wrote:

> I have been thinking about this, too. AMZN is so highly valued that
> I see no way it can deliver a reasonable return to the investor.
> BKS, on the other hand, pays a reasonable dividend, has the cashflow
> to maintain it, and you can write covered calls against and make
> reasonable money. I kind of like BKS.

Nov 09 10:29 AM

[rrtzmd:]

...I think this chart says it all:

finance.yahoo.com/echa...;range=5y;compare=amzn...

Nov 09 01:21 PM

[rrtzmd:]

...try again -- copy and paste:

"finance.yahoo.com/echa...;range=5y;compare=amzn...

Nov 09 01:22 PM

[Alton70:]

Amazon is far more than a book seller or on-line retailer. It is morphing into a powerful technology vendor. Not only does it offer an internet platform for many other retailers, but the Amazon cloud computing environment (as well as the Google cloud) is spawning a massive resurgence in small internet software companies. The advent of 'cloud computing' dissolves the old price barrier to powerful computing resources, and this definitely has the potential to be a major game changer in many industry sectors.

Nov 09 10:34 PM