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Introduction and Thesis

In this article, I explain why Barnes & Noble (NYSE:BKS) is well positioned to turn around in the next year and remain a stable and profitable company. The consensus among many investors is that bookstores will gradually become obsolete, as traditional books are replaced by eBooks, and Barnes & Noble will follow Borders into bankruptcy. As evidence, critics point to BKS's negative net income for the past three years. However, I will argue that the economics of BKS's bookstores are strong, and the potential sale of Nook Media would unlock value for BKS investors. Additionally, Barnes & Noble's bookstores have a sustainable niche position, which will continue to be profitable far into the future. Taking these factors into account, my estimated intrinsic value for BKS is $23-$28/share.

Company Profile

Barnes & Noble is the nation's largest book retailer, known for its expansive upscale stores. Besides a wide variety of titles, authors, and categories of books, the stores also offer Nook eReaders, magazines, newspapers, and café items. It currently operates 675 retail bookstores and 686 college bookstores in all fifty states, totaling 18 million square feet.

The Threat of eBooks

Many investors are concerned that eBooks will soon make print obsolete. However, the traditional book industry is mature rather than shrinking. Total sales of traditional books may continue a slow decline for the next few years as eBooks continue to gain traction, but this trend should level off. When eBooks first came to market they saw huge growth fueled by early adopters. The industry is now struggling to convert more readers to eBooks. According to a survey by Bowker Market Research in 2012, 59% of Americans have "no interest" in eBooks and only 16% of Americans have ever bought an eBook. Even more telling is that 90% of Americans who have bought eBooks continue to buy traditional books as well. This suggests that eBooks may be seen as a supplement to traditional books rather than as a replacement. Most of the growth of eBooks has been in the adult fiction genre. Other genres continue to be dominated by print. Total B&N bookstore sales have slightly decreased over the past few years as the company has closed a few of its unprofitable locations, (a value enhancing move). Same-store sales (excluding Nook) actually increased by 1.4% in 2012 and stayed flat in 2013.

Why Barnes & Noble Won't Share the Same Fate as Borders

Barnes & Noble will not follow Borders into bankruptcy because its stores are far more profitable and it is now the only game in town for brick and mortar bookstores. In the last few years before Borders closed, its same-store sales were decreasing greater than 10%/year, as compared to Barnes and Noble's roughly flat sales growth. Borders had sales per square foot of $173 in 2010, as compared to Barnes & Noble's sales per square foot in 2013, which was 49% higher at $258.

Amazon will remain a tough online competitor, but brick and mortar stores offer a much greater opportunity to explore and discover new authors and titles. Additionally, as brick and mortar stores drive online sales, publishers and authors are incentivized to make sure their books are on the shelves at bookstores. Amazon may steal some sales from Barnes & Noble, but it is in the best interest of both Amazon and publishers to make sure that Barnes & Noble continues to act as their showroom. This fact may help Barnes & Noble negotiate lower costs of inventory with publishers, especially now that they are the only national bookstore chain remaining.

Financial Overview

Barnes & Noble breaks down its sales into three segments: B&N Retail, B&N College, and NOOK. The sales breakdown is as follows:

Segment

Sales %

Gross Margin

B&N Retail

66.8%

30.6%

B&N College

25.8%

23.0%

NOOK

7.4%

-24.1%

Totals

100%

24.6%

Note the large negative contribution the NOOK segment is currently making to BKS's gross margin. Once SG&A, D&A, and interest expense are taken out of gross margins, this company is losing money, as shown by their Income Statement for the past three years:

2013

2012

2011

Sales

$6,839,005

$7,129,199

$6,998,565

COGS

$5,158,363

$5,213,019

$5,205,712

Gross profit

$1,680,642

$1,916,180

$1,792,853

SG&A

$1,670,376

$1,739,452

$1,629,465

D&A

$227,134

$232,667

$228,647

EBIT

$(216,868)

$(55,939)

$(65,259)

Interest (Expense)

$(35,345)

$(35,304)

$(57,350)

Income taxes (benefit)

$(97,407)

$(25,600)

$(48,652)

Net Income (loss)

$(154,806)

$(68,867)

$(73,957)

Now let's take a look at the balance sheet. The company has been paying down some of its long-term debt. However, it is worth noting that BKS has sold minority stakes in Nook Media (comprised of the NOOK and B&N College segments) to Microsoft and Pearson PLC, which leaves BKS with an 87.2% majority stake in Nook Media. If total sales continue to decrease, working capital will be a source of cash flow for shareholders.

4/27/13

4/28/12

Current Assets:

Cash and cash equivalents

$160,470

$54,131

Receivables, net

$149,369

$169,947

Net inventory

$1,410,769

$1,561,841

Prepaid Expenses

$326,527

$221,324

Total Current Assets

$2,047,135

$2,007,243

Noncurrent Assets:

Gross Property and Equipment

$3,110,429

$2,983,797

Less accumulated D&A

$2,525,520

$2,361,142

Net property and equipment

$584,909

$662,655

Total Assets

$3,732,536

$3,774,699

Current Liabilities

Accounts Payable

$805,194

$863,223

Accrued Liabilities

$569,240

$612,119

Gift card liabilities

$341,036

$321,362

Total Current liabilities

$1,715,470

$1,796,704

Long-term debt

$77,000

$324,200

Deferred taxes

$231,215

$242,748

Other long-term liabilities

$419,946

$366,503

Redeemable preferred shares

$193,535

$192,273

Preferred membership interests in Nook Media

$381,627

$0

Total Liabilities

$3,018,793

$2,922,428

Shareholder's Equity

Total shareholders' equity

$713,743

$852,271

Total liabilities and shareholders' equity

$3,732,536

$3,774,699

Lastly, let's look at the Statement of Cash Flows. BKS has an average CapX/Depreciation Ratio over the last three years of roughly 0.61. As BKS is no longer investing in new stores, this trend should continue to be a source of cash. Slightly decreasing inventories should also supplement cash flow.

4/27/13

4/28/12

4/30/11

Net income

$(157,806)

$(64,840)

$(68,836)

Operating Activities:

Depreciation

$232,604

$238,048

$244,734

Adjustments to net income

$(74,983)

$(2,458)

$26,342

Adjustments to AR

$(20,578)

$19,653

$43,718

Changes in liabilities

$51,129

$70,658

$25,949

Changes in inventories

$(151,072)

$186,479

$5,251

Changes in other operating activities

$197,794

$(105,402)

$32,123

Cash flow from operating activities

$117,391

$(24,112)

$199,072

Investing Activities:

CapX

$(165,835)

$(163,552)

$(110,502)

Other Investing Activities

$(9,845)

$(9,854)

$(9,274)

Cash flow from investing activities

$(175,680)

$(173,406)

$(119,776)

Financing activities

Dividends paid

$(15,767)

$(7,081)

$(44,783)

Sale purchase of stock

$378,450

$188,386

$15,397

Net borrowings

$(247,200)

$11,100

$(41,300)

Other financing activities

$48,706

$-

$-

Cash flow from financing activities

$164,628

$192,220

$(80,832)

Change in Cash

$106,339

$(5,298)

$(1,536)

Valuation

Investors often have a hard time valuing companies with a profitable segment, and losing segment, giving value investors a great opportunity to buy at a discount. Together, the segments produce poor results as shown above. However, to understand the true value of the business, a sum-of-parts valuation method must be used. Currently Barnes & Noble is organized as two entities: Nook Media, which contains the NOOK and Barnes & Noble College segments, and Barnes & Noble Retail. However, let's start by grouping the bookstores (B&N Retail and College segments), and finding their value.

The Barnes & Noble bookstores are a mature and profitable bookstore chain. Below are the combined earnings of B&N's Retail and College segments, as if they were a standalone company. These numbers are taken directly from BKS's SEC filings, which break down revenues and costs by segment, plus the assumption of a 35% effective corporate tax rate:

2013

2012

2011

Sales

$6,331,491

$6,596,575

$6,704,993

Cost of Sales and Occupancy

$4,528,556

$4,753,824

$4,894,515

Gross Margin

$1,802,935

$1,842,751

$1,810,478

SG&A

$1,317,251

$1,409,675

$1,437,966

EBITDA

$419,276

$433,076

$372,512

D&A

$207,990

$208,036

$208,082

EBIT

$277,694

$225,040

$164,430

Interest Expense

$35,345

$35,304

$57,350

Pretax Income

$242,349

$189,736

$107,080

Taxes

$(84,822)

$(66,408)

$(37,478)

Net Income

$157,527

$123,328

$69,602

Net income for the company's bookstores is very positive and growing, though I would not expect that growth to continue. To be conservative, we'll use average earnings for the last three years, which was $117MM. Benjamin Graham suggested using an 8.5 earnings multiple for a no-growth company, but we'll use 8 for a quick and conservative valuation. This gives us a value of $936MM (or $16/share) for the bookstores, which is 17% greater than the current market value of the entire company. Essentially, investors are getting a free option on the additional NOOK segment.

Company

Best Buy

Office Depot

Office Max

Staples

Wal-Mart

Family Dollar Stores

Target

EV/EBITDA

6.8

7.0

11.5

5.5

7.9

9.6

7.1

EBITDA multiples are another good measure of sum-of-parts value. Unfortunately, as the only remaining national bookstore, there are no close comparable companies to BKS, so we will look at other mature retailers.

The bookstores' average EBITDA over the past three years was approximately $430.4MM. After subtracting net debt, preferred and minority interests totaling $705MM, we reach a fair value of equity. Using these numbers, we can calculate the following for the values of the bookstores:

Multiple

3.5

4

4.5

5

5.5

6

6.5

Implied EV

1,506.40

1,721.60

1,936.80

2,152

2,367.20

2,582.40

2,797.60

Implied Equity Value

801.40

1,016.60

1,231.80

1,447.00

1,662.20

1,877.40

2,092.60

Est. Share Price

$13.45

$17.06

$20.67

$24.28

$27.89

$31.50

$35.11

Again, this is considering the value of NOOK as only an option. A sale of the segment would be the quickest way for shareholders to capture its value. Microsoft and Google are rumored to have interest, but there is no concrete evidence that the unit will promptly be sold. However, as shown by the valuation above, the bookstores have a standalone value far in excess of the current total market capitalization.

Summary

Barnes & Noble's bookstores remain very profitable despite its highly unsuccessful Nook Media division, which has driven down earnings. The economics of bookstores remains strong, and as the only major player left in the industry, Barnes & Noble stands to benefit. 95% of Barnes & Noble's bookstores were profitable last year, and net income would have been approximately $157MM without the NOOK segment. My estimation of Barnes & Noble's intrinsic value is between $23-$28 leaving investors roughly 100% upside.

Source: Buy Barnes & Noble At A Deep Discount