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Barnes & Noble, Inc. (NYSE:BKS)

F2Q10 Earnings Call

November 24, 2009 10:00 am ET

Executives

Joseph J. Lombardi - Chief Financial Officer

Stephen Riggio - Vice Chairman of the Board, Chief Executive Officer

Mitchell S. Klipper - Chief Operating Officer

William J. Lynch Jr. - President of Barnes & Noble.com

Analysts

Matthew Fassler - Goldman Sachs

Allen Rifkin - Banc of America Merrill Lynch

Bill Armstrong - C.L. King & Associates

Oliver Wintermantel - Morgan Stanley

Operator

Good day and welcome to this Barnes & Noble second quarter 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 Chief Financial Officer, Mr. Joseph Lombardi. Please go ahead, sir.

Joseph J. Lombardi

Good morning and welcome to Barnes & Noble's fiscal 2010 second quarter earnings conference call. Joining us today are Steve Riggio, Mitchell Klipper, William Lynch, 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 press release and public documents and is the property of 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 October 31, 2009. Included in our financials are Barnes & Noble College bookseller results, which I will be referring to as college, from September 30, 2009, the date of acquisition, to October 31st.

Consolidated sales totalled $1.161 billion for the quarter. Sales at Barnes & Noble stores were $950 million for the quarter, a decline of 2% from last year. Comparable store sales declined 3.2%, slightly lower than guidance of a 1% to 3% decrease. The company previously announced a comparable store sales decline of 4.1% for the nine-week period ended October 3rd. Sales trends improved in October as the company cycled against easier comparisons due to the prior year economic downturn.

Retail traffic continues to be the main driver in our comparable store sales performance, whereas our average ticket declined slightly.

Sales at Barnesandnoble.com were $120 million for the quarter, a 9% increase over last year due to higher traffic as well as e-book sales.

College's comparable store sales from the data of acquisition declined slightly, 0.2%, better than our forecast of a down 1% to 3%. College added $65 million to the top line since the date of acquisition.

Gross margin decreased by 70 basis points compared to the prior year. 40 basis points of the 70 basis points decline was due to the inclusion of College's results. You may recall from our October 8th conference call, College has a lower gross margin than the consumer bookstore business. The remainder of the gross margin decrease was primarily attributable to occupancy deleverage against the comparable store sales decline and product mix.

Selling and administrative expenses as a percentage of sales decreased 30 basis points this quarter or 50 basis points excluding college. Last year's expenses included an $11.6 million pretax impairment charge and a $3 million pretax severance charge. This year's expenses included an $8 million pretax one-time transaction expenses associated with the College acquisition. Excluding college and these items, selling and administrative expenses on an absolute dollar basis were $2 million lower than last year due to cost reductions as well as timing of certain expenses expected to be incurred later this year.

Depreciation and amortization increased by $5 million, due to primarily the inclusion of college's depreciation and amortization of intangibles related to purchase price accounting.

Pre-opening expenses were $2 million lower this quarter due to fewer store openings. Four stores opened this quarter compared to nine a year ago. Interest expense increased $2.6 million over last year due to higher interest costs associated with the college acquisition. The company's second quarter tax rate was 34.2%, due to the estimated non-deductible portion of the acquisition related fees. The company reported a net loss of $24 million, or $0.43 per share for the quarter, compared to guidance of a loss of $0.45 to $0.55 per share. Despite sales coming in slightly lower than expected, earnings per share exceeded the range due primarily to the timing of expenses expected to be offset later in the year.

At quarter end, the balance sheet now incorporates College's numbers. Inventories are up $228 million from a year ago; however, excluding College, inventories are down $95 million, or 6% versus a year ago. The company had $325 million of borrowings at quarter end, or $229 million net of cash on hand. Last year at this time, the company had net borrowings of $110 million. The increase is primarily due once again to the acquisition of College offset by lower short-term borrowing needs for the operations of the business.

During the quarter, the company completed its acquisition of College. In accordance with accounting rules, the purchase price has been primarily allocated to asset and liabilities based on their estimated fair value at the acquisition date. The value ascribed to intangible assets was approximately $500 million, which includes $255 million of amortizable intangible assets for the existing college and university relationships and $245 million non-amortizable assets for the trade name. Non-cash amortization for the school relationships is expected to be expensed over a period of 25 years. The company also recorded a deferred tax liability of $209 million related to the difference between the book basis and the tax basis of the net assets acquired. In addition, the company stepped up the value of certain other assets and liabilities resulting in a net increase to good will of $266 million.

Also reflected on the balance sheet is other non-current assets now include $37 million of deferred financing fees incurred in securing the new credit facility. This amount will be amortized to interest expense over the remaining four year life of the facility.

Capital expenditures for the fiscal year ended April, 2010 are forecasted at $150 million, which includes $125 million for Barnes & Noble and $25 million for College since the date of acquisition. We currently forecast $100 million of free cash flow for the full fiscal year, slightly reduced for the earnings guidance that happened today, the reduction to EBITDA guidance, but we intend to make that up with improvements in working capital, so we are sticking to the original $100 million. And we believe we will have approximately $359 million in year-end debt.

With the company's new credit facility, we have ample capacity.

Now I would like to comment on third quarter and full year outlook. For the third quarter, the company expects Barnes & Noble comparable store sales to decrease between 1% and 3%. This sales guidance is reflective of the slight improvement in sales trends from the second quarter. The company continues to expect full year comparable store sales to decline between 2% and 4%.

College's comparable store sales are expected to be in a range between flat to 2% up for the third quarter and to be in a range from negative 1% to positive 1% from the date of acquisition to the end of fiscal 2010.

Third quarter earnings per share are expected to be in the range of $1.30 to $1.50. As noted in this morning's earnings release, due to the overwhelming demand for Nook, the company is ramping up its production schedule and increasing investments in its digital initiatives. This includes adding people, increasing technology spend, and expanding in-store marketing support. As a result of the increased investment in the company's long-term digital strategy, combined with the anticipated continued general retail traffic softness during the holiday season, the company is lowering its full year earnings per share forecast for fiscal 2010 to be in the range of $0.33 to $0.63.

Please remember that this guidance includes the fees resulting from the College acquisition, which on an annual basis is $0.14 per share, and excludes College's earnings in the beginning of fiscal 2010 through the acquisition date.

At this point, I would like to turn the discussion over to our CEO, Steve Riggio.

Stephen Riggio

Good morning. It is clear to us that the retail book selling marketplace is consolidating and that the quality and flexibility of our real estate portfolio holds us in good stead. While our comparable store sales continue to be under pressure due to a decrease in traffic in shopping centers across America, we still continue to gain market share in the brick and mortar book selling business. We believe this is due to the outstanding service our booksellers have long provided day in and day out, the quality of our store locations, the continued growth of our member program, and to continued enhancements in our well-developed multi-channel strategy.

Customers know they can get any book anytime, anywhere from Barnes & Noble, whether they choose to shop in our stores or online. For example, our new pick-me-up service -- with our new pick-me-up service, customers can use our website to reserve any book that is in stock on our stores and to pick it up within our stores within 60 minutes. That's been a major success for us.

And I do want to comment a bit about the retail business in terms of competition among mass merchants. Much has been written recently about the price wars among mass merchants and discounters selling the very, very top end of the best-selling spectrum. We have commented on this before and we will say it again -- we believe this concern is over-blown because the impact of this competition has been absorbed for the past decade. The book-selling has been for a long time a long-tail business. Bestsellers represent less than 5% of our sales and among these very top bestsellers, less than 1% of our sales.

Our e-commerce business is doing great. We believe we've got lots of room to grow and we are very, very pleased to see sales accelerating there with a 9% growth in the second quarter. We believe in good part that's due to our fast and free shipping commitment. We deliver customer orders within three days at no extra charge and we think the growth is in part due to the traction that that has gained among more and more customers.

With the launch of the e-bookstore this year, we took our promise of any book, anywhere, anytime to a new level, enabling customers to download e-books in second to more platforms than any other online bookseller. And our iPhone app quickly became the most downloaded app in the iTunes store. The big news, of course, is the overwhelming response to Nook, our e-book reader. Pre-orders for Nook, they far, far exceeded our expectations and as Joe noted, in order to meet this overwhelming demand and to continue to serve this fast growing market, we are ramping up our production schedule and increasing our investments in the necessary people and technology to establish a strong market position.

As we've said from the beginning, however, our digital strategy is much more about selling e-books. The bookstore business is a long-tail business. The e-commerce business is a longer tail still, and the e-content digital business is still a longer tail business. We will soon be selling a much, much wider range of content, digital content than what we offer in physical format, either through our stores or online. It in a way represents a product extension for Barnes & Noble. We will be selling new and archived newspapers, blogs, magazines, periodicals and journals. We do not offer this content today in subscription form. We will offer it in subscription form, a la carte form, digital plus physical -- all sorts of new ways to deliver content. And our strategy has been to make all this content available to readers wherever they are, from a Nook device, PC, a Mac, a smart-phone, as well as from a coming wave of new devices with ever more amazing capabilities. And we believe that this is the first inning and that it will be a multi-billion opportunity for Barnes & Noble. As important, there are formidable barriers to entry for new players who want to jump in. Among those barriers are content aggregation on a massive scale -- content formatting for multiple devices and platforms, digital rights management technology, synchronization of all this content so a user can get it anywhere, anytime. We believe this will result, these barriers to entry are going to result in a less fragmented marketplace for digital content than the current marketplace for physical content.

Remember, books are sold in thousands and thousands and thousands of outlets in America and more than 50% of the books sold are outside of bookstores. We believe that digital content will be much, much less fragmented than that and we've established a strong position in order to gain a sizable market share as this market develops. Thank you.

Joseph J. Lombardi

And now we'd like to turn the call over to questions. Operator, we'll take questions now.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Matthew Fassler with Goldman Sachs.

Matthew Fassler - Goldman Sachs

A couple of questions initially -- first of all, can you please describe how you are going to account for revenues associated with Nook hardware? How that might differ from other revenue and when you would anticipate that start showing up on your P&L?

Joseph J. Lombardi

Nook will be recorded as revenue when we sell them. They will show up on the P&L in this next upcoming quarter. And we will --

Matthew Fassler - Goldman Sachs

Okay, so --

Joseph J. Lombardi

-- all of the accounting for that stuff as we add that.

Matthew Fassler - Goldman Sachs

So there won't be a deferred revenue element to that based on useful life? I know Amazon does it that way for the Kindle. You guys will record the sales, full sale as you sell them into the marketplace?

Joseph J. Lombardi

We have not announced anything related to our accounting on that and we are going through that with all of our experts an advisors and we will do whatever we are supposed to do, so I believe that that rule has changed somewhat.

Matthew Fassler - Goldman Sachs

Okay.

Joseph J. Lombardi

So you can record that at the time of sale. But we will update you in the next release.

Matthew Fassler - Goldman Sachs

And can you just give us a refresher on whether that is a gross margin positive product for you?

Joseph J. Lombardi

We have not commented on the margins related to Nook.

Matthew Fassler - Goldman Sachs

Okay. I guess my second theme relates to the digital book sales that you might have generated so far. You did have a good online sales increase or a dot.com sales increase. Was a meaningful portion of that related to digital books as of yet, off your e-bookstore?

Joseph J. Lombardi

No, we are not breaking that out, what the increase is related to that. We are very happy overall with the overall increase on dot.com and we are driving the business to physical and digital and whatever way the customers want it.

Matthew Fassler - Goldman Sachs

Got it. Joe, one last question, the tax rate going forward, you spoke about the 34 and change associated with the one-time items. Do we go back to something in the 39 range on a go-forward basis?

Joseph J. Lombardi

For the current year, yes. It's really a one-time discrete item for a non-deductible amount; 40% is still a number you should be thinking about.

Matthew Fassler - Goldman Sachs

Got it. Thank you so much.

Operator

Your next question comes from the line of Allen Rifkin of Banc of America Merrill Lynch.

Allen Rifkin - Banc of America Merrill Lynch

If you look at the magnitude of your new earnings guidance and really look at the two midpoints, you've taken the midpoint down from $0.74 to a midpoint of $0.48 -- how much of that reduction is due to the higher production costs associated with the Nook, due to the higher demand as opposed to the lower traffic that you also cited? Is it skewed towards --

Joseph J. Lombardi

We didn’t break that out. It's due to both of those things. The Nook investments would be slightly more than the impact of the comparable store sales being a little bit softer in traffic.

Allen Rifkin - Banc of America Merrill Lynch

Are you at liberty at all to provide any color in terms of what the demand curve is looking like? I mean, we now know that encouragingly a greater proportion of the reduction is coming from higher production costs and obviously that would mean that the demand has greatly outstripped your initial expectations. Any sort of color or quantification as to what those numbers are?

Joseph J. Lombardi

We are not going to provide any color or quantification of those numbers at this point, other than to say we are very, very thrilled with the response, both online and even in stores and the stores, our top stores have Nook fixtures in them and they are getting a lot of attention. And we are ramping up production because of the customers' desire to get these things in their hands. So we are just pretty thrilled overall with how it is going and we are not going to break those numbers out. That is not what we are here to do today.

Allen Rifkin - Banc of America Merrill Lynch

One follow-up, if I may -- College was remarkably resilient in the last couple of years. I believe the comps were in the 44, 45 range and now in the last three to six months or so, they have kind of fallen pretty significantly, which at least to us is somewhat counter-intuitive in that we would have thought that the environment was a little bit more difficult last year. What specifically are you seeing on the college side of the equation that has caused the comps to really fall off here in the last six months or so?

Joseph J. Lombardi

Well, I mean the College comps were flat for October, so we've had at least a 3% to 4% decline from our trend line over the previous recession, so I would say they are not totally immune to that and the results are flat, so to say it was an extreme fall-off I think is a bit of a -- a little bit of a stretch. But they are not immune to the overall impact of the recession and peoples looking and shopping where they can shop and there is -- obviously textbooks are sold in a number of places and College does them online as well as Barnes & Noble.com, so kind of think that they are managing through this. They had a rush season that was down, which was the period prior to our consolidating, down slightly. And though we think our outlook is flat to a positive 2 for the January rush period, so we kind of think they are on board and that they are achieving the numbers that we have stated that they were going to achieve in our last couple of sets of conference calls.

Allen Rifkin - Banc of America Merrill Lynch

Thank you very much.

Operator

Your next question comes from the line of Bill Armstrong of C.L. King & Associates.

Bill Armstrong - C.L. King & Associates

On the Nook, the higher production costs, is that all because you are increasing the number of units? Or are you seeing any increases in the cost per unit as well?

Joseph J. Lombardi

We are not going to break that out but you should note that the increase in costs is a number of things. In addition to ramping up production, we are also going to be adding some more people than we originally thought and obviously we think that the power of the in-store marketing is going to be even more powerful than we originally thought, so we are making sure that we had adequate resources at retail to support the customer demand for information. So it's a number of things. We are not stressing certainly one thing over any of the others.

Bill Armstrong - C.L. King & Associates

Is the need for additional people a function of higher volumes than expected or because the cost of the project is increasing faster than you expected?

Joseph J. Lombardi

No, I think it's the need for -- it's the growth of the demand for the product, the ability to support that, and the ability to get those things in the customers hands and we think the power of this as we have kind of alluded to in the past is the ability to sell this face to face with customers and our booksellers in stores and making sure that we are invested appropriately well to do that and to have the amount of devices that our customers need.

Mitchell S. Klipper

I just finished touring the stores around the country and I ask everybody to do the same -- when you see the enthusiasm not only from our trained booksellers but from our excited customers when they walk into stores, they see the signs or they see the dedicated counters, and this is without even live demos, and they are basically surrounding these counters inquiring on the look, the feel, the functionality, what makes the device so good. And we spent a lot of time training our people and the demand is showing it, so -- I mean, we have over 700 retail outlets that are going to be selling this product with live demos in another two to three weeks, so we are just gearing up for what's starting to come through. I mean, the stores are in absolutely fantastic shape as far as inventory levels. The people are trained. The gift cards are kicking in and think there's going to be, you know, as Steve says, a halo effect to this Nook device in our stores driving people into our stores to really see and feel and road test this device before they place their orders, so we are very excited about it.

William J. Lynch Jr.

I would also just build on the point that Steve made about the digital investments -- it's not just short-term nook management production. It's really about capitalizing on the market opportunity that Steve articulated earlier in digital and whether that is content, acquisition and build-out of that asset, our digital content repository, whether it's looking at managing Nook correctly, whether it's the marketing in stores -- it's a function of all of those things to allow us to continue to be a leader in selling digital content.

Bill Armstrong - C.L. King & Associates

Okay, great. Thanks for that.

Operator

(Operator Instructions) Your next question comes from the line of Oliver Wintermantel with Morgan Stanley.

Oliver Wintermantel - Morgan Stanley

Joe, you said that the impact, the gross margin was down 71 basis points, was due to College results and the occupancy deleverage. So the Dan Brown book didn’t have any meaningful impact on the gross margin line?

Joseph J. Lombardi

The bestsellers were a bit stronger for the quarter as predicted but not -- it was not a significant impact on margin.

Oliver Wintermantel - Morgan Stanley

Okay, so I have a question regarding just the e-book market in general -- so in the physical book market, in the new book market you have about a market share of around 17%. Is this what you target for the e-book market as well or do you think you have a much better chance of getting a higher market share in the e-book market?

Joseph J. Lombardi

You know, this market is very, very nascent and I think we are going into it and we are going to capture the market share -- I think to share what our target goal is at this point is a bit premature.

Oliver Wintermantel - Morgan Stanley

Thank you.

Operator

Your next question comes from the line of Matthew Fassler from Goldman Sachs.

Matthew Fassler - Goldman Sachs

Just to follow-up on the Nook from an accounting perspective, you are baking in some costs associated with the Nook to your guidance. Does your guidance also account for the actual sell-through of the hardware that you would expect for the fourth quarter?

Joseph J. Lombardi

Yes.

Matthew Fassler - Goldman Sachs

It does? Okay, so that's in the comp numbers and presumably that's accretive to the comp number?

Joseph J. Lombardi

We baked in our guidance for the sales of the Nook into all of our guidance through April.

Matthew Fassler - Goldman Sachs

Okay, that's helpful. Second question, just to get some clarity, Joe, you talked about the retail environment being tough. I believe that you reaffirmed your revenue guidance so to the extent that your core retail number comes down a bit, core retail concerns or retail backdrop concerns, is it reflected in gross margin to some degree? I'm trying to figure out how to work that into our model.

Joseph J. Lombardi

I think what we are saying is obviously we were a little bit shy in our range in the third quarter. We had said one to three. October was better but it certainly wasn’t what we saw. We certainly are looking at the mix trends in November and reading what everybody else is reading, as well as looking at our own numbers, and I think we have guided appropriately to what we think is going to happen.

Matthew Fassler - Goldman Sachs

Got it, that's helpful and the just two quickies on College -- as you have included College in the balance sheet, the only surprise that we saw in working capital is that the payables ratio appears to be a bunch higher in that business than in the book business, just based on the year-to-year move, unless that reflected a move in the core bookstore. So could you just shed a little bit of light on that?

Joseph J. Lombardi

No, that's a timing item and related to the fact that most of the rush inventory purchases are paid out in October and relates to timing solely. So there is a large -- you know, they build up a lot of cash October, September and there is a large pay on the inventory that has already been purchased as it comes out. So that's a timing thing.

We should be able to -- you will see that as we post quarterly balance sheets in an 8-KA in a relatively short period of time.

Matthew Fassler - Goldman Sachs

Got it, and then my final question, obviously you reported the numbers with one month of College. We had done our best based on the information that you provided publicly a month or two ago to model out a full quarter of College, so is there any comment on what College might have earned sales and EBITDA for the full October quarter?

Joseph J. Lombardi

I believe we gave guidance in the last quarter on what sort of they look like on an annualized basis and they were essentially on plan with those numbers, so I don’t have that schedule right in front of me but we had said that the October month was largely about a $7 million EBITDA decline month and that is relatively what they have done in line with the guidance.

Matthew Fassler - Goldman Sachs

Got it. Okay, thank you so much.

Operator

There are no further questions at this time. Mr. Lombardi, I would like to turn the conference back over to you for any additional or closing remarks.

Joseph J. Lombardi

Thank you for listening to our second quarter conference call. Please note that our next scheduled financial release will be our holiday sales release on or about January 7th. Thank you.

Operator

Once again, that does conclude today's conference call. We thank you for your participation.

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