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Executives

Andy Milevoj - Vice President of Investor Relations

Michael P. Huseby - President and Chief Executive Officer of Nook Media Llc

Mitchell S. Klipper - Chief Executive Officer of Barnes & Noble Retail Group

Allen W. Lindstrom - Chief Financial Officer

Analysts

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Michael Souers - S&P Capital IQ Equity Research

John Tinker - Maxim Group LLC, Research Division

Rory Wallace

Barnes & Noble (BKS) Q2 2014 Earnings Call November 26, 2013 10:00 AM ET

Operator

Good day, everyone, and welcome to this Barnes & Noble's Second Quarter 2014 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the conference over to the Vice President of Investor Relations, Mr. Andy Milevoj. Please go ahead.

Andy Milevoj

Good morning, and welcome to Barnes & Noble's fiscal 2014 second quarter earnings conference call. Joining us today are Michael Huseby, CEO of NOOK Media and President of Barnes & Noble, Inc.; Mitch Klipper, CEO of Retail; Max Roberts, CEO of College; and Allen Lindstrom, CFO; as well as other members of our senior management team.

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

During this call, we will be making forward-looking statements, which are predictions, projections or other statements about future events. These statements are based on current expectations and assumptions that are subject to risks and uncertainties, including those contained in our press release. The company disclaims any obligation to update any forward-looking statements that may be discussed during this call.

And with that, I'll turn the call over to Michael Huseby.

Michael P. Huseby

Thanks, Andy. Good morning to everyone. In spite of the 8% decline in revenues, the company grew consolidated second quarter EBITDA 13.7% over the prior year as a result of improved margins and reduced expenses.

I'll first review NOOK Media's results, which include our College and NOOK digital businesses. Next, Mitch will review retail's results and Al will discuss the company's financial performance.

College completed the back-to-school rush period during the second quarter and continued to see significant adoption of textbook rentals, which provide a great value for students and improved margin for the company. Year-over-year, second quarter textbook rental revenue grew 63%. It's important to note that as we expanded our rental inventory, we have been able to increase the margin on textbook rentals due to flexible pricing. College's second quarter comparable store sales declined 3.6% for the quarter, although overall College margin increased due to rental and general merchandise sales mix. Additionally, College benefited from its considerable new store growth over the last 12 months, which is not reflected in the comparable store sales comparisons.

It's important to remember that as rental adoption grows, revenues deferred over the rental period, which generally spans the term of the semester. This deferral impacts top line and EBITDA performance during the current quarter while benefiting subsequent periods in which the deferred rental revenue is recognized.

We continue to see upside in our College business through new contract acquisitions and through the investments that we are currently making to develop our digital education product offerings. We expect to release our initial higher educational -- higher education digital product offering prior to the end of the fiscal year. As the College bookstore business continues to evolve in terms of rental mix and digital offerings, Barnes & Noble is poised to be the content and services provider of choice to educational institutions that seek to offer course materials in all forms: new, used, rental or digital to their students and faculty members. As further evidence of this trend, we opened 6 new stores during the quarter and 21 year-to-date.

Regarding our NOOK digital business, I'm very pleased to report that we strengthened NOOK's -- NOOK Media's senior leadership team with the addition of Mahesh Veerina as Chief Operating Officer; and Doug Carlson as EVP of Digital Content and Marketing. As we continue to make strategic progress at NOOK, our primary focus continues to be on driving revenue growth opportunities while managing expenses and inventory commitment levels. We are also actively pursuing opportunities to rationalize our NOOK business from a financial and competitive perspective.

NOOK's digital content sales declined 21.2% during the second quarter, primarily due to lower content average selling prices and fewer device sales as compared to a year ago. To improve content sales, we are focused on increasing sales to NOOK's active user base and selling e-reading devices that are closely aligned with selling content.

To that point, after the quarter ended, we launched our new NOOK GlowLight. With this new NOOK, we focused on improvements that matter most to long-form readers. The redesigned GlowLight has a new contemporary design, is amazingly light, features perfectly lit pages, sharper text and an advanced display technology that offers paper-like readability. We also improved the user interface and made the new NOOK GlowLight even simpler to use while enhancing the shopping and discovery experience through the device.

In addition to our critically acclaimed E Ink devices, we continue to sell NOOK HD and NOOK HD+, which are terrific color devices at tremendous values for reading and entertainment. That product inventory is selling in line with our expectations. While the sale of existing inventory and value pricing is progressing as expected, the holiday season does remain an important component of our plans to sell through that inventory.

In addition to selling content through our own devices, we are also focused on growing other channels of distribution. Yesterday, we announced that NOOK for Windows 8.1 is now available in 32 countries and 21 languages. We're excited to offer the NOOK experience to millions of new customers around the world. Microsoft Live users can shop and read without having to set up an additional account, providing a dramatically simplified reading and shopping experience. As always, purchased reading content will seamlessly sync across all their devices on the NOOK ecosystem.

The company previously disclosed that it's expected to be selling content in 10 international markets by mid-2013 pursuant to our Microsoft commercial agreement. We have made substantial progress in meeting this commitment, which should be accomplished by the end of this fiscal year. We continue to work closely with Microsoft to explore how we can better mutually leverage the benefits of our partnership.

In addition to Microsoft, this morning, we announced that we are teaming up with Samsung to make NOOK available on the new Samsung Galaxy Tab 3 kids device. The NOOK app for kids became available yesterday as part of an over-the-air software update for current owners and will be preloaded on this Samsung device later this year. This NOOK app provides a curated reading experience for children and access to thousands of new and classic kids titles.

The company's balance sheet remains solid, ending the quarter in a net cash position of $192 million. College completed its back-to-school rush during the quarter. NOOK continued to sell through its inventory of NOOK HD and HD+ devices. And Retail began to build inventory ahead of the holiday season, which led to the cash and debt balance increases from the prior quarter.

NOOK Media has been self-financed since formation, and that should continue by further reducing cost, converting existing device inventory into cash, with cash flow from College and cash payments we continue to receive from Microsoft.

Now I'll turn the call over to Mitch for a review of Retail's performance.

Mitchell S. Klipper

Thanks, Mike. Second quarter core retail comp store sales declined 3.7%, in line with expectations. Comps were impacted by the comparison to the Fifty Shades Trilogy a year ago, which will subside as we progress through the remainder of the year.

As we enter the all-important holiday season, our book sellers are prepared to welcome the holiday shoppers coming through our doors and recommend thoughtful gift suggestions. We're encouraged by the tremendous depth and breadth of title line-up this holiday season, including Doris Kearns Goodwin's The Bully Pulpit, Amy Tan's The Valley of Amazement, Stephen King's Doctor Sleep, Scott Turow's Identical, Donna Tartt's The Goldfinch, Giada's Feel Good Food by Giada De Laurentiis, along with other great gift books, such as Humans of New York. And for children and teens, we have Rick Riordan's House of Hades, Jeff Kinney's Diary of a Wimpy Kid and Veronica Roth's Allegiant.

Our stores are also stocked with leading assortments of Educational Toys & Games with brands like Lego, Leapfrog, Alex and many, many more. And as far as NOOK goes, we have a tremendous value this year on our HD and HD tablets starting at only $129. And our new NOOK GlowLight, which is our best reading experience yet which weighs in at only 6.2 ounces.

Barnes & Noble has a gift for everyone in your list, and our book sellers are prepared to make the customer's holiday shopping easier. To highlight this, we recently kicked off our multimillion dollar advertising campaign, It All Happens at Barnes & Noble, that focuses on the in-store shopping experience and our new NOOK GlowLight.

We know that Barnes & Noble is a leading place for the discovery of titles. And last Friday, we celebrated with our 40,000 booksellers through our discovery Friday 1-day event that officially launched our holiday season. This event was a great success and a testimony to our book sellers. Discovery Friday invited customers to come in and utilize our booksellers to discover the perfect gift for friends and family and discover what we have in store at Barnes & Noble.

These in-store events also featured games, activities, giveaways and hundreds of special guests to create a truly unique in-store holiday shopping experience.

Let me conclude by saying this is my 28th holiday season with Barnes & Noble. And I can tell you the retail stores are in great shape. Our distribution system worked flawlessly. Our systems are robust. The holiday merchandising levels are appropriate and brimming with great values. And perhaps, the greatest assets we have are our 40,000 enthusiastic, energized, well trained and knowledgeable booksellers, who are ready to assist our customers this holiday season.

We're wishing you all a happy holiday. And now, I'll turn it over to Al.

Allen W. Lindstrom

Thanks, Mitch. This morning, we released our fiscal 2014 second quarter results for the period ending October 26. Comparisons are to the prior year quarter unless otherwise noted.

Consolidated sales declined 8% to $1.7 billion for the quarter. Retail sales decreased 7.5% to $921 million, primarily as a result of a 4.9% comparable book store sales decline, store closures and lower online sales. Core comparable book store sales, which exclude sales of NOOK products, decreased 3.7% on lower store traffic and comparisons to the Fifty Shades Trilogy last year.

Sales of NOOK products at Retail declined as a result of lower device unit volume and lower device average selling prices. College sales decreased 4.6% to $738 million during the quarter, which included the fall back-to-school rush period. Sales were impacted by the continued growth of textbook rentals, which have a lower price than new or used textbooks, plus rental sales are deferred and amortized over the rental period. On a comparable basis, College sales declined 3.6% on lower textbook sales and a higher mix of lower-priced used textbook rentals. The comp decline was partially mitigated by an increased store count.

Second quarter NOOK sales, which include sales of digital content devices and accessories decreased 32.2% to $109 million. Digital content sales of $57 million declined 21.2% on lower average selling prices and lower device sales volumes.

Device and accessories sales of $51 million declined 41.3% on lower unit selling volume and lower average selling prices. Please note that we added supplemental disclosure providing quarterly NOOK digital content and device and accessory sales for fiscal 2013.

Consolidated gross margins increased 100 basis points during the quarter. Retail gross margin decreased 20 basis points on occupancy deleverage against the sales decline, partially offset by a higher mix of higher-margin core products. College's gross margin increased 100 basis points on sales mix, driven by a higher mix of higher-margin textbook rentals and general merchandise.

NOOK's second quarter margin rate increased on lower device markdowns and a lower mix of device sales. Due to the holiday selling season, the company expects a higher mix of device sales in the third quarter. As a percentage of sales, second quarter selling and administrative expenses increased 20 basis points over the prior year. Retail expenses declined $31 million during the quarter on strong expense management, primarily payroll and payroll-related costs. Retail SG&A improved 120 basis points despite the sales decline, primarily as a result of lower compensation costs. However, College's SG&A rate increased 100 basis points as expenses delevered against the lower sales, as well as continued investments in digital product development.

NOOK's expenses delevered on a percentage basis against the sales decline. The company's second quarter EBITDA was $75.7 million as compared to EBITDA of $66.5 million a year ago as a result of the factors just discussed.

Consistent with last quarter, and as reflected in our estimated annual effective tax rate, the company continues to not record a benefit for deferred tax assets generated in the current year. Consolidated second quarter net earnings were $13.2 million or $0.15 a share as compared to net earnings of $0.5 million or a loss of $0.07 a shared a year ago.

Turning to the balance sheet, the company ended the quarter with $297 million of cash, driven by the seasonality of the College business and $105 million of bank borrowings under its $1 billion credit facility. Inventories decreased $204.3 million, or approximately 11%, driven by reductions in College textbooks, lower net realizable value of NOOK devices and reduced retail trade book inventory.

Consolidated capital expenditures for the second quarter were $42 million, relatively flat with the prior year. In the second quarter, the company opened 2 new Retail bookstores and closed 3. College opened 6 new stores during the quarter while closing 3. For fiscal 2014, the company continues to expect Retail comparable book store sales to decline in the high-single digits with core comps expected to decline in the low to mid-single digits. College comparable store sales are expected to decline in the low single digits.

With that, we will open the call for questions. Operator, please provide the instructions for those interested in asking a question.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll first hear from Matt Fassler of Goldman Sachs.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

A couple of questions, if I could. First of all, within the bookstore business and the comp store sales decline that you generated, I know you broke out comps x the NOOK. Any directional sense of how the book business performed versus other categories?

Michael P. Huseby

Well, as we said, we had a lot of bestsellers this quarter. And there's a general decline of the overall book business, which is in keeping with where we've been. But there's no major difference between the books. And some of the non-book categories actually outperformed the book business this quarter with some of the work we've done, particularly with gift, cafe, bargain, Toys & Games. They're a little better than the book business.

Michael Souers - S&P Capital IQ Equity Research

Secondly, on NOOK SG&A, the gross profit rate was substantially better than we had modeled. The SG&A seems to hang reasonably close to last year's level. So if you could give us some color on where the spending sort of continues to linger and what their game plan is for ratcheting that spending down if we're able to do that in the context of your broader business plans?

Michael P. Huseby

Yes, in terms of -- Matt, this is Mike Huseby. In terms of continuing to rationalize both the cost structure and the competitive position of NOOK, we do have additional opportunity to be more efficient. I think that right now, what we're focused on is the holiday execution, selling the inventory, and really, as the top priority, reversing a decline in content revenue. So the expense structure that we built over NOOK -- over time at NOOK, I should say, has a lot to do with the fact that it was very device centric. So on the context of how we reduce expenses, a lot of that will have to do with introduction of new devices that we decide to go forward on. None of those plans are public yet and the timing of that, those introductions. So in other words, to answer your question directly, that there's opportunity in all aspects of the products at NOOK, depending upon how we elect to go to market. As you can see, one of the things we're trying to do is leverage a relationship with other companies, Microsoft, the Samsung release that we put out this morning, with an emphasis on growing content revenue in a way that leverages what we're already doing in the international expansion. And -- but we do understand the need to have devices in our stores and on our online shop because selling devices is the best way to get content attachment. Trying to get content attachment simply over a client type of an approach is not as effective as selling devices. So yes, there's additional opportunity to rationalize the cost. Right now, we're focused on executing the holiday and then we'll step back and look at it in the context of further rationalization we can announce once we get to the point where we're ready to do so.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Got it. And then my last question very briefly, you're clearly stabilizing the business for some degree. The management structure remains a little unconventional in that you haven't named a CEO for Barnes & Noble Inc. Is there -- do you anticipate doing that? Or is this is a sustainable structure from your perspective?

Michael P. Huseby

That's a board decision that the board will entertain at its discretion and at the right time. And it's not something I can comment on.

Operator

Next question from John Tinker of Maxim Group.

John Tinker - Maxim Group LLC, Research Division

Could you just discuss a little more the announcement that you made yesterday when you -- you're going to be involved in Windows 8.1 in 32 countries. So exactly how does that work in terms of the -- how do you actually sell products over there, but given your based here? And how many relationships do you have and deals you have set up in place so you can sell products internationally?

Mitchell S. Klipper

Yes, John, we've been spending a lot of time being very active in acquiring content internationally since we entered into our commercial agreement with Microsoft. So we are well positioned and have, as we've said, launched in those 21 countries based on the content that we've acquired in the -- what we've put in place through our relationship with Microsoft and their capabilities to market and sell as well through Windows 8. So within Windows 8, we'll have a presence that will be easy to find, easy to access and easy to use, so that our customers in those countries can avail themselves of our rich content catalog. It is local content. We've been spending a lot of time and as we've said in the past, effort money on acquiring that in accordance with our, not just our commitment under the commercial agreement but our intention to expand internationally. And as I said before, one of our primary ways of expanding our content reach and growing content revenue.

John Tinker - Maxim Group LLC, Research Division

The -- I think in last quarter, you highlighted that you actually went through your number of NOOK unit sales and app sales. Do you have any -- is it possible to ask about that, since it's directionally which way it's going?

Mitchell S. Klipper

I don't think we actually disclosed our NOOK unit sales. I think we disclosed a percentage, Andy?

Andy Milevoj

Well, John, on the last call, we did say that cumulatively, we've sold over 10 million devices.

John Tinker - Maxim Group LLC, Research Division

n

I thought you meant the quarter.

Mitchell S. Klipper

Right. We have not broken out the quarterly device sales.

John Tinker - Maxim Group LLC, Research Division

Okay. And final question...

Mitchell S. Klipper

John, one thing I would say about that, and I mentioned it in my remarks, is that the holiday season that's coming up is still a very important selling season for the devices for us. I think we've been, as I mentioned, selling through the inventory that we've built in line with expectations. But beginning now and through the end of December is a very important time for us.

John Tinker - Maxim Group LLC, Research Division

So just final question, you mentioned the $192 million in cash. How much of that is in the NOOK versus Barnes & Noble? And how much more money is Microsoft committed to invest in the NOOK?

Mitchell S. Klipper

Well, the amount of money that Microsoft is committed to invest is set forth in the agreements, which are public information. We've talked about it. And as I said, we've been receiving those payments according to the schedule. So we entered into that agreement on early October of last year. And you can go back and look at the agreements and see how much we've received. And to a certain extent, when you see the Q, you'll be able to see how much of the money has come in, in our cash flow statement, okay? So what was the other question?

John Tinker - Maxim Group LLC, Research Division

That balance that's actually in cash and NOOK versus on Barnes & Noble's balance sheet?

Mitchell S. Klipper

Yes, we don't break that out by entity. What I did do is I made some comments in the body of my remarks about what the companies have been doing in the context of retail building inventory. College has completed its back-to-school rush, so you can presume that it's somewhat flush with cash. And College and NOOK are both within NOOK Media. So we don't break those balances out separately.

Operator

[Operator Instructions] Next we'll hear from Rory Wallace from DHC Partners.

Rory Wallace

I just wanted to drill a little more into the Q4 holiday season or Q3 holiday season, which you guys have highlighted as very important. And in particular, it seems to me that you'll be looking at a bit of a softer comp in the fourth quarter on the Retail business, which did perform above expectations in this third quarter -- or in the second quarter. And so I wonder, is it reasonable to think that you would continue to see that core comp improve on a sequential basis? And then I also want to ask about the NOOK business. And since you've taken about $250 million almost of write-downs that occurred towards the end of last year, how should we think about cash flow into the fourth quarter and just how the NOOK margins will be impacted by the write-downs that you took earlier in the year?

Michael P. Huseby

Yes, this is Mike Huseby. First off, you're talking about fourth quarter, I think calendar year, right, our third quarter...

Rory Wallace

Yes, that's right.

Michael P. Huseby

Right. And so we're not going to provide guidance about what's going to happen in any of our segments in the third quarter. We're comfortable with the guidance that we have out there, which talks about the high-single digits in the Retail core comps line. And in College as well, our guidance, it's all been reaffirmed. It's in the press release. We're not going to get into that in the context of trying to speculate how that's going to be impacted by holiday with respect to NOOK and the write-downs that we took last year that you're referring to in the third and fourth fiscal quarters primarily. As we've said, those -- the cash that we're receiving in fiscal year '14 on device sales, the majority of it does relate to inventory that was built in fiscal year '13 prior years. And in terms of how that cash flows in the subsequent quarters, that's obviously going to be a direct function of how many units are sold. We expect it to -- with the pricing that we have in place and the values for the tablets and eReaders we put out, we expect to have sales that will generate substantial cash flow relative to the rest of the quarters in device sales in our third fiscal quarter. But we're not going to get into specifying how much that is. And in talking about the reserves and their impacts on EBITDA et cetera, we made our best estimate at the time those write-downs were booked. We continue to assess them each quarter when we report. The 10-Q will have more information, but that's really the answer that those inventory reserves will respond to the sales in the market for the devices as they respond. Obviously, we think they should respond as we've estimated they will. Whether they do or not will be a function of what actually happens. We're not going to try to predict that. We've learned not to do that in the holiday period with all the competition that we have and the way that these markdowns have occurred.

Rory Wallace

Yes, I appreciate that. And I wonder, it seems to me that as the mix shifts more towards digital, that's clearly a benefit to the NOOK gross margins, and we saw that this quarter. But it still strikes me that the hardware margins on an implied basis are still running quite negative. And in the past, you guys have said that you like to run the hardware business at a breakeven gross profit margin. You've over-produced in the past and had to write off your inventory. But kind of tying that into your comments on rationalizing the product lineup, I wonder if you could just elaborate a bit more on how you plan to achieve those goals of getting the hardware business to break even.

Michael P. Huseby

Well, first off, I agree with all your comments. Those are our goals. How we plan to do it, we're not going to talk about it in detail. We want to get through the holidays, I mentioned before, see how sales respond in the market. And then we'll go forward with our plans on hardware. And as I said, it is important for us to have hardware. We are in the device business to stay. And how we deliver those devices to the stores and to our online sales and wherever else we decide to deliver them is something we'll announce when we're ready to do it.

Operator

And it appears there are no further questions. At this time, I'll turn the conference back over to Mr. Milevoj for any additional or closing comments.

Andy Milevoj

Thank you for joining us on today's call and for your interest in Barnes & Noble. This will conclude today's call.

Operator

Once again, that does conclude today's conference. Thank you, all, for your participation.

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