A Buyout for the Books? by Jonathan R. Laing
Highlighted companies: Barnes & Noble Inc. (BKS), Amazon.com Inc. (AMZN), Borders Group Inc. (BGP)
Summary: Barnes & Noble Inc. (BKS) shares have not climbed in unison with the recent surge in retail stocks; they currently trade at $39, 20% lower than their March highs of $48.41. Reasons: Weak sales (-2.6% last quarter), competition from Amazon.com Inc. (AMZN), concerns about slowing consumer spending for discretionary items such as books, and an ongoing SEC stock-option practice investigation. Amid all the negativity, a SEC filing reported that Pershing Square hedge fund acquired a 2.3% position; its principal, Bill Ackman (known as "Mr. Pressure") tells Barron's that's now up to 8%, and he thinks it could gain 50% in the next year and a half, and double in the next three. Ackman dismisses the above concerns: Barnes commands 17% vs. AMZN's 10% of the market; superstore sales have risen 80% since AMZN's arrival. Book prices are still reasonable enough that a consumer cutback is not a serious concern. Gross margin has been rising (30.2% vs. 29.3% y/y). Barnes shrewdly reduced its less-profitable B. Dalton stores (from 700 to 112) in favor of superstores. They have not been hurt by the implosion of CD sales to the extent that competitors such as Borders Group Inc. (BGP) have; they never invested much space or effort into selling CDs. Concentrating on buying directly from publishers instead of wholesalers has boosted margins; and they now self-publish 10% of their books. BKS has also successfully began pushing more high-margin merchandise such as wrapping paper, cards, and picture frames. Cash flow is strong; it presently holds $373M in cash after paying off all its long term debt, allowing it to self-finance a 4% increase in superstore capacity, pay a $0.60 dividend, and reduce outstanding shares by 6% over the past 1 1/2 years. Booksellers grossly understate earnings due to tax law that require them to depreciate store assets over 10 years, despite an average life of 20; true depreciation estimates would place their P/E multiple at 13 instead of the current 17. Ackman also thinks current earnings forecasts of $2.25 are too low; he foresees $2.90 this year and $3.50 next. All this makes them an extremely attractive buyout prospect. Taking into account factors such as its debt-free balance sheet, strong cash generation, enterprise value (market value + debt - cash), lease obligations, and ebitdar (earnings before interest, taxes, depreciation, amortization and store-rental expense) gives Barnes an enterprise-value-to-ebitdar-ratio of 6.5-7, which compares favorably with recent buyouts. Shareholders could command a minimum 25% premium. But Ackman hopes they don't get bought out, or go private, any time soon -- the payday a couple years down the road could be even more lucrative; Ackman foresees share prices in the mid-to-high 50s in a year or so.
Quick comment: Earnings conference call transcripts: Barnes & Noble Q206, Amazon.com Q206 • Related Seeking Alpha commentary: Barnes and Noble: 14% Decline in Sales Pinned to Lack of Harry Potter Magic • Borders Wobbles: Could It Be Ripe for a Takeover Bid? • Amazon's Short Future • Barnes & Noble Joins the Stock Options Backdating Spotlight • Barron's Tips for a Prosperous Retirement • Second Life for Amazon • Amazon's $500 Million Buyback Plan -- Dumb Money • Borders Needs a Savior