Joel Greenblatt, in one of my favorite books on investing, said the following:
"The reason why major corporate restructurings may be a fruitful place to seek out investment opportunities is that oftentimes the division being sold or liquidated has actually served to hide the value inherent in the company's other businesses."
It was with this basic scenario in mind that I began studying Barnes and Noble (NYSE:BKS) a few months ago.
The Case For BKS
I think Barnes and Noble is significantly undervalued and likely worth somewhere between $20 and $30 per share. Although there are industry headwinds in the traditional book business, Barnes and Noble has a strong brand name, significant insider ownership, strategic partners in Liberty (NASDAQ:LMCA) and Microsoft (NASDAQ:MSFT), a clean balance sheet, and best of all-the core business trades at just 5 times the average pretax earnings from the past 15 years and 4 times the trailing year's pretax earnings.
Why Is It Undervalued?
Barnes and Noble has three basic operating businesses:
- B&N Retail (the traditional bookstores and the bn.com ecommerce business)
- B&N College (college bookstores located on or around college campuses)
- Nook Media (sells digital books for any device as well as Nook ereaders)
The thesis for investing in Barnes and Noble is simple. The profitability of the Retail and College divisions is being significantly masked by the money losing operations of Nook Media, LLC. This is not really a secret, but the market continues to price Barnes and Noble at a significant discount to the intrinsic value of the Retail and College businesses (without the Nook).
Here are the operating profits from each division from the fiscal year that ended April 2013:
- B&N Retail: $227 million
- B&N College: $65 million
- Nook Media: ($512 million)
So on the surface, Barnes and Noble is losing about $220 million per year. But if we remove Nook Media from the picture, we are left with a company that produced $292 million in operating earnings last year. Better yet, this business has been profitable for more than 15 consecutive years, with stable margins and consistent free cash flow. The risk is that management continues to invest in a money losing enterprise, throwing the proverbial good money after bad. But with significant insider ownership and strategic partners/board members, I don't think this will be the case for too much longer.
Two years ago, Liberty Media invested $204 million into B&N preferred stock that is convertible into common shares at $17.00 per share. If we include these 12 million shares, Barnes and Noble has 71.7 million shares outstanding, which gives it a market capitalization at $14.00 per share of around $1 billion.
So we have a $1.0 billion business that produces $292 million in operating earnings. If we assume the brick and mortar business pays all of the current interest, the pretax profit of this business is $256 million. So ex-Nook, BKS trades at about 4 times pretax earnings.
The common misunderstanding is that the recent losses at B&N are due to the fact that the book industry is in decline and the brick and mortar business is dying a slow death at the hands of Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), and other internet competitors.
I wouldn't argue against the fact that ereaders and digital content poses strong competition for traditional bookstores, but this is not the reason for the losses at B&N (at least they haven't been yet). The irony is that Barnes and Noble is sustaining operating losses because of the Nook business, which is supposed to be the business that allows the company to survive and compete in the new digital content world.
So despite the common misperception, the traditional bookstore business at Barnes and Noble is consistently profitable, despite top line and overall industry headwinds.
15 Year Data
In fact, the bookstore has produced positive free cash flow in each of the last 15 years. I went through the last 15 years of annual reports and separated out the Nook business, and the formerly owned Gamestop (which B&N owned around 15 years ago). My objective was to create a picture of the last 15 years of operating results from just the bookstore and traditional ecommerce business (includes Retail, College, and bn.com). This chart shows the profitability of the traditional bookstores:
So the traditional business (not including Gamestop and Nook) has averaged $195 million of pretax profits per year. At the current price of $14, you get a business that has averaged $2.72 per share in pretax earnings and $2.00 per share in free cash flow over the past 15 years.
Estimating for taxes, the traditional business trades at about 7 times average 15 year free cash flow.
Margins have historically been quite stable in this business as well (note: I didn't find segment gross margin data for 1999-2001):
So we have a consistently profitable bookstore business that without the Nook trades at mid single digit earnings multiples.
But what about the Nook? That's of course the reason why BKS stock has been floundering. Ideally, Len Riggio, the founder, chairman, and 26% owner of BKS will at some point decide to sell or separate the Nook business. Although management has recently seemed to indicate they plan to continue investing into the Nook (a dubious strategy), at some point-if the Nook continues to lose money and destroy value-I think Riggio will want to stop the bleeding. Barnes and Noble is his pride and joy, and represents a sizable amount of his personal fortune.
There are some large shareholders with sizable amounts of money resting on the fate of this business:
- B&N Founder Len Riggio has a 26% ownership stake in Barnes and Noble
- Liberty Media (run by media mogul billionaire John Malone) invested $204 million into convertible preferred shares, which effectively gives them around 17% ownership along with two board seats
So you have two key insiders with large stakes. And although I think BKS is significantly undervalued even if the Nook shut down tomorrow and was worth $0, there is likely some sizeable value there as well:
- Microsoft invested $300 million into Nook in 2012 at a valuation of $1.7 billion for Nook Media, LLC
- Later in 2012, Pearson invested $89.5 million into Nook at a valuation of $1.789 billion for Nook Media, LLC.
So you have strategic investments from major companies that have valued just the Nook business at around $25 per BKS share, which values the rest of BKS (the profitable business) for -$11 per share.
These investments by Microsoft and Pearson have liquidation rights, meaning that they essentially get their money back, but along the way, Microsoft has agreed to pay B&N up to $85 million per year as part of that investment deal.
While I don't think Nook is worth twice what the entire company is worth, it likely is worth more than $0. Maybe it's worth half of the $1.8 billion valuation ($12 per share), maybe it's only worth 25% of that valuation ($6 per share). But let's assume it's worth $0. If Nook closed its doors tomorrow, what would BKS be worth?
Here are some numbers to consider when valuing the Retail and College business (excluding Nook):
- Average 15 year pretax earnings per share: $2.72
- Average 10 year pretax earnings per share: $2.76
- Average 5 year pretax earnings per share: $2.50
- Average 3 year pretax earnings per share: $2.64
- Last year's pretax earnings per share: $3.57
So the earning power of these traditional bookstore businesses seems to be quite intact. Here is one more look at the last 15 years of pretax profits (again, this excludes Gamestop and Nook operations):
It's a business that--although is not growing and facing industry headwinds--continues to be consistently profitable. Pretax earnings were positive each year and ranged from a low of $116 million to a high of $256 million, the latter which happened to be 2013!
So while we can speculate about the future, it's hard to make an argument that the brick and mortar business is currently in terminal decline.
The other thing to consider is that Barnes and Nobles-unlike Borders, Blockbuster, and other brick and mortar bankruptcies-has a very strong balance sheet with just a modest amount of debt to total capital.
I think that the profitable Retail and College business is collectively worth somewhere between 7-10 times earnings. Historically, a business this consistent would likely be worth at least 10 times pretax earnings over a full cycle (or about a 6.5% after tax earnings yield), but given the industry headwinds, I'll use that number as the high end, but maybe the value is closer to the low end.
At 7-10 times average 15 year pretax earnings, we arrive at a value of somewhere between $19 and $27 per share. Again, this values the Nook at $0. So if the Nook is equal to $0, then I think BKS is modestly to materially undervalued at $14 per share.
But I see some catalysts that could happen that will likely increase this value:
- Nook business could get sold for cash to Microsoft or some other competitor
- Nook could get separated or spunoff
- College business could get spunoff or sold
- Len Riggio could decide he wants to personally buy the Retail business
- Len Riggio decides he wants to sell the Retail business to a private buyer (unlikely, but possible)
- Something that I wouldn't count on, but could occur-Nook Media becomes a successfully profitable business
I think a private buyer would likely have to pay closer to $30 per share for the collective value of those assets.
Keep in mind a few other quick points in this sum-of-the-parts consideration:
- College is a consistently profitable business that was purchased in 2009 for $596 million
- BN.com (the original ecommerce business prior to Nook development) was purchased by Barnes and Noble at a valuation of $446 million
- Microsoft and Pearson invested into Nook Media at a valuation of $1.7-$1.8 billion
- BKS Current Market Capitalization: $1.0 billion
It's also interesting (although irrelevant to the current value) to note that in 1999 Len Riggio sold Gamestop to B&N for around $208 million, and it was subsequently partially sold to the public at a valuation of $1.2 billion, or a six-fold increase for shareholders in just a few years. B&N then spun off the remainder of Gamestop in 2004, and this company now sports a market valuation of $5.6 billion, nearly 6 times the value of Barnes and Noble. For long term B&N shareholders that held Gamestop, they have seen significant gains despite the poor performance of BKS. This is more or less just an interesting anecdote on an investment that created enormous value for shareholders.
To Sum It Up
I think you have a consistently profitable and stable bookstore business with steady free cash flow, stable operating margins, a powerful brand name, significant insider alignment, trading at a price of just 5 times long-term average pretax earnings. This value is masked by the money losing operations of the Nook, which may at some point get sold, separated, or-most unexpected of all-turn around and become a profitable division for Barnes and Noble.
In the words of the billionaire retail investor Rob Burkle (who was a large BKS shareholder but sold his stake after losing a proxy battle):
"We always try to buy companies that are doing O.K. but that have some issues. We buy at a price that if they just muddle through, we don't go broke. And if they do better, we make a lot. Since I was 13, I've been buying things because they are ridiculously cheap."
I think given the brand, insider alignment, and the core business profitability, Barnes and Noble will achieve results somewhere between "muddling through" and "doing better", which should result in satisfactory results for shareholders.
Disclaimer: John Huber owns shares of BKS for himself and for clients. This article is not a recommendation and represents only an opinion. Please conduct your own research.
Disclosure: I am long BKS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.