Barnes & Noble (NYSE:BKS)
Q3 2014 Earnings Call
February 26, 2014 10:00 am ET
Andy Milevoj - Vice President of Investor Relations
Michael P. Huseby - Chief Executive Officer, 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
John Tinker - Maxim Group LLC, Research Division
Good day, and welcome to this Barnes & Noble Third Quarter 2014 Earnings Conference Call. Today's call is being recorded.
At this time, for opening remarks and introductions, I would turn the call over to the Vice President of Investor Relations, Mr. Andy Milevoj. Please go ahead, sir.
Good morning, and welcome to Barnes & Noble's Fiscal 2014 Third Quarter Earnings Conference Call. Joining us today are Michael Huseby, CEO 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 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 or 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.
At this time, I'll turn the call over to Michael Huseby.
Michael P. Huseby
Thanks, Andy, and good morning, everyone. We are pleased with our third quarter performance. The company significantly improved its bottom line and strengthened its balance sheet while progressing on our strategic priorities in all segments. Each business line executed extremely well on its operational objectives and strategic initiatives.
Retail, which represented approximately 70% of our sales volume this quarter, generated $200 million in EBITDA. Core sales trends improved as compared to the first half of this year as we benefited from a strong lineup of best-selling titles, growth in Toys & Games and an effective advertising campaign. This campaign highlighted Barnes & Noble's depth and breadth of our physical and digital product offerings. Our team of booksellers and merchants executed at the highest level during the 2013 holiday season.
College, which represented approximately 25% of our sales volume this quarter, continued its steady profit trend, generating $35 million in EBITDA for the quarter and over $100 million year-to-date. Textbook rentals continued to grow at a rapid pace, and the company continues to invest in digital product development. Excluding this digital product development investment, year-to-date investment -- year-to-date EBITDA would have been flat with the prior year. We continue to see significant adoption of textbook rentals as more students become comfortable renting their textbooks, and we're expanding the inventory available for rent. Year-over-year third quarter textbook rental revenue grew 63%.
Barnes & Noble is a leader in the collegiate market, and we plan to aggressively leverage this knowledge and experience to innovate and become the leader in digital education. Our education applications are approaching their initial release. We're planning to have a soft launch of our product prior to the end of the fiscal year to allow for testing and updates and plan a broader launch ahead of the 2014 fall back-to-school season. We will leverage our almost 700 campus bookstore relationships, which encompass 25% of the U.S. higher education student and faculty base, to bring the product to market. Our offering will also be available via a national website to students who are not served by a Barnes & Noble College bookstore and want a leading-edge digital learning experience. We believe that our educational applications will become the most innovative and demanded educational platform.
Our content development has been significantly enriched by our strategic partnership with Pearson Education. Users will be able to search across a robust, academically-relevant catalog both through our deep Barnes & Noble College integration and our -- and on our national commerce site. Our device-agnostic platform will enable students to not only purchase textbooks but to also organize, read and annotate textbooks on the device of their choosing. Students can easily highlight, bookmark and add notes to their textbooks with a simple interface that's supported by the cloud.
As the College bookstore business continues to evolve in terms of rental mix and digital offerings, Barnes & Noble continues to enhance its offerings and as a result, is positioned in the marketplace. 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. Max Roberts and his team are doing a fantastic job of positioning B&N College in what we believe is a strong growth opportunity.
With respect to NOOK, which represented 5% of our consolidated revenues this quarter, I'd like to discuss the following. Since August, we have discussed how we plan to compete differently in the digital business. We've been clear that we need to focus on rationalizing the NOOK business and positioning it for future success and value creation. In tandem, we are strengthening our commitment to our existing and future NOOK customer base. NOOK customers will continue to receive the best digital reading experience as a result of the actions we have taken and that we're planning to take.
We have taken the following steps to rationalize our NOOK business thus far. First, we sold through and converted much of our device inventory into cash while reducing expenses. Third quarter SG&A declined $52 million or 40% on lower advertising, headcount, consulting and other costs. Since the beginning of the fiscal year, including attrition and job eliminations, NOOK's headcount has been reduced by 26%.
Second, we've reduced our device costs and exposure by engaging with third-party manufacturers to bring new devices to market. In fact, we are actively engaged with several world-class potential third-party partners to bring devices to market. While there's no assurance these discussions will be successful, we believe they will result in our further leveraging third-party partners to reduce our exposure to device operational issues and inventory exposure. We remain committed to providing our customers with the best eReading experience in the market as evidenced by our successful launch of NOOK GlowLight in October. And I'm pleased to announce that in early fiscal 2015, we expect to launch a new NOOK Color device in collaboration with a third-party partner.
Third, our entire organization is focused on turning around our content sales decline. We have curated a very valuable digital content repository with over 3 million titles and a leading selection of magazines and newspapers. In addition, we are in the process of building an expansive international content catalog. We continue to pursue partnership opportunities to further leverage these catalogs with worldwide technology companies on their platforms. We also continue to actively discuss opportunities with Microsoft to mutually leverage the benefits of our existing partnership.
On February 3, 2014, earlier this month, the Board of Directors of the company approved a specific component of a plan to rationalize our NOOK business. This action included a workforce reduction, reflecting a shift in strategy, to reposition NOOK's platform to hardware and content distribution partnerships, thereby reducing our internal hardware-related burden and cost structure. This workforce reduction resulted in the elimination of approximately 75 positions. Thus far, charges associated with the recent reduction in force were approximately $2.4 million, which include benefits and severance arrangements, which will be recorded in the fourth quarter of fiscal 2014. Since fiscal 2014 began, approximately 190 NOOK positions have been eliminated both through reductions and attrition.
As the company further refines its strategy, it could incur additional rationalization charges, including occupancy, asset impairments, severance and other overhead-related charges. The company currently estimates that these future net charges could be as high as approximately $40 million. Substantially all of such estimated future charges are related to the potential consolidation and/or relocation of our NOOK offices and associated charges that may occur to improve cost efficiency while, at the same time, providing our NOOK employees with a better environment to work.
Our new NOOK management team is focused on managing the business efficiently so it becomes financially strong while, at the same time, aggressively moving to stabilize content revenue and eventually drive its growth. We firmly believe that having a digital offering is vital to our mission and our relevance as booksellers and will offer all reading formats, hardcover, paperback and digital, to delight our customers. We also have opportunities to better package physical and digital content offerings together that we are actively considering and testing.
During the third quarter, NOOK narrowed its EBIT loss -- EBITDA loss by 68% from the prior year on cost reductions in comparison to prior year charges. As the company executed on its plans to sell through most of its existing device inventory, we converted inventory to cash and drove significant improvements to the company's liquidity position. The company ended the quarter with $490 million in cash, which was an improvement of $276 million over the same period last year, with no bank debt under drawn its $1 billion credit facility.
Before I conclude my prepared remarks, I would like to address a public proposal that Barnes & Noble received last week. As you know, an entity called G Asset Management put out a letter last week proposing 2 alternative transactions. From what we can tell from publicly available information, G Asset Management has 1 employee, extremely limited financial means and as set forth in his letter, he has no debt or equity financing to support his proposal. And accordingly, we do not consider it to be a proposal worthy of further discussion or action by us.
Now I'll turn the call over to Mitch for a review of Retail's performance. Mitch?
Mitchell S. Klipper
Thanks, Mike, and good morning, everyone. I'm extremely happy with the solid performance that the Retail group delivered during the third quarter. Core comps declined 0.2% during the all-important 9-week holiday period, an improvement over year-to-date trends. Our core comps benefited from the flawless execution by our merchants and our booksellers, as well as successful advertising campaigns. Our It All Happens at Barnes & Noble theme was effective in driving awareness of the in-store shopping experience and all the terrific products available at Barnes & Noble.
Our holiday title lineup was particularly rich this holiday season, with popular titles like Charles Krauthammer's Things That Matter, John Grisham's Sycamore Row, Malcolm Gladwell's David and Goliath, Jeff Kinney's Hard Luck and Veronica Roth's Divergent trilogy, which led the pack. Our merchants did a tremendous job of merchandising and highlighting the season's biggest books, making these titles easier for our customers to discover. Our highly trained and knowledgeable team of 40,000 booksellers provided unparalleled customer service to our customers. It's important to note that our team drove sales while maintaining fiscal discipline as inventory levels and SG&A costs were all well controlled during the quarter.
Improving bookstore sales trends during fiscal '14 indicated that customers are reigniting their love affair with physical books and they're coming back to our booksellers more often. This trend supports industry reports that suggest eBook growth has moderated and was essentially flat in 2013. As this trend continues, we believe we're well positioned to serve our customers on whatever platform they choose to connect with us.
Additionally, we continue to grow our Educational Toys & Games and gift businesses in the third quarter, and we have solidified our position as a destination for these categories. Our Educational Toys & Games comp store sales increased 12% for the quarter. Based upon feedback we're getting from our industry partners, Barnes & Noble outperformed the industry and gained share in the business. For the full quarter, core comps declined 0.5%. Comps deteriorated slightly after the holiday period due to the winter storms. As a national retailer, we never behind -- hide behind weather, but this winter has been the exception. We've never had as many store closures as we did this winter season, and it's impacted our stores from East to West and as far south as Atlanta. This unusual severe winter weather continues during February and has negatively impacted our early fourth quarter sales.
I want to take this opportunity to thank all of our booksellers for their outstanding effort in making this an excellent holiday season for the company. Because of their commitment and dedication, I believe Barnes & Noble bookstores will continue to thrive.
With that, let me turn it over to Al.
Allen W. Lindstrom
Thanks, Mitch. This morning, we released our fiscal 2014 third quarter results for the period ending January 25. Comparisons are to the prior year quarter unless otherwise noted.
Consolidated sales declined 10.3% to $2 billion for the quarter. Retail sales decreased 6.3% to $1.4 billion, primarily as a result of a 4.9% comparable bookstore sales decline, store closures and lower online sales. Comparable store sales declined primarily on lower sales of NOOK products. Core comparable bookstore sales, which exclude sales of NOOK products, decreased 0.5%, an improvement as compared to a 5.5% decline during the first half of the fiscal year. For comparison purposes, first half core comps, excluding Fifty Shades and Hunger Games trilogies, declined 2.7% versus the prior year.
College sales decreased 6% to $486 million during the quarter. Sales were impacted by the continued growth in textbook rentals, which have a lower price than new or used textbooks, plus rental sales are deferred and amortized over the rental period. During the quarter, the deferral amount of spring rentals was higher than the amount of fall rentals recognized from the previous quarter. On a comparable basis, College sales declined 4% on lower textbook volume and a higher mix of lower-priced used textbook rental. Factoring in the 2 additional weeks in February that contributed to this year's spring rush season, comparable sales decreased 3.1% for the quarter. The comp decline was partially mitigated by an increased store count.
Third quarter NOOK sales, which include sales of digital content, devices and accessories, decreased 50.4% to $157 million. Device and accessories sales of $100 million declined 58.2% on lower unit selling volume and lower average selling prices. Two NOOK Tablet products were launched last year versus 1 new E Ink product this year as the company sold through most of its existing device inventories at reduced prices. Digital content sales of $57 million declined 26.5% due primarily to lower device sales volumes.
Turning to gross margins. Retail decreased 10 basis points on occupancy deleverage against the sales decline and higher core markdowns, partially offset by a higher mix of higher-margin core products and favorable vendor settlements. College's gross margin increased 280 basis points on sales mix, driven by a higher mix of higher-margin textbook rentals and general merchandise sales, as well as the favorable LIFO adjustment, partially offset by higher net textbook rental deferrals and occupancy deleverage.
NOOK margins improved as the prior year included $74.1 million of previously disclosed charges, which included $15.4 million of promotional allowances and $58.7 million of inventory markdowns. Current year NOOK margins include a benefit of $26 million as the company sold through devices at higher average selling prices than originally anticipated and was also able to use parts and components, which were previously written down, to build more devices to meet higher-than-expected demand. This benefit was partially offset by $19.2 million of inventory charges during the quarter to write down device development and other costs reflective of the company's current device strategy.
As a percentage of sales, third quarter selling and administrative expenses decreased 60 basis points over the prior year. Retail SG&A was flat as the company managed expenses, commensurate with the sales decline. College's SG&A rate increased 210 basis points as expenses delevered against the lower sales and due to continued investments in digital product development. NOOK reduced expenses by $52.1 million, primarily as a result of lower advertising, payroll and consulting costs. The company generated third quarter EBITDA of $173.1 million as compared to EBITDA of $59.4 million a year ago as a result of the factors just discussed.
As previously disclosed, the company evaluates its deferred tax assets on a quarterly basis. Under ASC 740, the company continues to not record a benefit for deferred tax assets generated in the current year. During the quarter, the company recorded an additional valuation allowance against certain deferred tax assets as a result of decisions made regarding the company's future device strategy in international markets. The impact of this item on the third quarter income tax provision was $44 million. Consolidated third quarter net earnings were $63.2 million or $0.86 a share as compared to a net loss of $3.7 million or $0.14 per share a year ago.
Turning to the balance sheet. As Mike mentioned, the company ended the quarter with $490 million of cash, $276 million higher than the prior year, with no borrowings drawn under its $1 billion credit facility. Cash is expected to be utilized to fund working capital requirements, commensurate with the seasonality of the business, as well as the upcoming payment of the short-term note payable in September of $127.5 million. Inventories decreased $343.1 million or approximately 19%, driven primarily by the sell-through of NOOK devices, as well as lower retail Trade Book inventory.
Consolidated capital expenditures for the third quarter were $26 million, bringing the year-to-date total to $96 million. In the third quarter, the company closed 10 Retail bookstores. College opened 3 new stores during the quarter while closing 2. On a year-to-date basis, Retail closed 15 stores while opening 3. College opened 24 stores while opening 14 -- while closing 14, excuse me. For fiscal 2014, the company continues to expect Retail comparable bookstore 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.
[Operator Instructions] And we'll take our first question from John Tinker with Maxim Group.
John Tinker - Maxim Group LLC, Research Division
Could you just talk a little more, there were a lot of numbers, about the NOOK in terms of what is your actual headcount at the moment? And secondly, as we sort of separate out the hardware side and the content side, how would a partnership on the manufacturing side with another distributor sort of actually work? And finally, how do we get a handle on sort of the fixed costs side of the eContent side? Because, obviously, the marginal profitability should be extraordinarily high in an agency business, but in terms of how many people, infrastructure do you need to actually run that business.
Michael P. Huseby
The first question? I got the other 2.
Michael P. Huseby
Yes. On NOOK, I think what we disclosed in my comments, John, were that we cut about 26% of the workforce, and we said that it was 190 people. So you can do the math, kind of work backwards to what it was at the beginning of the fiscal year. And if you take the 190 away, you'll find out it's just over 500 people in Palo Alto and New York who do all the various functions that we have in NOOK from content acquisition and purchasing and software and the hardware-related functions in Palo Alto make up the NOOK business, both here and in the U.K and also that service, the Microsoft commercial agreement that we have, which is an important partnership to us. So it's a little over 500 people currently. On your second question as how does the partnership, total partnership works, that will depend on the partnership deal that we cut or don't cut, depending on whether it's successful, I think, we will end up with a partnership deal. I announced that we're going to introduce a new device in early 2015, fiscal 2015. So obviously, we already have -- we have a relationship that we're very comfortable with, but we want to expand those relationships and broaden them, both in terms of our ability to put quality devices in our stores and online and also, in tandem with that, negotiate on the platforms of those technology companies the distribution of our content. We're not going to get into the specifics about how a partnership can work because they can be different. But as we said, we've always had hardware partners. We've also had a cost structure reflecting a fairly self-sufficient model of hardware design and development, as well as sophisticated and broad internal software design development capabilities. So going forward -- I'll answer your question this way, generally our plan is to produce reading-centric device with more of an emphasis on leveraging collaboration with hardware partners. We still have some stuff internally that we'll interface with those partners and also have more of a role in NOOK GlowLight, for example, and bringing that eReader product to market. We believe we can leverage these third-party partner relationships to also reduce costs, exposure to operational issues, inventory exposures, the things we've been managing over the course of the last 9 months, I think, pretty well and also bring some world-class reading-centric devices to market. And then why do we want to do that? Well, as we've said in the past, we think reading devices are important in terms of driving content revenue, which is really what our business is about, that's where the margin is. The margin has not been and will continue not to be really in the device business, it's in the content business. Let's see the third question, which had to do with the fixed costs we need to maintain to conduct the content business. I guess that was it in essence. I just answered the question about how many people we have currently. And what we'll continue to do is, as we focus on trying to stabilize and then drive content revenues, we'll continue to evaluate the cost structure relative to the success of the progress of those plans we have to stabilize content revenue. I can get into -- content revenue is really are our toughest challenge at the moment, given the competitive landscape and the domestic trends in eBook adoption. These are long answers, but hopefully, they'll help satisfy some of the questions that others have as well. As I said in my remarks, we have a very valuable digital content catalog, and we're also in the process in connection with our work with Microsoft, to building an expansive international content catalog. We're in over 30 countries and when a -- we can leverage that content catalog that we're acquiring as we pursue these partnership opportunities with other technology companies and put that content on their platforms. There's other ways we can drive content that I've talked about in the past. But striking the balance between getting new content locker starts through devices and also as we expand our client application on these other technology platforms and controlling the cost structure and financial exposure, bringing those devices to market is really what we're trying to do. The way we describe it internally is we're in somewhat a rebuilding period. We've got -- we have to bring things down a little bit before we can take them back up, and that's what we're doing. You could see it in the cost numbers. You can see it in the management of the inventory and liquidity. And that doesn't mean we're going to go back to what we were doing in terms of how we are competing against other hardware providers, we'll do it in a much different way. But we do need to have hardware out there in the stores, we believe, and in our website to drive locker starts for content.
Hopefully that answered everyone else's questions.
We'll take our next question from Richard Schottenfeld from Schottenfeld Group.
Michael, first of all, I want to stay you're doing a really good job here in terms of rationalizing capital allocation at the company and steps it, we thought you guys should take for a long time, so we're pleased. But one capital allocation decision that doesn't really make sense to me is you said on the call earlier that you're going to keep the cash on hand to fund the seasonality of the business. If I adjust your EBITDA to EV for the cash on your balance sheet, you'll have an enterprise value to EBITDA of something around 2, which implies a 50% return on stock buybacks to remaining shareholders compared to cost of capital on your line of under 5%. So why not resume meaningful stock buybacks at this point just to return some capital to shareholders? I mean, we've squandered a lot of capital on the NOOK over the years. But now that you're rationalizing that, it seems like an opportune time to resume significant buybacks. Can you give us your thoughts on that?
Michael P. Huseby
Yes. I think that -- and Allen Lindstrom, our CFO, can comment on -- in more detail on the use of the cash and what we -- this time of the year is a peak obviously -- maybe not obviously but it is, for our liquidity. We just come off of the holiday season for Retail and -- segment and just gone through the winter rush for College. And we have bills to pay for the costs incurred to generate those revenues. We also, as Al mentioned, have a College acquisition short-term note to pay off in the late second quarter -- or in the second quarter of this coming fiscal year. Some of the rationalization activities we're undertaking at NOOK, I mentioned that we have -- it's a fairly broad estimate at this point. But I did want to give our shareholders and the public some idea of the fact that we do have a facility in Palo Alto that, given the reduction in size of our workforce and just other factors, probably makes sense for us to seriously consider, which we are relocating that facility to something that's more -- really more relevant the workforce and what they want to do going forward in terms of the size. And that's going to have a cost to it, I said -- I think we estimated about $40 million in future quarters. We didn't say which quarters. Obviously, we're going to continue to do this. We have some momentum on it. We're not going to wait a long time. But probably half of that -- about half of that we've estimated will be cash payments. Half has already been either incurred, in terms of leasehold improvements on the facility or other things. So that's another use of cash. And so I guess the point is, Rick, as you're saying, at least we now have some more flexibility to, even with those uses of cash going forward, consider other options for return of capital, whether it's your suggestion, a share repurchase, or other -- dividend or whatever. But that's a matter for the board, as we've said in the past, and that's something the board will consider. And have some flexibility, more flexibility to consider now. But that, in concert with considering, as we've discussed over the last 1.5 years or so, strategic alternatives about whether the companies can and should be separated, Retail from digital business or the College business from either of those businesses, is something that we continue to look at. But we don't have anything announced at this time. So you'd like to have -- if we're going to do something, pursue that in the near term, we'd like to have some more certainty around those discussions before we start using our cash. At least that's my own personal thought, it's not a board thought, to return capital immediately to shareholders either through repurchase or dividend. I'm not saying that the board may not decide to do that. I'm just saying, personally, we are still studying the possibility of separating the companies, although we have nothing to announce.
All right. I just wanted to point out that even after paying off the notes, you're going to have 35% of your market cap in cash right now. So I mean, you do have more cash, I think, than you need for the business. So hopefully the board will consider that.
Michael P. Huseby
Yes. Rick, that's based on today's -- or as of the end of the quarter, that cash balance. And as Al, I think, explained, that number is going to decline. Seasonally, it will decline fairly significantly. So you shouldn't expect that to be the cash balance for the rest of the year.
I understand. I understand the seasonality. It just seems like the stock's too cheap for you not to be buying back. You bought like a lot of stock in 30s. But hopefully, you'll consider it.
Michael P. Huseby
It's been a while, right? So okay, I appreciate your comments. We'll relay them to the board and -- for their consideration. Thank you.
And it appears we have no further questions at this time. So at this time, I'll turn the conference back over to today's speakers for any additional or closing remarks.
Great. Thank you for joining us on today's call and for your interest in Barnes & Noble. This will conclude today's call.
That does conclude today's conference. We appreciate your participation. You may now disconnect.
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