First, I want to say I agree with everybody who says print is dead or soon will be. I owned the first and second incarnations of Amazon’s (AMZN) Kindle and will be getting the third one when it comes out at the end of this month. I love my Kindle. I love e-books. I barely read paper books anymore. I read 2 newspapers a day and about 5 books a month on my Kindle. I can’t imagine reading 5 printed books a month anymore. And I never liked reading printed newspapers. The letters are too small; the pages are too big. The articles are broken up and the whole thing is full of ads. Newspapers were always written for advertisers first and readers second. And they always felt that way to me.
So I’m done with the printed page. I’ve kicked the habit. And no I don’t miss it. I don’t have nostalgia for the printed page. Why should I? I don’t have nostalgia for dial up modems or MS-DOS even though those were the first ways I experienced the internet and computers. I still use the internet. And I still use computers. I just use them in different ways. The same is true of words. I still use them. I still read. Maybe more now than ever. But I don’t read print. The fact I ever did is an accident of timing. If I’d been born 30 years later, I never would have known the printed page. Regardless of how many jobs we’re creating in the United States each month, we’re still creating 350,000 babies. And none of them are going to feel nostalgia for the printed page, because none of them are going to be raised on a literary diet of paper alone.
Fine. We all agree print is dead. So why am I buying Barnes & Noble stock at $15 a share?
I’m buying the stock at $15 a share, because Barnes & Noble (BKS) is not a cultural icon, a sign of the times, or a morality tale. Barnes & Noble is a stock. And that stock’s price is subject to supply and demand. In this case, supply is low and demand is high. Or it soon will be. Some of that demand is not yet influencing the market price of the stock because of legal restrictions. Those restrictions may never be lifted. But other demand for the stock is not acting on the market price, because of timing and the relative position of the two potential buyers. That demand may be felt in a quick negotiated flood instead of a slow open market trickle. And, finally, there is demand that is conditional on the stock’s price and the risk that it will move permanently higher. That demand comes from short-sellers.
Barnes & Noble has less than 59 million shares of stock. Ron Burkle and his allies own just under 21 million shares. While Len Riggio and his allies own just over 21 million shares. That leaves 17 million shares of Barnes & Noble stock for outsiders. And those outsiders have sold short 12 million of those 17 million shares. Both Burkle and Riggio want to control Barnes & Noble. Each contender needs another 7.5 million shares to take majority control of the company. Since the two men hate each other and neither is willing to sell his shares to the other, the only supply of shares available to them is the 17 million shares in outside hands. And since Riggio and Burkle both need to keep all the shares they already own to fight for control of the company, the only supply for the short-sellers to buy back their stock is those same 17 million shares in outside hands.
That puts outside shareholders in the catbird seat. In this unique takeover battle, passive minority shareholders – folks like you and me – are in a better position than Burkle, Riggio, or anyone who has sold a lot of Barnes & Noble stock short. We can supply any of the parties: Burkle, Riggio, or the short-sellers. And while demand for the stock has been pushed forward in time by the short-selling and the poison pill, no supply of stock has been pushed forward. In fact, the pro-Riggio faction which controls the board and therefore the issuance of new stock needs to avoid increasing the supply of stock unless it can directly place those new shares in the hands of Riggio supporters. That was made dangerously clear to Riggio’s board when Burkle enlisted the help of another fund, Aletheia, to buy more stock once Burkle hit the 20% ownership limit imposed by the poison pill. As soon as Burkle stopped buying stock, Aletheia started buying in a big way. It did the same thing in Great Atlantic & Pacific (GAP), another public company where Burkle now exercises influence. This second run at Barnes & Noble by a Burkle ally made it clear to the board that Burkle wasn’t going away and he wasn’t out of ammunition.
The fact that this alliance was written about in places like Bloomberg and Daily Finance added to Riggio’s control problems. Back in the 1950s and 1960s, Warren Buffett ran an investment partnership. One of his favorite activities was coat tail riding. Coat tail riding is exactly what it sounds like. A meek value investor like Warren Buffett or you or me follows a loudmouth value investor like Ron Burkle into a cheap stock.
Because the big disadvantage of most value stocks is the risk that nothing happens and the value just sits there. The big advantage of a loudmouth is that they make things happen. So the meek value guys follow the loudmouth value guys into a stock. They don’t talk to each other. They don’t have to. But they do support each other.
A poison pill is a weak takeover defense. It’s better than nothing. But it’s far from perfect. A staggered board, which Barnes & Noble has, is an even better takeover defense. But Barnes & Noble’s best takeover defense was removed in September 2009, a couple months before the takeover battle began in earnest. More on that later.
But first let’s talk about how control of a public company is contested. The easiest way to do this is to use the analogy of a political system. Although it does vote, a company’s board of directors is nothing like a legislature. It’s actually more like a cabinet. Under normal circumstances, there are no outright opponents of the executive on the board of directors just like there are normally no outright opponents of a Prime Minister in the cabinet. Over time this can change if the executive loses the confidence of his own people. Directors become disaffected. There’s infighting. Points of contention crop up that were not considered before the director joined the board. Things like that do happen. But just like in a cabinet the normal response tends to be for the executive to stay and the disaffected director to resign – the quieter the better. Personal reasons are the go to excuse.
Different takeover defenses work in different ways. They defend against different things. Let’s use the United States to find some ideas of checks and balances. They work just like takeover defenses. The founders put an anti-takeover provision into the Constitution in the form of the Senate. The Senate is meant to stop the people from taking over the government in one clean sweep. It is equal to the House, but Senate elections are staggered to prevent a sudden takeover in just one election.
Fine. So a staggered board is like the U.S. Senate. What is a poison pill? A poison pill is actually pretty simple to understand. It’s just that people in fully democratic countries don’t see the obvious analogy. A poison pill is a ban on all political parties. Shareholders can still elect whoever they want. They can vote freely. They just can’t work together.
The problem with a poison pill is the same problem you see in countries that outlaw political parties. Outlawing parties does not outlaw ideology. You can end up electing a lot of people who are officially not joined together, but are unofficially driven by the exact same motive. They want the same thing.
And that’s the problem Riggio’s board – or the Riggio government if you will – faced when Barnes & Noble stock dropped from $20 a share to $13 a share after Burkle and Aletheia bought their shares. The technically non-partisan shareholders who held the balance of power – the 30% of BKS shares not owned by the Riggio party or the Burkle party – were in danger of being joined together by the same rallying cry: get the stock price up now!
So that’s what Riggio had to do. And that’s why the board announced it was exploring strategic alternatives. It needed to increase the stock price and buy itself enough time to figure something out before the contested annual meeting on September 28th.
Riggio himself is up for re-election on September 28th. Barnes & Noble does not use cumulative voting. Cumulative voting strengthens the minority, so it is often seen as being anti-board and pro-shareholder. However, that is not true. Cumulative voting is merely pro-minority. It has nothing to do with who is currently in power. It only has to do with who has the confidence of the entire shareholder body at the moment the vote is taken. In this case, the lack of cumulative voting means Riggio faces a straight no-confidence vote on September 28th. Yes, he is in power. But so was the Labour Party back in 1979. Margaret Thatcher moved that “this house has no confidence in Her Majesty’s Government.” They took the vote, the Labour Party lost, and that was the end of that.
Well that’s the kind of test Riggio faces on September 28th unless he works something out before then. Riggio may win the no confidence vote or he may lose the no confidence vote, but because there is no cumulative voting, Riggio can’t guarantee himself a place on the board unless his supporters have an outright majority of the company’s shares going into September 28th.
And Riggio needs to stay on the board.
One, because he has a lot of his own money invested in Barnes & Noble. And two, because Riggio profits from a lot of related party transactions that depend on his control of Barnes & Noble.
Riggio is Barnes & Noble’s biggest creditor. The company owes him a $150 million 10% note due in September 2014 and a $100 million 8% note due in December 2010.
Barnes & Noble pays $16.5 million a year for freight services provided by another member of the Riggio family.
And the company pays Riggio $5.6 million a year to lease three locations from him. The leases expire in 2013, 2016, and 2024.
These are just some of the related party transactions Riggio profits from. Obviously, the $250 million owed to Riggio for his sale of B&N College is the biggest related transaction. That debt is a double-edged sword. Riggio could use it to reduce the amount of cash he needs to make an offer to buy out Barnes & Noble’s minority shareholders. However, if Riggio loses control of the company, the debt could cut against him because the transaction that created it was questionable. If someone who hated Riggio, or wanted him to sell out, gained control of the Barnes & Noble board, he could complicate Riggio’s financial affairs enormously. There is plenty of room for lawsuits and delays. Right now, Riggio is insulated from any conflicts between himself and Barnes & Noble, because he controls Barnes & Noble. If he lost control of the company, those conflicts could be used against him.
Has Riggio enriched himself at the expense of Barnes & Noble? I don’t have a view on that other than to say that his life will be a lot neater as long as he keeps control of Barnes & Noble and a lot messier if he leaves Barnes & Noble without coming to some sort of understanding with whoever controls the company.
So, Riggio has some extra reasons for wanting control of Barnes & Noble. So does Burkle. He has a long history of wanting to either control or influence the companies he invests in. He’s not known to be a passive investor. And he has told the board he wants to own as much stock as Riggio so he can wage a proxy fight on equal footing. He also testified in the poison pill trial that he considered offering $25 a share for Barnes & Noble, but decided not to because Riggio could easily block a deal.
But once Burkle and Aletheia bought enough stock to level the playing field and BKS shares dropped to $13 that changed. The best takeover defense is a high stock price. And the worst takeover weakness is a low stock price.
If Riggio and Burkle own roughly the same number of shares, it all comes down to the stock price. If the stock price is low, Burkle can offer a large premium easily. If the stock price is high, he can’t. And without offering a premium over the market price, it’s hard to dethrone someone who owns a third of the company.
How does this all play out? How do I actually get paid?
I don’t know. I never have an exact course plotted out ahead of time. The future is always uncertain. Investors don’t need a stock’s future to be certain; we just need it to be favorable. I bought Barnes & Noble stock between $15 and $16 a share on the assumption that something would happen that would allow me to sell to someone – presumably Riggio or Burkle at $20 a share. That means a 25% to 33% profit in a short amount of time.
I have to admit, I was also eager to invest in something that wouldn’t move in line with the overall market. I try to find “workout” type situations whenever I can. The majority of my portfolio is now in stocks where there is either a standing offer from the CEO to buy the company, there is a fight for control, or the board is looking at strategic alternatives. The market doesn’t look cheap to me. And even when I buy cheap stocks, I prefer ones that don’t look like they will move up and down along with the overall market. Barnes & Noble met those requirements.
The thesis is simple: The reasons for buying Barnes & Noble are Burkle, Riggio, the short sellers, the poison pill, the proxy fight, and the “for sale” sign the board just put out. You now have human emotions playing a role in what people are bidding for. They aren’t just bidding for BKS stock. They are bidding for control, pride, and spite. The short sellers will be bidding for safety. And the outside shareholders are in the best position.
What about those short sellers? Barnes & Noble was a different kind of investment for me. I researched it in a different way. I’ve been reading the SEC filings for a little under a year. That’s normal for me. What isn’t normal is all the time I’ve been spending reading about Burkle, Riggio, and the court case. I’ve been digging up old articles about how Burkle made his first buyout bid with money from Warren Buffett’s partner, Charlie Munger. The buyout failed. But it was an interesting story. And I’d love to tell you the things I learned.
But I don’t have enough time. Or at least you don’t. I was digesting various bits about Riggio and Burkle for weeks and months before the board made its announcement. I ruminated. You can’t do that now. I can show you the same articles. But you don’t have the same time. You can’t have the same perspective. You already know how the Act One ends. And you’re probably eager to know what all this means right now – not what I was chewing over a couple months back.
A big part of why I bought Barnes & Noble is that I was prepared. Maybe I was badly prepared. We’ll see. I may have been ill-educated. A lot of us are. But at least I was educated for better or worse about the stock before the board’s announcement. I talked to a former Barnes & Noble employee. I followed the court case. I read about Burkle. I tried to find stuff on Riggio. There isn’t much. But I got the picture Riggio wanted to keep control. Riggio had been too protective of his position for too long for me to think he would have it any other way.
One example is something I promised to talk about before. It’s actually the event that got me thinking seriously about Barnes & Noble as an investment. It was the deal to sell B&N College, which was owned by Riggio, to Barnes & Noble. The deal went through in September of 2009. And I wasn’t sure what to make of it at the time. Actually, I thought it was a sign of Riggio preparing to leave the company. I thought he was getting ready for a friendly buyout that would let him leave the company, because he didn’t see good things ahead for the book business and he wanted to take some chips off the table.
The sale of B&N College was a related party transaction in which Riggio sold a closely related, but separate, business to Barnes & Noble. He got cash for the sale. Riggio seemed to be unloading the business on public shareholders. After all, he only owns about a third of Barnes & Noble. So, selling B&N College to Barnes & Noble was like selling two-thirds of the company to the public. At first, that’s all I thought about it.
But what really got my attention was this one line in the 10-K that looked like a takeover defense:
As part of the acquisition, (Barnes & Noble) acquired the Barnes & Noble trade name that had been owned by B&N College and licensed to the company…
I thought that was a great takeover defense. Riggio held the Barnes & Noble trade name outside the public company and then licensed it for peanuts. That arrangement would really muddy the waters for anyone trying to take over the public company. Did Barnes & Noble control its own trade name? If not, what did that mean? Did that mean anyone looking to buy Barnes & Noble had to strike a special deal with Riggio to secure the trade name? Did it give Riggio a veto over any sale of Barnes & Noble?
That’s what I thought. Then, in September 2009, Riggio sold the Barnes & Noble trade name to the public company. I figured Riggio was killing two birds with one stone. He was cashing himself out of the related business, B&N College, while also transferring the trade name to the public company so the path was now clear for a sale of Barnes & Noble.
Apparently, that’s not what he had in mind. A couple months later, Burkle started buying Barnes & Noble stock like crazy and Riggio got the board to adopt a poison pill.
Now, as the September 28th annual meeting approaches and the poison pill verdict looms, the board says it is evaluating strategic alternatives. And the exact way the board said it was interesting. These press releases are usually pretty similar. They aren’t identical. Some companies have no comment even when it’s already been reported who the potential buyer is and what price range they’re thinking of. Other companies just issue a blanket statement.
Barnes & Noble’s press release was interesting because it talked an awful lot about the current management team. The board said
[We] are confident in Barnes & Noble’s strategy and fully supportive of the senior management team…the board has concluded that a review of strategic alternatives is the appropriate next step to take…
Then, there’s a quote from Riggio who says:
Regardless of whether I participate in an investment group that buys the company, I, as well as the senior management team, am willing and eager to remain with the company and see it through the challenging years ahead.
All of this sounds a lot more like a takeover defense than an attempt to shop the company. That’s what really got me excited. You have Riggio and Burkle both still taking actions that say they want majority control of the company, you have the upcoming annual meeting, and you still have the short sellers.
Thinking about the short sellers was the last part of the unusual research I did. In his 1987 letter to shareholders Warren Buffett quoted an old poker tip: “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”
I never think about who the patsy is. I just never worry about it. I’ve bought stocks below net cash, and frankly I’ve never stopped to think who the heck sells a stock for less than cash. But I did think about that a lot here. I kept wondering who would short this stock when there was a battle for control going on between two very driven men with very deep pockets. I didn’t get into all that here, but Riggio owns a lot of GameStop (GME). Burkle owns a lot of a lot of things. They’ve both got plenty of money and plenty of friends with plenty of money. And they’ve both got the kind of personal business histories that tell you they aren’t going to take no for an answer.
So why short the stock?
That question didn’t so much bother me as intrigue me. I really didn’t understand it. I looked at the balance sheet. It’s fine. Barnes & Noble owes Riggio money and it has a lot of long-term leases. They’re nice leases. Good properties. The landlords have as much to lose from Barnes & Noble leaving as the company does. The other debt is owed to Riggio who is right now fighting to keep control of the company. So, all in all, the balance sheet hides more good surprises than bad surprises.
That just made me more curious about the short selling. So, I tried to read everything negative about Barnes & Noble. I tried to listen to people who were short the stock. Really listen. I did my best to get a clear picture of what the shorts saw.
And, for the first time in my life, I knew who the patsy was: the short sellers. Now I’m sure some short sellers read everything they could about Burkle. I’m sure some of them have been following the poison pill case down in Delaware. I’m sure there are folks who studied everything about the takeover battle and decided to short Barnes & Noble anyway. There must be. But my general impression of the short sellers was that they were dumb money. I didn’t think they did their homework. I thought they were betting on an idea, the death of print, that I totally agreed with. I felt like the shorts and I had exactly the same view of the company and exactly the opposite view of the stock.
There is one point some short sellers made that I have to disagree with though. Some of them compared Barnes & Noble to Blockbuster. That makes perfect sense if we’re talking about trends in the industries. But they seemed to be under the impression that Blockbuster, which is expected to file for bankruptcy next month, obliterated the value of its stock by not adapting to technological change. That isn’t true. Blockbuster failed in part because it didn’t adapt. But that alone would never have destroyed the value of the stock. It certainly never would have caused a bankruptcy so soon.
The real story at Blockbuster, like most soon to be bankrupt companies, is a deadly cocktail of operational and financial recklessness. The financial recklessness was key for Blockbuster. The stock had long scored terribly on every measure of financial strength that doesn’t include the stock price. The only reason Blockbuster ever had a decent Z-Score was that it had a high stock price at one time. On every other measure it was a financial failure. And, honestly, if you look at the last 10 years, Blockbuster caused itself more problems by chasing higher sales instead of being satisfied with zero growth. If Blockbuster had turned in on itself, stopped growing, and tried to fix its finances – well, it probably still would have failed. But it would have stayed alive a few more years.
The basic problem was that Blockbuster always had a bad balance sheet. Blockbuster has been on life support for a decade from a financial perspective. The stock was never a value trap, because it was never a value. Comparisons between Barnes & Noble and Blockbuster make perfect sense from a technology perspective. They make perfect sense from a customer perspective. They make no sense from an investment perspective.
I’m going to throw out some numbers that illustrate how safe Barnes & Noble is compared to a balance sheet zombie like Blockbuster. Over the last decade, Blockbuster’s average Z-Score was 2.67 and its median Z-Score was 0.46. Barnes & Noble’s minimum Z-Score was 3.30. It’s higher now.
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The working capital picture is even more interesting. Blockbuster had negative working capital in most years. Blockbuster’s average working capital was -1.82% of total assets. Barnes & Noble’s average working capital was 14.32% of its total assets. The best part is that the trend has been completely opposite. Blockbuster increased its working capital as a percentage of total assets as it approached bankruptcy. Although increased working capital is statistically a net positive, it makes sense that higher working capital can be a bad sign for a business like Blockbuster. Barnes & Noble has done exactly the opposite. Barnes & Noble reduced working capital as a percent of total assets in a complete reversal of Blockbuster’s trend.
I don’t know if Blockbuster was getting better as Barnes & Noble was getting worse or vice versa. But it’s clear the two companies have totally different trends in working capital.
One of the best bankruptcy indicators is a very simple ratio. You just take retained earnings and divide by total assets. The higher retained earnings is as a percentage of total assets, the lower the bankruptcy risk is. The idea behind this one is simple: companies that go bankrupt are usually companies that can’t self-finance.
Blockbuster could never finance itself. It always needed more capital. Barnes & Noble has had the opposite situation. At least for the last 10 years.
Another financial strength ratio is EBIT (that’s earnings before interest and taxes) as a % of total assets. Barnes & Noble does much worse on this measure now than it used to. But it’s never done nearly as bad as Blockbuster has. Blockbuster’s earnings before interest and taxes averaged -9.33%. Barnes & Noble has averaged positive 7.17%.
And finally there’s sales as a percent of total assets. This one is my favorite because Blockbuster and Barnes & Noble have almost the exact same average. The beauty of it is that Barnes & Noble’s asset turnover has been very steady for 10 years while Blockbuster’s has been climbing higher and higher for the last 10 years. That’s right, Blockbuster actually turned its assets over faster as it approached bankruptcy. That doesn’t make a lot of sense if you’re focused on higher and higher sales as the key to survival. If you focus instead on a solid balance sheet and good cash flows – which Barnes & Noble has tended to have and Blockbuster has tended not to have – well, then it makes a lot more sense.
My point is not that Barnes & Noble won’t go bankrupt one day. My point is that there isn’t any evidence in the financial data that suggests it will happen in the next few years, even if sales of physical books fall very far very fast. And there’s a ton of evidence that shows Barnes & Noble is nothing like Blockbuster.
Finally, I wouldn’t be a value investor if I didn’t leave you with some idea of Barnes & Noble’s intrinsic value. The truth is I have no idea. I was just telling a friend of mine that the best I can do with Barnes & Noble is to value it the way you might value a house. I can look at what other houses go for. I can look at what the land alone sells for. But, basically, yes it’s a Keynesian beauty contest. I’m trying to guess what Burkle and Riggio think Barnes & Noble is worth.
On a 10-year average free cash flow basis, Barnes & Noble would be worth $50 a share. That’s obviously ridiculous. The company will never see those kind of cash flows again. So let’s chuck the $50 estimate. Barnes & Noble stock will only reach $50 a share if the company closes a lot of stores and cuts a lot of costs. The way it’s structured now, there is no way Barnes & Noble’s intrinsic value gets back to $50 a share. Print is dead. And so are the days of Barnes & Noble being worth $50 a share.
But what about $23 a share? There’s nothing magical about that number. I just took a list of publicly traded grocery store chains and averaged their price-to-sales ratios. For price I used enterprise value. Grocery stores tend to use debt. Barnes & Noble has about $5 a share in debt, and a grocery store type price-to-sales ratio would give the stock (which has $98.72 a share in sales) an intrinsic value of $23 a share.
Again, that’s valuing Barnes & Noble’s book sales as if they were grocery sales. Is that crazy? Probably. But I can’t think of a lower margin retail business than groceries. And I can think of an investor who might compare a chain of book stores to a chain of grocery stores. One of the Barnes & Noble directors testified that he hated how Burkle talked about selling books like it was the same as selling groceries. I kind of like that.
That’s why I’m buying Barnes & Noble stock at $15 a share. Print is dead. And Barnes & Noble is worth 20 bucks a share to Riggio, Burkle, and the shorts.
It’s not my usual investment. I might be wrong. That’s why I’m telling you now. We’ll watch the results together. I’ll do a post mortem in a few months or a few years or however long it takes this investment to work out or fail miserably.
Disclosure: Author is long BKS