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Barnes & Noble, Inc. (NYSE:BKS)

F4Q06 Earnings Call

March 22, 2007 10:00 am ET

Executives:

Joseph J. Lombardi - Chief Financial Officer

Stephen Riggio - Vice Chairman of the Board, Chief Executive Officer

Analysts:

Nancy Hoch – JP Morgan

Matthew Fassler – Goldman Sachs

Bill Armstrong - CL King & Associates

Blaine Marder - Loeb Partners

Kenneth Marcus - First New York Investment

Presentation:

Operator

Good day and welcome to the Barnes & Noble fourth quarter 2006 financial results conference call. Today’s call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to the Chief Financial Officer, Mr. Joseph Lombardi.

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Joseph J. Lombardi

Good morning and welcome to Barnes & Noble’s fourth quarter and year end 2006 conference call. Joining us today are Steve Riggio and other members of the senior management team.

Before I begin, I would like to remind you that this call is covered by the Safe Harbor disclosure contained in our public documents and is the property of Barnes & Noble. It is not to be broadcasted or used by any other party without the written consent of Barnes & Noble.

This morning before the market opened, we released our preliminary results for fourth quarter and full year ended February 3rd 2007.

As previously announced, the special committee of Barnes & Noble’s board of directors and its independent legal counsel have not yet finished their review of the company’s stock option practices. Accordingly, the company has not yet determined the amount of any additional non-cash stock based compensation expense related to stock option grants that may be recorded.

As a result, the preliminary results and guidance discussed on this call do not include any such additional charges and are subject to adjustments based on the results of the internal review. As you will understand, given the circumstances, we will not be able to comment further on the internal review and related matters at this time.

Now, for the operating results for the fourth quarter and full year: Consolidated sales totaled $1.9 billion for the quarter and $5.3 billion for the year; Sales at Barnes & Noble stores were $4.5 billion for the year up 2% over a year ago; Comparable store sales decreased 0.1% for the quarter and decreased 0.3% for the year, slightly below guidance which called for a flat to low single digit increase.

In the fourth quarter, we opened nine Barnes & Nobles stores and closed six, for a quarter end total store count of 695. Comparable stores sales at B. Dalton, stores decreased 7.5% for the quarter and 6.1% for the year. B. Dalton sales now represent less than 2% of consolidated sales and even less of profits. As a result, we are not going to break out B. Dalton sales in future reporting as we continue to close stores in this format going forward. We will, however, continue to report on the progress of the store closures. We have closed eleven more B. Dalton stores this quarter, resulting in a total B. Dalton store count of 98.

Sales at BarnesandNoble.com were $164 million for the quarter, a 5.1% increase on a comparable basis for the prior year. Before I discuss earnings, I would like to highlight a few items which impacted our results in 2006.

On March 5th, the company announced the closing of its internet distribution center located in Memphis. As a result, the company incurred charges of $0.03 per share in the fourth quarter. Those charges impacted cost of goods sold, SG&A, and depreciation. In addition, earlier this year we reported that we had completed the conversion and transition plan related to our new state of the art warehouse facility in Monroe, NJ. Redundant costs previously reported related to this conversion plan were $0.05 per share for the year. These costs impacted costs of goods sold in the first three quarters of the year for $0.02, $0.02, and $0.01 per share.

On October 23rd, the company announced an enhancement to its membership program whereby adult hardcover discounts would be increased by an additional 10%. On our third quarter conference call, the company noted its guidance reflected that the additional margin investment expected in the fourth quarter related to the program was approximately $10 million.

As we indicated in our March 5th press release, the response from our customers to the new offer was better than anticipated. As a result, our $10 million estimate was low by a few million dollars.

By far, the biggest impact to our estimates was a higher-than-expected increase in membership enrollments which has continued into March. To a lesser extent, we also saw increases in unit sales of hardcover books.

In addition, the company is undergoing an internal review into its stock option practices as noted earlier. In 2006, the company incurred approximately $15.5 million in costs to third parties related to this review.

Finally, the company experienced some favorability in gross margins this year due to a number of factors; notably, a historically low inventory shrinkage. Both the stock option costs and the gross margin favorability were nearly offsetting amounts, and enabled the company to achieve the earnings per share guidance it announced last March, albeit at the lower end of the range. Both of these items have been factored into our guidance in the latter half of the year when they were known and estimated.

Our sales and administrative expenses were 70 basis points unfavorable as a percentage to sales, which is primarily due to three factors.

First, the adoption of SFAS-123(NYSE:R) and the related expense associated with the stock compensation costs. Second, the stock option review costs previously noted, and, finally, some de-leveraging un-expenses due to the slightly negative comparable store sales performance.

The company’s effective tax rate for 2006 was 40.25% favorable to our guidance of 40.75%. Preliminary net earnings increased 3% for the fourth quarter to $1.84 per share. Preliminary earnings increased 3% for the full years to $2.18 per share in line with guidance. The company’s capital expenditures for 2006 were only $180 million, lower than guidance of $190-$200 million. This favorability is largely timing and relates to projects that will roll over into 2007.

The company’s operating free cash flow was only $70 million for the year, less than the $200 million forecasted. Working capital was impacted by two major items. First, the company’s 53 week year had the result of a significant number of month end payables to hit the end of 2006 rather than the beginning of 2007. These items are related to inventory purchases and rental obligations, and impacted year-end cash flow about $60 million dollars.

In addition, cash taxes paid in 2006 were about $60 million higher than the previous year primarily related to three items. First, the company’s voluntary change in its tax year-end to conform with its financial reporting year-end. Second, a reduction in the excess tax benefit for stock options exercised resulting from fewer exercises in 2006, and the company had a large refund in 2005 that it was comparing against.

At year-end, the company’s balance sheet and financial condition remain in excellent shape. Inventories were well managed, and the company was able to report for the second year in a row an inventory turnover of 2.6 times.

The company has no debt at year-end, and our borrowings under our revolving credit agreement peaked at about $90 million early in the fourth quarter. The company’s cash balance at year end was $349 million. In the fourth quarter of 2006, the company did not acquire any shares under its share repurchase program. The company has $52 million remaining under the current program.

For the guidance of 2007, as previously announced the company’s full year earnings are expected to be in the range of $1.49 to $1.67 per share. 2007 earnings will be impacted by a number of items as follows. First, the closing of the internet distribution center should impact 2007 by $0.07 per share. Second, legal expenses related to the stock option review are estimated to range between $0.06 and $0.09 per share. Third, the company has a regular 52 fiscal year against last year’s 53 week calendar. The company estimates the impact of the 53rd week to 2006 earnings was approximately $0.08 per share. Finally as previously announced and most significantly, the gross margins for the company are expected to be reduced by 90-100 basis points, resulting in a $0.42 to $0.47 per share impact.

As indicated on our third quarter conference call, the company forecasts that the new member discount program would results in an estimated $10 million reduction in margin of fourth quarter, which implies a $30 million impact for the full year. The actual fourth quarter reduction margin was about $13 million. As a result, the company has revised its full year estimate to about $40 million.

In addition, 2007 margins will include significant sales of the Harry Potter book which is sold at very low margins. Based upon these factors, the company has forecasted the declining gross margin of 90-100 basis points.

There are a few other items to note in the 2007 guidance. The company’s effective tax rate was forecasted to be 40% as compared to 40.25% in 2006. Capital expenditures are expected to be between $205-215 million this year. This increase is due to the number of planned store openings, 35-40, as compared to 32 last year, and a project rollover from 2006 as previously discussed.

The company’s operating free cash flow is projected to be about $150 million next year, and as is the company’s standard practice, no assumptions have been made regarding share buy-backs in the guidance for 2007. At this point, I’d like to turn the discussion over to our Chief Executive Officer, Steve Riggio.

Stephen Riggio

Good morning. There are three primary take-aways from 2006 results. First, it was a year that produced two titles that garnered significant media attention. But while the lack of traffic producing new releases didn’t help our top line, what’s important is that our core booklist was solid.

Unlike many other forms of specialty retail, most of our sales are made up of older titles which have provided stability in periods of drought. Secondly, the business is becoming increasingly competitive. All the major players are having some form of loyalty program that gives extra discounts, earns customers points, or offers subsidized expedited delivery. We’re seeing a vastly different environment than just three years ago. Lastly, and perhaps most importantly, we believe we managed our business well in this environment of a lackluster new release schedule and increasing price competition. Solid expense management at every level of the organization, and better than planned gross margins helped us to meet our earnings expectations.

Looking ahead to 2007 we must first look back at 2006 and the most significant event of last year was our decision to lower our prices to our members, which took effect last October. The decision for us was simple, our cash flow is strong and we are virtually debt free so we decided to reinvest a portion of our earnings to reward out best customers in the form of lower prices.

Though that action will have a negative impact on our earnings in the short term, we strongly believe it is the right move for the long term success of the business. There are other important foundational elements that enable us to do this.

The quality of our real estate is better than ever. Over the past decade we've steadily closed our under-performing smaller format stores and what remains is some of the highest quality locations of any retailer in America. Having the best retail combined with the number one brand is a good place to be in such a competitive environment. Our supply chain and replenishment systems are solid and was recently strengthened by the new 1.1 million square foot distribution center. In addition our investments in the main components of e-commerce infrastructure and website technology are well behind us.

BarnesandNoble.com is the best shape ever, enabling it to maintain its number one ranking in customer service for the third year in a row, according to the University of Michigan's America's Customer Satisfaction Index, the most widely respected and quoted survey available.

And the traffic to our website, what must be recognized is the massive amounts of traffic to the website is equal to tens of millions of advertising dollars if we were to go out in the market and purchase those impressions from websites and portals online. So its value as a broadcast channel and an advertising medium is very critical to our business.

Let's take a quick look at the first quarter and the first months of 2007. I'll give you a preview of what we're seeing. The new releases include some major new books from several brand name fiction writers, including Lisa Scottoline, Jonathan Kellerman, Mary Higgins-Clark, David Baldacci, Michael Chabon, and we're excited about the second novel from Khaled Hosseini, author of the phenomenal bestseller, The Kite Runner, his new book comes out in May.

Our Barnes & Noble Recommends program, which launched last year and showcases one newly published book as selected by a panel of booksellers, has been hugely successful. Our second book as the first book, Chris Bohjalian's The Double Blind, became our number one fiction bestseller on the day of its publication. We're excited about our next selection, which will be announced in April.

The Oprah effect on books continues. This year it started with YOU: On A Diet, continued with Bob Greene's Best Life Diet, The Measure of a Man by Sidney Poitier which Oprah selected earlier this year, but it really exploded with The Secret by Ronda Burn. The book came out in the fall, had some early success after being on the Ellen Degeneres show, but with two shows on Oprah it pushed The Secret into the bestseller list. It's probably one of the fastest non-fiction selling books we've had in recent memories. And the good news also is that she has another selection which will be announced on March 28.

A few strong non-fiction titles are due soon including Einstein by Walter Isaacson, Folks by Lee Iococa, Barbera Kingsolver, and Paula Dean's memoir, It Ain't All About the Cooking. And we are just beginning to see a wave of books about politics and those related to the 2008 Presidential election at this time and by far, Barak Obama's The Audacity of Hope leads the pack. We expect many more to come in the coming months and throughout the fall season.

Thank you.

Joseph J. Lombardi

At this point we'd like to turn it over to questions.

Question-and-Answer Session:

Operator

Thank you. The question and answer session will be conducted electronically. If you would like to ask a question, please press * followed by the digit 1. If you are on a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Once again *1 to ask your question.

And our first question today will come from Nancy Hoch with JP Morgan.

Nancy Hoch – JP Morgan

Good morning. Question first on the gross margin. In the fourth quarter, it's actually a little stronger than I would have expected to see with the members' discount. Can you talk about what the positive drivers of gross margin enhancement in the fourth quarter were?

Stephen Riggio

I wouldn't acknowledge it just to be the fourth quarter. I would suggest that the margins have, over the past couple of years, been enhancing, and in the fourth quarter perhaps there was a condensing a bit because it was much stronger year-over-year earlier in the year. However, that's just the normal. What we do with wholesalers, how much we do for our distribution center, our supply chain, publishing, etc., nothing unusual there, with a little bit of benefit from the inventory shortage as well.

Nancy Hoch – JP Morgan

OK. And then you talked about longer term, the enhanced member program being a positive for the business. Is that from either, I guess, defensively from a share perspective, or from incremental sales leverage or is there a point in time where you could see the margins getting back to a more neutral point?

Stephen Riggio

As it was the last time when we launched our member program back in 2000, the short terms effects are negative in terms of gross margin but over time they tend to come back and build. The program is designed for our best customers and designed to lock in their purchases with us, both in our stores and online. We're about six years into the program, we're very pleased with it and this last recent lowering of prices has been very successful for us.

Nancy Hoch – JP Morgan

OK. Do you have a time frame in mind as to how long you feel it might take to recover some of that initial hit?

Stephen Riggio

I think what we're doing now is just forecasting for '07 and as we go through the year we'll update you on the progress of that.

Nancy Hoch – JP Morgan

OK, great. And I think you guys mentioned a pickup in hardcover book sales as a result of the program enhancements. Can you just remind us how hardcover gross margins compare to either the company average or other categories?

Stephen Riggio

Hardcover book sales are...generally priced in similar margins to other formats so it's in that and in the average of the company's book margins.

Nancy Hoch – JP Morgan

OK. (inaudible) off gross profit dollars should be up then?

Stephen Riggio

Yes, that would imply that.

Nancy Hoch – JP Morgan

OK, and just one last question on the growth in e-commerce business. It was nice to see a positive sales growth in the fourth quarter. Are you attributing that to the enhanced members' program or is there something else? Are you're seeing any changes in the e-commerce business that led to a pickup there?

Joseph J. Lombardi

Yes, well according to a US Census Bureau of the Department of Commerce, I think they said that fourth quarter e-commerce sales were up across all categories, around 6%. We were up a little over 5%, so pretty much in line with that. But I think it's just in general more people coming online, shopping online coupled with some very specific things we did around merchandising and marketing.

Stephen Riggio

I believe it's also due to the service. For three years in a row we've been recognized as the number one e-commerce company in America and that builds word of mouth.

Nancy Hoch – JP Morgan

Great, thank you.

Operator

And next we'll move to Matt Fassler with Goldman Sachs.

Matthew Fassler – Goldman Sachs

Thanks a lot, good morning. I've got two questions and the first is on the loyalty program. Clearly having launched advantage in the past you had a pretty good sense as to how the economics tend to play out. I understand that you're confident on what goes down with this program in the future. But if you can talk to us to the extent that you had to take down your earnings expectations as a result of what's actually played out over the past few months. Where was the difference from your expectations? Was it more sign ups, was it greater penetration with the existing customers? Any kind of color would be very helpful there.

Joseph J. Lombardi

Yeah. I think we did comment and let me make sure we were clear. By far the biggest impact is the amount of sign ups, and the people who've entered the membership program after we launched the program was much larger than we anticipated and we have actually said that as continued until today, as well as secondarily there was a pickup in unit sales of hardcover books, which is a good thing, and it was not enough obviously to offset the other discounts we've offered to the members. And that's basically what's happened. It's the increase in the enrollments that's driving a larger impact into the margin.

Matthew Fassler – Goldman Sachs

What's the path to winning some of that margin back? Presumably you envision that the profitability of the business can recover. How does one try to map that out?

Stephen Riggio

I think over the years our gross margin has benefited from a number of factors. We're talking about supply chains, selling more of our own published books, increasing sales of books we publish.

We have decided that it is in our long-term interests to lower our prices. How much those members spend over time, depends on how effective we are at building multi-channel wings to them, selling them more product, getting them to buy from both channels.

In terms of the margin rate, I don’t think that I want to speculate right now beyond 2007. But we are in a position and we can afford to do this.

Matthew Fassler – Goldman Sachs

Thanks, Stephen. Second question, on the CapEx numbers, you just gave us guidance from ’07…I guess the numbers are up a little bit from 2006. You’ve talked in various conversations in the past about a maintenance CapEx level that’s substantially below the CapEx you’re talking about for 2007.

Is there a point where in the future where you think the CapEx can come down significantly from the numbers we’ve seen from the last couple of years and we’re likely to see next year as well?

Stephen Riggio

When we talk about maintenance CapEx, we’re generally talking about the physical maintenance of the stores, which is something we have to do to keep the stores fresh. But within CapEx in general, there’s lots of things that in running a company that are maintenance to us, such as upgrading servers, and upgrading equipment, and upgrading systems and evolving systems as we need to do things for the business.

So we don’t see these as one time things that pop and go away. We’re always evolving and maintaining and improving our systems…warehousing in order to deliver the systems we need. BarnesandNobles.com is based on systems.

So we suggest that the level of CapEx is about the right level that we’ve been reporting, given the store opening count we’ve been achieving.

Matthew Fassler – Goldman Sachs

Thanks so much.

Operator

Next we’ll move to Bill Armstrong, with C. L. King and Associates.

Bill Armstrong - CL King & Associates

Steve, you mentioned the competitive impact of competing rewards or loyalty programs. I was wondering if you could maybe flesh it out a little bit. What are you seeing now and how do you see that impact in the business going forward?

Stephen Riggio

Business has always been competitive. Ever since we’ve operated stores, we’ve had competitors of all different sizes and forms. Whether they be direct bookstore competitors or non-booksellers.

What may be different now is that the industry is not growing as it was through the 90’s and the early part of 2000 and 2001. So the industry is flat and the competition among the major players is more for share than it ever was before.

We think we’re in a very good position. We’ve got real estate, which is the number one, the most important thing, the most valuable asset we’ve got. Our job is to sell more to our existing customers.

Every bookstore customer shops multiple places for their books. It’s kind of delusional to think that one would get 100% share of anyone’s share or wallet. We’re just trying to increase what we have by making it easier for people to shop both online and in stores and giving them a better deal. We think we’re in a very good position to do that.

As we go through this year, I think we’ll see the best of the new lower prices begin to impact.

Bill Armstrong - CL King & Associates

With retail prices effectively coming down with your program and other programs, are you seeing publishers making any progress in lowering the prices that they’re charging on books they sell to you?

Stephen Riggio

Do you mean the list price or the discount? They’re both pretty stable. List prices of books have been pretty consistent for about three years now. After growing in the late 90’s and in 2000 and 2001, we’ve seen book prices fairly stable I think the last three years. And in terms of the discount, there’s no change there.

Bill Armstrong - CL King & Associates

So, then these lower prices are essentially being eaten by the retailers, including you, without really any offset to lower cost to you in terms of product cost?

Stephen Riggio

Yes, correct.

Bill Armstrong - CL King & Associates

OK, thanks.

Operator

Next, we’ll move on to Blaine Marder with Loeb Partners.

Blaine Marder - Loeb Partners

Stephen, are the board and management hopeful that this options investigation will be behind the company in the near future?

Stephen Riggio

Yes the company is hopeful that that’s the case and will comment more when it can.

Blaine Marder - Loeb Partners

The near future being in the next couple of months?

Stephen Riggio

I really don’t want to comment any further than that.

Blaine Marder - Loeb Partners

Has management thought about ways to enhance shareholder value once you get past the options investigation, can you at least share with your investors in terms of how you would utilize your cash balance and enhance your shareholder value?

Stephen Riggio

I don’t think we have any new comments to make on that. We’ve obviously, in the numbers over the last few years, been buying back stock, and we initiated the dividends, and all of that’s been good for shareholders. We have nothing new to discuss today.

Blaine Marder - Loeb Partners

Every other day there’s something in the financial press about Barnes & Noble and the potential private equity interest in the company. Private equity interest in the retail sector is obviously very high right now. Can you at least tell your investors that at least you’ve actively explored that as an option? Has the board actively explored that as an option?

Stephen Riggio

We’re not going to comment on that. I think if you are interested in seeing the type of value that we’ve given to our shareholders, study what we’ve done over the past three or four years, inclusive of our share re-purchases, the issuance of the dividend, even the spin off of stock. So, look at the historical track record of the company. We are not going to comment or speculate on anything in those regards.

Blaine Marder - Loeb Partners

OK, very good. But the past is the past. And as you’ve said, your exact language is that ‘it is vastly different than how it was three years ago.

Stephen Riggio

OK, thank you very much.

Operator

Next we have Kenneth Marcus with First New York Investment.

Kenneth Marcus - First New York Investment

Frankly, my questions have been addressed. Among them was your posture towards using the strength cash flow to appease shareholders. In might be the right tone in spite of the past questions.

Joseph J. Lombardi

OK, thank you.

Stephen Riggio

Thank you for listening to the final 2006 conference call. Please note that our next scheduled financial release will be our first quarter sales release on our website on May 24th. Thank you.

Operator

And that would conclude today’s call. Thank you for your participation.

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