Barnes & Noble Education: A Slow Death Looms

| About: Barnes & (BNED)

Summary

More cost-effective competitors will continue to steal market share from campus book stores.

Book publishers are skipping the distribution step by selling directly to students.

Declining book sales will erode product margins.

Rental revenues boost margins in the short term, but face growing competition in mid-long term.

I want to preface by saying that I am a graduating senior who has witnessed the headwinds that Barnes & Noble Education (NYSE:BNED) currently faces firsthand. I believe Barnes & Noble Education has a deteriorating business model and 4 main headwinds that should cause further financial deterioration for the business.

Business Overview:

Barnes & Noble Education was spun out from its parent company Barnes & Noble (NYSE:BKS) last June. Barnes & Noble Education is one of the largest contract operators of bookstores located on university campuses in the United States. BNED operates 724 bookstores nationwide reaching over 20% of the student population. BNED operates stores under multi-year agreements with universities to be the official bookstore on campus. In turn, they pay the school a percentage of store sales and sometimes a minimum fixed fee. Barnes & Noble Education co-brands with the university, and also operates the school's bookstore website.

1. More cost-effective competitors will continue to steal market share from campus bookstores - Amazon (AMZN), Chegg (CHGG)

The truth is that the only students who buy books from the bookstore are freshmen. It takes one semester of spending $800-1,000 on brand new books from the bookstore before students look for new ways to get textbooks. A brick and mortar campus store cannot compete with the lower prices that are offered on Amazon. Used books can often be found for 50-60% of the price for USED books from the campus bookstore. A used book on Amazon can be over 75% cheaper than buying the book brand new from the bookstore. Given that college students are an extremely price elastic demographic, I see this trend as disastrous for textbook distributors. Additionally, having grown up surrounded by technology, millennials are much more comfortable with both purchasing items online and also using e-books as a primary form of text.

2. Book publishers are skipping the distribution step by selling directly to students

Publishing companies such as Cengage Learning, and Mcgraw-Hill are now offering online supplementary software with textbooks. These supplements allow students to do all the homework for a class online, as well as take practice quizzes and watch pre-made instructional videos. These supplements make it easier for professors, as it eliminates the need to grade quizzes and tests manually. Additionally, they track how much time students are spending reading the textbook and are taking quizzes. This allows professors to see what areas students are struggling in and alter lectures to the weakest areas.

In the past two years, the majority of my professors have required us to purchase the supplement for class. In addition to the online supplements, publishers package either an e-book with the purchase, or offer the option to purchase the hard copy for an extra cost. These bundling options tend to be cheaper than the bookstore version. Most professors post a custom link in the syllabus that allows students to purchase the correct package directly from the publisher at the price negotiated by the professor.

This is causing some professors to completely bypass the bookstore. I believe this is a trend that will only continue and could be a very strong competition to campus bookstores. For examples of the learning supplements, I have written about prior please look into Mcgraw-Hill Connect or Cengage Mindtap.

3. Declining book sales will erode product margins

The only benefit of going to a campus bookstore is the guarantee that you will be able to purchase all books in one place. However, this benefit comes at a cost. In order to stock the required textbooks for every section of every class offered at the university, bookstores are required to carry a large inventory. Additionally, this inventory value tends to depreciate at a fast rate as new versions of most textbooks are published every 1-3 years. Once a new book is published, the value of prior editions drops 50-70% instantly. Thus, if sales volumes decrease more than expected, bookstores are left with excess inventories that need to be written off at large discounts.

According to the Prospectus:
"Merchandise inventories, which consist of finished goods, are stated at the lower of cost or market. Cost is determined primarily by the retail inventory method. Our textbook and trade book inventories are valued using the last-in first out, or LIFO, method and the related reserve was not material to the recorded amount of our inventories."

"Market value of our inventory is determined based on its estimated net realizable value, which is generally the selling price"

BNED inventories grew 7% in the past fiscal year. What is concerning is that since inventories are marked to market, it is nearly impossible to tell the actual composition of the inventory. For example, a store holds 100 copies of Book A selling at $300. Next month, a new edition Book A Volume 2 is out and the store slashed the old book prices by 50%. Now the 100 copies of obsolete Book A possess the same value in inventory as 50 copies of the new edition. Rising inventories are deeply concerning because the actual volume of books in inventory can be much higher than is shown in the number. Over time, this can erode margins due to increasing storage costs as the volume of books in inventory increases, or with inventory write-downs.

If BNED is unable to maintain volumes (unlikely), I would expect to see inventories to continue to rise and margins to contract.

4. Rental revenues boost margins in short term, but face growing competition in the mid-long term

In the past 4 years, the number of textbook rental services has grown significantly. These online rental services are able to rent textbooks at prices much lower than the rentals at the school bookstore. Amazon typically offers rentals at 50% of the price of campus bookstore rentals. Proof can be found by going to a campus bookstore website ran by BNED and comparing the rental prices to that on Amazon.

You will quickly discover that the price differential is large for most books. For this reason, I would expect rental revenue growth to continue slowing going forward. Rental income grew at a 5-year CAGR of 61% from 2010-2014, including growth of only 7% in 2014. It is realistic for rental income growth to remain in the single digits going forward.

Valuation:

With the help of 2015 Q4 estimates, I achieved an EPS of 0.26 in 2016 assuming a 4% decline in Product Sales and a 4% increase in Rental Income. Cost assumptions include SG&A expense at a conservative 20.4% of sales and Depreciation at 2.8% of sales. Other assumptions are a 40% tax rate and 200 million in interest expense with no growth in shares.

At a 0.26 EPS, BNED trades at a Forward P/E of 37.33.

Given the dismal growth prospects of the business, I would expect BNED should trade in the upper teens on a P/E basis. Thus, BNED has potential for downside and I anticipate this to be a strong short prospect. If BNED traded at a 20X forward P/E like that of its parent company Barnes & Noble, its target price would be $5.20. Given the previously noted headwinds, this is reasonable.

On a DCF basis, I achieved a target price of $6.40 using a three stage DCF and a terminal P/E value of 20.

Cost to borrow:

The cost to borrow is low at only 0.7% making it a very actionable short idea.

Risks to Recommendation:

  • The migration toward e-books and technology could occur at a slower pace than I project.
  • Barnes & Noble Education could be successful in increasing sales of non-book items such as apparel.

Summary:

In summary, given a long-term point of view, campus bookstores are going the way of VCRs. Technology driven headwinds will cause a constant decline in sales volumes and eventual margin pressure due to it being a fixed cost based business. In the long term, BNED faces grim prospects.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.