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Barnes & Noble, Inc. (NYSE:BKS)

F2Q07 Earnings Call

August 23, 2007 10:00 am ET

Executives

Joseph Lombardi - Chief Financial Officer

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

Mitchell Klipper - COO

Marie Toulantis – CEO, BarnesandNoble.com

Analysts

Matthew Fassler - Goldman Sachs

Danielle Fox - Merrill Lynch

David Schick - Stifel Nicolaus

Bill Armstrong - CL King & Associates

Dave Weiner - Deutsche Bank

Presentation

Operator

Good day, and welcome to the Barnes & Noble second quarter 2007 earnings 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 Chief Financial Officer Joseph Lombardi. Please go ahead, sir.

Joseph Lombardi

Good morning, and welcome to Barnes & Noble's second quarter 2007 conference call. Joining us today are Steve Riggio, Mitchell Klipper, Marie Toulantis and other members of the senior management team.

Before we 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 and is not for rebroadcast or use by any party without the prior written content of Barnes & Noble.

This morning, before the market opened, we released our results for the second quarter ended August 4, 2007. Consolidated sales totaled $1.244 billion for the quarter, a 7.6% increase over last year. Sales at Barnes & Noble stores were $1.108 billion for the quarter, up 7.3% over a year ago. Comparable store sales increased 4.4% for the quarter, which was in the range of guidance, which called for a low to mid single-digit increase. Excluding sales of Harry Potter and the Deathly Hallows, comparable store sales were 1%.

In the second quarter, we opened four Barnes & Noble stores and closed two, for a quarter end total store count of 698. We closed three more B. Dalton stores in the second quarter, resulting in a total B. Dalton store count of 94. Sales at BarnesandNoble.com were $97.5 million for the quarter, a 17.9% comparable sales increase compared with the prior year period. Excluding the Harry Potter book, comparable online sales increased 7.3%.

Second quarter net earnings were $0.26 per share. The company's results include an $8 million, or $0.12 per share increase in net earnings on the income tax line, primarily due to unrecognized tax benefits for items in which the statute of limitations expired in the second quarter. The quarter also includes a $0.03 per share benefit for lower than expected costs related to distribution center closings. Excluding these items, net earnings were $0.12 per share at the high end of company guidance of $0.8 to $0.12 per share.

Operating earnings have declined as compared to last year, largely due to gross margins, which declined 110 basis points this quarter. Our guidance for the year reflected a 90 to 100-basis point margin reduction, due to the impact of the rollout of our new membership discount structure, which went into effect last October. In addition, the significant discounting associated with the Harry Potter book negatively impacted margins about 30 basis points.

Our selling and administrative expenses were 30 basis points unfavorable as a percentage of sales and were impacted by store closing and legal costs. At quarter end, the company's balance sheet and financial position remain in excellent shape. Inventories increased less than 2% compared to last year, with 5% more sales year-to-date. The company has no debt at quarter end and our cash balance was $208 million.

In the second quarter of 2007, the company acquired 456,000 shares under a share repurchase program for $19.5 million at an average price of $42.75. In the third quarter to date, the company has acquired 1.2 million shares for $39.8 million at an average price of $33.20. The company has $365 million remaining under its existing share repurchase authorization. Capital expenditures were $49.4 million for the quarter and $82.1 million year to date.

Now for third quarter guidance. The company expects comparable store sales to increase from flat to an increase in the low single-digits, in line with trends excluding the Harry Potter book. The company is reducing its current near store opening count from 35 to 40 new stores, to 30 to 35 new stores and the number of planned openings have moved into 2008. As a result, capital expenditure guidance for the year has been reduced slightly from a range of $205 million to $215 million, down to $200 million to $210 million. The company is forecasting a net loss per share for the third quarter in the range of $0.06 to $0.10 per share.

Our full year guidance for earnings per share has been updated to be in a range of $1.69 to $1.87 compared with previous guidance of $1.49 to $1.67 which was reconfirmed on May 24. This update reflects the previously mentioned second quarter benefits from income taxes and distribution center closing costs, as well as a $0.05per share benefit from a reduced fully diluted share count. The weighted average basic share count forecasted for the third quarter is 64.6 million shares. The weighted average fully diluted share count forecasted for the full year is 68.3 million shares.

Please note that we expect our effective tax rate this year to be approximately 36%, but continue to guide 40% as the normalized effective tax rate going forward. At this point, I would like to turn the discussion over to our Chief Executive Officer Steve Riggio.

Steve Riggio

Good morning. We planned a healthy rise in comparable store sales in the second quarter due to the expected record sales of JK Rowling's Harry Potter and the Deathly Hallows. The book sold even better than our expectations in its first days on sale, but in the following weeks, sales of the book tailed off quite a bit, as it was available in abundant quantity in a large number of mass merchants and non-book store retailers. Nevertheless, Harry Potter and the Deathly Hallows continues to sell well. It remains our number one best selling hard cover title, and we expect to sell hundreds of thousands of copies through the end of the year.

In its first week, the book was sold at a lower price than we usually do, 40% off its list, but then it returned to the normal 30% off about a week later. We've additionally sold hundreds of thousands of copies of all the other volumes in the series, and those have been sold at regular gross margins. We believe that sales of the entire series are going to continue to dominate children's bestseller lists for many, many years. While the Harry Potter cycle may be complete for those who have read the entire series, it is yet to be discovered by millions of readers now and in the years ahead. Young kids as they come of age are going to discover the books, as well as an increasing number of adults that are captured by its spell. This phenomenal series has been great for our business, no doubt about it. It's inspired more kids to read and to read more, and it's truly given inspiration to a new generation of writers.

A little bit more about the second quarter. We had a mix of expected bestsellers from brand name writers and the emergence of a few sleepers. Three well-known fiction writers had new books: Khaled Hosseini’s A Thousand Splendid Suns, Janet Evanovich’s Lean Mean Thirteen and James Patterson's two books, The Quickie and The Sixth Target, all were immediate bestsellers. The sleepers included Conn and Hal Iggulden’s The Dangerous Book for Boys. Thomas Cathcart’s Plato and A Platypus Walked Into a Bar, Denise Jackson's It's All About Him, and Ellen Hilderbrand's sixth novel, Barefoot. We also saw strong sales from the fourth Barnes & Noble Recommends selection, Paulette Giles' Stormy Weather.

We're very pleased with our inventory management for this year and have been for a number of years. From the consolidation of our online and retail distribution functions to our ability to grow our sales at a faster rate than our inventories, especially this year. We've been focusing on better management of our supply chain, and that's been reflected in higher inventory turns and improved working capital management. We will continue our efforts on this front: to maximize the productivity of our inventory, minimize the supply chain costs, but always in sight of providing our customers with unparalleled selection.

I'll give you a preview of the third quarter releases. I'll begin by mentioning an already published book. Stephanie Meyer is a writer we have supported since the publication of her first book, Twilight, in 2005. She published a second novel, New Moon, in 2006 and with each book, her fan base grew. The publication of Eclipse a few weeks ago, her latest book, catapulted Stephanie Meyer into the ranks of mega bestselling authors. It outsold Harry Potter, toppled it from the bestseller list and it actually became the fastest-selling teen novel in our history.

There are other notable forthcoming titles for the rest of this quarter, some sure to get significant media attention, including President Clinton's Giving, which goes on sale September 4; Alan Greenspan's the Age of Turbulence, the late David Halberstam’s The Coldest Winter, John Grisham's Playing for Pizza, another novel; Alice Sebold, author of The Lovely Bones, has a new book called The Almost Moon; and of course we're waiting for the new Ken Burns series on World War II to debut on PBS in mid-September and there will be a tie-in book and DVD. Thank you.

Joseph Lombardi

At this point, we would like to turn it over to questions.

Question-and-Answer Session

Operator

We'll go first to Matthew Fassler - Goldman Sachs.

Matthew Fassler - Goldman Sachs

First of all, just a quick housekeeping question. Can you give us a sense as to the Dalton sales number, please?

Steve Riggio

We have stopped talking about B Dalton due to the fact it's less than 1% of sales, so it is immaterial.

Matthew Fassler - Goldman Sachs

That's helpful. Secondly, can you give us some color, generally speaking, on the discounting environment? I know that you made the changes to the card, your competitor made a change to its card. What are you seeing in terms of consumer reception, sign-ups for the Reader's Advantage program, et cetera, any kind of general sense as to how that's going?

Steve Riggio

Since the launch of the program over six years ago, growth in the card base has been unabated each and every quarter. We're very, very pleased with it. From the very beginning, we saw the card as a discount card. It is not a loyalty program. It's a very simple program. It has an annual fee and gives a discount on everything people buy in this store and online. We decided to increase the discount on hardcover books late last year. We thought that it was a good strategic move in light of the competition, in light of the environment, both online and in retail. Our customers are very pleased with it.

The discounting has been prevalent in non-book store retailers for many, many years. I don't know that I would say there are more outlets selling books today than ever. It's been, Matt, it's been competitive for so many years, we just felt that with the industry having low single-digit growth potential for the next few years, we thought that it was good for us to give some of the profits back to our customers. We've got a strong balance sheet, good cash flow, and we thought it was the right time to take a piece of our profits and put it in the hands of the customers, and we're very pleased with the results since the launch last year. Customers love the card. They like the extra discount and we're seeing extra growth.

Matthew Fassler - Goldman Sachs

You mentioned a small cutback to your store opening plans for this year. My sense is that would be completely unrelated to what's going on the in real estate market, but I do want to ask you, since you guys are front and center of so many of the new developments out there these days, what are you hearing and seeing from the development community in terms of their appetite for new deals in the context of credit market volatility?

Mitch Klipper

Every year we say 30 to 40 stores, and it's really depending on the timing and when the development happens across America. We could clearly turn that up and open more stores if we so choose, but our criteria is extremely high. We're opening best location, not best available location, as we have in the last seven or eight years. The opening pace, we're very comfortable with it. I think there's a lot of business out there. The ICSC that happened in April/May with the biggest turnout in the history of the convention with some 60,000 attendees. There's plenty of business out there and up to the last month, there's still tons of money out there, chasing money and a lot of development around America, but a lot of it is just space. I don't think we open stores in locations that are considered space. We open locations in locations we consider important.

Stores we are opening, as we have in the past, are right on target individually and in aggregate of the year that they open, and so we're happy with our opening plan and are going to continue with that 30, 35 stores a year.

Operator

We'll go next to Danielle Fox - Merrill Lynch.

Danielle Fox - Merrill Lynch

First, I was wondering if you could talk a little bit more about the effect that Harry Potter had on the comps in the quarter? I'm wondering if the difference between the 1% comp and the 4.4% is just the Harry Potter book itself, or whether there was any traffic benefit? How did the attachment rate on the Harry Potter book sales compare to previous launches? Thanks.

Steve Riggio

The attachment rate is the same as it always was. It's a little more difficult to determine, frankly, because people spend two, three, four hours in the store and buy product and check out. Then at midnight, all they want is the one book. So our sense of it was that it drove sales in some categories more than others, I think especially in our cafe. But it's all behind us now. We think it was great for business, and we don't think it's over, because the book continues to sell well. All the other volumes are really doing well.

Danielle Fox - Merrill Lynch

On the swing from SG&A leverage to deleverage between the first and second quarter, Joe, I think you mentioned store closing and legal expenses, should those moderate over the course of the year?

Joseph Lombardi

Yes. They should. There's a little tick-up because of that, but I'm not trying to imply that we had a ton of leverage either. I mean we had a great book, there was a lot of volume that happened in 48 hours. Given that, there's no big upside, but certainly nothing, we're watching everything closely.

Danielle Fox - Merrill Lynch

Were there costs, SG&A costs associated with the Harry Potter launch in terms of any sort of special events in keeping the stores open that prevented you from getting the type of leverage that you might expect on a 4%-plus comp?

Joseph Lombardi

Well, there's a little bit of investment, but not more than the previous Harry Potter books. We've run them now, had the parties for a while.

Operator

We'll go next to David Schick - Stifel Nicolaus.

David Schick - Stifel Nicolaus

Absent the Potter impact, can you talk about traffic and ticket and rolling into that, you had talked about hard cover trends were weak last year was part of the reason for some of the changes in your program and you were more pleased I think in the first quarter. If you could update us on traffic and ticket and how hard cover plays into that.

Steve Riggio

We don't actually measure traffic. We don't have counters in our stores that measure the same stores year over year over year. I think we can speak to the general trends in publishing. We think it's a bit of a better year than last year and particularly in the arena of children's books. I tend not to want to forecast or handicap, let's say, the fall or the holiday season.

I guess the thing that we try to point out most often is that while the business tends not to have lots of peaks other than Harry Potter, it also doesn't have many valleys and it's a relatively stable industry. On balance, we think this year was a bit better in the publishing season than last year, but so much is dependent on the second half of the year. September looks like a good release schedule, but we'll have to see what the customers say about all these books.

David Schick - Stifel Nicolaus

On BarnesandNoble.com, again absent Potter, did you do anything different in terms of online advertising or trying to get customers?

Marie Toulantis

No, pretty much the same as always. We just saw increased traffic, increased conversion, increased interest. So there was nothing unusual in terms of any advertising or promotions or whatever.

David Schick - Stifel Nicolaus

I think in the first quarter you talked about the business kind of bouncing around volatility, again, trying to take out the weeks that were impacted by Potter, a little bit that was impacted by Potter. Was the second quarter as volatile? I think you called it out last time, so it was maybe a little more than normal month to month to month or perhaps I'm wrong. If you could just speak to whether top line trends are volatile or less so than your longer-term experience.

Joseph Lombardi

I would say for the quarter, obviously July was enormous because of Harry Potter, but the business was relatively smooth throughout the quarter, the rest of the period.

Operator

We'll go next to Bill Armstrong - CL King & Associates.

Bill Armstrong - CL King & Associates

The $0.03 DC store closing benefit, is that a reversal of previous accruals you had made?

Joseph Lombardi

No, that is the estimate of what the tail costs were going to be prior to closing some building and the cleanup costs associated with it, that we expected to be incurred as we hit the second quarter and it came in better than we thought.

Bill Armstrong - CL King & Associates

Was that in the SG&A line or the cost of sale?

Joseph Lombardi

The distribution center costs are all in costs of goods sold.

Bill Armstrong - CL King & Associates

Next, were there any option review expenses during the quarter?

Joseph Lombardi

There were legal costs related to ongoing litigation, but there are no option review costs in the quarter.

Bill Armstrong - CL King & Associates

Do you expect anymore, or is that pretty much done now?

Joseph Lombardi

To the best of my ability, I believe those costs are behind us.

Bill Armstrong - CL King & Associates

I think, Joe, you might have mentioned what the gross margin impact on Harry Potter is expected to be for the full year. Could you tell us what the impact was for the quarter?

Joseph Lombardi

On the margin?

Bill Armstrong - CL King & Associates

Yes.

Joseph Lombardi

About 30 basis points.

Bill Armstrong - CL King & Associates

So that was for the quarter, not for the full year.

Joseph Lombardi

That was for the quarter.

Bill Armstrong - CL King & Associates

Now, excluding the nonrecurring items, you came in at $0.12, which was at the high end of expectations. We already knew obviously that Potter was going to be part of it. What factors do you think provided the upside in your view?

Joseph Lombardi

Well, I think we guided the sales to the low to mid single-digits and obviously we came pretty close to the mid single-digits. The margin came in pretty strong. It was a relatively smooth quarter. We only did a 1% comp, so we managed our internal expectations and our costs associated with that and did what we could do. I think it was a relatively good quarter. It's within the range. So I mean we're happy with the success of the book and obviously as Steve mentioned before, we've got a lot of work to do in the back half.

Bill Armstrong - CL King & Associates

Finally on the dot-com side, even if you strip out Harry Potter, sales were up 7.3%. That's pretty good performance, above recent trends. Anything going on there that you think accounted for that?

Marie Toulantis

No. I think that while it's true if you exclude the actual sales from the Harry Potter book itself, the comparable online sales increase of 7.3% is obviously higher than recent trends, but the effect of the Harry Potter sale was to drive perhaps more interest, more traffic, and I think that drove to some more conversion. So we saw more traffic and more conversion in the quarter Again, I think a lot of it was around Harry Potter, so people coming to buy that book also when they come online, were buying some additional items.

Operator

Your next question comes from Dave Weiner - Deutsche Bank.

Dave Weiner - Deutsche Bank

I want to firm up the second quarter guidance. 8 to 12 was kind of the range, but my understanding was that that included some internet closing and some other one-time costs. I thought that the ex-one-time type range was more like in the 9 to 13 or 10 to 14 range. Am I off on that, or were you not expecting some, someone-time costs in that $0.08 to $0.12?

Joseph Lombardi

No. The $0.08 to $0.12 was the guidance. The only thing that you may be referring to in the first quarter, we had said we had a little bit of a benefit in store closing costs that we're going to move to the second and third quarters and that obviously was reflected in that guidance.

Dave Weiner - Deutsche Bank

Then on the full-year plan, are you still looking for $0.08 to $0.12 in the total stock option expense costs? I think that's what you called out last quarter for the full year.

Joseph Lombardi

We have not updated that number, correct. That is the same guidance.

Dave Weiner - Deutsche Bank

So that hasn't changed. Finally on the operating free cash flow, still looking for around $150 million for the year?

Joseph Lombardi

Correct. We have not changed that guidance either.

Operator

We'll return to Matthew Fassler - Goldman Sachs.

Matthew Fassler - Goldman Sachs

If you could talk about some of the other categories, Steve alluded to cafe being strong, but anything else just to get a sense of relative performance during the quarter?

Steve Riggio

We've never broken out any of the other categories. I think we pointed out beginning about two years ago that the music business has been running negative, probably less negative than the rest of the industry because our focus on the adult music customer, but we don't break it out and we will not report anything more specific than that.

Matthew Fassler - Goldman Sachs

Finally, just on the tax rate, Joe, just to make sure I got it right, the 36% for the year, that's largely a reflection of the $0.12 of impact from these one-time items in the second quarter, whereas the ongoing tax rate should be 40% or so?

Joseph Lombardi

That's correct. Thank you. There are no more questions. Thank you for listening to our second quarter conference call. Please note that our next scheduled financial release will be our third quarter earnings release on or about November 20.

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Source: Barnes & Noble F2Q07 (Qtr End 8/4/07) Earnings Call Transcript
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