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Barnes & Noble, Inc. (NYSE:BKS)

F3Q07 Earnings Call

November 20, 2007 10:00 am ET

Executives

Joseph Lombardi - CFO

Steve Riggio - CEO

Analysts

Aaron for Charles Grom – JP Morgan

Bill Armstrong - CL King

Deron Kennedy - Goldman Sachs

Dave Weiner - Deutsche Bank

Operator

Good day and welcome to the Barnes & Noble third 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 the Chief Financial Officer, Mr. Joseph Lombardi. Please go ahead, sir.

Joseph Lombardi

Good morning and welcome to Barnes & Noble's third quarter 2007 conference call. Joining us today are Steve Riggio, Mitchell Klipper, Marie Toulantis 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 for rebroadcast or use by any other party without the prior written consent of Barnes & Noble.

This morning before the market opened we released our results for the third quarter ended November 3, 2007. Consolidated sales totaled $1.176 billion for the quarter, a 5.7% increase over last year. Sales at Barnes & Noble stores were $1.015 billion for the quarter, up 4.5% over a year ago. Comparable store sales increased 2.6% for the quarter, which was at the high end of guidance for a flat to low single-digit increase.

In the third quarter, we opened 14 Barnes & Noble stores and closed three for a quarter end total store count of 709. We closed two more B. Dalton stores in the second – I mean, third quarter resulting in a total B. Dalton store count of 92.

Sales at BarnesandNoble.com were $108 million for the quarter, a 14.5% comparable sales increase compared with the prior year period. Third quarter net earnings were $0.07 per share.

The company's results include an after-tax benefit of $6.2 million, or $0.09 per share, resulting from a more favorable physical inventory shortage rate than previously estimated and accrued. Excluding this benefit, third quarter net loss per share was $1.8 million, or $0.03 per share, better than guidance for a loss of $0.06 to $0.10 per share.

As a result of the physical inventory benefit, gross margins were 30.2% or 40 basis points higher then last year. The previously mentioned inventory benefit was $10.3 million on a pre-tax basis. Excluding this benefit, gross margins were 29.3%, or 50 basis points lower then last year. Our guidance for the year reflected a 90 to 100 basis point reduction in gross margins due to the rollout of our new membership discount structure a year ago.

Despite the higher sales of discounted bestsellers this quarter, our gross margins were better than guidance primarily due to two factors:

  1. Our distribution costs were lower than planned;
  2. Our comp store sales gains enabled us to leverage fixed occupancy costs.

Our selling and administrative expenses were favorable to last year by 30 basis points as a result of sales leveraging. Operating earnings were 0.4% for the quarter. After adjusting for the inventory benefit, operating losses as a percent of sales was flat with a year ago at negative 0.5%.

At quarter end, the company's balance sheet and financial condition remain in excellent shape. Inventories increased less then 2% compared with last year with 5% more sales on a year-to-date basis. The company has $4.4 million of debt, net of cash on hand. Seasonal borrowings peaked at $38 million in early November.

In the third quarter of 2007, the company acquired 4.9 million shares under its share repurchase program for $172.5 million at an average price of $35.36. Year-to-date, the company has acquired 6 million shares for $220 million at an average price of $36.50. The company has $232.4 million remaining under its existing share repurchase authorization.

Capital expenditures were $58.2 million for the quarter and $140.3 million year-to-date.

Now for fourth quarter and full year guidance. For the fourth quarter and full year, the company expects comparable store sales at Barnes & Noble stores to increase in the low single-digits. The company previously expected full year comparable store sales to range from flat to slightly positive.

Fourth quarter earnings per share is expected to be in the range of $1.67 to $1.86. The company is increasing its full year earnings guidance to be in the range of $1.91 to $2.09, compared with previous guidance of $1.69 to $1.87.

Guidance has been raised $0.22 per share for three reasons:

  1. The third quarter out performance of $0.14 per share;
  2. The reduced fully diluted share count as a result of third quarter share repurchases, which will benefit the year $0.04 per share;
  3. Improved net earnings from higher projected fourth quarter sales guidance of $0.04 per share.

The weighted average fully diluted share count forecasted for the fourth quarter is 64.3 million shares and the weighted average fully diluted share count forecasted for the full year is 67.1 million shares.

In addition, full year capital expenditures are now forecasted to be about $10 million lower then previously announced. Updated capital expenditures guidance for fiscal 2007 is now $190 million to $200 million.

Now I would like to turn the discussion over to our Chief Executive Officer Steve Riggio.

Steve Riggio

Good morning. We are pleased with our third quarter results, especially in light of the comparatively soft retail environment. Our comparable store sales grew 2.6%, and that was on top of a 2% growth in the third quarter of 2006. Our Internet sales grew 14.5%, compared to slightly negative sales in the third quarter of 2006.

I think there are three factors we want to point to that were behind the numbers. First and most importantly is the effect of media on the book industry and on the sales of individual titles. Following the enormous publicity generated by JK Rowling's Harry Potter and the Deathly Hallows, we were frankly prepared for the book business to return to a relatively quiet period.

While we did believe it would be a good quarter for new releases, one can never bank on extensive media coverage of writers and their books. It's just a hard thing to predict. We were pleasantly surprised when the third quarter opened quite strong with the release of Stephanie Meyer's Eclipse, which became the fastest-selling teen novel in our history. The Stephanie Meyer phenomenon was covered extensively in the media and the anticipation for the next August release of the final volume in her series actually started building the day that Eclipse went on sale. So that was terrific news.

Indeed, media coverage of adult books was more extensive then typical, led by two shows, the CBS news magazine 60 Minutes and Oprah Winfrey. 60 Minutes featured stories of Alan Greenspan's The Age of Turbulence, Clarence Thomas' My Grandfather's Son and Joel Osteen's Become a Better You, and Valerie Plame Wilson's Fair Game shot those books onto the top of our bestseller list. We see the impact immediately in our Internet sales and in the days following after these stories run.

The Oprah effect -- which of course, everyone in the industry knows about -- I think was stronger then typical and it was probably due to the sheer number of books that she mentioned on her shows, not just the selections from her Oprah Book Club.

The phenomenal demand for Jessica Seinfeld's Deceptively Delicious Cookbook was a pleasant surprise, as was Oprah's support of Elizabeth Gilbert's Eat, Pray, Love; her full hour show on Cathy Black's Basic Black; and her coverage of Michael Roizen's YOU: Staying Young. Of course, her book club selections are still the most powerful and trusted endorsement in the business, even sending classics such as Gabriel García Márquez’s Love in the Time of Cholera to the top of bestseller lists.

In terms of other media, we also saw the growing impact of shows like Jon Stewart and Stephen Colbert, with the latter producing one of the major bestsellers of this year, I Am America (And So Can You!).

The second factor, it was a particularly good quarter for new releases for brand name fiction writers and those included John Grisham, David Baldacci, Patricia Cornwell, James Patterson and the return of Ken Follett with his World Without End.

Lastly, the third quarter saw the launch of our new website which impacted Internet sales. Utilizing the latest web technologies, our new site enables more and better and faster browsing. It features an updated design and we think it makes it feel, more than ever, like a natural home, just as our bookstores do. We've increased the amount of rich media on the site, including podcasts, original video programming, live webcasts and that gives users an opportunity to become more intimate with books and writers. We launched our new site with an extensive email towards the end of the quarter and that generated a great deal of interest, accolades from our customers and the resulting traffic.

The strength of the new release schedule, the attention of the attendant media did enable us to deliver sales at the higher end of our expectations and we did that without ramping up promotional coupons or discounts. We did about the same amount of activity as in the prior year.

Our member base, Barnes & Noble members who pay a $25 annual fee to get extensive discounts in our stores, continued to grow through the year as more and more customers see the value in being members.

As we look ahead to the fourth quarter and the holiday season, on a negative note, I think the writers' strike is certainly not good news for the book business, as we are already hearing of cancellations of writers that were scheduled to be on some of the major talk shows. Nevertheless, several books by brand name writers with new and forthcoming titles including Sue Grafton, Jim Cramer, Steve Martin and Dean Ornish. There's a very, very strong lineup of gift books for this year.

As in previous times, we expect a film version of Mitch Albom's For One More Day, which airs I believe on December 9 to be perfectly timed for the holiday season, as that will be a great gift book.

Thank you.

Joseph Lombardi

Now we would like to turn it over to questions.

Question-and-Answer Session

Operator

Your first question comes from Charles Grom – JP Morgan.

Aaron for Charles Grom – JP Morgan

Congratulations on a good quarter. As we head into the holidays, several retailers have called out toys as an underperforming category. Are you guys seeing any signs that some of that share might be shifting into the book channel as we head into the fourth quarter?

Steve Riggio

We've had a pretty solid business in the adult game business, classic board games and the like. That has grown pretty steadily over the last few years, but we're not particularly in the children's toy business so we don't see anything there.

Aaron for Charles Grom – JP Morgan

But do you see a shift towards board games or maybe additional share headed into the channel for children's books, things along those lines?

Steve Riggio

I don't think I would correlate that. I would hope that parents buy books for their kids instead of toys. Children's book sales have been fairly healthy for some time, but I don't see a direct relationship between those. Maybe we'll know in January.

Aaron for Charles Grom – JP Morgan

A question on the competitive front. Qualitatively it seems that there may be a little more promotion from one of your competitors in the third quarter and headed into the fourth quarter then last year. Are you guys seeing any changes?

Steve Riggio

Seeing changes where?

Aaron for Charles Grom – JP Morgan

In the competitive environment?

Steve Riggio

I think it's fairly obvious that the amount of special offers and coupons out there have been ramped up in the marketplace, but we've kept it pretty much to the same as prior year. We are satisfied with our performance based upon that.

Aaron for Charles Grom – JP Morgan

We shouldn't think about that strategy headed into the fourth quarter as well?

Steve Riggio

No. I mean, we're always looking at it, it is always something we study but coupons are the kind of thing that you can ramp up very easily, but when you turn them off you have pretty ugly comparisons you're facing in the following year.

We think our strategy is pretty sound. We give everyday discounts. We do have promotional coupons going out through the year on top of it. We think we're in a pretty good place.

Operator

Your next question comes from Bill Armstrong - CL King and Associates.

Bill Armstrong - CL King

Joe, why is CapEx down $10 million from your previous plan?

Joseph Lombardi

We had some projects, particularly IT projects, that won't get completed this year and are moving so we're just going to take the number down in '07.

Bill Armstrong - CL King

They're not going to be cancelled they are just getting pushed out to next year?

Joseph Lombardi

Basically, yes.

Bill Armstrong - CL King

On Q4, it looks like your comps guidance is a little higher. Is that just looking at Q3 trends and extrapolating them out to Q4, or are there specific titles or other trends that you see that cause you to be more optimistic?

Joseph Lombardi

I think our guidance is based upon what we see, what we think is happening in the trend line.

Bill Armstrong - CL King

Are we seeing maybe the beginning of a turnaround after a couple of years of pretty soft overall industry book sales?

Steve Riggio

I think the book business, if I had to use a word to describe it would be more like “stable”. It's never really had major declines or actually any unit decline in the past several years. It's low single-digit growth; it's not double-digit growth nor is it double-digit decline.

I think that the media effect on the third quarter was probably more pronounced then we've seen in a long time. We do hope the writers' strike gets settled so we can get authors and books back on the talk shows. If that's not settled, I think that may impact the sales of some of the media-sensitive books.

Of course, going into the first quarter of next year -- we haven't seen it yet -- but we would expect that the Presidential election and it's effect on book sales hopefully will be the same as it was the last time around, which was positive.

Bill Armstrong - CL King

Given that the third quarter was driven at least in part by the media plugging some titles, if we don't see a repeat of that at that level in Q4, does that put your comps guidance at risk?

Joseph Lombardi

We're very comfortable with our comp guidance and we're comping off the slightly negative number last year in the fourth quarter, so the comparison is easier as well.

Bill Armstrong - CL King

Finally on your Q3 gross margins coming in above plan, it looks like you were able to leverage some of the fixed components of the cost of goods sold line. Was there any movement either in the mix or margins within categories that helped?

Joseph Lombardi

No, the margins were pretty predictable and on plan. I think what we're noting when we talk about why margins improved, our markdowns were also on plan; our membership discounts as well as other promotions we had planned so that was not a source of any surprise.

Bill Armstrong - CL King

Should we look for the margin hit from the member discounts to pretty much anniversary by the first quarter of '08?

Joseph Lombardi

I think it's a little early to start talking about '08. We're lapping in this quarter the anniversary of the discounts so I think we need to see. Obviously because we've grown our membership base, we have a lot more members and therefore more member discounts. Margin is going to have pressure in the fourth quarter, it is in our plan.

We'll see when we get out of the fourth quarter and start to talk about what we think the impact is then going forward.

Operator

Your next question comes from Deron Kennedy - Goldman Sachs.

Deron Kennedy - Goldman Sachs

Can you explain again the inventory benefit? Describe what your typical accrual is and why it differed and what the gross margin operating earnings were excluding it? I'm sorry if I missed that earlier in the call.

Joseph Lombardi

Sure. The company has been focusing on shrink and shortage control, particularly for a number of years now and I think our effects are starting to pay off. Our shrinkage rate has been declining and it declined to a level that we weren't sure was sustainable. We estimated and accrued to a higher level and as a result, we're truing up our numbers based upon the results, as the results were more favorable than we thought they'd be.

I think the good news here is that if we sustain the improvement, this gross margin benefit is permanent albeit obviously spread more proportionately throughout the year. So just good news for us and we're pretty happy overall with the result.

Deron Kennedy - Goldman Sachs

The operating earnings margin excluding the benefit was what year to year?

Joseph Lombardi

Operating earnings year to year was flat; as a percent of sales, a negative 0.5%.

Deron Kennedy - Goldman Sachs

Could you describe the pace of sales during the quarter?

Steve Riggio

Sales were up throughout the whole quarter. There's not a material variance from month to month.

Operator

Your next question comes from Dave Weiner - Deutsche Bank.

Dave Weiner - Deutsche Bank

Good morning. Joe, I think you might have just answered this one but I'll ask it. I think last year on the third quarter call you gave a membership investment or program impact for the next 12 months, an effect of around $40 million. Is that pretty much what you experienced over the last 12 months? Was that in line with plan?

Steve Riggio

Actually in the third quarter call last year we had said the number was $30 million and we raised that, I believe, when we did our year end release because the membership signups were more then we anticipated -- 240. We basically have been on plan this year and tracking to what we thought was going to happen, and so that's been the case.

Dave Weiner - Deutsche Bank

On your consolidation of distribution center space, is that benefiting your gross margin on an ongoing basis as well?

Joseph Lombardi

I think certainly we're very pleased with the way the distribution center is going. It's now handling everything for retail and online and our goal is to continue to improve there. We're continuing to work on it. I think it's early yet to say it is benefiting gross margin, but we certainly believe that to be the case on a go forward basis and we are working toward that.

Dave Weiner - Deutsche Bank

But currently it's not hurting gross margin?

Joseph Lombardi

No, correct.

Operator

At this time, we have no further questions so I would like to turn the conference back over to the speakers for any additional or closing remarks.

Joseph Lombardi

Thank you for listening to our third quarter conference call. Please note that our next scheduled financial release will be our holiday sales release on or about January 10th. Thank you all.

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