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Barnes & Noble, Inc. (BKS)

Q1 2008 Earnings Call

May 22, 2008 10:00 am ET

Executives

Joseph Lombardi - Chief Financial Officer

Steve Riggio – Chief Executive Officer

Analysts

Charles Grom – J.P. Morgan

Darren Kennedy – Goldman Sachs

Bill Armstrong – C.L. King & Associates

Dave Weiner – Deutsche Bank

Analyst for Gary Balter – Credit Suisse

Operator

Good day everyone and welcome to this Barnes & Noble first quarter 2008 earnings results conference call. (Operator instructions) At this time for opening remarks and introductions I’d like to turn the call over to Chief Financial Officer, Mr. Joseph Lombardi.

Joseph Lombardi

Good morning and welcome to Barnes & Noble’s first quarter 2008 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 first quarter ended May 3, 2008. Consolidated sales totaled $1 billion $158 million for the quarter, a 1.1% increase over last year. Sales at Barnes & Noble stores were $1 billion $25 million for the quarter, up 1.1% over a year ago.

Comparable store sales declined 1.5% for the quarter which was marginally lower than guidance which called for a slightly negative decrease. In the first quarter we opened 11 Barnes & Noble stores and closed 7 for a quarter end total store count of 717. We closed two more B. Dalton stores in this quarter resulting in a total B. Dalton store count of 83.

Sales at Barnes & Noble.com were $99.6 million for the quarter, a 7.2% comparable sales increase. Gross margins improved 80 basis points this quarter. Last year’s gross margins included distribution center closing costs of $1.7 million. Excluding the impact of those costs on last year’s results, gross margins improved 70 basis points this quarter due to merchandising and supply chain initiatives, notably increased volumes from the company’s distribution centers which products contain higher margins.

Gross margin as also strengthened by favorable product mix, including lower sales of low margin music as well as lower unit sales of highly discounted best sellers. Selling and administrative costs were impacted by the company’s settlement with the state of California regarding collection of sales and use taxes on sales made by Barnes & Noble.com.

The total settlement was $9 million, $700,000 of which was recorded and paid in 2003. As a result, the company took a pretax charge of $8.3 million in the first quarter or $5 million on an after tax basis. In 2007, selling and administrative expenses were impacted by legal costs of $11.1 million and distribution center closing costs of $2 million for a total of $13.1 million.

Therefore, excluding settlement costs of $8.3 million this year and last year’s non-operating costs of $13.1 million, the SG&A rate increased 120 basis points from 24.6% last year to 25.8% this quarter. Approximately half of the increase relates to the timing of store closing cost this year.

The remaining unfavorable variance largely relates to deleveraging fixed expenses with the negative comparable store sales. Depreciation expense is approximately flat with a year ago excluding $2.6 million of accelerated depreciation last year related to the distribution center closing.

Pre-opening expenses were $3.5 million higher this quarter due to the timing of new store openings during the year, 11 stores opened this quarter compared to 4 a year ago. Interest income is lower than last year due to the company’s utilization of cash to buy back shares under its repurchase authorization.

In the first quarter of 2008, the company acquired 6.5 million shares under its share repurchase program at an average price of $30.57 per share or $199.7 million. The company essentially completed most of its recent $400 million authorization and has utilized its credit facility for working capital needs since April.

With this quarter’s activity, the cumulative share repurchases made by the company now exceeds $1 billion. The company reported a net loss per share of $0.04 for the quarter. On an operating basis, excluding the impact of the charge related to the sales tax settlement, the company reported earnings per share of $0.05 at the low end of the company’s guidance of $0.05 to $0.10 per share.

At quarter end the company’s balance sheet and financial condition remained in excellent shape. Inventories declined 1% this quarter with a sales increase of 1%. The company had borrowings of $87 million at quarter end or $61 million net of cash as a result of the share repurchase activity.

Now I’d like to talk about second quarter and full year guidance. Based on lower than expected first quarter sales as well as the overall retail sales environment, the company is lower its full year comparable store sales guidance from slightly positive to slightly negative.

Additionally for the second quarter, the company expects comparable store sales to decrease in the low to mid single digits against last year’s 4.4% increase driven by the sales of Harry Potter and the Deathly Hollows.

Although the full year sales forecast has been lowered, the company continues to expect earnings per share to be a range of $1.70 to $1.90 based on a reduced fully diluted share count of 58.5 million shares as a result of the share repurchase activity.

Second quarter earnings per share are expected to be in a range of $0.08 to $0.13 per share based upon a fully diluted share count of 57.7 million. The company is also raising guidance for full year capital expenditures to $220-$230 million or $20 million higher than previous guidance.

As you may recall, over the last few years the company rationalized its distribution center capacity, moving from five separate buildings to one facility. The company continues to lease one of its original distribution center facilities from the New Jersey economic development authority under the terms of an operating lease which expires in 2011.

The lease includes a purchase option under a formula which averages the appraised market value with the remaining lease payments. Since the company’s borrowing rate is favorable to the least rate and the appraised value of the building is now higher than the remaining lease obligation, the company has decided to purchase the building.

The company has determined that purchasing the building today will generate expense savings that will be accretive to earnings $0.02 per share on an annualized basis in 2011. As a result of the additional $21 million purchase of the New Jersey facility, the sales tax settlement and the updated guidance for the year, the company now expects free cash flow from operations of $75-$100 million this year.

Finally, since the company is now borrowing under its credit facility for working capital needs, interest expense for 2008 is expected to be approximately $4 million. At this point, I’d like to turn the discussion over to our CEO, Steve Riggio.

Steve Riggio

Good morning. While our sales were less than we expected, it still remains that the book business is a relatively stable one which we’ve said time and again. We believe our comp sales, while slightly negative, held up well compared to most of the retail sector and there were two factors behind that.

First, we annualized against the sales of one of the biggest selling non-fiction books in our history, Rhonda Byrne’s “The Secret,” which sold hundreds of thousands of copies in the first quarter last year. And secondly, we actually started, we’ve begun to reduce the amount of promotional discounting and inclusive of couponing.

So that and better purchasing and management of our supply chain had a positive effect which we’re very happy with and an improved gross margin. On the internet front, we’re pleased with the sales increase of 7.2%.

It’s only been six months since we’ve re-launched our website, but we’ve continued to add new products and features and services and customers have especially embraced a lot of the media that we’ve developed inclusive of much exclusive programming, inclusive of weekly shows about books and authors and other series that are either produced exclusively for us or taped in our stores.

Customers that can’t get to our stores for events now can look at them online in our archives. As Joe mentioned, the second quarter comparisons will be tough. We’re going against the sale of the last Harry Potter book but the quarter should end with some excitement with the publication of “Breaking Dawn” by Stephanie Meyer and we think that’s the most anticipated book of this year, if not actually in a couple of years.

Even though it’s a teen book, it has wide appeal. It is an unusual year for store openings because more will occur in the first half of the year. We’ve already opened 11 new locations. And the point we’ll make here is that we’ve fully completed the job of right sizing the store base and now what we’re doing is strengthening it.

So while we opened 11 stores, we did close 7 and our goal is to make the store base as strong as we can with the best locations we can secure and do nothing less than that. Thanks you.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Charles Grom – J.P. Morgan.

Charles Grom – J.P. Morgan

Joe could you give us a sense for how the comp trended during the period, the minus 1.5%.

Joseph Lombardi

The comp was down throughout the quarter and it was lightest in April. I will say though that May improved a bit because we had a number of big books in the first couple weeks, including Barbara Walters “Audition, the Stephanie Meyer adult fiction book “The Host” and the continued strength of the “Last Lecture.” So I don’t want to suggest that that continued into May but certainly April was the most difficult of the three months.

Charles Grom – J.P. Morgan

And then a traffic ticket breakdown for us.

Joseph Lombardi

Ticket was up a little bit, traffic was down, it was the reason for the comp.

Charles Grom – J.P. Morgan

And then just in terms of the speculation out there about Borders, I was wondering if you guys wanted to go on record and make a comment just to kind of clear the air, I’m sure it’s on everybody’s mind at this point.

Steve Riggio

We’ve put together a team of senior management people and financial advisors to study the feasibility of a transaction with Borders. We’ll provide no further comments about any discussions we may or may not have.

Operator

Your next question comes from Darren Kennedy – Goldman Sachs.

Darren Kennedy – Goldman Sachs

Darren Kennedy here with Matt Fassler. I don’t think your guidance before implied any share buybacks and you’ve done a significant amount, I’m wondering if you have room or intention for more?

Steve Riggio

Over the last three years the company has been utilizing its excess cash flow to buy back shares and pay quarterly dividends. We did so again this first quarter and now we are in a net debt position. We generate all of our cash in the fourth quarter so we’re not, at this point, suggesting that we’re going to lever up to do more buy backs immediately but we’re certainly evaluate all the opportunities available to us.

Darren Kennedy – Goldman Sachs

Your discussion that you’re raising cap ex, that should be incorporated into how we look at this right, in terms of what you’re going to use your cash flow for?

Steve Riggio

Yes, absolutely.

Operator

Your next question comes from Bill Armstrong – C.L. King & Associates.

Bill Armstrong – C.L. King & Associates

I think I heard you say earlier that you’ve begun to reduce couponing and some other promotional pricing, I was wondering if you could elaborate on that a little bit?

Steve Riggio

The primary benefit of our member program comes with everyday discounts. And since we launched the program over six years ago, we’ve experimented and we’ve done a tremendous amount of testing at every time of the year with various types of offers. And we found that the strongest appeal of the card is its everyday discount and it’s not necessary to provide additional discounts on top of that to the degree that we had in 2007.

So we think that’s good news. There’s very much value in the card, our base continues to grow and we’re very happy with it. So we don’t think there’s a need to do the level that we did in 07 and for much of 06.

Bill Armstrong – C.L. King & Associates

How much do you think you lost in gross margin in 07 from these additional discounts which sounds like you may not have to repeat this year.

Joseph Lombardi

We’re not going to quote a number, I think we’re certainly working on our promotion plans for the back half of the year and when we finalize them I think we’ll have a sense of that. I think we’re suggesting that some of the margin improvement in the quarter is due to planned right sizing some of the promotions we’ve done and some of the margin gain obviously is due to that.

Steve Riggio

It’s also due to some improved purchasing and certainly the volumes that were flowing through our distribution center as well.

Bill Armstrong – C.L. King & Associates

On Borders, can you tell us if you have been contacted by their bankers and have received the book?

Steve Riggio

Other than the statement I just made earlier, we’ll have no further comment.

Operator

Your next question comes from Dave Weiner – Deutsche Bank.

Dave Weiner – Deutsche Bank

I read some articles about some publishers perhaps trying to change the way the inventory structure of your business is run. Could you comment a little bit about on that prospect and kind of how you feel about that or what you think might be a positive or negative outcome from that for you guys?

Steve Riggio

I believe you were referring to the practice of returning unsold books. As long as I’ve been in the business, some 30 odd years, we’ve wanted to work with publishers on an alternate approach to that. It’s probably the most insane practice in the business because the books go back and forth and the freight companies make all the money.

So we’re very open to alternative approaches to sending the books back. And we have been open for many years. Let’s hope that the publishers become more motivated to do so and we’d love to explore any and all ways to reduce costs. Both for us and for them, because it’s expense for both of us.

Dave Weiner – Deutsche Bank

So my understanding is that this has been in some form or another or on some scale tried before, is that correct and it didn’t work out as an industry standard or is that not true?

Steve Riggio

I don’t think there have been many efforts that were well developed enough to comment on that, to have any kind of conclusive opinion. I think the environment now is much more receptive. The publishers seems to be much more receptive.

So I think there’s upside in it, so we’re excited about that because it’s very expensive to take the books off the shelves, pack them up, crate them, give them to a trucker and send them across the country. So it’s labor and freight for us and we would hope to find a solution in the next year or two and I think it’d be quite liberating.

Operator

Your next question comes from Charles Grom – J.P. Morgan.

Charles Grom – J.P. Morgan

On interest expense, is that a net interest expense number, the $4 million guidance?

Joseph Lombardi

Yes.

Charles Grom – J.P. Morgan

And then just looking at your assumption now for a slightly negative comp which I believe would be a minus 1, if I incorporate the negative 1.5 and let’s say you’re down 4 in the second quarter, that implies on a two year basis a flat comp. In order for me to squeeze out to a minus 1 on a two year basis would imply almost a 2 comp.

So that’s an uptick of a couple hundred basis points. I’m just wondering if there’s a pipeline of books or if there’s something that we’re not aware of that you are that suggests that the core business will improve in the back half of the year.

Steve Riggio

[Inaudible] trend line and we think that obviously is what we’ve done in the fourth quarter last year that we think that it’s an achievable number and it’s a number we’re working toward.

Operator

Your next question comes from Gary Balter – Credit Suisse.

Analyst for Gary Balter – Credit Suisse

It’s actually Seth [Basham] for Gary, just a follow up question related to some of your comments about reducing promotions and couponing. As we looked at other hard line sub-sectors like the home goods sector and what Bed Bath’s bound to do to its primary competitor and we look at your sector and see your primary competitor in a much more tenuous financial position. We’re trying to understand why you’re deciding to lighten up on the couponing?

Steve Riggio

We don’t think it’s necessary. We think it’s more profitable to build business with a strong member base of highly motivated individuals that pay our annual membership fee and we continue to test and we’re learning quite a bit. Understand we have about seven years of history in this mailing hundreds of millions of emails and coupons of all different types.

So we have tremendously sophisticated analysis about what works, what doesn’t, what drives traffic profitably, what drives traffic unprofitably. So it’s not something that we will completely back away from testing because it is a good thing to do. But we believe that the path forward is to focus on the everyday discount that the card offers and it makes a lot of sense to us, that’s what the numbers are saying

Operator

With no further questions I’ll turn the conference back over to Mr. Lambardi for any closing or additional remarks.

Joseph Lombardi

Thank you for listening to our first quarter conference call. Please note that our next scheduled financial release will be our second quarter earnings release on or about August 21. Thank you.

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