Barnes & Noble (BKS) was in focus in the beginning of 2012 as speculation rose following the company's announcement that it would pursue strategic exploratory work to separate the NOOK business. The company fulfilled its promise and on April 30, announced a strategic partnership with Microsoft (MSFT) to include the NOOK and College businesses. The release noted that Microsoft will make a $300 million investment in the new subsidiary at a post-money valuation of $1.7 billion in exchange for an approximately 17.6% equity stake. Barnes & Noble will own approximately 82.4% of the new subsidiary. Shares sky rocketed following the announcement, trading as high as $25.79 before closing at $20.75, or up 52% on the day. Despite the optimism seen following the Microsoft announcement, shares have fallen since and are now trading at levels last seen in April, before the announcement.
For some background, the company has three segments: retail, NOOK and College. The retail segment consists of nearly 700 brick and mortar stores offering the NOOK, books, DVDs, music, magazines and other various offerings. The FY12 EBITDA recorded for the segment was $317 million. The College business consists of nearly 700 brick and mortar stores located in colleges and universities, offering primarily textbooks and other education-related materials. The College business, which is pretty stable, had FY12 EBITDA of $116 million. Finally, the NOOK segment, which consists of the company's digital business (including Readers, digital content and accessories), had total revenue of $933 million in FY12 while reporting an EBITDA loss of $262 million as the company continued to invest in its digital business.
With the shares falling to the pre-Microsoft announcement days, the market is choosing to completely ignore the $1.7 billion valuation for the NOOK and College businesses. Here is the math: the company has 70.1 million fully diluted shares outstanding (58.1 million shares outstanding plus Liberty's (LMCA) preferred stake that converts into 12 million shares at $17/share) for a market cap of about $840 million ($12/share) and had net debt of $282.6 million at the end of Q1 for an enterprise value of $1.12 billion. Just based on the Microsoft valuation of the College and NOOK segments, the shares would be worth over $20/share, or upside of over 65%. Adding in the retail business at a reasonable market multiple (2-3x EBITDA) sends the fair value of the shares somewhere into the $30 range.
What has changed in the past four months to cause the drop in the shares? In two words: very little. Still, results have been less than stellar. The Q1 report was mixed as the company was able to post a positive EBITDA driven by the Retail business but NOOK sales were basically flat y/y while the EBITDA loss increased for the NOOK segment. That spooked investors as the growth business did not show the growth that growth businesses should be showing. Still, it seems more likely that there has just been a temporary slowdown as the company continued to invest in the business through the opex line. Furthermore, digital content sales increased 46% y/y. BKS noted that device sales declined for the quarter due to lower average selling prices and production scaling issues surrounding the popular newly launched GlowLight product resulting in unmet demand.
The content is the key driver of the business. On its Q1 call, management noted that "overall gross margins on our NOOK segment were 23%. This 23% gross margin rate was a big expansion quarter-to-quarter from the NOOK segment to Q4 GM rate of 1% related to the markdowns on Simple Touch. A better comparison of this 23% gross margin in Q1 is to the full year fiscal 2012 rate of 13%. This 10 point improvement in the gross margin over the last full fiscal year reflects the growing share of higher margin content sales as part of our overall NOOK business."
Now as we move into the fall, we are now one step closer to the closing of the Microsoft transaction, which should serve as a catalyst for the shares. BKS noted in the Q1 release that it continues to be actively engaged in the formation of the new company and is in the process of implementing the work necessary to complete the Microsoft transaction. The company expects the Microsoft transaction to close this fall.
The closing of the Microsoft transaction will provide BKS more liquidity and a new access point to millions of customers to sell digital content. The digital bookstore will be launched with Microsoft on Windows 8, which is expected to start selling this fall.
BKS is also working toward an international launch of the NOOK this fall, which should also act as a catalyst. This is just the beginning of its international push for the NOOK. The U.K. is first up and a NOOK digital storefront should start appearing in the U.K. in mid-autumn.
Lastly, nothing has changed with the company's outlook for the NOOK. On its Q1 call, management said that "we anticipate additional content gains through the Windows 8 NOOK reading app and bookstore, once launched. We are maintaining our previous projection that the NOOK business will achieve operating leverage this fiscal year in 2013, shrinking year-to-year losses as we drive rapid digital content growth and prudently manage expenses."
There are two notable shareholders of BKS that provide some backstop in case things go south. Liberty, run by John Malone, which offered $17/share for the company last year, is a key shareholder in the company. Also, Jana Partners, a noted activist, owns 9.9% of the shares outstanding. Back in April, Barry Rosenstein, who runs Jana, said that Barnes & Noble's share price doesn't factor in the growth prospects of Nook and that there will be significant cash flow from the company in "many years to come."
Even though the Chairman, Leonard Riggio, has at times been criticized, he has made some solid decisions over the years including the GameStop spin off, investing in the NOOK, and the NOOK/Microsoft partnership. Buying the College business for 4x EBITDA has also worked out (EBITDA for that segment is at about the ~$115 million when he bought it). Notably, he owns a hefty position in BKS, nearly 30% of the shares outstanding, which helps align his incentives with shareholders.
Disclosure: I am long BKS.