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Indigo (OTC:IDGBF), Canada's beloved book store, will most likely face the same fate as its US counterpart Barnes and Noble (BKS). It has a monopolistic grasp of the Canadian brick and mortar operations of book retailing, but even a monopoly has its downfall. In the past, if customers did not like Indigo for whatever reason, such as having a vendetta against the corporate book store, they had the option to go to smaller bookstores. Nowadays if customers do not like the prices that Indigo is offering, there are not many bookstores left, so these customers must now turn to Amazon (AMZN), the massive online retailer.

The only counter-measure Indigo has is the cozy experience it provides to customers, which itself is an inherent flaw in their business, as it promotes the "free rider" problem. If you have ever noticed, people can sit in their stores for hours, reading any book or magazine without ever being interrupted. Additionally, with Starbucks (SBUX) conveniently placed in each store, why would a bookworm ever leave? This may put the idea into people's minds that Indigo is more of a public library than a for-profit bookstore. With the majority of their stores generally in locations with a lot of pedestrian traffic, many people use their stores as resting hubs to skim through a book while waiting for a bus, a taxi or a friend and eventually leave without a book in hand. Management should capitalize on this and find effective ways to persuade these "free riders" to purchase something.

Lastly, Indigo has a 14 day return policy for books if they remain in good condition. How is that possible? If a book is accompanied by a gift receipt, the customer can receive credit, but if the book was not a gift, a customer can return it with a receipt for cash. Indigo may want to pursue a tactic in which all books can only be refunded for credit (gift card) only, no cash. This will help reduce the "free rider" problem. and increase their top line. I know several people that could finish a book in less than 14 days while keeping the book in good condition. With the tough economy, I would not be surprised to see people buy, read then return the book. This seems like a viable option instead of reading a germ-infested public library book. With this inherent problem in addition to the global transition to e-books and online retailing, Indigo may not be in the best strategic position unless they can quickly transition into a more technologically adaptable organization.

From a balance sheet perspective, Indigo has a strong ability to pay off its short-term obligations and has close to no debt on its books.

2012

2011

2010

2009

Current Ratio

1.976601

1.431703

1.434807

1.351072

Their capital structure appears sound, but after delving deeper into their other assets, it becomes apparent that there are material issues with the balance sheet. Recently the company wrote-off their entire goodwill of $27m which was solely attributable to the Indigo division. Taking such a large impairment charge generally indicates that the company is not as promising as it may have thought. Also, with inventory turnover decreasing for several years now, it is a clear sign that they are stockpiling unsold books which is indicative of the growing e-book industry and online retail industry.

Inventory Turnover = Sales/Inventory

2012

2011

2010

2009

Inventory Turnover

4.065953

4.110404

4.317677

4.240429

With decreasing free cash flow, increasing operating expenses and stagnant revenue growth, the growth prospects do not seem promising. Taking a glance at their cash flow statement, it reveals that CAPEX has decreased continuously since 2009 possibly illustrating that cash is being spent on short-term expenses rather than on long-term tangible projects.

2012

2011

2010

2009

Gross Margin %

42%

43%

40%

44%

Operating Margin %

-3%

3%

5%

5%

2012

2011

2010

2009

Cash from Operating Activities

-12.49

18.07

62.24

94.79

- CAPEX

-20.69

-35.43

-41.16

-46.22

= Free Cash Flow

-33.18

17.36

21.08

48.57

With a dwindling market share, Indigo needs new growth opportunities and with their Kobo division being recently acquired by Rakuten, what other areas of growth do they possibly have? A desperate sale of the company's key growth driver is a sign that they may be in need of financing in order to compensate for low cash flow from operations. With Indigo incurring their first net loss in the most recent fiscal year, I see a negative trend emerging as Amazon eats away at the company's retained earnings resulting in decreased dividend payouts.

On the bright side, Heather Reisman, the CEO of Indigo, is the wife of Gerald Schwartz, CEO of ONEX Corp, one of Canada's most reputable and largest private equity firms. Given that ONEX already assisted Indigo with a hostile takeover of Chapters, providing some external financing to his wife's company will be chump change for this behemoth firm. With Indigo's current dividend yield close to 5%, it may be hard for them to maintain this with decreasing cash flows. If future financing is ever obtained, make sure it is not solely directed towards dividends. This funneling approach is not sustainable and sounds very similar to a Ponzi Scheme. Dividends should come from cash flows from operations, not from external financing.

Golden "Buy" Opportunity?

With Indigo's book value at approximately $350m and their market cap is at around $224m, it may be a golden opportunity to purchases a share in the company. With continual drops in its P/B Ratio over the past 4 years, it may the opportune to buy into the company. With $188m in cash and cash equivalents, $220m in inventory, $140 in PPE and $210m in current liabilities, even if we were to discount the inventory and PPE, it may be worth more than the current market price if valued from an asset-based approach.

2012

2011

2010

2009

Book Value per Share

13.18621

7.942721

8.429669

7.626172034

Price

8.85

13.1

17.88

10.75

P/B Ratio

0.671156

1.649309

2.12108

1.409619394

As long as Indigo Books and Music is here, I will continue to go to their stores every so often to relax, read and sip my tall vanilla latte.

Source: Indigo Books & Music: Analysis