Barnes & Noble (NYSE:BKS) reported a pretty disappointing set of 2Q15 results a few days ago, significantly missing bottom-line estimates despite decent topline performance. As someone who's been bullish on the turnaround for a little while, I was clearly surprised by the operating numbers, especially given that top line, comp sales and gross margins (at least in the Retail and College businesses) were better than I had expected. Unfortunately, College saw a significant SG&A increase (due to investments tied to the buildout of the digital business), while Retail saw a similar SG&A step-up, without much of an explanation beyond 'deleverage on lower sales.' Of course, the biggest disappointment was the NOOK business, which - after massive improvement in 1Q15 - saw gross margins regress roughly 19pts QoQ (from ~51% adjusted to ~32%) and the pace of expense cuts decline considerably (SG&A fell just $10mm YoY despite sales -$45mm).
For those unfamiliar with my initial thesis on BKS, a goodly portion of the bull case was built upon 1) stable earnings and even improving margins at the Retail and College businesses; and 2) a much-reduced pace in negative EBITDA at the Nook business. Clearly, if these lackluster results occurred in a vacuum, they would force at the very least a re-evaluation of my estimates for FY15, as well as a reconsideration of the appropriate multiple to apply to those earnings.
However, BKS also announced some crucial changes to the ownership structure of Nook Media LLC (the holding company owning NOOK + the College business) that affect the overall sum-of-the-parts (SoTP) valuation for the company far more than one quarter's results. This is the reason, I believe, why BKS stock, after opening -15% the day of the numbers, ended just -5% and rallied 7% the next day.
Let's take a quick look at the new SoTP for BKS, business by business, to see how it has changed.
Since BKS owns 100% of the retail business, this is the simplest piece to update (irrespective of the MSFT/Pearson transactions). In my previous model, I had estimated FY15 Adjusted EBITDA in the Retail business of $322mm (-9% YoY), based on a -5% decline in sales, a slight increase in GMs and some slight SG&A leverage. Unfortunately, 2Q results saw adjusted EBITDA -$11mm YoY to $25.4mm, despite 60bps of gross margin expansion (driven by a +0.5% increase in comp sales ex NOOK). The culprit was SG&A deleverage on the lower sales base.
I have adjusted my segment numbers to account for this deterioration as follows:
- slight improvement in comp sales assumption (to -2% in 3Q-4Q from -3%) given better comp performance, similar comp lapping
- GM gains largely maintained (40-50bps YoY improvement in 3Q-4Q)
- significant SG&A deleverage in 3Q-4Q (in line with 2Q deterioration)
As per model below, my new estimate for Adjusted EBITDA falls to $307mm (-13% YoY):
(source: company filings, my estimates)
Regarding valuation of this segment for the SoTP, I had previously used a multiple range of 4-6x given where similar cash-generative, structurally-impaired businesses traded, and had argued that these multiples were conservative. While 2Q results were disappointing, I still feel the low-end of the multiple range is appropriate (given how discounted it remains and the still solid cash-generative profile of the business); however, I discount the base and bull case multiples by 0.5x and 1x, respectively, to account for the worsened performance (we will come to the overall SoTP later).
College performance in 2Q was similarly weak, though perhaps for better reasons: despite comp sales improving to +0.4% YoY (from -2% in 1Q), adjusted EBITDA declined to $80mm from $84mm YoY due to higher SG&A expense as the company continued to invest in its new digital offerings. I had previously estimated adjusted EBITDA for the year at $100mm (-13% YoY); I now update my FY15 estimates as follows:
- slight improvement in comp sales (from -2% in 3Q-4Q to -1%, -1.5% respectively)
- small GM improvement in 3Q, small deterioration in 4Q
- meaningfully higher SG&A spend in 3Q-4Q
As a result, I cut my Adjusted EBITDA estimate to $86mm (-25% YoY):
(source: company filings + my estimates)
Now, when it comes to applying a new multiple for the College business, we first need to consider the impact of the new agreement with Microsoft (and Pearson), as it has crucial implications for how we should think about valuing the College business going forward. Let's look at the new agreement quickly before returning to discussing the right multiple for the College business.
The new BKS/MSFT agreement (and why it is great for the SoTP bull case)
In a separate 8-K filed along with the earnings agreement, BKS outlined how they will buy out Microsoft (NASDAQ:MSFT)'s 16.8% stake in the Nook Media subsidiary for $62.4mm + 2.7mm shares (total $119mm assuming $21/share). Beyond just the price, there are other crucial details in this agreement (my emphasis):
...In addition, the funds that the company received as part of the Microsoft Commercial Agreement are currently in long-term liabilities, which liabilities will also be extinguished at Closing....As a condition to the Closing, the companies entered into a Digital Business Contingent Payment Agreement...pursuant to which the Investor became entitled to 22.7% of the proceeds from...any... dividends or other distributions from the Company's digital business...and the sale of the Company's digital business until the date that is three years from Closing...
There are a few important points to unpack here. Firstly: the accumulated Microsoft Deferred Revenue - $127mm as of last quarter, likely higher now - will be completely extinguished. Since this was accounted for as debt, and I previously (conservatively) modeled it as debt in my SoTP, this is a source of significant upside to the SoTP case, just by its removal (I had speculated that this was a potential 'wild card' upside catalyst in my earlier article).
Secondly: MSFT is entitled to 22.7% of any dividends/sale of the NOOK business (NOT the College business), for the next three years - but is not on the hook for any more deferred revenue/payments to support NOOK in the meantime (optically, this is BAD for BKS). Separately, Pearson accepted a similar contingent payment for its 5% stake in NOOK. A couple of key takeaways:
- Why 22.7% (not 16.8%, their ownership level)? MSFT likely argued they had invested significantly more than $300mm in NOOK (via the $127mm+ in deferred revenue), and so pushed for a higher payout on any residual value in return for letting BKS off the hook regarding any potential deferred revenue payback.
- Sale/shutdown implications? Without MSFT capital and strategic support, BKS is effectively having to carry this cash-burning business all by itself, which should incentivize a sale or some other status-quo altering decision in the near term. With the ownership structure of NOOK now cleared up, the business is readily saleable, assuming a buyer could be found. Clearly the agreement gives MSFT+Pearson a 3yr option, but in practice I expect BKS to shop the business immediately (before any further precipitous decline) and, should no miracle buyer appear, to try to shut down or put the business into runoff - maybe within the next 12-15 months. Either outcome should be positive for BKS shareholders (given we assumed a significant negative value to NOOK in our SoTP). While I am pessimistic and think there will be no buyer for NOOK, in my new SoTP, I raise the valuation by $50mm (from $-300mm-200mm to $-250-150mm) to account for at least a higher likelihood of early shutdown. Clearly, any sale, even at firesale prices, would be a large win for BKS shareholders.
Returning to the College business: segment valuation
Given the structure of the MSFT contingent payment for the NOOK business, it appears to me highly likely that the ~$119mm from BKS to MSFT accounts purely for the value of the College business. If we assume that within the context of this transaction, the NOOK portion is worth zero (outside of the contingent payment), this implies a valuation for the College business of $708mm ($119mm divided by MSFT's 16.8% ownership stake) - or 8.2x my heavily-discounted estimate of FY15 EBITDA, a much higher multiple than originally estimated in our first SoTP analysis (again, the benefit of being conservative). Of course, if we were to assume a negative valuation for NOOK, this would make the implied College valuation even higher, but let's discount that possibility for now. Instead, we can safely raise our multiples in the new SoTP to a range that at least accounts for this higher multiple (even if there is some premium being paid by BKS to take MSFT out). I select a 6-8x multiple range (versus 5-6x previously), which still looks reasonable and conservative at the bear case, given the price just paid to MSFT.
Putting it all together - new SoTP
To summarize, here are the new key inputs to the updated SoTP:
- lower Retail estimates, and cut multiple range to 4-5x from 4-6x
- lower College estimates, raise multiple from 5-6x to 6-8x on account of MSFT transaction (note - Pearson 5% stake in College should remain)
- raise NOOK negative valuation slightly to account for higher sale/shutdown likelihood (despite worse operating performance)
- remove deferred revenue completely (as per new MSFT agreement)
- increase share count (+2.7mm shares to MSFT)
- continue to assume pref shares remain unconverted
- working capital adjustment now a $40mm headwind (versus $140mm tailwind in 1Q) given significant cash generation in 2Q is seasonal (all adjustments are to smooth out working capital fluctuations from affecting 'true' net debt)
(source: company filings, my estimates)
As you can see, upside to the base and bull cases remains significant at 24-45% (even if the bull case target of ~$33 is lower than the previous target of $36) while even in the bear case I see equity value north of the current price, thus still providing a nicely asymmetric scenario to the upside.
Conclusion + risks
Clearly, BKS remains a fairly complex situation with a number of risks, the most significant of which is further deterioration in the Retail + College businesses. Should my new, even more conservative estimates prove too optimistic, clearly you could see downside based both on lower earnings and lower assigned multiples. On the other hand, I feel I have tried to remain conservative in my new appraisal, especially in hair-cutting the College multiples (even in the face of transaction valuation support from MSFT). Of course, NOOK remains the largest 'wild card', both to the upside and downside. But from here, even a shutdown of the business would be net positive (in terms of removing the negative valuation completely), while the impossible dream of a sale at some token value could catalyze further strong upside in the stock. As such, I still feel there is a lot more that could go right than go wrong for BKS at the current price. BUY BKS.
Disclosure: The author is long BKS.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.