Barnes & Noble: No Friend To Shareholders

| About: Barnes & (BKS)

Barnes & Noble, Inc. is the world's largest retail bookstore. It operates as a content, commerce, and technology company in the United States and provides access to books, magazines, newspapers, and other types of content.

I wish to highlight two warning signs that stand out when carefully reviewing the company's annual and quarterly reports for the fiscal year of 2011.

One of the most interesting gauges I like to look at is the ratio between Gross Profit and Selling & Administrative Costs. This ratio reflects which portion of gross profit is being 'consumed' by the costs incurred by administrators. The rationale underlying this metric is that a disproportionate and consistent increase in this metric indicates that the company's profits do not find their way back to shareholders. This metric usually gives a very straightforward answer as to whether the company serves its shareholders or its officers.

The following are the results of my metric when applied to Barnes & Noble over the past 5 years:













This table shows that the portion of administrative costs as a percentage of gross profit has been gradually increasing over this 5- year period, with an end nowhere in sight.

One of the consequences of what I showed above is the fact that even as sales increased by 20% between 2010 and 2011 (highest increase recorded) and even as the company benefited from a one time tax return from the IRS in the amount of $48 million, the company still wasn't able to turn a profit for the year 2011. It was all consumed by administrative costs.

Whenever one reads one of Barnes & Noble's press releases, one always finds the measure of EBITDA standing out. What one is not likely to find there is FCF (free cash flow). It is imperative to explain the difference between them: The definition of EBITDA factors out interest, taxes, depreciation and amortization. This can make even completely unprofitable businesses appear profitable and is also easily susceptible to fraudulent accounting. Many companies include EBITDA and refer to it as though it represents cash earnings, since depreciation and amortization are non cash expenses. This is a common misconception. EBITDA does not represent cash earnings. EBITDA is a good metric to evaluate profitability, but not cash flow, which makes it a very poor (and risky) substitute for an actual FCF.

I believe that Barnes & Noble, with its currently rich valuation, is an excellent candidate for a short and begins to resemble Netflix Inc. (NASDAQ:NFLX) of which I previously wrote and warned prior to its plunge from $130 to its current $70.

I recommend to short BKS at the current price of $15, place a protective stop at $16.

As always, I will issue timely updates on this trade.

Disclosure: I am short BKS.

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