Barnes & Noble: Uninteresting From Cover To Cover

Summary

• The company's core business continues to erode as the company seeks the balancing point between online and physical retail.
• The generous dividend is at risk as core operating cash flow metrics decline and the company increasingly relies on one-time adjustments from working capital and other balance sheet accounts.
• We find little of interest in this story and would pass on the shares.

Barnes & Noble (NYSE: NYSE:BKS) is the largest retailer of books and related materials through physical stores in the United States. The company has been under pressure for something approaching two decades due to the rise of Amazon (NASDAQ: AMZN) and other online and physical competitors which have radically changed the market within which the company operates. The result has been an incremental erosion in the company’s revenues and store counts over time accompanied by losses and/or thin profits. The company’s online revenues remain a small percentage of total revenues – less than 8% - reflecting the company’s continued reliance on physical stores.

The result has also been a sustained decline and stagnation in the company’s share price for more than a decade. The low valuation and generous dividend provide a basis for value oriented investors to assess the company’s operations and market for potential opportunities.

However, as we outline in this article, we find little compelling rationale for an investment in the company from either a dividend or market standpoint. The ongoing risks to the company continue to far outweigh the potential benefits and it’s unclear that the company’s intrinsic value is significantly different – much less significantly higher – than the current market price. In addition, we view the increasing challenges the company will likely face in maintaining its generous dividend to be a material risk to the share price as income investors essentially play chicken with the company’s finances as to when (more so than if in our view) the company adjusts the dividend.

Investment Perspective

First, we find little of particular interest in the company from an investment perspective. The company’s consistent decline in revenues and highly variable net profitability does not lend itself to our value oriented investment approach. In addition, despite relatively little long-term debt, the significant majority of the company’s assets outside of intangibles are store inventory which, in a liquidation scenario (whether due to bankruptcy or seasonal inventory adjustments), would likely not be realized at carrying value. Indeed, beyond the inventory, the company has very few assets which would permit the company to access credit or, in a worst case scenario, retain any material value in a bankruptcy.

Interestingly, despite the ongoing decline in revenues, the company’s operating metrics have either improved or remained relative stable over the last several years. In many instances of companies in decline, the decline in revenues is accompanied by challenges in the gross margin (as gross margin is surrendered to retain sales) and/or in SG&A expenses as it’s difficult to reduce SG&A expenses as quickly as the decline in revenues. In the case of Barnes & Noble, however, the company has been able to maintain relatively stable gross margins and SG&A expense, suggesting that the company’s problem isn’t so much competition on price per se but the secular shift of revenues from physical stores to online platforms.

Source: Company Financial Statements

Indeed, credit is due to the company on its ability to maintain gross margin and SG&A expense ratios despite the steep decline in revenues even if a portion of those gains are due to divestitures and other transactions within the business.

However, it’s also here that the company’s core challenge becomes clear – the lack of differentiation of its product assortment from online competitors. The company continues to rely on physical store sales and has struggled to gain much traction in the online channel. The “store brand” is relatively rarer in the bookstore space and although Barnes & Noble does carry private label lines of books and other products, in many cases (especially books) the actual product is virtually identical. A copy of Moby Dick printed under the Barnes & Noble nameplate is going to be – barring abridgement – identical to any other version of Moby Dick in the market.

The company has pursued various strategies to differentiate itself from online competitors. However, for the most part, this differentiation occurs in areas that have, at best, tangential relationships to its core business.

A frequently discussed example is the Kitchen concept which couples a more full-service oriented restaurant environment with the bookstore and represents an extension, to some degree, of the company’s longstanding coffee shops. The Kitchen concept is interesting and has received generally positive reviews for the handful of existing trial locations, but it brings into question whether one is ultimately investing in a bookstore or a restaurant. The track record of both industries outside of the major restaurant chains is spotty with thin margins and high volatility related to consumer preferences, so it’s unclear that such a conversion would be attractive.

We believe there is a place for destination physical bookstores and, from a national perspective, Barnes & Noble is the natural company to maintain a dominant position in this segment of the market. However, we also believe that the number and size of physical bookstores will continue to shrink in the near to intermediate term as the physical footprint across the industry adjusts to the shift of revenues from physical to online platforms. The question is when the market will find this natural balance between online and physical channels and the company’s revenue decline will begin to abate. Our sense is that there remains a way to go before reaching this balance.

Barnes & Noble may also ultimately be successful with the Kitchen concept, possibly as a component of the destination physical bookstore concept, assuming the company can access sufficient funds on reasonable terms to fund a broad rollout. However, even if so, the company will be much different than its current incarnation and, most likely, far smaller.

In total, despite the handful of attractive businesses under the corporate umbrella and the potential strategic options available which have been broached by various parties on speculative buyouts and other restructurings, we find little from an operating standpoint that would make an investment in the company a compelling option. Indeed, even with a buyout or other transaction, the potential return is highly speculative and we don’t base our investment decisions on speculative outcomes of this type. Moreover, we see few rationales for a significant reversal in the company’s revenues or improvement in its operating metrics in the near or intermediate term and potentially significant challenges implementing its trial concepts.

Dividend Perspective

The company also pays a very generous dividend (especially considering the depressed share price) which warrants specific attention despite the challenges of the underlying business. A case for investment can be made for some companies in relative decline when sufficient value can be realized from ongoing distributions to shareholders as the company reduces operations and liquidates inventory and property as it closes stores, etc.

In the case of Barnes & Noble, the most relevant figure to assess is the company’s potential free cash flows which represent the company’s ability to continue funding dividend payments. We therefore turn an eye towards the company’s cash flows.

We approached our cash flow analysis for Barnes & Noble by consolidating the working capital accounts and focusing on the contributions from what we would term more reliable ongoing sources, primarily net income and depreciation and amortization expense. We next calculate the differential between actual reported cash flows from operations and our calculated values which represents the consolidation of the working capital and other miscellaneous operating accounts to provide a perspective on core versus reported cash flows. The data is summarized in the following table:

Source: Company Financial Reports

A few observations stand out in these figures. The first is that “core” cash flows from operations, i.e., those that tend to be recurring over time, have consistently declined over the last three years. The volatility in net income is significant, but the decline in depreciation and amortization expense, which increases net income, has also been highly consistent over the last few years. In effect, core cash flows from operations have declined by half in this time frame.

The second is the high variability in the “other” sources line item while noting that, as one would expect, the contribution to reported free cash flows from these various line items has been offset to a large degree over time and, on net, amounts to a little more than $17 million a year. We’d anticipate a net positive figure for a company in the company’s position as it closes locations and slowly decreases its working capital requirements.

However, it’s also worth noting how much the company has relied on deferred tax contributions to support positive free cash flows over the last two years. A third and a half of the contributions from other sources, which includes the deferred tax line item, were comprised of deferred taxes. The magnitude is concerning in part because it is not sustainable in the long term and, indeed, for the current year to date the company has reported cash outflow due to deferred tax adjustments of $26.7 million versus no contribution or deduction for the prior year period.

The core free cash flow contribution has quickly approached the dividends paid placing the dividends at risk in the future due to an increasing reliance on highly volatile and non-recurring adjustments to working capital and other accounts.

Moreover, the positive contributions from depreciation and amortization expense will likely continue to decline and further impair core free cash flows. The company’s capital expenditures over the time period presented have remained relatively flat at around $95 million per year while depreciation and amortization expense has declined from $149 million to $120 million and is set to decline further in the current year. The result is that the net free cash flow benefit between the two figures has declined from around $54 million to $24 million, greatly compressing free cash flows.

The differential between capital expenditures and depreciation and amortization expense for the free cash flow calculation is likely to continue to decline. A significant portion – 89.7% - of the company’s depreciable property and equipment has already been depreciated leaving few additional depreciable assets on the books. The remaining amount, which amounts to less than $263 million, is insubstantial and depreciation and amortization expense will soon approximate capital expenditures assuming capital expenditures remain constant going forward. Alternately, the company could reduce investment in the business to maintain margin between capital expenditures and depreciation and amortization expense, but this would in turn impair the company’s operations. In addition, in the event the company were to focus on expansion of the Kitchen concept through operating cash flows, free cash flows would be further constrained, and dividends would have to be financed largely by incurring additional debt.

We also developed a rough projection of the company’s free cash flows and dividend coverage for the year ahead using only prior annual data (and before current year-to-date results), as presented in the following table:

Source: Proprietary Calculations

On this basis, the company may be able to generate just enough cash to continue to pay the dividend in the immediate future. However, based on actual year-to-date results, it’s highly likely the company will fall well short of the midpoint (and possibly even short of the low estimate) for the current year. The fact that the company will almost certainly continue to face ongoing declines in depreciation and amortization expense as well as stock based competition only further emphasizes that, outside of significant and non-recurring contributions from working capital accounts, the company will almost certainly not be able to cover the dividend without incurring additional debt (and impairing net income) in the relatively near future.

The company may be able to realize additional free cash flows by better aligning its inventory with revenues as the store base continues to shrink, but this would at best be a temporary solution reflective of the declining core business and we don’t place much emphasis on this opportunity as a source of cash to support the dividend. In fact, aside from its inventories, the company has very few tangible assets and those which it does have – such as leasehold improvements and prepaid assets – cannot contribute meaningfully to cash flows to support the dividend.

Ultimately, we see few options for the company to maintain the current dividend in the intermediate term (that is beyond the next couple years) short of a significant turnaround in the business (which we consider unlikely for the reasons noted above) or the unpalatable assumption of additional debt to fund the dividend payment. The company is therefore also unattractive from a purely dividend on income perspective.

Conclusion

We find little compelling about the company, its operations, and its finances to warrant further investigation and consideration of an investment despite the depressed share price and generous dividend. The company will likely retain a leading position in the physical bookstore segment of the market – and may well ultimately thrive – but on a much smaller scale and with a significantly different business profile. In the meantime, the ongoing market challenges and risks related to the dividend, finances, and funding future expansion of its test concepts will remain elevated for some time. Barnes & Noble is a highly speculative option reliant on questionable assumptions and opportunities which will yield little in the intermediate term.

We would therefore recommend looking elsewhere for compelling investment opportunities.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.