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Barnes & Noble Education: A Retailer In Transition

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About: Barnes & Noble Education, Inc. (BNED)
by: Busted IPO Forum
Busted IPO Forum
Long only, value, contrarian, event-driven
Summary

Barnes & Noble Education, Inc.’s stock is down some 40% from early March as students shift away from physical textbooks.

The company is undergoing a digital transformation that includes a foray into high-margin homework help subscription services.

Despite its gradually declining Retail and Wholesale segments, B&N Education generates solid cash flow – enough to support an over 10% dividend at its current price if it chose.

We take a look at this name as another potential activist has recently taken a five percent stake in the firm.

God works in mysterious ways but at least he works, he's never on welfare in a mysterious way."― Steven Colbert

Today, we look at a 'Busted IPO' that has popped up a bit in recent sessions and might see some activist pressure as a potential agitator for change has taken a five percent stake in this small cap concern.

Company Overview

Barnes & Noble Education, Inc. (BNED) is a Basking Ridge, New Jersey based contract operator of nearly 1,500 physical, virtual, and custom bookstores for college and university campuses and K-12 institutions in the U.S., serving over six million students. Additionally, the company is a large textbook wholesaler and a provider of inventory management and digital education solutions. B&N Education was spun out of Barnes & Noble (NYSE:BKS) in 2015, opening on the NYSE at $14 per share. Since that time, the stock has steadily declined to slightly above $3, now commanding a market cap of ~$150 million. It operates on a fiscal year (FY) ending the Saturday closest to the last day in April.

Reporting Segments

The company disaggregates its revenue into three reportable segments: Retail; Wholesale; and Digital Student Solutions {DSS}.

Retail. Retail operates the bookstores, consisting of ~777 physical and ~714 virtual bookstores. Nearly all the physical locations are on college campuses where ~2/3rds of the virtual locations are for K-12. Reinforcing the monopoly nature of each storefront, B&N Education typically operates under agreements with the educational establishments whereby it is the exclusive seller of their course materials and supplies. The company pays the colleges a percentage of sales for this exclusivity and the use of the physical premises with more than half of the agreements devoid of any minimum guaranteed sales.

B&N Education Retail competes primarily with privately-held Follett (~1,200 campus and ~1,600 virtual stores) and the likes of eCampus and Akademos for virtual business. It is responsible for the vast majority (89%) of the company's top-line, generating FY19 Adj. EBITDA of $89.1 million on sales of $1.89 billion, representing 12% and 7% declines over FY18, respectively.

Wholesale. Wholesale distributes new and used textbooks to ~3,500 physical bookstores (including its own locations) and sources textbooks to its own virtual bookstores. This division also sells point-of-sale and inventory management hardware and software solutions to ~400 college bookstores.

Not surprisingly, this operating segment competes with Amazon (AMZN), as well as Texas Book Company (that services ~2,000 campus stores), and Nebraska Book Company (OTCPK:NEEB) (2,000+ stores). Wholesale accounted for FY19 Adj. EBITDA of $35.0 million on revenue of $223.4 million, representing 14% decreases in both metrics compared to FY18.

DSS. The drops in metrics at Retail and Wholesale reflect a shift toward lower cost options (such as digital offerings and direct from publisher offerings) and a decline in college attendance, specifically at two-year community colleges. To counteract these headwinds, B&N Education purchased subscription-based writing services business Student Brands in August 2017 and writing services provider PaperRater in August 2018, which are both part of the company's DSS division. DSS provides students with products and services to improve academic performance.

Also housed in DSS is bartleby textbook solutions, which was launched in 2HFY19. Bartleby learn provides nearly 2 million step-by-step textbook solutions, a searchable library of answers to homework questions, and subject matter experts on standby 24/7 to students for $9.99/month. It also recently soft launched bartleby write, which checks grammar, detects plagiarism, and provides an AI generated grade for a student's paper, also for $9.99/month.

This relatively new operating segment competes primarily with Chegg (CHGG), the market leader with expected 2019 Adj. EBITDA of ~$123 million on revenue of ~$400 million from its annual subscriber base that will approach 4 million - for its 5 million step-by-step textbook solution sets, amongst other services - this year. By contrast, B&N Education's DSS division only generated FY19 Adj. EBITDA of $6.2 million on sales of $21.3 million from a subscriber base just north of 50,000; however, the company is targeting this segment to drive both growth and value going forward.

These three divisions (after corporate expenses were factored in) combined to generate Adj. Net Income of $25.4 million and Adj. EBITDA of $104.9 million on revenue of $2.03 billion in FY19, representing declines of 55%, 17%, and 8% over FY18, respectively.

1QFY20 Results and FY20 Outlook

This downward sales trend continued in 1QFY20. On August 27, 2019, B&N Education reported an Adj. loss of $0.63 a share on sales of $319.7 million versus an Adj. loss of $0.82 a share on sales of $337.5 million in 1QFY19. The 5% YoY sales decline was fueled by a 3.5% drop in Retail same store sales (which, in turn, was precipitated by an 11% decrease in course materials comps) as the transformation from physical textbooks to virtual offerings accelerated. Each segment experienced a YoY decline in sales with Retail down 4%; Wholesale off 20%; and DSS declining 5%.

Even though 1QFY20 Adj. EBITDA improved to -$25.1 million from -$32.5 million in the prior year period, investors didn't put much weight in these results as the company's business is seasonal with its important quarters being fiscal 2Q and fiscal 3Q. When B&N Education last announced earnings for a meaningful period (3QFY19) in early March 2019, it was caught off guard by the quickness of the paradigm shift to digital and was forced to lower its FY19 outlook. Shares of BNED, which were trading around $7 at the time, dropped below $5 on the news and have stayed there even with the recent rally in the shares.

Management's FY20 outlook did not change with Adj. EBITDA expected at $95 million with free cash flow (defined as Adj. EBITDA less capex, cash interest, and cash taxes) anticipated at $32.5 million (versus $39.7 million in FY19) given maintenance capex of $55 million (up ~$10 million over FY19 to reflect increased investment in digital) - all based on range midpoints.

Bay Capital

While its stock has floundered in 2019, B&N Education has rebuffed three takeover proposals from Bay Capital Finance, LLC, a California based investment firm. The offers were ~$7 a share in February 2019; ~$5.50 a share in June 2019; and $4.50 a share in July 2019. Calling the offers highly conditional, not credible, and substantially undervaluing its digital transformation, the company's board has refused to engage Bay Capital, who does not currently own a meaningful position in BNED.

Balance Sheet & Analyst Commentary

As of July 27th, 2019, B&N Education held $8.2 million of cash and $174.1 million in short and long-term debt on its balance sheet. Given the seasonal nature of the business, all of its outstanding debt is expected to be paid off during the Fall Rush season, only to be re-tapped in subsequent quarters. The company expects average debt during FY20 at ~$100 million. Although B&N Education generates decent cash flow, it does not pay a dividend and its buyback program has not purchased any shares over the past two fiscal years. There is $26.7 million remaining under the authorization.

The company does not have much of a following on the Street. Sidoti downgraded B&N Education on September 17, 2019 from a buy to a hold and currently projects a twelve-month price target of $4 a share. Needham recommends purchasing shares with a $7 price target while Craig-Hallum rates the company outperform with a $6 price target.

Beneficial owner Outerbridge Master Fund LP continues to aggressively add to its position. It now controls 13.7% of the shares outstanding.

Verdict

B&N Education is attempting to stem the secular movement away from physical textbooks toward digital by pivoting to digital. Part of that move involves using its entrenched position on university campuses to promote its homework help subscription services. Chegg, the leader in this space, commands a market cap that is more than ten times its 2019E revenue; whereas B&N Education trades at just over 10% of its FY20E revenue (of $1.9 billion). There are reasons for this orders of magnitude valuation gap: chiefly, B&N Education's lower gross margin (~20%) legacy businesses are gradually shrinking whereas Chegg's very high gross margin (~77%) business is growing revenue in the mid-30% area.

With its infrastructure, B&N Education will surely make inroads with its homework help services. The question is: will it come quick enough to offset and outpace the decline in its Retail and Wholesale segments? The decline in its two legacy segments is not guaranteed as a reversal in declining college enrollment trends could counterbalance students' shift away from higher margin physical course materials. In the meantime, its legacy businesses generate solid cash flow, enough to support a dividend yield of ~13% assuming a 60% payout ratio.

I think the company is going in the right strategic direction and certainly currently has an impressive cash flow yield. However, the retail space is littered with previous retail icons that have failed to adjust to the new landscape created by the likes of Amazon. Forever 21, being just one recent example. The stock has also had some 'false starts' since becoming public. Therefore, we are passing on any investment recommendation on BNED at this time even as we offer up this analysis.

You can either have individual liberty, or dependence on the government. One is designed to undo the other."― A.E. Samaan

Bret Jensen is the Founder of and authors articles for the Biotech Forum, Busted IPO Forum, and Insiders Forum

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.