LONG BKS

After trying and failing to restart the dialogue on the old BKS thread, I thought I would start a new one given recent developments and how the story has evolved in the last year or two.   It is worth reading the old write up and the comments.  Notice that the focus was clearly on the NOOK business at the time.

For The Elevator

Barnes and Noble is a classic case of a decent/good business paired with a money losing business.  The company operates 3 business lines: Retail, College, and NOOK (College and NOOK are held together as NOOK Media with MSFT owning 16.8% and Pearson owning 5%).  A quick glance at financials shows an operating loss of $220M in FY13 which leads popular perception to be “bricks and mortar is dead,” “AMZN is eating their lunch,” and a general revulsion toward the company. 

However, a look past the headline shows a core retail business with $376M of EBITDA in FY13 after having compounded at 18% since 2011, a college store with growing revenues that contributed $111M of EBITDA in FY13 on reduced margins, and a NOOK business that contributed negative $480M in EBITDA in FY1.  The enterprise value reveals that the entire company trades for 3.4x FY13 Retail EBITDA or 3.9x FY13 Retail EBITDA-Retail CAPEX or 5.7x FY13 Retail FCF assuming Retail paid all interest and was taxed at 35%: levels which are far too low for a business that is being managed for cash flow by excellent capital allocators.  It is true that the retail business may be caught in a slow decline, but it will not disappear any time soon. Importantly, management, key share holders, and the owner operator are all incentivized to let the core business shine through in the not too distant future.

From 40,000 Feet

An investment in BKS comes down to 2 questions:

1)      What is the core business worth?

2)      Will the core business be allowed to shine?

For the purposes of brevity I will largely look past the college business and NOOK business, but note that they have some value and add to a margin of a safety.

Why Does the Opportunity Exist?

Broadly speaking, the opportunity exists because “everybody knows” that book stores are dead in a digital age.  The bankruptcy of formerly highly levered competitor Borders Group proves this, right?  While it is true that retail revenue has declined in recent years, and will likely continue to decline in the future, a post holiday ’13 press release indicated that retail sales were basically flat YoY (core comparable sales down .2%).  I believe any future decline in revenues will be at a manageable pace on a store level, and tied to store closures on an income statement basis.  Similarly, “everybody knows” that the NOOK stands no chance in an iPad / Kindle world.  This may be true, but any negativity here depends on the company continuing to throw good money after bad in seeking to develop hardware to play the tablet game.  I believe this to be unlikely.

In the more immediate term, the December decline and subsequent volatility in the stock are attached to a disclosure that the SEC is investigating the company’s accounting practices, and the subsequent predatory law suits that come with that sort of thing.  Of course this is never a good thing.  However, the investigation is based on a former employee claiming that expenses tied to NOOK were improperly attached to the Retail business, essentially making NOOK look BETTER than it otherwise would and making Retail look WORSE than it otherwise would.  I am operating under the assumption that NOOK may be worth $0, so if the allegations prove true, I am fine with Retail being better than I assume now (not withstanding any fines etc).

Question 1: What is the Core Business Worth?

 “Reports of my death have been greatly exaggerated.”  ~ Samuel Clemens

In order to answer this question, it is first necessary to get over the popular perception that there is no room for brick and mortar book stores in today’s world.  A bit of history and a commentary on some of the major investors may be useful.

In late 2008 – early 2009 Ron Burkle of Yucaipa became an 8% holder of BKS stock before boosting his stake to almost 20% and kicking off a campaign to wrest control of the company from founder and Chairman Leonard Riggio.  That saga in and of itself is worth reading up on if you have the time, but in the interest of brevity, I will just give some background on Burkle.  If you’re not familiar with him, he is a college drop out that made billions in the ultimate low margin / “efficiency is key” business – super markets.  Early on in his career while seeking funding to buy a super market he became acquainted with Charlie Munger, who supposedly helped him further develop what came very naturally to him: only buying something if you think it is worth a lot more than you’re paying.  The point here is that Burkle is not the type of investor who would make an investment based on a speculative push into a new area such as E-Books.  The core of his investment was based on the belief that there were many levers to pull in the Retail business including cost cutting, stream lining distribution, closing stores, and ultimately managing for cash flow.  The NOOK business was just a lotto ticket.  Burkle eventually abandoned his stake for what I believe were personal/emotional reasons after losing a proxy battle to take control of the company.

In May of 2011, Liberty Media bid a hair over $1B for control of BKS, and ultimately settled for a ~17% stake via a convertible preferred in August of 2011 (7.75% convertible at $17).  Similar to Burkle, Malone is not the type of investor that is likely to make a speculative bet on a foray into a new product line.  Rather, he must have first gotten comfortable with the core business, and viewed the NOOK as a lotto ticket.

Dan Tisch, second son of the Tisch family of Loews Corp fame, also owns 8.4% of the company, having bought shares within the last month.  Once again, this is not someone who makes speculative investments on unproven technologies or fast moving industries.  This is the scion of a value investing legend who presumably has learned a thing or two.

 Moving on – on one hand we have 3 extremely sharp investors, who are all known to be patient and disciplined, who have made substantial investments in BKS not because they were so confident in the future of the NOOK, but rather because they were comfortable with the core business and viewed the NOOK as a lotto ticket.  On the other hand we have “everyone” who is more than happy to tell you that bricks and mortar are dead, Amazon is taking over the world, and there is no future for a company like Barnes and Noble.  I know which side I want to be on.

Here we are a few short years later, and the future of the NOOK is uncertain.  The company has dumped hundreds of millions of dollars into developing hardware – clearly not their area of expertise – and the iPad, Kindle, etc etc have basically beat them to the punch.  So how has the core business fared?

• Note corporate year ends in April        

Revenue has obviously come off a bit, but since 2011 Riggio has pulled many of the levers that Burkle referred to, and EBITDA has compounded at ~18%/year.  Importantly, ~35% of leases are up in the next 2 years, providing substantial opportunity to downsize where appropriate, increasing margins and reducing CapEx.  A few notes on YTD results: CapEx YTD is elevated due to a website overhaul – which also leads to higher SG&A on some level.  According to management this new site will yield cost savings.    This may or not be true, but what seems certain is that the increased spend will roll off.  Also increasing SG&A are several million in severance costs which will roll off.  On the sales line, YoY comparisons are also difficult to last year’s blockbuster sales of The Hunger Games and Fifty Shades of Gray – there don’t seem to be any major hits this year.

In sum, it is unclear how much more EBITDA margin can be squeezed out of the business, and surely it can’t go on forever.  Importantly however as of this past holiday season’s press release, sales were basically flat.  Given the difficulties the consumer has been facing and the extremely promotional environment across the retail landscape clamoring for consumer dollars, I’d say that this is reason for confidence – or at the very least tempered pessimism going forward. 

If the numbers alone aren’t enough and you are still in the camp that believes that AMZN is taking over the world, a few additional data points may interest you.  As reported by a recent Barron’s article, according to the American Booksellers Association, book stores are experiencing a resurgence.  Since 2009 membership and locations have grown by 16% and 19% respectively.   According to Nielsen, the volume of printed books is down since 2009, but it rebounded 5% in 2013.  There is some associated commentary that indicates communities like having book stores. 

This is not to say that AMZN is not a serious threat – it clearly is –  in terms of pricing, in terms of those people that like physical books and plan their reading list in advance and order books from AMZN, and in terms of people who are migrating to E-Books (AMZN may wind up “taking all” in the E-Book battle. It is worth noting however that a recent survey by the Pew Research Center indicated that only 4% of Americans exclusively read E-Books).   However, there is clearly still a section of the population that enjoys shopping in a physical book store where they can more easily browse, sample a chapter or two, and/or find something they didn’t know they were looking for.  This is a clear niche.  Bears chuckle at this comment, but the fact is that Barnes and Noble is the dominant force in bricks and mortar book retail. 

Valuation

As a base case, I think it is fair to say that the core business is worth 5x FY13 EBITDA.  However, given that D&A greatly overstates CapEx which will continue to shrink due to a declining store base, and given that tax efficiency and capital allocation are virtually guaranteed to be top notch due to John Malone’s influence, I think 6x (or 7x EBITDA-CapEx) is nowhere near crazy.  Using FY13 numbers is obviously imprecise for a declining business, but as mentioned previously the increased CapEx tied to the website and the fact that holiday sales were ~flat are enough for me to be comfortable with this number given the huge margin of safety involved on these numbers, and given that we haven’t even added any value for College or Nook.  For reference, GME and BBY, 2 other retailers that are getting “killed by AMZN” recently traded at a 6x EV/EBITDA.  Of course both of these companies have aggressively bought back stock – BKS Retail will almost certainly do the same once it is on a stand alone basis.  (It is worth noting that GME was originally a BKS spin and Riggio was on the board until 2011. If Malone’s influence is not enough I am sure Riggio noticed the success that GME has had with buybacks.)  Also note that the above includes total lease liability.  Given that 1/3 of the leases are up for renewal in 2 years one could easily justify reducing this liability by 1/3, which would add ~$2/share.  In fact, given that bankruptcy is extremely unlikely, one could argue that the leases could be excluded from an EV entirely.  However, in the interest of conservatism, I have included them at full value.  Additionally cash and share count have not been adjusted for buybacks, which would be accretive and build in another layer of conservatism.

Question 2: Will the Core Business Be Allowed to Shine? 

Answering this question requires a peak at the motivations of the key players.

1)      Founder Len Riggio owns 26% of the company and is presumably self interested and thus will not continue funding NOOK throwing good money after bad forever.  It is worth noting that in December Riggio sold 2,000,000 shares.  These shares had purchases prices north of $35, allowing him to book a $40M tax loss.  Of course I’d prefer to see him buying stock rather than selling, but harvesting a tax loss in a year when everything else ripped higher seems reasonable.  Additionally a common complaint has been that Riggio runs the company as if it were private – this led to the aforementioned battle with Burkle and is a valid concern.

2)      John Malone’s Liberty Media owns ~17% of the company (and has 2 board seats) via a 7.75% preferred that is convertible at $17 and will presumably agitate for the company to not throw good money after bad forever.  Importantly, current CEO Mike Huseby is a Malone guy with spin off experience at Cablevision.  Upon being named CEO in January '14 (he was previously CFO and President of NOOK) he stated, ““My role, as I see it, is to enhance and unlock the value of these businesses for our shareholders.”

3)      MSFT invested $300M in NOOK in October of 2012.  As part of the agreement there is a 5 year put in place under which MSFT can receive “fair market value” for their share of NOOK if it has not been spun off from the core business.  The clock is ticking, and presumably Riggio, Malone etc do not want to write MSFT a check.  If you figure there is a ~3.5 year timeline until the spin “has” to be completed, I believe it is likely that the market will figure this out within ~2.5 years and start to price BKS stock on the value of the core business.

Other reasons to believe that a spin or other change in the NOOK strategy will come within the next three years include:

1)      The company has openly talked about a spin.  In fact, when MSFT made their investment in NOOK it was specifically structured to facilitate a spin of the NOOK and College business.  However, it has not happened yet, which has caused impatient investors to head for the door.  Once again though, the clock is ticking.

2)      On Feb 10, 2014 BKS announced that they had laid off engineers attached to the hardware side of NOOK.  As of the last K there were 750 employees attached to NOOK – there have been conflicting reports as to how many people were laid off with “less than 100” being the most common. It is impossible to know exactly what this means at this point, but it certainly means reduced CapEx and SG&A.  It seems likely the company will be continuing to develop a simple E-Reader while licensing the NOOK concept to outside developers for color/full service tablets.  Other theories out there range from giving up on NOOK all together, to allowing MSFT to take the lead.  A report that MSFT was looking to hire engineers to develop an Xbox branded reader adds some intrigue to the story and licensing deals.

In summary, I think it is a foregone conclusion that the NOOK business will be either spun off, sold off, or downsized appropriately allowing the strength of the core business to shine through within 3.5 years.  Importantly, at these prices investors are paying $0 for an asset that could potentially be worth a decent chunk of change.

A Brief Word On Other Businesses

College

The college business is more difficult to get a handle on than the retail business.  While the traditional book store segment seems to have stabilized and is generally a slow moving business, the way college students access books is rapidly changing.  College used to be a business with a captive clientele, but the last few years – or perhaps more appropriately semesters – have seen a rapid shift toward renting books.  While there will likely always be a subset of students that like to own books so that they can highlight, make notes in the margins etc, and another subset that at least wants a physical book to more easily flip pages, it is not hard to see most perpetually cash strapped students moving to a rental model on the cheapest basis possible, which is E-Books.  With E-Books of course there is no benefit to physical proximity, and price will likely be the sole determinant of who wins the business.  AMZN seems likely to be the clear winner, although Pearson’s investment in NOOK is interesting. 

Sales and gross margins have been improving in the college business, but EBITDA has been declining as the company is investing more money into “higher ed initiatives” which to me basically means “trying to figure out the future.”  Given this dynamic I think a 3x EBITDA is probably fair, equating to a touch shy of $4/share after backing out MSFT and Pearson’s interest in NOOK Media.  Importantly, at these prices investors are paying $0 for this business, and it may wind up being worth quite a bit more depending on how the future of text book rentals shakes out.

NOOK

I have no idea what NOOK is worth.  As recently as May of 2013 there were unconfirmed reports that MSFT would pay $1B for the whole NOOK business (note this may include all of College as College and NOOK are held at the NOOK Media level).  This is a rapidly changing market, and obviously AMZN is taking the lion's share of it.  I like to think that the folks at MSFT are smart enough to have some visibility on the future of the E-Book business and thus were not completely crazy when they made their initial investment and when they allegedly tried to buy complete control, but who knows.  If MSFT goes the “devices and services” route I suppose it makes sense to keep a foothold in the E-Book world, but predicting this sort of thing is not my game.  I’m fine with that though since at these prices investors are not paying for it.  What I do know is that if MSFT were to buy the whole business it wouldn’t be the first time they bought assets in an attempt to keep up with AAPL/AMZN/GOOG etc.   

What really matters is that the key players are incentivized to not let NOOK take down the whole ship.  The recent layoffs and reports that NOOK will continue to develop simple readers while abandoning full function tablets are evidence that NOOK will not take down the whole ship.

It is also worth noting that the publishers seem to hate AMZN due to AMZN constantly squeezing them on everything and anything, as well as the fact that AMZN has entered the publishing world as a competitor.  The publishers are likely incentivized to keep NOOK around as a foil to AMZN, and publishers also benefit from being able to negotiate w/ one BKS entity for both print and digital.   It may also be worth noting that  NOOK may benefit from the aforementioned upgrade of www.barnesandnoble.com (part of the Retail segment, although EBook sales flow through NOOK) which quite simply has been historically less user friendly than AMZN.  An improved website experience could/should help E-Book and possibly NOOK sales.  

And lastly, BKS has $29M of NOLS which are likely held at the NOOK Media level, although a company rep would not confirm that.  It is not clear if these NOLs will be able to be harvested as they have been recording valuation allowances, but I am confident that if anyone can maximize their value, it is John Malone et al.  I give them $0 value for now.

Suffice it to say that NOOK is likely worth more than zero, and possibly substantially more than zero depending on how the E-Book world / MSFT ecosystem develop.  Importantly, at these prices investors are paying $0 for NOOK.

Summary:

Barnes & Noble’s retail segment is far from a sexy business, but it does spit off a lot of cash into very capable hands, and its decline will likely be slower than “everyone” thinks. The key players in this story are motivated to let the core business shine through in the not too distant future, and NOOK and College are free lotto tickets.  The stock has spiked ~15% in the last few sessions on the back of the news of layoffs at NOOK – this was likely largely short covering, and prices are likely to drift back down to the ~$15 level in the coming weeks, making the potential for a doubling of the stock’s price in the next 2-3 years a reasonable possibility.  If sales at Retail decline faster than expected, the excellent capital allocators at the helm will likely aggressively repurchase shares, limiting any downside.

Disclosure: LONG