Summary

Barnes and Noble Ed has been written three times on this platform since the introduction of the company’s First Day Complete (FDC) offering. Since then, the company has consistently disappointed shareholders by falling short of management’s FDC rollout expectations and accumulating unsustainable levels of asset-backed financing. More recently the company confirmed a reshuffling of the capital structure at extremely dilutive terms for shareholders. The stock crashed 70% on the announcement as shareholders expected a refinancing of the maturing revolver credit facility or an equity issuance at better terms. BNED now trades at a very compelling price as disappointed old shareholders dump their stock at overly depressed prices. The company now has a historically low leverage and it is growing profitability. Further financing risks should dissipate as the BNED is now EBITDA positive and expected to keep growing. Barnes and Noble operates in a mature industry with low competition. Additionally, if the company continues to transform its stores, the business could be tremendously appealing for a private acquirer because of the recurring nature of FDC revenue. We believe the stock is worth at least twice the current average price assuming all 16 purchase rights per share are exercised. Expectations for the transformation have bottomed. It doesn’t take a lot to rerate investors’ expectations higher.

This was written for the VIC membership application a week ago when the stock traded at close to 20c per share, so the valuation is updated to reflect the recent price movement.

Background

The company was spun off from Barnes and Noble in 2015 at a stock price of $14.75, or close to a $600m market cap. Today it trades at 18c per share, or a $150m Pro Forma market cap. The company was a victim of an industrywide trend of declining textbook sales and questionable capital allocation decisions which ended in 2020. This was fueled by a decline in enrollment of students in universities combined with a steep decline in students buying their school materials from their Barnes and Nobel college bookstore. The rise of digital channels along with many students opting for simply not buying their required school supplies decimated the legacy business model. Publishers like Cengage, McGraw-Hill and Pearson began selling textbooks on their digital platforms and skipped BNED in the process. Other companies like VitalSource and RedShelf, where students can buy and rent e-textbooks digitally, also changed the industry dynamics. Additionally, students looked for other cheaper alternatives including piracy. Many use websites like libgen.is, which is hosted in Russia and has a plethora of free textbooks where many students download their materials for free. The decline in students getting their required materials resulted in a substantially lower sell-through for the industry.

Around the pandemic, Barnes and Noble began to aggressively convert their portfolio of schools into their First Day Complete program which was successfully piloted in 2018. The program reversed the fatal trend of declining sales and margins and since then revenue has steadily increased until today. As a result, sell-through rates from converted schools have more than doubled to 80%+ compared to less than 35% under the legacy business model. Since 2020 the business has struggled to generate cash and has invested in their First Day transformation. The combination of limited cash inflows from the business and consistent, significant outflows from growth inevitably led to unmanageable debt levels. BNED accumulated $235m in debt ($205m ABL and $30m 2L term loan) on $7.9m of LTM EBITDA, or 29.75x levered. On top of that the Department of Education issued a proposal which is up to review to eliminate opt-out programs like FDC. As such, ABL lenders were pitched to roll the revolver maturing on Dec 2024 under the promise of rapidly growing profitability and the DOE eliminating the proposal against opt-out programs. The company surprised shareholders by announcing they will issue 2.58bn new shares through a combination of the 2L note being equitized, the issuance of 16 purchase rights per share, and a $50m cash infusion from Immersion Corporation in addition to agreeing to fully backstop the rights offering. All of these at a subscription price of 5c per share, or 93% below where the stock traded pre-announcement, and with 53.1m shares outstanding.

The stock price should serve as a rough indicator of management’s performance over the years. The CEO, Michael Huseby, came from Barnes and Noble in 2015. Since the pandemic when BNED began to aggressively expand their FDC program, the company has done a stellar job at missing guidance and expectations. Management guided overly optimistic adoption rates of FDC which have not been met. According to management’s past expectations, the business should now be gushing $100m+ of EBITDA and FCF. On the contrary the company evaporated hundreds of millions of dollars of wealth from their old shareholder. The team has been nothing short of a disappointment. As such, their comments on the future should be treated carefully. To their credit, they are executing store conversions at a very fast pace, but they missed the timeline of the success by a wide margin. In the past, Michael and some directors have bought shares of the company, although the CEO has not acquired any significant amount.

We believe BNED is currently an extremely compelling opportunity. As decimated old shareholders give up on the company for pennies on the dollar and a new strategic shareholder joins the register with great alignment to succeed, the business will keep growing EBITDA and generate substantial cash in the near future. The company now has a much cleaner balance sheet and is now EBITDA positive. Therefore, going concern risks should now materially deflate and the business should continue to grow.

Business Description

The business is divided into 2 segments: retail and wholesale. The company formerly operated a third segment called Digital Student Solutions, which was sold for only $20m. DSS was thought by many investors to be potentially worth substantially more under the right execution. It held assets like Bartleby which at some point could have been valued as generously as Chegg by private acquirers. One should think of Barnes and Noble as the middleman between publishers and universities, where they take a cut of every sale. The company has sticky and long-term relationships with the universities they serve with close to an average 90% contract renewal rate. Similarly with emblematic apparel merchandisers, BNED takes a commission of every sale, and all the inventory is owned by Fanatics.

-. Wholesale. The segment serves 2,900 physical bookstores and 592 virtual bookstores. It distributes an inventory of 264,000 used textbooks. It also provides inventory management. It represents 7% of revenue and even less of gross profit. As students have switched to e-textbooks, this segment has reduced in size and may continue to do so.

-. Retail. BNED partners with universities to be their official bookstore and the exclusive supplier of digital and physical course materials. It currently works with 1,272 colleges and K-12 schools, including 717 physical bookstores and 555 virtual bookstores. Additionally, they operate the e-commerce platforms of most of their schools. In 2020 they partnered with Fanatics and Lids for their experience in emblematic merchandise assortment and capabilities in e-commerce. The company doesn’t pay a fixed monthly rent rate for the bookstores. Instead, the institutions take a commission on all sales. Typically close to 7% for digital materials and 15% for physical materials. Historically the company’s most profitable product has been physical textbook rentals, where the company can leverage their wholesale arm to rent textbooks over their lifetime very profitably. So the recent trend in change of sales mix toward digital has pressed on margins. Contracts with schools tend to be 5 years long, but they can be canceled by either party with a 3-4 month notice. Within retail is also their growing First Day programs. Retail is by far their biggest and most relevant segment.

The First Day programs are referred to as Inclusive and Equitable Access in the industry. The universities automatically charge students for the required textbooks for their classes as part of tuition once the add/drop period of courses ends. Students can opt out of the programs. By enrolling in FDC students can save close to 40% on their school materials vs buying them individually from BNED or other e-commerce retailers or directly from publishers. The lower prices are negotiated with the publisher where both parties benefit because of a higher sell-through to students. The model has been received enthusiastically by universities and faculty, to say the least. In the past faculty have complained of students not being engaged in classes. Also textbooks make faculty’s life easier as they can assign homework from them. Students miss these exercises by not buying materials. The pitch to universities is that IA improves student outcomes and makes faculty happy. IA also relies on the idea that students don’t know what is best for them and hence they are nudged and automatically opted into the program. “The school knows what is best for students”.

--. In First Day Complete the university adopts the program and all students are automatically enrolled and pay a fixed rate per credit hour of classes. These days the rate seems to be close to $24 per credit hour. However, this might lower if students continue switching to digital textbooks, which are lower margin. As students are charged when the add/drop period ends, the cash collection schedule for the company is pushed back. The massive increase in sell-through to students outweighs the potential negatives of a pushed cash collection period and lower average selling prices. Essentially, BNED can double their gross profits per school at little cost of margins. The program has boosted traffic because more students come to pick up their books in a predictable fashion.

FDC continues to grow extremely fast and will continue to do so. Revenue for 3Q24 YTD grew 57% to $271m from $173m in the period last year.

--. The First Day program is adopted only by the faculty for a single course and the course material is mostly digital. First day grew 28% to $173m from $135m in the period last year.

Despite the company has closed 155 unprofitable stores since 2022, retail revenue has remained strong and grown consistently. This further highlights the success of FDC. Gross margins have also been impacted by markdowns from store closures. This should reverse as the company slows store closures and FDC continues to penetrate.

FDC Economics

Again, the First Day programs are divided in two as outlined above, where FDC is growing the fastest and where the transformation of the business has relied on the past 4 years. For every sale of a textbook in FDC, there are 4 stakeholders. The publishers get roughly 70% of sales, while the remaining 30% margin goes to BNED. This is further divided almost equally between Barnes and Noble, the university and the technology provider. There are 2 companies that provide the technological backbone of Inclusive Access programs: VitalSource and RedShelf. Essentially, the companies solved how to deliver textbooks digitally including developing a virtual bookshelf and e-reader before anyone else. In 2019 the company partnered with VitalSource to use their technology to power their BNC First Day digital platform. Thus, Inclusive Access programs rely tremendously on their technology providers. According to my research, these typically take less than 10% but more than 5% of sales. Schools take 12-15.5% from physical textbooks and 6-7% from digital textbooks according to many contracts. Thus, Barnes and Noble is left with close to a 10% commission from sales.

Publishers have also benefitted from Inclusive Access programs. Although they sell textbooks at lower average prices and must give a significant 30% margin, they still achieve substantially higher sell-through rates of more than three times higher and can manage inventory more predictably. Therefore, despite the lower margins, profits are higher and recurring. We believe there is also some resentment from publishers toward the big margins they give away. An employee at Cengage recently pointed out that, although they believe there is value in IA programs, the 30% margin is unsustainable and excessive. We believe the margins split can change over time as most schools are converted to FDC, but in any case BNED would keep a sizable commission from sales. The company provides a lot of value to the university, digital providers, and publishers. Admittedly, FDC saved the channel from a lethal trend. However, it is also reversing a damaging trend for publishers of students simply not buying school materials because they can pass the course without them or because they can download them for free online. Although they sacrifice margin they achieve folds higher of sell-through and higher profits. Universities and faculty get more engaged students and better outcomes for them.

BNED operates in a duopoly with Follett, which also offers Inclusive and Equitable Access programs. Follett is a private corporation, so it is hard to know the exact size and profitability of the company. However, it is surely big and similar in size. Follet was acquired in 2022 by “Tony” James, a Blackstone private equity veteran. There is certainly private market interest in these businesses given the industry landscape and the recurring SaaS-like revenue of Inclusive Access programs. As FDC and Follet Access keep growing, interest will naturally increase. Also, Follet’s new owner the James family signals to a low probability or impossibility of intense competition between the two. On the contrary, a docile and symbiotic industry environment seems the likely course of action.

Clearly management projections are not trustworthy, but the conversion of schools to FDC keeps growing at enticing rates. 76 campuses were FDC by the 2021 school year. 116 campuses or 580k students by the 2022 school year. And 160 campuses or 805k students by the 2023 school year. Management has expressed that growth hasn’t lessened and that they are having hundreds of conversations, which have been “robust” and “consistent with past trends”. We expect the number of students and campuses to increase significantly for the 2024 academic year in line with previous years, which should be announced during the summer in their fourth quarter report. Interestingly, participation rates have also increased in older cohorts of converted schools, perhaps because of students realizing the value of the program. Gross profits for converted cohorts have shown to almost double 1-year post-conversion, which should increase as participation rates improve with time. All of this also creates more profitable stores from operating leverage as some relevant costs like CapEx/D&A are mostly fixed in-store renovations/investments and software improvements.

Department of Education Proposal

We don’t believe the DOE will ban Inclusive Access opt-out programs. The idea was first proposed during the first session that covered many proposals related to cash management regulation, which delineate how Title IV funds can be used. The session occurred on January 8-11, 2024, and the initial proposal explicitly said “Eliminate the provision allowing institutions to include the cost of books and supplies as part of tuition and fees”. However, the proposition was quickly met with big push back from many schools. By the second session held during February 5-8 the proposal that eliminated Inclusive Access Programs was tweaked in favor of IA with some caveats. See below the new proposal:

The amount incurred by the student for the payment period for purchasing books,

supplies, and other educationally related goods and services provided by the institution for which the institution obtains the student's or parent's authorization […]

provided that –

(A) For each payment period, the institution individually discloses the cost of

such books, supplies, and other educationally related goods and services to the

student prior to any authorization being signed and the student or parent

chooses to purchase those materials provided by the institution; and

(B) The institution makes those books or supplies available to students at or

below competitive market rates;

The third and last session to date was held on March 4-7 and the proposal stayed intact from the last session. Given the strong support from educators, we think it is unlikely IA programs will be prohibited.

We believe it is worth broadly outlining, however, other possible paths if the DOE fixated itself on battling IA, which doesn’t seem to be the case now. Firstly, Barnes and Noble and Follett’s offer is labeled as Inclusive and Equitable Access. The former ensures that all students have access to affordable school materials. Equitable access refers to all students paying the same rate for credit hours of classes. Basically, students who take classes that require cheap textbooks finance those who take classes that use expensive materials. One can imagine narratives like “Why do liberal arts students have to pay inflated prices whilst STEM students pay extremely cheap prices? That does seem fair!”. EA programs rely on all students participating or else the system does not work. One can think of this like an insurance pool where risky and safe policyholders must participate in it to work. Thus, if the discussion in the DOE evolves, some change or ban in the EA portion is possible. We don’t believe this would kill FDC, however. But BNED would be forced to change the pricing model, which could optically lower the appeal of the program. A noticeable promotional factor is that all students pay the same rate and receive the same discount. BNED and publishers have still agreed to sell textbooks at a 30% discount. The company would still offer the books for cheaper than other legal alternatives and automatically enroll students. There have been no discussions about banning EA programs.

Hyper Dilutive Equity Issuance: De-risked Capital Structure and Eliminated Bankruptcy Fears

As BNED’s debt load increased and the DOE threatened to kill Inclusive Access, creditors decided not to roll the Dec 2024 revolver as-is and agreed with the company to issue 2,580m new shares at a subscription price of 5c per share (or almost 90% lower than the last traded price) to deleverage the capital structure. Specifically, (1) 900m shares will be issued as purchase rights (16 PRs per share owned), (2) 1,000m shares from a $50m cash infusion from Immersion Corporation, and (3) 680m shares from an equitized $30m 2L note from Fanatics and VitalSource issues in June 2022. Given the modified proposals from the DOE, the involvement of other commercial partners in the 2L note, and the improving profitability, many shareholders and value investors thought that the revolver would be refinanced and/or equity would be issued at a more favorable subscription price.

Instead, the company diluted tremendously its shareholders and invited a new party to the table who will own more than 37% of the Pro Forma company: Immersion ($IMMR). Some would simply describe IMMR as a patent troll with 15 employees, a licensing business, and bad corporate governance. Others would emphasize how cheap it is at only $20m of EV and a market cap of $225m. Another way of investing in BNED’s is through IMMR: a double of BNED’s PF stock price roughly equates to more than half of IMMR’s market cap today. Regardless, Immersion as a major shareholder should comfort new and existent shareholders as they have a strong interest in this turnaround succeeding. This a major investment for IMMR which is almost half of the marketable securities they own and, depending on the backstop, could exceed the size of their current equities portfolio. IMMR is headed by Eric Singer and William Martin, who collectively own 7% of the company. Both have investing experience and started their hedge funds: VIEX Capital (Eric) and Raging Capital Management (William). In the past, they have actively engaged with other companies in their portfolio, including Turtle Beach ($HEAR) which has done well recently. Thus, we believe they have done a lot of homework and will treat the deal very seriously. There is currently a poison pill in place, which is triggered if a shareholder acquires 10%+ of the shares. So there is little old shareholders can do to block the transaction.

As the stock now trades in the 30c per share range, we believe many old shareholders will exit their positions. They are surely disappointed and may simply close their investment out of long-term pain. Many event driven investors formerly betting on a more favorable negotiation with creditors may also exit their position further driving the stock price down. Fanatics and Lids who invested $15m in Dec 2020 at $6.5 per share may also liquidate their position. It is an unknown as they also decided to equitize their loan. Similarly, VitalSource may decide to dump its portion of the equitized 2L note in the open market. We believe there is strong reason to think that many will sell in the near term. Given Follet is a private corporation it is hard to grasp their recent financial health and performance.

Valuation

We believe most of Barnes and Noble’s partner institutions will eventually enroll in FDC. We are not sure of the exact timeline but given the strong growth and momentum in school conversions, FDC will continue to take share from the legacy business model. We believe the business model is clearly inflecting. Management plans to move the majority of stores to FDC by the coming 2024 academic year, with continued growth thereafter. Again, these forecasts should be taken lightly. We don’t believe you need more than 50% of schools to adopt FDC to win, which highlights the opportunity. Currently, less than 15% of schools are enrolled.

To management’s credit, they have done strong cost and CapEx reductions through the last year. They guided to 30-35m of run-rate cost reductions for FY24 and by the third quarter they have already achieved their goal. CapEx was slashed by more than half for the first three quarters of the year from $21.7m to $11.5m. CapEx ranged from $25m-$35m in recent years. We believe $25m is a conservative baseline for maintenance CapEx in the future given the company has recently invested significantly in stores and software.  The company has also incurred outsized restructuring expenses stemming from severance and related costs associated with store closures and advisors. $17.6m was spent during the last twelve months on restructuring expenses compared to $10m in recent years as the company was also closing stores. Summing all of this up BNED has generated $17m in EBITDA LTM assuming $10m in annualized restructuring cost going forward (which should lower further as the company reduces store closures).

Despite the company struggling to become profitable on a P&L basis, they generated $15m of free cash flow from FY21 to FY23, while also investing in FDC growth initiatives. Currently less than 15% of stores have been converted to FDC and the company is now EBITDA positive and unlevered FCF positive. As more colleges convert, EBITDA and FCF will increase significantly. There is still operating leverage to be realized from stores converting to FDC. This would mostly come from D&A which includes investments in stores and software that are mostly fixed. Now that the company has manageable leverage, BNED is set to keep expanding FDC with no going concern risks.

Old Capital Structure:

Revolver Facility: $224.1m

2L + Accrued Interest (Fanatics and VitalSource): $34

Total Debt: $258m

Cash: $8.1m

Net Debt: $250m

Existent SO: 53.15m

Stock Price: 70c

Market Cap: $37.2m

EV: $287.2m

New Capital Structure:

Revolver Facility: $224.1m @ 3.5% + SOFR

2L + Accrued Interest: $0

Total Debt: $224.1m

Cash (net of transaction fees): $83.1m

PF Net Debt: $141m

Existent SO: 53.15m

PR Shares (16 rights per share): 900m

Immersion Equity Shares ($50m): 1,000m

2L + Accrued Interest (Fanatics and VitalSource, $34m): 680m

New Total SO: 2,633.1m

PF Stock price: (0.30 (current stock price) + 16 (number of rights per share) x 0.05 (subscription price))/17 = 6.47c

PF Market Cap: 6.47c x 2,633.1m = $170m

PF EV: $311m

Currently, 160 schools, or 805k students, are enrolled in FDC. Assuming

-.. the number of committed schools and students increases by 37% (lower end of past growth) to 219 and 1,100k respectively for the 2024 academic year.

-.. participation rate of 82%. Lower end of recently reported.

-.. annual revenue per student remains at $425. In line with FY23 and has shown to be rising. Significantly lower than management’s 2021 prediction of $600 revenue per student annually.

-.. GM of 22% for all the retail segments and 17% for wholesale. Both lower end of historical margins.

BNED will generate close to $45m of EBITDA by FY25. By FY26, if FDC conversion grows similarly, the company would make $75m in EBITDA and $33m of EBIT (and +$33m of FCF). At this point Barnes and Noble would have converted only a quarter of their stores to FDC. Given the clear runway ahead for FDC, a 4.15 EV/FY26 EBITDA is simply too cheap. Participation rates should also grow as indicated. We believe the company is conservatively worth at least $450m, or a 6x EV/ FY26 EBITDA and a $309m market cap. This is twice as much as the current PF market cap. The equity is worth 11.7c per share. A reverse split is surely to come.

Doing a classic DCF where the company (1) enrolls 33% of their students to FDC by FY27, (2) maintenance CapEx stays at $25m, (3) and there is some cannibalization from the legacy business model, the company would be similarly undervalued. At 80.6m EBITDA and 55.6m FCF by FY27, the company would be worth $472m, or a $331m equity value at 12.5c per share. We emphasize these are pessimistic assumptions as they predict FDC will have a slow rollout. Unfortunately, there are no similar publicly traded companies, but businesses with recurring SaaS-like revenue can trade for more than 10x EV/EBITDA.

As the FDC model takes over most schools and BNED becomes much more profitable, the company will become very appealing to private acquirers. The recurring nature of revenue is very valuable for PE sponsors and could command a premium of more than 10x EV/EBITDA. It is a business they could comfortably lever once FDC fully penetrates. Follett is an example of interest even pre-full adoption of inclusive access programs. Unfortunately, the acquisition price and financials were not disclosed at the time of the transaction.

Barnes and Noble doesn’t have any proprietary strategic technologies or publish their books. Its value comes from the long and sticky relationships with universities. Colleges don’t want to deal with individual publishers and distributors. So they benefit tremendously from a middleman like BNED or Follet to handle all the relationships and deliver the school materials. There is little publishers or technology providers can do to displace the status quo.

Risks:

-. FDC cannibalizes the existent legacy a-la-carte segment which results in a low participation rates and lower margins from discounted textbook prices and further migration to digital textbooks. Students actively look for cheaper alternatives like libgen.is or do not buy materials because they can pass classes without them.

-. Growth of store conversions is slow because schools prefer the legacy model.

-. The Department of Education bans or limits Inclusive and Equitable Access programs.

-. The 30% margin taken from publishers shrinks and BNED’s net commission is squeezed.