Description

We believe Barnes and Noble Education (BNED), the higher-ed segment spun out from Barnes and Noble in 2015 (and described well in a 2015 write-up by Osonegro), represents an attractive risk-adjusted investment with potential near-term upside of 50 - 100%+ in a take-out, or much more significant long term upside from a successful turnaround of its business and the realization of potential from its new digital study products. 

The potential for an acquisition to take place in the near-term is not at all speculative -- on its last earnings call BNED (which at the time traded at $5) announced its board had authorized retaining a financial advisor to explore strategic alternatives following inbound interest in acquiring the company. BNED subsequently retained Morgan Stanley in early January, and we believe a formal process could yield actionable bids by mid to late calendar Q2. 

BNED's Business

BNED has three reportable segments, which will soon be consolidated down to two, retail and digital student solutions:

1) Retail - BNED, along with Follet Corp, is one of the two leading outsourced campus bookstore operators. BNED retail is a ~1.7bn revenue business with footprint at universities and colleges serving 6 million students. Outsourced campus bookstores currently account for about 50% of the total addressable marke and have consistently gained share over independents due to economies of scale, and most recently as course material delivery has grown more complex. Campus bookstores have some important economic advantages over traditional retail models:

• Campus bookstores have contractual exclusivity with their higher ed institutions. Technically, professors can't go outside the campus bookstore to acquire course materials (though of course in some cases they do so). This extends to digital sales as well. 
• Campus bookstores are typically long-tenured and sticky relationships (BNED relationships average 16 years) that go up to the highest levels of the administration and faculty at a school. Renewal rates at end of contract are in the mid-90% range. BNED has "pull" with the university by virtue of these relationships, and can often renegotiate successfully at lower-margin stores. The contracts are also typically run as rev-shares (typically low double digits remitted to the school, with a downward trend), rather than fixed lease payments which is crucial given near-term sales deleverage dynamics in course materials. 
• Campus bookstores also sell collegiate apparel and general merchandise. As anybody who has shopped at a campus bookstore can surmise, these are high margin items (as much as 40% gross margins to BNED net of the school's cut) that now account for nearly 40% of BNED retail revenues, and are growing with catalysts to accelerate growth. 
• Campus bookstores are in front of a high-demand and difficult to access demographic, thus large brands like Target, Urban Outfitters, and many banking, lending and other CPG brands are willing to do advertising-like partnerships with campus bookstores.

2) Wholesale - BNED acquired MBS Textbook Exchange from BNED and MBS founder Len Riggio in 2017, paying $170m in cash (greater than the current market cap). BNED wholesale is a ~380m revenue business selling to over 3000 colleges and universities. Wholesale is essentially a logistics / procurement company that distributes new and used textbooks to bookstores both within BNED's footprint, outside of BNED's footprint and to BNED-branded "virtual bookstores" -- schools that don't have physical bookstores but need a vendor to run the logistics and procurement. Wholesale also runs textbook rental programs for McGraw Hill and Pearson consignment rental programs. The business is in decline due to the shift from physical to digital course materials, a decline that we do not see abating; however wholesale still has utility and strategic value to BNED and generates strong cash flow. 

3) Digital Student Solutions (DSS) - DSS is a collection of digital assets pieced together through various acquisitions, that is now starting to yield organic products with real upside potential. The business currently does only $20m in revenue, but has catalysts to accelerate growth and we believe could be worth multiples of than BNED's current enterprise value in a 2-3 year horizon. DSS was formed via a series of acquisitions, the largest of which was Student Brands in 2017 ($58.5m cash). The bulk of DSS revenue comes from Student Brands, which operates education websites and apps in 10 countries. DSS also contains software used by faculty and administrations to manage curricula and courseware, though this software is not currently monetized by BNED. 

Historically, DSS has grown modestly, however we see a significant catalyst for the segment to accelerate growth with the recent launch of a susbcription study and tutoring platform marketed to US college students called Bartleby. While the kernels of Bartleby (namely the website and domain) were part of the Student Brands acquisition, Bartleby was built organically by BNED's product team in less than two years since the acquisition. Bartleby offers textbook solutions, study guides and on-demand Q&A, writing help with citation / plagiarism monitoring, and online tutoring. Essentially, Bartleby is BNED's answer to Chegg (CHGG), the market leader in this category. Chegg has to date largely had the segment to itself, along with Course Hero, which relies on a crowd-sourced model (CH has pulled in content like old exams from students, and thus is particularly hated by faculty). Bartleby is priced at $9.99 / mo with one month free, versus Chegg priced at $14.99 / mo. There are several reasons we see Bartleby and BNED as well positioned to succeed in subscription study solutions:

• BNED has a Physical store footprint. Chegg acquires virtually all customers through promotional materials packaged in rented and sold textbooks, and via online SEO / SEM (SEO is aided significantly by Chegg's repository of content, built up over the past 15 years, and SEM spending averages only $10m annually). Bartleby can duplicate Chegg's efforts in SEO, SEM and packaged promotional materials sent througout the MBS wholesale footprint of bookstores, but also has a significant advantage with its Physical store footprint covering 1500 physical and virtual stores serving 6 million students where it can easily mail market and promote to students at point of sale.
• BNED is more faculty friendly than Chegg and is incorporating faculty feedback into its product. This, combined with its university relationships, means that BNED has the opportunity to bundle Bartleby in a school-wide sale. Assume that subscriptions could be sold as a bundle through universities for $50 / annum (a 40% discount to BB list and a 73% discount to Chegg), but that BB attach rates would be 50%+ as a result -- this could be a very powerful sales engine for BNED whose idea has only just begun to be explored with the hiring of executive Gary June to run institutional bundling in September. 
• BNED is not starting from zero: In the Spring 2019 rush, Bartleby acquired more than 50k gross subscribers, while in the Fall 2019 rush BNED disclosed having acquired more than 100k gross subscribers through November. Assuming half of the subs have churned and an additional 100k subscribers have been acquired through Jan end, BNED now has a base of 125k paying subs or a nearly 15m SaaS revenue stream, not bad for a year-old product. Anecdotally our checks with stores and tracking web traffic to BB and review counts on Trustpilot also suggest good growth for Bartleby (though it has terrible reviews for its billing practices, similar to Chegg).  
• Chegg's historical competitive advantages in this space are set to diminish markedly in the coming years, as many of Chegg's contracts with publishers to obtain textbook Q&A solutions to offer in its subscriptions expire in the coming years, and, per our checks, are not likely to be renewed. In addition, as the market shifts off of physical textbooks, Chegg's major customer acquisition channel of textbook rental and sale gets disintermediated. As Chegg drops off, there is nobody else to grow into the opportunity besides BNED.

Investment Thesis:

The education industry has been in a rapid period of transition driven by the migration of course materials from digital to physical, which is driving down ASPs and margins at both publishers and campus retailers. BNED's comp store sales have been under pressure for the past five years due to cyclicalty (community college enrollments are countercyclical to the economy and employment) mix shift to digital and rental, and in the past two years the physical to digital migration accelerated and drove course material comps from -LSD to -HSD / LDD declines. General merchandise sales have been growing, but only LSD and not off a sufficiently large base to invigorate total comp growth, and new contract wins have been contributing to revenue growth for BNED but not at sufficient size to offset the comp declines (this fiscal year new sales will add nearly 50m to retail revenues, but negative comps are likely to erode nearly 100m). New contract wins have accelerated recently following management changes (Mike Huseby, the former BKS CEO, replaced Max Roberts in 2018). 

This acceleration in revenue declines has recently begun to impact overall corporate profitability, which peaked with 127m of EBITDA two years ago (a number we consider artificially inflated, since this was the year BNED acquired MBS which was known to be a declining asset) and has since declined over two years to 83m at the midpoint of management's most recent guidance. The vast majority of deleverage has come on the SG&A line, and we think that BNED will soon take actions to right size the corporate cost structure and streamline operations, thus restoring some of this lost profitability. School contracts also need to be right-sized for the new course materials environment, which we think is also in progress but a slower ship to turn (this will show up as leverage on the gross margin line). 

Notably, BNED has been a consistent generator of free cash flow, having generated between $25 - $50m of free cash flow (M&A excluded) each of the past four years, despite heavy capex investment in digital growth initiatives including a new e-commerce system and Bartleby. This year has been guided to $25 - $35m of FCF. There is a board authorized share repurchase program in place, however management has not utilized it in several yeras. 

We see two ways to win from a BNED investment, as well as multiple catalysts for the company's performance to inflect:

1) The company may be sold imminently. Obviously, this stock is cheap, trading at an EV / sales of 0.12, a forward EV/E of about 3x (using forward average debt of $70m, which we derive from this year's average debt balance of $100m with this year's $30m of FCF generation added in) and an FCF yield of nearly 20%. There has been inbound interest and Morgan Stanley has been hired to organize a process. In addition, while the moving parts in the business are admittedly complex, we are confident that the cost structure is quite bloated with high executive comp and no major RIFs having been implemented despite five years of negative comps. Coupled with aggressive capex spending in recent years that will sunset as the next generation, drop-ship capable, e-commerce system is fully implemented this summer and as initial Bartleby spending ramps down, a PE with footprint in the education space should see a clear path to run this business for $50-60m or more of annual free cash flow. In addition, the digital assets, general merchandise sales and transformational courseware opportunity (to be described below) mean that terminal value multiples could actually rise significantly during a PE's holding period on the investment, particularly if unemployment and CC enrollment rises during said holding period. We think a PE can underwrite a $6 - $7 acquisition (or <8x TEV / post-synergy FCF) quite comfortably. 

Furthermore, BNED could be a highly strategic asset to certain acquirers given its valuable relationships with faculty and school administrations. BNED can and should be a sales channel for IT services and software vendors targeting the higher-ed space with vertical solutions. We note Learning Management System (LMS) providers Blackboard and Instructure have both been targeted and acquired by PE and we believe these same firms could see value in BNED as a synergistic channel for courseware / LMS integration. 

BNED's general merchandise segment is a $600m plus business with high margins and an attractive, captive demographic -- this is not just another retailer in a mall. E-commerce may be poised to inflect significantly for BNED's GM segment post the new platform rollout. Consequently, this business alone could be worth a substantial amount to an acquirer.

Finally, DSS and Bartleby are clear positives to a potential strategic acquirer. If BNED were to achieve a 12% paid student penetration within its 6 million student footprint with an average duration of ~6 months (in line with Chegg), that alone would yield ~$45m of high margin SaaS revenue. For context, Chegg currently trades at a valuation of 13x forward SaaS revenue, so in such a scenario Bartleby alone could be worth $585m or $12 per BNED share. Even on today's modest subscriber numbers, we believe Bartleby could already be worth $3+ per BNED share, compounding on a 100% growth trajectory. 

2) Core business performance in retail and general merchandise could accelerate. As mentioned above, BNED has retrofitted its e-commerce system in time for this year's 2020 fall rush. Currently, only 10% of BNED's GM sales are e-commerce, which management has characterized as "woeful" performance. In concert with more branded partnerships, we think e-commerce acceleration could drive GM growth to 10%+ from current low single digits. As GM is now nearly 40% of the sales base, this could quickly stabilize comps and return them to growth even absent any improvement in enrollments, with comp profit accretion given higher gross margins. 

In course materials (still 60%+ of retail sales), there is a significant opportunity to increase sales via bundled inclusive access programs, which are revolutionizing the higher-ed space. Under inclusive access, all course materials for a class are pre-sold at the start of the semester. Typically, the sell-through rate of course materials is <30% as many students do not purchase their assigned materials, but under IA models, it is 100%, though at significantly discounted ASPs. The net economics of a shift to inclusive access appear to be a greater than 50%+ increase in gross profits per class for BNED and publishers. The value proposition is also universal, as these programs have been demonstrated to increase student GPAs (makes sense as the students have all the materials they need), while driving sales for publishers and bookstores up. The costs of course materials in inclusive access programs are bundled into the financial aid / tuition system. 

Currently, only 5 of BNED's ~770 physical stores are operating under a campus-wide inclusive access model, however our conversations with experts suggest that inclusive access adoption is poised to materially inflect in the coming years, with BNED best positioned to be the accelerant given its blend of wholesale / logistics expertise, campus retailing expertise, school relationships and digital assets. We think that Bartleby can be a key ingredient in the inclusive access recipe for schools -- by bundling a white-labeled, custom version of Bartleby, schools add an additional revenue center and help improve student outcomes while also reducing the usage of Course Hero and Chegg, which are widely bemoaned by faculty as cheating. In a scenario in which BB gets adopted across 50% of its student base at a heavily discounted $50 / year with the school taking 20%, this would still be a 120m / year revenue stream for BNED and could be worth $30+ / share at prevailing market valuations. 

Summary 

BNED is a higher-ed retailer, logistics and digital solutions company trading at trough valuation multiples for an underlevered, cash generative business. The business was undermanaged for many years and has only recently begun to generate traction in its growth initiatives, and many levers still exist to drive revenues and cash flows higher. Far from a terminally melting ice cube, we think BNED is poised to win in the coming years via accelerated general merchandise sales, Bartleby, and inclusive access model transition. We also think BNED is poised to take share in the marketplace from both independent stores and Follett by virtue of its improved suite of products and logistical and bundling capabilities.

The optionality around a successful sales process or good Bartleby traction in 2020 make BNED extremely attractive from a risk / reward standpoint, coming from a position of very low expectations and valuation multiples. 

We believe the upside is $6 - $7 in a PE takeout, higher if a strategic bids, and higher still if Bartleby inflects and the core stabilizes, then grows as a standalone company (this could potentially be a $20+ stock in three years if execution is strong). 

Risks

Execution and capital deployment since the spin has not always been stellar, to put it mildly. The hiring of Morgan Stanley to run a process at least shows the board's independence and commitment to deliver value for shareholders. Next step should there not be a sale or improved execution in the near-term would likely be management changes. 

EBITDA guidance could still be revised down, though we would view such downward revisions as a final trough given the substantial opportunities that exist for BNED both on the cost and revenue side. 

Catalyst

See above.