3/24/2011
By Brian Sozzi, Research Analyst

On our November 2010 monthly newsletter for clients, I assigned an emphatic "go short" call on shares of book retailer Barnes & Noble (BKS).  Since then, the ink has been sucked dry from the Barnes & Noble storybook.  Ink in this instance is the shareholder base who has signaled to the market that the story on Barnes & Noble will be anything but a fairytale ending.  Below is an excerpt of what I penned back in November:

"Barnes and Noble is for sale, management has no qualms letting that be known.  However, in a period in which private equity firms are flush with cash and debt markets have basically headed, and there have been deals conducted in the retail sector, I find it peculiar that Barnes & Noble can't stick a sold sign on the lawn of its corporate headquarters.  Actually, I don't find it strange at all having done a deep dive into the company's fundamentals.  Negatives include:

1. Structural change in the industry where downloading books online is increasing, therefore killing the traditional book business. Barnes & Noble has made inroads into the industry trend by way of the Nook, but the product lacks the name notoriety of Amazon's (AMZN) Kindle and the functionality of Apple's (AAPL) iPad.  Moreover, sales of the Nook are lower margin for Barnes & Noble, and the device has become the company's biggest-selling product.

2. I sense a reluctance by management to shrink the Barnes & Noble store footprint, despite the obvious downloadable book trend intensifying.  Square footage only declined 1.5% in 2009, and will stay somewhat consistent this year.  Maintaining 1,300 or so stores is unwise and unproductive as sales to them slow.

Barnes & Noble shares have retreated 21% YTD, underperforming the S&P Retail Index which has advanced 13%, and nearly every retailer I cover for our institutional service.  Consensus earnings are being lowered, and performance on the earnings line relative to consensus continues to disappoint.  With the structural changes I outlined, it's hard to imagine that private equity will step up to the plate at the current price level of the stock.  I expect weak comparable store sales and pressured margins to support a stock price of $10.00 over the next 12-18 months."

All went relatively quiet on the Barnes & Noble news front during the holiday season.  The Nook Color had a reasonable degree of success in the competitive e-reader space and attention was being fixated upon the structural upheaval in the industry that forced Borders Group to shutter a majority of its stores.  Then on February 22 Barnes & Noble dropped a bomb, announcing that it was suspending its way too generous $0.25 per share common stock dividend.  In my discussions with contacts, I remember saying "what took so long?"  That question in and of itself raises a litany of other questions on Barnes & Noble, all of which triggers doubt as to the integrity and forward-looking ability of a management team running a publicly traded entity.

Question One

Why did a company selling books not properly anticipate the transition to e-books ahead of do everything Amazon (AMZN)? 

In failing to get ahead of the curve, Barnes & Noble missed out on an opportunity for a first mover advantage.  A book company not developing strategies to capitalize on a fundamental shift in how its products are consumed is a serious red flag.

Question Two

Why shell out $346 million in precious cash to fund part of the B&N College acquisition?

There was a conflict of interest in this transaction in my view given Leonard Riggio's ownership  of B&N College and his holdings of Barnes & Noble.  A more shareholder friendly strategy would have been to include a significant stock component in the transaction.   Did Mr. Riggio internally balk at that proposition in light of his own views on where Barnes & Noble's shares were headed in the not too distant future?  Remember, cash offers provide the interested party with certainty of value.  Partly as a result of this deal, Barnes & Noble has had to tap its $1 billion credit line to the tune of $304 million to fund capex (store maintenance and digital investments predominantly).  The credit agreement, as is my understanding, does not become prohibitive until there is $110 million left of availability.  That said, it would have been a wiser decision to preserve cash so as to not have to pay interest under a credit agreement.  Red flag.

Question Three

Why is this company operating 1,300 stores and maintaining a reluctance to aggressively close stores?

Barnes & Noble's management seems infatuated with the concept of marrying a physical store presence to a world of digital.  So, basically, each time a person drives by one of Barnes & Noble's hulking stores (26,000 square foot average) that is supposed to trigger a sale of digital content on the Nook or via the company's iPod software.  I am all for multi-channel retailing.  The integration between physical stores and the digital world is vital to the long-term success of large box retailers, and others for that matter.  Unfortunately, many retailers continue to believe there is a need to maintain a material amount of large box retail stores in operation that require the payment of taxes, insurance, maintenance, and payroll when the customer traffic is being lost to a web store.  Big box retailers must reduce the leverage points of their businesses to be viable in the future of retailing.  That means Best Buy (BBY) has to exit leases as they come up for renewal and shift funds to smaller, more productive stores and pricing schemes.

As for Barnes & Noble, it has 300 plus in total operating leases up for renewal in the ensuing three years, and it should be focusing on closing 50% of these stores for the sake of not going the way of Circuit City, Blockbuster, Borders, and countless others in the retail history books.  Consumers are voting that the convenience and price transparency of online and mobile is their preference as opposed to the experience of navigating a supercenter.

A Sleep on this Question

If Borders buckled under the weight of change, why not Barnes & Noble?

Some will argue that Borders was a second rate player to Barnes & Noble at the store level and no competitor whatsoever to Amazon's online dominance.  These same people could add that Borders' balance sheet was weaker than Barnes & Noble's and it lacked a comprehensive digital book strategy.  All fair points.  At the core, however, I say both companies are strikingly comparable:

1. Merchants operating too many stores with merchandise that is very price competitive.
2. Merchants that are stuck between a rock and a hard place for not identifying industry change.
3. Merchants that will be forced to compete aggressively on price to capture e-reading dollars.

Bloomberg broke the news yesterday that Barnes & Noble was having trouble selling itself.   Absolutely no surprise to me.  Think about what a private equity firm seems when conducting their due diligence on Barnes & Noble:

1. Three years of negative comparable store sales.
2. 298 bps in gross margin compression from the 2006 peak; weak sales and a sales mix shift are exposing a store base that is too large to run profitably.
3. Operating margin down close to 400 bps from 2006 peak as Barnes & Noble has had to play catch up on digital.
4. A retail business that is faltering despite a recovery in consumer spending.
5. A 56% decline in the market cap from the 2006 peak.
6. Operating losses from the alleged growth vehicle online business.
7. Negative tangible book value.

The actionable advice to investors at this point is to (1) stay short the stock from my prior call; (2) engage new short positions; or (3) avoid the stock as it's not for the faint of heart.  I can't rule out periodic spikes in Barnes & Noble's stock price on murmurs that a sale is impending, therefore causing a short position to move against said investor.  Long-term I have serious reservations on Barnes & Noble being around in its present form or in a much scaled down form, both of which suggests a steeper valuation haircut from present day.

Brian Sozzi
Wall Street Strategies

Add a Comment!