Barnes & Noble Stock Analysis


(This is a guest post by Bernard)

After seeing the discussion regarding Books-A-Million, I figured I should add my report about Barnes & Noble [[BKS]] which I believe is also undervalued.

Looking at Barnes & Noble

One sector that has certainly been out of favor since the tech bubble is the one of brick-and-mortar booksellers. The extremely quick expansion of Amazon.com shortly after it was founded 15 years ago followed by the arrival of the ebook reader and more recently, the iPad, means the beginning of the end for bookstore chains according to many.

Analysts often compare the industry to the one of CD’s and DVD’s. Companies like Barnes & Noble, Borders Group and Books-A-Million have all seen a significant decline in their stock price over the past 5-10 years.

I will get into some thoughts regarding macro trends later on but for now, let’s look at the potential upside that represents an investment in the dominant player: Barnes & Noble.

Since its spinoff of video game seller GameStop in 2004, BKS had seen its sales grow at an average pace of 3.5% until FY 2009, when they fell from $5,410.8M to $5,121.8M.

While books are generally considered a discretionary expenditure, many started to wonder if this decline was actually of secular nature rather than a simple cyclical downturn.

Nevertheless, although the operating earnings went down significantly last year along with the sales, BKS continues to amass a considerable amount of free cash flows.

While part of the decline in sales is probably secular due to the increasing sales of ebooks and books through online stores, the market appears to be too pessimistic when it comes to “brick-and-mortar” sellers.

Valuation

(Using Bruce Greenwald’s EPV method)

It would be reasonable to estimate that even if its sales continued to decline, BKS would still eventually be able to maintain sales of at least $4,500M through its superstores and bn.com and $1,500 through its newly acquired college booksellers, for a total of $6,000M.

Last year, BKS produced an operating margin of 2.8%, its worst year in a very long time.

Staying conservative, let’s assume BKS was only able to sustain a 2.5% EBIT margin in the future on those $6B sales. Additionally, one could assume that in the past, 10% (~135M$) of BKS’s SG&A expenses have served strictly for the purpose of growing through new stores and the development of its ebook reader and online store.

It is also worth noting that during the Q4 2008 earnings call, management stated that only $25M of the $125M in capital expenditures that were projected in 2009 would serve for maintenance while the rest was for new stores and initiatives.

Once again, to be conservative, I will assume that $55M/year would be needed on the long run to maintain the brand and the stores on the Barnes & Noble side and $15M/year more on the B&N College Booksellers side.

Sustainable Free Cash Flow Calculations

Considering that none of the analysts covering BKS rate it as a “buy” and that 29% of the float is currently short, it becomes more and more apparent that this share has been way oversold at its current price of $20.33 (May 4th, 2010).

The question now becomes, is this type of free cash flow actually sustainable or will the “brick-and-mortar” model eventually die off?

At the current price, the market seems to believe that Barnes & Noble won’t be able to collect much more than $150M in FCF/year in the future.

Considering what the company has achieved recently, even while Amazon was grabbing away a tremendous market share of book sales, I believe this number to be ridiculously low. Barnes & Noble remains a cash cow with a solid relationship with its customers and in my opinion, could make the necessary adjustments to offset some of its lost revenues was there to be a tipping point in the way people purchase and read books.

Industry Overview: Brick & Mortar

The main reason why this stock has been beaten up so badly is probably the poor outlook that many have on the future of book stores. Amazon.com is definitely a tough competitor when it comes to book selling and it is easy to imagine many seeing long Amazon, short Barnes & Noble as a solid pair trade.

This brings us to the first major concern regarding the future of the brick-and-mortar stores which now have to face an increasing share of books being sold and shipped online. While Amazon is a runaway leader in this field, BKS’ long established brand and relationship with its customers still make it a reputable player in the area with its growing online sales.

Moreover, while it is very convenient to have access to a wide range of titles along with customer reviews and have them delivered at home, there is still a certain appeal to slowly browsing through an actual bookstore and reading in a nearby café. This type of store also allows BKS to demonstrate the capabilities of their new e-book reader, a device that many are still unfamiliar with, in person.

Industry Overview: Ebooks

Ebooks have been around for a long time on the internet but have not quite yet caught on in the mainstream like digital music has. Many have blamed this on the lack of available devices that make it convenient to read them on the go, away from the computer.

The trade-off between the portability and the readability of the screen of such a device also makes it difficult to design a product that the casual reader will want to buy. The Kindle and now the nook are certainly interesting and are a step in the right direction in my opinion. The eInk technology really gives the impression of reading an actual book but at the same time, makes it tougher to read charts and tables and look at pictures when needed.

Industry Overview: iPad

The new iPad on the other hand is easy on the eyes and has a lot of potential but its shorter battery life and its similarity to the already available netbooks makes one wonder if they are even going after the same customers. It also remains to be seen what Android and Microsoft have in store. All the hype around these new products in the last couple of months certainly hasn’t helped BKS’s stock but now that the dust settles down, I would be surprised to see B&N’s book sales decline as much as what seems to be anticipated by the market.

Part of the struggles in the recent quarters may be secular but the current economic conditions probably explain the majority of the disappointing couple of recent quarters. There is considerably less traffic in and around malls these days where a lot of their stores are situated.

Industry Overview: Baby Boomers

Finally, one positive trend that could act as a tailwind for Barnes & Noble going forward is the ongoing retirement of the “baby-boomer” workforce. A lot more people who are a big part of BKS’s target market will soon have a considerable amount of discretionary income and free time to spend and a good portion of that generation may never decide to switch over to the ebook format.

A survey concerning book buying behaviour done by Verso Digital mentioned that “of those surveyed, only 9.8 percent said they were “very likely” to purchase an e-reader within the next six to 12 months, and 65 percent of Boomers and “seniors” were not likely to purchase an e-reader”. For the ones that do, BKS should still be an important player in the market with the nook and its large inventory of digitized books, helping offset some of its lost revenues.

It should also be considered that was there to be such a major shift, Borders , Books-a-Million, and independent sellers would probably be first to go, leaving BKS as the only player in the brick-and-mortar sector.

B&N College Booksellers and Activism

Another story that has gotten some attention recently is the accumulation of shares by activist Ron Burkle that started over a year ago.

Burkle stated that he was not pleased with the management’s acquisition of their other company, B&N College, adding debt to the balance sheet and using up the cash that BKS had on hand. He also expressed concern with the recently implemented poison pill which prevents any outside shareholder from holding more than 20% of the company’s shares.

More information can be found in the 11/13/2009 and 02/01/2010 SC 13D/A fillings. It is interesting to note that Burkle now owns close to 19% of the company while Aletheia Research & Management, with whom he has done business at A&P Supermarkets, owns about 18%.

These two clearly see the company as undervalued and could act as a catalyst in pressuring management into improving operations and free cash flows, and closing the gap between the stock price and the intrinsic value. In the meantime, shareholders still receive a nice dividend yield of close to 4.5%, not counting potential stock repurchases.

Disclosure

The author is long BKS.

Jae Jun has no position in BKS.

  • Very nice synopsis thanks! I will certainly look carefully at B&N once the dust has settled on this latest down leg.

  • G.Best

    Agree that book stores have a great appeal for the consumer, I believe they are still a viable buisness, having said that I do not like the razor thin margins here.

    1.5% nett income is 60% drop from last and stagnent/failing for the last 4years.
    free cash is down 20% from last Owners down 48%.decreasing for the last 3years
    Balance sheet looks ok at SE at 921mil, but they only have 281cash (recievables 81mil), accounts payable and accurred lias are 1.4bil

    I like the business model, I think it is still viable, but If I was Amazon and looked at there finacials I would inflict more pricing pressure on them big time, with amazon’s 2.5 times higher net profit and FCF & onwer earnings double from last years @1bil & 2.9bil.

    Barnes, needs the economy to keep going and it could well do it and valuation could be met, but at these margins and this cash level, to risky

  • Bernard2222

    Thank you for the comments Simon and G.Best.

    It is true that BKS has a considerable amount of operating leverage and that its net margin suffers whenever sales go down. I believe that you have to keep in mind however that we just went through a difficult economic period at the same time as investments in the new e-book reader were being made, leading to additional SG&A expenses. Acquisition-related costs and property write-downs also came into play over the last year and a half. As a result, I don’t think you can really extrapolate what happened over the last two years into the future.

    In addition, D&A expenses are much higher than what is actually required in maintenance expenses. I think it is better in this case to look at the FCF numbers which, although volatile, reflect a better picture of the company’s potential. The CEO just recently said that he expects the number of stores to remain flat over the next two years and I think we can expect a lot of cash to come in over that time. The B&N College acquisition did hurt the balance sheet but with no long term debt, it is still in very good condition (especially compared to Borders).

    Finally, regarding AMZN, they have probably already been putting all the pricing pressure they can, even selling some of their ebooks at a loss! A good portion of their margin comes from the other types of products that they sell. It is definitely a threat but in my opinion, not as a big as the market makes it to be.

  • G.Best

    Bernard,

    It may prove to be a good contradictory call here.

    I would rather buy amzn on a downturn in the stock market which we may be experiencing or we may not and things could hold together, growth continues and Barnes should become profitable through growth in the economy. I like their business model and I believe more could be done if they think creativly(better coffee experience & quality gifts, better layout in these area’s)
    Browsing a book store as to be the #1 shopping experience for most people.

    Margins, margins though,
    Inventories and SG&A only take up 50% right off the bat
    Nett income as never exceeded 3%
    Croic never exceeded 10%
    FFC 7% highest ever, in the economic boom of 05
    Owners FFC 2% in the same boom in 04(-7% over 10 years)

    not strong enough, it does not through off enough cash.

    Personally I would prefer the industry leader if stocks continue to decline or a business with better margins in another industry

  • Bernard2222

    G.Best,

    Yes ideally I would prefer to own AMZN here if the two companies were selling for the same price, but that is far from being the case. I’d like to know how you get to your FCF and CROIC numbers… do you use only the maintenance CapEx here or do you include the growth CapEx as well? BKS has been opening a large number of stores until the last couple of quarters. A lot of that money would not be necessary were we to assume that the company would stop growing (as explained in Greenwald’s book).

    It seems to me that $320M FCF p.a. is not far fetched for at least the next two years if the company stops opening new stores as they said they would (depending on how much additional investments they decide to make in the digital/ebook business). This would lead to a 29% yield on the current enterprise value of $1104M. That seems rather very cheap compared to AMZN and companies in other industries.

  • George Best

    Bernard,

    I take all capex off to get FCF, looking at 10 years. If capex is steady, D&A is much lower, I will use D&A instead for maintence. CROIC is agaisnt owner earnings over 10years, bit strict maybe. CROIC against FCF was 20% last qtr, v good.

    Anyway I do agree the stock is undevalued, if they stop spending and this is my main point, the economy will continue to grow, this is very important for consumer discretionary going forward and with low margins it is vital, I simply don’t like the margins.

  • G.Best,

    Yes ideally I would prefer to own AMZN here if the two companies were selling for the same price, but that is far from being the case. I’d like to know how you get to your FCF and CROIC numbers… do you use only the maintenance CapEx here or do you include the growth CapEx as well? BKS has been opening a large number of stores until the last couple of quarters. A lot of that money would not be necessary were we to assume that the company would stop growing (as explained in Greenwald’s book).

    It seems to me that $320M FCF p.a. is not far fetched for at least the next two years if the company stops opening new stores as they said they would (depending on how much additional investments they decide to make in the digital/ebook business). This would lead to a 29% yield on the current enterprise value of $1104M. That seems rather very cheap compared to AMZN and companies in other industries.

  • gbest

    I am not the best with lots of intricate analysis, but low profit margins in an consumer indebted goverment economy is not the best investment. Ratio’s are great and what if’s, but you have to look at the actual busines, I own a run a business so it helps my stock picking. This was to risky, it was $21 when this post came out, it’s $15 now with result just out, losses are widening. They are indebt bricks and morter, with a bad e-reader, Apple/amazon own e-readers now, amazon own books. There are safer bets.

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