I got some great comments to my earlier articles in this ongoing Barnes & Noble series. Many of them were about how Barnes & Noble wasn’t a value investment: “I have never seen a value investing article with so much space written about non-business or valuation related things. Even the little space that valuation got was dubious.” And: “Going long BKS on these reasons alone however is PURE SPECULATION. It has nothing to do with the fundamentals of BKS, which is deteriorating. Burkle is taking the risk that he can turn around BKS, but remember as Buffett admonishes, turnarounds ‘seldom’ turn around!”.
So, let’s see what Warren Buffett’s mentor, Benjamin Graham, had to say about analyzing a business with deteriorating fundamentals:
“Where the trend has been definitely downward…the analyst will assign great weight to this unfavorable factor. He will not assume the downcurve must presently turn upward, nor can he accept the past average – which is much higher than the current figure – as a normal index of future earnings. But he will be equally chary about any hasty conclusions to the effect that the company’s outlook is hopeless, that its earnings are certain to disappear entirely and that the stock is therefore without merit or value. Here again the qualitative study of the company’s situation and prospects is essential to forming an opinion whether at some price, relatively low, of course, the issue may not be a bargain, despite its declining earnings trend. Once more we identify the viewpoint of the analyst with that of a sensible business man looking into the pros and cons of some privately owned enterprise.”
What is Barnes & Noble Worth as a Privately Owned Enterprise?
Ron Burkle is the practical manifestation of Ben Graham’s ideal of a sensible business man looking into the pros and cons of Barnes & Noble as a privately owned enterprise. Burkle approached Bank of America and Deutsche Bank to consider a leveraged buyout at a price higher than $15 a share. So we know Burkle is interested in Barnes & Noble as a private enterprise. He isn’t looking to just buy and sell shares. Burkle wants to own the business. He may be wrong, but he’s definitely thinking of Barnes & Noble in terms of a privately owned enterprise.
We also have some idea of how our sensible business man, rightly or wrongly, looked into the pros and cons of Barnes & Noble: “Before investing in Barnes & Noble, Burkle and his team asked publishers, book agents, consumers, and tech companies the same question: In the era of the e-book, what good is a bookstore? What Burkle learned was that Barnes & Noble has a deep and abiding relationship with its customers and could do a lot more to exploit it.”
What Would Benjamin Graham Think of Ron Burkle’s Proxy Fight?
Ben Graham would be for Ron Burkle’s proxy fight. Graham was a proxy fight pioneer back in 1926 when he took on and beat the entrenched management at Northern Pipeline.
Graham found Northern Pipeline by looking through government regulator reports on the pipeline industry. Back then, some public companies did not provide detailed balance sheets like they do today. Northern Pipeline reported what assets it had. But it did not give a detailed list of its investment portfolio to investors. It did, however, file that information with the government. Graham went down to Washington and read the report: “I soon found I had a treasure in my hands. To my amazement I discovered that all of the companies owned huge amounts of the finest railroad bonds; in some cases the value exceeded the entire price at which the pipeline shares were selling in the market!...Here was Northern Pipeline, selling at only $65 a share, paying a $6 dividend – while holding some $95 in cash assets for each share, nearly all of which it could distribute to its stockholders without the slightest inconvenience to its operations. Talk about a bargain security!”
Northern Pipeline was one of Graham’s greatest finds. It would turn into a great investment for him. But not before he fought a tough proxy battle with the company’s management. Graham started by buying 5% of Northern Pipeline. That made him the second biggest shareholder behind the Rockefeller Foundation, which had 23% of the stock.
Northern Pipeline was the first of many activist investments in Benjamin Graham’s career: “My operations consisted largely of buying common stocks selling well below their true value as determined by dependable analysis…It was my policy to first acquire a substantial interest in such companies and then to endeavor by one means or another to bring about the appropriate changes in the company’s capitalization or operating policies…almost invariably management resisted my endeavors.”
Graham would sympathize with Burkle. Just as Ron Burkle is now battling the Riggio brothers at Barnes & Noble, Ben Graham battled the Bushnell brothers at Northern Pipeline.
Benjamin Graham’s investment in Northern Pipeline didn’t stat well. First he bought 5% of the company. Then he talked to management. The Bushnell brothers wouldn’t listen to anything Graham said. So he went to the annual meeting in Oil City, Pennsylvania. There were six people in the room. Graham was the only outside shareholder. The other five were employees. When Graham stood to read his speech, no one seconded his motion. The meeting was adjourned: “I felt humiliated at being made a fool of, ashamed of my own incompetence, angry at the treatment given me. I was able to control my feelings just enough to say quietly to the president that I felt he had made a great mistake in not permitting me to have my way. For I would come back the next year, and then I would have a second with me, and more.”
Now it was personal. Graham had a year to prepare his attack: “I bought more shares of Northern Pipeline. I committed as much of the partnership’s funds as I could risk.” He hired one of the best corporate law firms in New York. He researched cumulative voting laws and used them to prepare a proxy slate that could win 2 of the 5 board seats. Graham decided not to seek a majority of the board, because he did not want responsibility for running the company. Two seats against three would be enough to send a clear message and get what he wanted for the company’s shareholders.
Graham was very successful in winning over independent shareholders: “After all this time I still remember old Bushnell’s involuntary exclamation of pain when we established our right to one proxy for three hundred shares. ‘He’s an old friend,’ he gasped, ‘and I bought him lunch when he gave me his proxy.’”
Graham’s group had 37.5% of the votes. The Rockefeller Foundation had 23%. Graham was so convincing the Rockefeller Foundation told the Bushnells that while they were happy to vote their proxies for the incumbent management, they were also happy to have as much capital as possible distributed as quickly as possible. So the Bushnells added Graham’s two insurgent candidates in place of two of their own and the unity board was elected by unanimous vote. Northern Pipeline went on to distribute all its cash to shareholders. Graham’s proxy battle won him a 30% annual return.
Graham won other contested battles at Unexcelled Fireworks and National Transit. He lost some fights with insurance companies. But, over the years, Graham’s activist and control situations were his best performing investments.
Graham would be on Burkle’s side in the Barnes & Noble proxy fight. And he’d also know that situations where a value investor takes on an incumbent management team that is squandering corporate assets are some of the best investments you can make.
Warren Buffett learned from Ben Graham’s example. Buffett loved to coat tail ride on activist situations when he ran his investment partnership back in the 1950s and 1960s. He even went activist himself at Sanborn Map, Dempster Mill, and – of course – Berkshire Hathaway (BRK.B).
Why Wouldn’t Benjamin Graham Buy Barnes & Noble?
Graham pioneered activist investing. He wrote and lectured about management mistreatment of minority shareholders. And he fought a couple successful proxy battles himself. So why wouldn’t Ben Graham buy Barnes & Noble?
It comes down to tangible book value. Graham liked to invest in stocks that were selling for less than their book value. He especially liked to invest in stocks that were selling for less than two-thirds of their net current assets. Barnes & Noble isn’t selling for less than its tangible book value, because Barnes & Noble doesn’t have any book value.
If you look up Barnes & Noble’s book value at most websites, it will say something like $15.35 a share. And that’s right. But that’s not tangible book value. Barnes & Noble has $18.85 a share in intangible assets. That means that Barnes & Noble actually has more liabilities than tangible assets.
Now, personally, that doesn’t bother me one bit. I’ve invested in a couple companies with no tangible book value over the years. And those investments worked out great. But they were Warren Buffett type investments. They weren’t Ben Graham investments. Buffett invests in companies with little or no tangible equity all the time. He owned Moody’s (MCO) and Gillette when each of those had no tangible book value.
Benjamin Graham and Warren Buffett are very different investors. They have different attitudes toward book value. If you listen to what they preach, that might not be obvious. But as we all know, what we preach isn’t always what we practice.
Here’s Ben Graham preaching on intangible assets:
“It may be pointed out that under modern conditions the so-called ‘intangibles’ e.g., goodwill or even a highly efficient organization, are every whit as real form a dollar-and-cents standpoint as are buildings and machinery. Earnings on those intangibles may be even less vulnerable to competition than those which require only a cash investment in productive facilities…We do not think, therefore, that any rules may reasonably be laid down on the subject of book value in relation to market price, except the strong recommendation already made that the purchaser know what he is doing on this score and can be satisfied in his own mind that he is acting sensibly.”
That’s what Graham preached in the 1940 edition of Security Analysis. And I’m sure he believed it. But I’m also sure Graham’s record shows he didn’t practice what he preached in the above paragraph. Graham the academic may not have had any qualms about investing in a stock with a lot of intangible assets. But Graham the investor did. He liked to stick with tangible assets. And that’s one reason why I don’t think Ben Graham would ever buy Barnes & Noble.
The other reason is qualitative. One of Graham’s most famous quotes is: “An investment operation is one which, upon thorough analysis, promises safety of principle and a satisfactory return. Operations not meeting these requirements are speculative.”
We can argue about whether Barnes & Noble meets those requirements. That’s not the point. The quote I actually want to show you comes one page after that famous quote: “An investment is one that can be justified on both qualitative and quantitative grounds.”
And that’s the test Barnes & Noble fails. So even though I own Barnes & Noble, I don’t think Ben Graham would consider it an investment. His reason for saying Barnes & Noble is a speculation is the same reason most people cite: an investment in Barnes & Noble cannot be justified on qualitative grounds.
Obviously, an investment in Barnes & Noble can be justified on quantitative grounds. No one argues that point. If the future was the same as the past, we’d all agree that Barnes & Noble is undervalued. But most of us think the future will be very different from the past. Barnes & Noble’s low stock price and huge short position illustrate that.
How Would Benjamin Graham Analyze Barnes & Noble?
That’s easy. One of Graham’s favorite stock analysis techniques, which I almost never see mentioned, was to look at a company’s capital structure and pretend all the shares of stock were actually bonds.
This is a great mental exercise. But it sounds odd to some folks. I’ll let Graham explain why it works:
“A common stock cannot be less safe than it would be if it were a bond, i.e., if instead of representing full ownership of the company it were given a fixed and limited claim, with some new common stock created to own what was left…it is little short of idiocy to assume that the stock holders would be better off if they surrendered their complete ownership of the company in exchange for a limited claim against the same property at the rate of 5 or 6% on the investment.”
So let’s look at Barnes & Noble. What if we replaced all of the company’s stock – at current prices – with bonds. Barnes & Noble has an enterprise value of $1.15 billion. According to Bloomberg, junk bonds currently yield around 8.47%. So, if we replaced all 58 million plus shares of Barnes & Noble stock as well as all the debt owed to Riggio, we’d end up with annual interest payments of $97.5 million.
If we compare those fixed charges of $97.5 million to Barnes & Noble’s actual performance, we see that the company’s operating income could cover that at all times up until this year. Graham never used one year averages. He focused on the average coverage ratio over 7 years. On average, Barnes & Noble’s Earnings Before Interest and Taxes (EBIT) would have covered that $97.5 million in junk bond interest a little over 2 times. And on average, Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) would have covered junk bond interest 3.87 times over the last 7 years.
The lowest EBITDA coverage ratio was 2.88. Not surprisingly, that was this year. Again, we see the problem with performing any kind of valuation analysis on Barnes & Noble. Even if the stock is so cheap that you could replace the entire capital structure with bonds based on the company’s past performance, you could never really replace all the stock with bonds, because everyone knows the coverage ratios will get worse and worse for years and years to come.
So, maybe Barnes & Noble stock isn’t cheap. Maybe it just looks cheap based on the past.
That might be right. But that’s pure speculation too. We need some way of quantifying something here. Unless, of course, you believe Barnes & Noble will never turn a profit again. If things are only going to get worse and worse forever, well then the stock is clearly worth zero.
Benjamin Graham would never allow that kind of thinking. In fact, in Security Analysis, he explains why even a company that has had declining earnings for 10 straight years can still be a good investment. How? By having a huge margin of safety.
What is Barnes & Noble’s Margin of Safety?
Every investment needs a margin of safety. We know there is a big margin of safety baked into Barnes & Noble’s current share price relative to past performance. But we aren’t worried about past performance. We’re worried about the future. So we need to quantify how big that margin of safety is.
The easiest way to do that is to value the stock based on future free cash flow. How far do Barnes & Noble’s sales and margins have to fall to make the stock worth no more than $15 a share?
If sales fall 33%, from $5.81 billion to $3.87 billion, and the free cash flow margin narrows from a 10-year average of 3.87% to just 2%, Barnes & Noble would have $1.32 a share in “normal” free cash flow. That means today’s price of $14.46 a share would be 11 times free cash flow. A normal “Shiller P/E” type number is 15. So, that means sales would have to fall not 33%, but more like 50%.
So there’s our margin of safety. If a steady future free cash flow margin is 2% for Barnes & Noble, sales have to fall 50% to eliminate the margin of safety and bring the stock’s intrinsic value down to the level it now trades at.
The reason for this huge margin of safety is Barnes & Noble’s low price-to-sales ratio. The company trades for $14.46 a share. It has $98.72 a share in sales. That kind of discrepancy can’t continue to exist unless you expect the company to have a free cash flow margin of nothing. In other words, you expect it to go broke.
If you do, I can’t quantify anything. A company that will never turn even 2 cents per dollar of sales into cash is a company I can’t evaluate. No one can. It would be worthless at any price.
And maybe Barnes & Noble’s stock is worthless at any price. I have a hard time believing that. Barnes & Noble is not facing a near-term bankruptcy risk. It is only now on the verge of reporting annual losses. In fact, Barnes & Noble isn’t so much a turnaround as it is a company on the verge of permanently declining sales.
I know no one believes me on this, but as I wrote when I compared Barnes & Noble to Blockbuster, permanently declining sales are not a common reason for a stock going to zero.
There are many industries that are smaller today than they were in the past. If the stocks of companies in those industries traded at normal price-to-sales ratios when their sales started to decline, than obviously those stocks kept dropping. But, if a stock’s price-to-sales ratio is already low, there is no guarantee that permanently declining sales will lead to a permanently declining stock price.
One reason for that is timing. The margin of safety calculation I did, that Barnes & Noble stock is now pricing in a 50% drop in sales and a free cash flow margin of 2% assumed that happened instantly. In other words, it assumed we reached a steady state tomorrow.
We won’t. It takes time for sales to drop 50%. In the meantime, you either make money or lose money. You either generate cash or consume it. If Barnes & Noble was pursuing a store growth policy like Blockbuster did long after it made sense – and if Barnes & Noble was in terrible financial shape (like Blockbuster has long been), I wouldn’t take that margin of safety so seriously.
But, because the company is not in a weak financial position, and because everyone involved has said they have no intention of putting more capital into new brick and mortar stores, I do take that margin of safety seriously.
And, of course, that isn’t your only protection here. The biggest danger in this kind of investment is that the management completely ignores reality and continues to move down a doomed path. Barnes & Noble hasn’t done that when it comes to the e-book. And I don’t think Burkle would do that if he took over the company.
So, in addition to the quantitative margin of safety you get from a 50% sales decline and a narrow 2% free cash flow margin still being enough to cover the current stock price, you also get a kind of defense in depth.
You have the possibility of someone – maybe Riggio or Burkle – bidding for the company. You have a large short position that creates future buying demand for the shares. And you have the possibility that Burkle will win the proxy battle. If he does, that both increases the chance of a buyout and puts someone in charge who shares Ben Graham’s active value streak.
So, even though Ben Graham wouldn’t buy Barnes & Noble, his approach to analyzing stocks is what led me to buy the stock.
Disclosure: Geoff Gannon owns shares of Barnes & Noble (NYSE:BKS)
This is the fifth article in Geoff Gannon's series covering the Barnes & Noble proxy fight. For additional background read:Why Would Anyone Buy Barnes & Noble () Stock at $15 a Share?,Who is Ron Burkle? Why Does He Want to Control Barnes & Noble ()? And How Does He Know Charlie Munger?, Who Will Win the Barnes & Noble (NYSE:BKS) Proxy Fight? Ron Burkle? Or Len Riggio? and What Does Ron Burkle See in Barnes & Noble (NYSE:BKS)?