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Barnes and Noble--A Bargain Hiding in Plain Sight

December 18, 2013 | About:

Joel Greenblatt, in one of my favorite books on investing, said the following:“The reason why major corporate restructurings may be a fruitful place to seek out investment opportunities is that oftentimes the division being sold or liquidated has actually served to hide the value inherent in the company’s other businesses.”It was with this basic scenario in mind that I began studying Barnes and Noble a few months ago.

The Case For BKSI think Barnes and Noble is significantly undervalued and likely worth somewhere between $20 and $30 per share. Although there are industry headwinds in the traditional book business, Barnes and Noble has a strong brand name, significant insider ownership, strategic partners in Liberty and Microsoft, a clean balance sheet, and best of all—the core business trades at just 5 times the average pretax earnings from the past 15 years and 4 times the trailing year’s pretax earnings.Why Is It Undervalued?Barnes and Noble has three basic operating businesses:

  • B&N Retail (the traditional bookstores and the bn.com ecommerce business)
  • B&N College (college bookstores located on or around college campuses)
  • Nook Media (sells digital books for any device as well as Nook ereaders)

The thesis for investing in Barnes and Noble is simple. The profitability of the Retail and College divisions is being significantly masked by the money losing operations of Nook Media, LLC. This is not really a secret, but the market continues to price Barnes and Noble at a significant discount to the intrinsic value of the Retail and College businesses (without the Nook).Here are the operating profits from each division from the fiscal year that ended April 2013:

  • B&N Retail: $227 million
  • B&N College: $65 million
  • Nook Media: ($512 million)

So on the surface, Barnes and Noble is losing about $220 million per year. But if we remove Nook Media from the picture, we are left with a company that produced $292 million in operating earnings last year. Better yet, this business has been profitable for more than 15 consecutive years, with stable margins and consistent free cash flow. The risk is that management continues to invest in a money losing enterprise, throwing the proverbial good money after bad. But with significant insider ownership and strategic partners/board members, I don’t think this will be the case for too much longer.Two years ago, Liberty Media invested $204 million into B&N preferred stock that is convertible into common shares at $17.00 per share.

If we include these 12 million shares, Barnes and Noble has 71.7 million shares outstanding, which gives it a market capitalization at $14.00 per share of around $1 billion.So we have a $1.0 billion business that produces $292 million in operating earnings. If we assume the brick and mortar business pays all of the current interest, the pretax profit of this business is $256 million.

So ex-Nook, BKS trades at about 4 times pretax earnings.Common MisperceptionThe common misunderstanding is that the recent losses at B&N are due to the fact that the book industry is in decline and the brick and mortar business is dying a slow death at the hands of Amazon, Apple, and other internet competitors.I wouldn’t argue against the fact that ereaders and digital content poses strong competition for traditional bookstores, but this is not the reason for the losses at B&N (at least they haven’t been yet).

The irony is that Barnes and Noble is sustaining operating losses because of the Nook business, which is supposed to be the business that allows the company to survive and compete in the new digital content world.So despite the common misperception, the traditional bookstore business at Barnes and Noble is consistently profitable, despite top line and overall industry headwinds.15 Year DataIn fact, the bookstore has produced positive free cash flow in each of the last 15 years. I went through the last 15 years of annual reports and separated out the Nook business, and the formerly owned Gamestop (which B&N owned around 15 years ago).

My objective was to create a picture of the last 15 years of operating results from just the bookstore and traditional ecommerce business (includes Retail, College, and bn.com). This chart shows the profitability of the traditional bookstores:
BKS-10-Year-Data.jpg

So the traditional business (not including Gamestop and Nook) has averaged $195 million of pretax profits per year. At the current price of $14, you get a business that has averaged $2.72 per share in pretax earnings and$2.00 per share in free cash flow over the past 15 years.Estimating for taxes, the traditional business trades at about 7 times average 15 year free cash flow.Margins have historically been quite stable in this business as well (note: I didn’t find segment gross margin data for 1999-2001):

BKS-Margins.jpg

So we have a consistently profitable bookstore business that without the Nook trades at mid single digit earnings multiples.But what about the Nook? That’s of course the reason why BKS stock has been floundering. Ideally, Len Riggio, the founder, chairman, and 26% owner of BKS will at some point decide to sell or separate the Nook business. Although management has recently seemed to indicate they plan to continue investing into the Nook (a dubious strategy), at some point—if the Nook continues to lose money and destroy value—I think Riggio will want to stop the bleeding. Barnes and Noble is his pride and joy, and represents a sizable amount of his personal fortune.There are some large shareholders with sizable amounts of money resting on the fate of this business:

  • B&N Founder Len Riggio has a 26% ownership stake in Barnes and Noble
  • Liberty Media (run by media mogul billionaire John Malone) invested $204 million into convertible preferred shares, which effectively gives them around 17% ownership along with two board seats

So you have two key insiders with large stakes. And although I think BKS is significantly undervalued even if the Nook shut down tomorrow and was worth $0, there is likely some sizeable value there as well:

  • Microsoft invested $300 million into Nook in 2012 at a valuation of $1.7 billion for Nook Media, LLC
  • Later in 2012, Pearson invested $89.5 million into Nook at a valuation of $1.789 billion for Nook Media, LLC.

So you have strategic investments from major companies that have valued just the Nook business at around $25 per BKS share, which values the rest of BKS (the profitable business) for -$11 per share.These investments by Microsoft and Pearson have liquidation rights, meaning that they essentially get their money back, but along the way, Microsoft has agreed to pay B&N up to $85 million per year as part of that investment deal.ValuationWhile I don’t think Nook is worth twice what the entire company is worth, it likely is worth more than $0. Maybe it’s worth half of the $1.8 billion valuation ($12 per share), maybe it’s only worth 25% of that valuation ($6 per share). But let’s assume it’s worth $0. If Nook closed its doors tomorrow, what would BKS be worth?Here are some numbers to consider when valuing the Retail and College business (excluding Nook):

  • Average 15 year pretax earnings per share: $2.72
  • Average 10 year pretax earnings per share: $2.76
  • Average 5 year pretax earnings per share: $2.50
  • Average 3 year pretax earnings per share: $2.64
  • Last year’s pretax earnings per share: $3.57

So the earning power of these traditional bookstore businesses seems to be quite intact. Here is one more look at the last 15 years of pretax profits (again, this excludes Gamestop and Nook operations):
BKS-Pretax-Profits.jpg

It’s a business that–although is not growing and facing industry headwinds–continues to be consistently profitable. Pretax earnings were positive each year and ranged from a low of $116 million to a high of $256 million, the latter which happened to be 2013!So while we can speculate about the future, it’s hard to make an argument that the brick and mortar business is currently in terminal decline.The other thing to consider is that Barnes and Nobles—unlike Borders, Blockbuster, and other brick and mortar bankruptcies—has a very strong balance sheet with just a modest amount of debt to total capital.I think that the profitable Retail and College business is collectively worth somewhere between 7-10 times earnings.

Historically, a business this consistent would likely be worth at least 10 times pretax earnings over a full cycle (or about a 6.5% after tax earnings yield), but given the industry headwinds, I’ll use that number as the high end, but maybe the value is closer to the low end.At 7-10 times average 15 year pretax earnings, we arrive at a value of somewhere between $19 and $27 per share. Again, this values the Nook at $0. So if the Nook is equal to $0, then I think BKS is modestly to materially undervalued at $14 per share.Possible CatalystsBut I see some catalysts that could happen that will likely increase this value:

  • Nook business could get sold for cash to Microsoft or some other competitor
  • Nook could get separated or spunoff
  • College business could get spunoff or sold
  • Len Riggio could decide he wants to personally buy the Retail business
  • Len Riggio decides he wants to sell the Retail business to a private buyer (unlikely, but possible)
  • Something that I wouldn’t count on, but could occur—Nook Media becomes a successfully profitable business

I think a private buyer would likely have to pay closer to $30 per share for the collective value of those assets.Keep in mind a few other quick points in this sum-of-the-parts consideration:

  • College is a consistently profitable business that was purchased in 2009 for $596 million
  • BN.com (the original ecommerce business prior to Nook development) was purchased by Barnes and Noble at a valuation of $446 million
  • Microsoft and Pearson invested into Nook Media at a valuation of $1.7-$1.8 billion
  • BKS Current Market Capitalization: $1.0 billion

It’s also interesting (although irrelevant to the current value) to note that in 1999 Len Riggio sold Gamestop to B&N for around $208 million, and it was subsequently partially sold to the public at a valuation of $1.2 billion, or a six-fold increase for shareholders in just a few years. B&N then spun off the remainder of Gamestop in 2004, and this company now sports a market valuation of $5.6 billion, nearly 6 times the value of Barnes and Noble. For long term B&N shareholders that held Gamestop, they have seen significant gains despite the poor performance of BKS. This is more or less just an interesting anecdote on an investment that created enormous value for shareholders.

To Sum It Up

I think you have a consistently profitable and stable bookstore business with steady free cash flow, stable operating margins, a powerful brand name, significant insider alignment, trading at a price of just 5 times long-term average pretax earnings. This value is masked by the money losing operations of the Nook, which may at some point get sold, separated, or—most unexpected of all—turn around and become a profitable division for Barnes and Noble.

In the words of the billionaire retail investor Rob Burkle (who was a large BKS shareholder but sold his stake after losing a proxy battle):

“We always try to buy companies that are doing O.K. but that have some issues. We buy at a price that if they just muddle through, we don’t go broke. And if they do better, we make a lot. Since I was 13, I’ve been buying things because they are ridiculously cheap.”

I think given the brand, insider alignment, and the core business profitability, Barnes and Noble will achieve results somewhere between “muddling through” and “doing better”, which should result in satisfactory results for shareholders.

About the author:

John Huber
I am the Portfolio Manager at Saber Capital Management, LLC. Saber manages an investment partnership as well as separately managed accounts for clients interested in a focused value investing strategy. My investment style has been most influenced by Ben Graham, Walter Schloss, Warren Buffett, and Joel Greenblatt. I am also the author of www.BaseHitInvesting.com, a value investing blog.

Visit John Huber's Website


Rating: 4.1/5 (7 votes)

Comments

20punches
20punches - 1 year ago
Great write-up and thanks for the in-depth analysis, John. Can you comment on how Barnes and Nobles is different from Borders? What strategies BKS has in order to effectively fend off Amazon's rising power? 
John Huber
John Huber premium member - 1 year ago
Thanks Ning. That's a good topic (Borders) to discuss, and might be another post... but I have some off the cuff opinions... Barnes and Noble often gets compared to Borders for good reason. They are (were) the two largest bookstores. But there are two major differences. Although both dealt with the same industry headwinds, B&N has two things that Border's didn't... a clean balance sheet and a profitable cash flowing bookstore.  As I mention in the article... B&N bookstores are quite profitable, and Borders were not.  My thesis is really that at 4 times bookstore earnings, I'm really not paying much. I get paid back in less than 6 years after tax. My guess is B&N will still be around, so that leaves little chance of permanent capital loss when only looking at the bookstores.  I assume (like everyone else) that sales will slowly decline due to Amazon and other internet competitors. But even if sales go down another 25%, and they can close stores and shrink the business and maintain a sales and operating level that they had in around the mid 2000's, say $5 billion in sales and 3.5% operating margin, you'd still be getting $100 million of net income on a $1 billion company.  B&N has been closing stores and operating margin has actually increased the last couple years even with lower store count and lower sales. Plus they have very little long term debt, and best of all, they have high insider ownership that most likely will do whatever it takes to protect their stake.  Riggio and Liberty own what amounts to nearly half the shares, and they will shrink the store count to maintain profitability if they have to.  Of course, all this is moot if they keep spending capital on the Nook with no (negative) returns. But at some point, I think they have to separate that business or sell it, and I expect they will.  When that happens, you're left with a cash flowing bookstore with high insider ownership. Even in a declining industry, it's tough to lose money on something this cheap. One last thing... without Borders, I'd argue that B&N's position is that much stronger. I think books are lot different than music/video (Blockbuster) and as a Peter Lynch anecdote, every time I'm in the stores, they are packed... and it's not just shoppers, the checkout lines seem busy too. With $6.3 billion in sales, they seem to be holding up well. But none of that is priced in at 4 times pretax earnings.  Get rid of the Nook... it's a money losing business, but it's worth something to someone (Microsoft). Sell it or spin it, create some value for the shareholders, and operate a profitable bookstore even if the industry winds are against them... 
20punches
20punches - 1 year ago

John, thanks for your detailed response. That was helpful. I agree at this price, BKS does look very attractive with a clean balance sheet. Nook has been losing the battle to Kindle and BKS may very well better off just selling off the Nook segment. It also looks like sales from non-book items such as gifts, games, toys are accounting for a rising percentage of total sales too.

I hope you don't mind another two questions.

1)Have you done any study on why BN bookstores are quite profitable, and Borders were not?

2) Is there a way to look at the detailed revenue and expenses for the segments? My concern here is that as the disclosure in the annual report and 10qs are a little vague, they can easily reallocate expenses among these 3 segements. For example, depreciation and amort expenese for Nook segment accounts for almost 20% of total dep and amort expenses for YTD 2013 vs only 10% for 2012. That doens't make sense to me as Nook sales only accoutns for less than 10% of total sales.

I'm definitely not trying to be annoying here. I've had a few experiences with similar situations (industry headswind) and wanted to proceeed with caution.

Thanks

ansgarjohn
Ansgarjohn - 1 year ago
My guess is you don't own a Kindle John. Is that correct?
John Huber
John Huber premium member - 11 months ago
Hi Ansgarjohn, I don't own a kindle, although I think it is a very nice product. I don't really have a comment on the Nook or Kindle or how superior/inferior they are.  Also, regarding Ning Jia's questions... I think the big picture here is more important, because although there might be small line item adjustments coming from this "probe", I think there is such a disparity between price and value that these adjustments--although might be large--will likely not affect my overall investment thesis.  This investment is really of the special situation/corp restructuring type that masks a profitable business. I don't have time to go in depth into the financials--although I've studied them in depth, but let me just paint a general picture of this investment using a metaphor.  As I explained in a comment on my blog: imagine you can buy a car wash holding company in your town. The company comes with two individual carwash locations. The business costs you $140,000 for the two locations. One location makes $40,000 of income before interest and taxes, the other location loses $70,000.  Plus, you have a strategic partner who has invested into the second location (the money losing carwash) at a valuation of $250,000.  Would you buy this holding company?  I'd certainly be interested in taking a closer look. Shut down or liquidate the losing location and you're left with a profitable car wash that makes you $40,000 per year on a $140,000 investment. Even if the national carwash company is gaining market share and competition with other carwashes and gas stations is fierce, you're still paying just 3.5 times earnings for the car wash. You wouldn't necessarily be thinking about the long term growth opportunities of the car wash. You'd make your return by milking it for cash. If it lasts 10 more years, it will be paid you 2-3 times your initial investment in cash flow.  That's kind of how I approach B&N. I never once presumed that it will become a better business than Amazon or other competitors. But at 3.5 times operating earnings and the chance to spin/sell Nook Media for a value that is likely greater than $0, I found it an attractive special situation.  The numbers in the car wash example correspond to the share price of B&N. $14 per share gets you one profitable (actually two-but I combine College and Retail for simplicity) making $4 per share. The other business loses $7 per share. Microsoft and Pearson have invested into the losing business at a valuation of $25 per BKS share.  It seems like there is more value here than $14, regardless of the quality (or lack thereof) of Nook, the competition, and other factors.  The key of course is management. The car wash example is easy, because you control the fate of the losing location. Here you have to rely on management to make good decisions. With key insiders owning around half of the company, I believe at some point, they will make value accretive decisions. 
20punches
20punches - 11 months ago

John, I absolutely agree the big picture here is more important and I think your thesis may work out very well. My point is, if the thesis is that you can buy a business that makes 292 million reported pretax profit for 1 billion, the reliability of the reported 292 million is important because it could be less or it could be more on a look-through basis. And if it is more, it's even better but if it is less, it could change the game. And agreed that high insider ownership% is a big plus and the incentive is in place to make value accretive decisions.Thanks againf for taking the time and answering my questions. - Ning

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