Thursday, August 26, 2010 1 comments ++[ CLICK TO COMMENT ]++

The Beginning of the End of Barnes & Noble?

On the first page a donkey asks a monkey, "What do you have there?" The monkey replies: "It’s a book."

"How do you scroll down?" the donkey asks. "Do you blog with it?"

Then he asks: "Where’s your mouse? ... Can you make characters fight? ... Can it text? ... Tweet? ... Wi-Fi? ... Can it do this? TOOT!"

No, the monkey repeatedly replies. "It’s a book."

A few weeks ago, writing for GuruFocus, Geoff Gannon laid out the bullish thesis that underpinned his purchase of Barnes & Noble (BKS). For those not familiar, Barnes & Noble is the largest bricks & mortar book retailer in North America (and possibly the world?). Since this was a contrarian decision—many have given up on book retailers—and it involved a mid-cap company—I don't generally like investing in microcaps and smallcaps, which are common with many amateur value investors—it piqued my interest.

A Bullish Case for Banes & Noble

Initially, Gannon's investment seemed uncharacteristic of him. He doesn't disclose all his transactions so it's not clear what his strategies are but I always felt that Geoff Gannon was a classic value investor—very Benjamin-Grahamesque but possibly with concentrated holdings—and Barnes & Noble seemed like a specualtive bet on a merger. But reading some of his other articles and comments in some messages, it appears he has invested in similar takeover-type situations so this may not be as foreign for him as it seems. In any case, here is a bullish investment thesis for Barnes & Noble:
We all agree print is dead. So why am I buying Barnes & Noble stock at $15 a share?

I’m buying the stock at $15 a share, because Barnes & Noble (BKS) is not a cultural icon, a sign of the times, or a morality tale. Barnes & Noble is a stock. And that stock’s price is subject to supply and demand. In this case, supply is low and demand is high. Or it soon will be...

Barnes & Noble has less than 59 million shares of stock. Ron Burkle and his allies own just under 21 million shares. While Len Riggio and his allies own just over 21 million shares. That leaves 17 million shares of Barnes & Noble stock for outsiders. And those outsiders have sold short 12 million of those 17 million shares. Both Burkle and Riggio want to control Barnes & Noble. Each contender needs another 7.5 million shares to take majority control of the company. Since the two men hate each other and neither is willing to sell his shares to the other, the only supply of shares available to them is the 17 million shares in outside hands. And since Riggio and Burkle both need to keep all the shares they already own to fight for control of the company, the only supply for the short-sellers to buy back their stock is those same 17 million shares in outside hands.

That puts outside shareholders in the catbird seat. In this unique takeover battle, passive minority shareholders – folks like you and me – are in a better position than Burkle, Riggio, or anyone who has sold a lot of Barnes & Noble stock short. We can supply any of the parties: Burkle, Riggio, or the short-sellers.

For those not aware, there is a takeover battle for Barnes & Noble. One party is the founder, current CEO, and majority owner; the other is an outside activist investor who is trying to gain board representation. Gannon appears to be betting on one of these parties taking over the company. In such a case, it is likely the parties will pay well above the current $15ish share price for full control.

There is a lot of behind-the-scenes action in this takeover battle so you may want to read some articles about the characters. If interested, you might want to check out a piece written by Geoff Gannon about Ron Burkle—it includes a link to a long biography from Bloomberg Businessweek. If interested in the legal machinations, this article from New York Times' DealBook should bring you up to speed. Perhaps the best article on this matter is the following article, "The Billionaire and the Book Lover," by Andrew Rice for New York magazine (if you are interested in this as an invesment opportunity, read this latter article).

In a very rough sense, Gannon's position is almost like a risk arbitrage bet. He is betting on some favourable event to materialize. The favourable event in this case would be an offer by either Riggio or Burkle to buyout the company at higher prices, or short-sellers covering their bets by buying back shares at presumably higher prices.

I wouldn't invest based on Gannon's thesis (or at least my interpretation of what his strategy appears to be.) The problem is that there is a fairly high probability—this is just my guess—of the status quo being maintained. Namely, if Riggio wins and maintains his influence over the board of directors, it's quite possible that he may just leave the company as is (i.e. not take it private). In such a scenario, it's possible that the stock price may collapse back to $13 (I wasn't following the situation closely but, like in risk arbitrage, $13 appears to be the price before the latest round of buyout rumours and speculation caused the price to gap up).

For what it's worth, my view based on limited readings is that Riggio is probably the better bet to rescue Barnes & Noble. However, there will be poor corporate governance if he controls the company. For instance, the deal to buy Barnes & Noble College looks like a dubious deal, since Riggio was the key individual that cashed out, while Barnes & Noble ended up with fairly sizeable debt and ownership of a potentially declining college/university book business. Burkle, on the other hand, has some radical strategies that can easily make or break the company. As an example, Burkle's idea of potentially merging with Borders is a likely disaster-in-the-making. Barnes & Noble will be far better off if it lets Borders go bankrupt (William Ackman may disagree with me but there is a very high chance of Borders going bankrupt).

So, although intriguing, I wouldn't invest based on Gannon's thesis... If that was the end of the story, I wouldn't be wasting my time writing this post. Simply writing an article to dismiss someone's investment case doesn't accomplish much.

Is Barnes & Noble Still Worth Contemplating?

I'm more top-down so I started thinking about whether it's worth investigating Barnes & Noble, ignoring the takeover scenario. In other words, is Barnes & Noble a good long-term buy & hold investment? That is my interest with Barnes & Noble; I don't really care that much about the buyout scenario.

I think I decided to contemplate Barnes & Noble because it is a contrarian stock and it is somewhat akin to the newspaper industry (I spent a lot of time researching the newspaper industry.)

I have to do way more research on valuation but Barnes & Noble looks somewhat cheap. Geoff Gannon actually did some solid thinking on this and came up with some ballpark figures that seem reasonable to me:
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.
Barnes & Noble may be in a declining industry and can go broke so one better be sure that's not the case (i.e. assumption has to be a declining, struggling, industry and not one that is going to zero tomorrow). But overall, Gannon's argument is pretty powerful—at least to me.

Gannon astutely points out how price to sales is very low for this company. Running a quick stock filter from Yahoo! Finance—note that numbers are not always accurate on Yahoo! Finance but it's a good rough check—shows that there are only around 70 stocks with market cap over $500m with P/S of 0.2 or less (and positive). Needless to say, most of those are very-low-margin businesses like oil refineries, supermarkets, auto parts suppliers or airlines. Also unlike many companies with such low price-to-sales ratios, Barnes & Noble doesn't have much debt.

So, even if sales fall, as long as Barnes & Noble is earning something, it will probably do ok. I haven't done enough research but I think same-store-sales has been declining for a few quarters already. I typically use P/E to value a company and I don't have anything yet; I need to do more research. The balance sheet is fairly clean and there is room for financial flexibility (dividend can be cut, etc.)

How About the Macro Picture?

I did a lot of research on the newspaper industry in the last 2 or 3 years and although I didn't post much on the blog about it (mostly because there wasn't much of a bullish case and I couldn't come up with a business model for their survival), I thought a lot about what happened, is happening, and may happen. Books appear to be somewhat similar to newspapers. Both are facing serious threats from Internet or electronic media. The general consensus is that both these industries are going to zero, at least in their current form.

I see very little hope that the newspaper industry will survive. Maybe two or three big brands can transition to the online world but due to legacy costs, even those will probably have a hard time surviving. Is that the case with books?

I see some articles suggesting that the book industry will follow the newspaper industry's path but my guess is that it won't. There are some big differences.

My Opinion on the Newspaper Industry

The reason the newspaper industry is dying is not just because people are reading less newspapers. It's also not because they lost their profitable advertising. Rather, it's because they lost all of their profit centers. I think newspapers would have survived for another one or two decades, but in a declining industry, if only their advertising rates kept declining (due to competition from Internet). Instead, what totally killed them is the complete loss of classifieds, real estate listings, auto sales listings, etc.
Remember, a huge swath of the population above 40 still read physical newspapers. Although circulation figures have been declining, they are still in the millions. The problem is that newspapers lost their highly profitable sources (such as classifieds.)

Opinion of the Book Industry

I know very little about the book industry—neither a book lover nor have I done much research—but I just don't get the feeling that books are facing the loss of their core profitability.

In some sense, books are facing problems similar to the music industry. The music publishers have been facing some difficulties due to the emergence of electronic forms of music (such as single songs sold through Apple's iTunes). Even if the book industry is starting to resemble that, it isn't quite the same. The music industry faced catastrophic declines in sales because a CD/record, containing up to 15 songs, generated way more sales than a few songs purchased individually. There were singles CDs but most people spent $15 or $20 buying a full CD but nowadays people spend $5 or $6 buying 5 of their favourite songs. The book industry doesn't appear to be set to see similar declines because there is no bundling problem, so to speak.

Having said that, there is definitely a challenge as books shift to electronic forms (such as e-books). Some, such as Mike Shatzkin, have pretty much written off physical books. Book retailers will see big declines in sale but they likely won't be as big as the CD music retailers. In his article, "The Billionaire and the Book Lover," Andrew Rice says this about the shrinking margins:
Under the prevailing system, it pays $13 wholesale for a hardcover book that retails for $26. With e-books, margins are far lower as of now, typically in the neighborhood of $3 or $4.
In other words, sort of like clothing, book retailers have a markup of around 100% on physical books right now.  With e-books, the markup appears to be around 23% ($3 for a $13 book).

So there is definitely huge compression in margins. The question is whether Barnes & Noble can handle this decline in margin. If it didn't have physical stores, like Amazon, the small margins won't be a problem. But for a bricks & mortar retailer, often located in malls with very expensive rents, it will be a challenge. (As a side note, many new industries are won by new companies, likely because of the lack of legacy costs for them.)

Unlike the music industry, or the newspaper industry, it is likely that people will consume physical books for a long time. Even with more advanced e-readers, the shift will be more difficult than music/newspapers. For example, school textbooks, books with pictures, and so forth, are still a long way away. So far, simple books, mostly fiction, has been the popular e-book genre.

Since Barnes & Noble has a very low price-to-sales ratio, all it needs to do is to turn a small profit and it will be satisfactory to shareholders. As long as it doesn't make questionable acquisitions, like Barnes & Noble College, it seems to have a high chance of surviving.

I may have mentioned this before but to repeat, one of the contrarian investment strategies is the so-called 'last-man-standing' strategy. Namely, you invest in something, even if the industry is declining, because one company will stand still in the end. It may collapse eventually but before it does, it will keep taking away market share, and hence profits, away from the competition. The situation here is a bit complicated because of Amazon—ironically my favourite company and probably the only company that will bankrupt Barnes & Noble. But nevertheless, Barnes & Noble will likely post a profit as competitors, such as Borders, fall, and the modern industry slowly declinines.

Final Word

I don't know what sort of valuation to put on Barnes & Noble. I am researching the industry and until I get more confident, I'll probably do nothing. I think the strategy of buying here due to potential takeover doesn't seem safe. The upside looks low: Burkle has suggested he was willing to bid something like $25 before but thinks it will be lower now. A conservative estimate is probably $20, which is a 33% upside (note: this isn't necessarily what I would expect the company to be sold for in a bidding war, but it is a good conservative guess.) The near-term downside (if Riggio wins and does nothing) is probably all the way down to $12, which is where the shares were a few weeks ago. That's a decline of around 20%. A price around $12 also would put it near a 15-year low so that's probably a good downside estimate (without doing a lot of detailed analysis). If the market continues to sell off, the shares could trend down but that's hard to predict.

Overall, I think this is an interesting contrarian situation even if you ignore the potential change in ownership. I don't exactly have a good track record calling these things but this is a far better contrarian situation than some of the other ones I have looked at over the years (such as homebuilders, forestry stocks, and newspapers.)

On its way to bankruptcy? Or not?

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1 Response to The Beginning of the End of Barnes & Noble?

February 6, 2013 at 1:47 AM

Book stores just are not what the used to be many long years ago. Just like newspapers

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