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Tough Times

Barnes & Noble (BKS) continues to have a rough go of it, and July-quarter results did not offer much encouragement. The bookseller’s top line increased 2%, to $1.4 billion, on the back of a 37% jump in revenue generated on BN.com. Sales declined everywhere else, however. At B&N stores, revenues dropped 3% and same-store sales were off 2%, as sales of traditional books remained soft. Finally, Barnes & Noble’s College Bookstore notched a 2% top-line decline. The only bright spot was the consolidated NOOK business, which includes digital content, device hardware, and related accessories. Comparables here were very favorable, but sales gains were not enough to mitigate other weaknesses.

The company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) remained in the red in the period, coming in at a loss of $23.6 million. Delving deeper, we noticed that gross margins widened nicely, on both the digital and retail fronts, but the bookseller’s high fixed costs and lack of operating leverage undermined this advance. All told, B&N lost $56.6 million, or $0.99 a share, in the quarter.

Can The Bookseller Turn It Around?

After looking at July-quarter results, the future of Barnes & Noble becomes more and more cloudy. The online business, which has been around for a long time, is still operating in the red, and competition is fierce. Amazon (AMZN) remains the key player in this space, and things are just not going to get any easier. The College Textbook unit’s performance also leaves a lot to be desired, considering the wide margins that are typical in this business.

Management has big plans for the NOOK, and the future of Barnes & Noble is riding on it. Currently, this product competes with Amazon’s Kindle and newly unveiled Kindle Fire, Sony’s (SNE) Reader, and Apple’s (AAPL) iPad, among others. The company currently expects that sales of its e-reader will surpass the $2-billion mark this fiscal year, and is estimating there will be plenty of profits down the road. We think sales will be very strong, but the earnings part is far less certain. B&N can potentially parlay the robust NOOK volume into profits if it can convince users to purchase extremely high-margin digital content on BN.com. However, the bookseller is quickly running out of cash and debt balances are high. So the real question is whether or not Barnes & Noble can build a loyal customer base and a profitable online enterprise before funds dry up or financiers go into hiding.

A New Partner

Last year, Barnes put itself up for auction, but the queue of buyers that management expected never materialized. One knight in shining armor came forward, Liberty Global Media (LBTYA), which offered $1 billion ($17 a share) for BKS. The deal was applauded by shareholders in large part due to the handsome premium it represented at that time. But as the two entities approached the altar, Liberty got cold feet. No precise reasoning was provided as to why the buyout talks broke off, but the recent market volatility is said to have made it difficult for the parties to agree on a valuation for the NOOK franchise. Some grumblings on the Street pointed towards issues with institutional investors that have sizable chunks of BKS shares.

Upon announcing there would be no full-scale sale, the bookseller disclosed that Liberty Global was going to invest $204 million in the company through the purchase of newly issued convertible preferred stock. Under the terms of the deal, Liberty’s shares are convertible into approximately 12 million common shares (or 16.6% of B&N) at a price of $17 a share. The annual dividend on the preferred is 7.75%.

The funds are a much needed cash infusion, as the company still has a lot of work to do, in our opinion. Barnes & Noble and Liberty Global have to stop the bleeding and turn the company around by creating a profitable business model. We think management should focus on the daunting task of competing with the likes of Amazon and Apple, and constructing the e-reader people want as well as the online shopping experience customers prefer. Along this same line, we think the company should scrap the idea of going head-to-head with companies like Wal-Mart (WMT - Free Wal-Mart Stock Report) and Target (TGT) in the bestseller space. It is just not worth the resources at this point in time.

Conclusion

Barnes & Noble seems to be plotting a course on the right track, and may well find a way to succeed in the long run. Maybe the bookseller will team up with Microsoft (MSFT) or Google (GOOG), and become a spoke in a much larger wheel? In the near term, though, we recommend these shares to only the most risk-tolerant investors. The dividend yield is excellent and 3-to 5-year capital gains could well be huge, but B&N has a lot of ground to cover.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.