books a million logoBy Eric of The Fit and Value Investor

Books-a-million Inc. ($BAMM)
Price at time of writing and research: $3,54
Current price: $3,24
Write-up: Friday the 17th of June, 2011
Estimated intrinsic value: $6,42
Estimated Margin of Safety: 37,4%
www.booksamillion.com

As promised, I hereby post my investment thesis about Books-A-Million. I found this firm via screening. I noticed that it looked undervalued on the basis of both the balance sheet and discounted cashflows. That was an immediate trigger for me to dig deeper into the world of brick-and-mortar retail and especially the book business.

Business

Books-a-Million is the third largest book retailer in the U.S. Books-A-Million sells for the most part books via a chain of bricks-and-mortar superstores, traditional stores and via the Internet. Next to this, they have successfully engaged in cross-selling other related merchandise like gifts, toys, cards, collectibles, magazines, music and movies. Customers can also enjoy a cup of coffee or tea in each instore Joe Muggs café to create a comfortable and ‘convenient reading experience’. Their main market coverage is within the Southeastern states of the U.S.A. and is through 210 Superstores which has an average size of 23.500 ft and 30 traditional smaller stores with an average size of 4.500 ft.

The books and magazine business is where they get 95% of their revenues from. The other 5% of the revenues come via internet sales. Underneath is a small breakdown given of their revenues. Clearly, books and magazines revenue is in a downward trend. However, in the case of Books-A-Million this seems to be filled up slowly by general merchandise and other products like DVD’s and E-books.

When breaking the revenue down in terms of distribution (i.e. via online sales versus store sales), we can see that Books-A-Million only gets around 5% of its revenue from Internet sales. 95% comes from retail sales in stores.

Their revenues are strikingly similar with those from Barnes & Noble. Just as Books-A-Million, Barnes and Noble also only has about 5% to 6% sales from their website. This virtually means they don’t have any penetration at all in this market. Borders Group states in their 2010 annual report (I use 2010 instead of FY2011 as the reported numbers are over 2010 and not 2011, kinda confusing :) ) that industrywide Internet-based selling is going to grow. Currently, about 10% of revenues come from Internet sales. My guess is that Internet sales and sales from other products fill up the gap that arises in the declining book revenues. While these other products revenues and online sales may rise, overall revenues could well stay about the same.

Looking at the key drivers of this business we can see that this business is driven by low margins and high volume. Therefore, economies of scale are important to have as it enables you to increase margins by buying large or put more cash into venturing into new business, new value propositions or fueling organic store growth.

The competitive landscape is can almost be called an oligopoly. Amazon is the largest book retailer with their Internet sales of books and E-books. Barnes and Noble is the second largest book retailer with their traditional stores followed by Books-a-Million which is the third largest and Borders group that is the fourth largest. Next to these four large retailers, there are several other relatively smaller book retail chains like Powell’s Books (Portland) or other book retailers. This setting puts pressure on margins but also gives enough room to earn a small but satisfactory margin. Companies are not competing to own the book reader, instead, every effort is toward creating a convenient shopping experience for customers. There is less risk of price wars in this sector. Recent developments in the E-reader business has put some pressure on the margins of the companies who engaged in the development of these innovations. Barnes and Noble in specific suffered from this development and the crisis that passed along as their management persisted on competing the Kindle.

Traditional stores concepts are all aimed at creating a comfortable atmosphere in which people are eager to read books and eventually buy these books. People want to learn, want to be entertained and want to be amazed. Books and magazines have always been a means of communication that provides these needs. The strong rise in Internet activity and the convenience that Internet offers makes it also suitable to read books and to receive this needed entertainment. Companies capitalize eagerly on this opportunity but it is to be questioned if this would lead to a complete replacement of traditional books. We have already seen such a (similar) disruptment in the movie rental and music business. Retail stores that sold music and/or rented out movies have suffered enormously from Internet developments and convenient buying behavior of consumers.

Companies like Apple with iTunes made it too easy and too convenient for consumers to buy music online. Illegal download sites were also amassing the interest of people as it made movies and music suddenly free. A final choice is easily made, if you are able to download music and films for free and you don’t even get caught. So why drive to the store in your spare time and buy a CD for $5 or $10? IF it even is in stock.. A dramatic shift has been made in consumer groups who choose to “buy” from the Internet and groups who still prefer to stroll through retail stores to search for music and DVD’s.

But will this be similar for books and magazines? I must honestly say that when it comes to books and magazines, I am emotionally biased. But who isn’t? I still like it to walk through book stores and buy hard copies instead of reading from a screen. It is easy to read from a screen, flip through databases and lists of books to choose from but what is not to like about going into a physical store, enjoy a cup of coffee and spend some quality time learning, flipping through books and being entertained by the written words of many writers. Thank God I didn’t buy Books-a-Million on sentiment but on its attractive margin-of-safety. I know that emotions are an investors Achilles’ heel, however, I have imprinted quite some diligent (I think) protection measures and one of it is to buy only with a margin-of-safety. One that offers enough room for mistakes and in this case maybe, emotional biases. Yet that I think that you have feelings with everything you get in touch with, therefore you are already a little bit biased.

I must honestly say that I do a lot of activities (as mentioned above) via the Internet but I love spending time in a book store flipping through the books of my interest. I know that with me are a lot of people that every time take time to go to a book store and buy books. This makes it that I am convinced that traditional book stores will not vanish out of the street scene but will remain. At least for sometime. Maybe this will disappear in the future just like we see slowly with music and movie stores. Maybe this will happen tomorrow. Who knows..

Simple DCF model

But even in this worst-case scenario, where further negative growth is imprinted, I think Books-a-Million is undervalued. When I input decreasing revenues, 2% FCF margin and a 10% discount in a DCF-model, I still count a value per share of $4,2 and thus a margin-of-safety of 15%. And this is still low in respect to other valuation models.

Sector analysis

Barnes and Noble

Barnes and Noble is the second largest book retailer. Only reading Mr. Riggio’s (CEO) annual letter to shareholders and the inviting ambiance the website creates would make you buy the company. But the valuation seems to be “fair”. It does not display a certain undervalue compared to Books-A-Million. But this might be the ‘premium’ that other investors (maybe you) are willing to pay for a good company. Because a good company it is. Almost on all fronts of book retail via stores, they are the market leader in book sales via stores, customer satisfaction and even personnel equality. They even cooperate with Starbucks, another great company. What is not to love about Barnes and Noble? I think their efforts will work out on the long-run but that it is easy for companies with sufficient size like Books-A-Million and Borders Group to coat-tail the successful business model and compete in that way. They do not need to be the best but average is enough. Enough to still have customers ‘conveniently’ buying their books. That’s why the quality of the stores and brand perception must be sufficient to compete. That’s why I like Books-A-Million in combination with their nice margin-of-safety.

At this point in time, Barnes and Noble’s returns are less than that of Books-A-Million. They are heavily investing in the development of the NOOK, their full-colour, superawesome E-reader. This is putting pressure on the ROE, CROIC and their debt-to-equity ratio. During this period, they suffered from the crisis as well which made them rethink about doing business and having to check their financial health.

Amazon

Amazon is leading in Internet sales. With a revenue of almost $35 billion they dominate the book retail market with sales via the Internet. All of their revenues are from Internet sales and they have a very large position in the E-book market. With their Kindle E-reader, they virtually own the market. With their efficient business operations, they have an operational excellence on their side. For them, it is the case that they need continuous innovation in order to stay ahead of the curve. Recently, their CEO Jeff Bezos has pointed out that they don’t mind being misunderstood by the market for a long time. This company I think is very valuable, they have a long-term focus and commitment and they manage to grow continuously, even through the crisis. Only their valuation multiples are obsessively high. A P/E multiple of 74,26 implies growth rates over 65% are being expected by the market. You pay 2 times the sales and 12 times the book value. Where’s reality in this price?

Looking at the sector overview I made, I must say that Books-a-Million is by far the most undervalued company of the peer group. Wal-Mart and Costco are companies that should be part of the peer group as well as Books-a-Million competes with those companies, however, those companies are for the most part in general retail (as they sell nearly everything) and therefore I do not think are suited to be compared in a peer group analysis.

Indigo Books & Music

Indigo Books&Music is a Canadian company that sells music, books, DVD’s and other merchandise. Despite the fact that it is not a direct competitor, it is a very comparable company looking at the nature of this business. Therefore, I included it in the sector analysis. Going over their numbers I see that it is pretty dispersed. The ROE and net margin are okay but their EBIT and cashflow are negative. The previous years looked better on these valuation metrics and makes this look as one of the better book and music stores. Their annual report almost reads like a book and the passion of the management is high. Yet which way you want to read it, their same store sales decreased in 2010 and did not increase much (0,6%) in 2009. The business model seems to be the same but the market is different. They are Canada’s largest book retailer, successfully introduced an E-reader (the Kobo) and does not seem to lose a lot of money on these changing operations. They do not compete with other large retailers like Barnes and Noble but compete with smaller, local book retailers. Their valuation multiples differ quite a lot and do not seem to provide a sufficient margin-of-safety for me. Again, this could be sufficient for you. If you are looking for a higher quality business against a fair price instead of engaging in riskier bargain hunting, this stock might be worth researching for you.

Yet again, I still think risks in Books-a-Million is mitigated for a large part thus making this a low-risk investment. Despite its beta of 2,09. This should imply that the company is risky in terms of having volatile past returns. Works for most statistical models and quantitative data-driven investors but not for me.

Borders Group

Borders Group is a book and music retailer that has stores throughout the U.S. Borders has recently filed for bankruptcy and is in conversation with several funding institutions to decide if it is continuing business or liquidating the business as a whole. Currently, it looks like as if they are going concern in a rather slimmed way. They have closed 226 underperforming Superstores as of the end of May 2011 from a former total store base of 489 Superstores. Next to this, they still ‘own’(read: rent) 263 Superstores and 126 smaller stores (approx. 36.000ft, carrying +-15.000 titles per store). They also closed down one distribution center, leaving Borders with 3 DC’s in total.

Borders has a recent history of losses and slumping business. For the past 5 years in a row they produce negative results including a decline in revenue of more than $1 billion, declining comparable store sales, increases in almost every type of cost, year-on-year net losses and a common shareholder’s equity decrease from $644 million to $(153,7) million.

Quite some debt agreements have been made in due time to ensure going concern business. Even one term loan by William Ackman’s Pershing Square of $42,5 million. This loan is paid off in March 2011. But Pershing got a better deal than ‘just a secured senior loan’ as you can read in the next paragraph.

Borders management team under the leadership of Bennet S. Lebow, is appointed in 2010. Most probably, former management has been replaced in order to make place for a turnaround management team. Former management was obviously not able to address the problems in the industry in time. Fighting the E-book war wit the so-called Kobo E-readers and E-books, they were hoping on capturing market penetration from Amazon (like everyone else) and retailers selling the all-feared NOOK. Turnaround seems to be brought in to provide capital as can be read from the Related Party Transactions page. Lebow bought 11,1 million shares at a price of $2,25 and acquired warrants exercisable for an additional 35,1 million shares. Next to issuing the term loan, Pershing Capital got warrants as well. They received 14,7 million warrants exercisable at $7,00 per share (expiry date October 2014). With this action, the value investors took a bet that Borders group will restart through bankruptcy or be taken over. They state that “in the event of a Public Share Merger….the company may elect to keep the unexercised warrants.. or redeem the warrants for cash”. But Eric, that’s a huge bet, it probably takes a while before the stock price will go to $7,00.

True, but the deal is amended to be extended. And the conditions changed. The term loan expires April 1, 2010 and the exercise price of the warrant is lowered to $0,65 (!). Next to that, LeBow got more warrants that are exercisable for 35,1 million shares at a price of $0,65. Due to these issues (as his former share purchase) Pershing got more warrants: 11,2 million at an exercise price of $0,65. This adds up to a total of 25,9 warrants at a strike price of $0,65.

All of this meaning that Pershing got a great deal when Borders Group manages to do a turnaround or, even more easy, gets purchased by for example Barnes and Noble or a private equity firm. And I guess that this is their biggest bet. Therefore, it would certainly be interesting to find more about this deal. Especially with last week’s rumors that Barnes and Noble is interested in taking over Borders Group.

Risks

When viewing risks in the business that Books-A-Million is in there is a lot to explain. It struck me to find almost nothing about Books-A-Million in general investing news and research sources. It seems like everyone either hates or despises the company or simply ignores it for some reason. More was found on Barnes & Noble and Borders Group.

Borders quickly fell into bankruptcy after the financial crisis of 2008. Barnes & Noble had troubles of their own as well. As being the prime book retailer, they suffered from the crisis to some extent. Revenues fell from $3.133 million in 2008 to $2.253 in 2010, a period in which all three years were loss-making. Books-A-Million on the other hand did not have had much trouble as Borders during the crisis. Surely revenue fell in 2008 with 4,1% and from 2007 to 2010 fell only 7,5%. Net profit fell more steeply with 36% from 2007 to 2008. Margins came under pressure but overall they still remained strong as can be seen in the margin analysis graph in the first paragraphs. Books-A-Million did good by lowering their long-term debt to zero and to control their total liabilities. Risk of lacking performance seems to be mitigated when looking at the historical ratios.

When looking at company-specific risks there are a few items that stand out:

  • Inventory risk
    Books-A-Million’s balance sheet is dominated by the weight of their inventory. Inventory (2010) is valued at 215 million and makes up about 92% of current assets and 72% of the total assets. As this inventory is subject to fashion risk (outdated books), physical risk (fire in a warehouse) and opportunity risk (they got to store the books somewhere, their supplier won’t do it for them), this is a substantial risk. And, in case of liquidation, what do you receive for this inventory?
    I found out that Books-A-Million mitigates this risk by having contracts with vendors to return books if they are not able to sell them all. This substantially lowers the inventory risk as they state that 80% or more can be returned to vendor at cost price. I was not able to find anything alike for Barnes and Noble, Indigo or Borders Group. However, as this is mitigates risk, it does not mean that the inventory can be liquidated at these prices. So apply conservatism, but be more optimistic than putting normally a discount on liquidation inventory.
  • Competition
    Competition is fierce in retail, especially in the book retail business. This is putting pressure on margins, diminishes returns on capital invested and in most cases raises costs as firms management teams feel pressured to engage in competing. The management of Books-a-Million seems to engage in competition as well but modestly. They will not engage in a heads-on competition with Barnes and Noble or Borders Group. The goal of creating shareholder value looks to be maintained.
    Past years, the management team of Barnes and Noble under the supervision of CEO le Riggio found itself to compete heads-on with Amazon for the E-reader business. While Amazon already had quite the market share, Riggio persisted on developing an E-reader (the NOOK) in order to compete, even at the cost of shareholder value destruction. He used a lot of resources even when the NOOK did not stand a chance to compete with the Kindle.
    Strangely enough, I believe there is an upside to the level of this competition namely in takeovers. If the market prices of these companies are being stressed because of their competitive business, there can be reason for takeovers. These takeovers can come from private equity funds or peers. A peer takeover in the book business would only be logical if one business takes over a lower valued or equal valued (merger of equals) business that share the same characteristics. Barnes and Noble taking over Books-A-Million is one of these logical steps, just like Books-A-Million taking over Borders group. The buyers are able to take over similar business and for a discount and apply their strategies to the acquired companies. Books-A-Million could take over Borders Group and implement the Books-A-Million structure, brand strategy, corporate branding and corporate governance. It is an easy expansion strategy. Unfortunately, at time of writing, Barnes and Noble found out the same. They are looking into takeover possibilities.
  • Shift in consumer characteristics
    For the past 10 years, the consumer trends are changing. Traditional stores have become less attractive compared to the Internet. The convenience and ease-of-use has become prevalent for the consumer. Awful for the traditional retailers, better for Internet retailers. However, it did created this opportunity for us value investors so the positive thing is the margin-of-safety of 37,4% offered currently.
  • Negative working atmospehere/Bad personnel reviews
    On the website www.glassdoor.com I found some disturbing negative reviews from (ex) employees talking about the pressure higher management puts on employees to sell their member card, the so-called Millionaire’s Club Card. Next to that, many employees feel underwaged, working too long, feel pressured to sell magazine deals or feel they receive no recognition whatsoever from anyone above store management. This is very, very bad for a company. It contributes to a negative working atmosphere and to higher costs as turnover rates will increase and people are working with no sense to fulfill any management goals. I sent IR a couple of mails but they don’t seem to reply. Another annoying and negative factor that does not add to many positives for management.
  • Vendor risk
    A big vendor to Books-A-Million is surprisingly, the Anderson family! The CEO and President have ties with one of the larger vendors of Books-A-Million, they own Anderson Media, Anderson Press, Anco Far East Importers which sells magazines, collectibles, gifts and music to Books-A-Million. Next to this, Books-A-Million leases from Anderson & Anderson LLC, a trust fund which owns real estate.
    I actually like this. Despite the fact that they might close deals more favorable for Anderson Media, I do like the fact that they are so tied up to this business. It gives them the incentives to perform. Next to this relation, they also own more than half of the shares in Books-A-Million which is also comfortable to know.
    Vendor risk is being mitigated by not buying more from one vendor than 10% of the inventory. They will not let vendors’ influence become too large so that they might squeeze Books-A-Million’s margins.
  • Takeovers
    Books-A-Million has last year taken a 40% stake in Yogurt Mountain Holding. The other 60% is bought by Anderson Private Capital Partners (40%) and Kahn Family Holdings (CEO) (20%). A frozen yogurt firm that has only 2 outlets and where Books-A-Million paid nearly $3 million for. Next to that, they committed to a $1,5 million line of credit. That’s an awful lot of money for a firm that is starting up. But basically, Books-A-Million acted as a Venture Capital investor here. Not something management would ordinarily do. But the idea was to scale the business model, start it up within stores of Books-A-Million, and leverage a great return. And the business seemed to have proven itself. “YoMo” has now around 33 stores, many located close to a Books-A-Million store, and it is very popular if I may read here and here.
    I feel that management has a task of deploying capital enterprising but conservatively. This takeover is definitely entrepreneurial sense. The takeover price on the other hand was far from conservative, which I do not like, but for some reason I think management already envisioned this franchise becoming a success with the help of Books-A-Million.

Valuation

The valuations part is by far the part that drives me wild. The valuations of Books-A-Million are so high compared to the current market price. I already worked with, what I think are conservative, estimations. Even with negative growth, there is still (for me) a sufficient margin-of-safety of around 30% in some of the models. Obviously, the market is implying very negative growth numbers of over 100% in the residual earnings model which is ultra-negative. For DCF models, the market implies a negative 15% growth which seems more reasonable as the bricks-and-mortar sector is assumed to shrink more.

Still, Books-A-Million is cheap. Really, really cheap in both fundamental terms as in relative terms compared to its peers. In my view, Books-A-Million can be valued in a lot of ways. In every way, DCF, asset value, residual earnings and retained earnings they are undervalued. However, they can best be valued with on the basis of and asset valuation and a valuation based on earnings. I will outlay all valuations but put special attention in asset valuation and valuation based on earnings.

An asset valuation is appropriate in case the company stops going concern. In this case, the company is being liquidated and money is returned to shareholders when debtors have been paid off. For my valuations, I have worked with a no growth scenario and even anticipating negative growth the company is undervalued.

Basic assumptions:
– no growth
– long-term debt
– discount rate of 10%

A friend of mine pointed out that I should use net debt instead of total liabilities to increase comparability between companies. This is a great idea and I will certainly implement this in my valuations as of next write ups.

NCAV
The floor is the NCAV value. Due to the high inventory, but which is for a large part covered by return contracts, the valuation on asset basis is also high. However, in this time, the NCAV value is still considered to be a very conservative valuation method. Especially in this current time screening for companies priced under NCAV does not return as many stocks as in the days Graham developed this concept. Overall valuations have risen since then. Mind, I don’t say that bargains cannot be found anymore! Therefore and taking into account the underlying factors of the NCAV formula I can reasonably assume that this provides a conservative floor value. Other asset valuations as in the valuation sheet are just beneath current market value (if total liabilities are deducted).

Retained Earnings model
If the payout stays the same and in ten years a P/E ratio is reached of 10, the present value is 4,06.

Residual Earnings model (Penman)
Based on the EPS, DPS and the Book value per share, even with a 100% negative growth Books-A-Million is undervalued with a value per share of $4,68. As bizarre as this is seems, it is to be explained by the large size of book value (equity). At current market prices, it can endure some years of losses. It seems to be already incorporated in the price.

DCF models
DCF models have different outcomes as the models input differ. Some take the last year as a basis, some take a ‘normalized number’ of an average of the past 5 years. With no growth, which is reasonable, I arrive at a value of $5,86 for the normal DCF. Using a ‘normalized’ DCF, I arrive at a value of $8,82. Using a normalized DCF is mostly appropriate to filter out business cycles as you are not being dependent on a single year’s values. The past 5 years have been reasonable and although I don’t expect gloomy prospects of the business, I am certain there is value in Books-A-Million.

Here is a summary of the valuations (no growth) of Books-A-Million. You can find my complete valuation sheet here..

Please let me know what you think of it.

Conclusion

In short an overview of the more positive and negative points:

+ Valuation and margin-of-safety!

+ Anderson family ties

+ Inventory risk mitigated by buyback contracts

+ Numbers seem to strong
– Shift in industry economics:

– Consumer demand changes
– Takeover Borders by Barnes and Noble
– E-reader popularity

– Maybe a dying business model

– Paying too much for Yogurt Mountain

– Negative reviews Glassdoor.com: negative atmosphere around Millionaire’s Card selling

To put an final word to what has become a huge piece, I must say that I am taking a bold position here in saying that Books-A-Million is cheap and that there is sure to be some value in it. Margins are strong, they have a history of having low debt, paying out dividends and are not afraid to pay out superdividends when they have no other investment options and the inventory being covered for a great part. However, the sector does has its problems, it faces the threat of diminishing returns. I am yet certain that Books-A-Million can stay profitable in the years to come just as they have always done so in the past. Following the market leaders in both Internet and store retail Books-A-Million can surely try to win over territory, increase their market penetration and stay profitable.

One thing I dislike was the takeover of Yogurt Mountain. With Books-A-Million money, management paid $3 million for a 40% share in the concepts which run 2 stores in 2010. Despite the very delicious website and marketing, it looks like they have overpaid at first for the company. However, it could also be seen as a VC investment and it seems like this investment is turning out quite well as the company now has around 33 stores and customers love it.

Update:

In the recent weeks there have been voices of a merger between Barnes and Noble and Borders Group. This could mean that Barnes and Noble instantly increases its store base with 389 stores that can quickly be turned around into a Barnes and Noble store. This would pose a threat to Books-A-Million BUT… because it still comes down to convenience, people wouldn’t buy at Books-A-Million and go to Barnes and Noble instead. Only when the quality of Books-A-Million is much worse than that of Barnes and Noble. This not being the case, I say Books-A-Million still has a fair chance of just doing what it does good: selling books.

Disclosure: Surprisingly…. Long $BAMM

I as well have seen that Books-A-Million has posted a loss in the first quarter and you might be wondering if I might be trying to catch a falling knife but value investing is about buying with a margin-of-safety. This means often buying to early when value comes out. I am prepared to double down if the price goes under $3. This will make the margin of safety 53% and after seeing this weeks prices go down I might be able to buy more quickly. I think that the margin of safety is somewhat higher than estimated due to the large conservatism applied in the estimations, therefore I keep a target price of $7.

 

Sources:

Annual reports

http://seekingalpha.com/article/269915-can-books-a-million-manage-its-way-out-of-bad-economics

http://www.fonerbooks.com/booksale.htm

http://www.gurufocus.com/

http://www.cnbc.com/id/40530696?__source=yahoo%257Cheadline%257Cquote%257Ctext%257C&par=yahoo

http://www.oldschoolvalue.com/blog/forum/b-stocks/bamm-books-a-million/

http://www.yogurtmountain.com/

http://www.businesswire.com/news/home/20110225005809/en/Yogurt-Mountain-Opens-Self-Serve-Frozen-Yogurt-Store-Memphis

http://www.urbanspoon.com/r/45/1475133/restaurant/Vestavia-Cahaba-Heights/Yogurt-Mountain-Birmingham

http://www.bizjournals.com/birmingham/stories/2010/04/12/daily48.html