From Whitney Tilson:
You might not believe this in light of this morning’s news (Barnes & Noble, Inc. (NYSE:BKS) has roughly doubled, but this is what I wrote over the weekend but hadn’t yet sent:
For only the fourth time in our 13+ year investing history, we’ve gone long something we were previously short. (Given how well it’s worked out the three previous times with Fairfax, General Growth Properties and Netflix, we should do it more often!) In the past, there’s been some period of time between our switch, but in this case we went from short to long Barnes & Noble on the same day last week. Such a rapid shift in opinion is unprecedented for us, but when we encounter new data/analyses that convince us that we’re wrong, we act quickly.
BKS had been a profitable short for us and we were already thinking of covering when two things caught our attention: we saw that Jana, a firm we know well and respect greatly, took a big stake, and read the write-up below on our favorite value stock idea web site, Value Investors Club. We largely agree with the analysis in the VIC write-up: that the base business is worth almost the entire current stock price, so you get a nearly free call option on the Nook, which is doing much better than we expected. Plus with more than 2/3 of the stock controlled by insiders and, according to Yahoo Finance, 67.2% of the float is sold short (87% if you include Jana’s new stake), even a hint of good news will likely trigger the mother of all short squeezes.
LONG Barnes & Noble (BKS)
Market Cap (fd): $800 mm
Enterprise Value: $1.3 b
Average Daily Volume: $17 mm
BKS is a long because it has an under-appreciated asset in the Nook eReader platform, whose value will be illuminated through a partial sale of that business segment in 2012. We believe a conservative sum of the parts valuation for BKS is $11/share for the existing Retail and College bookstores and $26/share for the Nook resulting in a $37 sum of the parts valuation or 230% upside.
BKS is 3 distinct businesses: 1) the 700 Retail bookstores that carry the Barnes & Noble brand name 2) the college bookstore business which operates campus bookstores at 640 different colleges and 3) the Nook eReader platform which sells the devices and digital content and will generate $1.5 b in platform sales in FY12 (FY ending in April).
The Retail bookstore is a dying business as we shift from physical to digital online purchasing of physical. We estimate underlying SSS are declining ~7% annually. However, due to the liquidation of Borders and downsizing of selling square feet for physical books at WalMart and Target, actual SSS will be positive 1$ in FY12 and flat in FY13. EBITDA in FY12 will be $325 mm (or ~$294 mm excluding the Nook EBITDA that is accounted for in the Retail segment) and flat in FY13. Importantly, we believe there is significant value in the retail bookstores because their leases are increasingly becoming more short term (average duration of the portfolio is ~2-3 years) allowing for significant flexibility (and minimal friction costs) in downsizing the store base as 4-wall profit contribution turns negative. BKS is closing 20-30 stores annually or 3-4% of their store base.
The College bookstore is a much better business than Retail. The majority of what is sold in a campus bookstore is not trade books, but rather textbooks and college paraphernalia. SSS and EBITDA are stable ($124 mm of EBITDA in FY12). BKS operates the store on behalf of the school; BKS pays a % of revenues as rent so if sales decline the rent payments decline as well. In addition, there is flexibility to adjust the rent payment % or terminate a management contract on 60 days’ notice should a store become unprofitable.
The Nook eReader is the hidden asset of BKS. Nook is the #2 player in the eBook market with 25% market share behind Amazon at 65% markets share (iPad, Kobo, and others share the remaining 10%). Nook went from a standing start in 2009 to 25% market share by leveraging their 700 physical retail stores to sell the Nook to a predominantly women audience who value the in-store customer support. Nook has grown from nothing in FY10 to $900 mm of platform sales in FY 11 to an expected $1.5 b in FY 12 (ending 4/12). While Nook currently loses money (~$250 mm in FY12) given the large R&D and marketing budget, we believe this platform has real value due to a rapidly growing market (50% expected CAGR for the next 3 years) and customer stickiness that should result in Nook maintaining its market share. We expect a positive inflection point in profitability by CY14.
Short Thesis & Our Variant View
There are 17 mm shares sold short which is 29% of the shares outstanding. Many smart investors do not agree with our bullish view on BKS. Below we lay out the short thesis and our variant view.
Short Thesis: Bookstores are a dying business
Variant View: We agree! However, that does not mean that the bookstore business is worthless. First, 1/3rd of the EBITDA of the bookstores comes from the College Bookstore business which is NOT dying but rather is a stable business that does not face the same secular headwinds the Retail bookstores have. We value College at 4.5x EBITDA for a $500 mm valuation. For the Retail bookstores, because of the short lease length, there is minimal friction costs as they wind down the business. We run a DCF of the Retail bookstores that assumes a hard run-down of the business and come to a valuation of $780 mm which is 3.0x EBITDA. As a reference point, BBY, another secularly challenged retailer, trades at 3.0x EBITDA.
Short Thesis: BKS is losing money… there is no margin of safety to make a valuation case on.
Variant View: You cannot look at BKS on a consolidated basis. The bookstores are quite profitable, but the cash flow is being reinvested into growing Nook market share while the eBook industry is still in its infancy and sticky customer relationships are being formed. If for whatever reason the Nook failed and was shut down you would still have the profitable bookstores. If you shut down the Nook, BKS would be trading at 3.5x EBITDA.
Short Thesis: Nook is not worth much because it is losing money and has deep-pocketed competitors.
Variant View: The argument that there is fierce competition in the eBook space is as true today as it was in 2010 when AMZN had ~100% market share. This did not prevent Nook from going from 0% market share to 25% in 2 years. The physical retail store presence is a large competitive advantage for the Nook that BKS has been able to leverage to grab share in this fast growing market. You do not need to assume further share gains in this fast growing market for the Nook to be worth a lot of money as a separate company or as a partner to a strategic investor.
Short Thesis: the recent anti-trust lawsuit and partial settlement over eBook price-fixing means that AMZN will be able to sell eBooks at a loss and drive out the competition (mainly the Nook).
Variant View: the anti-trust settlement is clearly not a positive and introduces uncertainty over the next 6 months in terms of how the eBook pricing regime will evolve. 3 of the big 5 publishers which represent ~30% of trade books have agreed to it, while Apple and the other publishers are going to fight it out However, the conclusion that AMZN will pursue a scorched earth pricing strategy and successfully destroy the competition is misguided. A key industry dynamic that is critical to understand is that the publishers despise AMZN because of their attempt to cause eBook price deflation while also trying to dis-intermediate the publishers with their own in-house publishing effort. Read Jeff Bezos’ annual letter where he spent half of the entire letter talking about their publishing business, then think about what your reaction would be if you are a publisher. Because of this antagonistic relationship, the publishers are hell-bent on ensuring that there are several healthy customers, primarily BKS as the last physical bookstore of scale as well as the biggest competitor to AMZN in eBooks. This was the entire reason for forcing agency pricing scheme in the first place; to level the playing field for new entrants. The publishers will be doing everything possible to ensure that BKS is a healthy competitor that can serve as a governor on AMZN’s potential to destroy the traditional publishing business. In what form this support for BKS and other competitors is still uncertain, but as an example, there is a specific clause in the anti-trust settlement agreement that expressly allows a publisher to support bricks and mortar stores (ie BKS) with promotional and marketing dollars.