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 & Noble, Inc. (NYSE:BKS) a few months ago.

The Case For BKS

I think Barnes & Noble, Inc. (NYSE:BKS) is significantly undervalued and likely worth somewhere between $20 and $30 per share. Although there are industry headwinds in the traditional book business, Barnes & Noble, Inc. (NYSE:BKS) has a strong brand name, significant insider ownership, strategic partners in Liberty and Microsoft Corporation (NASDAQ:MSFT), 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 & Noble, Inc. (NYSE:BKS) 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 Misperception

The 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.com, Inc. (NASDAQ:AMZN), Apple Inc. (NASDAQ:AAPL), 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 & Noble, Inc. (NYSE:BKS) 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 Data

In 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 Corp. (NYSE:GME) (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

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

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 Corporation (NASDAQ:MSFT) has agreed to pay B&N up to $85 million per year as part of that investment deal.

Valuation

While I don’t think Nook is worth twice what the entire company is worth, it likely is worth more than $0.

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