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:
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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.
Financials & Valuation
We arrive at a $37 sum of the parts valuation for BKS by using our CY12 estimates and putting 3.0x EBITDA on Retail, 4.5x EBITDA on College, and 1.0x platform sales on Nook. From this $3.3 b EV we subtract net debt and pension of $240 mm, deferred rent of $160 mm, and our estimate of Nook losses until breakeven after-tax of $200 mm. This arrives at an equity value of $2.7 b or $37/share after fully-diluting the shares outstanding to 72 mm due to the Liberty Media convertible preferred.
Obviously the most contentious part of this valuation is what the Nook is worth. It’s not worth zero just because they are currently spending through the opex line to grab market share in a rapidly growing space. We think 1.0x sales is conservative if it were to trade to a strategic or be IPO’d. There are no great comps but we found several data points that we think are relevant: 1) Kobo is a smaller ($100 mm of sales) eReader platform that was sold to Rakuten in Japan for 3.0x sales 2) NFLX traded as low as 1.0x sales when it was at $70 and the world thought the company was unprofitable and in a death spiral 3) LXK is priced to go out of business at 7x EPS and 0.5x sales. Additionally our conversations with bankers and cap markets suggest 1.0x would be conservative; rather, 2-3x sales could be on the table if properly marketed. Every ½ turn of sales is worth $13/share.
Another way to frame the valuation is to think about what you are currently paying for the Nook at the current BKS price of $11/share. We think the core business ex-Nook is worth $11/share which means you are paying nothing for the Nook today. That strikes us as a particularly asymmetric risk/reward.
Management & Board
Management and the board are an important element of the story to BKS.
Len Riggio is the founder of BKS and owns 30% of the shares out. He has created a lot of shareholder value over time through the success of the Barnes & Noble concept, the acquisition and growth followed by a spin-off of Game Stop, the IPO of B&N.com during the tech bubble followed by its buy-in post the bubble, and now the successful ramp of the #2 eReader platform which will be partially monetized this year. He made what must have been an excruciatingly hard decision to take all the cash flow the bookstores generated for the last 2 years and invest it in the Nook start-up which will speed up the disintermediation of his core bookstore business. Not many management teams can destroy a sacred cow like this (ie Borders).
John Malone via Liberty Media has a $200 mm convertible preferred that they completed in the Fall of 2011 that converts to 16% of the fully diluted shares at $17/share. Note that this preferred investment followed a terminated sale process where Liberty bid $17 for the entire company in May 2011. We believe the sale process was not terminated because Liberty found something they didn’t like but rather that the financing package that was offered to Liberty was pulled in the market melt-down in the summer. Liberty has 2 board seats (Greg Maffei & Mark Carleton). Malone has one of the best track records in the media business and we take his involvement in BKS seriously. We do not think it was a coincidence that only 4 months after the Liberty investment the company announced their intention to monetize a portion of the Nook business. Trackers, spins, and financial engineering that create shareholder value is vintage Liberty Media.
Mike Huseby was recently hired as the CFO of BKS which we think is another confirmatory data point to the Nook monetization thesis. Huseby was previously the CFO of Cablevision where he had extensive experience with trackers, spin-offs, leverage, share shrink, and MBO’s.
The biggest risk to our investment thesis is the future of the Nook and the execution of the Nook monetization. We could be wrong on the industry dynamics and Nook’s competitive positioning vs. AMZN. The market doesn’t give BKS credit for the Nook value today and without an event to illuminate the perceived value it is unlikely that the market will change its mind for the foreseeable future.
The Retail bookstores could decline faster than we expect and our DCF value could be optimistic.
The College bookstores could be less stable than we believe, most likely due to incremental pressure from digital textbook substitution. We think digital textbook disintermediation for college-level students is still several years out and even then will have a slow adoption curve.
Len Riggio has a mixed track record on corporate governance. Many investors believe the sale of College bookstores to BKS was not done on an arms-length basis. BKS also adopted a poison pill to fend off Ron Burkle in 2010. We are not concerned about this risk given Liberty’s involvement on the board.
The key catalyst is the monetization of the Nook. BKS announced strategic alternatives for the Nook in January and we believe there is a parallel process being run now to investigate potential strategic interest as well as prepare for a partial IPO of the Nook.
A secondary catalyst is separate segment financial reporting for the Nook which we expect in June on the Q4 earnings release. This will allow the market to more clearly understand the cash flows from the Bookstores vs. the Nook, which currently is jumbled into both the Retail segment as well as the B&N.com segment. We expect to see more SoP analysis from the sell side following this disclosure.
While we aren’t expecting it, we could see a potential bid for BKS from Liberty Media & Len Riggio again. They made an offer to buy BKS at $17 in May 2011 that we believe was pulled due to the credit markets falling apart that summer. Given the credit markets have now recovered to frothy levels we believe the original financing plan is now viable again (4x debt/EBITDA).