Barnes and Noble (BKS)

8/13/2019 Barnes and Noble (BKS)

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Barnes & Noble (BKS)

Recommending LONG on 2/13/2014 at $16.06

RecommendationI recommend going long Barnes and Noble by utilizing a Bullish Butterfly options strategy using the 2015 LEAPcall options. I believe the turnaround for B&N has already begun with the introduction of a new CEO, promisingcost reductions and enlightened investor sentiment. I expect B&N will trade between $20 and $24 a share in the next8-12 months.

BackgroundBarnes and Noble is the largest book retailer in the U.S. The company was founded in 1886, originally namedArthur Hinds & Company, and was located in the Cooper Union building in NYC. After nearly a century of lackluster growth, the company was sold to Leonard Riggio in 1971 for $1.2mm. Years of poor management hadreduced B&N to a single store on Fifth Avenue. Riggio rapidly grew the business, though, through discounting andexpanding with smaller stores. Leonard Riggios brother took over in 2002 as the CEO and was replaced by WilliamLynch in 2010. Michael Huseby joined the company as CFO in 2012 and replaced Lynch earlier this year.


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Barnes and Noble has three operating businesses: Retail, College, and NOOK. The retail segment includes 673 bookstores across the U.S. that offer books, media, and other discounted items. The College segment operates 695 stores,of which 5% are large superstores. Each College store signs a multi-year contract with a college to become theschools official book store and is located on or in close proximity to the schools campus. Finally, the NOOKsegment includes the Nook e-readers and its associated e-bookstore. The division spun out of the retail segment in

2012.

FinancialsThe Nook segment has been the worst performer of the businesses since the release of the first Nook in 2010. Thepoor performance is not only a drag on internal resources and costs, but also shutters investors from getting apositive first glance of the basic financials. Figure 1 shows the companys combined performance since theacquisition of the College segment. What we initially see is a poorly preforming company that cant figure out howto stop the bleeding. By breaking the company apart into its individual segments, though, the financial health ofB&N becomes much clearer.

Figure 1: Profitability by segment. ROA is calculated as Segment EBIT/Segment Average Assets in this diagram.

Current Market PerceptionB&N has been thrown to the curb, assumed to be another brick-and-mortar retailer who doesn't understand that I canorder something off Amazon without even having to put my shoes on. Revenue growth has turned negative, retailstores are shrinking and/or closing, college students are renting more textbooks than buying, and the NOOK is stillkicking despite Amazon's dominance in the e-reader space. By the way, didn't an activist investor just fail in tryingto bring Border's back to life?

The above is all true, but requires a much deeper look to understand why the negatives arent that bad. Below are afew more common points Ive come across when analyzing investor and Equity Research sentiment.


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Investor gripe #1: B&N doesnt make any money.-While on a consolidated basis B&N fails to bring home the bacon, the picture become clearer when you analyze theindividual segments as broken down in the Financials section above. The NOOK business hides the recent increasesof efficiency shown in the Retail and College segments.

Investor gripe #2: The retail business will turn into a Borders situation.-Borders strangled itself into bankruptcy with a multitude of poor management decisions. Their late adoption of anonline platform, the decision to keep selling physical CDs, DVDs and other media in bulk, the lost contract toStarbucks for their cafes (which B&N has), and the 10-15 year strict contracts that it had with its physical stores are

just a few examples that show how different B&N is from Borders.

Investor gripe #3: College students are poor and prefer renting books.-While renting has slowed growth in the College segment of its business, the margins in the segment still remainhigh. Though it may seem cheaper to rent textbooks, I have found it to actually be a more expensive option thanbuying in a number of cases. There were many times while I was at Georgia Tech where I could rent a book for $80a semester or buy it for $130 and then sell it to an online textbook store for $60+ once I was done with the course.The positives of ownership heavily outweighed renting.

Investor gripe #4: The NOOK will bring B&N down and they must sell it.-This is by far the most thrown around statement Ive seen. It makes sense since it seems the most logical way to letthe true value shine, but it just isnt practical. B&N uses the NOOK as a gateway to the ordinary individual who justwants to read an electronic book on the go. The release of their latest e-reader is a bare-bones model that is simply

just used for that purpose. Huseby has already stated that theyre no longer trying to compete with Apple andAmazon on tablets. By removing the e-books, B&N forgoes the $50mm a quarter in revenue theyve been receivingfrom pure digital sales.

Investment ThesisThough B&N has run into some significant trouble over the past few years due to poor management decisions andunlucky consumer trends, I believe theres a lot investors can look forward to this year.

A new experienced CEO will finally lead. Everyone knows that theres value in B&N, but they dontknow how much its worth and when theyll finally find out (if ever). With Huseby stepping in, an

executive with a deep history of spin-offs and restructurings, I dont believe it will be long before investorsfinally get to see a company that can be valued as a single entity. Hes also had time leading Nook Mediaso hes been able to closely observe where changes need to be made within the group.

B&N will continue to cut costs across the board . Management to close unprofitable stores in the Retailand College business. It was announced at the start of 2013 that B&N will close about a third of their retailstores over the next decade. This equates to about 15-20 stores a year (which they can do because of their


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to the school exactly what books and/or equipment was required for their class, the school would pass thatto B&N, and then B&N would create a custom order check out page with everything you needed.

Retail and College stores will sell higher margin items . The stores already do a good job of keepingmargins up no matter what theyre selling, but there are improvements being made as stores are shrunk ormoved. Stores still have roughly 10%-20% of the square footage dedicated to poor selling media productsand management has expressed in diversifying their store floors beyond books.

Catalysts The most important catalyst has already occurred. Mike Huseby has a history of spin-offs and other corporate

actions with his previous employer, Cablevision, where he was CFO. Though I dont believe he would ever spin-offa piece of the company right now, he knows how to analyze the weakness of segments and figure out ways to ensurethey harmonize better.

The next step in moving the stock toward my expected valuation is the implementation of expense-reductions. Therecent announcement of cutting staff on the NOOK engineeringstaff provides solid evidence that he sees where issues are. Heseven been publicly adamant of joining with a third-partymanufacturer to build the NOOK devices, so as to significantly

reduce costs while ensuring they still have some technologyinvolved in their business. The Retail and College segments aregaining more focus as well, ensuring that the return on capital atall of their stores makes sense.

Finally, time is on the investors side. William Lynch left theCEO spot in July of last year after failing to show any leadershipwith the noticeable decline of NOOK. Getting the bump from theCFO spot, Huseby accepted a ticking-time bomb and knows hehas shareholders and a Board who are demanding to finally seesome value get squeezed out of the company. I believe, asalready evidenced by his recent actions, that he has been given a

year to prove his resume lives up to its hype. Figure 2: Total stores open

Valuation Seeing as this is a hidden value play, a Sum of The Parts (SOTP) analysis makes most sense to use. Not only touncover what the more profitable segments of the company are worth, but also to gauge what the company couldpotentially be worth once NOOK is cleaned up.

Figure 3 shows each segment and the valuation metric that I used to calculate the range of firm values. The Retailand College businesses are steady generators of EBITDA, while the NOOK is clearly unprofitable and thus is valuedas a multiple of sales. The Bear scenario represents the case where management fails to continue planned cost cutsand keeps plowing away at rebuilding building the NOOK brand. Such a dim scenario would cause investors toscream Borders: Part Deux! and continue to sell the stock off. The Middle scenario represents a mildly optimisticcase where the upbeat economy and cost cuts allow B&N to grow at a slow, but modest rate. This case also assumes

a management-induced shrinking of the NOOK segment and/or discussions of reorganization of the unit. The finalBull case is the absolute best case scenario I could see occurring. This would entail a successful push into highermargin items in the Retail and College segments, only a modest decline in sales from NOOK, as well as buyout talkof one or more of the segments from an activist investor or private investor (Riggio).


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Figure 3: Valuation of individual business segments

The list of comparable companies to B&N is quite limited, but still offers us a few good data points. The almostdefunct Books-A-Million (BAMM) currently trades around 1.5x 2014E EBITDA. Due to the sheer lack of investor

interest and poor outlook for the company, caused by poor management in the companys most critical years, ittrades at a very low, but reasonable multiple. The founding family offered to buy the bookstore last year for a littleover $3 a share, leading to a rough multiple of 2.0x EBITDA. Though this provides little evidence to what a strongerbookstore should actually trade at, it gives us a nice floor to work off from.

Another comparable is Chegg, an online textbook/e-book renting service, who recently went public late last year.The stock is down ~25% since the IPO, makes nothing on the bottom line and trades at around 2.5x 2014 salesestimates. B&N College also rents textbooks/e-books, but has the obvious physical store presence that Chegg lacks.Deriving a comparable multiple from this company is a mistake due to the poor profitability and different structure anew online business requires versus a well-known physical store. However, Chegg does remind us that the businessof selling physical textbooks an intensive process that requires more than a highly advertised website. With suchdifficult constraints the business is facing with profitable growth, I feel more comfortable placing a higher multipleon the College segment of B&N.

Finally, a quick look at other national big-box stores (BBY, SPLS, ODP) shows them trading between 5x 6.5x2014E EBITDA. While I again dont think it makes sense to blindly apply this range of values, it shows that thesecompanies, who are also facing similar relevancy issues, can trade at moderately leveled multiples.

In terms of previous transactions, recent history provides us with a rich view of what a private buyer may pay forpieces or even the whole B&N business.

October 2009 Riggio sells B&N the College book stores for $514mm. Using LTM values from theexecution date, the bookstores were sold for roughly 4x 4.5x EBITDA

December 2010 Pershing Square offers to finance a $960mm merger with Borders, or $16 a share April 2012 Microsoft invests $300mm for a 16.6% stake in newly formed Nook Media, valuing the

segment at $1.7bn or 1.8x LTM sales December 2012 Pearson invests $89.9mm in Nook Media in exchange for a 5% stake, valuing the

segment at $1.8bn or 1.9x LTM sales May 2013 Rumors surfaced that Microsoft was looking to buy out the rest of Nook Media for a total

valuation of $1bn, or 1.3x LTM sales.

Taking a step back and thinking about the most real-world valuation today, I believe a mix of the Bear scenario andMid multiples are appropriate. As the NOOK segment evolves into a more stable platform like the rest of B&N,buyers would be willing to place a higher multiple on the business. Though NOOK has obviously been valued atmuch higher than 0.75x sales, Im being very conservative in my estimates due to the sheer volatility of the segment.

Valuation Multiple Enterprise ValueSegment Method Bear YoY % Mid YoY % Bull YoY % Low Mid High Low Mid High

Retail 2014E EBITDA $351.0 -5% $373.0 1% $377.0 2% 1.5x 2.0x 2.5x $527 $746 $943College 2014E EBITDA 106.0 -1% 113.5 2% 116.0 4% 2.0x 2.5x 3.0x $212 $284 $348NOOK 2014E Sales 665.0 -15% 700.0 -10% 720.0 -8% 0.60x 0.80x 1.00x $399 $560 $720

Total Firm Value $1,138 $1,590 $2,011

($180) ($180) ($180)Total Equity Value $958 $1,410 $1,831

58.9 58.9 58.9

$16.1 $16.1 $16.1

Premium/(Discount) to Market 1% 49% 94%


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A willing buyer, such as Microsoft, may use recent poor sales figures as a way to negotiate a deep discount for thebusiness.

As the dirt begins to get cleaned up in NOOK, investors should feel more comfortable putting their capital at risk,providing even greater valuations to the rest of the businesses. A 2.5x 2014E EBITDA multiple for the Collegebusiness accounts for a leaner organization that continues to grow stores strategically. Though Retail will alsobecome more cost efficient, I dont believe it will have the same potential for valuation as the College business, thusthe 2.0x 2014E EBITDA multiple. Based on these thoughts and calculations, I value B&N between $20 and $24 ashare. Taking into account comparables and the precedent/announced transactions, a private buyer with deeppockets in a giddy market could value the company around $25-$28 a share.

StrategyUsing a forecasted range of $20 - $24 with the scenarios detailed above, buying the stock before any majorrestructuring/ownership news provides an opportunity for a 25% - 50% gain based on todays closing price. Sincestarting this pitch, the stock has bounced between the low 13s and the high 16s. While I think the stock is attractivehere, I like to leave some margin of safety in my purchases. Thus, I would try to dollar-cost average in as the stockinevitably bounces from future market volatility (short interest of 19%) and would be a big buyer as the stock getsback to $13 and below. Bad earnings may give you a chance to buy, but that could be the day where a significant

Nook announcement takes the stock to new levels.

While buying the stock outright is obviously the easiest way to take a position, there comes a number of untold riskwith anticipating catalysts. From the large amount cash needed to purchase the stock, to the large amount of riskassociated with a continued decline in business, to the potential many months that the cash could sit stagnant earningnothing, buying stock isnt the most efficient way to participate in the potential upside. Thus, I recommend utilizinga Bullish Butterfly options strategy using the January 2015 LEAP call options.

Options allow you to participate in moves with a lot less capital outlay and in many cases, provides you a definedline of how much you can lose on a trade. Because I dont know how long it will take for investor sentiment to startturning over on B&N, but have an idea of what the marketplace will potentially value its shined-up separatebusinesses, we can use a Butterfly to pay for a range of stock prices in the future. If my timing is off, a biddingwar ensues, or B&N continues to let business slip, the risk is clearly defined and is less than the cost of an ATM calloption. If the planets align and the market values B&N as I suggested it might, the potential reward could be a250%+ gain. While this is the best case scenario, the trade will still net a gain if the stock closes between $18 and$26 a share. All the while, our loss is limited to $1.30 ($130 per butterfly). These numbers assume the options willbe held until expiration. The payoff diagram of this conservative strategy is below.


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I have also included a more aggressive Bullish Butterfly strategy below. Depending on your risk tolerance and howmuch conviction you have in my analysis, this could be a more appropriate trade for you. For this setup, we use thesame calls, but move the upper leg of the Butterfly to the next highest strike. Since I only expect the stock to bevalued over $25 in the rarest of cases, theres no reason to pay for the extra insurance. So while we leave ourselvesexposed to more upside risk, we buy a cheaper trade with an even higher potential payoff.

RisksThe biggest, most probable risk is that company stays on the same linear path that its been on for the past few years.Slow to negative sales, little to no management guidance for NOOK, slimmer savings from store closures, and slowimplementation of higher margin merchandise. My investment thesis relies upon Mike Huesby figuring out ways tostrip the junk off and let the value shine. If the Board or an activist investor comes in and butts heads with the CEO,potentially throwing him out, there could be a good probability of even worse returns for investors.


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Documents

Barnes and Noble (BKS)