M c I n t i r e I n v e s t m e n t I n s t i t u t e 1

MCINTIRE INVESTMENT INSTITUTE AT THE UNIVERSITY OF VIRGINIA

Max Katzenstein & Associate Team| October 31, 2013

Barnes & Noble (BKS)

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B&N IS A TENTATIVE SHORT

Uncompetitive in the Physical Book Space B&N lacks the ability to compete with the price and convenience of online competitors.

Uncompetitive in the e-book Market B&N struggles to capture significant market share in the e-book space.

Misperception The market may believe that B&N is taking or will take the steps necessary to recover.

Valuation B&N should trade at a significant discount to its comps.

Major Risk However, the market may have priced the stock accurately.

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PITCH OVERVIEW

1) Internal Analysis

2) Industry Analysis

3) Financial Valuation

4) Revisit Thesis

5) Risks

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POOR STRATEGIC POSITION

B&N fails in its strategy to be the dominant, preferred seller of physical and electronic books in the United States.

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Market Focus: Too Broad - B&N does not segment its market. It aims to offer any person any book both in physical and e-stores. - B&N struggles to gain significant market share because online competitors offer the same products at lower prices.

Differentiation: Almost Nonexistent -Though B&N is the leading “brick and mortar” bookstore, it does not offer a good alternative to buying products online. -The Nook E-reader is a weak product.

Relative Cost Position: High B&N operates at a high cost position relative to its online competitors.

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OPERATING SEGMENTS

Retail Stores College Stores

The Nook E-Reader

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B&N RETAIL AND COLLEGE RETAIL

B&N provides stores where customers enjoy browsing a broad collection of physical books. Employees can serve customers in person. Stores are attractive to read, relax, and meet.

College stores are personalized and strive to be “the college bookstore” of choice.

However, each store represents a huge fixed costs. Stores are leased, and therefore there are significant costs associated with closing a poorly performing store.

B&N has begun to close stores. This trend will not be reversed as they have announced a plan to continue with about 20 store closings each year. More closings are very possible as 442 of 674 leases are due for renewal within 3 years.

From a sales point of view we can also see a constant decline in retail sales beginning in 2011. During the same period B&N college stores have also seen a decline in sales.

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NOOK

B&N’s Electronic Presence B&N competes in the e-book market with the Nook e-reader and electronic book store.

The Tablet Market is Thriving Since the business is so profitable, technology companies, rather than for instance, bookstores, are hopping into the market. With far better features and experience, e-readers like the nook are being wiped off the map.

People Don’t Read Books on Tablets According to Forbes Research, tablet users spend 50 percent of their time on games, movies, and music. This is bad news for Barnes and Noble, who has just stopped producing their nook HD, thereby getting rid of these capabilities

Results: The Nook is a Failing Product In the first quarter of 2011, the nook held 17 percent of the tablet market share. By the end of 2012, this was down to 2 percent.

The Future is not Looking Good for the Nook Barnes and Noble recently announced they will no longer produce their color tablets (which were far more reminiscent of iPads than e-readers) and will instead continue co-production of these through third parties. They have, however, created a new e-reader the Nook Glowlight. This is an affordable reader STRICTLY for reading, no web-surfing or video.

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THE BOOKSELLING INDUSTRY

Overview

Bookselling Industry is Unattractive

Important Retail Trend: You Can’t Beat the Internet

Revenues are Shrinking

B&N Failed to Capitalize on Borders Bankruptcy

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OVERVIEW OF THE INDUSTRY

The bookselling industry includes a variety of retailers, both online and in-store, that compete to distribute the literary work of authors (ebook or print) to the public.

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THE BOOKSELLING INDUSTRY IS UNATTRACTIVE

Threat of New Entrants: Low, Stable High barriers to entry, decreasing margins on books, and the increasing threat of online book piracy constitute a low threat of new entrants.

Buyer Power: Moderate, Increasing Although buyers are able to price shop due to online offerings, buyers are generally price insensitive. Moreover, books comprise only a small fraction of total buyer costs and buyers are unallied.  

Supplier Power: Moderate/High, Decreasing Publishers possess influence when negotiating contracts with book distributors.

Threat of Substitutes: Moderate, Increasing Consumers are spending more time enjoying computers, videogames, and television rather than reading for pleasure and education.

Rivalry Among Existing Competitors: High, Stable Slow growth, little differentiation, price wars, and desire for market share create intense competition within the bookselling industry.  

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New Entrants

Buyer Power

Supplier Power

Substitutes Competition

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YOU CAN’T BEAT THE INTERNET

Fallacy 1: Compete on Convenience

Many believe that since retail can, in many ways, no longer compete with price or convenience, they can compete on convenience. It might work with Best Buy or Apple, but this cannot be imitated in the book selling space. In the case of technology or clothes, you may want to try the product before buying it. By nature of books, trying the product is its use so the incentive to go to a store is minimal.

Fallacy 2: Retail Consolidation

2012 saw a 33 percent rise in mergers among big-box retailers. The assumption is that when there are two competing big name retailers, and one fails, the other will automatically absorb all that business and thrive. This is largely incorrect, as BOTH retailers are likely being affected by the factors causing one to fail. For instance- When Circuit City dissolved, Best Buy was expected to have sales through the roof but, in the end, benefitted minimally. Circuit City customers didn’t just have the choice of Best Buy, they had the choice of the Best Buy, the internet, Wal-Mart, etc.

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RESULT: REVENUES ARE SHRINKING

•  For bookstores open more than one year (an important benchmark in the retail business), sales are up on average only 2.8 percent, a drop of 7 percent from last year.

•  Don’t forget, CDs and DVDs are dying

rapidly, a formerly profitable product for Barnes and Noble.

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B&N FAILED TO CAPITALIZE ON BOARDERS BANKRUPTCY

•  “Barclays Capital analyst Alan Rifkin predicts ultimately the chain could gain $220 million to $330 million in revenue, or about 10% to 15% of Borders annual revenue if the chain closes.”

•  However, with the demise of Borders, Barnes and Noble

was able to acquire IP and consumer data, but failed to capitalize by gaining revenues.

•  The above prediction proved to be wrong, as in 2012, and

so far in 2013, revenues have fallen.

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TRENDS

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2005 2006 2007 2008 2009 2010 2011 2012

Digital Album Sales

Digital Album Sales

E-Book Sales

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CD SALES

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1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

CD Sales

CD Sales

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B&N SALES

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COMP. SHEET

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Shares Mkt Cap Cash Debt EVName Ticker Currency (mm) Price (mm) (mm) (mm) (mm) x Signifies that ABB's data point is under the comp average

x Signifies that ABB's data point is the same as the comp averageBarnes & Noble BKS USD 85 14.57 1,236 80 583 1,740 x Signifies that ABB's data point is over the comp averageBest Buy Co Inc BBY USD 342 42.73 14,593 1,910 1,678 14,361Office Depot Inc ODP USD 289 5.51 1,592 472 1,056 2,176Dick'S Sporting DKS USD 101 53.39 5,372 135 15 5,251Home Depot Inc HD USD 1,432 77.88 111,559 3,419 12,758 120,898

Revenue EBITDAEBITDA-Capex EBIT EBITDA

EBITDA-Capex EBITDA

EBITDA-Capex

2014 EPS P/E Dvd Freq Yield

Barnes & Noble BKS 0.3x 8.5x 33.2x NA 2.9x 11.1x 2.5x 9.6x (1.27) NM 0.00 NA 0.00Best Buy Co Inc BBY 0.3x 6.1x 8.7x 9.8x 0.7x 1.0x NM NM 2.66 16.0x 0.17 Quarter 1.59%Office Depot Inc ODP 0.2x 6.9x 16.1x 18.0x 3.4x 7.8x 1.9x 4.3x 0.07 75.5x 0.00 NA 0.00%Dick'S Sporting DKS 0.8x 6.7x 11.4x 8.4x 0.0x 0.0x NM NM 3.02 17.7x 0.13 Quarter 0.94%Home Depot Inc HD 1.5x 10.4x 11.9x 11.9x 1.1x 1.3x 0.8x 0.9x 4.25 18.3x 0.39 Quarter 2.00%Min 0.2x 6.1x 8.7x 8.4x 0.0x 0.0x 0.8x 0.9x 0.07 16.0x 0.00 0.00%Average 0.7x 7.5x 12.0x 12.0x 1.3x 2.5x 1.3x 2.6x 2.50 31.9x 0.14 1.13%Max 1.5x 10.4x 16.1x 18.0x 3.4x 7.8x 1.9x 4.3x 4.25 75.5x 0.39 2.00%

EBITDA/ EBITDA

Interest-Capex/Interest (mm) FCF/Price EBITDA EBIT NI EBITDA EBIT NI

Barnes & Noble BKS 5.8x 1.5x (67) -4.6x 3% NA -1% 4% 0% 0.00Best Buy Co Inc BBY 17.6x 12.4x 936 21.9x 5% 3% 2% 6% 4% 3%Office Depot Inc ODP 4.5x 2.0x 97 17.5x 3% 1% 0% 2% 0% 0%Dick'S Sporting DKS 56.7x 33.1x 157 2.9x 12% 9% 6% 9% 7% 4%Home Depot Inc HD 19.2x 16.7x 6,072 78.0x 14% 12% 7% 11% 8% 5%Min 4.5x 2.0x 97 2.9x 3% 1% 0% 2% 0% 0%Average 24.5x 16.0x 1,815 30.1x 9% 7% 4% 7% 5% 3%Max 56.7x 33.1x 6,072 78.0x 14% 12% 7% 11% 8% 5%

Current Ratio Quick Ratio Debt/Equity Total Debt/EBITDA Credit Rating ROA Equity Multiplier ROE

Barnes & Noble BKS 1.11 0.11 11% 6.1x NR -5% 6.5x -34%Best Buy Co Inc BBY 1.34 0.44 75% 1.0x BB -2% 4.1x -7%Office Depot Inc ODP 1.30 0.64 106% 2.2x B- -3% 7.9x -27%Dick'S Sporting DKS 1.61 0.21 1% 0.0x NR 11% 1.8x 20%Home Depot Inc HD 1.30 0.38 61% 1.1x A 12% 2.5x 30%Min 1.30 0.21 1% 0.0x -3% 1.8x -27%Average 1.39 0.42 61% 1.1x 5% 4.1x 4%Max 1.61 0.64 106% 2.2x 12% 7.9x 30%

2014 EV Multiples Total Debt/ Net Debt/

Liquidity Leverage/Coverage Ratios Dupont Identity

Free Cash Flow 2014 Margins Hist 5yr Margins

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KEY METRICS

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EBITDA/ EBITDA

Interest-Capex/Interest (mm) FCF/Price EBITDA EBIT NI

Barnes & Noble BKS 5.8x 1.5x (67) -4.6x 3% NA -1%Best Buy Co Inc BBY 17.6x 12.4x 936 21.9x 5% 3% 2%Office Depot Inc ODP 4.5x 2.0x 97 17.5x 3% 1% 0%Dick'S Sporting DKS 56.7x 33.1x 157 2.9x 12% 9% 6%Home Depot Inc HD 19.2x 16.7x 6,072 78.0x 14% 12% 7%Min 4.5x 2.0x 97 2.9x 3% 1% 0%Average 24.5x 16.0x 1,815 30.1x 9% 7% 4%Max 56.7x 33.1x 6,072 78.0x 14% 12% 7%

Free Cash Flow 2014 Margins

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KEY METRICS

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Current Ratio Quick Ratio Debt/Equity Total Debt/EBITDA Credit Rating ROA Equity Multiplier ROE

Barnes & Noble BKS 1.11 0.11 11% 6.1x NR -5% 6.5x -34%Best Buy Co Inc BBY 1.34 0.44 75% 1.0x BB -2% 4.1x -7%Office Depot Inc ODP 1.30 0.64 106% 2.2x B- -3% 7.9x -27%Dick'S Sporting DKS 1.61 0.21 1% 0.0x NR 11% 1.8x 20%Home Depot Inc HD 1.30 0.38 61% 1.1x A 12% 2.5x 30%Min 1.30 0.21 1% 0.0x -3% 1.8x -27%Average 1.39 0.42 61% 1.1x 5% 4.1x 4%Max 1.61 0.64 106% 2.2x 12% 7.9x 30%

Liquidity Leverage/Coverage Ratios Dupont Identity

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PROFITABILITY TRENDS

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Gross Profit EBITDA Margin

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RETURN TRENDS

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Return on Assets Return on Equity

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PER SHARE TRENDS

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Earnings Per Share Cash Flow Per Share

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KEY FINANCIAL TAKEAWAYS

Comparably low liquidity

Declining revenues and profit

Poor cash flow

Declining per share metrics

Comparably low returns to shareholders

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EV/EBITDA VALUATION

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BKS Price $14.57Shares 58Mkt Cap $849

Debt $77Cash $160Preferred Stock $575Net Debt $492

EV $1,340

Bear Scenario: No REIT Conversion

2014E Mkt Low Avg High Comp Average MKT Low Avg High

Retail $115 6.0x 7.0x 8.0x 8.0x $688 $803 $917College $46 7.0x 8.0x 9.0x 8.0x $321 $367 $413Nook $23 3.0x 4.0x 5.0x 10.0x $69 $92 $115Totla EBITDA $183 7.3x 5.9x 6.9x 7.9x $1,340 $1,078 $1,261 $1,445

Debt $77 $77 $77 $77Cash $160 $160 $160 $160Preferred Stock $575 $575 $575 $575Equity Value $849 $586 $770 $953

Shares 58 58 58 58Price/Share $14.57 $10.06 $13.21 $16.36% Return 0% -31% -9% 12%

ValueEV/EBITDA Multiples

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EV/EBITDA VALUATION

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BKS Price $14.57Shares 58Mkt Cap $849

Debt $77Cash $160Preferred Stock $575Net Debt $492

EV $1,340

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EV/EBITDA VALUATION

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2014E Mkt Low Avg High Comp Average

Retail $115 6.0x 7.0x 8.0x 8.0xCollege $46 7.0x 8.0x 9.0x 8.0xNook $23 3.0x 4.0x 5.0x 10.0xTotla EBITDA $183 7.3x 5.9x 6.9x 7.9x

EV/EBITDA Multiples

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EV/EBITDA VALUATION

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Mkt Low Avg High Comp Average MKT Low Avg High

6.0x 7.0x 8.0x 8.0x $688 $803 $9177.0x 8.0x 9.0x 8.0x $321 $367 $4133.0x 4.0x 5.0x 10.0x $69 $92 $115

7.3x 5.9x 6.9x 7.9x $1,340 $1,078 $1,261 $1,445

Debt $77 $77 $77 $77Cash $160 $160 $160 $160Preferred Stock $575 $575 $575 $575Equity Value $849 $586 $770 $953

Shares 58 58 58 58Price/Share $14.57 $10.06 $13.21 $16.36% Return 0% -31% -9% 12%

ValueEV/EBITDA Multiples

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LIQUIDATION VALUE

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Balance sheet assets                         Value (M) Discount/Unsellable

Cash & short term investments 160.5 100% Receivables 149.4 80%  Inventories 1,400 75% (assumes books can be returned to publishers) 

Property, plant, equipment 600 (w/ Depreciation) 25%  (mostly store fittings) 

Other Current Assets 326.5 50%

Other assets and intangibles 2,100 10% (mostly goodwill and intangibles) 

Total Assets readjusted for liquidation 1,853.27 Deduct liabilities (2,400) 100%  (inventory returns will be netted against payables)

(546.73)

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RISKS

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Barnes and Nobles is able to reinvigorate the business model. Example: differentiate their stores, change their Nook business model, etc.

They can improve their “brick and click” model and win over market share from Amazon, Apple, Book-A-Million all while consolidating and shedding their psychical presence.

The company could be bought out, restructured, etc.

The market correctly values BKS.

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RISK: MARKET VALUES B&N CORRECTLY

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RECOMMENDATION

At this price point, we cannot recommend shorting B&N as the risk/reward is significantly favorable.

We believe that MII should monitor B&N’s stock price on a consistent basis.

We believe the stock will be an attractive short once it reaches $16, and should then be reevaluated.

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PRICE RECOMMENDATION

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$15.00 $10.06 $13.21 $16.36-33% -12% 9%

$16.00 $10.06 $13.21 $16.36-37% -17% 2%

$17.00 $10.06 $13.21 $16.36-41% -22% -4%

$18.00 $10.06 $13.21 $16.36-44% -27% -9%