Barnes and Noble (NYSE: BKS): To buy or not to buy?

For the past seven years, the Barnes and Noble bookstore chain (NYSE: BKS) has been pinned down by the pointy end of the pitchfork in the latest technology revolution to hit the print industry.

But ironically enough, the risk facing Barnes and Noble isn’t that it hasn’t embraced the changes sweeping through the print industry. Its problem is that its attempts to evolve have failed, sucking all the profit generated by its successful traditional bookstores. The company’s best hope might be as simple as getting back to the basics.

Will the appointment of new CEO Michael Huseby be enough to transform this dying business? Or will Barnes and Noble be burned to ashes as other book retailers have by the digital print revolt sweeping through the industry?

Attempts Have Been Made

First, we really need to give the previous administrative team at B&N some credit and cut them some slack.

In the face of both the worst recession in decades and the emergence of digital print and e-readers, the team did demonstrate sound decisive action to adapt and diversity their business.

Just look at how they embraced new markets in an attempt to broaden their consumer base, as described by Yahoo! Finance…

“Barnes & Noble, Inc. operates as a content, commerce, and technology company … in three segments: B&N Retail, B&N College, and NOOK [its electronic reader]. It provides access to books, magazines, newspapers, and other content through its multi-channel distribution platform. The company sells trade books, including hardcover and paperback consumer titles; mass market paperbacks, such as mystery, romance, science fiction, and other fiction; children’s books; eBooks and other digital content; NOOK products comprising NOOK HD, NOOK HD+, NOOK Simple Touch, and NOOK Simple Touch with GlowLight eBook reader devices and related accessories; bargain books; magazines; gifts; café products and services; educational toys and games; music; and movies.”

Over the years, the company has made serious and sound attempts at evolving with the reading public’s new digital demands. But they’ve done more, reaching out to new consumers at a younger age where they can strategically build life-long relationships, such as at colleges.

Barnes and Noble is the official bookstore for a number of colleges and universities, including top-tier schools like University of Pennsylvania and Johns Hopkins University. In the “B&N College” bookstores, the company sells textbooks and course materials, college-branded apparel and gifts, school supplies and general convenience items relevant to college life. Here, Barnes and Noble has also embraced the textbook rental trend popularized by the likes of Chegg and Amazon, and its Nook Study digital learning platform has extended this move into multimedia and e-texts.

The company has also diversified its means of delivery, selling its products “directly to customers through its bookstores and on barnesandnoble.com”, establishing a presence in both the traditional brick-and-mortar and online distribution venues.

As reported in its latest annual filing in July, 2013, the company “operates 1,361 bookstores in 50 states, including 686 bookstores on college campuses, operates one of the Web’s largest eCommerce sites, develops digital reading products and operates one of the largest digital bookstores.”

While B&N shares plunged during the recession for an all-time high of $48 in early 2007 to $8.50 in early 2011, the company’s new direction sent its shares tripling in price to nearly $24 in just two years by early 2013.

Until it was revealed that it may have received a helping boost from questionable accounting.

Loss of Revenue and Market Share Revealed

In July of 2013, B&N revealed that several quarterly reports “should no longer be relied upon because of a material error contained in such financial statements”. Upon restating the questionable reports, B&N stock plunged from $23.50 to $16 in one month, on its way to $12.60 by October.

Years of legitimate, well-intended and rather clever restructuring and restrategizing were undermined, as they company boosted profits by simply shifting funds from one of its businesses to another.

Another challenge for the struggling bookstore chain is its inability to take market-share away from giant Amazon – whose online book store has pummelled B&N stores, and whose Kindle electronic reader outsells B&N’s Nook by a significant margin.

Where Morgan Stanley estimated that Amazon will have generated some $4.5 billion from Kindle sales plus another $3.8 billion in digital media revenue in 2013, B&N reported its 2013 FY Nook revenue at just $776 million, with net annual losses of $475 million. The Nook lost market share over the past year, as compared to FY 2012 revenue of $933 million and net loss of $262 million.

Overall, B&N’s retail stores both online and brick-and-mortar also lost market share in 2013, generating $4.57 billion in revenue for FY 2013, down some 5.9% from FY 2012’s $4.85 billion. Although its college stores increased their revenue by 1.1% from $1.74 billion in 2012 to $1.76 billion in 2013.

The problem is that the company’s Nook e-reader has pretty much consumed all the profit generated by its traditional book stores. Where the company’s retail and college stores actually increased their EBITDA from a combined $438 million in FY 2012 to $485 million in FY 2013 for an annual increase of a very nice 10.7%, Nook operations increased their losses from minus $262 million to minus $475.

All totalled, the company’s net profit of $177 million for FY 2012 has been creamed to a mere $10 million in FY 2013 – all because of the Nook.

The Challenges are Many

This is the challenge incoming CEO Michael Huseby faces. As the company’s CFO since joining B&N in early 2012, and as President since mid-2013, Huseby has good inside knowledge of the challenges ahead. Will he be able to turn the company around?

It’s going to be an uphill struggle, considering the complexity of the company’s challenges, which involve more than just the ailing Nook e-reader business. In its July 2013 annual filing, the company noted a series of risk factors:

“The Company’s businesses have been adversely impacted by the economic downturn in the United States over the last several years which, among other things, has decreased discretionary consumer spending,” which could affect its “ability to fund its growth or its strategic business initiatives.”

“Barnes & Noble’s sales are primarily dependent upon discretionary consumer spending … ad other factors beyond its control”, citing decreasing traffic at shopping malls where its stores are located.

“B&N College’s sales are also affected by the overall economic environment, including as a result of reductions in funding levels at colleges and universities … Students also may spend less on textbooks and other general merchandise in a difficult economic environment.”

But perhaps most disconcerting of all is the lack of expansion opportunity. As the data above shows, B&N’s bread and butter are earned through its brick-and-mortar stores, whose market the company sees as pretty much saturated.

“Because of the Company’s existing penetration of attractive retail locations and the maturity of the market for traditional retail stores, the Company’s sales or net income may decline unless it successfully implements its business strategies”, the report cautions.

The company’s best area of business is fully matured and fully saturated, with little room for expansion. The only place it can grow is online. But the little B&N seedling is having a tough time getting any sunlight in the shadows of giant redwoods like Amazon.

And if that weren’t bad enough, the company also has legal problems, as it noted in its annual report:

“Barnes & Noble, Inc. and its subsidiaries are subject to allegations of patent infringement by various patent holders, including non-practicing entities (NPEs), sometimes referred to as ‘patent trolls,’ who may seek monetary settlements from us, our competitors, suppliers and resellers.”

And since “the Company is actively defending a number of patent infringement suits, [with] several pending claims in various stages of evaluation,” you just know the battle is going to be costly.

Greener Pastures Elsewhere

Now it is sometimes the case that a shakeup at the higher levels of administration can cause a floundering company’s stock to rise sharply just on high hopes alone. But unless the company can produce stronger numbers to support those high hopes, the stock usually comes rolling back down after the honeymoon is over.

Barnes and Noble has some serious issued to contend with. Since early 2012 it has been toying with the idea of selling its bleeding Nook business, but has yet to do so, prolonging the serious haemorrhaging of its revenues. Will it be able to score a victory against other popular e-readers for market share? With all of its ongoing patent battles? That is doubtful.

Until the company gets serious about getting rid of Nook and just focussing on its stable online, shopping mall and school campus stores, it will be unable to deliver any serious upside potential to shareholders.

Until that happens, there are greener pastures for your investment dollars to graze and fatten up.

Joseph Cafariello