Description

Barnes and Noble Education is a business transformation story that offers one of the most attractive risk/reward opportunities in the market. While the equity has appreciated YTD, we believe the market remains overly fixated on the near-term financial impact of school closures and is failing to appreciate how dramatically different BNED's business will be on the other side of the pandemic. We see 100%+ upside as the impact of covid dissipates and investors awaken to the transformation that is under way.

BNED is signing universities onto its institution-wide digital textbook offering (called First Day Complete, or FDC) at a sharply accelerating pace. This will be a huge driver of value as FDC offers over 2x the unit economics of physical textbook sales. We believe FDC has achieved broad market acceptance and is set to reverse BNED’s historical trend of declining textbook sales at a pace that will surprise the public markets. As large recurring revenue streams start to hit the P&L in the coming quarters, we believe the stock will rerate in a big way. In the scenario where BNED converts 75% of its customer base to FDC, which we believe to be achievable in the longer term, we think the stock should be worth $30+.

Declining textbook sales has been the dominating narrative for the entirety of BNED’s existence as a standalone public company. As it becomes clear that the core textbook business is stabilizing, we believe investors will start paying attention to the multitude of growth opportunities offered by the rest of BNED’s business, none of which we think are baked into the current share price.

BNED also operates two smaller, higher quality businesses – a high margin general merchandise business and a rapidly growing digital study solutions business. Both businesses have seen significant positive developments over the past 12 months and are set to exit the pandemic with materially higher baseline growth and earnings power than pre-covid.

Given the ongoing concerns around covid, management has not provided formal guidance but has suggested a return to 2019 EBITDA of $105mm by FY23 (’22-’23 school year). We believe this is conservative and that ‘normalized’ EBITDA will likely fall in the $150mm-$180mm range. At the current TEV of ~$625mm, this would imply BNED is currently trading at ~4x EBITDA. Given the current undemanding valuation, we think there is a comfortable margin of safety, and even moderate success in BNED’s many growth initiatives would result in a home run for the equity.

Lastly, we think ongoing takeover interest will set a floor on the share price. BNED conducted a strategic review that was called off in summer 2020 during the worst of the pandemic when financing markets were slammed shut. The company had also previously rejected several unsolicited offers as high as $7/share in 2019. The business is much stronger today, and should public markets continue to underappreciate its value, we think takeover rumors could swirl once again. Given BNED’s strong cash flow profile, and accommodating debt markets, we think private equity could underwrite a deal today at $10+. Private equity interest in ed tech assets is well known and we think BNED’s strong relationships with universities and unparalleled access to the 18 to 24-year-old demographic will draw significant interest.

BNED was last written up in Feburary 2020 by Thor25, who did a terrific job outlining the opportunity and providing subsequent updates. We think the situation has evolved quite a bit since. We will keep our business overview section brief and focus more on developments over the past 18 months.

Business Overview

BNED is an outsourced campus bookstore operating, operating 770+ university bookstores in the US. The company does not have the fixed cost structure burdening traditional retailers. Contracts with universities are structured as long-term revenue share agreements with BNED paying universities a commission (of typically 5-17%) on gross sales. BNED does not pay rent, meaning the company was relatively unscathed by the worst of the pandemic and school shutdowns. The company has strong relationships with schools, who view BNED as bona fide partner. The relationship is sticky and retention rates are 90%+ with an average relationship of 15+ years.

In addition to its retail segment, BNED also operates MBS, which is the nation’s largest textbook distribution business. The business was acquired in 2017 and has been declining due to lower physical textbook sales. The business is strategically important to BNED and most recently was instrumental in fulfilling orders during covid with its drop-ship capabilities.

BNED segments its businesses as Retail and Wholesale. We find it more constructive think of the business as a Course Materials business (retail + wholesale) and a General Merchandise business, given the significantly different growth and margin profiles.

• Course materials (~$1.5bn in 2019 sales) has been declining at 8-10% a year.

• General merchandise (~$500mm in 2019 sales) includes primarily collegiate apparel, but also gifts, stationary, and graduation products. SSS has been growing at ~1%, trailing category growth.

BNED also runs a small but growing Digital Study Solutions (DSS) business. Most of the DSS assets were purchased via the acquisition of Student Brands in 2017. The most interesting asset here is bartleby.com, which is BNED’s version of Chegg. Management has been investing heavily in Bartleby and we think there is a real opportunity to take market share (more on this later).

Thesis

1) The conversion to digital textbooks is well under way, and will result in strong earnings growth and multiple expansion

The most significant driver of value will be the growth of FDC, BNED’s digital textbook offering. The unit economics of FDC are 2x+ more attractive than physical textbook sales. As hundreds of thousands of students migrate onto FDC, the sales uplift will be extremely powerful. BNED will also emerge as a much more attractive recurring revenue business deserving of a higher multiple.

To understand why BNED has been so unloved and why we believe the company has turned the corner, we think it is helpful to start with some industry background.

The textbook publishing industry is dominated by Pearson, McGraw Hill and Cengage, who together hold 85% market share. For years, the publishers had enjoyed a cozy structure with annual above-inflation price hikes and limited capex.

In 2015, the same year BNED spun out of BKS, industry revenue started its collapse, as students shunned new textbooks (now priced at ~$250) in larger numbers and flocked to burgeoning used textbook marketplaces, namely Chegg and Amazon. As the secondary market flooded with used textbooks and rental options, publishers earned very little revenue beyond the first couple semesters of a textbook life cycle. 

Plummeting sell-through rates sent publishers scrambling to find viable alternative business models that could reclaim market share from Chegg/Amazon. Within the span of a few years, dozens of access and pricing strategies were trialed. None were effective in stopping the bleeding, and only confused students and pissed off school administrators. A few examples:

• Unique access codes that forced students to buy new textbooks in order to access supplemental online textbook problems; was extremely unpopular with faculty who share student concerns around affordability

• Offering digital-only textbooks; did not solve problem due to lower ASP + increased piracy

• Aggressive repurchase of used textbooks to limit secondary market supply

• Making certain textbooks "rental only" to eliminate secondary market 

The rapidly changing industry dynamics hit BNED with a double whammy. On top of contending with HSD textbook sales declines, management had little visibility into publishers' numerous new access/pricing models that came and went. A series of earnings misses shook investor confidence further. The risk of disintermediation by publishers also loomed. 

The situation has since stabilized. After several years of turmoil, the industry has finally landed on a win-win solution that offers compelling economics for all stakeholders. Under First Day Complete ('inclusive access model’ in industry jargon), universities automatically charge students a 'course materials fee' added to tuition when signing up for courses. Students receive digital course materials at a steep discount, typically 40 to 50%, negotiated by BNED with the publishers. Students can opt out, but few do. For BNED and publishers, ASP is lower but they benefit from significantly higher sell-through volume (~90% vs ~30% previously), lower inventories, and a more attractive digitized business. University administrators are appeased by the cost savings for students, and faculty are happy with improved learning outcomes as students show up to class prepared with the right textbooks.

Adoption of First Day Complete has inflected sharply. The program was piloted at 4 schools in 2019, before expanding to 12 schools in 2020. All have renewed. This fall semester, 64 schools (accounting for 300,000 students) will be rolling out FDC. Additional schools are slated for a spring semester roll out. Management is seeing increased momentum in sales, aided by the pandemic which further accelerated the migration to digital textbooks. Management also believes sales efforts are getting easier as more proof points are established. Interest from universities is high and the pipeline is robust.

The speed of the conversion to FDC and the magnitude of its financial impact will catch the street by surprise. During the analyst day in June, management did not offer guidance for the coming year, but expects the platform to have zero churn and to grow “at some kind of multiple” off the existing 300k base. Management also outlined the unit economics of FDC for the first time. For every school that adopts FDC, BNED expects a $300 per student sales uplift, with comparable margins. These are extremely attractive economics and the financial implications will be significant and immediate as hundreds of thousands of students migrates to FDC at a time. The runway is long and we are in the early innings. All in, BNED’s 6mm student base represents a massive $1.8bn incremental sales opportunity. We believe that FDC has reached critical mass and ultimately expect a large majority of schools to adopt the program, which would be a home run for the stock. As more schools adopt FDC and used textbooks are taken out of circulation in the secondary market, we expect the remaining schools to follow.

FDC will start to contribute meaningfully to sales in the near term, which we think will cause a big rerating in the stock. We also expect management to start breaking out digital sales, which could be another catalyst. We expect FDC will account for >10% of textbook sales this coming school year (FY2022). For FY2023, we estimate digital sales will be >25%, and the textbook business will return to growth vs 2019 sales. With increasingly large recurring revenue streams set to hit the P&L in the coming quarters, we believe the market will soon awaken to the power of the business transformation and its valuation implications.

2) BNED’s General Merchandise business will exit covid with much higher baseline profitability

The general merchandise business has been historically undermanaged, as much of management’s focus has been on stabilizing textbook declines.

We think the recently announced long-term partnership with Fanatics/Lids will materially increase general merchandise sales, while reducing costs, resulting in a much more profitable business going forward. Under the agreement, Fanatics will run BNED’s eCommerce operation while Lids will take over all in-store merchandising and inventory. Fanatics/Lids have also hired BNED’s in-house team of 20 employees, and have taken a minority stake in BNED. BNED will benefit from an increased product assortment as well as significantly enhanced supply chain, data, and marketing capabilities. Put simply, we think the partnership is a huge upgrade is every aspect of the business (management describes it as a “quantum leap”).

Growth in general merchandise sales will provide a huge uplift to EBITDA that we don’t believe investors are even remotely appreciating. General merchandise sales drop to EBITDA at 35-40%, as compared to incremental textbook sales with a 5-10% EBITDA margin. There are two reasons why we think this point may have slipped under the radar 1) BNED groups course materials and general merchandise into one reporting segment, which has obscured the significantly higher margin profile of the general merchandise business 2) investors have been laser focused on the unfolding crisis in Course Materials ever since the spinoff, while general merchandise sales have largely been flat, not moving the needle in either direction.

We are modeling a 20% increase in FY2023 general merchandise sales over FY2019 baseline levels of ~$500mm, resulting in a ~$35mm increase in EBITDA. About 10% of the increase will be from three years of net new business wins (mostly secured already), while the other 10% will be from optimization, which we think is reasonable as the business changes hand from a mediocre in-house team to best-in-class operators. There are lots of low-hanging fruit. eCommerce performance has historically been dismal (<10% of sales), especially when considering BNED’s access to student and alumni listservs. Fanatics has a strong track record in similarly structured partnerships, and points to several professional sports teams that saw 100%+ eCommerce growth in year one. Lastly, sales will also benefit from the recent completion of a multi-year buildout of a new eCommerce platform as well as additional shelf space freed up by textbooks.

3) We expect elevated growth in BNED’s revenue base as post-pandemic financial realities drive more schools toward outsourcing

The remaining independently operated bookstores will inevitably move to an outsourced model, providing a runway for BNED to grow its revenue base. Much of it could occur in the next few years, as universities grapple with the financial fallout caused by covid.  

Currently, about 35% of university bookstores are still independently operated. Based on the public university bookstore P&Ls we reviewed, we estimate that all but a few stores are operating at a loss. 

The outsourced model offers a clear value proposition, providing a guaranteed revenue stream to universities as well as enhanced product assortment and operational capabilities.

Universities are known to be notoriously slow to change. Adding to school administrators' hesitance towards outsourcing is that many of the bookstores have been operated by on-campus student unions for decades. Still, the industry was already steadily moving towards an outsourced model prior to covid, as independents struggled to navigate declining textbook sales and increasingly complex operations. We believe for many of the remaining holdouts, covid will be the final straw that will drive them towards outsourcing. 

For BNED, new business wins were already gaining momentum following a salesforce reorg in 2019 and completion and implementation of several faculty-friendly tech tools. The company won $45mm in net new business in FY2020, before notching $77mm in FY2021. Both numbers would have been even higher but were impacted by management actively culling unprofitable contracts over the past two years. FY2022 is off to a flying start with the recent Notre Dame win, which is as big as they come (we estimate a $30mm+ account).

The pandemic has further strengthened BNED’s competitive positioning, highlighting MBS’ strong fulfillment capabilities unmatched by competitors. Over the past few months, the company has also started going to market with Fanatics/Lids, who have established relationships with many Power Five athletic departments. Management believes the partnership will be a key differentiator and suggested it was a significant factor in the recent Notre Dame win.

We are modeling $60-80mm in net new wins going forward, in line with management commentary. While not earth shattering, it will contribute materially (3-4%) to overall growth. Each win is also an opportunity to upsell FDC.

4) Bartleby is an attractive call option that could unlock significant value

Bartleby is a direct-to-student online subscription service that offers college students study tools such as step-by-step homework solutions and essay help. Priced at $10/mo, Bartleby is a lower cost alternative to similar offerings by market leaders Chegg ($15/mo) and Course Hero ($20/mo).

Now entering year three, the core thesis has not changed since Thor25’s writeup so we will keep ours brief and focus on the recent developments:

·  Over the past year, BNED has invested heavily in building out content. The product gap versus competitors is shrinking and we think Bartleby will offer a competitive product come the fall.

·  BNED recently appointed David Nenke to lead the DSS division. Nenke previously spent 15 years at Amazon. Jury is still out but we view this as an upgrade.

·  BNED has the inherent advantage of leveraging its physical store footprint to sell subscriptions. This was the primary channel for customer acquisition prior to COVID, and we expect to again drive meaningful subscriber growth going forward

·  Bartleby has signed key distribution partnerships with Blackboard (LMS) and VitalSource (digital textbook platform). Both companies are leaders in their category and will broaden Bartleby’s reach to millions more students outside of BNED’s store footprint. More importantly, we think the partnerships demonstrate the willingness of leading ed tech companies to partner with Bartleby. We view Bartleby’s university-friendly reputation as a big advantage, as these ed tech companies have historically shunned Chegg and Course Hero, who are universally hated by faculty for enabling cheating.

We think there is real opportunity for Bartleby to take market share over the next 2-3 years. Bartleby is broadening its distribution through an ecosystem of top tier partners. Chegg, on the other hand, is increasingly relying on SEO, as its primary customer acquisition channel (its textbook rental / marketplace) declines.

The important thing to note here is that time is on BNED’s side. Chegg has little brand awareness among high schoolers, meaning Bartleby has the opportunity to compete on equal footing for each incoming freshman class. In the short term, we think the business contributes incrementally to EBITDA given its high margins. In the medium term, should Bartleby succeed in scaling meaningfully, it could be a home run for the stock (both Chegg and Course Hero are valued at 10x+ revenue).

Valuation Framing

Given the ongoing impact of covid, management has not given guidance, but has loosely suggested a return to 2019 EBITDA level of $105mm by FY2023 (’22 to ’23 school year), assuming a full return to campus.

We think BNED’s ‘normalized’ EBITDA will closer to $165mm. We outline our assumptions below. While hard to forecast with precision and management has not given specific targets, we don’t think any heroic assumptions are needed to easily get to $150mm+. We expect course materials sales will return to above-2019 levels by FY2023 (with ~25% coming from FDC). We add $35mm incremental EBITDA from general merchandise, $5mm from DSS, and $20mm from permanent cost cuts.

In the short term, we think BNED is cheap on an absolute basis and see 100%+ upside. With a current TEV of ~$625mm, BNED is trading at ~4x EBITDA. No good public comps exist, but we think 7-8x is a more appropriate multiple for a specialty retailer with a sticky revenue base, attractive cost structure, and multiple levers for growth. BNED also has counter-cyclical protection as college enrollments typically rise during recessions.

Longer term, we think the business earns a higher multiple as FDC adoption transforms BNED into an asset-light B2B services business with significant recurring revenues. Businesses with similar characteristics in the ed tech sector transact for double digit multiples. In this scenario, the stock would be a multi-bagger.

Risks

More school shutdowns and sports cancellations

COVID continuing longer than expected

Catalyst

Return to campus

Resumption of college sports / fan attendance

Upcoming earnings showing impact of FDC

Continued momentum in FDC adoption

COVID impact waning