Description
BKS has appeared on VIC before but we think it deserves another look – we think BKS offers a nearly 10%+ free cash flow yield at today’s prices and that its substantial free cash flow capabilities will become increasingly evident to the market over the next 12 months. BKS is the larger of only 2 major superstore book retailers – these 2 players (BKS and BGP) have made substantial investments that would be difficult to duplicate. BKS is the world’s largest book retailer, operating 665 book superstores, 175 mall based stores (B. Dalton), and selling books on-line through barnes&noble.com (100% owned as of May 04). BKS also self publishes books and is one of the largest publishers in the world through its Sterling Publishing subsidiary, acquired in Jan 03.
BKS recently completed the spin off of its 63% ownership of Game Stop (GME) to shareholders and is now a simpler, clearer story for investors. What attracts us to BKS is its very strong and stable free cash flow. We believe BKS offers investors a free cash flow yield of nearly 10% at today’s prices – based on our version of free cash flow (net income plus depreciation and amortization minus maintenance capital expenditures) to market cap – with a very strong balance sheet and owner-oriented mgmt team. Excluding GME, BKS mgmt estimates their version of free cash flow of $175m to $200m for FYE Jan 05 but, importantly, this estimate is after about $150m of capital expenditures. (In fact, the CFO stated on the Q3 call that a) BKS would probably exceed $200m of free cash flow for FYE Jan 05 and b) $175m to $200m of free cash flow was a sustainable level). Management’s definition of free cash flow appears to include working capital gains and deferred tax benefits that we do not include in our definition of free cash flow. We believe at least $100m of BKS’ $150m of capital expenditures to be growth-oriented rather than maintenance. Based on management’s comments, we expect BKS to generate $350m of cash from operations (excluding GME) for FYE 1/05. Again, this cash from operations includes gains from working capital and deferred taxes which we have not included in our definition of free cash flow. Based on net income plus depreciation and amortization minus maintenance capital expenditures, we come up with free cash flow of $225m, or over $3 per share of free cash flow ($225m / 72m shares). At the current prices BKS is trading about 10x this free cash flow number. Moreover, we think BKS’ free cash flow has the potential to grow over the next few years – BKS currently has about 650 superstores in the U.S. and mgmt thinks it can get to 950 to 1,000 stores. We also think BKS can generate substantial additional cash flow beyond the $225m number from deferred taxes and continued improvements in working capital / inventory turns.
Summary financial history
These are for the bookselling unit only (superstores, mall stores, and on-line):
FYE 1/31 2001 2002 2003 2004 9mos 9mos
Sales 3,618 3,749 3,917 4,372 2,788 3,201
EBITDA 251 330 303 361 135 153
EBIT 128 212 177 226 37 41
Cash from operations 80 379 237 440 89 46
Capital expenditures -109 -148 -140 -100 -62 -93
Net debt (a) 641 341 32 -187 175 59
Shareholders equity (a) 778 888 1,028 1,260 1,098 1,321
(a) Balance sheet numbers are for BKS including GME.
Superstores (yr end) 569 591 628 647 663
Mall stores (yr end) 339 305 258 198 176
Comp stores - Super 4.9% 2.7% 0.0% 3.2% 3.4%
Comp stores – Mall -1.7% -3.7% -6.4% -0.2% -1.6%
Mall stores (B. Dalton) are being gradually closed as their leases come up. Borders is pursuing the same strategy with its mall chain. Mall store sales are now only about 3% of BKS total sales.
Valuation numbers (book selling units only)
P / Rev (LTM) = 0.48x
P / EBITDA (LTM) = 6.0x
P / EBIT (LTM) = 9.9x
P / FCF (LTM) = 10x
LTM EBITDA = $379m
LTM Revenues = $4,787m
LTM EBIT = $230m
LTM FCF = $225m+
FYE 1/05 Est. EPS = $1.78 - $1.84 (including losses for now consolidated bn.com)
P = $2,250m
Net debt = $200m (a)
(a) Based on the 7/31/04 balance sheet excluding GME filed as an 8K post GME’s spin-off. We believe net debt will be significantly negative for the stand-alone book selling operations at FYE Jan 05.
Unit economics
Mgmt says it costs about $1.9m to open a superstore, including the inventory investment. An average store does about $5.5m in its first year with an after tax return of about $360k or 19%. Comp stores generally grow in low double digits in the initial years and trend towards the chain average by year 5. The capital spent on these investments is growing the business and should further increase consolidated cash flow going forward.
Capital expenditures
BKS expects to spend about $150m on capital expenditures for the book segment during FYE Jan 05 the major components of which are as follows: 35 new superstores at $1.2m each (plus $0.7m each in working capital) ($42m); $35m for new distribution center; $25m for store maintenance capital expenditures (paint and carpet); $25m (our estimate and should be also considered maintenance) for systems, etc.
BKS spent about $93m on capital expenditures during FYE Jan 04, opening 47 new superstores.
Balance sheet
BKS has a very strong balance sheet. Inventories are built up in Q3 and liquidated in the Q4 holiday season. Consequently, we expect BKS to end Q4 (1/31/05) with a large pile of cash. The Q3 balance sheet (including GME) was as follows (an 8-K was recently filed for BKS 7/31/04 balance sheet excluding GME):
Cash $186
Inventories $1,811
Total assets $3,656
Payables $1,076
LTD $245
S/E $1,321
Keep in mind that this represents the seasonal peak of borrowing for Q4 – the balance sheet will only get stronger into FYE 1/06. For that reason, and because we think mgmt has made all the strategic cash investments it thinks necessary at this point (mgmt has stated they are “not in an acquisition mode”), we think meaningful buyback and/or dividend actions are a very good possibility.
Recent strategic & financial investments:
BKS (excluding GME) has generated substantial free cash flow in recent years but has redeployed this capital into strategic investments that now appear to be complete – these investments were as follows:
(a) Purchase of Sterling Publishing for $123m (Jan 03)
(b) Purchase of Bertelmann’s bn.com ownership for $165m (Sept 03)
(c) Purchase of public’s ownership of bn.com for $156m (May 04)
(d) Call of 5.25% converts for $295m (July 04)
Total cash deployed = $739m
Despite all these strategic expenditures, plus investing substantial capital in new superstores in the past three years, BKS enjoys a very strong balance sheet, which could clearly support purchases of its undervalued stock. We view the retirement of the converts effectively as a large share repurchase and perhaps an indicator of where management is headed.
These $700m+ of strategic expenditures made within the last 3 years represent almost 30%+ of BKS market cap today – yet BKS balance sheet remains almost debt free. We think this demonstrates the powerful cash-generating capability of the BKS franchise.
BKS purchased Sterling Publishing in Jan 03 for $123m in cash. Sterling was one of the top 25 publishers in the U.S. and the leading publisher of how-to books. BKS purchased Sterling to backward integrate and capture additional margin as well as acquire proprietary book titles -- BKS is one of the largest book publishers in the world as a result. Sterling publishes over 1,300 new titles per year and has an active list of over 6,000 titles. Sterling is currently about 5% of BKS total sales with the goal of getting to 10%. BKS is highly focused on differentiating itself with proprietary product.
Barnes&Noble.com (bn.com)
BKS recently completed the complete repurchase (first from Bertelsmann and then from the public)of its online bookselling operation which is 100% owned as of May 04. Bn.com is the #2 seller of books online behind Amazon. Bn.com is still not profitable but mgmt is improving its profitability with the goal of breakeven EBITDA for FYE 1/05. Q3 sales decreased 8% to $92m resulting in a net loss of $6.4m or ($0.09) per share. This compares to a loss of ($0.11) per share for last year’s Q3 (on a pro forma basis as if Barnes&Noble.com was 100% owned the entire year). Sales are down as mgmt has started eliminating marketing deals that were unprofitable for the online business. We do not think mgmt would have spent over $300m to own 100% of bn.com unless it firmly believed profitability could be achieved.
Mgmt & moat
Mgmt owns a significant stake in BKS and appears motivated to enhance shareholder value. (One negative is that mgmt has been pretty liberal with their option programs). Bloomberg indicates that on Dec 6 – 8 CEO Leonard Riggio purchased 685,000 shares at $27.54 to $28.00 per share. Mgmt has stated they are not really in an acquisition mode – they do not categorically rule anything out but one gets the sense they have all the pieces they currently require – superstores, online selling, and self publishing.
Mgmt is very focused on supporting and expanding the “moat” surrounding its business, and frequently discusses the “moat” in presentations. This is something we like. Some of BKS competitive advantages (which we buy into) include:
• only 2 major players in the superstore bookselling space – BKS is the strongest in our opinion (but we also own BGP and think its undervalued);
• significant inventory of book titles (over 1m titles in inventory, the most of any book retailer), representing an inventory investment of over $1 billion;
• proprietary book titles through Sterling Publishing (mgmt is very focused on having proprietary product in its stores),
• established base of attractive and comfortable stores (exclusive arrangement with Starbucks for café, etc);
• its membership base of over 2m (and growing) card club members (10% discount on in-store books and 5% online) (BGP does not have a card club program);
• large investment in information technology, warehouse, and distribution facilities (the Book-master system in stores is able to search for titles at other local stores, warehouse facilities, and even with wholesalers in an effort to get the book to customers as quickly as possible)
Bookselling industry
While the domestic book industry is expect to grow only modestly (2% to 3% per annum), we think the superstore operators will continue to increase market share, enabling them to grow sales faster than the industry. BGP has a presentation on its website which shows superstores with a 24% share in 2003 (up from 5% in 1993), independents with a 12% share (down from 19% in 1993), internet with a 9% share (up from 0% in 1993), malls with a 3% share (down from 10% in 1993), and other with a 52% share (down from 66% in 1993) (other includes book clubs, mass merchandisers, etc. which are lower “value add” and focused exclusively on front list / best seller product). We think BKS can use its substantial purchasing power to continue to strengthen its hand with publishers and also continue to add higher margin proprietary product in its stores.
We realize there are concerns about BKS competitive position versus mass merchant bookselling, Amazon’s on-line business, and used book sales. While we plan to closely monitor these trends we do not believe they will significantly impair the superstores’ long-term competitive position. We think the average customer spends about an hour in a BKS store and we think they frequently purchase books based on browsing the merchandise. We think the BKS stores are built as localized destination centers that provide a service and experience that extends beyond just the purchase of a book. Mass merchants are selling a significant share of books within the industry but their focus will continue to be on higher turn bestseller items. Best sellers represent only 3% to 5% of BKS annual sales, and have lower gross margins than average, primarily as a traffic driver into the store. We think Amazon’s share of the book industry has stabilized – it provides a great service at a great price (also offered by bn.com) but it’s a different service than the superstore experience.
Probably our biggest question with BKS is the long term impact of used book sales on its business. You can get a sense of these discounts on Amazon, which lists discounted books alongside new book sale prices. They are significant and we will watch this trend closely. However, are people going to give used books as gifts (Q4 is BKS largest by far)? Also, how quickly do customers get these books? – having product immediately available is very important to many book purchasers (no one is better at this than BKS). We think the lower priced used books may appeal to different segment that the typical BKS customer. We think, perhaps, it is more an issue for publishers than BKS.
Our belief is that BKS will continue to be successful with its superstores as destination-type trips where customers will spend an average of an hour in the store and purchase higher margin books that may not be something they initially came into the store to purchase. BKS customizes its stores to their individual locations and customer base and works to integrate itself into the local community via special events in the stores. BKS substantial IT system allows it to monitor lower turning items and customize individual store inventories.
Comp store sales trends by quarter
Barnes & Noble B. Dalton
10/04 0.9% -3.3%
07/04 1.4% -6.8%
04/04 9.4% 6.0%
01/04 6.4% 4.1%
10/03 4.5% -1.3%
07/03 5.6% 0.7%
04/03 -5.2% -14.0%
01/03 -3.0% -11.4%
10/02 1.6% -6.5%
07/02 0.3% -3.7%
04/02 2.5% -1.0%
Conclusion
We think BKS current valuation at about 10x current free cash flow is attractive for a stable, billion dollar plus stock. BKS is a business with a unique niche – we essentially view BKS as an important component of the distribution of new books in the country - that produces stable financial results. We think Wall Street remains overly focused on monthly comp store sales and EPS, while the real story of BKS is its steady and growing cash flow. With annual free cash flow of $225m, modest growth, and a reasonable discount rate, we value BKS at over $45 per share.
Catalyst
Potential Catalysts
a) Liquid b/s at FYE 1/05 gives mgmt alternatives to enhance s/h value
b) Mgmt allocation of free cash flow and excess capital towards buybacks and/or dividends - we think they are done with strategic investments for the near term.
c) Market recognition of BKS strong free cash flow capabilities.
d) Continued reduction in losses at bn.com could significant increase EPS.