Description

This is an intriguing story in that standard valuation metrics make the company seem more expensive than it truly is (on, say, P/E ratios etc)...but a little extra digging can get you a stock with the potential to double in the next couple of years.

The core business is book superstores, but the company now has 20% of sales from the video game retailing business. The introduction of PS2 and XBox this year should provide a sales and profit boost for this division, after a tough 2000 (assuming Sony can get its act together and ship enough product!). The remaining businesses are the previsously mentioned B&N superstore business and about 350mn in revenues from B. Dalton, a mall-based book seller. The latter is a declining business, but B&N, as the largest book seller in the US, has grown very nicely over the past few years and has been virtually immune from the onslaught of on-line competitors such as Amazon.com.

B&N has an online presence itself, through 40%-owned B&N.com (BNBN). The other partner is Bertellsman with 40%. The remaining is free float. BN.com has enough cash on the balance sheet to fund itself to profitablity, so I don't expect further cash calls. Unfortunately, though, it does currently lose money and B&N accounts for it's dot.com sub as an associate, so BN.com's losses are reported pro-rata on BN's income statement. Worst case loss is 60mn for this fiscal year. Add to this loss the goodwill amortization from recent acquisitions Funco and Babbages, and the total non-cash expense on the income statement is roughly $80mn worst case in FYE Jan01. This is versus forecast net income of $115mn! You can see then, that net and EPS understate the true earnings power of B&N. At the current price, B&N trades at less than 10x "clean" EPS or 5x EV/EBITDA and .45x EV/Sales (valuing the bn.com associate at $0).

So what's it worth? it's a rare occasion that one can buy the leading company in a growing, profitable industry at such a low price. I forecast that free cash flow (available for buybacks and debt paydown) can average between 150 and 200mn over the next five years, giving a FCF yield of 10% at the current price. Buyout models suggest a price in excess of $40 based on cash generating ability and growth prospects. M&A activity doesn't provide a usuable multiple in this case, but I think that BKS should be valued the same as other leading, long duration, high quality retailers. I suspect fair value is around 11x EV/EBIT or between $40 and $50 per share. I expect the stock to reach this target within two years.

Catalyst

The stock is simply mispriced. And although the idea is valuation driven, not catalyst driven, there is a catalyst in the wings in that the next few years should witness a ramp up of growth in the video retailing segments as XBox and PS2 gain in popularity. Len Riggio (chairman) thinks that 20% compound is not out of the question. If true, then my target price will seem low.