Description

Note to reader – While another member recently posted for the ticker BNED.WI, despite the title, 80% of the discussion was about Barnes and Noble (BKS). After almost two weeks of silence on the message board, I had a different enough take that I wanted to share which was too long to discuss in the comments.

Why does this opportunity still exist? – Despite being the more defensible and attractive of the two businesses, BNED shares have actually underperformed those of BKS, post-split. If you include the period of when issued trading, BNED shares today at $12.50 sit closer to the lower end of its trading range of $15.98 to $11.75.

I am not an event-driven specialist, so I don’t have any specific insight as to what traders are saying at this particular moment. Maybe BKS got lucky and is still benefiting from the positive press around the July release of the book “Go Set a Watchman”. Or maybe the sell-off could be as simple as investors deciding to hold shares in the larger, more liquid, more familiar business, and sell the smaller, lesser known entity. Whatever the reason, let’s just thank Mr. Market for this opportunity.

Valuation – At $12.50 per share at the time of this write-up, BNED has a market cap of $603M. With a net cash balance of $95M, its enterprise value is $507M. It did about $85M in LTM EBITDA. I argue you need to add back $26M of investment spend on their Yuzu software (which will not go on forever), and about $3M in spin-related costs, giving you a PF LTM EBITDA of $114M. Total capex is about $50M per year, so normalized LTM EBITDA – Capex is about $64M.

We can debate how quickly they will add new college stores, but that number is growing. Benjamin Graham summed it up when he said, "The purpose of the margin of safety is to render the forecast unnecessary." I am very happy to pay less than 8x EV/LTM Normalized EBITDA-Capex for a growing business in a duopoly market.   

So upfront the stock is very cheap using normalized LTM figures. I will spend the rest of the write-up explaining why I think the business is defensible and will grow in the future.

Business Overview: BNED operates 720+ college bookstores on college campuses around the nation (only about 150 are branded with the Barnes & Noble name) under exclusive multi-year management agreements, operating as the official bookstore of the university. In addition, these stores have exclusive rights to sell university-licensed apparel and gifts through the bookstore channel, including operating the Universities’ online bookstores.

Campus bookstore industry is a comfortable duopoly - not much share shift between competitors

Of the 47% of schools that outsource bookstore operations, BNED stores account for about 16% - 18%. Privately held Follett (based out of Illinois) is estimated to be slightly larger than BNED. (Note – Direct comparisons are difficult directly because Follett has other businesses.) Nebraska Book Company used to be a distant #3 with ~5% share, until Follett acquired more than 200 of its locations back in June. Despite perceptions (Follett: “folksy Midwesterners”, BNED: “cutthroat New York”), both operate very similarly. Business is usually won or loss based on relationships with the schools. Both are setting their sights on the 53% of schools yet to outsource, rather than beat up each other.

Competitive advantages of the traditional campus bookstore players

1.   College bookstores are the only place where students can use their financial aid/scholarships/student loans to purchase books and other supplies. According to industry surveys, spending on required course materials averaged ~$638 last academic year. (Many sources incorrectly cite $1,200/year, but that includes office stationary, software, hardware, and course fees.) Regardless, this can be a large out-of-pocket cost for students, with ~41% paying for books with financial aid. This benefits BNED because their campus stores’ point of sale systems are connected directly to the school’s financial aid systems. Sure Amazon may be cheaper, but teenagers love to buying things on credit.  

2.   Colleges effectively grant BNED a local monopoly when it comes to advertising to students. People I spoke with repeatedly emphasized that rival textbook sellers are prohibited from advertising on campus. From a former Chegg employee: “You almost have to be there at the moment when the students are literally about to purchase the book.”

3.   The bookstore’s ability to hold significant amounts of inventory on campus is a big competitive advantage – particular during peak rush before each semester. Many colleges can’t, or won’t, let Amazon open a distribution center on or near campus. Freshman and sophomores can get anxious if they don’t have their books in time for class.

4.   Campuses bookstores have the exclusive right to sell collegiate licensed apparel and gifts on the campuses in which they operate. It is estimated that non-book items account for at least 35-40% of college bookstore sales, and have higher than avg. gross margins.

Watch senior management vote with their feet

Michael P. Huseby did an excellent job as CEO of BKS. It is worth noting that post-spin, he is resigning from BKS and joining BNED as its Executive Chairman. I do not have a strong opinion either way on the BNED CEO Max Roberts, so I find it an encouraging sign that Mr. Huseby is voting with his feet, and I am happy to follow him along for the ride.

There are signs that BNED has learned its lessons from their disastrous attempt at selling the NOOK. I don’t expect the Yuzu digital textbook platform to be a cash drain in perpetuity.

Yuzu allows students to organize and manage digital textbooks all in one place, with added digital note-taking, search, and highlighting features. To be clear: Student reception to the product has been very weak, to put it nicely. I think BNED is developing this app just so they have a seat at the table in case the nascent electronic textbooks market ever really develops. I don’t think this is a defensive spend that has to continue forever. What gives me confidence they will be rational? Well, back when he was BKS CEO, Mr. Huseby did right by shareholders by cutting back NOOK losses. And it was really the NOOK hardware that was the biggest cash drain. Yuzu software is hardware agnostic. I assume he will bring this knowledge to BNED, but this needs to be monitored.     

Addressing the Amazon threat

Surprisingly, no one on VIC has discussed Amazon’s entry into this industry. Over the year or so, Amazon has been establishing a physical store presence at 3 U.S. universities (Purdue, UC Davis, University of Massachusetts-Amherst), and counting. This has lead the press to speculate whether or not Amazon intends to more aggressively enter the college bookstore market. Under the name “Amazon Campus”, Amazon will operate co-branded websites with the schools, and open distribution centers where students can pick up packages from code-activated lockers. Similar to BNED, Amazon will pay schools a royalty fee as a percentage of sales.

1. “Amazon Campus” is not a full-fledged store, but more of a pick-up area for students who already buy things on Amazon very similar to Amazon Locker.  As demonstrated by BKS, there is still a large subset of shoppers who want a showroom experience.

2. Amazon’s presence has not eliminated the need for a physical campus store. Some of the reasons the first 3 colleges chose to partner with Amazon are idiosyncratic to their respective institutions, and are not necessarily applicable to other schools. For example:

UMass Amherst – Despite choosing Amazon to handle its textbook sales, Follett will continue to operate a campus store dedicated to higher-margin, non-textbook items.

UC Davis – Despite Amazon, they still have a separate store where they sell all other non-book items. In an article for the blog Inside Higher Ed, a college administrator said that the Amazon store doesn’t compete with the myriad of other products their school stores offer.

Purdue – Several independent stores still operate near campus despite Amazon. The owner of one of these independents said that adjusted for student enrollment, his sales were relatively flat over the past year since Amazon came.   

3. For all the talk of “disruption” in higher education, U.S. colleges and universities are notorious for being resistant to change. Having spoken with administrators who have heard both Amazon as well as the traditional booksellers give their sales pitch, Amazon’s model requires a higher capital investment from the schools and is not that scalable. BNED and Follett bring a consistency many admins desire.

Shift from book purchases to rentals is negative for revenue, but very positive for gross profits

Rentals have a lower price point, but much higher gross margins, so this has allowed BNED to grow gross profits with revenue essentially flat. Gross margins on rented text books are in the high 30%’s to low 40%s, while new book sales are in the low to mid 20%’s. Also, used books get recycled about 75% of the time, but rented books are returned virtually all of the time. This mix shift is positive for BNED’s as it will allow them to earn even more profit over the life-cycle of any given book. 

In conclusion – despite this being a summer of many spinoffs, I believe there is still a very attractive opportunity in BNED to acquire a strong, growing business in a dupoloistic industry, trading at less than 8x EV/Normalized EBITDA-Capex. I am happy to go in greater depth on any of the above points in the comments. 

Catalyst

-New college store wins can be tracked in real time if you follow higher-education blogs. Financial newswires sometimes miss these headlines

-More sellside firms should start research coverage

-Continued shift towards textbook rentals is accretive to gross margins