Description

Barnes and Noble (BKS) is the largest U.S. book retailer, with stakes in the second largest web-based bookseller (36% of BNBN) and the largest video game retailer (63.4% GME or 57.4% using diluted GME share count). Due to the recent IPO of GME, it is now possible to invest in the BKS stub, whose stub enterprise value is less than competitor BGP. This, in spite of the fact that the BKS stub has higher sales (and SSS growth), better allocates capital, has fewer mall-based stores (which are dying due to superstores) and receives substantial free advertising from BNBN. I believe that the BKS stub value is depressed mainly because it is difficult to determine a precise value for it. Now that GME reports separately, the undervaluation of the BKS stub should become increasingly clear over the next few months, especially after all the 10-Ks and annual reports are out for BNBN, GME, and BKS.


The industry:

There are 5 large booksellers in the U.S. – BKS, BGP, BAMM, BNBN, and AMZN. Before AMZN came into being, the book superstore concept of BKS/BGP/BAMM (with café, audio CDs, live performances, etc.) was rapidly gaining market share, at the expense of independents and mall-based book retail chains (including BKS’s Dalton chain and BGP’s Walden chain). When AMZN began to capture the imagination of the public, the press, and stock speculators in 1999, pronouncements of doom for BKS and BGP proliferated. Doomsayers claimed that if BKS and BGP didn’t start their own web sites to compete with AMZN, their sales would decline. But if they did start their own web sites, they would cannibalize their own sales. So BGP/BKS couldn’t win.

The doomsayers were wrong. Both BKS and BGP have continued to grow superstore sales (mid single digit SSS growth and 20-50 net new superstores per year for BKS). Like retailers in many other industries, competitor BGP set up a web site to sell its wares over the internet but it was too little, too late, and they finally gave up, losing over $70 million in the process (this is typical BGP –they are reluctant to cannibalize existing sales channels, then end up getting beat out by competitors). Meanwhile, BKS cleverly set up a bookselling web site at no cost to BKS, which went on to become a solid #2 (about 20% market share) behind leader AMZN. Recently, AMZN and BGP teamed together to compete against the potent BKS/BNBN combination.

While BKS and BGP have consistently generated healthy positive operating cash flow over the past few years (and their stock prices are finally starting to reward this), AMZN has proved that it is possible to destroy value faster than an airline. AMZN is burdened with so much debt that a couple of setbacks might lead to bankruptcy and it has generated negative operating cash flow for 3 years running (BNBN has no debt, and generates positive cash flow, but has only 20% market share due to its more financially conservative approach). Furthermore, the book-music-video segments of both AMZN and BNBN have stopped growing (Guess what – many people actually LIKE going to book superstores – browsing the aisles, reading while sipping coffee, etc.). AMZN would like you to believe they are still growing, but a careful reading of their 10-Qs makes it evident that all growth is coming from new categories. Even the supposed rebound in book revenues in AMZN’s fourth quarter was at least partly caused by a shift in how AMZN accounts for its borders.com revenue – it used to be in the service segment and is was shifted in Q4 into the books-music-video segment.

I conclude that the BKS superstore concept is NOT threatened by competition from the internet, as so many had previously believed. In general, the book industry is characterized by low cyclicality, slow but steady growth, and continued market share gains by leaders BKS and BGP as the superstore format continues to grow in popularity (while BNBN and AMZN have finished grabbing market share from mall-based bookstores and independents - they are no longer growing). And both BGP and BKS believe there are hundreds more U.S. locations in need of a book superstore.


More about BKS:

It is very hard to figure out true ROIC/ROE numbers for a rapidly growing retailer due to the ever changing mix of store maturities and store sizes. It is even harder for BKS, due to all the buying and selling (via IPOs) of businesses they’ve done over the past 3 years and the numerous Dalton store closings. Looking at the easier-to-interpret BGP financials (and BKS prior to 1998), one gets the impression that this is a mediocre ROIC/ROE industry. But there are a lot of hints that BKS’ Lenny Riggio (Chairman of the board, founder, and 24% owner – was CEO until 2 months ago) skillfully allocates capital despite mediocre industry economics. The following four examples illustrate:

1) In recent years, book superstores have become much more popular with consumers than mall-based book chains. Riggio’s response has been to stop allocating capital to the Dalton mall stores (currently 8% of BKS’ book business) and allocate capital to higher ROI opportunities, such as the superstores or video game retailers. In fact, BKS has been closing many Dalton stores over the past few years. BKS passed BGP many years ago in superstore count because they weren’t afraid to cannibalize their mall-based stores with the superstore format that consumers preferred. Mall-based stores represent over 25% of BGP sales, so I expect BGP to suffer from declining mall-based retail sales much more than BKS over the next few years.

2) BKS is the only company I know of which sells its wares over the internet without having invested a dime or having to pay a fee. BKS accomplished this by a combination of partnering with Bertelsmann, utilizing existing book distribution infrastructure and taking BNBN public. Moreover, BNBN managed to go public at the height of the internet craze, obtaining top dollar for BNBN (which still has cash!). Note that BNBN is essentially free advertising for BKS, and is likely the reason BKS’s superstore SSS growth rates have exceeded those of BGP’s superstores for the last 8 quarters in a row. Note also that BKS’ long-range strategy is to push multi-channel bookselling, with increasing integration between BNBN and BKS (i.e. for an annual fee, the Reader’s Advantage card allows a discount for books purchased at BNBN or BKS). In my opinion, no retailer has navigated the internet boom as successfully as BKS, and this is part of why I think Lenny Riggio is so good – he enthusiastically embraces change and somehow always manages to come out on top.

3) For a net cost of about $150 million over the past 2.5 years, BKS now has a 63.4% stake (57.4% after dilution) in GME (36 million shares). This partial stake is now worth $780 million. Funco and Babbage’s (GME’s predecessors) were both acquired for lower prices when video game retailing was unpopular with investors. GME went public a month ago, presumably at close to a peak in investor interest in the video game sector.

4) BKS recently announced a book publishing initiative, with the aim to increase self-published books to about 10% of sales within 6 years. This will increase profit margins as BKS gets to keep some of the publishing profits for itself. Perhaps more importantly, it pressures publishers to offer BKS low prices to reduce BKS’ incentive to self-publish. BKS claims that sometimes publishers sell books for lower prices to mass merchants (i.e. Wal-Mart) than BKS, and that this move into publishing will help address this issue. BKS will mostly focus on books in the public domain. They already do this to a small extent with classics. Even though the price of classics in BKS stores is far below that of contemporary books, it is very profitable for them.


More about GME:

Unlike book retailing, video game retailing is wildly cyclical due to the (approximately) 5-year lifecycle of video game consoles. 2-3 years ago, video game sales began to fall in anticipation of several new consoles coming out during 2001. They fell even further when Sony’s PlayStation 2 was delayed and then came out in limited numbers. By 2001, the PlayStation 2 was in full production and 3 other new consoles were released later in the year (Nintendo Gameboy Advance, Microsoft Xbox, and Nintendo GameCube). This caused sales to rapidly increase, culminating in Q4 SSS growth of 58.7% (Q4 ended Feb 2, 2002). This huge growth rate is finally translating into profits as the cycle peak is approached (.18 EPS 2001, projected .84-.90 EPS 2002).

While console sales have been growing the top line, the bottom line grows more slowly because consoles are low margin products. The bottom line will grow faster than the top line 1-2 years from now, when higher margin video game software sales and accessories become a greater portion of the product mix. This is because there are a limited number of video games available per console upon initial release, but then software writers come out with many more games over time. 3-4 years from now, sales will decline as the cycle repeats itself.

Such large cyclical swings make calculations of intrinsic value difficult. But it is rather obvious that irrational investors tend to bid the stock price above intrinsic value during the peak of the cycle (in this case, 2001-2002), and below intrinsic value (in this case, 1998-1999) at the trough of the cycle. Personally, I’m quite pessimistic about GME (and competitor ELBO) prospects over the long run. In addition to large cyclical swings, there is competition from mass merchants, electronics superstores, toy stores, direct sales (from software publishers), online retailers, and the potential for video game downloads as broadband becomes more prevalent. While consumers enjoy browsing through bookstores, I don’t think the same is true for video game stores. Consumers want to buy the game in the cheapest and most convenient fashion possible.

During the next 5 months, BKS has a large incentive to promote the stock price of GME, because officers, directors, and senior management have 5,781,627 shares of stock that are issuable upon exercise of stock options (Riggio alone holds 4.5 million GME options). These can be sold after the 6 month lock-up period expires on August 12. In fact, BKS has been hinting in recent press releases that these shares are certain to be sold; they have been claiming to have a 60% ownership stake in the diluted share count of GME instead of the 66.6% they had in the undiluted share count just after the IPO (and it now appears that the underwriter exercised their over-allotment option in full, driving the 60.0% down to 57.4%). BKS has 36 million GME shares, while GME had 54.1 million undiluted shares outstanding immediately after the IPO. 36/(54.1 + 5.8) = 60.1%. I don’t think this is a coincidence – those options will get exercised and the stock sold shortly after lockup. It is quite possible that GME’s stock price will go up during the next 5 months, as they will be reporting fabulous sales numbers as the peak of the video game cycle approaches.

Note that GME is unlikely to be spun off in the short term, because such a spinoff would be a taxable transaction to shareholders until after 10/1/04.

While BKS will own 57.4% of GME after lock-up (which expires 8/12/02), they will retain over 90% voting control due to two classes of stock with BKS’ class getting 10 votes per share. In the long run, I expect Lenny Riggio to favor BKS at the expense of GME because he has a much larger stake in BKS, and because historically this has been his pattern. Investors in the BNBN IPO have lost over 90% of their investment, for example. Like a good investor, Riggio buys businesses at their trough of performance and popularity, then cashes out at the peak of the same. In the next few months, Riggio, GME management, and the underwriters will generate as much excitement as possible to promote the stock so they get to cash out at a good price. In long run, though, I expect GME’s stock price to fall.

In calculations of market capitalization for GME in other parts of this writeup, I assume dilution of 5,781,627 + 155,448 = 5,937,075 additional shares (see p.13 of GME prospectus for source of these numbers), for a total number of shares outstanding of about 60 million. To this I then add the underwriter’s over-allotment to obtain 62,710,000 total shares. This differs from what you will see reported by most financial web sites which will be basing market caps on 54.1 million shares (which is BKS shares + the number of shares offered).


The Numbers:

Ticker Shares Price/shr MktCap EV 01Sales EV/Sales

GME 62.71m 21.9 1.36b 1.36b 1.12b 1.21
BNBN 162.90m 1.62 .264b .164b .405b 0.41
BKS 67.16m 31.5 2.12b 2.48b 4.90b
BKS stub 1.24b 1.61b 3.51b 0.46

BGP 81.5m 22 1.79b 1.81b 3.39b 0.53
ELBO 25.8m 35.68 0.94b 0.94b .859b 1.09
AMZN 373m 16.41 6.12b 7.72b 3.12b 2.48

I know P/S and EV/S ratios are not good valuation metrics in general, but it is difficult to determine the sustainable earnings for most of the companies listed above. I thought the EV/S presentation would more clearly highlight the differences between BKS segments and their competitors, without having to explain all the short term factors causing various companies earnings to be higher or lower than usual in 2001.

I calculate a forward EV/E ratio for the BKS stub to be 14.5 versus 14.7 for BGP, based on projected 2002 earnings for BKS (retail segment), GME, and BGP in their most recent press releases. Using the same assumptions, I get forward P/E ratios of 11.2 for BKS and 14.6 for BGP. I will explain how I got these numbers if anyone asks.

While this idea may not seem like such a bargain based on the forward EV/E, keep in mind that margin expansion is likely to occur over the next few years due to the publishing push, cost cutting, and economies of scale. I don’t have a precise number, but Lenny Riggio believes 10% operating margins are possible long term (from the current average of about 6% in the book division for the last few years). Combine modest improvement in operating margin each year with sales driven growth, and I believe EPS growth of the BKS stub is likely to be in the range of 10%-30%/year for the next few years, warranting a forward EV/E of at least 20. I’ll be able to narrow down the wide growth range over the next few quarters once there are several quarters worth of 10-Qs with the new BKS/GME/BNBN combination.


There are several ways you can invest in BKS:

If you think GME is a good business too, you can simply buy BKS.

If, like me, you think GME is a lousy business in the long-run, you can buy BKS, and short GME .536 shares for each BKS share you buy (BNBN isn’t worth shorting because it’s a small part of BKS and it is reasonably valued).

If you want to bet on GME’s stock doing well in the short run but poorly in the long-run, you can buy BKS now, and short GME a couple months from now as described above. I already did this (I purchased BKS at 29 on 2/15 and shorted GME today at 21.6). Or you could do this backwards by shorting GME now and hoping for a stock price drop before going long BKS.

The BKS convertible bond may be a good deal, though I haven’t looked into it.

You could forget BKS and just short GME now, or a few months from now.

Or you can skip the BKS/GME part of this write-up and go long BNBN and short AMZN on the theory that each $1 of AMZN sales cannot possibly be worth 6.5 times as much as each dollar of BNBN sales. Given the willingness of AMZN investors to pay just about anything for AMZN, I don’t recommend this.


What not to like:

Lenny Riggio is anxious to do more acquisitions. While GME worked out well for BKS, there is no assurance that future acquisitions will work so well. It is partly for this possibility that Moody rates BKS bonds (barely) below investment grade.

There is $300 million of 5.25% convertible debt outstanding, with a conversion price of 32.51. BKS cannot call back this debt until after 3/20/04. This is potentially 9.23 million shares of dilution. Furthermore, BKS is rather generous with stock options – averaging over 2 million options per year during the last few years (vs. a total current share count of 67.2 million).

Lenny Riggio has a history of extracting a lot of value from related party transactions (see p.52 of prospectus for the most blatant example with GME’s predecessors). Another example is a 10 million dollar bonus being paid by BKS to Riggio and other executives due to GME meeting its EBITDA target for the just completed year (why isn’t this being paid by GME?). On the bright side, the majority of Riggio’s net worth is in BKS stock, so usually BKS shareholders benefit at the expense of other entities; BKS shareholders win while BNBN shareholders lose, and so too will GME shareholders lose in the long run.

Although BKS is currently winning the war for book market share, competition is very fierce. If BGP/AMZN merged, or somehow AMZN got an infusion of capital (perhaps by being acquired?), then perhaps AMZN would yet again burn through a lot of capital to gain market share. Why investors would want to support AMZN doing this is beyond me, but they did it before, so maybe they will do it again.

BNBN might need a capital infusion some day, and BKS might supply this capital.

Mid single digit SSS growth is partly due to large numbers of new stores being opened. The mature stores are probably growing very slowly, if at all.

Catalyst

As annual reports get released, BKS undervaluation will become more obvious.
Gradual margin expansion due to publishing push, cost cutting, and economies of scale
GME Spinoff could occur on or after 10/1/04.
Video game up-cycle combined with Riggio’s incentive to push up GME’s stock price for next 5 months, followed by lock-up expiration.
Declining BNBN losses (which flow to BKS).