Can Barnes & Noble Change One More Time?

By Stephen D. Simpson, CFA | September 06, 2011 AAA

One of the most dangerous things investors can do is confuse what they want to happen with what is most likely to happen. Barnes & Noble (NYSE:BKS) is a good example of that Achilles heel for me - I'm a book nerd and very much want this company to succeed. The trouble is, though, that Barnes & Noble's market has changed dramatically, Amazon (Nasdaq:AMZN) and Apple (Nasdaq:AAPL) are formidable competitors, and a sober and unemotional reading of the evidence suggests little more than "maybe" when it comes to the question of whether this company can make it.

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Another Tough Quarter
Unfortunately, Barnes & Noble's fiscal first quarter results don't offer a lot of encouragement. BKS missed the consensus with its revenue performance, as sales rose a little less than 2% this quarter. Retail revenue was down almost 3% (on a nearly 2% negative comp), while BN.com revenue rose 37% and revenue from the college business fell about 2%.

Profitability continues to be a real problem. Gross margins picked up fairly well, with over two full points of net improvement and about 66 basis points of improvement in the retail. Unfortunately, the company's high fixed operating costs just shred that, and the company reported negative EBITDA of almost $24 million. On a net basis, the company lost nearly $57 million.

Certainly it is a challenge to find the silver lining here. The company's online business is still loss-making, and it's not as though this is a brand new business. At this point, if Barnes & Noble can't find a way to compete profitably with Amazon online, will they ever? Perhaps even more disappointing is the loss in the college bookstore business. Seriously, with the ridiculous mark-ups that are still commonplace in college bookstores, a company that can't make a profit in that business has some issues.

Nook Looking for More Than a Niche
B&N management still has big plans for the NOOK, the company's e-reader product that competes with the likes of Amazon's Kindle, Sony's (NYSE:SNE) Reader and a host of lesser known competitors (to say nothing of Apple's iPad). In fact, management is looking for sales to double to nearly $2 billion this year.

Is this going to be enough, though? In theory there could be a lot of profits down the road if Barnes & Noble can lock in a lot of users to its NOOK platform and then sell them profitable digital content through BN.com. The question, though, is whether the company can actually build that sort of customer base and a profitable online sales model before running out of cash and willing financiers.

Who knows, maybe Barnes and Noble could hook up with Google (Nasdaq:GOOG) or Nokia (NYSE:NOK) and Microsoft (Nasdaq:MSFT) and find some sort of super hardware/software/distribution home-run. Sure, it sounds ridiculous, but then the idea that Apple would grow to rival Exxon Mobil in market value on the back of music players and phones would have had many people questioning your sanity not so long ago.

Markets Don't Always Mean Opportunity
Certainly there is a market for e-books and digital content. A lot of writers love the idea of breaking free of publishing houses, handling their own marketing and disrupting the "winner take all" structure that has evolved in publishing today. Maybe e-readers are the key to going back to a time when numerous writers across a wide range of genres could make a living as opposed to just a handful of romance, mystery and sci-fi/fantasy writers taking home all of the money. But that does not necessarily mean that companies like Barnes and Noble are going to make all that much money of it.

Right now, B&N has to prove that it can staunch the bleeding and create a real model. Companies like Wal-Mart (NYSE:WMT), Target (NYSE:TGT) and Costco (Nasdaq:COST) may be threats when it comes to selling bestsellers, but bestsellers aren't all that profitable for booksellers anyway. Instead of worrying about them, management should worry about how it competes with Amazon and Apple and how it creates both the machine that people want to use to read digital content and the publishing/shopping experience that both content producers and consumers want to use.

The Bottom Line
Clearly I hope that Barnes & Noble not only hangs around, but finds a way to evolve and succeed. After all, it can be argued that Barnes & Noble already played a major role in changing the world of publishing and book-buying once before. Though the company clearly missed the second act (the shift to online sales), the battle for the third revolution (digital content) is not over yet. These shares are not appropriate for any but the most risk-seeking investor, and the company still has a ways to go before it convinces the Street that it is more than a fading also-ran in the market. (For additional reading, take a look at 10 Books Worth Investing In.)

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