Will Microsoft Be Key To A Barnes & Noble Turnaround?

By Stephen D. Simpson, CFA | June 21, 2012 AAA

For the number of people seemingly willing to pull the plug on Barnes & Noble (NYSE:BKS), you'd think there was a fat inheritance at stake. There's no point in pretending that the traditional retail format for books and other print media is permanently impaired (if not condemned to a steady downward spiral), and there are no guarantees that B&N's NOOK is going to emerge as a viable long-standing e-reader/tablet platform. All of that said, Microsoft's (Nasdaq:MSFT) support, and a relatively thin float, could make this a pretty wild stock from time to time.

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Not Much Joy to Cap the Year
Although there were some bright spots in Barnes & Noble's fiscal fourth quarter results, they are against a pretty dark backdrop. Revenue was just barely up (less than half a percentage point), as the company saw minimal growth in retail (the traditional bookselling business), nearly 6% growth in the college bookstore business and a greater than 10% decline in NOOK and digital content-related revenue. On a comp basis, the retail operations did see a 4.5% increase, while the college business saw a 2.2% decline.

Gross margin did improve by a point and a half, despite a big decline in NOOK gross profits. Retail gross margin improved more than a full point and the college business saw a significant improvement. That helped fuel improved EBITDA, though this number was still a negative.

SEE: A Look At Corporate Profit Margins

Can Microsoft Really Make a Difference?
One of the bigger recent developments for Barnes & Noble was a partnership with Microsoft, built around the NOOK. Barnes and Noble will be restructuring part of the business into a "NewCo" which will include the NOOK (and related businesses) and the college bookstore business. In turn, Microsoft is paying $300 million for a fractional ownership (nearly 18%) and the possibility of investing more into the business down the line.

This should (or at least could) help Barnes & Noble on multiple fronts. For starters, the company can use the cash. Second, while NOOK currently uses Google's (Nasdaq:GOOG) Android, it is likely a matter of time before the company's switch to Windows. It may also prove to be the case that Barnes & Noble can rely on assistance from Microsoft when it comes to device/software design for further iterations; this isn't necessarily an expensive proposition (as Apple (Nasdaq:AAPL) has ably demonstrated), but it does take know-how.

What Microsoft gets out of this is perhaps not so immediately obvious. Microsoft certainly needs to get more mobile devices onto Windows if they want to stand shoulder-to-shoulder with Apple and Google in the ongoing evolution of computing. To that end, the NOOK does give them an entry in the lower-priced device market. It'll also be interesting to see if Microsoft can leverage Barnes & Noble's college bookstore business; Apple is quite strong at the college level and that's a market I'm sure Microsoft would like to grow.

SEE: Which is Better: Dominance or Innovation?

Can There Be More than Two ... and Is This the Team to Do It?
A partnership with Microsoft is likely to do more for Barnes & Noble than Liberty Media (Nasdaq:LMCA), but it is hardly fait accompli that Microsoft can help solve their problems. Not only do Apple and Amazon (Nasdaq:AMZN) have popular e-readers/tablet platforms of their own, but Microsoft is not exactly building a reputation for partnering with winning hardware platforms.

It's also worth asking if Barnes & Noble's management is up to the task. Leonard Riggio not only owns a large chunk of stock, but is still involved with the company as chairman, as well. There have been transactions between him and the company that raise the specter of self-dealing and Barnes & Noble has arguably always been the second-mover when it comes to big changes in the bookselling/media world.

The Bottom Line
Barnes & Noble produced positive EBITDA for the full year and the company's core bookselling business is profitable, albeit not really a growth engine anymore. If Microsoft's involvement with NOOK can really help that platform catch fire in the next year, this is still a business that can come back - although its future is going to be a lot different than its past and digital content has to be a bigger part of that.

Still, this is a very risky proposition and quite a lot can go wrong from here. Amazon and Apple look like relentless rivals at this point, although it's well worth saying that technology leadership has a way of changing faster than people expect. Valuation is almost moot with this company, as the outcome from here is likely to be binary (success and a higher stock price, or failure). That said, investors considering these shares need to be aware of the high short position and the low float - often a harbinger of exceptional volatility.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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