Barnes & Noble Will Survive

John C. Malone, Liberty Media (Nasdaq: LMCA  ) chairman, explained Liberty's recent $204 million investment for 17% of Barnes & Noble (NYSE: BKS  ) in a peculiar way, according to The New York Times: "It's kind of like the people that survive a small pox epidemic. If you're still alive, well, maybe you got a chance of living a long life."

That epidemic of shifting market dynamics already put Borders into bankruptcy and out of its misery. And while the $10 billion company that Malone runs has money to spare on what he calls "a bit of a flier," or speculative investment, should small investors have any faith in Barnes & Noble pulling through and surviving into old age?

The symptoms
Outside of selling books, Barnes and Noble actually looks very little like its fallen brethren Borders. For one thing, Borders had little semblance of a digital strategy, handing off any future business to outside partners. Borders punted any e-book market with an investment that gave it an approximately 11 percent share of e-book retailer and reader Kobo. Before this, Borders outsourced its website sales to competitor Amazon.com.

Barnes & Noble, on the other hand, is aggressively attacking the digital realm. Its Nook readers command 21% of the e-reader market, while Amazon's Kindle leads with 52% market share. Barnes & Noble just announced a market-grabbing strategy of free or discounted Nooks with subscriptions to The New York Times or People magazine. And while investors questioned its announcement to spin off the Nook to separate the capital-intensive growth segment and the mature retail segment, CEO William Lynch has assured that "whatever we do, we will continue to have a tight relationship between the Nook and those stores and the Nook will continue to be Barnes & Noble's e-reader."

Borders also was burdened by its long-term leases, making it somewhat inflexible to alter its retail strategy. Of Borders' 508 stores, not including its Waldenbooks shops, 73% had leases expiring in 2017 or later. Compare this to Barnes & Noble's 704 stores, not including its college shops; only 24% have leases lasting into 2017 and beyond.

And while Barnes & Noble's gross margins are trending downward, it's been able to maintain higher percentages compared to Borders':

Company

2011

2010

2009

2008

Borders N/A 22.6% 24.3% 26.1%
Barnes & Noble 25.6% 28.9% 30% 30.1%

Source: Companies' most recent 10-Ks.

The cures
Will Barnes & Noble's digital push save it? During its last quarter ended Oct. 31, B&N.com sales amounted to only 11% of total sales. This division includes the company's eBook Store and Nook product offering. The good news is that this season's digital holiday sales reportedly grew 113% over last year's. The growth is promising, but it seems unlikely that the Nook itself can support the large number of physical stores, especially in the near term, since the Nook remains unprofitable.

Thankfully, Barnes & Noble has much more flexibility in its store leases than Borders had, and it can and must adapt by continuing to close unprofitable stores. From 2010 to 2011, total number of stores decreased by 15. Continue to look for more stores closings as lease terms expire on 129 stores in 2012.

But with a reduced retail footprint and a promising digital strategy, Barnes & Noble seems poised to survive well into the future -- just less prominently than it did before. Still, for investors who cannot match Liberty's $204 million deal, in which it earns a 7.75% annual dividend, I doubt Barnes & Noble represents a good investment, which is why I'm giving it a thumbs-down CAPScall.

Those falling gross margins could also foretell Barnes & Noble's future. Ominously, Barnes & Noble earns similar gross margins to those Borders earned in 2008, which is the year that Borders stopped paying its dividend. Likewise, Barnes & Noble announced last February that it suspended its dividend. If Barnes & Noble continues to let its gross margins slip, it very well could end up in the same grave as Borders.

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Fool contributor Dan Newman does not hold any shares in the companies mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On January 11, 2012, at 4:17 PM, saron1 wrote:

    B&K is also benefiting from their in-store barista sales and game sales much more Borders.

    The coffee area is prominent as you walk-in, not hidden away like Borders. The seating/browsing area is a a "Clean, well lighted place" for students, families and mobile workers.

    To get to the barista, you walk past tons of premium games and project kits that are not easy to find elsewhere.

    Its hard to leave a B&K without a significant purchase regardless of why you came in. Retail is all about getting the little things right.

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