Barnes & Noble Should Have Stuck to Its Knitting

Barnes & Noble  (NYSE: BKS  )  on Monday confirmed reports that it was laying off some engineers in its Nook e-reader/tablet division. While the downsizing wasn't as severe as initially reported -- Business Insider believed that the company had eliminated the Nook division's entire staff -- it marks another setback for the troubled bookseller.

Barnes & Noble created the Nook e-reader in a bid to keep up with Amazon.com (NASDAQ: AMZN  ) , which introduced the Kindle in 2007. Similarly, the Nook line of tablets was largely a competitive response to Amazon's Kindle Fire.

At the time, it may have seemed obvious that Barnes & Noble could not stand by and let Amazon disrupt its business model unopposed. However, the Nook experiment has gone poorly: Barnes & Noble racked up big losses trying to support its device ambitions, without getting much growth in return. Instead, the company should have stuck to its knitting. In other words, it should have focused on getting as much value out of its declining retail business as possible.

Downsizing the Nook business
Barnes & Noble has been in full retreat from the Nook e-reader/tablet business recently. Last June, the company announced that it would stop manufacturing the Nook HD and Nook HD+ tablets. Since then, it has worked on clearing out its existing inventory of both devices with big discounts. Going forward, Barnes & Noble plans to partner with other companies that may be interested in selling co-branded Nook tablets.

Barnes & Noble stopped building the NOOK HD tablet last year. Image source: Barnes & Noble.

At the time of the announcement in June, Barnes & Noble remained fully committed to the e-reader portion of the Nook business. However, while Amazon has seen huge growth in digital content sales, Barnes & Noble has been going the other direction: digital content sales fell more than 20% in its second quarter (the most recently reported quarter).

This may have convinced the company's leaders that they needed to cut Nook division costs even more dramatically if they hoped to reach breakeven. During the second quarter, the Nook segment lost $45 million before interest, taxes, depreciation, and amortization.

Nook division is an anchor
In its most recently ended fiscal year, Barnes & Noble lost $252 million before taxes. In the previous year, it lost $91 million before taxes. However, in those two years, the Nook segment posted losses before interest, taxes, depreciation, and amortization of $475 million and $262 million, respectively.

In other words, but for the Nook division's big losses, Barnes & Noble would have earned respectable profits in each of its last two fiscal years. (In fact, the Nook losses reported above would be even bigger if they included depreciation and amortization costs.)

Barnes & Noble's decision to wind down tablet production and slash expenses has helped limit the Nook division's losses so far in this fiscal year. Still, through the first half of the year, the company posted a $57 millionpre-tax loss, which is more than explained by a $100 million loss before interest, taxes, depreciation, and amortization in the Nook segment.

Declining profits are better than big losses!
All of this demonstrates that it was foolish for Barnes & Noble to try to copy Amazon's Kindle strategy in the first place. Selling physical books in stores (and online) is a declining business, but it's not going to disappear overnight. In fact, Barnes & Noble has some important competitive advantages. For example, its presence on many college campuses makes the company an easy option for textbook sales and rentals.

Barnes & Noble's traditional business remains quite profitable.

Indeed, for the critical holiday period, Barnes & Noble's sales held up quite well. Comparable-store sales in the retail division (which excludes the college bookstores) fell 5.5%, but dropped just 0.2% excluding the decline in sales of Nook products. Barnes & Noble has also been fairly adept at squeezing more profit out of its stores and website through cost cuts, despite weak sales trends.

By contrast, while the introduction of the Nook brought in incremental revenue, it never made money. In hindsight at least, this seems like it should have been foreseeable. While Nook devices generally got good reviews, Barnes & Noble was going up against a competitor (Amazon) that had a two-year head start, a lower cost structure, and a willingness to survive on razor-thin margins.

Foolish takeaway
Today, Barnes & Noble's market cap is about $1 billion. To get a sense of the company's folly, consider that the Nook segment has lost more than $800 million before taxes in the last two-and-a-half years alone!

The Nook may have enhanced Barnes & Noble's relevance in the context of brutal competition from Amazon (and other sellers of e-books such as Apple). However, it's quite possible that investors would be better off if the company had stuck to selling physical books and other media in stores and online.

That strategy would almost certainly have led to Barnes & Noble's demise at the hands of Amazon eventually. However, the company could have made a lot of money in the interim. Instead, Nook has sucked hundreds of millions of dollars out of Barnes & Noble -- money that otherwise could have been returned to shareholders -- without doing much to secure the company's future.

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