Is Barnes & Noble's NOOK Separation a Miracle... or a Curse?

Source: Barnes & Noble

Jun. 25 will go down in history as a good day for Barnes & Noble (NYSE: BKS  ) . In its fourth quarter earnings announcement for its 2014 fiscal year, the bookstore chain let the world know that it has actively begun the process of separating its NOOK segment from the rest of its operations. In response to the news, shares of company shot up to touch a new 52-week high.

Although this move by management signals a new turn of the page for the retailer, its decision to separate the NOOK will could end poorly for the spun-off tech company in the face of competition from Amazon's (NASDAQ: AMZN  ) Kindle. The situation also begs the question of what kind of legal fallout Barnes & Noble might face from one-time business partners Microsoft (NASDAQ: MSFT  ) and Pearson plc (NYSE: PSO  ) , a partial owner of the firm's NOOK Media operations.

The NOOK probably can't survive on its own
Between 2010 and 2012, the NOOK segment was the pride and joy of Barnes & Noble. At a time when its college and retail operations grew, collectively, by just 14% from $5.8 billion to $6.6 billion, the company's NOOK segment saw revenue skyrocket 786% from $105.4 million to $933.5 million. During this three-year period, this top line growth appeared to justify the significant operating losses the retailer saw from its NOOK, which rose from $126.5 million to $286.3 million.

The story, however, changed during Barnes & Noble's 2013 fiscal year, when the NOOK segment's revenue plummeted 16% to $780.4 million. Despite the fact that sales of content on the NOOK jumped 16% between 2012 and 2013, the company suffered heavy losses from lower units sold and discounted prices. This resulted in Barnes & Noble booking a $511.8 million operating loss from the NOOK alone. This trend continued into 2014, with the segment's revenue falling 35% to $505.9 million (operating income has yet to be disclosed).

(millions) 2014 2013 2012 2011 2010
Revenue $505.9 $780.4 $933.5 $695.2 $105.4
Operating Loss Not Yet Disclosed $511.8 $286.3 $229.7 $126.5

Source: Barnes & Noble

Given the financial results attributed to the NOOK in recent years, a turnaround of the business appears highly unlikely. This is especially true when investors consider how well Amazon's Kindle has fared. As of Sept. 2013, approximately 24% of Americans own an e-reader. Of these, Amazon comprised a roughly 50% market share, while NOOK's presence has become greatly diminished.

Source: Pew Research Center

While Amazon's battle with Barnes & Noble appears to be over, the war for the broader tablet market is still just beginning. Right now, Amazon's Kindle has a large piece of a nice niche market, but with the iPad's share of the tablet market hovering around 91% while Amazon's has dipped below 4%, there's still a great deal of upside left for the tech conglomerate if it can find a way to grow away from just e-readers.

Microsoft and Pearson could pose a problem to Barnes & Noble
Although Barnes & Noble will benefit from the separation of its NOOK operations and Amazon will see its e-reader market share grow if NOOK cannot stand on its own two feet, the big loser from this transaction will likely be Microsoft. In April 2012, Microsoft and Barnes & Noble agreed to partner together in an attempt to save the NOOK.

In exchange for a $300 million investment, and installment payments that could total up to $305 million over a five-year period, Microsoft received a 17.6% stake in NOOK Media, a subsidiary set up by Barnes & Noble. In this set of operations, NOOK Media consisted of the company's digital device, digital content, and college bookstore businesses.

Source: Barnes & Noble

A couple months later, in Dec., Pearson made a strategic investment in NOOK Media in the amount of $89.5 million in exchange for a 5% stake. Even though this effectively decreased Microsoft's ownership interest in the business from 17.6% to 16.8% and Barnes & Noble's from 82.4% to 78.2%, the investment placed a value on the operation of nearly $1.8 billion. In spite of these cash injections, however, the NOOK has continued to deteriorate.

Foolish takeaway
Currently, Mr. Market is rejoicing over Barnes & Noble's well-reasoned move. By ridding itself of a shrinking and decreasingly profitable enterprise, the bookstore chain can return to its core operations and will see a nice uptick in profitability as a result. While this is good for Barnes & Noble's shareholders, it could prove problematic for anyone holding onto NOOK's shares once it goes public in 2015. Given the competition from rival Amazon, its future doesn't look bright.

Perhaps the most interesting angle, however, involves Microsoft and Pearson. With the splitting of the business, a quickly deteriorating NOOK could imply impairments for both companies. Because of its size, Microsoft's hit will be nothing more than a rounding error, but the impact on Pearson could be a bit bigger. In an attempt to protect themselves, legal proceedings by either of these companies wouldn't be out of the question and could be costly for Barnes & Noble.

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