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Barnes & Noble Education (NYSE:BNED)
Q3 2019 Earnings Conference Call
March 5, 2019 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning. My name is Adam, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Barnes & Noble Education fiscal 2019 third-quarter earnings conference call. [Operator instructions] Tom Donohue, CFO, you may begin your conference.

Tom Donohue -- Chief Financial Officer

Good morning, and welcome to our third-quarter fiscal 2019 earnings call. Joining us today are Mike Huseby, chairman, CEO; Barry Brover, EVP of Operations; Kanuj Malhotra, president of Digital Students Solutions; Lisa Malat, chief operating officer, Barnes & Noble College; as well as other members of our senior management team. Before we begin, I would remind you that the statements we make on today's call are covered by our safe harbor disclaimer contained in our press release and public documents. The contents of this call are for the property of Barnes & Noble Education, and they're not for rebroadcast or use by any other party without prior written consent of Barnes & Noble Education.

During this call, we will be making forward-looking statements with predictions, projections and other statements about future events. These statements are based upon current expectations and assumptions that are subject to risk and uncertainties, including those contained in our press release and public filings with the Securities and Exchange Commission. The company disclaims any obligation to update any forward-looking statements that may be made or discussed during this call. At this time, I'll turn the call over to Mike Huseby.

Mike Huseby -- Chairman and Chief Executive Officer

Thanks, Tom. Good morning, everyone, and thanks for joining us today. This quarter, we continued to accelerate our business transformation, advancing our efforts to shift to enhanced digital offerings in all of our segments. This acceleration is most evident in our DSS segment, where we successfully launched our Bartleby digital study subscription product in our BNC and MBS stores.

As a reminder, the Bartleby study subscription is a new direct-to-student product that provides access to step-by-step textbook solutions and expert Q&A. After initial soft launch in August, January marked the start of our first selling season for Bartleby within our store footprint. It was a very encouraging start to what we project as an important driver for long-term growth. In January and February, we proved out our strategy of leveraging our vast store footprint and strong relationships with faculty, administrators and students to introduce new scalable and valuable digital products and services.

Each day, we are improving Bartleby's ability to compete by significantly expanding the number of textbook solutions we offer students. We're pleased to report that we surpassed the $1 million mark of such solutions in January. Because of our unique role as the campus physical or virtual bookstore, we know which course materials are most widely adopted by faculty and used by students and which subject students are most frequently struggling to master. We're leveraging our deep knowledge of student course material consumption to better inform and manage the cost of our content development.

This is a key point of differentiation for us. In addition to saving time and development costs, our unique relationships and insight will allow us to scale Bartleby relatively quickly and efficiently. Bartleby gained more than 50,000 gross subscribers through the Spring Rush period, including the month of February. Importantly, the majority of those subscribers were originated by our in-store team members.

Our store personnel brought tremendous energy to the introduction of Bartleby and clearly proved that they can sell direct-to-student digital products. As I mentioned, Spring Rush was our first in-store sales push for Bartleby. This digital study product is relatively nascent with heavy reliance on promotional sales that we are working hard to convert to satisfy paying customers. We'll continue to test and adjust pricing models and content offerings based on the feedback we receive.

Additionally, we recently signed a content licensing agreement with a major publisher that allows us to further increase Bartleby's content library and more efficiently acquire subscribers. We expect to continue to scale this offering and anticipate that we will begin to see meaningful financial impacts 12 to 18 months from now. We strongly believe in Bartleby's ability to supplement and complement the academic support already provided to students on campuses today by faculty members and tutoring centers. We expect our direct-to-student offerings to add substantial value to our customers, company and our shareholders.

Looking ahead, our vision is to further integrate and leverage the strengths of our three business segments. Our DSS offerings can be packaged and priced to provide more value to the campus partners we serve through BNC and MBS. For example, we are exploring different ways to design First Day inclusive access bundles that not only include students' digital Courseware through a course fee but also include our proprietary or other sponsored digital learning products. Our institutional partners are increasingly being tasked with increasing affordability and accessibility objectives in order to compete with other universities in a current U.S.

robust job market. These all-in inclusive access bundles can provide a truly compelling price value proposition for affordable, seamless delivery of dynamic learning tools to students, driving efficiencies and improving outcomes for both the student and university. The industry shift from physical to digital has been under way for some time, but this quarter, we saw that shift continue to accelerate. Trends, such as lower average selling prices and the continued decline of physical Courseware, contributed to somewhat higher-than-expected declines in revenue and EBITDA for the BNC and MBS segments.

Total comp store sales at BNC decreased 7.7%, primarily attributable to declines in textbook sales, slightly offset by a 1.6% increase in our higher-margin general merchandise sales. Consistent with prior years, the Spring Rush period extended beyond the quarter due to later school openings and students buying materials later in the semester. So factoring the month of February, comp store sales at BNC decreased 4.9% on a year-to-date basis. Total sales at BNC decreased by 8% due to comp store declines as well as the impact of previously disclosed negative net store closings, representing approximately $4 million in revenue for the quarter.

As a result of an increased emphasis on our value proposition and improved sales execution, we are starting to see the reversal of revenue declines attributable to competitive losses. We restructured our sales team to ensure broader coverage and optimal efficiency and are aggressively targeting more accounts to reignite our managed stores growth. We've begun to win new accounts as a result of these efforts and are encouraged by our healthy pipeline for new business. We're also engaged in an expanded dialogue with both current and potential campus partners about our ability to serve them with digital offerings we now have the ability to provide.

These are discussions we would not be able to have had without the investments in digital platforms and offerings we have made and are continuing to make. Given the current industry dynamics, we're accelerating our efforts to move a higher percentage of our offerings to digital by continuing to make important investments in people, process and technology, including our virtual bookstores, our e-commerce business, OER plus Courseware and other institutional offerings, such as a new Courseware adoption and insights platform for faculty and academic leadership that we will introduce this summer. Our inclusive access offering, First Day, remains an important initiative in our institutional business. We're pleased with the continued adoption and acceptance of this model and saw a 133% increase in First Day sales for the quarter.

As a reminder, First Day results in sell-through of more than 90% compared to approximately 35% today. We also recently announced expanded relationships with multiple publishers, including Oxford, Wiley and Macmillan Learning, which allow us to offer even more content through our First Day platform. As a result, the faculty of colleges and universities who adopt our First Day model have the flexibility to choose content from multiple publishers. In short, by making publishers' digital content available through inclusive access programs on BNED campuses nationwide, we are delivering a variety of choice to ensure that faculty can choose the materials that are right for their class while still helping to save students' money.

At MBS, sales were down approximately 16.2% for the quarter. This decline was higher than we anticipated due to decreased demand for physical books in the wholesale business. MBS Wholesale was also impacted by lower publisher rental penetration than expected due to publishers offering lower-priced loose-leaf and other options. And finally, rental programs, in which the publisher retains the title to the books and we earn a fee on each book rented, results in lower revenue but will optimize margin and cash flow as MBS never has to take titles to the inventory.

While we originally anticipated benefits from these pub rental programs to be recognized in fiscal 2019, we now anticipate these cash flow benefits to be recognized by MBS in fiscal 2020. As publishers have shared both publicly and in our discussions with them, a large number of their top physical titles will be available for rental in the fall. MBS remains ready and able to distribute these titles. We continue to transform MBS to an innovative service provider for the industry, while we also explore new ways to best utilize MBS' advanced distribution capabilities.

Similar to BNC, MBS' direct sales were impacted by closed stores as well as the industry shift from physical to digital, which includes the use of inclusive access models offered directly from publishers. We are currently working to combine important functions, including unifying our BNC and MBS sales forces, to go to market as a cohesive unit to drive new store sales which we expect to have a positive impact going forward. While we continue to invest in high-value digital growth platforms, we remain focused on managing the BNC and MBS businesses for margin and cash flow as they evolve their products and business models. At the same time, we are making structural changes to reflect our go-to-market approach for new business to more effectively drive new business sales, whether new physical or virtual stores or custom store solutions.

We expect to discuss such changes in further detail at year-end. We are actively driving required and very significant change throughout our BNED -- throughout BNED to adjust to the needs of a shifting industry and a changing student. As a management team, we are highly confident in our vision for the future, and we'll allocate capital and manage our cost structure to maintain an acceptable level of short-term profitability and strong free cash flow. We are making necessary investments to drive scale digital revenue and related returns for many years.

While any digital transformation takes longer than many of us would like, or at times, even have the patience for, we believe that we have the right team and the right plan in place. As an industry leader with long-standing institutional and student relationships, we have a strong grasp on where this market is today, where it's heading and the actions we need to take to serve our customers, both now and in the future. Even though we are pushing tremendous change through our organization, we recognize the need to effect positive change faster, to move at what we call digital speed and with measurable and improved results. We are taking all steps possible to achieve that speed and those results.

I'll now turn it over to Tom for the financial review.

Tom Donohue -- Chief Financial Officer

Thank you, Mike. Please note that the third quarter ended on January 26, 2019, consisting of 13 weeks. All comparisons will be to the third quarter of fiscal 2018, unless otherwise noted. Total sales for the quarter were $550.3 million compared with $603.4 million in the prior year.

This decrease of $53.1 million or 8.8% was comprised of $39.9 million decrease from the BNC segment, a $22.5 million decrease from the MBS segment and a $0.3 million decrease from the DSS segment, partially offset by lower eliminations between BNC and MBS. Comparable store sales at BNC decreased by 7.7% in the quarter as compared to a 6.2% decline in the prior-year period. Comparable textbook sales for the quarter decreased by 11.2% as compared to a prior year decrease of 7.2%. Textbook sales continued to be impacted by lower average selling prices of course materials, enrollment declines and student purchases from publishers directly and other online providers.

General merchandise comparable store sales for the quarter increased by 1.6% compared with a 2.8% decrease in the prior year driven by strong growth of graduation products, computer and supply products and improvements in café and convenience product sales trend. As Mike mentioned earlier, consistent with prior years, Spring Rush period extended beyond the quarter due to later school openings and the continued pattern of students buying course materials later in the semester. Factoring in the month of February, comparable store sales at BNC decreased 4.9% on a year-to-date basis. Net sales for MBS in the third quarter were $116.4 million compared with $138.9 million in the prior-year period, a decrease of $22.5 million or 16.2%.

MBS Wholesale net sales were $77 million, a decrease of $15.1 million or 6.4%. This decline was higher than anticipated due to decreased demand for physical books in the wholesale business. MBS Wholesale was also impacted by lower publisher rental penetration than expected due to publishers offering lower-priced loose-leaf and other options. MBS Direct sales were $39.4 million, a decrease of 7.4% or 15.8%.

Direct sales were impacted by closed stores as well as the industry shift from physical to digital, which includes the use of inclusive access models offered directly from publishers. DSS sales were $5.2 million in the quarter compared with $5.5 million in the prior-year period. The decrease reflects lower sales at Student Brands with weakness at the StudyMode website, partially offset by growth in the sales at other English websites like Bartleby Writing, as well as foreign language properties. Going forward, we will forgo some near-term monetization for some of our websites in our Student Brands portfolio as we publish both free content and premium content to drive SEO for sustainable long-term growth.

The consolidated gross margin rate of 24.2% was down slightly from 24.4% in the prior-year period. This is primarily attributable to a shift to lower-margin digital products and a higher contract costs related to contract renewals and new store contracts. Selling and administrative expenses in the third quarter decreased slightly compared with the prior-year period. The decrease at BNC of $2.1 million or 2.3% was primarily the result of decreases in comp store payroll and operating expenses, a decrease in net new store payroll and operating expenses and a decrease in infrastructure costs, including LoudCloud digital operations.

MBS expenses decreased by $1.1 million or 8.9% driven by lower payroll and operating expenses. DSS selling and administrative expenses of $3.6 million increased by $1.2 million, primarily due to ongoing costs associated with the development of Bartleby, as well as costs related to Student Brands and other digital offerings. Corporate Services increased by $0.5 million as a result of higher professional fees, primarily related to our digital offerings. Given the revenue trends in BNC and MBS, we are focused on managing costs, realizing we are also relying on our store personnel to market and sell new digital offerings.

Our cash balance at the end of the quarter was $22 million, relatively flat to the prior year. There was $70.1 million in outstanding borrowings compared with $113 million in outstanding borrowings in the prior-year period. In fiscal 2019, we expect the average debt to be approximately $145 million with a peak borrowings of approximately $250 million fully recognized and repaid during Fall Rush. And with additional borrowings until the end of the fiscal year, this is a similar pattern to fiscal 2018.

As an indicator of our strong financial position, on March 1, we amended and extended our existing credit facility for a five-year term through February of 2024. Under the terms of the agreement, we will continue to have an asset-backed revolving credit facility and an aggregate committed principal amount of $400 million as well as the $100 million incremental first in, last out seasonal loan facility. Both facilities have slightly more favorable pricing. CAPEX for the third quarter was $8.6 million compared with $7.7 million in the prior year.

The increase from the prior year is a result of investments in digital for BNC and DSS. Currently, our BNC store count is 773, having opened one store and closed one within the quarter. As of today, we have contracts to open additional five stores in Q4 2019 or in fiscal-year 2020 with three additional known closings. The net new stores will result in $12 million in estimated annual sales and bring our total store count to 775 locations.

Our MBS Direct store count is 680, having opened six and closed three during the fiscal quarter. As of today, MBS has contracts to add 11 additional new stores and two closings again in the Q4 of 2019 or in fiscal-year 2020. The net new stores are expected to result in $1 million of additional annual sales, bringing our total store count to 689 locations. For fiscal-year 2019, we expect consolidated sales to be in the range of $2.15 billion to $2.2 billion before intercompany eliminations and consolidated adjusted EBITDA to be approximately $100 million.

Capital expenditures are expected to be approximately $50 million, increasing over fiscal-year 2018, primarily due to company's investments in digital content required to develop and offer new DSS products. With that, we will open the call for questions. Operator, please provide instructions for those interested in asking a question. 

Questions and Answer:

Operator

Thank you. [Operator instructions] And your first question comes from Greg Pendy. Greg, your line is open.

Greg Pendy -- Sidoti and Company -- Analyst

Yes. Thanks for taking my question. Can you just give us a little bit of color on -- it sounds like Student Brands, did you lose subscribers, I guess, during the current quarter? And can you guys give us kind of a rough estimate? You told us Bartleby had 50,000, I guess, subscribers. Are you ultimately looking to combine the two offerings of the -- of both Student Brands and Bartleby? Thanks.

Kanuj Malhotra -- President of Digital Students Solutions

Greg, this is Kanuj. In terms of looking at a bundle, it's premature to say. We're going to optimize the pricing plan that has the best use for students. There are different use cases riding in the study subscriptions, so I think, for the moment, the initial thought is that they remain separate à la carte subscriptions.

In terms of some of the weakness at Student Brands, some of that's been purposeful, as Tom referred to, in terms of the monetization opportunities. So last year, we had things like a $2 for two essays to promote increased new subscriber activity. We eased off of that because that actually exacerbates churn later on, so we're trying to monetize in a more responsible way where we're publishing a lot more content. That ultimately, that publishing content ranks through SEO.

That takes some time for Google to start indexing it. And longer term, we think with the acquisition of PaperRater, we see that there's a lot of white space, and we envision that, that business goes back to growth. Tom, I don't believe you disclosed subscriber numbers, so I won't say anything there in terms of that. But overall, in terms of writing, we think there's a lot of room for -- there's a lot of white space there for students to have, not only the existing product attributes, but things we'll launch in the future like our Triple Play writing, which has other features like plagiarism detection and revision assistance and other writing aspects.

Greg Pendy -- Sidoti and Company -- Analyst

OK. But is that being pushed, I guess, in the stores as much as Bartleby is? Or were you kind of focused right now -- it's an impressive ramp, 50,000. I assume some of those weren't paying subscribers on Bartleby. But are you also putting Student Brands', I guess, point of sale within the stores?

Kanuj Malhotra -- President of Digital Students Solutions

That's a good point. We did -- we actually did give preference to Bartleby as a new product, so whereas in the fall, we had marketed the writing product. But our goal is to really accelerate Bartleby. But we're becoming much more segmented where we can do both.

We think there's the opportunity to do both. But the use case for writing is different than Bartleby study subscriptions, but there was definitely a preference given to ramping Bartleby given it was a launch and an introduction.

Greg Pendy -- Sidoti and Company -- Analyst

OK. That's helpful. Thanks a lot.

Operator

And your next question comes from Alex Fuhrman. Alex, your line is open.

Alex Fuhrman -- Craig-Hallum Capital Group -- Analyst

Thanks for taking my question. Would love to get a better sense of the opportunity or perhaps risk ahead as some of the publishers you do business with are looking to have their top titles available for rental. I mean, it sounds like Barnes & Noble Education is, I think, in your words, ready and willing and able to help fulfill these rentals. Are there other companies that you're going to be competing with for some of that business? And can you just talk about the potential of that asset that you've maybe seen or heard from some of these other publishers perhaps going direct to the consumer with digital rentals? Just trying to gauge if we should think about that as potentially an opportunity for BNED or maybe equally as large of a risk.

Mike Huseby -- Chairman and Chief Executive Officer

Alex, it's Mike. It's both, obviously, maybe not obviously, but it is. In terms of the opportunity and MBS being ready and able, they're also under contract with a couple of the large publishers. We released those press releases early last year.

And as we talked about this in the last quarter, we anticipated Pearson and McGraw-Hill, and they've talked about this in their own earnings calls, really rolling out the pub rental program much more fully last fall. Without getting into the reasons why that didn't happen as we understand them, they're talking about it publicly now and our discussions with them. They are committed to doing it this coming fall. One of the things about this business is that it becomes into kind of big chunks every year.

The seasons are the Fall Rush and the Spring Rush. There are other things we sell all year long, general merchandise, etc., and our e-commerce business. But as you know, a high proportion of revenues and cash flow is earned in the fall and Spring Rush. So the opportunity is for MBS to be the distributor of choice for those two large publishers and possibly some other publishers.

Although those are the two that are really pushing the pub rental opportunity. They've disclosed they'll have over 700, I think, of their top titles available for rental. And it's a good opportunity for MBS because -- and it's a good opportunity for the publishers. MBS interacts with about 3,500 stores, including our stores, pallet stores and independent stores as a wholesaler.

And as a service provider, we have our systems in 400 of those stores. So from a publishers' perspective, if they want to rent their top titles, they can do with MBS and get basically one invoice for all that activity for 3,500 stores as opposed for -- to the publishers who really aren't able -- aren't set up to do this themselves, dealing with individual stores and students to rent books, buy them back, et cetera. So we're very confident that, as this rolls out in the fall, this will be a good opportunity for MBS as we've described in the past. It's not so much a revenue opportunity because we don't take titles of the book, so we don't have to grow sales price, but they're in a very healthy cash flow from performing these services.

I don't know about risk as it relates to others doing this. There are -- IndiCo was doing this, maybe still is, or some of the publishers, but I think we're in a better position to render this service than anybody given MBS' capabilities, and I'll just leave it at that. In terms of publishers going direct, that's been going on for quite a while. One of the ways we try to protect ourselves from that risk is by having exclusivity provisions in many of our bookstore management agreements, not just for physical product on the campus, but also for any digital product that goes through the LMS, or learning management system, of the school, and we've been somewhat successful in enforcing those rights.

Having said that, obviously those publishers are pushing digital direct as much as they can and in many different ways, and it is a risk. It's also an opportunity for us as they create more digital product to fill our inclusive access pipeline with their digital product. We do have agreements with all three of the major publishers for either inclusive access or digital distribution in the case of Cengage. So as we said in the speech, everything is going digital.

Everything is going e-commerce. That's what we're emphasizing. And our big emphasis internally is to go faster and more complete to digital as quickly as we can. Having said that, we still believe there's a fairly long tail on physical book, and we're very well set up almost uniquely to provide those services end to end.

So we're full of risks and opportunities, Alex, as you say, but we're really trying to scale the company toward digital to take advantage of the opportunities that exist with the increased penetrations, even though ASPs are going down.

Alex Fuhrman -- Craig-Hallum Capital Group -- Analyst

Great. That's really helpful. Thank you.

Operator

[Operator instructions] Your next question comes from Karim Foad from Barclays. Karim, your line is open.

Karim Foad -- Barclays -- Analyst

Hi. This is Karim Foad from Barclays speaking. Just two for me. So how was the introduction of Cengage Unlimited impacted the business, so that's the first one.

And secondly, focusing more on textbooks, you mentioned the Spring Rush season, including February. Has that been weaker than your expectations leading into it?

Mike Huseby -- Chairman and Chief Executive Officer

Can you clarify the second part of the question on textbooks? Would you mind repeating that which...

Karim Foad -- Barclays -- Analyst

So with textbook sales, with the Spring Rush season, has it been weaker than what your expectations were leading into the rush season?

Mike Huseby -- Chairman and Chief Executive Officer

Yes. I think that we said that it was textbook sales declined slightly higher than we thought they were going to in the Spring Rush, particularly wholesale. We anticipated that MBS would be able to sell through a higher percentage of the returns they received in the fall, for example, that demand would higher than it was. At the retail level, while we expected slightly higher demand, the 4.9% decrease in comp sales that BNC experienced was within our expectations and our guidance.

Regarding Cengage Unlimited, they're offering subscriptions through our physical and virtual campus stores and as well as school and branded e-commerce sites. We understand and agree with the intent of what they're doing, which is to offer more affordable course materials to drive student success and deal with one of the big pain points of students, which is saving money. Our role, just like any other offering from a publisher, is to aggregate and distribute Cengage Unlimited, and we don't market it as a preference over any other publisher product. We let the students make that choice or the faculty who are making the decision.

We share -- we have an agreement with them, specifically on CU, where we share in the margin. So we're very happy to help them and students take advantage of Cengage Unlimited.

Karim Foad -- Barclays -- Analyst

Thanks so much.

Operator

[Operator instructions] And we have no further questions at this time, so I'll turn the call back over to Tom Donohue for closing remarks.

Tom Donohue -- Chief Financial Officer

Thank you, Adam, and thank you for joining today's call. Please note that our next scheduled financial release will be our fiscal 2019 fourth-quarter earnings call on or about June 25. Have a great day. Thank you.

Operator

[Operator signoff]

Duration: 33 minutes

Call Participants:

Tom Donohue -- Chief Financial Officer

Mike Huseby -- Chairman and Chief Executive Officer

Greg Pendy -- Sidoti and Company -- Analyst

Kanuj Malhotra -- President of Digital Students Solutions

Alex Fuhrman -- Craig-Hallum Capital Group -- Analyst

Karim Foad -- Barclays -- Analyst

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