If you were to read Barnes & Noble's (NYSE: BKS) 2011 shareholder letter, you'd be excused for thinking the company is doing great. Chairman Len Riggio characterized its year as remarkable, heaped praise upon the company for being "one of the world's fastest growing providers of digital content," and claimed that the "numbers speak for themselves" when discussing the bookseller's digital strategy.
An independent examination of the numbers, however, reveals a company on the brink of illiquidity and insolvency. And to make matters worse, the lion's share of its business is a proverbial albatross -- namely, its 700 brick-and-mortar bookstores -- making the bookseller an unlikely takeover target despite the value of its digital division. Indeed, as much as it pains me to say this, for the reasons I discuss below, it's not so much a question of if B&N will perish, but when.
Looking beyond the rhetoric
B&N's financial statements disclose a number of startling truths about the company's fiscal health. The company is burning through cash. It reported a combined negative free cash flow of nearly $400 million in the last two quarters alone, and it possessed a mere $24 million in cash at the time of its last filing, as well as $275 million in long-term debt. And to top things off, it hasn't turned a profit in the most recent four quarters.
Although the company probably had a respectable holiday season in light of Borders' recent demise, its same-store sales have been abysmal over the last few years. In fiscal 2007, its retail division recorded $4.8 billion in sales. In fiscal 2011, on the other hand, its sales were less than $4.4 billion. While the company closed a handful of stores in the intervening period, the vast majority of this 9% decline is attributable to organic deterioration. And unlike other retailers that have stanched the bleeding from the economic downturn, B&N continues to suffer. In its most recent quarterly filing, its same-store sales decreased by an additional 0.6% -- and that was without Borders in the picture!
The company's gross margin has also deteriorated markedly over time. The significance and explanatory power of this metric cannot be overstated. It's a quantitative barometer of brand and pricing power. As such, companies like Apple and lululemon athletica regularly record gross margins in excess of 40% and 50%, respectively. These two brand darlings can thus command above-market prices with ease and thus generate more revenue per dollar of sales.
A company with low and/or declining gross margins alternatively is a cause for concern. And this is the situation that B&N finds itself in. After years of recording gross margins of 30% or higher, its recent margins have settled around 25%. It can be assumed that this is the result of competition from the likes of Amazon.com, which can sell books for less due to its distribution model with less overhead.
At the end of the day, B&N's biggest underlying challenge concerns the proliferation of digital books. Its 2011 Annual Report said it best by noting that "readers are flocking to our stores to browse for books they'd like to download, and while there we have the opportunity to sell them books and other merchandise." The irony is that this statement was offered as evidence of the company's inroads into the digital marketplace, which it claims to control a quarter of. What it suggests to me, however, is that customers see its stores as showrooms, more analogous to a library than a profitable enterprise.
The net result of these effects has left B&N struggling for survival. And nothing is more indicative of this than its tangible book value. While the company claims $760 million in shareholders' equity on its balance sheet, $1.1 billion of its assets consist of non-marketable intangibles such as goodwill, leaving the company with a negative tangible book value of $340 million.
Is this the final chapter?
The answer to B&N's problems is simple in theory yet challenging in execution. For the company to survive, it must unwind its traditional brick-and-mortar business in favor of its BN.com division. The problem is that the traditional Barnes & Noble retail locations account for 48% of the company's revenue while BN.com accounts for only 11%. And time is not on the bookseller's side, as its cash reserves and ability to borrow could force its hand in a matter of years if not months. While there's no question that the company gets this -- why else would it have switched to a nonretail, technology-based executive as CEO in 2010? -- managing this transition while the company is still liquid and solvent could be an insurmountable task.
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