Even some of the smartest minds in business occasionally make bad investments. Such is the case with Microsoft's (NASDAQ:MSFT) investment in Barnes & Noble's (NYSE:BKS) Nook Media division. In nearly three years, Microsoft turned its $300 million initial investment into about $120 million.
B&N bought out Microsoft's stake in the division earlier this month to clear the path to spin off the digital reader division that also includes its college bookstores. Whether the split will help Barnes & Noble recover from sales dips at both brick-and-mortar locations and its digital store remains to be seen, but investors have pushed the stock price higher in anticipation of the spinoff.
It's not hard to say goodbye
Microsoft's $180 million loss (a negative 60% return on investment) looks bad in the context of this deal, but it's minuscule for the company as a whole. As of the end of last quarter, Microsoft had over $100 billion in cash and investments, so losing $180 million over 32 months isn't even a rounding error on the balance sheet.
What's more, the breakup between Microsoft and B&N has been a while in the making. Microsoft removed the Nook app from its Windows 8 devices earlier this year in favor of developing its own reading application. Meanwhile, Barnes & Noble tapped Samsung to produce the latest iteration of the Nook.
Microsoft could also still see additional return from its investment. Microsoft received 2.7 million shares of Barnes & Noble, and it will receive 22.7% of Nook's total proceeds if the business is sold in the next three years.
Why the split?
Both Barnes & Noble's brick-and-mortar stores (it has 658) and its Nook division are seeing sluggish sales. Last quarter, retail sales declined 3.6% from the previous year, while Nook sales fell 41.3%.
The decline in popularity of the Nook dragged down sales in the retail locations. "Core" comparable-store sales, which exclude sales of Nook products, actually increased 0.5% in the most recent quarter compared to a decline of 1.5% in comparable-store sales including Nook sales.
Still, 0.5% sales growth excluding the stores closed over the last year is uninspiring for investors. Management hopes splitting off the Nook and college store businesses will allow the company to focus better on the retail segment, and to drive foot-traffic to its stores.
Meanwhile, the Nook continues to suffer at the hands of Amazon.com's Kindle line and other low-price tablets. It's clear Nook hardware sales drive digital media sales on the platform, as content sales declined 21.2% year over year in the most recent quarter.
Still, the increase in revenue share from digital content and the move to Samsung-made Nooks helped decrease the segment's loss. The freedom to make more strategic moves to decrease net loss is a key factor to the Nook spinoff.
Why investors see so much value in a spinoff
Producing two separate companies not only allows each to focus on their separate operations, it also increases the ability for other companies to acquire one or both of the businesses. That will build a premium into the price of both stocks, and it's why shares have had a bit of a run in 2014.
Nonetheless, the underlying businesses aren't particularly attractive. The brick-and-mortar business faces the unpleasant fate of many other retailers as it battles online sales and the move to digital content.
Meanwhile, the Nook is forced to compete with Amazon, Apple, Google, and others for sales of e-books. Without the support of hardware sales, which all three of these competitors seem to have no problem increasing, it will be difficult for B&N to grow content sales.
The one bright spot is the company's college segment, which makes deals with colleges to share revenue in exchange for lease-free real estate on campus. The business produced EBITDA more than three times higher than the retail segment last quarter. With the number of people attending college continually increasing, this business holds some very good long-term prospects.
Spinning off the unprofitable Nook segment looks to be the best course of action for B&N. Meanwhile, the loss won't impact Microsoft too much financially, and the move allows it to focus on more important things like its own software and hardware. Similarly, the spinoff will allow Barnes & Noble to focus on the important aspects of both of its businesses without having to worry about how they affect the other.
For investors, B&N stock already has a premium built into the price based on the spinoff now scheduled to be completed next August and a potential buyout after the fact.