Monday, May 23, 2011

What's the Book on Barnes & Noble?

Barnes & Noble (NYSE: BKS) popped 30% on Friday thanks to a takeover offer from Liberty Media (NYSE: LCAPA). Does this offer signal that it's time for investors to buy the stock?

Barnes & Noble (B&N) operates bookstores and it sells a so-called eBook reader. At the end of January 2011, B&N ran 705 bookstores, operated 636 college bookstores, and sold the NOOK eBook reader, in a business segment that also operates its web site.

B&N is in surprisingly good financial shape considering that the industry is so difficult that competitor, Borders, recently filed for bankruptcy. In the quarter ending January 2011, B&N comparable store sales increased 7.3% -- beating its 5% to 7% forecast. And its consolidated third quarter earnings were $60.6 million -- at $1.00 per share, this result was consistent with its guidance of $0.90 to $1.20.

The bad news for investors was that B&N used the Borders bankruptcy as an excuse to stop issuing guidance for sales and earnings. (Of course it's possible that taking out a competitor could help B&N gain sales). B&N also suspended its dividend -- that had cost B&N $45 million in the quarter ending in January. And when you consider that the company ran through $35 million of cash in the previous nine months and had a mere $26 million left, the decision to suspend the dividend signals a pretty serious cash flow problem.

So perhaps the May 20th offer from Liberty Media to acquire B&N -- after putting itself up for sale in August 2010 -- is well-timed. Liberty Media offered $500 million for a 70% stake in Barnes & Noble contingent on its current CEO, Leonard Riggio, staying on and holding on to his 30% stake. As Liberty Media CEO, John Malone, told the Financial Times, “I am also firmly of the view that there will be an enduring demand for physical bookshops, which are cultural centres within local communities.”

Most analysts consider Malone's offer as an opportunity to gain control of the NOOK. As James McQuivey, an analyst at Forrester Research, told Variety, "It's absolutely a play for the Nook. The real value of B&N right now is the ascent of its Nook platform, which is turning out to be a very solid foundation for building a digital media relationship with millions of consumers. And the fact that the Nook Color is being snatched up as quickly as B&N can make it is good evidence that the business has strong prospects in new directions like web apps and even video."

It's hard to know how much the NOOK is contributing to sales and profits since its sales are buried in reporting for its online unit. But that part of the company enjoyed a 52% spike in sales in the most recent quarter -- to $319.4 million. However, it represents a mere 13.7% of its revenues and lost $57 million during the period.

This leaves open the question of what will happen next. If the Liberty Media deal falls through, B&N stock will drop 30% back to where it was on May 19. If the Liberty Media deal closes, the stock will stay where it is for the time being -- but if Malone is correct that he's making a value buy, it could go up, say, another 30%.

How is an investor to decide what to do here? For that, I suggest taking a look at the concept of expected value (EV). EV theory says that you should consider the probability of a range of outcomes and multiply the probability of each by its payout and add up the EVs for each possible outcome. If the EV is positive, then you should invest, otherwise you should stay away.

The hard part of applying EV is that doing so involves making many assumptions -- all of which could be wrong. But for the sake of illustration, let's make the following assumptions (these figures are on a price per share basis):
  • EV of Deal Falling Through: ($0.84). This assumes that there is a 20% chance the deal will fall through meaning the stock falls $4.22 a share, to where it closed on May 19. 
  • EV of Higher Offer: $0.73. A 20% chance of a new offer coming in that values B&N at $22, a 20% premium over its current price. SeekingAlpha thinks it's possible that Microsoft (NASDAQ: MSFT), Google (NASDAQ: GOOG), SearsHoldings (NYSE SHLD), or Amazon (NASDAQ: AMZN) could put in a bid.
  • EV of Deal Going Through: $0. A 60% chance of Malone's deal going through -- which would leave the stock price unchanged.
Based on these assumptions, you should not invest in B&N stock because its EV/share is negative 11 cents. But if Malone makes the deal and B&N's value increases 30%, then the expected value of the investment would be positive. The only problem with that for a buyer of the stock today is that the benefit of that increased value would only go to Liberty Media and Riggio.

Avoid this stock.


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