Joel Greenblatt, in one of my favorite books on investing, said the following:

“The reason why major corporate restructurings may be a fruitful place to seek out investment opportunities is that oftentimes the division being sold or liquidated has actually served to hide the value inherent in the company’s other businesses.”

It was with this basic scenario in mind that I began studying Barnes and Noble a few months ago.

The Case For BKS

I think Barnes and Noble is significantly undervalued and likely worth somewhere between $20 and $30 per share. Although there are industry headwinds in the traditional book business, Barnes and Noble has a strong brand name, significant insider ownership, strategic partners in Liberty and Microsoft, a clean balance sheet, and best of all—the core business trades at just 5 times the average pretax earnings from the past 15 years and 4 times the trailing year’s pretax earnings.

Why Is It Undervalued?

Barnes and Noble has three basic operating businesses:

  • B&N Retail (the traditional bookstores and the bn.com ecommerce business)
  • B&N College (college bookstores located on or around college campuses)
  • Nook Media (sells digital books for any device as well as Nook ereaders)

The thesis for investing in Barnes and Noble is simple. The profitability of the Retail and College divisions is being significantly masked by the money losing operations of Nook Media, LLC. This is not really a secret, but the market continues to price Barnes and Noble at a significant discount to the intrinsic value of the Retail and College businesses (without the Nook).

Here are the operating profits from each division from the fiscal year that ended April 2013:

  • B&N Retail: $227 million
  • B&N College: $65 million
  • Nook Media: ($512 million)

So on the surface, Barnes and Noble is losing about $220 million per year. But if we remove Nook Media from the picture, we are left with a company that produced $292 million in operating earnings last year. Better yet, this business has been profitable for more than 15 consecutive years, with stable margins and consistent free cash flow. The risk is that management continues to invest in a money losing enterprise, throwing the proverbial good money after bad. But with significant insider ownership and strategic partners/board members, I don’t think this will be the case for too much longer.

Two years ago, Liberty Media invested $204 million into B&N preferred stock that is convertible into common shares at $17.00 per share. If we include these 12 million shares, Barnes and Noble has 71.7 million shares outstanding, which gives it a market capitalization at $14.00 per share of around $1 billion.

So we have a $1.0 billion business that produces $292 million in operating earnings. If we assume the brick and mortar business pays all of the current interest, the pretax profit of this business is $256 million. So ex-Nook, BKS trades at about 4 times pretax earnings.

Common Misperception

The common misunderstanding is that the recent losses at B&N are due to the fact that the book industry is in decline and the brick and mortar business is dying a slow death at the hands of Amazon, Apple, and other internet competitors.

I wouldn’t argue against the fact that ereaders and digital content poses strong competition for traditional bookstores, but this is not the reason for the losses at B&N (at least they haven’t been yet). The irony is that Barnes and Noble is sustaining operating losses because of the Nook business, which is supposed to be the business that allows the company to survive and compete in the new digital content world.

So despite the common misperception, the traditional bookstore business at Barnes and Noble is consistently profitable, despite top line and overall industry headwinds.

15 Year Data

In fact, the bookstore has produced positive free cash flow in each of the last 15 years. I went through the last 15 years of annual reports and separated out the Nook business, and the formerly owned Gamestop (which B&N owned around 15 years ago). My objective was to create a picture of the last 15 years of operating results from just the bookstore and traditional ecommerce business (includes Retail, College, and bn.com). This chart shows the profitability of the traditional bookstores:

BKS 10 Year Data

So the traditional business (not including Gamestop and Nook) has averaged $195 million of pretax profits per year. At the current price of $14, you get a business that has averaged $2.72 per share in pretax earnings and $2.00 per share in free cash flow over the past 15 years.

Estimating for taxes, the traditional business trades at about 7 times average 15 year free cash flow.

Margins have historically been quite stable in this business as well (note: I didn’t find segment gross margin data for 1999-2001):

BKS Margins

So we have a consistently profitable bookstore business that without the Nook trades at mid single digit earnings multiples.

But what about the Nook? That’s of course the reason why BKS stock has been floundering. Ideally, Len Riggio, the founder, chairman, and 26% owner of BKS will at some point decide to sell or separate the Nook business. Although management has recently seemed to indicate they plan to continue investing into the Nook (a dubious strategy), at some point—if the Nook continues to lose money and destroy value—I think Riggio will want to stop the bleeding. Barnes and Noble is his pride and joy, and represents a sizable amount of his personal fortune.

There are some large shareholders with sizable amounts of money resting on the fate of this business:

  • B&N Founder Len Riggio has a 26% ownership stake in Barnes and Noble
  • Liberty Media (run by media mogul billionaire John Malone) invested $204 million into convertible preferred shares, which effectively gives them around 17% ownership along with two board seats

So you have two key insiders with large stakes. And although I think BKS is significantly undervalued even if the Nook shut down tomorrow and was worth $0, there is likely some sizeable value there as well:

  • Microsoft invested $300 million into Nook in 2012 at a valuation of $1.7 billion for Nook Media, LLC
  • Later in 2012, Pearson invested $89.5 million into Nook at a valuation of $1.789 billion for Nook Media, LLC.

So you have strategic investments from major companies that have valued just the Nook business at around $25 per BKS share, which values the rest of BKS (the profitable business) for -$11 per share.

These investments by Microsoft and Pearson have liquidation rights, meaning that they essentially get their money back, but along the way, Microsoft has agreed to pay B&N up to $85 million per year as part of that investment deal.

Valuation

While I don’t think Nook is worth twice what the entire company is worth, it likely is worth more than $0. Maybe it’s worth half of the $1.8 billion valuation ($12 per share), maybe it’s only worth 25% of that valuation ($6 per share). But let’s assume it’s worth $0. If Nook closed its doors tomorrow, what would BKS be worth?

Here are some numbers to consider when valuing the Retail and College business (excluding Nook):

  • Average 15 year pretax earnings per share: $2.72
  • Average 10 year pretax earnings per share: $2.76
  • Average 5 year pretax earnings per share: $2.50
  • Average 3 year pretax earnings per share: $2.64
  • Last year’s pretax earnings per share: $3.57

So the earning power of these traditional bookstore businesses seems to be quite intact. Here is one more look at the last 15 years of pretax profits (again, this excludes Gamestop and Nook operations):

BKS Pretax Profits

It’s a business that–although is not growing and facing industry headwinds–continues to be consistently profitable. Pretax earnings were positive each year and ranged from a low of $116 million to a high of $256 million, the latter which happened to be 2013!

So while we can speculate about the future, it’s hard to make an argument that the brick and mortar business is currently in terminal decline.

The other thing to consider is that Barnes and Nobles—unlike Borders, Blockbuster, and other brick and mortar bankruptcies—has a very strong balance sheet with just a modest amount of debt to total capital.

I think that the profitable Retail and College business is collectively worth somewhere between 7-10 times earnings. Historically, a business this consistent would likely be worth at least 10 times pretax earnings over a full cycle (or about a 6.5% after tax earnings yield), but given the industry headwinds, I’ll use that number as the high end, but maybe the value is closer to the low end.

At 7-10 times average 15 year pretax earnings, we arrive at a value of somewhere between $19 and $27 per share. Again, this values the Nook at $0. So if the Nook is equal to $0, then I think BKS is modestly to materially undervalued at $14 per share.

Possible Catalysts

But I see some catalysts that could happen that will likely increase this value:

  • Nook business could get sold for cash to Microsoft or some other competitor
  • Nook could get separated or spunoff
  • College business could get spunoff or sold
  • Len Riggio could decide he wants to personally buy the Retail business
  • Len Riggio decides he wants to sell the Retail business to a private buyer (unlikely, but possible)
  • Something that I wouldn’t count on, but could occur—Nook Media becomes a successful, profitable business

I think a private buyer would likely have to pay closer to $30 per share for the collective value of those assets.

Keep in mind a few other quick points in this sum-of-the-parts consideration:

  • College is a consistently profitable business that was purchased in 2009 for $596 million
  • BN.com (the original ecommerce business prior to Nook development) was purchased by Barnes and Noble at a valuation of $446 million
  • Microsoft and Pearson invested into Nook Media at a valuation of $1.7-$1.8 billion
  • BKS Current Market Capitalization: $1.0 billion

It’s also interesting (although irrelevant to the current value) to note that in 1999 Len Riggio sold Gamestop to B&N for around $208 million, and it was subsequently partially sold to the public at a valuation of $1.2 billion, or a six-fold increase for shareholders in just a few years. B&N then spun off the remainder of Gamestop in 2004, and this company now sports a market valuation of $5.6 billion, nearly 6 times the value of Barnes and Noble. For long term B&N shareholders that held Gamestop, they have seen significant gains despite the poor performance of BKS. This is more or less just an interesting anecdote on an investment that created enormous value for shareholders.

To Sum It Up

I think you have a consistently profitable and stable bookstore business with steady free cash flow, stable operating margins, a powerful brand name, significant insider alignment, trading at a price of just 5 times long-term average pretax earnings. This value is masked by the money losing operations of the Nook, which may at some point get sold, separated, or—most unexpected of all—turn around and become a profitable division for Barnes and Noble.

In the words of the billionaire retail investor Rob Burkle (who was a large BKS shareholder but sold his stake after losing a proxy battle):

“We always try to buy companies that are doing O.K. but that have some issues. We buy at a price that if they just muddle through, we don’t go broke. And if they do better, we make a lot. Since I was 13, I’ve been buying things because they are ridiculously cheap.”

I think given the brand, insider alignment, and the core business profitability, Barnes and Noble will achieve results somewhere between “muddling through” and “doing better”, which should result in satisfactory results for shareholders.

—————–

Disclaimer: John Huber owns shares of BKS for himself and for clients. This article is not a recommendation and represents only an opinion. Please conduct your own research. 

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24 Responses to Barnes and Noble–A Bargain Hiding in Plain Sight?

  1. Jacob says:

    Dear John,

    This looks like a very simple pick! You did the research and found a no brainer investment. All you did was dig and research into Barnes and Nobles and found a unprofitable business. Shut the bad boy down, and now you have yourself a profitable business. It looks so simple and easy in my eyes. All you did was shut down the Nook business. How long did you research this investment?

    On another note – What made you choose the earning multiples? How do you know that a “a business consistent as this” trades 10x earnings? What made you choose 7-8x earnings?

    How do you choose your multiples?

    • John Huber says:

      Yep… it’s a pretty simple thesis. I try to make investments based on simple ideas–it is much easier to jump over the “one-foot hurdles” as a wise man once said. :)

      The earnings multiples… 10x pretax is about a P/E of 15 at the current tax rates. A 6.5% after tax earnings yield is a fairly good measure of what American stocks have averaged over very long periods. It’s not an exact science, it’s just a generality. A good business is typically worth 15 times earnings. It’s arguable whether B&N is a good business, so I discounted it to say 10-11 times earnings on the low end. But throwing out emotion and biased pessimism and just looking at the stability of the operating earnings and the free cash flow (15 years of consecutive positive free cash flow) and this looks like a good business. So I think the bookstores are worth somewhere between 10-15 times earnings, and these are average earnings over a 15 year period… something Ben Graham would prefer looking at for a business such as this one.

      • Very nice article BHI. Your website has a lot of thorough analyses.

        What do you think about today’s rumors around BKS?

        Dividend Growth Investor

        • John Huber says:

          Thanks… I appreciate that.

          As for BKS, I don’t really have much to say yet about the potential job cuts. My guess is that the stock will continue to bounce around for awhile as news like this comes out one way or the other. But I strongly believe that there is significant value at BKS. My thesis is basically that there is roughly $30 of value in the $15 stock, and that the large shareholders (Riggio, Tisch, Liberty) are rational economic actors (good value investors too) who will only go so long before they say “enough is enough” and at that point they will begin to do what is necessary to realize the value that exists there. A business that makes $4 of free cash flow per share can only be held down so long by a business that loses $6 per share. At some point, they’ll have to cut the cord.

          To me, the situation is obviously and blatantly undervalued, and I think they know this… It’s just that they really wanted to Nook to work. I did too, it would have been much better for the business, but I don’t see anything wrong with a business that cash flows as well as the bookstores do. It won’t be a growth business, but it will continue to throw off cash I believe. And if I’m wrong, I’m only paying 4 times the cash flow, so the downside seems really truncated to me.

          Long story short, I think we’ll continue to see news like this, and the stock will likely bounce around for a while until the situation resolves itself. The problem for people is that they aren’t willing to invest until they have the press release in their hands that says that BKS is selling the Nook for $10 per share (or whatever). At that point, it will likely be too late.

  2. Pam says:

    Thank you John. Makes sense. Do you happen to have any thoughts on the outstanding accounting allegations/ probe against B&N, and the recent sell of 2m shares by the chairman. Thanks once again.

    • John Huber says:

      Thanks Pam. I was talking to a friend about this yesterday. I highly doubt the probe will reveal anything meaningful. My investment thesis was not based on some razor thin disparity between the bookstore profitability and the money losing Nook. The difference is absolutely huge ($292 million of operating profits for the bookstore and $512 million operating loss for Nook). I can’t possibly see how even a significant error/manipulation could significantly change the thesis that B&N is undervalued from a bookstore ex-Nook standpoint.

      The other reason that made me feel comfortable was the fact that Riggio sold the shares. He declared the sale for tax reasons, which I have no opinion on… but I don’t think he’d be selling shares (risking the major lawsuits that would surely come with it) if there was a major accounting problem to be worried about.

      The financials going back 15 years all are basically saying the same thing… the bookstore is profitable. My guess is the cash flow won’t really be changed much, just some minor adjustments potentially… but having said this, there is no way to know for sure until it gets resolved.

      I used it as an opportunity to buy shares about 20% less than they were just a couple weeks ago.

      • Pam says:

        Thanks John. I think your analysis is very good and the angle very worthwhile. I am happy to accept the accounting probe for the better entry level it has provided into the stock. However The only thing that would stop be looking at it further is the sale by the chairman. Too much of a red flag for me, and ranks high on my natural checklist. Many thanks.

        • John Huber says:

          I can understand the trepidation. It certainly could be head scratching, but keep in mind he still owns around a quarter of the shares. Plus Liberty and Tisch, and you have some strong value investors who own half the company. To me, it wasn’t a major red flag, but I certainly could be misinterpreting it.

  3. Jimmy Egan says:

    First, I just wanted to say your pieces are always well written and I enjoy reading them.

    However, I think you underestimate the disruptive technology that (successful) tablets present and the failure of nook.

    You posted a while back a checklist for investments. Two questions on there were:

    1) Is this business a melting ice cube?
    2) Would I want to buy more if the stock drops?

    I’m interested in how you answered those questions when going through your checklist.

    Thanks!

    • John Huber says:

      Thanks for the comment Jimmy. I appreciate the feedback. You bring up very good and thoughtful points that I’ve spent a lot of time thinking about.

      I’ll answer the first part of your comment by saying that I don’t really have an opinion on the actual tech… however, my investment case is not dependent on my ability to judge the evolution of the products and the industry… I already assume they are very bad for B&N. But as we know, companies can be very profitable in declining industries just as companies can be ever unprofitable in booming industries (throat clear… airlines).

      But that aside, let me say that I assume things will be very difficult and very competitive for B&N. This is not a compounder. My favorite ideas are strong operating businesses that have ample reinvestment opportunities that produce high returns on tangible assets… and of course I like them cheap relative to those fundamentals.

      But I am always looking for a disparity between price and value… and often this comes from a second category-which can be broadly summarized as “special situations”. As you probably know, these consist of spinoffs, corporate events, mergers, liquidations, and in this case–a possible corporate restructuring.

      So in this case, I feel that even if you assume the business is a melting ice cube, it’s a $1 for $0.50. Now… let me say this… it might be an ice cube, but it isn’t melting yet–that is, it’s not if you look at just the numbers. The bookstore is very profitable.. and those profits haven’t declined thus far. I think that alot of the pessimism and negative outlook is built into the price, but as I demonstrated above, despite all of the competitive forces that the bookstores have dealt with already, they have recorded 15 straight years of significantly profitable operations. And those profits have been stable. So the talk of these terminal declines are to this point just speculation.

      But let’s assume that the business goes into terminal decline. I accept that as a possibility. But what does that look like?

      Here is a metaphor that is an oversimplified way that I look at B&N.
      I think the big picture here is more important, because although there might be small line item adjustments coming from this “probe”, I think there is such a disparity between price and value that these adjustments–although possibly large–will likely not affect my overall investment thesis.

      This investment is really of the special situation/corp restructuring type that masks a profitable business. Again, this will be oversimplified, but this represents a general way of how I look at B&N. Let me paint a general picture of this investment using a metaphor.

      Imagine you can buy a car wash holding company in your town. The company comes with two individual car wash locations. You can buy the entire holding company (two car wash locations) for $140,000. One car wash location makes $40,000 of cash flow before interest and taxes, the other location loses $70,000.

      Plus, you have a strategic partner who has invested $54,000 into the second location (the money losing car wash) at a valuation of $250,000. So maybe you can sell this money losing location to him… Or maybe you can separate it, or at worst, just liquidate it and shut it down… But considering he invested $54K for a minority stake in just the money losing location, you’re likely to be able to get some value from that location.

      Would you buy this holding company?

      I’d certainly be interested in taking a closer look. Shut down or liquidate the location that is losing $70,000 per year and you’re left with a profitable car wash that makes you $40,000 per year on a $140,000 investment. Even if the national carwash company is gaining market share and competition with other carwashes and gas stations is fierce, you’re still paying just 3.5 times earnings for your car wash. You wouldn’t necessarily be thinking about the long term growth opportunities of the car wash. You’d make your return by milking it for cash. If it lasts 10 more years, it will likely have paid you around 2-3 times your initial investment in cash flow. So the downside seems limited at 3.5 times pretax earnings. Of course, maybe the business does better than you think and the future prospects improve. But if not, you still have a business earning a lot of cash flow now, and given the 15 year results (despite the competition), it has remained profitable. There might be reason to believe that the cash flow will continue around the current level for at least the near term. If that happens, the downside seems quite small.

      That’s kind of how I approach B&N. I never once presumed that it will become a better business than Amazon or other competitors. But at 3.5 times operating earnings and the chance to spin/sell Nook Media for a value that is likely greater than $0, I found it an attractive special situation.

      The numbers in the car wash example correspond to the share price of B&N. $14 per share gets you one profitable (actually two-but I combine College and Retail for simplicity) making $4 per share. The other business loses $7 per share. Microsoft and Pearson have invested into the losing business at a valuation of $25 per BKS share.

      It seems like there is more value here than $14, regardless of the quality (or lack thereof) of Nook, the competition, and other factors.

      The key of course is management. The car wash example is easy, because you control the fate of the losing location. Here you have to rely on management to make good decisions. With key insiders owning around half of the company, I believe at some point, they will make value accretive decisions.

      • John Huber says:

        By the way, I just typed in those thoughts and realized I turned my “comment” into more of a post… and I forgot to directly answer your checklist question. Maybe I’ll repost some of these ideas later. I’ve spent a lot of time thinking about it, and I think it’s an interesting situation.

        As for the checklist… I think I described how I think about the ice cube question above… and the second question would I buy more? Yes… I certainly would. It goes back to the car wash example… as long as my estimate of intrinsic value doesn’t change, I always want the stocks I own to go down. It creates more opportunity to buy more, and a much less championed reason… low stock prices are great for companies that buy back shares (this doesn’t really apply here, but still… low prices are better than high prices if you intend to be a net buyer over time).

        The other thing I always ask myself on each investment that really helps me… if I were a wealthy businessman with a large family fortune of say $5 billion or so… and I looked to buy businesses that would create value for me over time, would I buy this business that I’m thinking about? If not, then why buy the stock?

        In this case, yes… if I could somehow wrest control away from Riggio and the others and I could own it, I’d do what I would do with the car wash. (Of course, this is oversimplified and there are other factors a private businessman would have to consider, but the point of the exercise is to think of the actual business as opposed to the stock).

  4. Greg S says:

    Good thoughts. I’ve heard this case described but laying out the numbers as you have really puts a fine point on it.

    What, if anything, gives you comfort that management will eventually come around and get rid of the Nook? My fear is that they feel their core business is doomed unless they get a foothold in digital. That they think Apple and Amazon will basically crush them on books and other media and B&N will be a melting ice cube without the Nook. I recall that many from Borders blame the company’s demise on the failure of their digital strategy. If my fear is right, then for B&N management it’s Nook or death. They’re locked in, despite the fact that the Nook is essentially hopeless.

    For me and you, the numbers make the decision clear – dump the Nook and focus on being the only national brick and mortar bookstore. I’m just not sure Roggio feels that way.

    • John Huber says:

      Thanks for the comment Greg. I think you’re exactly right on Riggio… I think he desperately wants the Nook to succeed, and thus has been willing to continue (at least to this point) investing in it. He has his identity tied up in B&N (which could be good or bad) and so he wants the company to succeed long term. It’s a tough spot because long term, they probably do need the Nook or some sort of digital content strategy. Ironically, the thing they need most for the very long term is the thing that is costing them dearly in the short term. But I think that B&N will survive, and Riggio at some point will make an economically rational decision. There are lots of smart value investors that own large stakes in this business (Liberty and Tisch to name two).

      But I’m just not sure that the bookstore is as doomed as everyone thinks. It’s a powerful brand without any direct brick and mortar alternatives and it is very profitable. I think a lot of the fear is already baked into the price. There is no doubt that the store will face even more competition in the future. And I would say most likely sales will decline. But I’m just not sure they will terminally decline. There are lots of businesses that operate profitably in a brick and mortar niche that is largely dominated by digital content and products.

      Lots of people thought Gamestop was dead, and the business continues to produce lots of cash and buyback stock. A year ago, people were prematurely calling for the death of Best Buy at $12 and 5 times free cash flow, and a simple change in perception has sent the stock up 200% in the last 12 months. I don’t necessarily know what the very long term future holds for these companies. They aren’t compounders, as I’ve said. But at mid single digit multiples of core cash flow, all you need it to do is survive a few more years and you get your money back. That’s a large margin of safety on the downside. On the upside, the business plugs along for a number of years, which is better than the consensus expectation.

      So I think there is a lot of downside in this price, but no upside. If the business just survives and they figure out a way to restructure, I really see a lot of disparity between price and value here.

      • Greg S says:

        After reading your articles and comments, I looked at Barnes and Noble with fresh eyes (doing my own work, of course!), and I came to agree with your point of view and took a position. I always agreed with your opinion on bookstores. For me, the question was the Nook. The more I looked into it, the more it became clear that economic rationality will win out, and soon. It just doesn’t make any sense to go through another year at this, and I think they know that.

        What I also came to realize is that there is more than one Nook strategy they can pursue. Selling or spinoff is a possibility, but they can also get rid of hardware (or maybe just have a single e-reader and no tablet) and focus on eBooks delivered primarily through their apps. This can be integrated into their store experience and means right-sizing the Nook business and related costs to maintain profitability. Competition with Amazon and Apple will still be stiff, but I think they can continue to be a leader in bookselling even if they are only #3 in eBooks. Publishers would be supportive of an additional channel. I’m not sure they will be highly profitable selling eBooks, but if they can stop the bleeding this stock has lots of upside.

        In any event, today’s news about layoffs, if true, suggests they are on their way to some change in strategy. But I do think you are right in your comments above – it will be bumpy.

  5. Jonathan says:

    I have barns and nobles on my watch list, I really want them to spin off the nook business before I invest in BN.

    your thought process is spot on though,

    happy holidays.

    • John Huber says:

      Thanks Jonathan. You too.

    • Neil says:

      As Buffett says, if you wait for the robins, spring will be over.

      I think it comes down to what is the probability that they spin-off the Nook business or limit its damage before it destroys the rest of the company that is generating positive cash flow.

      If it’s high probability enough, the investment makes sense now.

  6. Jim says:

    I get the car wash analogy, but it seems to me there is one vital difference.

    You’re talking about owning the business (car wash) versus owning shares in a public company. Despite having positive cash flow, BN might not declare decent dividends per share. And the share price might not rise even w/ profitability.

    Share price is based on sentiment, and BN is in a business perceived to be dying. (Besides, ebooks have been gobbling market share and it is indeed likely that bookstores are doomed long term.) Buying a profitable business in a sunset sector is a good way to make money, agreed — so long as you are buying the business outright. However if you’re buying shares, it seems to me you are shooting yourself in the foot, since the share price may stay depressed despite profitability right until the whole sector is eventually extinguished. You might never benefit from the cash flows.

    It seems to me that for a long term value strategy to pay off, you need to invest in a company with good prospects of long term survival, so in this case it’s important to make a call on the future of bookstore and bet appropriately. Personally I think there is a good chance of books surviving ebooks for decades . . . But that’s just a guess that is belayed by the rising ebook market share numbers.

    Thanks for this great post, and sharing the results of your analysis.

    Jim

    • John Huber says:

      Thanks for the thoughts Jim. And you’re right–the car wash example is oversimplified. But I thought it would represent my basic idea. But at the crux of my philosophy is the concept that I’m buying a piece of a business… as an outside shareholder when we own stock, we own a piece of the business and its assets and future cash flow. The big difference between the car wash example and B&N or any other stock where you are passive outside minority shareholder is that in the car wash example (as you correctly point out), we can control the distribution of the cash flow among other management decisions. With B&N, we have to rely on management to make those decisions.

      With B&N, I’m not really thinking about dividends… I’m thinking more about it the way I would if I owned the entire business. I think it can be operated very profitably for a long time. The bookstores have produced a lot of cash flow, and over time this will build on the balance sheet (assuming they get rid of the Nook). The public perception is fleeting and subject to huge volatility and emotional swings that can quickly reverse (see Best Buy 1 year ago and compare to today). That is a game I don’t try to participate in (anticipating when the change of sentiment might occur). I simply try to take advantage of situations where I find value, and that often coincides with negative sentiment and poor near term outlooks.

      I have found that over time, value tends to converge with market price eventually. If a business produces significant free cash flow and the share price remains low, management can often do things to correct the disparity between price and value such as buybacks, dividends, etc… Free cash flow often leads to steady increases in intrinsic value, and that’s all I’m focused on… eventually– the market tends to agree with this, and again–if the disparity lasts too long, the cash buildup itself can become its own catalyst. But the main thing is to focus on the disparity between price and value. Of course, I could be wrong in my estimation of value, and that will happen. But I’m never worried about when the value and price will converge if I’m right, because my experience tells me that it eventually does.

      In the end, we are effectively limited partners and we rely on management to make good decisions. In this case, I feel good about the board and although Riggio has made decisions that I don’t necessarily think were good ones regarding the Nook, I think the fact that he (along with Liberty, Tisch and others) own around 50% of the stock is a good thing… their incentives are aligned with ours for the most part, and I think that will lead to value accretive decision making at some point.

  7. I agree with your write up. I provided one that I did in January 2013 below. Though I am not very active in my posts, I try to post 2-3 investment ideas a year as a way to force myself to write out my investment thesis. At any rate, I agree with your logic in this post. I fortunately sold my position (since i thought whispers were driving the market valuation) at my low end valuation around $23 from the time of the right up. After it went back down to around the same price, I did my analysis again and entered back into the investment (which i typically don’t do). As you know, market price fluctuates a lot more than the intrinsic.

    Cheers and very good write up.

    http://www.smartvalueinvestor.com/2013/01/04/reading-the-book-uncovers-an-opportunity/

  8. Khursheed Alam says:

    One option is to wait until B&N management makes the decision to spin off the Nook; One can buy the parent after the spinoff. Usually the market is not that quick to reprice new entities.

    • John Huber says:

      That’s a good point. Often spinoffs become cheaper and give investors plenty of time to act. But I just see a large gap between price and value now, so I didn’t bother to wait. I felt that there was a chance that someone comes in with an offer for the Nook, or some sort of press release comes out with a gameplan for that business, and I felt that there would likely be a significant revaluation if that occurs. I was happy with the present gap between price and value, and wasn’t worried about knowing a firm timeline for when the potential catalyst rears its head…

      But you certainly could be correct regarding a potential spinoff…

  9. Dan says:

    Great article John. Do you have any opinion on the resent sales by Liberty and Riggio? I wonder if something is going on there that they don’t like. When Liberty sold I figured it’s just because they want to put their money to use elsewhere. Now with Riggio also selling it makes me wonder if maybe the new CEO is taking the company in a different direction, or some other big things are changing (this could be good). But then again if the company was moving in a way that these two large shareholders didn’t like couldn’t they do something to stop that? Riggio said it was for estate planning purposes and he has been selling some over the past year so maybe it’s just a continued long term selling plan on his part

    Thanks

    Dan

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