I’ve been getting a lot of feedback on the Barnes and Noble investment thesis. The feedback can basically be summed up as: “Yes, I agree that the price is cheap relative to bookstore profits, but what about the competition? Isn’t B&N a melting ice cube?”
Not All Brick and Mortar Retailers Will Go Bankrupt
I’ve I said in numerous email replies and comments to this general question, yes—B&N will continue to face fierce competition from Amazon, Apple, and other competitors. But this doesn’t mean that the bookstores are worthless. Not every brick and mortar retailer will go the way of Borders, Circuit City, or Blockbuster.
Last year around this time, everyone had left Best Buy for dead at $11 per share and 5 times free cash flow. One year later, the stock is 250% higher simply due to a change in perception. Talk about inefficiency. I’m not sure much has changed in the operating performance of the business, but all of a sudden, the market realized that Best Buy wasn’t going bankrupt—at least not in 2013:
A better example might be Gamestop. I say better because for one—it’s a former Barnes and Noble spinoff and two, the business’ operating performance has probably been better than Best Buy’s lately. For years, Gamestop was heavily shorted and traded very cheap relative to free cash flow. The business was profitable, had a clean balance sheet, and had management that were reallocating capital back into the undervalued shares, buying back significant amounts of stock at materially undervalued prices. This brick and mortar company that everyone thought would be the next Blockbuster has done surprisingly (at least to the majority) well:
10 years of positive and growing free cash flow, stable margins, and good returns. Not bad for a company in a declining industry with stiff headwinds. After 4 years of the stock going sideways despite solid free cash generation and significant buybacks, the market finally repriced the shares of GME, which are up around 100% this year:
So I don’t really think that a blanket argument based on industry fundamentals necessarily applies to Barnes and Noble. That idea seems too accepted and too cursory to me after really spending time looking at B&N. I certainly could be wrong and the accepted view might turn out to be accurate, but I think I have a huge margin of safety. Barnes and Noble has an incredibly powerful brand name with a very profitable brick and mortar bookstore, and the company founder who owns 26% of the stock alongside an insider roster filled with well-respected value investors with outstanding track records (Liberty, Tisch, etc…). At 4 times the cash flow of the bookstore, you aren’t paying for anything spectacular–you just need the management to eventually restructure (how long will they tolerate Nook losses?) and have the bookstores keep “muddling along”.
So to reiterate, this is not a compounder. This is a special situation where the combination of severe negative sentiment and significant losses in one division are masking the true profitability of the core business. 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.
In the end, the investment thesis is a special situation. It’s the opportunity to buy a company that is priced at less than 4 times the cash flow of one business whose profitability is masked by a high profile—yet unprofitable second business. At the current price of the bookstores (assuming separation from Nook Media) you’d get paid back in 4 years. That is quite a margin of safety on the downside. On the upside, if the business “muddles along” as Ron Burkle says, things will actually work out quite well.
Would You Buy This Business?
I’ll restate the investment thesis in the form of a metaphor—admittedly oversimplified—yet still effective at illustrating the basic idea. Let’s say you just got presented with the opportunity to invest in a local business. The business is a small car wash holding company that owns two car washes….
Imagine you can buy a car wash holding company in your town:
- You can buy this car wash company for $140,000.
- The company has two individual car wash locations.
- One car wash location has been steadily profitable for 15 consecutive years and produced cash flow of $40,000 last year.
- The other location lost $70,000.
Plus, let’s assume 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… even if it’s no longer worth $250K. 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 car wash chain is gaining market share in the area and competition with other car washes 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 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.
There are a couple other things to point out about this “car wash” business.
- It has no moat
- It operates in a fiercely competitive environment
“Price is What You Pay, Value is What You Get”
Again, the ideal long term investment is a business with high returns on tangible assets, ample opportunities to reinvest their cash flow at high rates of return, great management, and a durable competitive advantage (a moat). These are the true compounding machines. But not every investment I make is a compounder. Most non-compounders fall into some sort of special situation category… maybe it’s a spinoff, maybe it’s some sort of merger, maybe it’s just cheap on an asset basis… in this case, it’s the potential for corporate restructuring.
So not every 50 cent dollar has a “moat”. In fact, I like how Alice Schroeder explained it when she said that if you handed Buffett a dollar bill and asked him to buy it from you for 50 cents, he would. He wouldn’t say ‘Well there’s no moat!’
So I love moats, and high love strong operating businesses with economic tailwinds. But what I am really looking for is a disparity between price and value… keep in mind that a business’ moat, the ROIC, the growth rates, the management, the valuation ratios all matter and are all inputs into intrinsic value, but none of them are directly responsible or even necessary for a successful future investment result. That desired result is solely dependent on the difference between price paid and value received.
So in the car wash example above, if I were offered that opportunity, I would immediately understand that there really isn’t a moat. But I would identify the business opportunity as a “special situation”- one that I can buy, close/sell the unprofitable location, and own the profitable location at a cost of less than 4 times earnings. Even without a moat, there is a huge margin of safety based on the low purchase price. I would milk the car wash for the cash flow.
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.
Merry Christmas! I hope everyone enjoys the Holiday week.
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.