A Stock I Warned You About Looks Ready to Nosedive

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Right before the Thanksgiving break, I singled out Barnes & Noble (NYSE: BKS ) as a stock that looked vulnerable to overly-optimistic expectations. [ Read the original article here .]

At the time, I noted that an imminent quarterly earnings release merited a great deal of scrutiny. Barnes & Noble had been expected to generate a small $0.02 a share quarterly profit , "but rising expenses may make that impossible."

I had no idea how prescient that forecast would prove.

The bookseller indeed went on to post a massive spike in expenses, causing it to register a $6.6 million net loss , or $0.17 a share in its fiscal second quarter ended Oct. 31. In fact, the company has been missing consensus earnings per share ( EPS ) forecasts by at least a nickel for each of the past four quarters, setting up further pain for the company's supporters.

Shares reacted as they should, falling nearly $3 on Dec. 1 to $14.59. Yet hope springs eternal, and shares have already made a decent bounce back toward the $16 mark. Importantly, what looked like a reasonable case for short sellers now looks like a powerful one. Simply put, Barnes & Noble may just spend it itself into oblivion as it chases Amazon.com's (Nasdaq: AMZN ) increasingly elusive shadow.

Going the wrong way
For most business models, rising sales typically yield rising profits. But Barnes & Noble, which is losing money on every Nook e-reader tablet it sells (when hardware and marketing costs are accounted for), is clearly going the wrong way. Management doesn't break down margins on hardware devices, but thanks to Amazon's aggressive pricing of the Amazon Kindle -- which Barnes & Noble must match to stay competitive -- the company is likely yielding a loss on every unit sold.

Management contends that Nook sales will really take off in the current quarter, in part due to heavy promotional activity. Yet rising sales won't necessarily yield a surge in profits on these  devices.  Besides, it's fair to wonder how much this business can grow anyway because it already faces tough competition from the No. 1 tablet in the market , Apple's (Nasdaq: AAPL ) iPad, along with Amazon's Kindle e-reader (not to mention its new Fire tablet computer).

After all, sales of Nook readers (and associated content) fell sequentially, from $277 million in the fiscal first quarter of 2012 to $220 million in the quarter ended October. That's the first sequential drop in six quarters. Management blames the drop on seasonality, but the rising installed base of hardware should be yielding a fast-growing book download business. This doesn't appear to be the case. (Management doesn't actually break down hardware and software sales for the Nook platform, which strikes me as a red flag.)  

Baking in the recent data points into fiscal (April) 2012 and 2013 forecasts, it may be some time before this company can show a profit. Barnes & Noble lost $1.19 a share in fiscal 2011, and analysts just expanded their projected per-share loss for fiscal 2012 from ($0.23) to ($0.58). The fiscal 2013 forecasted profit has just been slashed nearly 80% to just $0.10. And I have my doubts that this small profit will even come to pass, as this company serially fails to meet its targets.

Why do I think losses will continue at least through fiscal 2013? Because many analyst forecasts appear to fail to take into account any cannibalization of traditional book sales by e-readers. Analysts say the combined strength of traditional book sales and digital book sales should push the company's overall sales up 5% by fiscal 2013. Yet it's worth noting Barnes & Noble hasn't posted this kind of growth (on an organic basis) since fiscal 2005. The steady drop in time spent reading traditional books and more time spent surfing the web is a trend that shows no signs of abating.

And this presents the real challenge to the business model . It costs a lot of money to operate traditional retail stores. Retailers need to generate a certain level of sales at each store to generate an incremental level of profit. Fall below this level, and we're talking about incremental losses. And this is what looks set to happen at an increasing number of stores, as e-reader downloads rise in volume , displacing traditional book sales. Same-store sales in the fiscal second quarter fell 3.3% from a year earlier. A random walk through any Barnes & Noble -- outside of the all-important holiday season -- provides a glimpse of slowing foot traffic. The company operates more than 1,300 stores, and it will be interesting to see how many of them slip from profitable to unprofitable if same-store sales keep dropping .

Risks to Consider: When shorting stocks like this, you need to stay abreast of intra-quarter data points. If it appears Barnes & Noble's Nook sales start to trend well above expectations, then it would be wise to close your short position and revisit the investment thesis after the holiday selling season.

Action to Take-- > Short sellers remain squarely focused on the current holiday season. The fiscal third quarter is the only profitable one for Barnes & Noble, generating almost enough profit to offset losses in the other three quarters. Yet the sobering just-released quarterly report doesn't provide hope for a solid fourth quarter. If Barnes & Noble misses expectations in the current quarter and analysts have to lower their forecasts once again, then even this stock's most ardent supporters could throw in the towel, likely causing shares to move quickly below $10. I know I'd want to if I owned shares. If you think that's likely to happen, then you should short this stock.


-- David Sterman

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.




The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Basics

Referenced Stocks: AAPL , AMZN , BKS , EPS

David Sterman

David Sterman

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