Barnes & Noble: A Valuation Blind-Spot With 800% Upside?

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By Michael Glickstein :

We believe that formally splitting Barnes & Noble ( BKS ) into three separate businesses would create substantial shareholder value, in both the near- and long-term. It will help investors allocate capital to the particular BKS segment that meets their needs. While this idea is not novel, we do think it is important to take action now with a spin-off or equity carve out of the e-reading business designed to take advantage of current high valuations of technology firms that support substantial value creation from an e-reading "pure-play."

Our belief is that the current configuration of the company presents a valuation blind spot for most investors. Equity investors are often structured to cover industries vertically, meaning, with respect to BKS, different groups of investors prefer to buy into the different opportunities the three segments represent. For example, technology and/or growth investors could choose from a "pure-play e-reader technology story," a secular growth story in the college bookstore division, or a capital cycle opportunity in the retail books business that may benefit from a decline in competition in the brick and mortar business. The fact that several members of the current board, including Mr. Riggio, Mr. Maffei and Mr. Dillard have all previously announced or completed successful spin-offs in their respective careers gives us further confidence that the right leadership is in place to effectively execute this strategy.

We were pleased with Liberty Media's ( LMCA ) May 2011 offer for the company, which we believe recognized the value inherent in the businesses. However, following the preferred shares transaction the common shares are now 24% below their June high of $21.06 (closing price as of 12/16/11), despite sales in the e-reading business projected to more than double to $1.8 billion over the next 12 months (source: BKS 1Q12 financial results, 8-K filed 8/30/11).

The market has recently shown the price it is willing to pay for exposure to the growth of the e-reading business. Rakuten's recent purchase of the Kobo e-reading business from Indigo Books and Music, the largest brick and mortar book retailer in Canada, for $315 million highlights the demand for this high growth segment. As a diversified Japanese e-commerce company, Rakuten is hardly an e-reading pure play and the $315 million investment in Kobo represents only a fraction of Rakuten's multi-billion dollar market capitalization. It is our belief that a spin-off or equity carve out of the e-reader business would create the only e-reader pure-play and would have substantial value to technology investors, who currently have few other avenues to invest in this theme.

To quantify this value, we looked at the $315 million price for Kobo which represents a 5.2x multiple on last year sales (source: Indigo Books Annual Information Form, 5/31/11). Applying this multiple to the current year sales projection of $880 million for the e-reader business, results in a value greater than $4.5 billion. With conservative assumptions for the remaining retail and college bookstore business, and backing out liabilities, this represents a value of $41.50 per share for BKS, over 2.5x times the current market price. B&N Retail segment a 0.32x Price/Book (same as Books A million) for a value of $813M, the College Bookstore at the acquisition price of $460M, and backs out liabilities and preferred shares of $3.3B (source: company filings, yahoo finance and our estimates).

While valuations in the world of bricks and mortar books stores could not be worse, tech post-IPO valuations are robust, approaching levels that are reminiscent of the late '90s. For example, consider a few recent tech IPOs: Zillow ( Z ) currently trades at a 6.7x forward price/sales multiple, LinkedIn ( LNKD ) at 8.0x, and Pandora ( P ) at 4.1x, and Zynga (ZNGA) at 5.1x, based upon consensus estimates of forward sales. Zillow and Pandora are not yet profitable, while LinkedIn is approaching break-even and Zynga managed a small profit last year. More established technology companies like Amazon (AMZN) and Microsoft (MSFT), trade at 1.3x and 2.7x forward price/sales multiples, respectively (source: yahoo finance, consensus next year revenue estimate, pricing as of 12/16/11). Applying the average forward price/sales multiples of these two firms (2.0x) to the projected $1.8 billion in sales of the e-reader business, that would imply a valuation of $3.6 billion for the Nook. Even using these conservative multiples, this represents a share price over $25, with the same assumptions as the Kobo valuation.

Moreover, this valuation does not account for the tremendous growth of the e-reader market, which suggests that higher multiples may be warranted. The four current tech market darlings, Zillow, LinkedIn, Pandora, and Zynga, have all had over 100% annual revenue growth, which is comparable to the projected growth of the e-reader business. If we take the average forward price/sales multiples from these four firms of 6.0x, and apply it to next year's projected revenue of $1.8 billion, with the same assumptions for the remaining businesses and liabilities as above, that would imply a valuation of approximately $8.7 billion (i.e., $145 per share, or over 800% upside from the current stock price) for the firm's equity. We are not saying that this extreme valuation will be achieved, but this at the very least suggests that it is an appropriate time to take action to announce a spin-off.

We believe separating the Nook and e-reading business from the other businesses is feasible. An equity carve-out, where the parent still has majority control of the business, can be used since management may benefit from staying interrelated. In this situation, the actual sales of the devices can be booked at the superstore level, and the e-reading business and online business can be part of the e-reader pure-play carved-out business.

We believe the correct management is in place with a track record of maximizing shareholder value to execute this strategy. The 2004 spin-off of GameStop is one example of this, with BKS shareholders benefiting as an independent GameStop outperformed the S&P by 108% over the two-year period from 11/12/04 to 11/12/06. BKS previously took advantage of high technology valuation in March of 1999, when it conducted an IPO for ((BNBN)) and raised ~$518 million, another example of Mr. Riggio creating shareholder value by understanding the capital markets. Similarly, if BKS pursued the spin-off strategy for the Nook/e-reader business at this time, we believe it would unlock substantial value for shareholders based on the market's current demand for a technology growth story, which likely will not last forever.

Disclosure: I am long BKS . Funds managed by our firm and/or its affiliates currently have a long a position in BKS. The Funds' ownership represents under 5% of the total shares outstanding. We have recently made trades in the common stock as well as derivative securities and may buy or sell securities at any time. This analysis represents the sole opinion of Michael Glickstein.

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

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

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