Quick Thoughts on Barnes & Noble & Valuation

In the Daily DL for today (2-2-10), there was an article discussing Ron Burkle’s attempt to increase his ownership of Barnes & Noble (he currently holds 19% of the company on a direct and indirect basis).  One of the items he mentioned in a letter to Barnes & Noble was that he believed the company was undervalued.  After reading that article, CB decided to quickly look through the company.  The reader should note that the following is a very quick review of the company, based primarily on filings.

These are CB’s brief thoughts:

• The company has high operating leverage.  It tends to operate anywhere from a small profit to a loss in most quarters except the fourth quarter (November to the end of January).  The fourth quarter is the company’s most profitable quarter as sales are usually between 40% to 50% greater than the other quarters.  Furthermore, the net profit margins in the fourth quarter for fiscal 2008  and fiscal 2007 were roughly 5.0% and 6.6%, respectively, while the net profit margins ranged from -2.1% to 1.3% during the most recently reported eight quarters.  The difference in margins experienced during the fourth quarters demonstrate the strength of the operating leverage. Currently, margins have been dropping due to sales decreasing at a faster rate than the operating costs.
• The operating leverage implies that if sales could achieve fiscal 2007 levels, which would require an increase of nearly 3.2% on the latest-twelve month sales figure, and maintain those levels then this company is certainly undervalued considering it would most likely be able to produce earnings per share (“EPS”) ranging from $1.80 to $2.13 ($2.13 is the EPS figure reported for fiscal 2007).  With this range of EPS the company would be trading near a 10x price/earnings ratio.  Nevertheless, at present, the company continues to forecast declines in same store sales.
• Unlevered free cash flow (EBIT(1-Tax) + D&A – CapEX – Change in Working Capital)  for fiscal years 2008, 2007, and 2006 has been 12%, 16%, and 6% of the current enterprise value, respectively, for an average of11% over those three years.  However, in fiscal years 2008 and 2007, the positive cash changes in working capital accounted for 48% and 46% of the free cash flow, respectively.  CB would prefer to see changes in working capital play less of a role in a strong free cash flow number.  Yet, the company is definitely capable of generating the cash flow, as seen by its dividend and share buybacks – which CB likes, for this industry.
• Looking at the assets, if one believes that: (1) the company can monetize at best 85% of the inventory, which is roughly $1.5 billion; (2) the fair market value of the fixed assets is equal to the net book value of $852 million (CB assumed $700 million to be conservative, because it does not have a firm grasp of the company’s assets – perhaps the fair market value is much higher than book?); and (3) one can monetize all of the receivables for a value of nearly $146 million, then with the roughly $96 million in cash and cash equivalents the company has an asset value of approximately $2.41 billion, excluding any intangibles or assets that were not clearly defined.  Yet, the company has total liabilities of $3.22 billion.  Thus, this is not an asset play, unless the fair market value of the fixed assets is much higher than the net book, which would be another key item to figure out during the research process.  Nevertheless, the assumptions made on inventory and accounts receivable were fairly optimistic.
• Barnes & Noble’s value, if CB is right about the fixed assets not being worth more than net book value, will be very dependent on operations and free cash flow.  If one believes the company can improve on its current $1.28 earnings per share and reach a range of between at least $1.80 and $2.13 (fiscal 2007) in the near future and maintain it, while continuing to produce free cash flow between $152 million and $196 million, then the company is undervalued.  Due to its high operating leverage, an increase in the sales number is critical to improving earnings per share and free cash flow.  Research should be conducted on whether the brick-and-motor business model is dying?  Can the store continue to compete as profitably as it has in the past as more consumers go online to do shopping?  How does it compete against Amazon?  The company does have an online presence, what strategy is it seeking to expand that business? This is where CB would start.  The numbers don’t leave a large enough margin of safety to have confidence in Barnes & Noble being a buy or sell.   In CB’s opinion, its one to move on from.  The company, when the economy improves, will probably experience an increase in sales, profits, and stock price.  However, in the long-term can this be maintained?   There are better companies to invest in if one is betting on an economic recovery.

Tagged with Amazon, Barnes & Noble, Free Cash Flow, Ron Burkle