Now’s the Time to Buy this Comeback Stock

Len Riggio must be kicking himself. The chairman — and largest shareholder — of Barnes & Noble (NYSE: BKS) rebuffed a takeover last summer from Ron Burkle of Yucaipa Investments for a reported $20 a share.

At the time, I thought any buyer of the beleaguered bookseller would simply inherit a bunch of problems. [Read my original analysis.] Shares went on to fall 40% since then.

Seven months later, I’m changing my tune. Not because shares are much cheaper — but because recent events have altered the dynamics for this retailer. Even though hurdles remain, the odds are increasing for a convincing turnaround.

When competition shrinks
One of the greatest challenges in the retail sector is too much capacity. In certain niches, there are simply too many stores to profitably satisfy demand. Yet, when the number of stores in a niche is reduced, profitability for the remaining stores can soar. Pier One Imports (NYSE: PIR) saw rivals Bombay and Linens ‘N Things close stores in 2007 and 2008. Since then, shares of Pier One have risen from $0.11 to $9 in the past two years — and that’s during a time when retail spending has been depressed. Credit goes to shrinkage in the total industry store base.

This factor is just one of the reasons I’m shifting gears on Barnes & Noble. Rival bookseller Borders, as part of a bankruptcy plan, will close 200 stores. And that may not be the end of it. As we’ve seen with video-rental firm Blockbuster, the first round of store closures doesn’t necessarily return a company to profitability. Blockbuster is on its fourth round of store closures. I expect Borders to keep retrenching.

Many of the Borders stores that are slated for closure are in reasonable proximity to similar Barnes & Noble locales. So it’s logical to assume that Barnes & Noble will pick up a chunk of business. Goldman Sachs now assumes Borders-related sales boosts will add more than $30 million to Barnes & Noble’s bottom line.

A growing dot-com
Part of my change in sentiment is also due to a factor that I got flat wrong. I assumed’s (Nasdaq: AMZN) Kindle would run away with the e-book field. It didn’t help that Apple’s (Nasdaq: AAPL) iPad makes for a pretty good e-book reader as well. Yet, Barnes & Noble’s Nook e-reader is actually holding up well. Market share is just above 20%, well below Amazon’s 67%, but still impressive when you consider the total market doubled from the third quarter to the fourth quarter of 2010 and now generates more than 6 million quarterly unit sales. This means Barnes & Noble is selling more than 1 million Nooks per quarter.

As time passes, that rising installed base of Nook readers is likely to help to generate rising profits for the bookseller’s Internet arm, Digital titles downloaded to the Nook carry far higher profit margins than hardware sales. The website posted a 52% jump in sales in the third quarter of 2010 (ended December) to $319 million and is one of the fastest-growing e-tailers in the country. I had my doubts that Barnes & Noble could effectively compete in the online and brick-and-mortar worlds simultaneously, but each part of the business looks better than it did six months ago.

To be sure, Barnes & Noble’s legacy store base still has room for improvement. The company just missed estimates for the fourth straight quarter, though the bar for future expectations appears to be set lower and the periods of serial disappointments appears to be over.

Management should seize the initiative where possible as Broders retrenches, but it will have its own hard choices to make as well. It would be wise to cull the bottom 20% of the stores (in terms of profitability) from the store base. That would prove management is serious about addressing profitability while retaining market share.

Action to Take –> This has surely been a challenging year for Barnes & Noble, which is expected to generate a free cash flow (FCF) loss of around $60 million ($0.77 a share) in fiscal (April) 2011, according to Goldman Sachs. Yet, the bookseller’s period of heavy investments in its web operations is winding down and FCF should swing back into the black. Goldman Sachs is modeling for FCF in excess of $1.50 a share in fiscal (April) 2012. Not bad for a $9 stock.

In the near-term, expect a bumpy ride. Border’s store closures could steal some traffic as inventory is sold off. That process usually takes a quarter to complete. And investors are still sore about the decision to eliminate the $1 a share dividend. It was a wise move, but it led to a churn-out of institutional holders that focused on the payout. The shareholder churn process seems complete, as shares have ticked back up on Monday after dropping for six straight sessions. Most investors have simply thrown in the towel on this stock, but the recent set of industry events is actually more positive for the company than many currently realize. I like that set-up.