This Hot Stock Shot up 50% in Less Than a Month — What’s Next?

Long-time readers of my articles will notice a predilection for the phrase “love ’em when they’re hated.” That phrase has surely applied to Barnes & Noble (NYSE: BKS) after its stock fell 80% in the past five years to less than $10 a share. Many had concluded that the nation’s largest bookseller was in a terminal death spiral as fewer customers ventured out to its stores.

Back in March, I suggested “the odds are increasing for a convincing turnaround.” My logic rested on two pillars: First, a massive shrinkage in the store base of rival Border’s would help drop-in traffic in those neighborhoods affected. Second, the company’s Nook electronic reading device was starting to emerge as a real contender among the small group of e-readers. As it turns out, it’s the Nook that explains why shares of Barnes & Noble have taken off like a rocket, rising 50% in less than a month.


Spreading through retail
Shares first started to rebound in late April when office supply retailers Staples (Nasdaq: SPLS) announced plans to sell the Nook in its 2,200 stores — that’s triple the number of stores Barnes & Noble operates. As investors started to take a closer look at the Nook e-reader, they began to see reports circulating that the device was actually taking root not just for book readers, but for consumers who wanted a basic tablet computer without paying the full freight for Apple’s (Nasdaq: AAPL) iPad or Motorola’s (NYSE: MMI) Xoom. Those devices cost 100% to 200% more than Barnes & Noble’s Nook (a color device goes for around $250). For the low price, you don’t get a camera and you’re saddled with a slower processor, but there’s not much difference otherwise.

#-ad_banner-#Ad campaign and software upgrade
Shares really took off in the last week of April when Barnes & Noble formally upgraded the Nook and kicked off an ad campaign highlighting the Nook’s unsung capabilities. (Forget books. What about streaming movies, reading e-mails and all of those other time-sucking hobbies that the iPad is known for?) Barnes & Noble has even cobbled together a few hundred applications for users to download.

Make no mistake, the iPad is far “cooler,” with better hardware, thousands of apps and that unmistakable smug glow that can be seen on the face of any Apple devotee. But the Nook is good enough for the rest of us, and some are suspecting that if Barnes & Noble can get this right, then it may have a blockbuster on its hands. To cap it off, management announced plans in early May to come out with a major upgrade for the Nook later this month. It’s as if management has suddenly found their groove.

The brick-and-mortar millstone
Then again, believing in Barnes & Noble management requires a leap of faith. This is still a company that has slowly sat by as $400 million in annual free cash flow (back in the middle of the past decade) steadily shrank until the red ink started to flow in 2010. Foot traffic continues to slump at its stores, and a rising number of them are no longer profitable (and would have been culled by a tougher management team). The race is on for the Nook and (the company’s web arm) to boost profits high enough to offset losses from the brick-and-mortar stores. Barnes & Noble will take a 30% cut of all downloaded apps, but it’s far too early to know how that will add up.

In their favor, management has deep ties with the publishing world and is doing a nice job of getting everyone from children’s book publishers to leading magazine publishers to help highlight the Nook’s tablet-like interactive multimedia qualities (replete with catchy divisional titles such as NOOK Kids or NOOK Magazines).

For investors, the future profit levels may not matter in 2011. Instead they’ll simply focus on the prospects for the Nook to take market share (and worry about profits another day). Market share now stands at 25%, according to the company, and will it need to stay at that level or rise even higher, even as Apple and (Nasdaq: AMZN) fight for their own share with the iPad and Kindle, respectively. (Amazon may look to kick off a price war. The online retailer has a nasty habit of sacrificing near-term profits in order to to make life miserable for a rival.) That’s why these next few quarters are “make or break” for Barnes & Noble, a suddenly hot stock. If the Nook gains real traction, investors will start to see this as a technology company with a brick-and-mortar stub, rather than the other way around.

Action to Take –> Goldman Sachs analysts, who are fairly bullish on the Nook’s prospects, have yet to figure out how much it will mean for Barnes& Noble in terms of sales profits. They figure companywide sales will stay in the $7 billion range for the next few years and, even with a better focus on trimming costs, they still see earnings per share (EPS) of just $0.21 by fiscal (April) 2013. Either Goldman and other firms are simply being cautious about the timing and strength of the Nook’s momentum, or shares are likely to fall back to new lows in coming quarters as the Nook fails to make a dent in the ossified profit and loss statement.