Microsoft (MSFT) buying the Nook e-reader?

the news

Yesterday, the stock of Barnes and Noble (BKS) soared 22% on more than 10x normal volume.

The reason?

…a TechCrunch post saying MSFT is preparing a $1 billion offer for the company’s Nook-related digital assets.  The assets are held in BKS’s Nook Media subsidiary, which also contains the company’s college bookstore operations.  Leonard Riggio, who controls 31% of BKS, owned the college bookstore business privately but sold it it BKS in 2009 for $514 million.

The TechCrunch report is based on its examination of internal MSFTdocuments which the New York Times says are genuine, though perhaps dated.

is the headline figure, $1 billion, all that it seems?

Maybe not.  The most favorable interpretation of the TC scoop is that MSFT is willing to pay $1 billion for the portion of the BKS digital assets it doesn’t already own.  The least favorable is that the offer values the entire Nook Media at $1 billion.

The difference?  Three factors:

1.  MSFT already owns 17.6% of Nook Media.  Pearson owns another 5%.  Under the more favorable interpretation, the $1 billion would be split between Pearson and BKS, with the latter getting $940 million.  Under the less favorable, which I think is probably the correct interpretation, BKS would collect $774 million.

2.  Does the $1 billion value include the college bookstores, which–as I read the BKS financials–are the company’s most profitable operations?  If so, cut the MSFT offer in half.

3.  In its original deal with BKS, MSFT promised to fund up to $180 million in Nook R&D.  I think this was a loan, not a gift.  If so, part of the $1 billion may be forgiveness of the loan, not a new cash inflow.

In the least favorable case for BKS, subtract $500 million from the $1 billion headline number if the college book stores aren’t included.  Another $176 million represents the stock MSFT already owns.  Let’s say a further $100 million represents repayment of the R&D advance.  Then, the “$1 billion” offer would mean a cash outflow of  about $250 million, of which BKS would get about $235 million.

the Nook is bleeding red ink…

…for three reasons.

In the Darwinian world of consumer electronics, stand-alone e-readers like the Nook are an evolutionary dead end.  They’re being replaced by small, light tablets.

The Nook is an also-ran among e-readers.

As I read the BKS  financials, the company has a razor/razor blade strategy for the Nook.  It prices the device roughly at cost in the hopes of generating a lot of high-profit e-book sales from users.  In fiscal 2013 (ended in April), however, BKS appears to have lost $350 million trying to persuade consumers to take Nooks off their hands.  It’s hard for me to see how BKS can sustain deficits of this size.

why buy the Nook? 

1.  MSFT takes in $1 billion in cash every two weeks.

2.  To compete in the tablet and smartphone businesses, MSFT needs an e-reader feature.  Because of the company’s tiny market share in both businesses, developers aren’t beating down the doors in Redmond to make reading apps for it.  MSFT’s plan would apparently be to stop making e-readers and refocus the Nook division on creating/enhancing e-reader apps, especially for Windows devices.

3.  According to TechCrunch, the MSFT documents project Nook ” revenues to gradually recover, up to $1.976 billion by fiscal year 2017, for EBITDA profit of $362 million.”

Given that sales of e-readers make up the huge bulk of Nook Media’s sales, the most polite thing I can say is that this forecast is extremely optimistic.  Revenue growth appears to assume a rocketship ride for sales of digital content.  The $750 million positive swing in EBITDA looks too good to be true.  But it does make Nook Media look cheap.  My hunch is that this is its main purpose–to justify the purchase.

(One caveat:  it’s impossible for me to judge how revenues and costs for the Nook devices and for digital content are figured and split between the retail and Nook divisions of BKS.  The only way I can see for Nook Media revenues to rise without hardware sales is if the whole basis of revenue calculation is somehow changed.  EBITDA of $362 million is only plausible to me if somehow post-acquisition Nook Media’s SG&A expense of around $400 million a year completely disappears, or if somehow a whole bunch of digital content profits are now being attributed to the retail division but revert to Nook Media post-acquisition.)

For what it’s worth, TC says the MSFT documents value BKS as presently constituted at $1.66 billion.

4.  MSFT is anything but a shrewd acquirer, in my view.  Just look at its $40+ billion bid for YHOO in 2007 (it has taken a 70% rise in YHOO’s stock price over the past year for that company to recover to a market cap of $30 billion-).

5.  Nook Media may be MSFT’s best alternative–and it may feel it can’t allow the business to die.

I don’t have an investment opinion about BKS.  I don’t own the stock and I have no inclination to be a buyer.  Any holder must ask himself where he sees upside from the current level, and how much that might be.

PS:  I wonder who leaked the documents   …and why.

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