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.

demise of the e-reader: implications

e-reader sales

A Christmas Eve Financial Times article indicates that while e-reader sales in 2012 will still be robust, the category may be on the brink of a rapid decline in popularity.  Its source is IHS iSuppli.   I’ve found the data in a graph from emarketer.com (note the convoluted chain of attribution–PSI cites emarketer, which in turn cites CNET citing IHS).

The reason for the falloff?   …the rise of light, powerful cheap multi-function tablets, which can serve as e-readers as well as do a lot of other stuff, for within a reasonable distance of the price of a dedicated e-reader alone.  This development wouldn’t be surprising, since the multi-function smartphone has replaced the dedicated music player for many users.

(The above is what I see as the consensus view. It’s not a unanimous one, though.   The Market Intelligence and Consulting Institute, which presumably has special insight into the Taiwanese companies that actually make the e-readers, predicts a bounceback in sales for 2013.  So we should at least keep in mind that the consensus may not be correct.)

Implications, if the FT is right?

In a world where the decision on what merchant to buy an e-book from hinges on what dedicated e-reader you own, the firm with the largest number of e-readers in circulation (Amazon) should be the dominant factor.  Other, non-compatible e-reader makers, like Barnes and Noble, should have small relative market shares.  Other would-be booksellers are footnotes, at best.

The game changes substantially, I think, if the key decision becomes what app the potential buyer has on his tablet.  That’s because any customer can download a new book app with a couple of taps.  Unlike the case with music, where users may want to construct playlists, it probably doesn’t matter much whether one’s entire library is on one app or several.  So the key factor in the purchase decision probably comes down to price.

It’s possible that AMZN can develop a tablet that’s the full equivalent of a Samsung or Google offering.  The performance of the Kindle Fire suggests that’s not likely.  But, if it can, perhaps AMZN can preserve its “ecosystem” with avid readers for a while longer.  And in doing so it would be able to bar the download of other booksellers’ apps onto its machines.

Personally, I doubt Barnes and Noble will be able to create a viable tablet.  Yes, it does have its alliance with MSFT.  But that only seems to me to guarantee that BKS can have the Zune of tablets.

AAPL is in an unusual position.  Its strategy has been to generate superior profits by selling up-market devices at premium prices.  Does it want to compete in the (eventual) $100 tablet market?  My off-the-cuff guess is that it doesn’t.  By default, this makes AAPL less of a player in the e-book market.

On the one hand, this would make the big publishers’ alliance with AAPL of a few years ago look extremely short-sighted.  On the other, it creates the opportunity for them to have a common app that bypasses both BKS and AMZN.

the stocks?

Any restructuring book distribution by cutting out dedicated e-readers is obviously not a reason for the companies that control the e-reader market to celebrate.  The biggest single loser, I think, is potentially BKS, since AMZN has 3x the market share in e-books that BKS has.  It isn’t that AMZN escapes the change unscathed.  But it already has lower prices than BKS; its large relative size gives it another big advantage in the price-drive. environment I think will develop.  Also, it’s not clear that AAPL will abandon the up-market strategy that snatched it out of the jaws of bankruptcy to become a serious competitor in the mass tablet market.

All in all, I score the situation as a net plus for AMZN.

The wildcard is potential new competitors who might be able do offer superior app performance.

Apple, book publishers and the Justice Department

the investigation

Media reports yesterday indicate the US Justice Department is investigating five of the top six book publishing firms (Random House is the exception) and Apple for price-fixing in the e-book market.  Settlement talks aimed at avoiding litigation are apparently going on, at least with some of the publishers.  A parallel investigation by EU regulators seems to be happening, as well.

what’s at issue

It’s all about trade books.  Publishers have traditionally wholesaled physical bestsellers to bookstores at 50% of the suggested retail price.  The store owners then figured out how much to mark them up–or whether to sell them as loss leaders.  A hardcover with a retail price marked on it of $25, for example, would be sold to a bookstore for $12.50.  The store might retail it for, say, $16–or for $10, if they so desired.  Stores could return unsold copies for a refund.

As little as two years ago, publishers were following the same procedure in the nascent e-book market.

This created a potential problem, however.

AMZN was aiming to become the dominant seller of e-books, to be read on its proprietary Kindle device.  It was taking every e-book it paid a publisher $12.50 for and retailing it for $9 or $10.  Yes, the company lost around $3 a book.  But short-term profits have never been an AMZN concern.  And the company was shifting avid readers in droves from being physical book buyers to becoming Kindle aficionados.

Publishers began to hear the giant Perot-ish (Perotian?) sucking sound of their physical book distribution network disappearing into cyberspace.  How to respond?

AAPL, which was just about to launch the first iPad, came along with a proposal.  Publishers shouldn’t necessarily wholesale e-books to e-retailers.  Instead, they should (technically, anyway) remain owners of the e-books (with no physical inventory, what difference would it make?) and hire companies like AAPL as commission-earning agents to put buyer and seller together…kind of like the way real estate agents sell houses.  That way, publishers could set retail selling prices themselves. This wasn’t an entirely new idea.  Publishers already had similar deals with some small independent bookstores.

AAPL proposed to charge a fee of 30% of the proceeds for each sale.  And, oh…by the way…publishers would also agree not to allow their e-books to be sold anywhere else at a lower price.

Publishers said okay and then broke the news to AMZN.  No more selling e-books at a loss.  E-books had to be priced at the publisher-determined price of around $13-$14; AMZN had to take 30% of the proceeds.

AMZN said no.  The five publishers now being investigated immediately responded by revoking AMZN’s permission to sell their e-books.  AMZN took the books off its website.  But a few days later, AMZN caved and agreed to the publishers’ terms.

consequences

Saying what might have been is a little like writing an alternate history, which is rightly classified as a branch of science fiction.  Nevertheless, here’s my take on the effects of APPL/publisher deal:

–imposing what amounts to the agency model on AMZN broke the company’s momentum in the e-book business and slowed the growth of the medium.

–this gave the publishers time to try to figure out how to support the physical book distribution network.  I don’t know what good that’s done.  It certainly didn’t save Borders

–it caused AMZN to refocus its competition strategy on the price/quality of the reader

–it gave BKS time to perfect the Nook and allow it to emerge as a viable competitor to the Kindle

–it gave APPL another selling point for the iPad, although the device seems to me to be much better for magazines, scholarly journals and textbooks than for regular trade fiction/non-fiction.

what would a settlement mean?

I’m assuming that the main result of any settlement would be to allow AMZN to set the retail price of e-books wherever it wants.

Under today’s rules, a newly-released bestseller in e-book form sells for about $14.  Sale proceeds are split, with $9.80 going to the publisher and $4.20 to the retailer/agent. AMZN might reduce its e-book bestseller price to $9.99.  I think that’s an easy decision.  That was its desired price point two years ago–and one which, at least at that time, proved to be a powerful psychological motivator for customers to choose an e-book over a physical one.  Unlike the situation in 2010, AMZN could pay the publisher $9.80 and have $.19 left over.

What about $7.99?  That would put AMZN back into roughly the same the loss-leader position it had adopted a few years ago.  To my mind, this would be a vintage AMZN move.  But is it necessary?  Given the much larger size of the e-book market today relative to the physical book market, are the losses this strategy would produce manageable?

Maybe a smaller form factor iPad would make AAPL a bigger player in the bestseller book business, but as things stand now AAPL doesn’t need trade e-books to spur iPad sales.

What about Barnes and Noble (BKS)?  The company seems to me to be the obvious loser if AMZN is able to lower e-book prices.  That would accelerate the demise of the BKS bricks and mortar bookstores.  Having a competitor sell e-books at cost would also appear to diminish the chances of the Nook ever becoming a profit-making device.

On the other hand, the AMZN move would likely increase pressure on BKS to sell its Nook name and technology.  GOOG has been rumored as a possible buyer, which, I presume, is the reason BKS has a market cap north of $750 million–and has been rising since the price-fixing investigation was leaked to the press.

The real question, of course, is the price someone like GOOG would be willing to pay.  I have no clue.  I also don’t have any confidence that I’d be able to come up with a meaningful estimate.  That’s okay with me, though.  As an equity investor, you’re in this position a lot. It just means I won’t get involved with the stock.

 

 

 

 

 

I’m suddenly a tablet advocate: here’s why

my take on tablets

I like gadgets.

I’ve had my eye on a tablet since I first saw one in a university bookstore (a MSFT product) almost a decade ago.  But that one was very clunky and didn’t let you do much more than highlight Word documents.  I looked at a Lenovo combination laptop/tablet a few years later, but it was very underpowered.  And there was still no infrastructure of applications to justify the tablet part.

Now there’s the iPad.  It’s the usual well-designed AAPL consumer device.  But to me it has seemed little more than another device to lug around that’s not much more than an expensive e-reader and an extremely costly way to play Angry Birds.

my newspaper problems

Then the Financial Times newspaper stopped coming to the house.

Yes, I still read the physical newspaper.

I read:

–the FT (comprehensive global business news; a UK perspective on US/world economic and political developments),

–the NY Times (reasonable, US-oriented business news, good–though weakening–sports coverage) and

–the Wall Street Journal (good sports, lots of gossip in the NY section, almost no useful business coverage–meaning I won’t renew).

why the physical paper

I’m not a fan of wood products per se.  But I’ve thought the physical paper has several advantages over the web version:

–the amount of news in the physical paper is greater than on the front page of the newspaper website.  So the editors’ selection of what’s most important is a greater influence on what you see online than in the physical paper.  As a result, the chances of finding information whose significance is not adequately understood is greater in the physical paper.

–I think the web presentation is organized to highlight stories that will maximize visits.  In contrast, the physical paper is organized to deliver information.

–I thought (not any longer) that it’s easier to reconstruct with the physical paper a timeline of information flow by reading back editions you might not have gotten on the day of publication than it is to go back a day or two in time on the website.

my call to the FT

When I called the FT last Saturday to get replacement copies of the papers that didn’t come, the representative I talked to mentioned the e-paper that’s available through ftnewspaper.com.

The site is run with software from Olive Software, a private company in Aurora, Colorado.  ftnewspaper.com has daily back editions.  You can turn the pages of each edition, just like an online catalog.  You can pop out to larger size and different formats the articles you want to read in depth.  I also discovered that, through FT email alerts, I had already read most of “today’s” paper online yesterday!

ftnewspaper.com has been around for a couple of years.  I just didn’t know about it.

my calculation

Anyway, I can cancel my physical paper subscription and save a couple of hundred dollars a year.  No more worries about cancelling delivery when we may be travelling.  No more toting around piles of unread orange newsprint.  Less recycling to do.

All of that just means that I can rationalize paying for a tablet with the money I’ll save by stopping a newsprint subscription.  But I’ve also found a sophisticated and valuable application, other than email, that’s completely suited to what a tablet can do and that I use every day.  This means that I have a positive reason to buy one.

I’d like to see the new Google tablets, as well as iPad 3, before I take the plunge.  I have only one concern.

one concern

In my career on Wall Street, I’ve observed the long struggle for control of brokerage houses between researchers and traders that has been decisively won by the latter.  I’ve thought of this as somewhat like the age-old high school contest between jocks/cool people and the nerds.

It seems to me that the same battle is going on in newspaper firms between traditional reporters and online search engine optimizers–the latter being more interested in eyeballs than in information.  As I study successful financial websites with an eye to improving this blog, I can see the same dynamic in play in this arena–well-crafted and very popular websites with lots of advertising, but almost no useful investment information.

By shifting my financial support from the reportorial nerds to the online jocks, I’m most likely speeding the day when even the FT will suffer from a content deficiency.    But that’s a problem for another day.

 

No one wants to buy Barnes and Noble?

That’s what the Bloomberg news service said the other day, citing interviews with five (count ’em, five) unnamed sources knowledgeable about the auction of the company that’s now underway.  It appears potential buyers–at least seven, according to Bloomberg–have all lost interest as they have had an opportunity to study the company and its financials more deeply.

What could be their concerns?

Well, for one thing, BKS is a big-box retailer with a lot of real estate under lease that it has to pay for.  And big-box retailers are all trying to shed floor space as fast as they can.   They are suddenly realizing that this floor space has been rendered much less valuable by the rapid growth of online sales.

For another, BKS sells books, a merchandise category that is showing little, if any, growth.  In fact, the company most similar to BKS, Borders, has just gone into bankruptcy, illustrating the parlous state of the industry.  Potentially more relevant, Chapter 11 will likely allow Borders to free itself of many financial burdens and to streamline operations very quickly, presumably turning it into a much more formidable competitor as it reemerges from bankruptcy.

Finally, BKS is a force in internet sales, both of physical books and of e-volumes readable on the firm’s proprietary e-reader, the Nook.  While this puts BKS in a strong competitive position vs. Borders (which has neither kind of online presence), it also puts the company directly into the sights of two larger, much better capitalized, aggressive digital competitors in AMZN and AAPL.

That’s not good.

For one thing, a recent survey by the Boston Consulting Group suggests that, although digital is the future of publishing, most people want to buy tablets, not e-readers.  Score one for AAPL.  For another, the accord that the publishing industry forced on AMZN about a year ago compelled the e-tailing giant to stop competing on price in the digital book industry.  That didn’t mean competition in digital books ceased, as I think the publishers thought.  It just meant AMZN had to shift the focue of competition to another arena, namely, the price/performance of the e-reader.  At the moment, BKS’ color Nook may be in the lead.  But AMZN has much more R&D money to toss around than BKS.  Score one for AMZN.

Given my description, why would anyone even consider bidding for BKS?  A growth investor like me wouldn’t, even though I was a very big holder of BKS fifteen years or so ago.  But deep value investors are another breed entirely, with a very different–and somewhat counterintuitive–investment philosophy.

I look for healthy companies where I think the consensus has seriously underestimated their growth rate.  Deep value investors, on the other hand, look for mediocre companies, or worse, where they think the consensus has seriously overreacted to the bad news that’s in plain sight.  They hope to find assets worth 100 that they can buy for 30 and sell for, say, 60.  This is a tough business, where you’ve got to be very sharp to survive.  But it’s also one where the chance to acquire a company fitting my description above would have such investors rubbing their hands in anticipation.

To my mind, the surprise isn’t that value investors have started to investigate.  It’s that they’ve apparently all lost interest.  This implies they’ve found something in doing their due diligence that wouldn’t be obvious from the SEC filings and that makes them think the situation is riskier than they had imagined it would be.

What would such a risk be?  In my experience, deep value investors are most comfortable with mature businesses.  They tend to like basic industries (like cement or pulp and paper) and simple manufacturing, where the world changes slowly.  They also tend not to like, or to do well with, technology.

So I think their new-found worries come in the digital side of BKS …that once they peeked under the hood they concluded that BKS is in a more fragile condition there than they had estimated.  My guess is that the bone of contention is the cost/market position of the Nook, not the state of actual e-book sales.  The auction is supposed to be over in a couple of weeks.  We may learn more then.