Barnes & Noble Inc. (BKS:US)’s stock surged a record 52 percent on April 30, the day Microsoft Corp. (MSFT:US) swooped in with an offer to buy a stake in the money-losing retailer and fund its expansion into electronic books.
The euphoria has evaporated (BKS:US) as it becomes clear that even with Microsoft’s considerable resources and push into tablets and mobile computing, a rapidly changing competitive environment means the largest U.S. bookstore chain will still struggle to avoid the fate of the music and movie stores.
The shares have slid 41 percent since the announcement as investors digest Barnes & Noble’s mounting woes: another loss, sliding sales of printed books, and slowing revenue growth of Nook e-readers and tablets, which could soon face new competition from a smaller and cheaper Apple Inc. (AAPL:US) iPad. Analysts project more losses when the bookseller reports first-quarter earnings tomorrow, according to data compiled by Bloomberg.
It doesn’t help that Microsoft and Barnes & Noble have been vague about how their partnership will turn things around, said Peter Wahlstrom, an analyst for Morningstar Inc. (MORN:US) in Chicago. Barnes & Noble must “prove they can make this into a viable model and they haven’t done that yet,” he said. Microsoft’s involvement “doesn’t fix it.”
On a price-to-sales basis, Barnes & Noble trades at a 90 percent discount to the 32-company Standard & Poor’s 500 Retailing Index, according to data compiled by Bloomberg. The bookseller has annual revenue of $7.1 billion and a market capitalization of $739.5 million.
Both companies declined to offer more details, or make executives available to be interviewed for this story.
When Barnes & Noble released its first tablet, the Nook Color, in 2010, it quickly gained a foothold as one of the few inexpensive alternatives to the iPad. The chain managed to grab share in large part because it converted a section of its stores into Nook showrooms. A majority of the company’s e-readers and tablets are sold at its 691 locations.
About a year after the Nook Color debut, Amazon (AMZN:US).com Inc.’s Kindle Fire arrived with a similar price and began grabbing customers. Google Inc. (GOOG:US) entered the market last month with the Nexus 7 and Apple may join the fray in October.
Faced with rising competition, the New York-based chain tried luring customers with free gift cards and e-books; now it’s discounting. On Aug. 12, it marked down the Nook Color and Tablet, cutting the price on the 8-gigabyte Tablet 10 percent to $179. Comparable Fire and Nexus 7 versions sell for $199.
While the discounting squeezes margins, Barnes & Noble is trying to protect and expand its hard-won 25 percent share of the U.S. e-book market -- a portion it never attained in printed books. It’s easy to see why. Content sales, which include digital books and such apps as Angry Birds, more than doubled last year to $483 million while sales at its stores and website declined 1.5 percent to $4.85 billion. Content also generates gross margin above 30 percent, compared with a 27 percent margin for the whole company.
Like Amazon, Barnes & Noble is selling its e-readers and tablets at a loss or break-even to lock customers into its system. Chief Executive Officer William Lynch has called this acquiring “digital lockers” with the belief that once consumers begin building an e-book collection within the Nook universe, they will keep buying from it.
“The idea is not to get every human being to have a Nook device,” said David Schick, an analyst for Stifel Nicolaus, who recommends holding the shares. “It’s to get people who read a lot to be on their platform.”
The company has said it will focus less on hardware going forward. That means Barnes & Noble will become increasingly reliant on selling e-books via devices from Apple, Google and Microsoft. Many Kindle owners traded to the iPad and still buy books from Amazon and use its app to read them. The big question is whether the tie-up with Microsoft will help Barnes & Noble pull off the same trick -- keeping its millions of Nook customers loyal and hooking new ones.
All the companies have said about the deal is that it’s expected to close before the end of the year and the Nook app will be “deeply integrated” into Windows 8, the first version of Microsoft’s operating system that will power tablets.
That may mean users are prompted to make a pre-loaded Nook app their default reader, as Apple does with its iBooks, or it could be promoted in the Windows app store with free e-books. Yet because Amazon and Rakuten Inc. (4755)’s Kobo brand are also making apps for Windows 8, Barnes & Noble will have plenty of competition as it chases new customers, Wahlstrom said.
Windows 8, debuting in October, will be installed on 122 million devices, including 6.7 million tablets, by the end of 2013, according to IDC, a Framingham, Massachusetts-based researcher. That potentially will give Barnes & Noble wider distribution and its first move overseas.
Under the deal, the Nook digital bookstore must be available via Windows 8 in 10 countries within a year. The digital book market is more up for grabs outside the U.S., where e-reading isn’t as widespread, although Amazon and Rakuten are already selling e-books in more than 100 countries. Barnes & Noble said today that it will begin selling the Nook and e-books in the U.K. by the end of this year.
Barnes & Noble should have the cash to stay competitive. Besides paying $300 million for an 18 percent stake in a Nook subsidiary that may be spun off into a standalone company, Microsoft has also agreed to spend another $305 million over five years on revenue sharing and capital expenditure payments.
Still, Barnes & Noble has yoked its future to a company struggling with its own reinvention. While Microsoft is releasing its own tablet, Surface, the software maker has mostly failed to create best-selling gadgets, with the exception of the Xbox game console.
Moreover, Apple and Google have a formidable head start in the fastest-growing part of the computer industry. “There’s no question Microsoft is late to the tablet market,” said Al Gillen, an IDC analyst. “They have some catching up to do.”
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