Geoff Gannon March 16, 2011

Barnes & Noble – The Human Element

A reader sent me this email:

The way Barnes & Noble (BKS) is trading is starting to bother me.  I don’t see anything in the recent 10-Q that wasn’t already announced.  Borders CEO is saying they hope to come out of (bankruptcy) by end of summer, ok but that is not the end of B&N.  Other than that there is nothing but the market trading as if B&N is going to end in (bankruptcy) itself.  I don’t get it.

Can you offer your take?  I realize you no longer like B&N or maybe you are not interested to offer comments but this sort of movement seems irrational and I am getting uncertain.

One of the really big issues with Barnes & Noble – and probably the reason I sold out – is that the non-profit motivations of Riggio and others didn’t align with my (as an outside investor) very much for profit motives of buying the stock. My fear was that once Riggio defeated Burkle in the proxy contest, the company would be more geared to relentless pursuit of being a big, relevant force in bookselling regardless of what that meant for profits that could actually repay shareholders.

In other words, I was very scared that Nook spending wasn’t a one-time thing. That the existential threat to Barnes & Noble as a company was what management would respond to instead of minimizing direct investment in the Nook and maximizing the milking of today’s cash flows from the actual stores. Basically, I thought Burkle’s motives were safely capitalistic while Riggio’s motives were dangerously paternalistic.

I still do.

Maybe things will work out for Barnes & Noble the company, for Barnes & Noble the institution – but I didn’t think they’d work out well for shareholders. The actions they are taking are crazy from a return on capital perspective. But they obviously make sense from a long-term survival perspective. Still, they are unnecessarily dangerous from a short-term survival perspective. Barnes & Noble’s financial health would be fine without the Nook. It isn’t fine right now and that’s entirely because of the combination of cashing Riggio out of B&N College and spending on the Nook combined with maintaining the dividend through the proxy fight.

Ironically, this pursuit of long-term relevance has endangered the financial health of the company. Unless they stop spending on the Nook, they’re going to be flying a lot closer to the sun than they ought to be. A company with these cash flows shouldn’t be doing this kind of new product investment. They’d say the level of spending is temporary. I’d say you either commit to an arms race or you don’t. But once you commit, it’s out of your control how many missiles you’re going to need next year. Both sides get a say in how much you have to add to the arsenal each year. If Amazon raises the bet, you have to match them or fold. But you no longer get to choose your level of investment. That’s how the game works. It’s brutal. And it’s stupid to play it. But they’re playing it.

Anyway, Japan and Barnes & Noble both illustrate one of the most important concepts in investing. When I got started at age 14, I thought companies would be all profit driven and heartless and perfectly rational. What I found out is that investing often involves figuring out how and why companies behave irrationally and emotionally. Why they keep factories open they should’ve closed a decade ago. Why they try so hard to stay in the industry they started in – even when it’s obvious they can’t earn an adequate return on capital. Things like that.

That human aspect of investing is actually a really big part of what I do. Sometimes the biggest part. And that’s the real reason I sold Barnes & Noble. Once I saw the proxy contest was over, the human element became such a huge impediment to the investment that I had to sell out. With Riggio firmly in control and irrationally determined to battle it out in e-books despite the destruction of shareholder wealth – well, my entire investment argument for Barnes & Noble was undermined by the human element. That happens. Human factors can destroy an investment that would otherwise make sense based on the numbers. Barnes & Noble stock would be a terrific bargain today if Burkle was in complete control. Instead, it’s a dangerous investment because Riggio is in control.

So, like I said, the human element can destroy an investment that would otherwise make sense based on the numbers.

That’s true at Barnes & Noble and normally that’s been true in Japan. I can’t stress enough how strangely public Japanese companies are run. They don’t have any interest in getting good returns for their shareholders. They think of employees, customers, and suppliers first and investors last. They pursue sales just to increase their size. They improve technology merely for the prestige. Profit is the very last thing on their minds.

But Japanese stocks have gotten so cheap, I’m interested.

Could the same ever be true of Barnes & Noble?


Not for me.

I wouldn’t buy Barnes & Noble stock at any price.

As long as Riggio is in charge and the company is focused on spending big bucks on the Nook – I’m unwilling to buy the stock at any price. It’s too dangerous. It has such a huge liability in terms of management – in terms of who the steward of your capital is – I just can’t buy the stock at any price.

For an investor, the story you read in the press is totally wrong. The press will tell you Barnes & Noble is having all these problems but at least there’s the Nook. Well, that might be true for employees – not in the stores, but at Barnes & Noble’s offices – but it’s not true for investors. The Nook isn’t offsetting some problem.

The Nook is the problem.

Barnes & Noble is taking the free cash flow from its stores and then spending it – and then some – on direct investment in cutting edge consumer technology that it has no business developing.

Look, Barnes & Noble and Amazon are not analogous to Nokia. The business that matters isn’t making the device. It’s the stuff delivered on the device. Barnes & Noble and Amazon are carriers of e-books. Fundamentally, that’s all their customers want them to be. They just have to subsidize Kindle and Nook. They don’t have to get directly involved in producing the device.

The e-book business has always been headed in one direction: selling e-readers as part of a subscription to an e-book carrier.

Eventually, Amazon is going to give away the Kindle with a subscription to Amazon Prime.

Economically, that’s the end point here. It’s always been the end point. The whole device thing is just a spur to get the e-book market going. But it’s never been about selling devices. It’s always been about selling e-books.

Two companies – Amazon and Barnes & Noble – have the established “network” of e-books that every e-reader needs to tap. They are the only special properties. The carriers. Amazon and Barnes & Noble. The existing customers of those companies combined with their relationship with publishers – that’s it. Nothing in e-books is special except Amazon and Barnes & Noble being the two places where book publishers and book readers meet. You can’t replicate that. You can replicate anything else.

You can replicate the devices.

The devices themselves are not special.

Anyone willing to sink ungodly amounts of capital into developing the devices can do it.

Barnes & Noble has decided to develop the device themselves. That was stupid. And it still is stupid. And eventually it may prove suicidal.

But that’s the decision management made. So, if the decision stands and the management stays – I’m not going to buy Barnes & Noble at any price.

As long as the company is aggressively investing directly in the Nook, I have no interest in the stock.

Given Riggio’s hold over the company – and his love for the book business – I see no reason why anyone in Barnes & Noble management is going to pursue the rational choice from an investor perspective. Instead, they’ll pursue the rational choice from an employee perspective.

And that choice is to destroy shareholder wealth in an attempt to maintain Barnes & Noble’s place in the world of bookselling – both in print and digital form.

Which means shareholders are screwed.

So – for me personally – I don’t care what the price of the stock is. That’s not the signal to buy. The only signal to buy would be a complete change in strategy or management. And by management, I mean Riggio, so there’s no way that’s happening.

Whether other folks should buy or sell Barnes & Noble stock – I can’t say. I can only tell you that I would never be comfortable holding the stock with the current management and current strategy they are pursuing.

It’s suicidal.

Right now, they’re intent on death by Nook.

And I’d rather not join them.

Talk to Geoff About Barnes & Noble (BKS)