Description

BNBN (short)

BKS just announced a buyout offer for the 25% of BNBN it doesn’t own at $2.50/share, yet shares are changing hands for $2.82/share on speculation that BKS will sweeten its offer. Shorting BNBN at $2.82/share offers a high probability of 10% return in a few months, and a very low probability of a capital loss (and I found the shares easy to borrow). If the transaction occurs at $2.50/share 4 months from now, the 10% return would be equivalent to an annualized rate of return of 33% for very minimal risk. And the annualized return could be higher if speculators give up on the “sweeter offer” hope before the transaction occurs, letting the stock price drop down to the $2.50/share or so it should be trading at.

THE POSSIBLE OUTCOMES

I see three possible outcomes to this story:

1) BKS raises the offer to $2.80/share due to criticism from shareholders and/or BNBN requiring this price after its special committee of the board reviews the offer (this is about the amount BKS recently paid to acquire Bertelsmann’s BNBN stake). For reasons explained below, I believe this is a low probability outcome, but it would result in a break-even investment.
2) BNBN approves the offer at $2.50/share, and the transaction closes in 4 months or so. I believe this outcome is very likely.
3) BKS withdraws its offer due to criticism from shareholders and/or BNBN requiring a higher price after its special committee of the board reviews the offer. I believe this outcome is unlikely, because it is in the best interests of BNBN shareholders to get $2.50/share rather than have BKS withdraw its offer, which would likely result in the shares falling to below $2.30 (stock was at $2.25 prior to the offer), and could result in a further stock decline in the future when the company is forced to raise money on unfavorable terms.

Note that worst case scenario results in no capital loss.

HISTORY

BNBN is an internet book retailer that was started as a wholly owned subsidiary of BKS in 1997, in response to AMZN selling books over the internet. In 1998, BKS raised capital for BNBN by granting Bertelsmann a 50% stake. In 1999, 20% of BNBN was floated in a public offering, raising nearly half a billion dollars for BNBN. Since then, BNBN acquired enews and Fatbrain, which diluted the shares and destroyed value.

This year, Bertelsmann sold its stake to BKS for the equivalent of about $2.80/share as part of a strategy shift to return to their core businesses that involved shedding most of their online ventures. Prior to this transaction, BKS had been purchasing BNBN share on the open market for several months. The combination of the stock buybacks and Bertelsmann purchase brought BKS’ ownership stake in BNBN to 75%.

Shortly after going public at the height of the internet craze, BNBN’s stock price exceeded $20/share. When it became obvious that BNBN was a distant second to AMZN, sales growth was stalling, and profitability seemed forever on the horizon, BNBN’s share’s drifted into a trading range between .4 and 3 over the past 3 years, rising recently due to share buyback activity and the Bertelsmann offer.

THE BUSINESS

BNBN is a leading online retailer of books, music, and DVD/video. Through its brand name association with parent company Barnes and Noble (BKS) and a variety of promotions and incentives (most notably free shipping and the Reader’s advantage program), BNBN rapidly grew its sales to over $400 million/year. However, sales growth flattened and BNBN now appears to be generating a steady, nongrowing annual revenue rate of about $425 million per year.

There’s no need to go into great financial detail as this is a special situation that should resolve itself within a few months. Worth mentioning though is that BNBN has never had a profitable year, has always been cash flow negative, and has now essentially run out of cash (the cash on the balance sheet is more than offset by the amount BNBN owes to BKS). Should BNBN remain a public company, it will need to raise cash within a few quarters, and I suspect that the terms will not be very favorable.

There have been several prior predictions of when profitability would be reached, which did not occur. To BNBN’s credit, cost controls are gradually moving them towards break even, which should be easily achievable if sales growth were to occur. Whether sales growth will occur is anyone’s guess, but even AMZN is struggling to grow its sales of new books, in the face of competition from overstocks and used book sales on EBAY, AMZN, OSTK, and others, that sell for much lower prices. Furthermore, AMZN’s new book prices are usually lower than BNBN. The $2.50/share buyout offer values BNBN at roughly $400 million, nearly 1x sales, even though the company has never made money is not projected to do so in the near future, and will likely need to raise cash within a few quarters.

WHY $2.50/share IS THE LIKELY OUTCOME

Lenny Riggio, Chairman of the Board of BKS and CEO up until recently, has a history of hanging tough and making very smart capital market transactions – see the BKS writeup for some details. Riggio has withstood criticism in the past of seemingly related party transactions, most notably related to his transactions with Babbage’s Etc., a precurser to Gamestop.

Babbage’s was spun off over a decade ago, went bankrupt, was bought by Lenny Riggio for a pittance when video game stores were out of favor, and then bought by BKS in 1999 as video games were starting to come back into favor. Riggio made out wonderfully on these transactions. This did create value for BKS shareholders, as GME sold shares to the public in early 2002 at a price much higher than was paid for Babbage’s. Not a surprise that BKS shareholders benefited, as Lenny Riggio owned over 20% of BKS throughout this time period. But Riggio made out better than anyone. In spite of the heavy criticism Riggio never compromised on pricing.

In the current BNBN situation, BKS holds all the cards. There is no natural bidder to compete with BKS (who would want to own a minority stake in a 75% owned BKS subsidiary that is losing money and will need to raise cash soon?). There is no short-term catalyst to drive the stock price higher: sales have stalled and the balance sheet is weakening. And BKS does not have a huge need to own BNBN – if shareholders or BNBN demands a higher price, BKS can just walk away and wait for another day when the buying environment is more favorable.

Buying BNBN at $2.80/share makes no sense. While perhaps one could imagine BKS sweetening its offer to the same price it just paid Bertelsmann, but then the reward is zero while the downside is 10%. Meanwhile, BKS is announcing its intention to hold firm, as illustrated by the following press release:

"Barnes & Noble sees online unit offer adequate
November 07, 2003 1:17:00 PM ET
NEW YORK, Nov 7 (Reuters) - Leading U.S. bookseller Barnes & Noble Inc. (BKS) said on Friday it considers its $2.50 a share offer for each share it does now already own in Internet bookstore Barnes & Noble.com (BNBN) as adequate.

Asked if Barnes & Noble would consider raising its offer -- as suggested by a jump above $2.80 in Barnes & Noble.com's stock, Larry Zilavy -- the company's executive vice president for corporate finance and strategic planning -- told Reuters in an interview: "We believe this (our offer) is a fair and full price."

He said he expects the transaction to close during the first quarter of the upcoming fiscal year. REUTERS "


I don’t know how long this opportunity will remain available so I’m cutting short this writeup in the interests of posting before the stock price begins its descent. I’ll be happy to answer any questions in followup posts.

Catalyst

BKS buyout at $2.50/share occurs as scheduled in Q1, 2004.