Barnes & Noble Could Succumb to the Retail Apocalypse

Over the past few years, a combination of declining retail traffic and rising competition has led to a slew of retail bankruptcies. Many well-known retailers have disappeared recently, including Toys R Us (and sister chain Babies R Us), fashion retailers like The Limited and Wet Seal, and electronics stores HHGregg and RadioShack (with the exception of some dealer-operated franchise stores). Mall standbys Payless ShoeSource, Gymboree, and Crazy 8 are going out of business in 2019, while Sears and Kmart barely avoided liquidation earlier this year.

So far, Barnes & Noble (NYSE: BKS) has survived this big shakeout despite being one of the first companies to have its business disrupted by (NASDAQ: AMZN). That said, the bookseller's recent results suggest it could be living on borrowed time.

Revenue and profitability are declining

Barnes & Noble's revenue has been shrinking for years thanks to a series of comparable-store sales declines and occasional store closures. Total revenue fell from $4.2 billion in fiscal 2016 to $3.9 billion in fiscal 2017, $3.7 billion in fiscal 2018, and an estimated $3.6 billion in fiscal 2019 (which ends next month).

While Barnes & Noble has implemented aggressive cost cuts to offset these sales declines, they haven't helped much. Adjusted EBITDA fell from $186 million in fiscal 2016 and $187 million in fiscal 2017 to $145 million last year.

Barnes & Noble's initial guidance for fiscal 2019 called for adjusted EBITDA to rebound to between $175 million and $200 million. However, management recently revealed that the company will fall far short of that mark.

Decent holiday season performance wasn't good enough

In early January, Barnes & Noble reported that comp sales surged 4% between Black Friday and New Year's Day. This offset weak performance in early November, driving a 1.3% comp sales gain for the nine-week holiday period. However, Barnes & Noble needed to ramp up advertising and promotions to achieve this level of sales growth. As a result, management warned that the company might reduce its earnings guidance by as much as 10% when it reported earnings.

The outcome was even worse. Last week, Barnes & Noble reported that comp sales rose 1.1% in the third fiscal quarter -- the company's best sales performance in several years -- but adjusted EBITDA still declined to $133 million from $139.5 million a year earlier. Furthermore, Barnes & Noble now expects full-year adjusted EBITDA to come in between $140 million and $155 million. That's more than 20% below its previous guidance, based on the midpoint of the range.

This result is particularly disturbing because Barnes & Noble benefited from several tailwinds last quarter. The liquidation of Toys R Us provided a lift for Barnes & Noble's educational toys and games business. Meanwhile, there was a strong lineup of new titles last quarter, led by Michelle Obama's memoir, the best-selling adult book since 2015.

Posting sales growth will be a lot harder after Barnes & Noble laps the Toys R Us store closures -- especially in quarters that have a less favorable new title lineup. Management acknowledged during the earnings call that Barnes & Noble's sales continued to decline in the first month-plus of the fourth fiscal quarter.

The future doesn't look bright

Barnes & Noble's projected adjusted EBITDA for fiscal 2019 will barely cover its annual interest expense of around $13 million and its planned capex of $110 million to $120 million. Free cash flow probably won't be sufficient to cover Barnes & Noble's dividend, which costs about $11 million per quarter. That's a dismal result for a year in which the company has benefited from strong retail sales trends, along with some unusual tailwinds.

Looking ahead, Barnes & Noble faces secular challenges. Amazon plans to continue expanding its brick-and-mortar Amazon Books chain. The e-commerce behemoth has also made it virtually impossible to compete for online sales. Amazon's superior scale gives it a cost advantage for shipping books -- particularly when it can ship the books along with other items. The result is that Barnes & Noble's e-commerce sales peaked years ago.

Given that Barnes & Noble is struggling to eke out a profit and post positive free cash flow when market conditions are favorable -- and that Amazon's expansion will continue to pressure the business -- the company seems likely to fall into distress in the next recession.

The one thing in Barnes & Noble's favor is that it has only $129 million of debt -- although that's up from just $60 million a year ago. On the other hand, the company is trying to sell itself, which might benefit shareholders but could result in the buyer taking on more debt.

Despite the return to comp sales growth last quarter, Barnes & Noble seems to be as far as ever from finding a viable strategy to deliver sustainable, profitable growth. And without that, the company is probably doomed to failure.

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