Barnes & Noble Education, Inc. — Fiscal 2016 Second-Quarter Form 10-Q
Reporting period: Quarter ended October 31, 2015; comparable periods ended November 1, 2014. The company operates college bookstores, e-commerce sites, textbook rental services and the Yuzu digital education platform. It operated 743 stores at quarter-end, versus 714 a year earlier, after opening 28 and closing 9 stores during the first 26 weeks.
Important comparability issue: Barnes & Noble Education completed its spin-off from Barnes & Noble, Inc. on August 2, 2015. The current quarter is presented on a consolidated basis, while prior periods and the first quarter of fiscal 2016 are presented on a stand-alone basis with allocations of Barnes & Noble corporate expenses. Historical results therefore may not represent the company’s future cost structure as an independent public company.
Financial Performance and Position
| Metric | 13 weeks ended October 31, 2015 | 13 weeks ended November 1, 2014 | 26 weeks ended October 31, 2015 | 26 weeks ended November 1, 2014 |
|---|---|---|---|---|
| Total sales | $755.9 million | $751.7 million | $994.8 million | $977.4 million |
| Gross profit | $175.1 million | $173.5 million | $226.7 million | $220.8 million |
| Gross margin | 23.2% | 23.1% | 22.8% | 22.6% |
| Operating income | $59.5 million | $65.4 million | $11.3 million | $18.9 million |
| Operating margin | 7.9% | 8.7% | 1.2% | 1.9% |
| Net income | $33.4 million | $37.0 million | $6.5 million | $10.7 million |
| Diluted EPS | $0.69 | $0.95 | $0.14 | $0.26 |
| EBITDA | $72.7 million | $77.9 million | $37.5 million | $44.0 million |
Revenue mix: Product sales and other revenue increased 0.8% to $684.0 million in the quarter and 2.0% to $902.7 million for the six-month period. Rental income declined 1.3% for the quarter and 0.2% for the six-month period, although management stated that rental income excluding increased revenue deferrals rose 1.9% and 1.8%, respectively.
Margins and expenses: Gross margin improved modestly due to better used-textbook inventory management, favorable merchandise and rental mix, and improved rental margins. Selling and administrative expense increased 7.2% in the quarter and 6.9% for the six-month period, reaching 13.6% and 19.0% of sales, respectively. Drivers included new-store payroll and operating costs, separation-related corporate infrastructure, and continued Yuzu investment.
Cash flow: Operating cash flow was $192.2 million for the first 26 weeks, compared with $187.6 million in the prior-year period. Investing cash flow was $(28.0) million, including $24.5 million of capital expenditures. Financing cash flow was $(9.7) million. Cash increased from $59.7 million at May 2, 2015 to $214.3 million at October 31, 2015.
Liquidity and debt: The company had no outstanding borrowings under its new $400 million, five-year asset-backed revolving credit facility at October 31, 2015, although it borrowed and repaid $8.7 million during the six-month period. Letters of credit outstanding were $3.6 million. The facility is secured primarily by inventory and receivables, permits up to $100 million of additional commitments subject to restrictions, and contains customary covenants and cash-control provisions if availability falls below specified levels.
Balance sheet: Total assets were $1.475 billion and total liabilities were $745.8 million at October 31, 2015. Merchandise inventories were $431.0 million and textbook rental inventories were $83.8 million. Accounts payable and accrued liabilities totaled $612.5 million. Stockholders’ equity was $729.7 million.
Material Changes Versus the Prior Comparable Period
- Quarterly sales increased $4.2 million, or 0.6%, while six-month sales increased $17.4 million, or 1.8%, primarily because of new-store openings.
- Comparable-store sales declined 3.0% for the quarter and 1.9% for the six-month period, with weakness attributed particularly to two-year community-college enrollment.
- Textbook revenue declined $24.4 million in the quarter and $27.9 million for the six-month period, primarily from lower new and used textbook sales.
- General merchandise sales increased $2.2 million, or 1.3%, in the quarter and $9.2 million, or 3.5%, for the six-month period, led by emblematic apparel.
- Quarterly operating income declined 9.0%, and six-month operating income declined 40.4%, as higher selling and administrative expenses more than offset gross-profit growth.
- Net income declined 9.6% in the quarter and 39.6% for the six-month period. Interest expense increased following the post-spin-off financing arrangement, although debt was fully repaid at quarter-end.
- The effective tax rate was 43.4% in the quarter versus 43.5% a year earlier, and 39.5% for the six-month period versus 43.2% a year earlier.
Outlook, Risks, Contingencies and Unusual Items
Management did not provide specific quantitative revenue, earnings or EBITDA guidance in the filing. Management expects cash from operations, availability under the revolving facility and short-term vendor financing to support operating and financing needs for the foreseeable future.
- Spin-off transition: The company is incurring costs as it establishes independent corporate, technology and other infrastructure. Barnes & Noble continues to provide specified transition services, generally for no more than two years after the distribution.
- Growth strategy: Management intends to add outsourced campus bookstore accounts, increase sales at existing stores, expand digital sales through Yuzu, and pursue acquisitions and strategic partnerships.
- Seasonality: Sales and operating profit are concentrated in the second and third fiscal quarters; the six-month results are not necessarily indicative of full-year performance.
- Competitive and operating risks: Key risks include declining textbook demand, digital and online competition, college enrollment and funding trends, contract non-renewals, inventory obsolescence, supplier concentration, technology and data-security incidents, and execution risk related to Yuzu and other strategic initiatives.
- Tax exposure: Other long-term liabilities include $63.5 million of tax liabilities, primarily associated with the LIFO reserve. Management considers payment or a foreseeable cash tax obligation remote, assuming continued acceptability of LIFO for tax purposes.
- Spin-off tax indemnification: Under the Tax Matters Agreement, the company could be required to indemnify Barnes & Noble for taxes and related expenses if the spin-off failed to qualify for non-recognition treatment because of specified actions or ownership changes.
- Legal proceedings: In the Adrea patent litigation, a jury previously awarded $1.3 million, but the court invalidated one asserted patent and was considering post-trial motions. Barnes & Noble is obligated to indemnify the company for expenses and liabilities related to this matter.
- Accounting matters: The company early adopted inventory and debt-issuance-cost accounting updates without material impact on the financial statements; the expected impact of the future revenue-recognition standard had not yet been determined.
- Controls: Management concluded that disclosure controls and procedures were effective as of October 31, 2015, and reported no material changes in internal control over financial reporting.
Investor Verification Checklist
- Reconcile post-spin-off operating expenses, transition-service costs and other standalone-company costs against the allocated historical periods.
- Assess whether comparable-store sales and textbook revenue trends improve, particularly at two-year community colleges.
- Monitor gross-margin gains against rising occupancy costs and higher selling and administrative expenses.
- Evaluate Yuzu investment levels, adoption, digital-sales growth and whether digital activities are approaching profitability.
- Verify seasonal working-capital needs, inventory aging and availability under the asset-backed facility.
- Review compliance with credit-facility covenants and the potential impact of cash-control provisions.
- Consider the $63.5 million long-term tax liability and the tax indemnification obligations related to the spin-off.
- Track the outcome of the Adrea patent litigation and the scope of Barnes & Noble’s indemnification.
- Review store-contract renewal rates, new-account wins, supplier concentration and exposure to textbook rental and digital-content competition.