Would you pay $300 million for a slice of the #2 eBook & eReader business?

Microsoft just did. Thanks to Roger Knights for the heads up.

Bloomberg reports that Microsoft invested $300 million to get a 17.6% share in a new B&N subsidiary which combines B&N’s Nook digital reader business with its college bookstore business. The companies are calling it a ‘strategic partnership’ in the B&N + Microsoft Press Release – A strategic partnership to accelerate the transition to e-reading.

Microsoft gets 17.6% while B&N keeps 82.4%. The exact shares were decided after a game of hopscotch in kilts.

This is hugely important to both the ebook and eReader markets (the investment, not the game of hopscoth). It might also be hugely important to the high value Tablet market. An almost doubling in B&N’s share price certainly suggests the market thinks so (of course, that probably means the venture is going to inadvertently create a new monkey virus that wipes out humanity).

Even analysts are chiming in with words of encouragement –

The partnership with Microsoft could give the Nook the kind of content and global expansion to make it a bigger player in the tablet business, said Michael Glickstein, chief investment officer with G Asset Management LLC.

That kind of partnership makes the Nook business more valuable, Glickstein said.

No kidding. Nook is suddenly a Microsoft backed business and connections to Gigantically Profitable Software Makers are far more fetching than comparisons to brick and mortar anything.

Microsoft’s Investment in B&N’s Nook Business is Hugely Important

Let’s see why this could be a huge, huge thing (you could just skip to the second list, the one after this one, for why it’s important for Kindle owners and book lovers):

  1. It values B&N’s ebook and college bookstore business at $1.7 billion. The second biggest ebook business is a billion dollar business (or nearabouts). Still think this is discounted by a factor of 3 or more.
  2. B&N’s new Nook Inc. subsidiary will develop a Nook eReader application for Windows 8. That app will probably get default eReader App placement in the Windows 8 App Store. There are already signs that B&N is becoming increasingly important in ebooks (a stronger #2). This will cement Nook as the #2 ebook business. Perhaps even give Amazon a run for its money.
  3. The hundreds of questions about B&N’s stability and how that would affect Nook’s future just got put to rest. Which means that the biggest competitive advantage Amazon had (stability) just got eliminated. This will force Amazon to innovate Kindle and Kindle Tablet more. It will give B&N more confidence to keep making Nook Tablets and Nook eReaders.
  4. Microsoft has a sharp eye for billion dollar businesses. It has 9+ such businesses of its own and you can be sure it thinks highly of Nook to actually invest in it. I’d make a serious bet that over the course of the next 10 years this 18% share would end up being much more important to Microsoft than Microsoft’s share in Facebook (which, to be fair, is in the very low single digits i.e. 1.6%).
  5. Microsoft and B&N settled their patent litigation. More stability for Nook Inc. 

Let’s jump ahead to the really important stuff. The impact on readers, on ereaders, and on tablets. 

Hugely Important to Readers and eReaders

Much more interesting to us Kindle owners and book lovers is why this ‘strategic investment’ by Microsoft is hugely important for books and ebooks and eReaders:

  1. B&N claims 30% market share in eBooks. Combine that with it probably becoming the default eReading App on Windows 8 and suddenly Amazon is looking over it shoulder.
  2. A separate Nook & College Bookstores businesses (Nook Inc.) isn’t saddled with the legacy brick and mortar bookstores. Nook revenue grew 38% to $542 million in the last quarter. This is a seriously big business. Revenue for the fiscal year ending in April 2012 is projected to be over $1.5 billion. If Nook Inc. were unprofitable and run by a college dropout it would be considered worth $10 billion (unless it also stole people’s personal information – then it’d be $25 billion).
  3. B&N has been innovating on both the eReader front (Nook with Glow Light) and the Tablet front (the $199 Nook Tablet). This $300 million investment from Microsoft means it has more security and can keep innovating. That pushes Amazon to improve Kindle and Kindle Tablet more.
  4. Windows 8 means hundreds of millions of users. The importance of being the default Windows 8 App can’t be understated. Much of the Microsoft Anti-Trust lawsuits revolved around IE and Media Player being defaults shipped with Windows. B&N’s Nook eReader App gets that privilege and advantage now. The huge and undefeatable power of the default.
  5. The inclusion of College Bookstores is being touted as important. It might be. It supposedly puts B&N’s new Nook Inc. in position to challenge for the eTextbook market.
  6. Amazon, like any other company, has always needed a serious competitor to keep it honest and hungry. While B&N has done a good job there’s always been doubt around how long it would be around. The double measures of a Microsoft investment and the creation of a fast-growing subsidiary suggest that B&N, the strong #2 player in ebooks and eReaders, will stick around for a while.
  7. In the best case, this move might actually help accelerate the growth of ebooks. At worst, it will ensure that ebook growth doesn’t come to a standstill. You can bet that both B&N and Amazon will now make really, really good reading applications for Windows 8.

Amazon has shown that it improves the Kindle most when it has a strong competitor breathing down its neck. It’s also shown that it is quick to learn from innovations B&N makes. It took its sweet time to release the Kindle Fire – However, once Nook Color validated the market for high value tablets Amazon did release Kindle Fire.

The investment by Microsoft in B&N’s Nook Inc. will revitalize the Kindle team and energize B&N’s Nook Team. In one swift stroke Microsoft has breathed life into the competition in eBooks and eReaders and High Value Tablets.

Hugely Important to High Value Tablets

There are some very interesting questions about the future of Nook Tablets and Kindle Fire Tablets that come up –

  1. Firstly, as the analyst points out above, this gives B&N the strategic knowhow to go international with Nook Tablet.
  2. That would force Amazon to go international with Kindle Fire.
  3. Secondly, it raises the possibility of a Windows 8 powered Nook Tablet. Surely, now that it owns 18% of B&N’s Nook Inc., Microsoft will push for Windows 8 based Nook Tablets.
  4. B&N might be offered the inside track and might very well move to Windows 8 Nook Tablets. Android lacks one huge thing Windows 8 promises – a connection to all the desktop software that Windows 8 will have. It makes little sense for phones – but a lot of sense for 7″ Tablets.
  5. It would force Amazon to also move to Windows 8. A Kindle Fire Android App Store just wouldn’t be able to compete with the Windows 8 App Store in the long run.
  6. Thirdly, the investment and the Nook Inc. subsidiary means that Nook Tablet won’t have to pay for the sins of the brick and mortar bookstores. Nook Inc. gets a clean sheet. It’s a business growing at 38% per year (approximately) and it won’t be Border’ized.
  7. Fourthly, Microsoft will absolutely provide a lot of business connections and relationships. Think better ties with manufacturers, intelligence from Microsoft divisions, and lots of other potential benefits. Wouldn’t be a surprise to see Nokia phones coming with the Nook App as the default ebooks app.
  8. Fifthly, given that B&N’s Nook Tablet is the second best-selling Android Tablet and has the potential to atleast stem slightly the tide of migration to Apple devices, there is very strong motivation for Microsoft to keep strengthening Nook Tablet. Even if Nook Tablet sticks with Android – It’s still one less customer lost to the Apple family. A customer who would then proceed to buy iEverything and MicrosoftNothing.

Overall, the Nook Tablet part might be the real reason Microsoft has invested in B&N’s Nook Inc. Saying it’s all about ebooks might be a convenient cover. Just the way that Amazon claimed Kindle was all about ebooks and reading and then proceeded to create the real Kindle Killer, the Kindle Fire.

In the Final Analysis

Barnes and Noble, the #2 ebook seller, the #2 eReader seller, the #2 High Value Tablet seller, is suddenly a lot stronger.

Amazon suddenly has very strong and stable competition.

Microsoft has made an investment which could be strategic in multiple ways. It might very well be that Microsoft sees three billion dollar businesses – Nook eReaders & eBooks, eTextbooks, Nook Tablets.

This 17.6% investment (for just $300 million) is about a million times smarter than the billions Microsoft is burning up on its badly strategized search engine business. On that note, it’s time for Microsoft to buy a certain small and sweet search engine (that rhymes with Luck) and unleash two horses in the search engine wars.

Wondering about B&N's strategy, especially Nook Color, Nook Study, and Nook Kids

The Kindle might have won the first few eReader Wars (War for Book Readers in 2009, War for Book Readers in 2010) – However, a few recent observations have been making me wonder whether B&N has a more effective long-term strategy.

A strategy it has been forced into because of Kindle’s excellent success in books.

Is the Nook Color built specifically for Children’s Books?

If you look at the retail box of the Nook Color, you notice something rather interesting about the Nook Color displayed on it –

  1. There are 3 books displayed in the top row (on the screen of the Nook Color on the box). 
  2. The second row on the screen has 2 magazines and 1 newspaper.
  3. The third row is 3 children’s books.

That, in a way, signifies the focus of Nook Color – Books, Children’s Books, Magazines, and Newspapers. Or, to view it in terms of target demographics – readers, parents, magazine readers, and newspaper readers.

Nook Color is undoubtedly better for parents and magazine readers. It represents a big shift from Kindle and Nook, which were both great for books/readers and terrible for everything/everyone else.

Nook Kids highlights B&N’s focus on parents and children

It’s not just that B&N has built Nook Color with a view to capture the children’s eReader market. It’s also released an iPad app specifically aimed at children. It’s called Nook Kids and there are already 100 books available for it – all of the read-along and picture-book variety.

If you go to B&N’s NookKids section on its website, there are books for various age groups – Up to 2 years, 3 to 5 years, 6 to 8 years, 9 to 12 years. The books include classics like Curious George and Thomas the Fire Engine. There are both picture books and read to me books.

Perhaps most interesting is a section called ‘Mom Favorites’. B&N is clearly targeting parents.

Nook Color is the #1 eReader for parents

If you’re a parent, there’s little doubt what you’ll pick – either Nook Color, or Nook Kids for iPad.

B&N might be behind Kindle in books. However, in Children’s books it’s far, far ahead. Not only does it have an iPad app tailored for kids, its reading tablet, the Nook color, caters to parents and children as one of the main target demographics.

And all those kids will grow up with fond memories of Nook Color, and with their books locked into B&N’s special format.

Getting tired of writing this – If Amazon doesn’t release a Kindle Tablet soon, it’ll be in a lot of trouble.

B&N is going after the textbook market too

B&N has Nook Kids and Nook Color to go after parents. It also has Nook Study to go after the textbook market and students.

Nook Study = B&N going after another demographic Kindle has ignored

Amazon did do university trials with the Kindle DX. However, the DX wasn’t really built for students – note-taking was horrible, there were very few features built for students, there were no page numbers, there was no color or touch.

Nook Color is much closer to the type of textbook eReader students would want – although with a screen that’s too small. However, it isn’t Nook Color that B&N is using to go after students – It’s Nook Study.

The Nook Study hard-sell

Got an email from B&N about Nook Study, and here’s what they’re advertising –

  1. The 132 free textbooks from Kaplan.
  2. Save up to 60% on eTextbooks.
  3. Nook Study for PC and for Mac. Features advertised include – ability to take and share notes, search, customize highlights.
  4. Free $5 gift card if you rent a textbook by January 21st.
  5. Save 90% on used textbooks, and 30% on new textbooks.

Visit the site and more things hit you –

  1. B&N is offering eTextbooks free for 7 days.
  2. It’s offering access to 1 million free books.
  3. It’s offering a College Kick-Start Kit.

The software itself is pretty well done. In fact, it’s downright impressive. Nook Study is a very decent option for eTextbooks – All that’s needed is an iPad app and a 10″ Nook Color and B&N will suddenly be in prime position in the War for Students.

637 B&N College Bookstores

B&N has a great channel to advertise Nook Study, sell the Nook Color, and (in the future) sell the 10″ Nook Color- its 637 college bookstores.

Which means that all it has to have is a textbook Reader and a textbook reading app that are as good as the competition – From there its retail channels will give it the win.

B&N is better placed than Amazon in Children’s Books, and might be better placed than Amazon in Textbooks

Let’s consider three separate wars that are part of the larger eReaders Wars –

  1. The War for Readers and Books – Amazon is clearly the leader here.
  2. The War for Parents and Children’s Books – Nook Color and Nook Kids give B&N a lead here. In fact, Amazon isn’t even trying much in this area.
  3. The War for Students and Textbooks – Amazon tried to sell a general eReader to students. B&N is selling a reading app, and has 637 college bookstores. They’re about even. Whichever company is the first one to release a reasonably priced textbook reader, one that’s built from the ground up as a textbook reader, is likely to win.

These are 3 of the most important wars making up the greater eReader Wars. We have others like the War for Magazine Readers and the War for Newspaper Readers. However, these three are amongst the pivotal ones.

That does leave a fourth war and a fifth war – the War to replace Paper with an eReader+eWriter, the War for the Enterprise. Amazon and B&N are not fighting those wars at the moment. There might be others.

For the 5 huge wars that make up the core of the eReader Wars –

  1. Amazon has almost fully won one (books).
  2. B&N is set to win one (children’s books).
  3. There’s a third (textbooks) that’s just starting off.
  4. There’s a fourth (eReader+eWriter) which neither company seems inclined to fight.
  5. The fifth war (Enterprise) is still far off.

If you consider the huge importance of getting children and students on to your platform – the War for Parents and the War for Students might end up being far more important than the War for Readers.

Wondering about the financial health of B&N

The deep trouble Borders is in makes you wonder how stable Amazon and B&N are, and what the implications might be for Kindle and Nook.

Amazon is in great health, and Kindle ought to be fine

The Kindle has got Amazon behind it, with nearly a billion dollars a year in annual profits, and $14.162 billion in assets. For all practical purposes, there’s little to worry about. In Q3, 2010, Amazon saw its revenues rise 39% to $7.56 billion, and its net income rose 16% to $231 million.

Given the huge assets, the huge revenue flow, and the increasing revenue and profits, there’s little reason to worry about the Kindle’s future. 

There are also the supposedly great Kindle sales – which put Amazon into a great position, where it can make loads of money from ebooks.

What’s the real status of B&N?

2010 has been a very interesting year for Barnes & Noble. On the surface there’s a lot to worry about –

  1. B&N saw losses.
  2. Ronald Burkle tried to buy it, and there was an ownership struggle.
  3. B&N has admitted it’s looking for buyers.
  4. One of the main investors in Borders tried to get Borders to buy up B&N. Apparently, Borders can’t pay Publishers, but it can pursue B&N.
  5. There was lots of talk of B&N struggling, and of bookstores being a dying proposition.

However, it’s important to cut through to the underlying facts. The real financials will give us a much better clue as to B&N’s health, and the implications for Nook and Nook Color.

The Financials reveal a quarterly net loss of $12.6 million

B&N is a pretty stable company. Here are some details from B&N’s Q2, 2011 results (this is for the quarter ending October 30th, 2010) –

  1. Total sales were $1.9 billion.
  2. Sales from B&N College bookstores were $798 million.
  3. Sales excluding College increased 1% – This included BN.com sales increasing 59%, and Toys & Games sales increasing 42%.
  4. EBITDA earnings were $46 million. That’s earnings before things like interest, taxes, depreciation, and amortization.
  5. Net loss was $12.6 million.

That’s not a very big problem.

If your sales are $1.9 billion, and you’re ending up with a loss of $12.6 million, all you have to do is optimize. Turn an extra 1% of your sales into profits, and you’re in the black.

$12.6 million is dwarfed by B&N’s assets and revenue

Here are a few things to consider –

  1. B&N has current Assets of $2.1 billion.
  2. B&N has property and equipment worth $756 million. Note that it’s $2.81 billion minus $2.1 billion in depreciation and amortization. That seems a bit strange – Property and equipment seems like it might be worth more than $756 million. There are 717 stores and over 600 college bookstores. How is that worth just $756 million?
  3. Goodwill and intangible assets of over a billion dollars.
  4. It also has current liabilities of $2 billion, long-term liabilities of $1.2 billion, and shareholder equity of $823 million.
  5. We’ve already covered that it had sales of $1.9 billion in the last quarter.

Not an expert, but it seems that the $12.6 million in quarterly losses is hardly a concern given that B&N has $1.9 billion a quarter in sales, and at least a few billion in assets. This is a company that is unlikely to go under in 2011. In fact, it paid out a 25 cents dividend on December 31st, 2010. 

Even B&N’s market capitalization of $823 million seems low. Low enough that buying it might be a steal – which would explain why everyone from Ronald Burkle to Borders’ main investor wants to buy it

B&N has a $1 billion revolving credit facility, with $627 million still available

From the earnings release –

 At the end of the second quarter, the company had borrowings of approximately $377 million under its $1 billion revolving credit facility. 

The company’s financial position remains strong and the revolving credit facility provides ample room for the company to fund its strategic investments.

$377 million in borrowings isn’t very reassuring. Still, it’s nice to know there’s still $627 million available. B&N is definitely set for 2011, and perhaps for quite a few years after that.

$12.6 milion is dwarfed by what B&N is doing in eReaders and eBooks

The really interesting aspect is what B&N is doing in eReaders and eBooks. Nook and Nook Color are B&N’s crown jewels, and quite possibly 90% of its future.

Here are some estimates and figures –

  1. B&N expects digital content sales will hit a $400 million per year run rate by the end of fiscal 2011.
  2. It’s the #2 eReader maker in the US.
  3. It’s selling half a million Nook Colors a month.

B&N’s Nook and Nook Color business alone are worth a few billion. If Google decided to get serious about ebooks it would have to buy either B&N or Sony’s eReader division.

How much do you think B&N would sell its Nook division for?

Perhaps not at all. Perhaps for a few billion dollars.

B&N’s losses are due to investing heavily in Nook and Nook Color

B&N is seeing losses because it’s put a lot into Nook and Nook Color and into selling ebooks. It’s something it has to do to survive, and is also the smart thing to do – It can’t fight Kindle with physical books. It has, however, fought the Kindle reasonably well with Nook and Nook Color.

B&N mentions that it’s investing heavily in Nook and Nook Color and in ebooks, and that it will continue to do so –

The additional investments are expected to continue and peak during the second half of the year, and then increase moderately in the years ahead.  Payoff for these expenses is estimated to begin to appear in the third quarter, when NOOKcolor is expected to be one of the world’s most sought after eReaders, …

B&N also said it had captured 20% of the ebook market. If it can increase this, the investment will be more than worth it.

B&N is investing heavily in the future of books, racking up some minor losses, and setting itself up for profitability in the future. It’s exactly the sort of thing you’d want a company to do – if you had invested in it for the long-term. It’s also exactly the sort of thing you’d hate – if you only cared about your year-end bonus, or were doing short-term trading.

Why would B&N be considering a possible sale of the company?

Not an expert, so please keep that in mind.

Let’s say you’re mining for copper, and you hit a vein of gold. You start to invest heavily in setting up the facilities to mine for gold.

Your investors go crazy. They don’t think the vein of gold means there’s actual gold – Also, even if there is, it won’t be arriving soon enough to meet their year-end goals from their investments. The way they see it – the profits from copper mining are going into building a gold mine, which isn’t going to pan out soon enough for it to be worthwhile to them. They’d rather get instant gratification and see the profits from copper mining go into their pockets.

So they hammer your perceived value. They start saying your mining business is done. Suddenly, its value is a quarter of what it should be.

What do you do?

Well, it’s a huge opportunity for you – You can kick out all these greedy investors, you can get total control of your company, and you can take your company private so no one knows just how much gold you’re making.

That, in my opinion, is what B&N is doing.

Lots of people feel B&N is just exiting the stock market

This thread at the Nook forum has a lot of people that think B&N just wants to get away from the joke that is the stock market. 

Here’s a snippet of what flyingtoastr wrote –

BN has been investing heavily in digital strategy over the last twelve months. These short-term costs, while costing a lot in the short-term, will end up helping the company remain profitable, and even increase profits in the future.

BN’s move to put the company “for sale” is most likely a move simply to get the company off of the stock exchange and privately held.

IAmBrad also agrees –

Most likely if B&N is sold, it will be done so in a manner that uses either a buyer or buyers that bear a different name, but are actually funded by the current B&N structure.

B&N sees an opportunity to buy itself for a quarter of its real value. It also sees an opportunity to free itself of all the pains of the stock market – market manipulators, short-sighted investors, Sarabanes Oxley, and so forth. It’s a really smart move for B&N to try and buy itself and go private.

Nook and Nook Color are going to be fine. Even in the extremely unlikely case that B&N goes down – they support ePub, and you can switch to Kobo or Google eBooks.