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BarnesandNoble.com
Targeting Mass Market
Barnes & Noble's objective on the internet, with its
BarnesandNoble.com website, is to be the largest bookseller
online with the deepest, most robust database, the fastest
shipping and the best price-value offering. Through its store
and direct mail infrastructure, Barnes & Noble has a deep title
database, relationships with 20,000 suppliers and state-of-the-art
distribution capability. Although with latest twelve month
sales of $24 million, it currently trails Amazon.com with $219
million in latest twelve month sales, Barnes & Noble plans to
leverage its dominant "bricks and mortar" brand name to the
emerging online community. Only 20% to 30% of the US
adult population is currently online and only about 10% of the
adult population has shopped on the internet. As internet
shopping expands beyond the early adapter, Barnes & Noble
wants to be the site of choice for the book buyer. Through
national advertising, an internet affiliate network, exclusive
online "real estate" deals, an improving website and superior
execution, BarnesandNoble.com believes it can accomplish
this goal.
National Advertising Beginning to
Impact Sales
Last year, BarnesandNoble.com did not do any meaningful
advertising as it developed its fulfillment capability and tested
its systems. In April 1998, BarnesandNoble.com launched its
first national advertising campaign that has begun to increase
both page views and sales online. An enhanced website will
be launched in June featuring one-click ordering, better
editorial content, deeper search capabilities and an updated
design. To support this enhanced site, BarnesandNoble.com
recently raised its advertising budget for 1998 to
approximately $45 million from $30 million originally
planned for the year. This large budget will outpace the
advertising dollars of about $20 million Barnes & Noble
spends for its superstores. These advertising dollars will be
used for national television, radio and print media as the
company attempts to build awareness of its internet site with
the mass market consumer. As part of its national advertising
campaign, Barnes & Noble has signed exclusive sponsorships
with some celebrity personalities including Charlie Rose on
PBS and Charles Osgood on the CBS radio network.
Affiliate Program Growing Rapidly
Barnes & Noble established an affiliate program with many
major brand names online. Affiliates receive up to 7% of
every book sold through their site. Currently 10 of the largest
20 websites and nine of the top ten news information sites are
in the program including CNN, New York Times, USA Today
and MSNBC. More than 1,000 sites join the affiliate network
each week. This affiliate network helps to build
BarnesandNoble.com's brand name and gain share of online
"eyeballs".
Fulfillment Center
Up and Running
BarnesandNoble.com has a 700,000 square foot state-of-the-art
distribution center in New Jersey. The center has 600,000
titles in stock and ready for next day shipment. This in-stock
delivery should satisfy 80% to 90% of customer orders with
24 hour shipping capability. The center should enable Barnes
& Noble to achieve synergies between its online operations
and its retail stores. For instance, titles that are not in-stock in
a store can be ordered through the internet fulfillment center
and sent to the customer's home within 48 hours.
Management Expects Sales to
Reach $100 Million in 1998
After just one year online, BarnesandNoble.com has attracted
over 500,000 customers in 158 countries. Approximately
40% of those customers are repeat buyers, indicating
satisfaction with the site's assortment, service and offering.
By its one year anniversary, management believes it could
reach 50% repeat purchases. By year end 1998, management
expects BarnesandNoble.com should achieve $100 million in
sales from approximately one million customers. While
growing the business rapidly, BarnesandNoble.com should
lose approximately $0.33 per share in 1998 and tentatively
$0.25 in 1999, up from $0.13 in 1997. While management's
goal is to turn profitable online as quickly as possible, it is
necessary to invest in marketing and fulfillment early on to
build sales and a loyal customer base.
Adding Complementary Products
to Online Offering
Management's goal is to be the supplier of choice online for
books as well as complementary information based products.
As a result, magazines have been added to the
BarnesandNoble.com website. The online "magazine stand"
leverages off the periodical business Barnes & Noble does in
its stores nationwide. Barnes & Noble sells music in some of
its stores and Amazon.com has announced the addition of
music to its site. Borders recently launched internet
commerce site offers books, music and video.
BarnesandNoble.com could eventually decide to add music to
its site as well although it has not done so at this time.
Sense of Community
Established Online
Book superstores have become community centers where
people go to buy books, read magazines, drink coffee and
socialize. Barnes & Noble is trying to create a similar sense
of community online. Live author chats are held everyday,
similar to the in-store events superstores host. Members are
encouraged to write reviews of books they have read and
these reviews are available to other consumers searching for
books. More than one-third of the 600,000 titles carried in the
fulfillment center have at least one review. The ultimate goal
is to have a book jacket picture, synopsis and review of every
Barnes & Noble Inc - 27 May 1998
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book available. These services help to retain loyal customers
who like the feeling of being part of a community.
Internet Retailers Receiving
Premium Valuations
Publicly traded internet retailers are valued at a premium to
sales since they are all losing money on an operating basis
making a multiple of earnings impossible to calculate. We
looked at five publicly traded pure internet retailers,
Amazon.com, N2K, CDNow, Peapod and ONSALE, which
are currently trading at an average of 7.4 times latest twelve
month sales. Investors are paying the high premiums because
of the rapid growth in revenues. These internet retailers grew
sales in the first quarter of 1998 an average of 311% on a year
over year basis. On a price to sales to growth basis (based on
first quarter 1998 year over year revenue growth), these five
internet retailers are trading at an average premium of 2.5
times.
We forecast sales at BarnesandNoble.com should grow 585%
in 1998. Assuming price to sales to growth premiums for
internet retailers remain constant, by early next year the
BarnesandNoble.com division should be valued at
approximately $21 per share as a stand-alone internet retailer
based on 1998 sales and growth rate. Barnes & Noble's
biggest competitor online is Amazon.com and using
Amazon's current valuation on our forecasted sales growth
rate for BarnesandNoble.com, the division should be valued
at about $17 per share. If the internet operations of Barnes &
Noble were currently accorded this Amazon valuation, the
core business would be valued at $15 or a price to earnings
multiple of 10.5 times 1998 earnings (excluding the internet
losses of $0.33). Therefore, BarnesandNoble.com is not
receiving a similar premium as its online competitors.
Core Business Valued at Discount
to Other Growth Retailers
We project that Barnes & Noble's core "bricks and mortar"
retail business should grow earnings at an average annual rate
of 24% over the next five years. This growth forecast is the
same as the earnings growth projected for the total company
as we assume that the internet operations lose money in the
first three years of operation and make money in years four
and five, and be breakeven over the five-year period.
To evaluate the core business, we looked at a group of 25
"sustainable growth" retailers all of which should grow
earnings over the next five years at an average annual rate of
15% or greater. We purposely excluded Barnes & Noble and
Borders Group as internet operations could cloud their
valuations. These 25 growth retailers are currently trading at
a price to earnings multiple of 24 times 1998 Merrill Lynch
earnings estimates. On a price to earnings to growth basis,
these retailers are trading at an average multiple of 1.3 times
based on 1998 earnings estimates and Merrill Lynch's
forecast of five year earnings growth. Our 1998 EPS estimate
for Barnes & Noble is $1.13 which includes an estimated loss
of $0.33 per share from BarnesandNoble.com. Therefore, we
expect core retail earnings to be $1.46 this year. Valuing
Barnes & Noble's traditional retail business at the average
price to earnings to growth rate of the 25 "sustainable growth
retailers produces a price of about $44 per share, well above
the current price of $32 5/16. Therefore, there appears to be
no value in the current Barnes & Noble stock price for the
potential of the internet business.
Internet Still Too Small to Hurt
Bookstores
Concerns about the internet business adversely affecting store
sales appear overblown. While book sales on the internet
have grown rapidly over the past couple of years, the internet
remains a very minor player in the book retailing business.
Internet book sales over the past twelve months accounted for
about $300 million or less than 2% of total book sales in this
country and less than 1% of global book sales. Although we
believe that the internet is a viable medium for book sales, we
do not expect the internet to have a significant impact on
traditional book retailers' sales over the next five years. In
fact, we believe that most internet sales are additive as they
come from international consumers, domestic markets
Table 1: Valuation of Publicly Traded Internet Retailers
LTM Sales Shares Sales Per Price Price/ 1Q98 Sales P/S to
($ in millions) Outstanding Share 5/26/98 Sales YTY Growth 1Q98 Growth
Amazon.com 219.2 23.3 9.40 85 3/4 9.1 446.1 2.0
N2K 17.2 12.1 1.41 17 1/4 12.2 539.2 2.3
CDNow 24.8 12.0 2.06 20 7/16 9.9 287.8 3.4
Peapod 65.8 15.0 4.38 6 13/16 1.6 55.8 2.8
ONSALE 116.8 18.7 6.25 27 1/8 4.3 226.3 1.9
Average Internet Retailers 9.5 311.0 2.5
BarnesandNoble.com 1998 Forecasted Value Using Current Amazon Valuation BarnesandNoble.com 1998 Value Using Current Internet Valuation
1998 Sales Estimate $100.0 1998 Sales Estimate $100.0
1998 Sales Per Share 1.4 1998 Sales Per Share 1.4
1998 Sales Growth 584.9% 1998 Sales Growth 584.9%
P/S/Growth 1Q98 for Amazon.com 2.0 P/S/Growth 1Q98 Industry Average 2.5
Implied Value $16.76 Implied Value $20.64
Company information, Merrill Lynch estimates
Barnes & Noble Inc - 27 May 1998
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without superstores or consumers who dislike traditional
shopping.
Price Objective of $50 Could Be
Conservative
Using our comparable company methodology for both the
traditional retail business and internet operations result in a
total company value of about $61 per share currently. This
value equals a total company price to earnings multiple of 44
times our preliminary 1999 EPS estimate of $1.40. Our price
objective of $50 reflects a 36 times multiple on our 1999 EPS
estimate and 1.5 times price to earnings to growth rate. We
believe this is conservative as it values the core book store
business at 1.3 times our earnings growth rate (the average for
25 "sustainable growth" retailers) and the internet business at
only three times sales (versus 9 times sales for Amazon.com).
Barnes & Noble is currently trading at 23 times our 1999 EPS
estimate, in line with the 23 times multiple for the S&P 500.
Table 2: Valuation of Select "Sustainable Growth" Retailers
Price 5 Year P/E P/E To
Ticker 5/26/98 1998 EPS 1999 EPS Growth Rate 1998 Growth
Circuit City CC 41 1/2 1.76 2.15 15 23.6 1.57
Gap GPS 53 11/16 1.70 2.00 18 31.6 1.75
Kohl's KSS 46 3/8 1.12 1.35 23 41.4 1.80
Lowe LOW 78 9/16 2.55 3.10 17 30.8 1.81
Dayton Hudson DH 46 3/8 1.93 2.20 15 23.9 1.60
Dollar General* DG 39 1/8 1.09 1.36 25 35.9 1.51
Family Dollar FDO 16 7/16 0.58 0.70 23 28.3 1.23
Tandy TAN 45 1/8 2.35 2.75 15 19.2 1.28
Home Depot HD 75 3/4 2.10 2.60 25 36.1 1.45
Best Buy BBY 63 15/16 2.80 3.40 20 22.9 1.14
Tiffany TIF 47 15/16 2.38 2.78 16 20.3 1.27
Office Depot ODP 29 3/4 1.25 1.55 20 23.8 1.19
Autozone AZO 33 1/16 1.53 1.85 18 21.6 1.20
TJX TJX 47 3/16 2.17 2.47 18 21.7 1.21
Ross Stores ROST 42 5/8 2.72 3.12 15 15.7 1.04
Intimate Brands IBI 29 1.53 1.78 16 19.0 1.18
Abercrombie & Fitch ANF 41 11/16 1.37 1.77 30 30.4 1.01
Sears S 62 13/16 3.53 3.90 15 17.8 1.19
Zale ZLC 31 7/16 1.62 1.87 17 19.4 1.14
Consolidated Stores CNS 39 13/16 2.00 2.40 20 19.9 1.00
Proffitt's PFT 39 1/8 1.78 2.15 20 22.0 1.10
Gucci GUC 47 1/2 3.00 3.45 15 15.8 1.05
The Sports Authority* TSA 15 5/16 0.76 1.01 17 20.1 1.01
ShopKo SKO 35 1/4 2.14 2.42 15 16.4 1.10
Brylane BYL 52 1/2 3.28 3.90 18 16.0 0.89
Average Growth Retailers 19 23.77 1.27
Barnes & Noble BKS 32 5/16 1.13 1.40 24 28.6 1.19
Borders BGP 33 1/4 1.22 1.50 25 27.3 1.09
Barnes & Noble Core Retail Business Barnes & Noble Implied Valuation
1998 EPS Estimate 1.13 Core Business 44.5
Estimate of 1998 Internet Losses 0.33 Internet 16.9
1998 EPS Estimate excluding Internet 1.46 Total Value 61.4
X Five Year Forecasted Earnings Growth 24
X P/E /Growth for "Sustainable Growth" Retailers 1.27
= Implied Value of Core Business 44.47
Merrill Lynch estimates
* First Call estimates
[BKS] An officer, director or employee of MLPF&S or one of its affiliates is an officer or director of this company.
Opinion Key [X-a-b-c]: Investment Risk Rating(X): A - Low, B - Average, C - Above Average, D - High. Appreciation Potential Rating (a: Int. Term - 0-12 mo.; b: Long Term - >1 yr.): 1 - Buy, 2 - Accumulate, 3 - Neutral, 4 - Reduce, 5 - Sell, 6 - No Rati ng. Income
Rating(c): 7 - Same/Higher, 8 - Same/Lower, 9 - No Cash Dividend.
Copyright 1998 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). This report has been issued and approved for publication in the United Kingdom by Merrill Lynch, Pierce, Fenner & Smith Limited, which is regulated by SFA, and has been considered and
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