Price: $42 1/16
12 Month Price Objective: $60
Estimates (Jan)*** 1997A 1998E 1999E
EPS: $0.93 $1.13 $1.40
P/E: 45.2x 37.2x 30.0x
EPS Change (YoY): 24.0% 21.5% 23.9%
Consensus EPS: $1.13 $1.43
(First Call: 01-Jul-98)
Q2 EPS (Jul): -0.02 -0.08
Cash Flow/Share: $1.63 $1.96 $2.20
Price/Cash Flow: 25.8x 21.5x 19.1x
Dividend Rate: Nil Nil Nil
Dividend Yield: Nil Nil Nil
Opinion & Financial Data
Investment Opinion: C-1-1-9
Mkt. Value / Shares Outstanding (mn): $2,860 / 68
Book Value/Share (Jan-98): $7.61
Price/Book Ratio: 5.5x
ROE 1998E Average: 13.9%
LT Liability % of Capital: 39.0%
Est. 5 Year EPS Growth: 24.0%
Stock Data
52-Week Range: $48-$21 19/32
Symbol / Exchange: BKS / NYSE
Options: AMEX
Institutional Ownership-Spectrum: 50.4%
Brokers Covering (First Call): 14
ML Industry Weightings & Ratings**
Strategy; Weighting Rel. to Mkt.:
Income: Underweight (07-Mar-95)
Growth: Overweight (07-Mar-95)
Income & Growth: Overweight (07-Mar-95)
Capital Appreciation: Overweight (05-Oct-95)
Market Analysis; Technical Rating: Above
Average
(24-Nov-97)
**The views expressed are those of the macro department and do not
necessarily coincide with those of the Fundamental analyst.
For full investment opinion definitions, see footnotes.
*** Fiscal year ends in January of following calendar year
Investment Highlights:
* Raising our 12 month price objective to $60
from $50, which assumes a $52 value for the
core business and roughly $8 for the internet
business.
* Despite recent stock price strength, believe
Barnes & Noble valuation is currently being
penalized for its internet business rather than
benefiting
* Expect multiple expansion as investors
become convinced that Barnes & Noble can be
a viable competitor online
Fundamental Highlights:
* A composite of retailers growing earnings at
over 15% per year is trading at a premium of
50% of their growth rate. If Barnes & Noble's
core business received that same valuation, it
would be valued at $52 per share or 36 times
1998 earnings per share
* Amazon.com is currently being valued at 8.1
times concerns analyst 1999 sales forecasts of
roughly $650 million
* If BarnesandNoble.com receives just 50% of
that valuation and can achieve between $150
and $250 million in sales in 1999, its value
would range from $8 to $14 per share
Comment
United States
Retailing - Other Specialty
16 July 1998
Daniel Barry
First Vice President
Gerri Sommers
Assistant Vice President
Barnes & Noble Inc
Internet Business Still Undervalued:
Raising Price Target to $60
BUY
Long Term
BUY Reason for Report: BarnesandNoble.com Valuation
Analysis
Merrill Lynch & Co.
Global Securities Research & Economics Group
Global Fundamental Equity Research Department
293279/293200/293197/293100/293000 RC#20119740
Stock Performance
8
12
16
20
24
28
32
36
40
44
48
0.016
0.018
0.020
0.022
0.024
0.026
0.028
0.030
0.032
0.034
0.036
0.038
0.040
1995 1996 1997 1998
Barnes & Noble Inc
Rel to S&P Composite Index (500) (Right Scale)
Barnes & Noble Inc - 16 July 1998
2
Raising Our Price Objective
We are raising our 12 month price objective to $60 from
$50. We believe at current levels that the core business is
being discounted because of the internet operations rather
than benefiting from it. To place no value on the internet
business seems unreasonable when most internet
companies, including online retailers, are receiving
premium valuations.
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 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. Therefore, the internet is
expected to be breakeven over the five-year period.
Table 1: Valuation of Select "Sustainable Growth" Retailers
5 Year P/E P/E To
Growth Rate 1998 Growth
Walgreen 15 45.3 3.02
Kohl's 21 49.4 2.35
CVS Corp. 15 35.2 2.34
Gap 18 36.5 2.03
Circuit City 15 30.0 2.00
Fred Meyer 17 32.6 1.92
Home Depot 25 45.0 1.80
Dayton Hudson 15 26.8 1.79
Dollar General 25 41.7 1.67
Rite Aid 17 27.4 1.61
Best Buy 20 32.3 1.61
Tandy 15 23.9 1.60
Lowe's 20 31.6 1.58
Family Dollar 23 35.9 1.56
Office Depot 20 29.4 1.47
99 Cents Only 25 35.9 1.44
Hannaford Bros. 15 20.1 1.34
TJX 18 23.9 1.33
Autozone 18 23.7 1.32
Tiffany 16 19.6 1.22
Zale 17 20.6 1.21
Gucci 15 18.0 1.20
Abercrombie & Fitch 30 35.6 1.19
Ross Stores 15 17.6 1.17
Sears 15 16.9 1.12
Initmate Brands 16 17.4 1.09
ShopKo 15 16.2 1.08
Proffitt's 20 21.2 1.06
Consolidated Stores 20 18.1 0.91
Brylane 18 13.0 0.72
Average Growth Retailers 18 28.0 1.52
Barnes & Noble 24 37.2 1.55
Borders 25 31.5 1.26
Merrill Lynch estimates
To evaluate the core business, we looked at a group of 30
major "sustainable growth" retailers, all of which should
grow earnings at an average annual rate of 15% or greater
over the next five years. We purposely excluded Barnes &
Noble and Borders Group as internet operations could
cloud their valuations. These 30 retailers are currently
trading at an average price to earnings multiple of 28 times
1998 Merrill Lynch earnings estimates. On a P/E to
growth basis, these retailers are trading at an average
multiple of 1.5 times on 1998 earnings estimates and
Merrill Lynch's forecast of five years 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 earnings
to be $1.46 this year. Valuing Barnes & Noble's
traditional retail business at the average P/E to growth rate
of 30 major "sustainable growth" retailers produces a price
of about $52 per share, well above the current price of $42
1/16. Therefore, there is no value in the current Barnes &
Noble stock price for the potential of the internet business.
In fact, the internet business seems to be depressing the
valuation of the core operations.
Table 2: Barnes & Noble Core Retail Business
Valuation ($ per share)
1998 EPS Estimate $1.13
Estimate of 1998 Internet Losses 0.33
1998 EPS Estimate excluding Internet $1.46
Five Year Forecasted Earnings Growth 24%
Average P/E to Growth "Sustainable Growth" Retailers 1.5
Implied Value of Core Business $52.56
Merrill Lynch estimates
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. In order to value BarnesandNoble.com we
looked at the value accorded Amazon.com, Barnes &
Noble's biggest competitor online. Amazon.com is the
largest retailer of books and music online with latest
twelve months sales of $219 million. According to
industry forecasts, Amazon.com's sales are expected to
grow to approximately $650 million in 1999. Therefore,
Amazon.com is currently trading at about 8 times 1999
sales at its current price of $112 1/2 (July 15, 1998).
BarnesandNoble.com's latest twelve month sales are $24
million and management expects them to reach $100
million in 1998. While management has not yet given an
estimate for 1999 sales, we believe a range of $150 million
to $250 million is achievable. Using this sales range and
Amazon.com's price to 1999 sales multiple discounted at
50%, we believe that BarnesandNoble.com is worth
between $8 and $14 per share. We discounted the current
multiple of Amazon.com by 50% in order to be
conservative since Amazon.com's stock price has
Barnes & Noble Inc - 16 July 1998
3
appreciated 273% year to date. If the internet operations
of Barnes & Noble were currently accorded the mid-point
of this discounted Amazon.com valuation, the core business
would be valued at $31. This valuation would result in a
price to earnings multiple of 21 times 1998 earnings
(excluding the internet losses of $0.33), or only 87% of the
24% five year earnings growth rate, the lowest P/E to growth
multiple of any major sustainable growth retailer.
Table 3: Valuation of BarnesandNoble.com
($ in millions except per share)
Amazon.com
1999 Sales Forecast* 650.0
Shares Outstanding 46.6
Price as of July 15, 1998 112 *
Market Capitalization 5,245.0
Price to Sales 8.1
BarnesandNoble.com
1998 Sales Estimate 100
1999 Sales Estimate - Low 150
1999 Sales Estimate - High 250
Amazon.com Price to Sales 8.1
Implied Value - Low 1,210.4
Implied Value - High 2,017.3
Discounted Value (@50%) - Low 605.2
Discounted Value (@50%)- High 1,008.6
Shares Outstanding 1999 74.9
Value Per Share - Low 8.1
Value Per Share - High 13.5
* Average industry forecasts
Merrill Lynch estimates
Using this valuation technique, Barnes & Noble's
valuation is obviously sensitive to that of Amazon.com.
Our analysis indicates that for every $10 move in
Amazon.com's stock price, BarnesandNoble.com's
valuation moves by $1. However, even if Amazon.com's
valuation drops drastically, BarnesandNoble.com should
still add value to the total company rather than depress
total company valuation. For example, if Amazon.com fell
back to its early June price per share of about $43, using
our same valuation technique, BarnesandNoble.com would
be worth about $4 at the midpoint.
Total Company Valuation
Combines Both Businesses
Using our comparable company analyses for both the core
business and the internet operations results in a total
company value of between $60 and $66 per share
currently. We are using the low end of that range to be
conservative. This value of $60 per share represents a total
company price to earnings multiple of 43 times our 1999
EPS estimate of $1.40.
We believe the high valuations of internet stocks are
beginning to spill over into the valuation of Barnes &
Noble. Since June 1, 1998, Amazon.com's stock price has
appreciated 162% and Barnes & Noble's stock price has
increased 24%. During that same time, the S&P Retail
Composite has risen 11%. Assuming Barnes & Noble's
core business performance tracked the S&P Retail
Composite, the internet operations have accounted for 13%
of that stock appreciation. We believe the value of the
internet should continue to be realized. We also believe
"sustainable growth" retailers, like Barnes & Noble,
should benefit as investors look for companies that can
report double digit earnings gains as corporate profits
slow. Therefore, we are reiterating our strong Buy rating
for the intermediate and long-term.
Chart 1: Barnes & Noble P/E Relative to S&P 500*
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Dec-93 Jun-94 Dec-94 Jun-95 Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98
Historical Average
As of July 15, 1998
Price $42 1/16, Rel. P/E 1.47
Average since 12/93 1.75
Minimum 0.88
Maximum 3.59
* Data on rolling four quarter basis
Internet Still Too Small to Hurt
Bookstores
We believe Barnes & Noble is being punished over
concerns that the internet could adversely affect store
sales. These concerns 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 today. Internet book sales over
the past twelve months accounted for about $300 million
or less than 1% of total book sales in this country. In
addition, included in those sales figures are shipping and
handling charges which makes the actual dollar value of
the books being sold lower than it appears. 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
without superstores or consumers who dislike traditional
shopping. We estimate that internet sales should reach
about $600 million this year (2% of US book sales) and
could impact Barnes & Noble superstore comps by about
1.5%. If internet book sales reach $2.5 billion in five years
(7% of the U.S. market), we estimate the comp impact for
Barnes & Noble superstores in 2002 would be about 3%.
While this impact is meaningful, it still allows for
significant growth in Barnes & Noble's superstore sales.
We also believe that, in time, Barnes & Noble's internet
presence should more than offset the negative comp
impact in the superstores in terms of stock valuation.
Barnes & Noble Inc - 16 July 1998
4
Barnes & Noble Should Have
Operating Advantages Online
As the largest "bricks & mortar" bookseller in the world
and a leading direct mail competitor, we believe that
Barnes & Noble has many operating advantages over pure
internet competitors. In addition to its brand name, Barnes
& Noble has a state-of-the-art distribution center,
relationships with 20,000 publishers and distributors, mail
order experience and approximately $20 million of
national advertising for its stores on which the web address
rides for free. Barnes & Noble's distribution center has
600 thousand titles ready for same day shipping which
should shortly increase to 750 thousand titles. This
fulfillment capability saves a substantial amount of money
versus using third party distributors resulting in a higher
gross margin to Barnes & Noble. We also believe that the
Barnes & Noble brand name is well regarded by book
purchasers and should translate into additional internet
sales as more book purchasers begin to buy online versus
the more technologically advanced customers that are
currently shopping online. Although today we are valuing
BarnesandNoble.com at a discount to Amazon.com, if
these synergies between the core business and the internet
result in improved profitability, we believe
BarnesandNoble.com could actually achieve a premium
valuation to its online competitors.
National Advertising Beginning to
Positively 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 began
to increase both page views and sales online. In June, an
enhanced website was launched featuring one-click
ordering, better editorial content, deeper search capabilities
and an updated design. To support this enhanced site,
BarnesandNoble.com raised its advertising budget for 1998 to
approximately $45 million from $30 million originally
planned for the year versus virtually nothing last year. This
large budget outpaces the advertising dollars of about $20
million Barnes & Noble spends for its superstores. These
advertising dollars are being used for national television, radio
and print media as the company attempts to build awareness
of its internet site with the mass market consumer. While
sales are only released on a quarterly basis, management has
indicated that it is seeing increased page views and purchases
as a result of the advertising
Management Expects Sales to
Reach $100 Million in 1998
After just one year online, BarnesandNoble.com attracted
over 500,000 customers in 158 countries. Approximately
40% of those customers were repeat buyers, indicating
satisfaction with the site's assortment, service and offering.
In 1998, management expects BarnesandNoble.com to
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. Although internet losses are expected
to increase absolutely this year and possibly next year,
losses as a percent of sales should decline. Over time, as
the internet becomes less of a drain on core profits, it
should result in an acceleration in total company earnings
growth. While this acceleration may be a year away, it
should be positive for the stock once investors begin to
realize that it will occur.
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 added
music to its site. Borders recently launched its internet
commerce site that 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.
Company Description
Barnes & Noble is the largest bookseller in the U.S.
through its Barnes & Noble superstores and mall-based B.
Dalton units. There are currently 481 Barnes & Noble
superstores and 520 B. Dalton bookstores nationwide. In
1998, we expect the superstores to account for 81% of total
sales and the mall stores 15%. The company operates an
e-commerce website (barnesandnoble.com) and is the
exclusive bookseller for the America Online community.
Barnes & Noble also owns a leading direct-mail
bookselling business. Management owns approximately
36% of the shares outstanding, about two thirds of which
are owned by Chairman and CEO Leonard Riggio.
[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 Rating. 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 issued in Australia by Merrill Lynch Equities (Australia) Limited (ACN 006 276 795), a licensed securities dealer under the Australian Corporations Law. The information herein was
obtained from various sources; we do not guarantee its accuracy or completeness. Additional information available.
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This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific
person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that
statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Accordingly, investors may receive
back less than originally invested. Past performance is not necessarily a guide to future performance.
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