Why Barnes & Noble should (and shouldn’t) spin off the Nook

barnes & noble via stevenferrari.com

Barnes & Noble is facing a dilemma. On the one hand, the company is seeing success with its Nook e-reader and digital book ecosystem. Today, it trumpeted that sales throughout the Nook business — including its tablet and e-readers, as well as content — were up 70 percent this holiday season, compared to last year. However, at the same time, Barnes & Noble has been forced to scale back its financial guidance for its overall business: Just over a month ago the company was expecting to pull in $210 to $250 million for the year, albeit at the “lower end” of that range. Now B&N has been forced to scale that back by 20 percent or so, saying it expects to earn between $150 and $180 million for the year. And, yes, part of that shortfall is actually due to some Nook sales being lower than expected.

Nonetheless, Barnes & Noble is signaling it wants to break out the Nook business from the rest of its operations. That may mean simply reporting on the Nook as a separate segment within the company’s overall operations, or finding a way to “separate” the Nook business, perhaps selling it or spinning it off into a separate company with investment from strategic partners.

Can an e-reader and e-book business prosper if it’s not tied to a major book brand like Barnes & Noble?

The case for setting Nook free

Barnes & Noble’s argument for setting the Nook business off on its own is essentially that the Nook is where Barnes & Noble is seeing its strongest financial results. The company thinks the business could do even better, and attract more money from investors, if it weren’t lumped in with (and burdened by) financial results from Barnes & Noble’s substantial retail businesses.

barnes-and-noble-nook-tablet-frontWhat are those numbers like? Barnes & Noble won’t be releasing combined results for its current (2012) fiscal year until mid-2012 (gotta love how fiscal years and calendar years get out of sync) but we can start to put a picture together now. Overall, Barnes & Noble says it expects to ring up between $7 and $7.2 billion in sales across all its businesses for its 2012 fiscal year, ending in June. Last fiscal year (2011), Barnes & Noble reported $7 billion in overall sales revenue. That means at best B&N expects its 2012 fiscal year will represent a three percent increase in sales revenue compared to 2011, and it might actually wind up being flat, showing no year-on-year growth at all. Either way, investors are likely to see 2012 as a disappointment compared to 2011. After all, in 2011 B&N was able to increase its overall sales revenue by 20 percent year on year (thanks to some felicitous accounting that rolled textbooks sales into overall totals and significant revenue increased through online sales at bn.com).

Here’s the kicker: Even with $7 billion in sales for its 2011 year, Barnes & Noble chalked up a net loss of $74 million. That didn’t make investors very happy either. And (see above) the company just lowered its overall guidance for fiscal 2012, and now expects full year losses of $1.10 to $1.40 per share. Can you hear the grumbling?

In contrast, Barnes & Noble’s Nook business looks like it has healthy potential. Like Amazon, Barnes & Noble has never disclosed how many e-readers and tablets it sells, but the company says it expects digital content sales to reach $450 million this year, with the company’s overall Nook business reaching $1.5 billion for fiscal 2012. If those numbers play out, the Nook business could account for more than a fifth of Barnes & Noble’s total sales revenue for the year — and that’s pretty impressive for a business and product line the company only launched in 2009.

Barnes & Noble also says it had a solid holiday season. Despite Amazon launching the much-anticipated Kindle Fire tablet, combined sales of Nook products for the nine-week period leading up to December 31 were up 70 percent compared to the same period in 2010, with sales of digital content nearly doubling. It did decently at retail too: Same-store sales rose 3.4 percent year-on-year during the nine-week holiday period, with overall sales of $1.2 billion across its retail operations.

For the time being, the Nook business remains a bit of a money pit. The company has to continue to invest in its electronic book ecosystem and in developing new e-reader products to grow the business and compete with the likes of Amazon. Doing that requires money, and attracting investors to Barnes & Noble — which still has respectable sales volume but is failing to earn money on it — is a difficult proposition.

Barnes & Noble Nook Tablet unveil - Nook Tablet comic booksHowever, if the Nook business were a separate company with revenue approaching $1.5 billion and year-on-year holiday sales growth of 70 percent, investors would probably be jumping all over it. Looking into the Nook business’s medium-term future, it’s important to note that Barnes & Noble’s Nook business (like its retail and textbook operations) is currently only running in the United States. Although Barnes & Noble has never really looked at taking its retail business international, the company says it is working to take the Nook international in the next year, mostly likely via partnerships. That could create significant new revenue for the Nook. After all, companies like Apple derive nearly two thirds of their sales revenue from outside the United States.

If Barnes & Noble wants to compete with the likes of Amazon and Apple over the long term, it probably needs to expand the Nook ecosystem beyond e-books and start looking at music, movies, and television programming. New investors, potentially with their entertainment industry connections, could probably make that happen more quickly than Barnes & Noble could on its own.

Separating out the Nook business would also improve the bottom line for Barnes & Noble’s online and retail businesses: their financial results would no longer be weighed down by the investments the company has had to make to build and grow the Nook business. In other words, if Barnes & Noble weren’t sinking so much money into the Nook, it might be able to prove there’s still money to be made in running brick-and-motor bookstores. And a website.

One downside: A spun-off Nook business would have a cloud hanging over its head from Microsoft, which is suing Barnes & Noble for patent infringment for using Android in its Nook Tablet and other products. Barnes & Noble might be willing to go toe-to-toe with Microsoft, alleging the Redmond company is abusing its position in the marketplace, but potential Nook investors may not have the same sort of chutzpah.

Which way to go?

Barnes & Noble’s tribulations are all about attracting investors to the Nook business. If the company creates a separate reporting category for the Nook, it will be easier for potential investors (and analysts) to evaluate the Nook business separately from Barnes & Noble’s other operations, and assess whether it would be a good idea to put money into Barnes & Noble despite lackluster results from other aspects of its business.

However, that’s unlikely to be enough to satisfy potential investors from the technology sector, who are famously willing to take substantial risks, but only if they’re tightly focused. Even if the numbers from Barnes & Noble’s Nook business look stunning, many investors will be unwilling to take an equity stake in Barnes & Noble’s overall business just to get a crack at the Nook. After all, the Nook might succeed handsomely, but the overall return would be dulled by less-stellar performance from the rest of Barnes & Noble’s business. Separating the Nook into a separate concern with its own investors separate from Barnes & Noble would seem to be the best way to attract revenue.

However, it’s not clear if the Nook would be seeing the same levels of success with consumers if it weren’t associated with the well-known Barnes & Noble brand. Most people who buy e-books (and e-readers) are also consumers of physical books, and a significant part of the reason Amazon was able to launch its Kindle ecosystem was because Amazon had successfully established itself as a leading bookseller (actually, the leading bookseller). The successful launch of the Nook has likewise depended upon consumers’ recognition and relationship with the Barnes & Noble brand. Part of the reason why e-reader ecosystems like Kobo aren’t seeing tremendous levels of success in the U.S. market is that they aren’t associated with a well-known book retailer. (Kobo did have a relationship with Borders, which didn’t work out so well.) These same factors might hurt Barnes & Noble’s efforts to bring the Nook to international markets.

Unfortunately for the Nook, there’s no clear-cut way forward here. If the Nook stays with Barnes & Noble, it’ll remain hobbled by the company’s brick-and-mortar performance. If it spins out, it loses the Barnes & Noble brand. And, meanwhile, Apple and Amazon continue firing on all cylinders.