Barnes & Noble, Inc. (BKS)’s Dangerous Decision

Investors were undeterred by the poor quarterly results that Barnes & Noble, Inc. (NYSE:BKS) released last week. Shares in the bookseller are up 5% in early trading, and it seems likely that the rally will hold out through the day. It’s an unlikely jump, as the company reported lackluster sales of both digital and physical inventory. On the conference call, CEO William Lynch laid out the future of the company, saying of the newest Nook devices, “Despite generating very strong reviews and the highest preorder volume we received on any NOOK launch to date, sales of those products didn’t materialize at the rate we expected through holiday.”

As a result of that slowdown in sales, the company is rethinking the Nook strategy. Just short of coming right out and saying it, the company indicated that the focus would be shifting from hardware to digital content. Competition in the marketplace has made the Nook one of many devices, and the development and marketing costs have been unable to generate the level of sales required to keep that part of the business at its current level. As a result, Barnes & Noble, Inc. (NYSE:BKS) is going to “rightsize” — a word I hate — the Nook business over the next year. In light of all this, and the bid for the retail business, what does the future hold for Barnes & Noble investors?

The tragedy of the commons
Barnes & Noble, Inc. (NYSE:BKS)is a poster child for the victim of its own success. By helping to popularize the Nook and the e-reader concept, it made the market attractive to other companies, which subsequently squeezed Barnes & Noble, Inc. (NYSE:BKS) out. The biggest of these is obviously Amazon.com, Inc. (NASDAQ:AMZN) , which has a stronger background in technology, and is pushing the envelope on low customer costs. On the earnings call, Barnes & Noble called out Amazon as being the other main player in the e-book market due to its content licensing.

That licensing is where Barnes & Noble, Inc. (NYSE:BKS) sees itself earning the bulk of its revenue over the next few years. The mold that the company has in mind is the deal struck with Microsoft Corporation (NASDAQ:MSFT) last year. Microsoft is currently pumping $20 million per month into the Nook business, and is being paid back in revenue sharing. That stream of cash, along with the cash generated by the college bookstore business, has so far kept the Nook business afloat. But that system now seems unsustainable. Revenue in the Nook segment declined 26% last quarter, but revenue from content increased 7%.

The tragedy of the everything-else
The most alarming number wasn’t the fall in Nook revenue, though — that was expected after the company’s holiday sales release. Investors also discovered that the physical stores were doing worse than anticipated. Comparable sales in the retail business, excluding Nook sales, were down 2.2%. If the Nook is included, comparable sales were down 7.3%. That changes the calculus on a buyout from chairman and founder Leo Riggio.