3 Takeaways From Barnes & Noble-Microsoft Deal

We are placing  Barnes & Noble  under review following Monday's announcement that the firm has reached an agreement with  Microsoft (MSFT) to form a strategic partnership. The company will host a conference call this morning, after which we will digest the news and revisit our fair value estimate. Shares are up sharply (roughly 60%) as of mid-morning, and we believe investors are focused on three key takeaways from the release.

First, the formation of "Newco" allows Barnes & Noble to side with a substantially larger and financially stable partner; Microsoft has nearly $50 billion in net cash and equivalents. We have long said that Barnes & Noble faces an uphill battle on its own and that a capital injection could be needed to support its near-term growth ambition. Today's news theoretically fills that void, at least for now. Under the agreement, Newco and Microsoft will share revenue, while Microsoft will invest $60 million annually for the first three years as well as fund Newco's research and development, to the tune of $25 million each year for the first five years.

Second, the relationship with Microsoft provides a tremendous opportunity for Barnes & Noble's Nook software to gain preferred placement on the Windows operating system. Although the Nook applications currently can be downloaded and accessed through Windows, Android, and  Apple (AAPL) platforms, we think the pending launch of a new Windows-based touch-screen operating system tablet later this year could prompt consumers to consider Barnes & Noble as a method of content delivery, over competing Kindle ( Amazon (AMZN)) or Apple devices/platforms.

Third, the company mentioned that Newco will blend the digital and college bookstore platform, which we view as an interesting move for both parties. It's important for Microsoft in that the company hasn't had much of an e-book presence to date and is late to the party. By targeting education, Microsoft can enter this vast and growing marketplace while differentiating its offering slightly (and not becoming a me-too in digital trade books). For Barnes & Noble, this is a clear win, as it has looked to evolve its mature college booksellers business into a more proactive and technology-based platform.

We still think Barnes & Noble is an important player in bookselling, and its management and merchandising teams have executed well in a difficult industry. However, as we wrote last month, our structural thesis on the company (and industry), which bakes in an increasingly competitive marketplace and diminishing fundamentals, remains intact, and we see few near-term catalysts outside of a renewed interest from Liberty Media to warrant a more optimistic outlook.

Although the Nook is capturing headlines this morning, we appreciate the underlying value in the brick-and-mortar business, though uncertainty surrounding the strategic path of the digital Nook business (not to mention its drag on profitability) has clearly weighed on shares and our fundamental outlook. As we have stated previously, both the brick-and-mortar and college segments generate operating profits and, in a sum-of-the-parts analysis, there is an upside scenario in which shares would look attractive (provided the free cash flow produced from these segments actually flowed to shareholders). Today, the market appears to be pricing in this upside scenario, which is likely due in part to short covering. There will undoubtedly be questions surrounding where this leaves Liberty Media and the other Schedule 13 holders--including insiders, who collectively own more than 30% of the firm's shares--but we view today's announcement as an incremental positive.

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