Barnes & Noble Education: Lifting Of The DOE Overhang Is A Significant Positive

Summary:

• BNED has successfully transformed its business with First Day and First Day Complete courseware solutions, leading to significant EBITDA improvement.
• FDC revenue has rapidly grown, with potential for further growth as the majority of students are not currently enrolled in schools offering FDC.
• Proposed regulations by the DOE that could have impacted FDC programs were ultimately abandoned, providing a positive outlook for BNED’s future growth.
• As BNED’s FDC transformation continues, shares could appreciate significantly, with a $2 billion valuation ($73 / share) potentially attainable by FY27.

For months on Seeking Alpha, there has been an active debate about Barnes and Noble Education (NYSE:BNED) concerning the trajectory of its business and valuation. Since January 2024, this debate has been primarily focused on the potential outcome of the US Department of Education’s (“DOE”) potential rule changes impacting BNED’s innovative and accretive inclusive and equitable access courseware delivery models First Day and First Day Complete. Materials related to these past DOE proceedings, including full transcripts, are available here.

Two weeks ago, we believe this potentially significant overhang was put to bed as the Biden / Harris Administration declined to move ahead with the potential changes to inclusive and equitable access programs via a Notice of Proposed Rulemaking (“NPRM”). As a result, we believe BNED shares should begin to price in the Company’s rapidly improving fundamentals and the significant future growth prospects of First Day Complete. As revenues from First Day Complete become a larger share of the business, BNED could command a premium valuation in the future, leaving significant future upside from today’s ~$380 million enterprise value and $250 million equity value. Note that our assumption of $380 million in enterprise value is a pro forma figure accounting for Fiscal 2024 average ABL borrowings of approximately $210 million, less net cash infusion of $80 million from the refinancing and recapitalization transactions that closed on June 10th (as has been discussed by other contributors, $34 million of second lien debt held by strategic BNED shareholders Fanatics & Lids and VitalSource was also equitized as part of the transactions).

For the past several years, Barnes and Noble Education has been transforming its business with its First Day and First Day Complete inclusive and equitable access courseware solutions. The First Day courseware delivery models, which are sold on a “B2B” basis to academic departments or entire institutions, offer discounted prices and convenient access for students while greatly improving BNED’s reach and relevancy by bundling all the course materials students need into an easily accessible package prior to the first day of class. In December 2022, BNED announced it would accelerate its strategic focus, specifically on First Day Complete (“FDC”), its campus-wide bundled courseware offering. The strategy has been successful and, along with a significant reduction in operating expenses, led to over $45 million of positive EBITDA in BNED’s Fiscal Year 2024 ended 4/30/2024 – a significant improvement from a loss of nearly $10 million of EBITDA in its Fiscal Year 2023 and the highest level of EBITDA generated since BNED’s Fiscal 2019 (which was pre-COVID).

BNED’s transformation is underscored by the rapid growth in FDC revenue, which increased from essentially zero in BNED’s FY20 to $293 million in FY24 (see FY2024 10-K). Encouragingly, while 805,000 students are enrolled at BNED institutions as of April 30, 2024, BNED has approximately 5.8 million total students in its current footprint, and there are another 13 million undergraduate and graduate students in the market writ large, meaning the bulk of the growth opportunity remains untapped, with close to 95% of undergraduate and graduate students not currently enrolled at a school that offers FDC. As the Company has repeatedly highlighted in investor presentations and earnings calls, BNED’s FDC model is both more predictable and more profitable for the company than its legacy courseware delivery model, selling on a transactional basis to students at the campus bookstore. It is also a far superior model for colleges and universities, as their students are prepared from day one of class on a level footing (hence “equitable access”) and end up successfully completing courses at a higher rate, thus improving the overall ROI of the degree delivered by the university and lowering unwanted attrition.

Over the past several years, in no small part thanks to BNED’s evangelism and market leadership in the category, FDC and equitable access programs have been embraced by all relevant stakeholders in the higher education ecosystem. The programs are responsive to an overall sharpened focus at higher education institutions and in society at large on the value provided by undergraduate and graduate degrees. While higher education generally remains a strong investment when measured over by career earnings, one of the most significant factors weighing against the overall return of higher education lies in the unfortunate reality that over 1/3 of students that matriculate at universities fail to earn their degree even in six years. A systemic lack of academic preparedness – captured in the fact that 20% or more of students at colleges and universities forego acquiring their course materials entirely due to concerns about their cost – is likely responsible for this high attrition rate. By making course materials more affordable and easily accessible, and removing the friction or “sticker shock” inherent in the transactional, “a la carte” model, FDC and equitable access programs have played a direct role in ameliorating this dilemma to the benefit of society.

It thus came as a great surprise and disappointment to many higher education stakeholders when the United States Department of Education unveiled potential regulations in its 2024 unified policy agenda that could have restricted or revised the way affordable access courseware programs like First Day Complete are structured. While BNED offers FDC at all of its schools with a seamless “opt out” function for those students that do not wish to enroll in the cost savings and preparedness program, during three separate week long sessions of hearings that concerned many topics, including distance education, Federal TRIO programs and the return of Title IV Funds, DOE regulators displayed a dogmatic focus on requiring schools to change the way affordable access programs are offered from “Opt Out” – whereby all students are enrolled upfront and then can voluntarily opt out – to “Opt In,” whereby all students would have to voluntarily select the program before receiving access. This change could obviously have had the effect of lowering student participation in the programs, which currently sits at around 80%, but which could drop to 60% under “opt-in” based on publicly available data (though certain bears have argued participation would be even lower). Many college professors and administrators generally argued vociferously against the changes, stating that First Day, First Day Complete and similar programs had helped their students and had specifically most benefitted students of underrepresented minority, single parent or other “at risk” backgrounds. Nevertheless, the DOE remained persistently committed during its public hearings up through Mid-March, leading many observers – including authors and commenters on this forum – to conclude that the regulatory changes impacting FDC were likely a done deal.

As has been publicly viewable on Reginfo.gov, the DOE submitted its final set of proposed rule changes from the unified agenda to OIRA on June 17^th, 2024. The NPRM draft was not publicly viewable while under OIRA review, but on the afternoon of Wednesday, July 17^th, the DOE posted a press release formally announcing the scope of the NPRM. On July 23rd, the NPRM was formally posted to the Federal Register, opening public comment. Completely excluded from the scope of the NPRM were any changes to “cash management,” the subject that involved potential regulatory changes to inclusive and equitable access programs. We believe that the DOE decision to abandon these changes was directly correlated to strong pushback from students, faculty and administrators – including at key constituencies like HBCUs — throughout higher education that ultimately reached the highest levels of the Biden / Harris administration. The DOE was thus effectively given a preemptive veto or stand down order on its misguided proposal, and as a result, we believe the proposal is highly unlikely to return regardless of the result of the 2024 election – in which one candidate, Donald Trump, stands ready to “abolish the department of education” and another, presumptive nominee Kamala Harris, is viewed as pro-higher education and would be highly unlikely to push through policy that is viewed negatively by the HBCU and overall university constituency.

All of this is fantastic news, not just for students and schools, but for BNED, as FDC has the potential to continue to transform its business for the better. BNED has previously shared slides highlighting an implied $6+ billion addressable market, that will now come into full focus as the Company benefits from the lifting of a key regulatory overhang as well as its recent balance sheet recapitalization (which has been thoroughly discussed by SA author Henrik Alex in two recent articles).

With the DOE overhang removed, and the balance sheet recapitalized, we believe BNED’s sales efforts to convert both existing and new clients to FDC will be greatly enhanced. In its Fiscal Year 2027 (ended 4/30/2026), by offering FDC to 2.6 million of its 5.8 million addressable students (~45% penetration of BNED’s current student base and ~15% penetration of the overall higher education student TAM) we expect BNED to deliver over $1 billion of FDC revenue. We expect revenue from non-FDC courseware to decline to around $650 million in FY27, from $810 million in FY24, representing a decline of around 8% annually, in line with recently observed rates. In aggregate, we expect BNED’s courseware and rental revenues to increase to ~$1.6 – $1.7 billion, from ~$1.1 billion in FY24. With FDC carrying a higher gross margin than other non-rental courseware revenues, courseware gross profit margins should trend higher, leading to significant gross profit dollar growth.

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One of the best parts of BNED’s FDC conversion story is that it does not require much capital to grow. Indeed, BNED was able to deliver a $50 million reduction in SG&A expenses in FY24 alongside ~$100 million of FDC revenue growth and $20 million of courseware gross profit growth. As a result, we expect a large portion of the potential $180 million improvement in courseware gross profit dollars between now and FY27 to flow to the bottom line, implying over $200 million of EBITDA potential in FY27 (FY24 ~$45m + $180m of incremental courseware gross profit dollars = FY27 $225m).

At 9x EBITDA, a multiple in line with publishing comparable Pearson and the takeover of Houghton Mifflin Harcourt by Veritas Capital, and with 26 million shares presently outstanding, BNED would be worth approximately $2 billion or $73 / share in this scenario (assuming today’s $130m of net debt or approximately $5 / share remains, though in all likelihood, this figure would come down as free cash flow is generated), representing significant upside from today’s $10 trading price.

This article has largely left out discussion of BNED’s merchandise business, which contributed around $110 million of gross profit in FY24. The simple math and growth accretion of FDC means that the courseware business will be much more pivotal for BNED’s success over the mid to long-term. However, we do believe there are some positive drivers for the merchandise business to contribute more profit in the future. One of these is that, post refinancing, BNED will have the ability to fully serve clients to their highest satisfaction in the coming quarters and satisfy student and alumni demand for merchandise, without being plagued by issues like inventory shortages caused by the previously distressed balance sheet.

In sum, BNED – and its recently promoted CEO Jonathan Shar – has off late proved capable of driving significant FDC growth and EBITDA improvement even in the face of existential headwinds. In the coming quarters, we expect a convergence of tailwinds and broader appreciation of its new business model to drive shares higher.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of BNED either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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