Microsoft Invests in Barnes & Noble’s Nook Technology

Firm size often dictates business strategy.
Diversifying away from a firm’s core skills often is fraught with risk.
Accumulated corporate cash balances often create potential agency problems.
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Microsoft, like Apple, has been in business for three decades. Unlike Apple, Microsoft has failed to achieve and sustain the high growth in earnings and cash flow needed to grow its market value. For years, Microsoft has attempted to reduce its dependence on revenue generated from its Windows operating system software and the Office Products software suite by targeting high-growth segments in the information technology industry. Despite these efforts, the firm continues to generate more than four-fifths of its annual revenue from these two product lines.

The firm’s ongoing dependence on its legacy products is not due to a lack of effort to diversify. Since 2009, Microsoft has spent more than $10 billion in financing strategic alliances and takeovers. A 2009 Internet search partnership with Yahoo Inc. designed to assist Microsoft in overtaking Google by increasing use of its Bing search engine has gained little traction. In 2011, the firm agreed to supply the mobile operating system for smartphones sold by Nokia Corp. Thus far, Windows-powered smartphones have yet to gain significant market share. That same year the software maker also acquired Skype, the Internet telephony firm, for $8.5 billion in the biggest acquisition in the firm’s history. Its contribution to Microsoft’s revenue and profit growth is unclear at this time.

Despite a number of acquisitions during the last few years, Microsoft amassed a cash hoard of more than $60 billion by the end of March 2012. The amount of cash creates considerable pressure from shareholders wanting the firm either to return the cash to them through share buybacks and dividends or to reinvest in new high-growth opportunities. In recent years, Microsoft has tried to do both.

Continuing to move aggressively, the software firm announced on April 30, 2012, that it would invest a cumulative $605 million (consisting of $300 million upfront with the balance paid over the next five years to finance ongoing product development and international expansion) in exchange for a 17.6% stake in a new Barnes & Noble (B&N) subsidiary containing B&N’s e-titles and the Nook e-reader technology. The new subsidiary also houses B&N’s college business, viewed as a growth area for e-books. Analysts valued the new B&N subsidiary at $1.7 billion, more than twice B&N’s consolidated value at the close of business on May 1, 2012. After the announcement, B&N’s market value jumped to $1.25 billion.

As a result of the deal, the two firms will settle their patent infringement suits, and B&N will produce a Nook e-reading application for the Windows 8 operating system, which will run on both traditional PCs and tablets. Microsoft, through its Windows 8 product, has been forced to radically redesign its Windows operating system to accommodate a future in which web browsing, movie watching, book reading, and other activities occur on tablets as well as PCs and other mobile devices. While Windows 8 will have an “app store,” it is likely to have to be closely aligned with a service for buying books and other forms of entertainment to match better the offerings from its rivals. The partnership is not exclusive to Microsoft, in that B&N can pursue other alliances with the likes of Google. B&N’s e-book business is to remain aligned with the brick-and-mortar stores, of which the firm has 691 retail stores and 641 college bookstores.

In making the B&N investment, Microsoft is placing another bet on an industry in which it lags behind its competitors and puts it in competition with Amazon.com Inc., Apple Inc., and Google Inc. The Nook currently runs on Google’s Android software, as does Amazon’s Kindle Fire. The two firms will share revenue from sales of e-books. The partnership also has the potential for Microsoft to manufacture e-readers and for future Nook devices to be powered by Microsoft operating systems. In addition to a much-needed cash infusion, B&N will capture additional points of distribution from hundreds of millions of Windows users around the world, potentially reaching consumers who did not do business with B&N.

Previously concerned that B&N would be a marginal competitor in the e-book marketplace, investors boosted B&H shares by 58% to $20.75 on the news. This was the firm’s highest closing price in two years. The firm’s conventional (physical) book business has declined rapidly. With revenue and profits declining, B&N was looking for a strategic partner to accelerate the growth of its e-book business globally. B&N had been accepting offers from a number of potential partners since it accepted a $204 million investment from Liberty Media in 2011 and had been considering a sale or spin-off of the e-book business.

B&N claims to have 27% of the U.S. e-book title sales, with Amazon capturing 60%. At one time, Amazon had almost a 90% market share of the e-book market, but this has eroded as new players, such as Apple, Google and now Microsoft, have entered. According to market research firm IHS iSuppli, Apple had 62% of the tablet market in 2011, reflecting the success of its iPad, with Amazon’s Kindle having a 6% share and B&N’s Nook a 5% share. Book publishers appear to have been encouraged by Microsoft’s investment in B&N due to their growing concern that Amazon would dominate the e-book market and the pricing of e-books if B&N were unable to become a viable competitor to Amazon.com.

Unlike rivals such as Apple, Microsoft has relied mainly on partners to create hardware that runs its software, with the exception of the Xbox video game unit and the company’s ill-fated Zune media player. Microsoft is constrained by its partnerships, in that if the firm begins to create its own hardware, then it puts itself into direct competition with partners who make hardware such as tablet devices powered by Microsoft operating systems.
-are the key factors external and internal to Microsoft driving its investment in Barnes & Noble?

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