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Why Does Microsoft Need the Nook?

Friday - 5/10/2013, 1:59pm  ET

Shares of Barnes & Noble surged over 20% on May 9, after tech website TechCrunch reported that Microsoft was considering a complete acquisition of the bookstore’s Nook Media business for $1 billion. Nook Media consists of Barnes & Noble’s Nook e-reader and tablet division as well as its college bookstores. Barnes & Noble originally intended for its Nook devices to compete with Amazon’s Kindle, but the initiative failed to dent Amazon’s dominant market share. Microsoft is reportedly offering $1 billion to buy out the rest of the business segment.

However, this news has raised some major questions. Without the Nook Media segment, all Barnes & Noble will have left is its low-growth business of selling books through brick-and-mortar and online channels. Meanwhile, Microsoft will gain a loss-leading tablet, which runs on Google Android, as its own. How could this deal possibly benefit these two parties?

What the Nook means for Barnes & Noble

During its third quarter earnings, reported in February, Barnes & Noble reported a major decline in sales of e-books and its Nook e-book readers. Sales of digital media - which include digital books, newspapers, magazine and Android apps - climbed just 7% year-on-year last quarter. Sales had previously risen 38% in the second quarter and 46% during the first quarter. Therefore, it didn’t come as much of a surprise when the Nook unit’s sales slid 26% year-on-year to $316 million. Nook’s college bookstore unit also posted a 2% decline in sales to $517 million.

As a result of these losses, Barnes & Noble’s top line declined 9% year-on-year to $2.22 billion, missing Wall Street’s consensus estimate of $2.4 billion. The Nook unit also exacerbated a 7.3% decline in total same-store sales. Excluding sales from the Nook unit, same-store sales only declined 2.2%.

Therefore, if Barnes & Noble sells the entire unit, then it can receive a quick cash infusion of $1 billion and post slightly better (but still negative) same-store sales. While that could be give a short-term top line boost, it’s hard to imagine how Barnes & Noble can revive long-term sales growth again. The company has already reduced its total brick-and-mortar stores to 689, down from 720 in 2010.

Sales of the Nook were tepid during the 2012 holiday season, and the company has been increasingly putting heavy discounts on new tablets for weeks at a time. The company’s flagship 10” Nook HD+ is now sold for $179, down from its original price of $269. This price reduction was apparently made to stay competitive with Amazon, which recently reduced the price of its 7” Kindle Fire HD from $199 to $179 for Mother’s Day. Amazon’s 8.9” Kindle Fire tablet still sells for $269.

What the Nook means for Microsoft

TechCrunch also speculated that Microsoft was buying Nook to halt production of its Google Android-based tablets by the end of fiscal 2014. Microsoft would then distribute its Nook content through apps on other platforms, such as iOS, Android, and Windows. Last April, as part of its initial $300 million investment in Nook, Microsoft gave Barnes & Noble a $180 million advance to develop Nook content for its Windows 8 devices.

In my opinion, a more expensive and ambitious route would be to turn the Nook into its own low-end Windows 8 tablet platform, as Microsoft has done on the smartphone front with Nokia. The Nook has only sold 10 million units since its 2009 release, compared to Apple’s 58.3 million iPads sold in fiscal 2012 alone.

However, that idea has major flaws. Amazon’s success with the Kindle stems from its ability to sell the tablet at a loss in order to recover the lost revenue through sales of digital content. To remain competitive, Microsoft would have to continue selling the Nook at breakeven or negative margins with the hope of recovering the sales from its digital media segment, which has been posting steep sequential declines.

What’s really going on here?

That brings me to my theory of why Microsoft might take the Nook off of the market - to simply keep it out of the hands of its competitors.

Barnes & Noble recently inked a deal with Google that allows Google to install its Google Play store on Nook devices. Prior to the agreement, Nook had been using a forked version of Android, similar to the Kindle Fire, that locked users out of the Google Play app store. The reason was simple - both Barnes & Noble and Amazon wanted their tablets to be recognized as unique products that showcased their digital media, rather than cheap Android tablets that funneled advertising and app store revenue to Google.

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