Barnes & Noble (BKS) booksellers was trounced in Tuesday’s market action as the finished the day 19% lower on three times its average daily volume.  The reason for the decline is clear as the company reported a wider than expected loss in their fiscal fourth quarter, and in the guidance for the current quarter as well.  Sales improved in all three distribution channels (in-store, online and digital delivery) and they expect to continue to increase sales 20% to 25% in the coming year.  However, they are growing capital expenditures just as quickly as they look to expand their digital bookstore presence as well as their Nook eReader device.

Our primary concern with Barnes & Noble’s current strategy is the strength of their competitors in the digital book market.  The Apple (AAPL) iPad has sold extremely well in a relatively short amount of time, and Amazon’s (AMZN) is a formidable competitor and was the original eReader device.  BKS’s traditional rival Borders Group (BGP) is also looking to make a dent in this rapidly expanding market, and they plan to rival the Nook at the lower end of the price spectrum (Borders Banking on the Low End of the eReader Market).  There are other smaller players in the market, and there is always a chance that the market gets even more crowded with new entries.  All of this competition makes one wonder if Barnes & Noble would be better served focusing their attention on selling physical books.

It is clear that the highest growth potential is in digital book sales, but that is also because it is still a new phenomenon.  People have been buying books at bookstores ever since the advent of the printing press, and we have to believe that will continue in spite the rise of the eReader.  We cannot say that BKS should have denied the current trend in book sales towards the digital, but maybe that they should not be devoting such a large investment in that direction.  Only time will tell whether bookstores will go the way of Blockbuster (BBI), Hollywood Video, et al, which have been forced to shrink or close bricks and mortar stores in the face of new technology and distribution.  Some of this has already been prevalent in some areas as bookstores begin to disappear, but I have to believe the appeal of a physical book to consumers may be worth the fight and BKS is probably best positioned in that arena.

Coming into the week, we had a Fairly Valued rating on BKS, and the sell off today does make the valuation look more appealing.  The dividend yield is an eye-popping 7.4% after the huge decline, but cash flow will have to be strong enough to support that payout and that increasingly demands growth in digital sales.  With that said, the significant ramp up in spending to fight against the other big guns in the eReader market is a tough sell to us at this time.  We will likely reaffirm our neutral stance on BKS in our upcoming report despite the much lower price level.