Dear Mr. Berko:

I bought 300 shares of Barnes & Noble in 2001 and paid $42 a share for the stock. Back then it had sales of $4.9 billion, and today sales are $5.3 billion. Why have sales grown so slowly? Is there something wrong with its marketing strategy, its inventory selection and its management? Will Barnes & Noble be hurt by new competitors? My objective is long-term growth. Have I made a wrong choice?

P.G., Kansas City, Kan.

Dear P.G.:

You may be unwilling to believe this, but we’ve been facing a phenomenon called “the dumbing down of America,” which had its genesis in the early 1960s and gained momentum in the mid-1990s. Americans are reading less and less, because more and more are unable to read, and it’s going to get “worser and worser.” The problem is first evident in our school system.

It’s not that our school system is failing our children; rather it’s their culture and their expectations that are redefining our school system.

In the early 1990s, the Florida Legislature thought its Comprehensive Assessment Tests were too difficult. So the Legislature demanded changes on two occasions (and got them) to make the test easier to pass. Well, that didn’t work, so the school system demanded that teachers “teach to the test.” That didn’t work, either. Test scores continued to show poor results. Today, the Florida Legislature is blaming the messenger, accusing those who grade the tests of being incompetent. This sort of thing is happening all over the country.

That’s the best way to tell you why Barnes & Noble Inc. (BKS-$36.22) won’t book any meaningful increases in revenues. Its coffee shops are selling lots of coffee and pastries, gift items are doing well and so are the sales of knickknacks and bric-a-brac. BKS’s www.barnesandnoble.com (which handles 10 percent of its book sales) is popular, and the sales of maps, compact discs, calendars and gewgaws continue to grow.

BKS has a superb balance sheet, zero long-term debt and net profit margins of 2.8 percent, which should improve with the opening of a 1.1-million-square-foot New Jersey distribution center. Free cash flow has increased nicely and management’s earnings guidance for this year does not include the continuation of its share buy-back program beyond the first quarter. Since 2004, BKS has bought back more than 4 million shares. I reckon that the incremental cash flow will be used to increase the dividend over the next few years. I think today’s 60-cent dividend might be increased to 70 cents before the end of 2006.

The company’s same-store sales should grow between 2.2 percent and 2.8 percent yearly. But that’s not good enough for bragging rights. Earnings for 2006 may come in at $2.28 per share, giving BKS a 16 price-earnings ratio. The dividend should grow by 17 percent annually to $1.05 per share by 2011 and earnings should grow 3 percent annually to $2.78 per share in 2011.

There shouldn’t be any meaningful competition from a new book superstore. The returns on invested capital are terribly low at 12 percent. Renting a 40,000-plus-square-foot store, installing attractive and solid bookcases, comfortable reading chairs, coffee tables, bakery cases, paneling, special lighting, inventory and escalators to a second floor are quite costly, making it difficult to compete.

My concern is the competition from Amazon.com and ongoing competition from Borders, which has co-branded with Amazon.com. Borders has 500 more stores (1,255) than BKS but lower per-store sales, lower net profit margins and much lower return on capital.

My son and I each spend between $55 and $80 a month at Barnes & Noble and try to buy hardback novels on sale for $5.99. When he completes his selections, and I’ve finished mine, we exchange 10 to 12 books at a time. So I’ve become incurably fond of BKS. I like the way the store smells, I’m in tune with its ambience and can locate any book in the store without asking.

So it pains me to tell you to sell your stock, because it’s not going anywhere unless the Library of Congress makes an offer at $57 a share. Morningstar places a “fair value” of $36 on BKS stock.

Please address your financial questions to Malcolm Berko, P.O. Box 1416, Boca Raton, Fla. 33429 or e-mail him at malber@adelphia.net.

© Copley News Service