Can you still make money from bookshops?

One of the biggest trends in retail has been the rise of e-books.

When Amazon released the Kindle in 2007 few people realised the impact it would have. Today, nearly one in seven books sold in the US are in digital format. Pressure from downloads has already forced many bookstores out of business; the US chain Borders went bust last year.

However, in the US, the Barnes & Noble (NYSE: BKS) book chain is fighting back. Not only does it continue to maintain a large number of bricks-and-mortar stores, but it also has a strong online presence and its own e-reader: the Nook.

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Last week, shares in the company surged as mutual fund group Fidelity revealed it has taken a 10% stake in the group. Is Fidelity on to something?

The Nook is a serious rival to the Kindle

The part of Barnes & Noble (B&N) that has people most excited is the Nook. With a 25% share of the e-book market in the US, it is the Kindle's biggest rival. And experts believe that the latest versions of the Nook are superior to the Kindle.

As well as another update in spring this year, B&N is also due to launch the Nook outside the US, and is in talks about a deal with UK chain Waterstones. If it can repeat its US success in other markets, it could boost its e-book sales greatly.

A final choice would be to set the Nook up as a spinoff in which B&N owned a major stake. This would allow B&N to raise cash and insulate it from development expenses, while still giving it the lion's share of any profits.

How bricks-and-mortar can thrive in a digital age

However, digital only accounts for 20% of B&N's total sales. The part of B&N that investors should actually be most excited about is its old-fashioned physical stores.

The stores and the digital side complement each other well - the ability to get customer service for the Nook from any of B&N's 1,300 outlets across the US gives it a major leg up in the e-book market.

There is also evidence that the death of print has been overdone. There are limits to digital growth: up to now, e-book sales have been driven by genre fiction, especially romance novels. This suggests that one of the main selling points of e-readers may be the privacy that they provide for readers.

There are also some types of book that will always struggle to do well as e-versions you can hardly display a Kindle on your coffee table. Surveys also show that customer satisfaction with electronic books is low, and that younger book-buyers are also suffering from 'digital fatigue'.

And sales are up. In the nine weeks since Christmas, sales at B&N's physical stores are up by 4% on the same time last year.

Maybe that's little wonder. After all, Borders' demise means that its $1bn in sales is up for grabs. And fears that Amazon might get a monopoly on distributing e-books is giving publishers nightmares. Because of this, they are eager to help B&N succeed in both the print and digital sectors.

This has led to some interesting suggestions, including the idea of B&N sharing readers' data with publishers. Experts feel this could help both sides boost sales.

Getting back into the black

One of the biggest problems with B&N is that the company is currently expected to make a loss for the full year, which immediately places it firmly in the not for widows or orphans' category. However, much of this is due to the amount of money it has invested to get the Nook to a level where it can compete with the Kindle. Once the digital market stabilises, the need to re-invest will be much lower.

And Amazon, B&N's big rival, has its own problems. While its sales have surged, its margins and overall operating profits - have fallen. Indeed, it makes little profit from selling the Kindle, and may even lose money on each device. As we've pointed out, (B&N) such a strategy cannot last forever.

However, if Amazon does put up prices to restore margins, this will allow B&N to grab digital market share and reduce the pressure on the physical business. Both should boost B&N's bottom line.

Overall, B&N should be able to return to profitability rather than following Borders into bankruptcy. The shares have now slipped back to where they were before the Fidelity announcement. With its strong network of bricks-and-mortar stores and a good position in the digital market, and trading for barely the sum of its assets, the company is worth a look as a potential recovery play for bolder investors.