Kindle Unlimited: publishers as collateral damage?

At one time there was only the Kindle.

Then came the Kindle Fire and Amazon Prime.  Now there’s the Fire phone and Kindle Unlimited–all five programs (along with a bunch of smaller ones) launched by Amazon (AMZN) to bind customers ever closer to the shopping service and get them to buy more stuff through it.

For AMZN, it’s not that important that any of these be moneymakers straight out of the box.  That can always be straightened out later, when the customer has been transformed from a buyer of X who happens to use AMZN to an AMZN customer who happens to want to buy X.

Kindle Unlimited, the just introduced subscription service for e-books and audio-books, is a particularly interesting instance.  That’s because it may end up being the tipping point in AMZN’s favor in its long-running battle with the five big publishing houses for control of the English-language book reader.

Another intriguing aspect of Kindle Unlimited is that AMZN has more relevant information, I think, than any other party at the table–but it isn’t talking.  So analysts, both the Wall Street kind and the planners inside the publishing companies, have less than normal to work from as they create their castles in the air.

Here’s how I view the situation:

1.  For $9.99 a month–about $120 a year–Kindle Unlimited lets subscribers read as many e-books as they want, from a collection of over 600,000, as well as to listen to as many Audible audiobooks, from a list of “thousands.”

No titles from the big five publishing houses are included, although, for example, all the Harry Potter books are.

The rollout of KU suggests that the very public spat between AMZN and Hachette, the smallest of the big five, may have been aimed at persuading Hachette to take part.

2.  Most industries exhibit a “heavy half.”   The idea is that, say, 20% of the purchasers buy a huge amount, usually put at 80%, of the stuff.  For e-books, only AMZN knows what the exact proportions are.  My guess is that heavy users easily spend $50 a month ($100+?) on e-books.  For them, signing up for KU is a no-brainer.

3.  It seems to me that KU users will dig deeper into “free” content in the 600,000 titles instead of buying expensive bestsellers launched by the big five.  Presumably, AMZN has surveyed the heavy half, and maybe even run small tests to figure out what will likely happen.  Certainly AMZN must believe that KU will redirect a lot of e-book use away from the big five and toward AMZN self-published content, or content from smaller presses that may sign up.

4.  Until yesterday, I hadn’t looked at AMZN’s financials for years.  From my perusal, I’ve decided, for no particularly good reason, that AMZN makes $60 million in operating profit per quarter from e-books in the US.  The company could easily let that drop to zero, as sales of high-priced best sellers wane. However, AMZN seems to be indicating–who knows whether bluster or not–that it is willing to go deep into the red to get KU off the ground (remember, AMZN is generates about $5 billion in yearly cash flow, so it can afford to lose money on KU for a l-o-o-ng time).  Last night it guided to a possible operating loss of over $800 million for the coming quarter.

5.  The big five could be squeezed in a number of ways.  KU users switch away from them, constricting their cash flow.  Fewer pre-orders from KU users would mean new titles fall off the bestseller lists, hurting sales further.  Authors complain about diminished royalty payments and ponder self-publishing through AMZN themselves, where, for sales in the US, the author receives 70% of the sales price vs. 25% from the big five.

6.  AMZN has lots of customer information; the publishers probably have much less.  Therefore, this negative money cycle may end up being much larger than the big five anticipate.  One or more may break ranks.

It will be interesting to see how this plays out.

 

 

rent vs. buy: digital goods

My daughter, who’s very interested in digital goods, suggested that I write about them.

Why?

They’re new, and they’re different.  Also, Laura supplied a lot of the information in this post.

Part of the difference between the digital goods we have now and their physical counterparts is in the nature of the beast(s).  Part, however, comes the desire of sellers–particularly Apple–to recreate the AOL-style “walled garden” that tethers the buyer to a given seller’s product line and secures fat profits for the retailer.

Some examples:

Generally speaking, for digital goods like e-books, or songs or movies, you don’t really own the digital copy you download.  You only have a license to use it.  Kindle owners found this out early on.  Amazon was inadvertently distributing 1984 without having bought the digital rights.  When the company found out–presumably when the rights holder called asking for money–Amazon simply went “Poof!” and made the book disappear from all the Kindles it had appeared on.  Apparently very few of the shocked Orwell fans had read the fine print in the Kindle service agreement.  It is kind of funny, though.

Usually, you can’t give your download to someone else.  You may be able to lend it for a short period of time, but maybe not.

The digital good may appear on all of your devices.   …or it may appear just on all your Android devices but not Apple, or vice versa.

 

The most peculiar aspect of digital goods, to my mind, is what happens with e-books in (if that’s the right word) libraries.  Many authors or imprints won’t sell e-books to libraries, so the selection is limited.  At least some sellers place counters in the downloads, so that the copy disappears after a certain number of borrowings.  It isn’t a quality control issue–a worry that the digital copy has somehow degraded;  it’s to mimic what happens to physical books, which eventually fall apart after repeated use.   In other words, it’s to force the library to pay again after a certain number of uses.

 

investment significance?

Maybe there’s none.

On the other hand, I think we’ve got to distinguish carefully between essential characteristics of digital goods and those that are a function of sellers’ desire to create closed “ecosystems.”  After all, the AOL walled garden lost any allure it had (I never got it) when people discovered there was a big wide world outside the AOL server farms that AOL got in the way of people experiencing.

I suspect the same will eventually happen with Apple–personally, I think this might be happening already.  As/when this occurs, I’d expect the price of digital goods in general to fall (maybe a lot).  A sharp separation will probably also emerge between high-quality content, whose unit sales will increase (again, maybe by a lot), and me-too content, which will disappear.

 

 

 

 

 

Microsoft (MSFT) buying the Nook e-reader?

the news

Yesterday, the stock of Barnes and Noble (BKS) soared 22% on more than 10x normal volume.

The reason?

…a TechCrunch post saying MSFT is preparing a $1 billion offer for the company’s Nook-related digital assets.  The assets are held in BKS’s Nook Media subsidiary, which also contains the company’s college bookstore operations.  Leonard Riggio, who controls 31% of BKS, owned the college bookstore business privately but sold it it BKS in 2009 for $514 million.

The TechCrunch report is based on its examination of internal MSFTdocuments which the New York Times says are genuine, though perhaps dated.

is the headline figure, $1 billion, all that it seems?

Maybe not.  The most favorable interpretation of the TC scoop is that MSFT is willing to pay $1 billion for the portion of the BKS digital assets it doesn’t already own.  The least favorable is that the offer values the entire Nook Media at $1 billion.

The difference?  Three factors:

1.  MSFT already owns 17.6% of Nook Media.  Pearson owns another 5%.  Under the more favorable interpretation, the $1 billion would be split between Pearson and BKS, with the latter getting $940 million.  Under the less favorable, which I think is probably the correct interpretation, BKS would collect $774 million.

2.  Does the $1 billion value include the college bookstores, which–as I read the BKS financials–are the company’s most profitable operations?  If so, cut the MSFT offer in half.

3.  In its original deal with BKS, MSFT promised to fund up to $180 million in Nook R&D.  I think this was a loan, not a gift.  If so, part of the $1 billion may be forgiveness of the loan, not a new cash inflow.

In the least favorable case for BKS, subtract $500 million from the $1 billion headline number if the college book stores aren’t included.  Another $176 million represents the stock MSFT already owns.  Let’s say a further $100 million represents repayment of the R&D advance.  Then, the “$1 billion” offer would mean a cash outflow of  about $250 million, of which BKS would get about $235 million.

the Nook is bleeding red ink…

…for three reasons.

In the Darwinian world of consumer electronics, stand-alone e-readers like the Nook are an evolutionary dead end.  They’re being replaced by small, light tablets.

The Nook is an also-ran among e-readers.

As I read the BKS  financials, the company has a razor/razor blade strategy for the Nook.  It prices the device roughly at cost in the hopes of generating a lot of high-profit e-book sales from users.  In fiscal 2013 (ended in April), however, BKS appears to have lost $350 million trying to persuade consumers to take Nooks off their hands.  It’s hard for me to see how BKS can sustain deficits of this size.

why buy the Nook? 

1.  MSFT takes in $1 billion in cash every two weeks.

2.  To compete in the tablet and smartphone businesses, MSFT needs an e-reader feature.  Because of the company’s tiny market share in both businesses, developers aren’t beating down the doors in Redmond to make reading apps for it.  MSFT’s plan would apparently be to stop making e-readers and refocus the Nook division on creating/enhancing e-reader apps, especially for Windows devices.

3.  According to TechCrunch, the MSFT documents project Nook ” revenues to gradually recover, up to $1.976 billion by fiscal year 2017, for EBITDA profit of $362 million.”

Given that sales of e-readers make up the huge bulk of Nook Media’s sales, the most polite thing I can say is that this forecast is extremely optimistic.  Revenue growth appears to assume a rocketship ride for sales of digital content.  The $750 million positive swing in EBITDA looks too good to be true.  But it does make Nook Media look cheap.  My hunch is that this is its main purpose–to justify the purchase.

(One caveat:  it’s impossible for me to judge how revenues and costs for the Nook devices and for digital content are figured and split between the retail and Nook divisions of BKS.  The only way I can see for Nook Media revenues to rise without hardware sales is if the whole basis of revenue calculation is somehow changed.  EBITDA of $362 million is only plausible to me if somehow post-acquisition Nook Media’s SG&A expense of around $400 million a year completely disappears, or if somehow a whole bunch of digital content profits are now being attributed to the retail division but revert to Nook Media post-acquisition.)

For what it’s worth, TC says the MSFT documents value BKS as presently constituted at $1.66 billion.

4.  MSFT is anything but a shrewd acquirer, in my view.  Just look at its $40+ billion bid for YHOO in 2007 (it has taken a 70% rise in YHOO’s stock price over the past year for that company to recover to a market cap of $30 billion-).

5.  Nook Media may be MSFT’s best alternative–and it may feel it can’t allow the business to die.

I don’t have an investment opinion about BKS.  I don’t own the stock and I have no inclination to be a buyer.  Any holder must ask himself where he sees upside from the current level, and how much that might be.

PS:  I wonder who leaked the documents   …and why.

demise of the e-reader: implications

e-reader sales

A Christmas Eve Financial Times article indicates that while e-reader sales in 2012 will still be robust, the category may be on the brink of a rapid decline in popularity.  Its source is IHS iSuppli.   I’ve found the data in a graph from emarketer.com (note the convoluted chain of attribution–PSI cites emarketer, which in turn cites CNET citing IHS).

The reason for the falloff?   …the rise of light, powerful cheap multi-function tablets, which can serve as e-readers as well as do a lot of other stuff, for within a reasonable distance of the price of a dedicated e-reader alone.  This development wouldn’t be surprising, since the multi-function smartphone has replaced the dedicated music player for many users.

(The above is what I see as the consensus view. It’s not a unanimous one, though.   The Market Intelligence and Consulting Institute, which presumably has special insight into the Taiwanese companies that actually make the e-readers, predicts a bounceback in sales for 2013.  So we should at least keep in mind that the consensus may not be correct.)

Implications, if the FT is right?

In a world where the decision on what merchant to buy an e-book from hinges on what dedicated e-reader you own, the firm with the largest number of e-readers in circulation (Amazon) should be the dominant factor.  Other, non-compatible e-reader makers, like Barnes and Noble, should have small relative market shares.  Other would-be booksellers are footnotes, at best.

The game changes substantially, I think, if the key decision becomes what app the potential buyer has on his tablet.  That’s because any customer can download a new book app with a couple of taps.  Unlike the case with music, where users may want to construct playlists, it probably doesn’t matter much whether one’s entire library is on one app or several.  So the key factor in the purchase decision probably comes down to price.

It’s possible that AMZN can develop a tablet that’s the full equivalent of a Samsung or Google offering.  The performance of the Kindle Fire suggests that’s not likely.  But, if it can, perhaps AMZN can preserve its “ecosystem” with avid readers for a while longer.  And in doing so it would be able to bar the download of other booksellers’ apps onto its machines.

Personally, I doubt Barnes and Noble will be able to create a viable tablet.  Yes, it does have its alliance with MSFT.  But that only seems to me to guarantee that BKS can have the Zune of tablets.

AAPL is in an unusual position.  Its strategy has been to generate superior profits by selling up-market devices at premium prices.  Does it want to compete in the (eventual) $100 tablet market?  My off-the-cuff guess is that it doesn’t.  By default, this makes AAPL less of a player in the e-book market.

On the one hand, this would make the big publishers’ alliance with AAPL of a few years ago look extremely short-sighted.  On the other, it creates the opportunity for them to have a common app that bypasses both BKS and AMZN.

the stocks?

Any restructuring book distribution by cutting out dedicated e-readers is obviously not a reason for the companies that control the e-reader market to celebrate.  The biggest single loser, I think, is potentially BKS, since AMZN has 3x the market share in e-books that BKS has.  It isn’t that AMZN escapes the change unscathed.  But it already has lower prices than BKS; its large relative size gives it another big advantage in the price-drive. environment I think will develop.  Also, it’s not clear that AAPL will abandon the up-market strategy that snatched it out of the jaws of bankruptcy to become a serious competitor in the mass tablet market.

All in all, I score the situation as a net plus for AMZN.

The wildcard is potential new competitors who might be able do offer superior app performance.

Apple, book publishers and the Justice Department

the investigation

Media reports yesterday indicate the US Justice Department is investigating five of the top six book publishing firms (Random House is the exception) and Apple for price-fixing in the e-book market.  Settlement talks aimed at avoiding litigation are apparently going on, at least with some of the publishers.  A parallel investigation by EU regulators seems to be happening, as well.

what’s at issue

It’s all about trade books.  Publishers have traditionally wholesaled physical bestsellers to bookstores at 50% of the suggested retail price.  The store owners then figured out how much to mark them up–or whether to sell them as loss leaders.  A hardcover with a retail price marked on it of $25, for example, would be sold to a bookstore for $12.50.  The store might retail it for, say, $16–or for $10, if they so desired.  Stores could return unsold copies for a refund.

As little as two years ago, publishers were following the same procedure in the nascent e-book market.

This created a potential problem, however.

AMZN was aiming to become the dominant seller of e-books, to be read on its proprietary Kindle device.  It was taking every e-book it paid a publisher $12.50 for and retailing it for $9 or $10.  Yes, the company lost around $3 a book.  But short-term profits have never been an AMZN concern.  And the company was shifting avid readers in droves from being physical book buyers to becoming Kindle aficionados.

Publishers began to hear the giant Perot-ish (Perotian?) sucking sound of their physical book distribution network disappearing into cyberspace.  How to respond?

AAPL, which was just about to launch the first iPad, came along with a proposal.  Publishers shouldn’t necessarily wholesale e-books to e-retailers.  Instead, they should (technically, anyway) remain owners of the e-books (with no physical inventory, what difference would it make?) and hire companies like AAPL as commission-earning agents to put buyer and seller together…kind of like the way real estate agents sell houses.  That way, publishers could set retail selling prices themselves. This wasn’t an entirely new idea.  Publishers already had similar deals with some small independent bookstores.

AAPL proposed to charge a fee of 30% of the proceeds for each sale.  And, oh…by the way…publishers would also agree not to allow their e-books to be sold anywhere else at a lower price.

Publishers said okay and then broke the news to AMZN.  No more selling e-books at a loss.  E-books had to be priced at the publisher-determined price of around $13-$14; AMZN had to take 30% of the proceeds.

AMZN said no.  The five publishers now being investigated immediately responded by revoking AMZN’s permission to sell their e-books.  AMZN took the books off its website.  But a few days later, AMZN caved and agreed to the publishers’ terms.

consequences

Saying what might have been is a little like writing an alternate history, which is rightly classified as a branch of science fiction.  Nevertheless, here’s my take on the effects of APPL/publisher deal:

–imposing what amounts to the agency model on AMZN broke the company’s momentum in the e-book business and slowed the growth of the medium.

–this gave the publishers time to try to figure out how to support the physical book distribution network.  I don’t know what good that’s done.  It certainly didn’t save Borders

–it caused AMZN to refocus its competition strategy on the price/quality of the reader

–it gave BKS time to perfect the Nook and allow it to emerge as a viable competitor to the Kindle

–it gave APPL another selling point for the iPad, although the device seems to me to be much better for magazines, scholarly journals and textbooks than for regular trade fiction/non-fiction.

what would a settlement mean?

I’m assuming that the main result of any settlement would be to allow AMZN to set the retail price of e-books wherever it wants.

Under today’s rules, a newly-released bestseller in e-book form sells for about $14.  Sale proceeds are split, with $9.80 going to the publisher and $4.20 to the retailer/agent. AMZN might reduce its e-book bestseller price to $9.99.  I think that’s an easy decision.  That was its desired price point two years ago–and one which, at least at that time, proved to be a powerful psychological motivator for customers to choose an e-book over a physical one.  Unlike the situation in 2010, AMZN could pay the publisher $9.80 and have $.19 left over.

What about $7.99?  That would put AMZN back into roughly the same the loss-leader position it had adopted a few years ago.  To my mind, this would be a vintage AMZN move.  But is it necessary?  Given the much larger size of the e-book market today relative to the physical book market, are the losses this strategy would produce manageable?

Maybe a smaller form factor iPad would make AAPL a bigger player in the bestseller book business, but as things stand now AAPL doesn’t need trade e-books to spur iPad sales.

What about Barnes and Noble (BKS)?  The company seems to me to be the obvious loser if AMZN is able to lower e-book prices.  That would accelerate the demise of the BKS bricks and mortar bookstores.  Having a competitor sell e-books at cost would also appear to diminish the chances of the Nook ever becoming a profit-making device.

On the other hand, the AMZN move would likely increase pressure on BKS to sell its Nook name and technology.  GOOG has been rumored as a possible buyer, which, I presume, is the reason BKS has a market cap north of $750 million–and has been rising since the price-fixing investigation was leaked to the press.

The real question, of course, is the price someone like GOOG would be willing to pay.  I have no clue.  I also don’t have any confidence that I’d be able to come up with a meaningful estimate.  That’s okay with me, though.  As an equity investor, you’re in this position a lot. It just means I won’t get involved with the stock.

 

 

 

 

 

AAPL’s 4Q11: another strong quarter

the results

AAPL reported 4Q11 results after the close of trading in New York yesterday.  The company earned $6.6 billion ($7.05 per share) over the three months, on revenue of $28.2 billion.  This is an advance of 52% in eps, year on year, on sales growth of 39%.  Although the company exceeded its guidance of $5.50 per share handily, it failed to beat the Wall Street analysts’ consensus, $7.39 a share, or the first time in a long while.  (The StarMine consensus of analysts who have historically been the most accurate forecasters–which in this case may simply have been the most aggressive–had been $7.51.)

EPS for the full fiscal year 2011 (ended September 24th) were $27.68, or 82% better than results for fiscal 2010.

AAPL also gave guidance for the holiday quarter we’re in now.  APPL’s 1Q12 will have 14 weeks in it instead of the normal 13.  This is an adjustment companies who organize themselves on a “weeks” basis rather than a “months” basis must make every six years or so to make sure their fiscal year remains aligned with the calendar year.  Anyway, AAPL’s guidance for 1Q12 is eps of $9.30.  My rough guess is that this equates to a “normal” quarter of $8.50,  which would be a gain of about a third over the $6.43 AAPL reported in 1Q11.

As a result of its earnings “miss,”  AAPL shares are down about 6% in pre-market trading as I’m writing this.

details

iPhone

Let’s get straight to the heart of the earnings “shortfall,” if that’s the right word to describe a quarter that’s up more than 50% year on year.  It comes in the iPhone.

AAPL sold 17.1 million iPhone units in 4Q11.  That’s up 21% year on year, and an all-time record for a September quarter, but down 16% from the record 20.4 million the company sold in 3Q11.  There were two reasons sales weren’t higher, both related to the introduction of the new iPhone 4s.

–AAPL decided not to add any new carriers to its iPhone network in the September quarter; and

–consumers slowed down purchases of the iPhone 4 in anticipation of the new model they expected to debut during 4Q11.  As demand waned toward quarter end,  carriers slowed down purchases of iPhones from AAPL.  Apple Store sales of iPhones were particularly weak.

APPL has since reported that the iPhone 4s has sold over 4 million units during the first three days of its launch in early October, more than double the rate at which the original iPhone 4 left the warehouses when it first came to market.  At $645 each, those sales amount to $2.6 billion, or about $.85 a share.  They could just as easily have occurred in 3Q11 if AAPL had moved the launch date of the 4s back to late September rather than early October.

How good is the iPhone business today? “In our wildest dreams we couldn’t have gotten off to a start as great as we have on the 4s,” says CEO Tim Cook.  Cook also noted that AAPL had anticipated a much larger reduction in telecom purchases of the original iPhone during the quarter than what actually occurred.

iPad

AAPL sold 11.1 million units during the quarter, an all-time record.  That’s up 20% quarter on quarter and 166% year on year.  AAPL finally seems to have obtained enough manufacturing capacity to keep up with demand.

Macs

Unit sales were up 37% year on year and 30% quarter on quarter.  That’s also an all-time record.  AAPL sees some cannibalization of the Mac business by iPads, but is still producing growth much greater than the PC industry.

iPods

Once half the company, iPods are now less than 10% of AAPL’s revenue.  Unit sales were 6.6 million during the quarter, down 27% year on year and 12% sequentially.

my thoughts

Even with an extra week to work with, I don’t think AAPL’s profits can be up 82% again this fiscal year.  Suppose they “only” reach $35, with (to make the arithmetic easy) $1 of that coming from the 53rd week.  Organic growth would then be in the low 20% range, which I think is easily doable.  It could be very much higher.

At a $400 stock price, AAPL would be trading at a forward multiple of under 12x on my low-ball figure.  Subtract out the $86 a share in cash (remember, AAPL has no debt) on the balance sheet from the stock price and the multiple shrinks to about 9x.  Even factoring in a substantial maturing of AAPL’s businesses, of which there’s no credible evidence yet, AAPL shares seem very cheap to me.

 

the Silk browser on the Kindle Fire

what a browser does…

A web browser is a software program that finds web pages for you and renders them on your computer.  It locates the page you want and then reads and follows the HTML instructions it finds there.  The instructions may require the browser to travel to separate locations so it can get detailed–and sometimes complex–formatting instructions, or favicons, or to call up images that belong to the page.

…takes time and effort

All this can mean lots of round trips communicating between your browser and the page you’ve asked it to look for.  Once you’re on a given page, you’ll most likely want to follow links to other pages, either to watch a video, read an article or get more details about a possible purchase.  That’s a bunch more round trips.  Yes, we’re talking milliseconds (1/1000 of a second) for each one, but even milliseconds eventually add up if there are enough of them.

how AMZN makes Silk “super-fast”

Most of this has to do with the massive “cloud computing” infrastructure AMZN has built in becoming the online department store to the world.

In particular,

–AMZN links directly to the internet backbone.  So it can connect Silk to “outside” web pages up to 20x faster than other services.

–AMZN maintains continuous connections to the “top sites on the web,” eliminating the need for initial introductions between you and the page you want.

–AMZN has a big web hosting business, so lots of sites are inside the AMZN cloud already; AMZN caches others.  No need to go hunting for them.

–for the most popular destinations, AMZN cuts through the back-and-forth between browser and web page and starts to send information it knows you need, even before your browser asks for it.

–AMZN studies how people generally behave on a given page.  Based on its conclusions, it pre-loads content on your browser that it anticiates you may ask for next.

pretty impressive–

In fact, AMZN’s description sounds an awful lot like AOL back in the heady days when dial-up was king and the AOL server farms were all the internet many people ever used.

one caveat

Anyone using the Silk browser may well spend most or all of his time inside the “walled garden” of the AMZN cloud.  This means that, like AOL decades ago, or GOOG or AAPL today, AMZN will be able to see–and analyze–large chunks of the internet life of any such customer.

This stands to give a tremendous marketing advantage to AMZN, in two ways:

–in all likelihood, AMZN will “own” the Silk customer in the way AAPL “owns” users of its app store, and

–AMZN will be able to collect huge amounts of new data about consumer behavior.

Will customers balk at giving so much personal data to AMZN?  …not at all, in my opinion.  But AMZN will have to walk a finer line than before between using customer data for marketing analysis and respecting the privacy of users.