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.

 

 

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.