4 points about the Kindle Fire

1. Thank book publishers for the Kindle Fire.

AMZN’s initial strategy for e-books was to compete on price.  In fact, it started out offering e-books as a loss leader.  It was paying the publishers $12.50 for a new release and selling it as an e-book for $10.

The book industry didn’t like this one bit, however, because it feared the tactic would destroy the independent bookstore distribution channel.    So it forced AMZN, by threatening not to sell books to the company, to charge $13-$15 an e-book for new releases and keep 30% for itself (see my posts on Kindle economics for more details).  Take that, AMZN!

As I pointed out then–nothing requiring much insight, only having watched Jeff Bezos operate over the years, I thought AMZN would likely shift to using its hardware as a loss leader to build up sales volume.  The process took a little longer than I anticipated, but the Kindle Fire is the result.

According to iSuppli, the components in the Fire and their assembly cost AMZN about $210 a unit, meaning the company gets no recovery of its research and development costs, and loses $10+ for each unit sold, to boot.  If AMZN marked up the Fire the way AAPL does the iPad, it would sell for $275-$300.  Vintage Bezos.

Presumably, though, the early devices have a lot of redundancy built in (what a disaster if the first ones broke a lot).  But component prices will fall, and the device will gradually be simplified.  My guess is that AMZN will cross the breakeven line in the second half of next year.

2.  Fire is the star, but there’s a mini-explosion of regular Kindles as well. 

Along with the 7″ color-screen Fire, AMZN is introducing a new 6″ e-ink Kindle with audio and text-to-speech.  The latter comes in touch screen and physical keyboard models.  With 3G connectivity, they cost $189.  They’re $40-$50 less with wi-fi only (which is what the Fire has).  You can knock another $30-$40 off is you’re willing to accept advertising.

And, of course, there’s still the original 6″ Kindle at $109 and the jumbo-size 9.7″ Kindle DX at $379.

3.  AMZN is already offering Fire extras.

For example, there’s:

–a two-year extended warranty, that also covers three instances of accidental damage, for $44.99,

–a cover for, $24.99-$44.99, and

–streaming of TV shows and movies through Amazon Prime–which costs $79 a year and also gets you free two-day shipping on all AMZN purchases.

4.  AMZN’s formidable cloud computing capabilities back the Fire, too

AMZN is promising super-fast internet browsing with the Silk browser every Fire comes equipped with.

How so?

AMZN’s on-line retailing operations require massive server banks.  Because the company has to have enough capacity to handle surges in demand during peak selling periods, it can often be left with as much as 90% of its servers idle.  Years ago, it turned to providing cloud computing services to third parties as a way of using this asset better.  Its careful study of its customers’ behavior while on the Amazon site has also given it the ability to anticipate their needs–meaning it will be able to pre-load onto a Fire device likely next pages even before the user tells the browser to request them.

More about this tomorrow.

my thoughts

Fire may not have the upscale cachet of the iPad.  But the price is right at the level where surveys of US consumers suggest they’re willing to buy a tablet.  It’s small, weighs less than a pound and has a battery life that AMZN puts at 8 hours of active use. 

It seems to me the Fire will prove very attractive to consumers on the go, just as the early netbooks drew traveling businessmen for their light weight and essential functionality.  I doubt the form factor will stagnate in the way that netbooks did, though, and I don’t expect the iPad will move downmarket to challenge.  AMZN could easily be a very big winner with the device.

Barnes and Noble (BKS) is putting itself up for sale. Why?

BKS’s announcment

Earlier this week, the board of directors of BKS announced it was considering putting the book retailer up for sale. The stock, which has been a severe laggard recently, jumped by about 20% in the following day’s trading. The straightforward interpretation of this market movement is that Wall Street feels the company would be better off economically in someone else’s hands. Zin this case, however, it may equally well reflect strong confidence that there is a wealthy buyer foolish enough to make the purchase at a substantial premium. There are, of course, already two significant holders of stock, Leonard Riggio with a 20% holding and Ron Buckle with 19%.  Mr. Riggio has already expressed interest.

What’s going on?

Securities analysts are often forced to make mountainous theories out of molehills worth of information. It goes with the territory. But like any scientist would, we outline our assumptions and conclusions based on the data we have, and then look for information that could prove our resulting theories false. BKS is a case in point.

Here’s my theory:

Three or six months ago, the board of BKS may have been debating selling the company. But it didn’t do anything before now. So it seems reasonable to me that some recent development has either focused their minds or tipped them over the edge toward sale. What could that be?

I don’t think it’s just the recent weak bookselling environment, since this unfavorable development can’t have come as a complete surprise. Nor is it likely the bad blood between the two significant holders of the company’s stock, since this too has been around for a while. Instead, I think the factor involved is an unintended consequence of the move by publishing houses, in concert with AAPL, to force AMZN to raise the price it charges for e-books.

As I’ve written in another post, I think the publishers saw AMZN’s aggressive e-book pricing—it was paying the publishers around $12.50 for a hardcover bestseller and retailing it for $10, thus losing $2.50 a copy—as a threat to mom-and-pop bookstores. The publishing houses’ fear was that the low price would spur rapid adoption of e-books by consumers, shifting business away from mom and pop and destroying a valuable distribution network. That, in turn, would leave AMZN in the very powerful position of controlling a major part of the book distribution network.

For its part, AMZN could afford to use e-books as a loss leader because, although it began as an online bookseller, it has long ago established a thriving online business selling all sorts of other stuff, both for itself and as an agent for others. The contrast between it and BKS is stark. BKS, a purely bookseller, will have cash flow around $250 million this year. AMZN, books + other stuff, will have cash flow of around $1.7 billion, or 7x BKS’s.

What the publishers did was compel AMZN to charge $12.50 a copy for e-books and keep 30% of the revenue and return 70% to the publisher. This is the same deal they offered to AAPL, and is modeled on the standard arrangement with independent bookstores. Note, also, that in using the new system, the publishers were receiving less than AMN was willing to pay them for e-books. So boosting the near-term bottom line was clearly not the reason the publishers were doing this.

Raising the AMZN e-book price by 25%, they apparently reasoned, would slow e-book adoption, preserve small booksellers’ profits and give the publishers some breathing room to figure out what to do next. Things haven’t worked out that way, however.

Maybe higher prices did slow the rate of adoption, but if so the consensus wildly underestimated what that the adoption rate would prove to be.

But I think they also stopped AMZN from making a strategic blunder with e-books and redirected it onto a much more effective long-term path.

To me it’s not surprising that AMZN would be willing to lose money while it established its e-book market position. After all, it spilled red ink for years in its online original book business, propped up only by the billions it cleverly raised from internet-crazed investors in the late Nineties, before the bubble burst. And that turned out ok.

AMZN’s mistake, I think, was to focus on using the book price and not on the readers as a way of gaining market share. Given that the publishers forced AMZN to make a profit on bookselling, they eliminated that option. More than that, they gave AMZN all that “found” cash flow that it could direct into its other strategic e-book weapon–developing better and cheaper e-readers. The first in what I expect will be a series of innovations have just come out. You can now buy an e-reader with better screen resolution (wi-fi only) for $139—or at least be put on the waiting list for one—which is about half the price of the older models a couple of months ago.

BKS is a bookseller. AMZN is a technology behemoth, running mammoth server networks for itself and renting space to other “cloud computing” users. BKS might be able to compete in a battle about who can sell the most books. I think it has decided it can’t compete in a war over who has the best e-reader technology. So it’s sending up a white flag.

It’s maybe too early to tell for sure, but a good guess that the book publishers have accidentally precipitated the demise of BKS. Given the weak condition of Borders and the likely fading away of mom and pop bookstores, this action may also have given AMZN a decisive edge in the battle for book-reading customers.

Kindle economics (III): the Macmillan book dispute

The dispute

The Macmillan publishing house and Amazon had a recent, very public spat about Kindle book pricing.  Amazon had been paying Macmillan about $12.50 per e-book for a $25 list-price new release–the same as it would have paid for a physical book–and then selling it through Kindle for $10.  Macmillan wanted that stopped.

Instead, it wanted AMZN to raise the Kindle price to $13-$15 and use the iPad (and now Kindle, starting in June) agency model to pay it.  That model, also used by publishers in dealing with independent bookstores, calls for the sale revenue to be split 70% for the publisher and 30% to the retailer.  If AMZN didn’t agree, Macmillan apparently threatened to withhold its titles from e-book sale on Amazon for six months after publication, while Apple would be allowed to sell them on day one.

The arguing even went as far as having AMZN cease selling Macmillan books through its website for a short time.  AMZN then issued a surly letter to customers and acceded to Macmillan’s demands.

What’s wrong with this picture? Continue reading

Kindle economics (II): it’s vintage Amazon

Some AMZN history

Jeff Bezos founded Amazon in 1995 as an online bookstore and brought the company public in 1997, at a price of $1.50 per share (adjusted for splits).

By 2000, the company diversified into distribution of music and films, as well as merchandise for third parties.  AMZN had grown sales to over $2.7 billion.  But it lost $417.5 million for the twelve months–its sixth consecutive year of red ink.  the company’s operating margin was negative.  It had more than $2 billion in debt and a retained deficit of close to $1 billion.

The stock, which had peaked the prior year at $113 and was on its way to $6.  The company survived long enough to hit $4 billion in sales (in 2002), which was apparently the size it needed to break even.  Then things turned up–in a big way.

Not initially a fan…

I’ll admit I wasn’t initially a believer–I was a customer, yes, but not a stockholder.   AMZN seemed to me then to be one of the core “internet cult” stocks.   The AMZN high priestess was Mary Meeker, not in virtue of any ability to read financial statements or project earnings, but because Jeff Bezos was willing to speak directly to her.

I remember attending a brilliant AMZN roadshow.  The company said nothing about itself.  It showed slides of the price appreciation for leaders of prior generations of technology, like ORCL, MSFT or CSCO.  They said that big fortunes would be made in the Internet Generation by those who found internet stars in their infancy.  The crowd went wild.

I think that if AMZN hadn’t capitalized on the internet frenzy  to raise over $1.6 billion in debt capital during 1998-1999, it would not have been able to survive.  On the other hand, it did.

In hindsight, it seems to me also that at first AMZN had more of a vision than a business plan.  It clearly overestimated the size of the online book market and wildly underestimated the amount of spending on physical distribution infrastructure it would have to do to succeed.  To its credit, however, it adjusted.  When it saw its original market mature, AMZN quickly diversified.  By 1999, it was selling music CDs, movie videos, electronics, video games and home improvement products.  And it found enough willing (read: gullible) lenders to finance its capital expansion.

One other lesson AMZN learned quickly.  Soon after it started up, Barnes and Noble launched its own website.  I don’t think BKS did this because it was so enamored of the internet as a source of profits.  Instead, it wanted to make sure that online prices stayed low enough that AMZN–and the threat it posed to BKS’s bricks-and-mortar bookstores–would have maximum trouble earning money.

…but it’s a different company now Continue reading

Kindle economics (I)

As a consumer,

I’m still not sure whether e-readers will have staying power and become mass-market devices, or whether they’ll be superceded by some more general device, like a netbook or smartbook or tablet, for which reading will be one of many functions.

I happen to own a Sony e-reader, one of the smaller-sized new models, which I like.  I don’t miss the feel of the paper, or the larger size of the pages, or the tactile message of how much of the book I’ve read.  The most striking negative–for me, anyway–is the lack of a backlist (an issue of publication rights and the subject of a later post).  And, of course, I can’t look for better prices from Barnes and Noble or Amazon, nor can I consider buying a used book instead of a new one.

As an investor,

on the other hand, these questions may not be relevant.  The investment issue is whether there’s a way to make money from thinking through the phenomenon of e-readers and figuring out who, if anyone, will profit from them.  It would be an added bonus if the conclusions were not yet widely known.

Let’s start the process by looking at the Kindle from Amazon.

The Kindle

Two perspectives: Continue reading