The ‘DRINK ME’ economics of the modern book business
There is a line in A.S. Byatt’s best-selling novel Possession that sums up the book business’s approach to figures perfectly. In this novel Beatrice Nest, an academic who had devoted her professional life to the study of an inscrutable diary, said of it:
“I think she wrote it to baffle. Yes. To Baffle”
In this blog I’m going to take a look at one specific number that underpins the book business: the operating margin of its main actors. This is because I think that this indicator — which publishers and booksellers do everything in their power to baffle us with — tells us a lot about what ails the industry at the moment.
But first, a chart: Amazon’s operating margin.
Amazon Operating Margin Q1–12 — Q2–14
Remember that when looking at a chart the relative size of the bars is much less important than the scale on the x axis. This chart tells us that Amazon has only reported an operating margin of more than 2% once since the beginning of 2012. We can look at this two ways. Either it’s an unprofitable business, or a business that is re-investing all the capital it generates on growth.
For the moment, Amazon is better described as the second of those types. Some of this has to do with the way it reports its numbers to market. It breaks its revenues down into three general buckets: media, merchandise and other. This makes it difficult to determine which operations make and lose money for Amazon. We just have to assume that some bits of Amazon are crazily profitable, but that it uses these profits to subsidise new ventures as they mature and distract attention from those initiatives that don’t catch fire — like the Fire Phone, for example.
Let’s compare this to the way Microsoft reports its numbers to market.
As we can see, Microsoft is much clearer in reporting where it makes and loses money. It’s a laudably transparent strategy with one big disadvantage. Everyone knows which Microsoft’s ‘dog’ businesses are (Bing, anyone?) and uses this knowledge to mercilessly rag the company. Clarity has its downsides if you’re a business whose record of making a success of new innovations (Surface, Bing, Zune) is patchy.
Now let’s compare Amazon to the ‘troubled’ British retailer Tesco, which was recently forced to jettison its chief executive. Even after issuing its third profit warning in two years Tesco is still on track to deliver an operating profit margin of 4% this year. This is a full a two point dip on the 6% it delivered from 2010 to 2012. Still, on paper, Tesco, a wide-ranging and powerful, if arguably past its best business, is proportionally twice as profitable as Amazon in its best quarter in the past two years.
There’s a reason why I’m using Tesco as a comparison to Amazon here, and that’s because there are more similarities between the two businesses than we might think. They’re both low margin businesses, and at points in their history they’ve both been called the ‘future’ of retailing. If we cast our minds back ten years, Tesco looked unassailable. It generated cash like no other and used most of that cash as capital investment for growth, as this FT article elegantly summarises. And the strategy worked a treat for a while, but then something (the internet) came along that Tesco hadn’t anticipated and it stopped working. This has put Tesco in a difficult position. In order to grow it needs to make heavy capital investment, but it’s no longer achieving the growth to justify that investment. A double-bind.
Keeping the idea that a business can only justify spending unbelievable amounts of money on growth if it keeps growing at an unbelievable rate, let’s take another look at Amazon’s revenue numbers.
What does this tell us? In the past two years, Amazon has started to see a levelling off in growth, even though revenues have continued to rise. And let’s also look at what’s happened to Amazon’s share price since the beginning of 2014, when those growth numbers started to look like a trend, not a blip.
Amazon Share Price — 1998–2014
The share price has started to slip. And for a business that had always kept investors happy with a rising share price instead of a dividend, this was a worrying development.
It might just be coincidence, but soon after this happened, the news emerged that Amazon had entered a new phase of aggressive negotiation with its suppliers. So far the Hachette dispute in the US has taken up most of the oxygen in the room, but it’s also fighting Warner Bros and Disney over DVDs, and a group of publishers in Japan over books. The sheer number of these stories now in the public domain tells us one thing: Amazon is pushing suppliers in its (presumably) profitable media division for higher margins.
Here’s another chart suggesting why it’s important for it to do so.
Amazon Costs as Proportion of Revenue (2010–4)
As we can see, in Q4 2010, Amazon spent less than 5% on ‘technology and content’, which is an aggregation of everything from blade servers for its data centres to the license to sell Gone Girl as an eBook. In Q2 2014 that had risen to more than 8%. In cases like this it’s good practice to make efficiencies, hence Amazon is going to its suppliers and demanding bigger discounts. Keeping these costs under control will mean it can protect profits on its mature, profit-making businesses and re-invest those in new growth businesses. The other option is to raise prices, but Amazon, with its relentless consumer focus, prefers to use this as a last resort.
In an ideal world, what happens next is a trade-off. The retailer demands higher margins but promises (theoretically) higher sales in the future as the market grows. The retailer can then continue to supply goods to consumers at a low price and the supplier takes a hit by making a smaller per-unit profit. The supplier wins in the long-term by making that back by selling more units at the lower price.
All this assumes, however, that the market is growing. If your market — in this case trade publishing — is mature and possibly in decline, retailers pressing for higher margins so that they can continue selling cheap books is a dangerous proposition. Indeed this model could actually be working to depress and possibly imperil the whole market.
Even if we assume that Amazon turns a handsome profit on books, this is not a general trend. Barnes & Noble has had a pretty catastrophic run of luck, mainly due to its loss-making digital Nook business, as this chart demonstrates.
Barnes & Noble operating margin (Q1–12 — Q2–14)
Here in the UK Waterstones is a private business again so doesn’t need to report numbers in detail, but its recent turnaround is on the basis of ‘narrowed losses’ rather than profits.
To find a book retailer that isn’t losing money one has to look outside the Anglophone world altogether. In France, the leading physical retailer Fnac enjoys a gross operating margin of 29.8%, but this is in an environment where book prices are fixed and eBooks a comparative rarity. And in Japan, the country’s homegrown equivalent of Amazon, Rakuten reported a margin of 17.4%. Given that this is a business that extends all the way from eBooks and messaging apps to life insurance, however, it’s impossible to determine what (if any) profit the bookselling part of the business delivers.
I’ve already written about the storm over Amazon’s paean to the virtues of cheap eBooks. If current market estimates are accurate, then the trend for lower eBook and print book prices in the US meant that publishers and authors in that country essentially gave away 50 million books last year. This might make sense as a loss leader if the market were growing, but what if there just isn’t sufficient margin to go around?
When it commented publicly about its dispute with Hachette, Amazon’s key message was that publishers enjoyed high profits on eBooks in particular and therefore it was only fair to share that around more equitably. The trouble is that there is no clear evidence that publishers are coining it in from eBook sales. If they were we would see an across the board strengthening in operating margins.
At the end of last week, Publishers’ Weekly published a summary the headlines from major publishers’ latest financial statements and it made sobering reading.
Only two of the listed publishers, Simon & Schuster and HarperCollins, had posted an increase in margin year-on-year. And even as this article was published, rumours were leaking out of Penguin Random House that alleged margins for Penguin had fallen as low as 5.4%.
Margin is important for publishers because as comparatively small businesses the margin, rather than the volume is where they make their money. Publishers are specialised businesses. If they don’t make money on books in one year they can’t subsidise it from their sales of t-shirts or tickets for author events (even if they should!). They live and die by the success of one product.
So Tesco might send the markets into convulsions when it issues a profit warning, but this is a highly diversified business with lots of scale. A catastophe in its case is profits dropping to £2.4bn from £2.8bn. By contrast, HarperCollins earns universal praise when its US operations accrue $198m (approx. £120m) in profit in a whole year.
While it’s not wholly fair to compare HarperCollins with Tesco, the difference in scale is instructive. Even though it is having its worst year in decades, this year Tesco will still be 20 times more profitable than HarperCollins.
The picture looks even less rosy when one takes a closer look at the other publisher that posted an increase in margin: Simon & Schuster. According to the results that S&S’s owner CBS released for the first quarter of 2014, book publishing profits did grow by $1m to $13m, but only because “lower revenues were more than offset by a decrease in operating expenses.” In other words, S&S achieved those by cost savings not by growth, and these savings did not lead to higher sales, which weakened year on year.
The picture we have here is of businesses that just can’t achieve the scale required to offset the lower margins. The Penguin Random House merger was intended to help address this and may yet still do, but the numbers involved stress how daunting their challenge is. Penguin and Random House’s combined sales for the first half of 2014 were $1.461bn. Amazon’s sales for same period were $39.08bn, and in the second quarter it still managed to make a loss of $127m on that.
A pessimist looking at these figures would conclude that the publishing industry is in a double-bind. Amazon wants to lower its costs, and thus has chosen to go to its suppliers to ask for higher discounts. It feels it can ask for this because it has enjoys a dominant position as a bookseller on both sides of the Atlantic. Publishers, however, cannot grant those higher discounts without destroying their margins. Even if they did accept lower margins, they know that these will not translate into the higher sales required to offset them.
Lower margins would at best yield slightly higher sales but lower revenues, and inhibit publishers’ ability to keep output at their current levels. They know that Amazon’s demand for higher discounts is like the bottle with the “DRINK ME” label that Alice picks up in Wonderland. It’s an invitation to shrink.
Publishers cannot pay their investors in hope. Everyone knows that publishers do not grow at anything like the rate of technology companies. This is why venture capitalists flee before book-focused start-ups like vampires before garlic (thank you for the simile, Jennifer Saunders). Mind you, some tea leaf readers would say that unless Amazon returns to 20% growth soon it won’t either.
In situations where profit cannot be achieved by growth it has to be achieved by two means. Either publishers can cut their way back to profitability, as Simon & Schuster has chosen to do. Or they can do the unthinkable and raise prices. And much as it goes against everything I’ve been taught to believe by the post-Reagan creed of free market capitalism, I think higher prices might have to be the answer. Together, the publishing and bookselling industries have conspired to sell their wares at below market value in the hope that it will magically grow the number of global book buyers. And it hasn’t worked.
So in order for books to be a sustainable business, perhaps everyone involved needs to focus a little less on the price of the book and more on the value of reading.