Making Sense of Amazon-Hachette

by Jake Kerr, www.jakekerr.com

The only thing that has exceeded the volume of the comments surrounding the ongoing Hachette-Amazon book retailing negotiation is the irrationality you see in those comments. On the one side you have authors that see Amazon as wanting to chew up Hachette on their path to a monopoly, while on the other side you have Amazon outlining that the publisher desire for higher prices will kill the ebook business. Of course neither is true. What we have is a simple battle over profit margin.

The first thing to note is that this negotiation is primarily, if not exclusively, about ebooks. Just read the recent Amazon letter to authors about the negotiations for evidence of this. Amazon may be using print book pieces as leverage, but the core disagreement is over ebooks.

Amazon’s fragile position

A key point that is almost universally missed outside of the tech world is that Amazon’s position in the ebook business is fragile. There is no greater chasm between author and Silicon Valley understanding than this. A very large percentage of authors feel that Amazon is in a commanding position in the ebook industry and that one of their goals is to create a monopoly position. While Amazon is in a commanding position, to think that monopoly is their goal illustrates a lack of understanding of Amazon’s relatively weak position.

Again, those in the tech industry understand the fragility of Amazon’s position: First of all, the barrier to entry for creating an ebook online store is absurdly low. In fact, Microsoft, Apple, and Google already have ebook online stores. Think about that for a minute: Three of the most formidable digital companies in the world are operating in the ebook space.

Another argument you hear is that Amazon also controls the device business. But this completely ignores the fact that Apple’s and Google’s devices are even more popular than Amazon’s. Microsoft certainly isn’t ceding this space either, as the recent purchase of Nokia indicates.

For Amazon to make any progress at all they would have to either make the ebook space not worth pursuing for those companies or to flat out beat them. But the reality is so much harsher than making progress. The assets that Apple, Google, and Microsoft bring to the table mean that Amazon’s market share is inherently tenuous. The result is that Amazon isn’t thinking offense, it is thinking defense, and this is the thinking behind their “not worth pursuing strategy.”

How Amazon is holding Apple, Google, and Microsoft at bay

So how is Amazon making the ebook business not worth pursuing? They are doing it by discounting so aggressively that the value of the book business for ebook retailers is so miniscule that it doesn’t even raise the eyebrows of the major tech companies. While the book business is big, why even bother with it if the profit margins are so small as to not even move the needle? Your time is better spent focusing on video games with in-app purchases, among many other things.

Apple’s collusion in fixing higher prices with the major publishers makes total sense in this light. The book business with Amazon cutting margins to the bone makes no sense for Apple. The book business with the major publishers setting prices and Apple getting a full 30% margin on those sales? That’s the kind of margin that gets Apple’s attention.

Unfortunately for Apple, they had to break the law to combat Amazon’s discounting. This should tell you two things: One is that the scope of Amazon’s discounting is obviously immense. If Amazon was just discounting on a small scale, Apple, Google, and Microsoft would be a lot more interested. The second is just how much Amazon subsidizes the publishing business and author earnings thanks to their discounting. Remember: They are still paying publishers and authors based on list price. When the customer pays the discounted price, Amazon eats the difference.

So we can see that Amazon has created a very low margin business, and we can also see that Apple at least has shown that if the margins are higher then they would put more attention to this line of business. The important take-away here is that Amazon is desperate to keep margins low. It is the key to defending their fragile position in the ebook space. The question is how low?

The publishing industry “Amazon windfall”

One of the key side-effects of Amazon’s strategy of turning books into a low margin retailing business is that publishers and authors have been reaping enormous benefits. With Amazon aggressively discounting, publishers were watching their books sell in greater volume at a higher price point. Authors similarly reaped the benefit by seeing the lower price point lead to higher volume for sales without hurting their royalties.

As the status quo stands, if you are Hachette you want nothing to change. Every negotiating point that is leaking out from Amazon is bad for the publishers: Lowering prices hurts your profits, since Amazon is discounting them. Paying a higher distribution fee to Amazon for price points above $9.99 also hurts your profit margins, as that is a signficant drop over the previous level (allegedly Amazon wants revenue for books priced above $9.99 shared at 50%, not the current 70%).

In this environment, it would be absurd for Hachette to negotiate at all. There is absolutely nothing for them to gain by changing the terms. Every single term works against their current healthy profit margins. Author Hugh Howey has outlined the reticence of Hachette to negotiate on his website multiple times. And who can blame them?

So what is Amazon thinking?

At this point, it is reasonable to assume that Amazon is caught between two difficult positions: The book business is fairly miserable for them at the current margins, but if they stop discounting the business becomes much more interesting to their competition.

Certainly they can look to things like Kindle sales and revenue from things like Kindle store advertising to augment the business, but at the end of the day the profit margins for selling ebooks has to improve for Amazon, especially when you consider books are the most mature of all of Amazon’s businesses. If books hasn’t evolved to a strong growth and profit-driven business by now, what does that say for their younger categories?

As I mentioned, the trouble for Amazon is that if they just stop discounting or cut back their discounting to select titles then the book retailing business is suddenly interesting to some pretty big players. Authors tend to think of Amazon’s strategy as driving Barnes & Noble out-of-business, but if they stop discounting they are much more worried about the aforementioned Apple, Google, and Microsoft .

Amazon’s solution appears to move things half-way. Improve their profit margins but do it in a way that doesn’t exactly scream major opportunity to other players. In light of this, what you read from Amazon makes total sense.

The most recent headlines are about Amazon “controlling pricing.” They want publishers not to publish ebooks over $9.99. This isn’t necessarily about helping the consumer (although it does), it is about reducing the gross revenue in the market. Is that enough to keep the wolves at bay? Well, it’s something.

The other scenario you may have heard is that Amazon wants to reduce Hachette’s publisher cut from 70% to 50% for books prices over $9.99. Make no mistake: Amazon still intends on discounting those books, but with a larger cut in their pocket, the margins are better. Again, this helps the retailer profit margin, but not as much as not discounting at all. Is this enough to keep the wolves at bay? Well, it’s something.

Who’s the bad guy?

I’ll make no friends here by simply saying there is no bad guy. Amazon just wants to make a bit more money while not putting their current market share at risk. Hachette is looking at an existing marketplace that is about as good as it gets for them. Expecting for them to be generous and give some of their money to Amazon is unrealistic. This is business, not a charity.

What happens next?

Amazon’s leverage here is minimal. They need Hachette’s books because, well, they sell books. Their lack of leverage can further be seen by their increasing appeal to authors and readers.

In a corporate negotiation like this, the real weapons are most likely things we haven’t seen, such as positioning within the Kindle store, co-op advertising, and stock levels. Basically, Amazon hurts the marketing of and pre-sale of the Hachette books that most need it, while the marketing doesn’t matter for the bestsellers. This can hurt Hachette but not necessarily Amazon.

The one thing that Amazon can do that will substantively hurt Hachette is to stop discounting their books. The trouble with this is that, while it is a win for Amazon (more profits per sale) and a loss for Hachette (lower sales) it goes against Amazon’s goal of maintaining their market share by keeping ebook business a low enough profit business to keep the other major players minimally engaged.

And this is where I think we are going to see this negotiation end: The terms don’t change, but Amazon severely cuts back its discounting. This will annoy consumers who will now have to pay more for books. This will hurt Hachette and authors in that it will see lower sales volume due to the higher prices.

Interestingly, this will help Amazon in the short run but create a scenario where a competitor can come in and make quick ground by doing their own discounting. Whether that happens or not and how Amazon responds remains to be seen, but the opportunity is there. As those that live in the digital world know, when margins are high, the barrier to entry is low, and Apple, Google, and Microsoft are already established in the space, disruption is just around the corner.

And with that in mind, maybe nothing changes in the end.