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Kindle Fantasies Are Running Wild -- But, For Now, Amazon Is Losing Its Shirt
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Wall Street can't help itself.
With all the buzz around e-readers, analysts expect big numbers out of hardware sales and e-book consumption. While hardware sales may experience huge growth in the coming years, we believe many underestimate the losses companies like Amazon will need to weather before selling e-books becomes a meaningfully profitable business.
Currently companies like Amazon lose about $2 for every e-book (we discuss this below). So, if it sells one million e-books the company loses about $2 million.
Analysts keep one-upping each other with forecasts of profits in 2012-2014. What they aren't telling you is that this will require publishers to radically reduce the prices at which they are selling e-book licenses.
Will this happen?
It should. Publishers should move to a high-volume model where they sell more units for less. But "should" is very different from "will."
In any event, in order for the e-reader market to thrive publishers must lower their wholesale prices so that distributors can turn a reasonable profit. We believe that if the price is lowered enough publishers may earn less per unit, but could ultimately earn more in overall revenue and profit through a greater number of sales. This, of course, benefits the e-book distributors as well.
Book publishers will likely be the largest supplier to e-readers, though we believe ultimately consumers will read magazines and newspapers on the devices and even listen to music. As a result, it’s important to understand how book publishers will be impacted and whether or not they will contribute to the transition to digital or fight it.
We believe that at first publishers will fight the trend by standing firm on wholesale prices that lead to a loss for most e-book distributors, but over time will be driven to lower prices and adjust their business models to maintain profit margins.
SOMETHING’S GOT TO GIVE
Amazon accounts for about half of US e-reader sales currently and is losing money selling e-books. Here is how:
- Book publishers are standing their ground on wholesales prices – selling books at about $12 to distributors regardless of if it is a print copy or digital copy.
- Amazon sells them for $9.99, losing about $2 per sale.
Clearly companies like Amazon have to start selling e-books at print retail prices or book publishers will have to lower their wholesale prices. We think it will be the latter.
WE BELIEVE MOST OF THE MONEY IS TO BE MADE IN CONTENT SALES
Margins on e-reader hardware sales are currently low – gross profit margins are in the 20% range before costs like marketing and overhead are even taken into account. E-Book sales on the other hand can generate high margins depending on the wholesale price charged to distributors. We believe that book publishers can sell e-books to distributors at a wholesale price that enables each party to turn a decent profit (we go into this in detail below). As a result, we see the shift to the sale of e-books going like this:
- Consumers force publishers to sell e-books by buying e-reader devices and an increasing number of e-books. However, most will not pay the higher print title price for an e-book.
- A price battle occurs between publishers and e-book distributors as both try to promote and sell e-books while still turning a profit (this is already happening).
- Over time publishers will generate less revenue from selling e-books, but profit margins could even improve somewhat.
- At this point e-books will be sold for less on both a wholesale and retail level, netting both distributors and publishers profits. Authors will inevitably make less money.
CONSUMERS WILL DRIVE THE TREND
We believe book buyers will start to buy an increasing amount of their books online, causing the negotiating leverage in determining wholesale prices for e-books to shift toward the distributors. We see a few drivers to this trend:
- The less than half of US citizens that read books are educated with high incomes, a profile that matches most early-adopters that would be interested in a new device.
- 2/3 of book buyers are below the age of 55, indicating they are likely technologically sophisticated.
- More people are buying and finding books online, which would support the next step – buying and reading digital books distributed and promoted online. For example, 30% of Generation X buy their books online and 21% of book buyers became aware of a book through online promotion, according to the 2008 US Book Consumer Demographics and Buying Behaviors Report.
In addition, as e-readers become more sophisticated with better graphics and technology there will likely be an increasing number of features that make reading e-books preferable to print books for many readers.
PUBLISHERS CAN ADJUST TO SALES BEING DRIVEN BY E-BOOKS AND STILL MAINTAIN CURRENT MARGINS
Currently, we estimate book publishers generate net profit margins of about 10% per book release. This does not leave a lot of wiggle room for price adjustment, which is likely why most are standing firm on wholesale pricing. However, book publishers can turn a profit from selling e-books. For example:
- We estimate over 50% of a book release’s costs (not counting returns) come from manufacturing/shipping and royalties to authors.
- Manufacturing/shipping costs will become nominal if all books are sold digitally.
- Authors will make less in royalties (typically 10% of retail)
Below is an example of a P&L for a typical print versus digital release:
Publishers should be able to sell e-books to distributors like Amazon at $5 and still maintain the profit margins they enjoyed on print book sales. In turn, distributors like Amazon should be able to sell e-books at the current $9-$10 price and still enjoy a healthy profit.
The bad news for authors is that their royalties will decrease since they are based off of retail sales price.
The Bottom Line: Like most traditional media industries, book publishers have a large legacy print business to maintain while they figure out the transition to digital. As a result, we believe in the short-term e-books will be a money loser for distributors since book publishers won't want to cannibalize their print sales with much cheaper e-books on the market. However, over the long-term we expect prices to come down, publishers to adjust, and the growing e-reader market to drive incremental profits for both distributors and publishers.
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For one thing such a direct flip is unlikely to occur anytime soon. Failing that direct flip, book publishers will be in the position that Newspapers are in, a large part of your market wants books in print that are expensive to produce and difficult to make money on and the rest are happy to read online or in digital format, the only saving grace might be that they are willing to pay something for it. The dream ebook p&L fails utterly to take that into account.
Authors are unlikely to take a lower royalty and few book publishers seem to be pushing that angle either. If it was pushed they would withhold ebook rights and simply issue an ebook themselves via smashwords or some other such service, so your notion that lower royalties will result is unlikely to pan out.
Bottom line: I am not convinced by your analysis.
Eoin
I have two comments:
you are assuming 90% of printed books are sold! That is every publisher's wet dream. The real average is between 40% and 80%, depending on the genre. This inefficiency is caused by book publishers over-hyping and overprinting, and shipping printed books (often through a distributor) to retailers on a CONSIGNMENT basis. Within the industry this is called 'returnable terms.' So HarperCollins may end up selling 1.5 million copies of Sarah Palin's book, though they have printed more than 2.5 million copies so far. Publishers are selling perishable items (who will want Sarah's book at full price next month, let alone next year) and accepting returns without penalty. Imagine a grower selling bananas to grocers on a returnable basis. lol. [insert your own joke here about Sarah and bananas] Of course this consignment selling practice doesn't make sense to any analyst who has experience in other industry sectors - it is a very dumb business model and wastes literally billions each year. I've calculated (see my analysis at www.bookindustrybailout.ca) the overprinting and associated shipping, warehousing and other costs all combine to a loss of efficiency equivalent to 20% of the industry's gross sales. Gulp.
you are assuming that publishers will act in a rational manner with respect to future ebook pricing and margins. If they were acting rationally about ending 'returns', I would have more faith in your assumption. The upside is that publishers don't have to be smart with eBooks to be smarter than they are with printed book sales terms (see above point). So as printed sales decline and eBook sales increase, they might do quite well almost in spite of themselves.
Keep up the good thinking!
thanks, cheers, Bruce
Thanks for your response. Certainly not the first time anyone disagreed with our analysis.
To be clear, the primary purpose of this analysis was to demonstrate that companies like Amazon are going to lose a lot of money if the current pricing relationship is maintained and to understand what will drive e-readers and their currently rocky relationship with book publishers. Look for a follow up piece where we cal on book pubishers to get a sense for how long this pricing standoff may last.
Ultimately the consumer will decide how successful the e-reader market is and how that impacts the book industry - from publishers to agents to authors. There very well could be room for books to live both in print and digital. On the other hand, consumers could vote in overwhelming numbers for e-books by buying an enormous amount of e-readers. There just isn't enough data at this point to make these kind of predictions with a degree of confidence.
What is clear is that the current pricing structure is unsustainable and until that changes Amazon will continue to lose money on e-books.
I think it's pretty clear that whatever happens, authors will likely make less money. I certainly don't envision a scenario where they are making more or are releasing e-books themselves.
Rory
It is clear that Amazon agree wit your analysis at least so far as it relates to the shift in consumer demand towards the ebook or else they'd not be engaged in the losses (which I don't think anyone in the industry needed to be told about).
There very well could be room for books to live both in print and digital. On the other hand, consumers could vote in overwhelming numbers for e-books by buying an enormous amount of e-readers. There just isn't enough data at this point to make these kind of predictions with a degree of confidence.
I agree that the level of data we have at this point suggests that intentions are unclear, I remain deeply suspect of any analysis that suggests a 100% shift, though I am also suspect of any analysis that doesn't take into account any change. But your model of future profit is predicated on a 100% shift which is exceptionally unlikely in anything other than the very long term and as Keynes said in the In the long run we are all dead. Your decision to use this flip as the basis for your analysis is VERY favorable to your contention that publishers can profit from ebooks. If we could guarantee that flip I would agree wholeheartedly with you but I would argue that you cannot with any certainty predict this outcome and so I would suggest that your model is not tenable, your analysis thus flawed.
I am curious that you don't see a model emerging that see authors releasing books themselves when even Amazon facilitates exactly that model but directly through the Amazon DTP and indirectly through Smashwords. There are multiple opportunities in the disintermediated supply chain for all the participants to reshape the chain to their own advantage as Amazon is trying with their Encore offering.
Eoin
Authors already are used to making widely varied royalty rates for different formats of their work. Audio rates are lower than book rates, for example. Electronic, international, etc. -- book contracts have paragraphs full of differing royalty rates. eBooks are just another format and as such, I don't see authors being able to resist market forces and dictate royalty rates.
Book publishers know they need a distribution point, which is why they won't issue e-books directly themselves.
-Julie
I'm conscious of the variety of rates that authors will agree to depending on their power vis-a-vis the publisher, the format, the territory and all the rest.
But the reality of the current model is that most publishers are already settling on higher rates for ebooks than print as it stands. I see no logic in authors willingly rolling back on that when they have options. This is not quite the same as hardback and paperback rates where the author is usually incapable of applying sufficient capital to producing the book themselves or lacking in alternative markets/publishers willing to finance the book in another format and so they must take what is offered. Creating and selling ebooks is easier even for an author and thus if anyone loses, it will be most likely the publisher not the author.
Lastly that key issue of the distribution point is as up in the air as the ebook take up point. Some publishers are doing well supplying ebooks themselves already, others are seeing great sales through kindle, but if epub emerges as the standard as seems likely, Amazon will not be the only distribution point of note even for amazon customers, giving publishers a bit of breathing space, though not, perhaps, enough!
Eoin
The second advantage of ebooks is the return of large out-of-print books or rare books in eformat which brings in a longer tail of consumers.
$5 for an ebook is so cheap... that the volumes will obviously increase compared to $22.99 for hardcover which u need to lug around or store ...the fact that most urban homes in Asia are "apartments" with smaller floor areas makes storing books a ridiculous option. Many people dont buy books even if they can afford to because they feel its such a pain to store books. Kindle solves this painpoint for millions of customers in Asia. India for example has around 150million people (minimum... max range is around 300mn) whose first language is english...and there is an absolute shortage of books...because of import headaches and high cost of international shipping from amazon etc. Now add China, Indonesia, Malaysia, Singapore, Aus, NZ to this...
A third opportunity, is the case of University reading material is even bigger... Students dont have to fight for limited books in the Uni library...(am talking about Unis outside the US). Formats are an issue..but am sure technology will solve it.
I feel Amazon should also embark on digitization of Uni rsearch books, thesis, papers, journals etc... and compete with Google in this regard... Amazon has more at stake..
"Currently companies like Amazon lose about $2 for every e-book (we discuss this below). So, if it sells one million e-books the company loses about $20 million. "
Wrong figure computed: 2 X 1milliion = 2 millions, NOT 20 millions.
Rumors are that Apple is in talks with publishers at this very moment about expanding its iTunes
(which is quickly becoming a misnomer) site to enable the distribution of ebooks. Unlike the music industry, the publishing industry is intent on establishing a favorable commercial model that allows them to earn adequate returns on their principal competitive activities (i.e., finding and nurturing authors, packaging, promoting and marketing books).
The manufacturing, stocking and delivery of books has long been a money-losing activity for the publishers and one that they will be pleased to leave behind.
A question: why does anyone believe that everybody except authors will make more money from digital distribution than they have from printed books? Won't the entire publishing pyramid still be balanced upside down on the author's output?
However, there's a major flaw in the analysis with regard to the sample P&L and the supposed equivalence of publisher margins.
First off, there's a category error in the P&L analysis. People get paid in dollars, not in percentages. Making less money is making less money. If a book delivers half the profit, the publisher has to either publish twice as many books that sell just as many copies, or shrink to meet the new market size. Imagine that you were given a choice of two meals, each with the exact same ratio of protein, fat, and carbohydrates, and the exact same vitamins and mineral in proportion to their size. One of the meal plans delivers 2000 calories, and the other 1000. Choose the second, and you will definitely lose weight.
However, there's an error in the P&L that partially offsets the problem, in that you apply the same overhead to both columns, while claiming that it's 15% of net revenue. It should be $54,000 for the second column, not $118,125. This difference will in fact more than double the net profit margin of the ebook column.
But that doesn't help, since if the book is contributing less than half as much to overhead, its greater net profit is washed out by its much smaller contribution to overhead.
If you combine the profit plus contribution to overhead from both columns, it comes out to $228,250 for the print book, and $169,250 for the ebook. The publisher (and the author) both end up making less.
The real answer is to find the price that delivers the best combination of increased unit sales and decreased cost, that maximizes both revenue (and royalties) and profit.
The biggest problem with Amazon's heavy handed approach is that they are the only one doing the price experimentation. By trying to corner the market, they are precluding the kind of competitive price experimentation that the ebook market needs to find the *right* price.
I do think that they are doing a good thing by pushing the industry towards lower prices - lower prices often (but not always) do spur an increase in demand. But the way they are doing it, especially with regard to the secrecy that surrounds all their dealings (publishers are forbidden to share any sales figures) means that it will take much longer before the industry gets engaged with the question in the right way.
Or not. On the iPhone, where books are sold as apps, price experimentation is common, and the market is learning fast.
Thanks for your reply. We should have been more clear in the table. While overhead typically accounts for about 15% of net revenue for a print release we assumed it stayed the same for an e-book release or some combination thereof since it typically is made up of admin and overhead expenses.
So in our analysis we assume they remain the same.
Not sure what you mean by the category error. Author royalties are paid based off of the retail price - about 10% of retail.
Rory
I am wondering:
1. What financial value have you attributed to the political stand-off between Amazon and publishers concerning the pricing of digital editions, and to that, does your cost analysis provide any insight into which party will be the first to buckle?
2. How and where have you factored digital piracy into your financial modelling?
3. Does you modelling yet predict ebook price equilibrium?
Thanks for your response.
1) Not sure what you mean by the financial value of a political standoff, but we followed up on this with a report on how these talks are progressing. You can read it here: http://www.tbiresearch.com/talks-between-amazon-and-publishers-going-nowhere-2009-11
2) We have not factored digital piracy into this analysis, but you bring up a good point that this is a risk.
3) Can you clarify what you mean by "e-book price equilibrium"?
Rory
I'm not sure I agree with your conclusion that the book publishers will survive the transition however. In the good old days, publishers acquired books (as talent scouts); edited manuscripts; marketed and distributed, navigating a complex system of national and local booksellers. These days they definitely still acquire, but as their business has been slammed, they do less and less true editing and, except for their "big books" of the season, virtually no marketing. The rapid move to digital distribution—where they really do nothing but attempt to bolster prices—might be the final nail in the coffin. Unless they quickly restructure around talent acquisition, editing and marketing, I don't see how they can last.
It's no surprise that John Tayman, Tina Brown and others see a huge opportunity here for a new kind of "light" publishing house that mainly acquires, edits and markets text—hopefully ensuring that the content creators receive healthy remuneration. (Which is, of course, all I care about.)
I'm rather sick of the idea that it's all the publishers' fault for the price of ebooks. Publishers have alway had a low profit margin, around 6% is the last figure I've seen, and they can't cut their expenses in the way manufacturers do by having all their books written in China or their shipping all their editorial work there, either. Nor are books the vast sellers that music is. Even a CD for a major record brand that does poorly probably outsells most NYT bestsellers. Even increasing sales of books with lower prices simply won't improve profit that much.
Meanwhile, some distributors charge, per title, for translation for the various formats then take 65% or more of the profit off the top for simply offering space in a server.
Compare this to the paper book selling model. The distributor makes 10% per book. The retailer makes 40%. Combined that means that 50% of the cost is in getting the book to the reader. (Figures from http://ireaderreview.com/2009/05/03/book-cost-analysis-cost-of-physical-book-publishing/)
The ebook distributor doesn't have to warehouse the ebook, pay for warehouse employees, and shipping, etc., and they take more off the top than those who handle paper books do. Something is seriously wrong here.
To make a profit after that huge hunk of profit is taken off the top by the distributor, a publisher must increase the price of his product.
The next time you want to talk about ebook prices being high, don't blame the publisher.
1. On your analysis, have you projected the total value of losses Amazon will wear in attempting to establish a US$10 price point for ebooks?
2. In assuming a 1:1 transfer of physical edition sales to digital editions without factoring piracy immediately impacts your top line analysis. I suggest it's a risk that should have a financial value attributed in your calculations.
3. What is the price at which ebook supply/demand will be roughly in equilibrium? $10 as Amazon believes? More? Less?
I wonder also, on the ebook side, why the same costs for galleys? Why not send digital galleys at a fraction of the price? (Disclaimer: Our business, NetGalley, does just that.)
Second, digitizing a typical text book costs about $350. Add some additional factors and maybe it costs $500, not $5,000. Third, at this sale level in hardcover, the author would be getting closer to 13% and on the digital side currently authors get about 25% of net receipts.
Fourth, if this is a medium sized house with an outside disrtibutor, the rate is closer to 23%. If it is a major house, the rate is zero.
Fifth, overhead is much higher than 15%. But on the digital side, overhead would be less than half of the print side due to no warehouse, no shipping, no return processing, no order entry, a much reduced A/R and A/P as well as accounting an royalties.
Sixth, you haven't figured in the trade paper and mass market profits on the print side and an equal amount of sales on the digital side.
So, what's really fair? What's fair is the retailer gets a third, the author get's a third and the house get's the last third.
Also, today, 100,000 hardcover copies is a major bestseller. You really have to look at the real world at about 25,000 copies in the commercial world and more like 2,500 copies in the non-profit world.
Best,
Jerry
In addition, we used 100,000 as a round number not as any indication of what a typical book sells.