To Beat Apple, Amazon Needs to Let Publishers Win

With Apple (Nasdaq: AAPL  ) and Amazon.com (Nasdaq: AMZN  ) battling to gain access to as much content as possible for their respective e-reader platforms, you can count on publishers such as McGraw-Hill (NYSE: MHP  ) and Pearson (NYSE: PSO  ) having the upper hand in their negotiations with both companies. But for Amazon, that might be a blessing in disguise.

Amazon can't let publishers walk
The New York Times recently reported that Amazon, while smarting from the concessions it made to Macmillan over the pricing of its e-books on the Kindle, is still trying to maintain a measure of control over this young industry's business model. While Amazon has agreed to let Macmillan and a handful of other publishing giants adopt an "agency model" for their content sales, in which the publisher sets e-book prices and Amazon takes a 30% cut, Amazon is still pressuring other publishers to stick with a "wholesale model," in which Amazon buys "copies" of e-books at a set price, and then decides at what price to sell them to consumers.

I'm sure there will be a lot of heated rhetoric from both sides in the coming months, but when the dust settles, I think you can count on most publishers getting to use the agency model that they seem to prefer, and which Apple has given its blessing to. With the iPad about to hit the scene, and e-readers from Sony (NYSE: SNE  ) and Barnes & Noble (NYSE: BKS  ) already putting a bit of competitive pressure on the Kindle, Amazon simply can't afford to alienate its content partners by dictating the industry's business model to them.

In some ways, this squabble brings to mind the sweetheart deals that content providers were able to strike with Sirius (Nasdaq: SIRI  ) and XM Satellite Radio back when those two companies were fighting tooth and nail for control of the satellite radio market. And while Sirius and XM were able to regain some negotiating leverage by merging, I'm pretty sure that nothing of the sort will happen between Apple and Amazon.

A new business model for the Kindle
But while the content deals that Sirius and XM struck were financially crippling for those companies, Amazon's acceptance of an agency model might have the opposite effect. Under the wholesale model, the company actually loses money on the sale of many best-sellers, which it often sells to Kindle users below cost in order to stimulate e-book demand. While under the agency model, Amazon is guaranteed to make a healthy gross profit on every e-book sale. And with a recent Cowen & Co. report estimating that Kindle content sales will grow from $160 million in 2009 to nearly $3 billion in 2015, those profits could quickly add up.

Amazon's squabbles with book publishers highlight the flawed nature of the Kindle's current business model. Whereas game console manufacturers and wireless carriers often take losses on hardware sales to consumers, and make it up by profitably selling content and services, Amazon is trying to do the exact opposite. Last April, iSuppli estimated that the current-generation Kindle, which Amazon now sells for $259, costs only $185 to manufacture -- and the tech sector being what it is, it wouldn't surprise me if manufacturing costs have dropped by more than 20% since then.

Amazon's strategy has the effect of not only alienating publishers who think that getting consumers accustomed to artificially low book prices will hurt their business long term, but also inflating Kindle prices to a point where many readers deem them to be too expensive. A Forrester Research survey from September, in which over half of all frequent book readers with household incomes above $75,000 said that they would only buy an e-reader at a price of $98 or less, bears this out; $98 is a far cry from the Kindle's selling price, never mind the $489 charged for the larger Kindle DX, whose 9.7" display matches the iPad's in size.

The Kindle clearly isn't going to compete against the iPad based on functionality. Its main selling points will have to be a superior reading experience thanks to its E Ink display, and a lower price tag. The sooner Amazon changes its business model to take advantage of the latter strength, the more successful it will be in weathering Apple's challenge.

Think Amazon should hold its ground against book publishers? Or that the Kindle has no chance against the iPad? Feel free to comment below.

 Fool contributor Eric Jhonsa has no position in any of the companies mentioned. Apple and Amazon.com are Motley Fool Stock Advisor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy looks pretty nice on the iPad -- it got an advanced edition.


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