Who Will Win the Tug-of-War Between Amazon and Book Publishers?

Source: Amazon

The Independent in the U.K. reported last week that an unnamed publisher accused Amazon (NASDAQ: AMZN  ) of 'bullying' and 'warned that the company was destroying the industry.' Amazon plans to own the right to publish books (if publishers run out of supplies) and wants publishers to match Amazon's pricing terms at competing distributors. This has not gone down well with book publishers.

At the same time, industry statistics show that the growth of e-books has slowed considerably in 2013, based on data released by the Association of American Publishers, or AAP. The number of adult trade e-books sold in 2013 increased by a mere 3.8% in 2013, in contrast with a 41% growth rate for e-books in 2012.

What implications does this have for Amazon and peers such as Barnes & Noble (NYSE: BKS  ) and Scholastic Corporation (NASDAQ: SCHL  ) ?

Leveraging bargaining power with suppliers
It's estimated that U.S. book sales totaled $15.05 billion in 2013, with Amazon accounting for approximately a third of industry sales. Within the e-books category, Amazon is even more dominant, boasting 65% market share. Based on research by Publishers Lunch, book publishers enjoy net profit margins of approximately 10% on average. Amazon obviously sees 'money on the table' that it can capture in terms of enhanced profit margins at the expense of its suppliers (book publishers).

However, that could potentially be a bad mistake. If book publishers find it difficult to earn decent margins in their businesses, they will have motivation to seek alternative sales channels. In addition, competing e-book sellers and independent publishing platforms have been on the rise.

For example, Kobo, owned by Japan's Rakuten, has been gaining traction as an online sales platform for e-books outside of the U.S. Kobo is the market leader for e-readers in Japan, Australia and New Zealand. Furthermore, Smashwords, which calls itself the 'world's largest indie ebook distributor', added 25,000 authors in 2013 and took its library of titles to over 270,000. With Smashwords paying 85% of sales proceeds to its authors, many indie publishers are jumping on board.

Source: Barnes & Noble 

Going back to physical roots
In June 2014, Barnes & Noble announced that it will separate its Barnes & Noble Retail and NOOK Media businesses into two different listed companies, and expects to complete this by the end of the first quarter of 2014. This decision is hardly surprising considering the financial results of the two divisions.

While the Barnes & Noble retail division saw a 6% decline in sales for the trailing-twelve-month period, the NOOK media business experienced a 35% drop in sales over the same period. In addition, the Barnes & Noble retail business registered a decent 8.2% EBITDA margin for the past 52-week period, while the NOOK media business continued to report losses.

Investors can also draw insights from the slowing growth momentum of e-books and Amazon's continued dominance of the e-book market.

Firstly, there could be a natural ceiling on the maximum penetration rate of e-books; some consumers still prefer the physical bookstore experience. In fact, Barnes & Noble mentioned in its latest results announcement that it will put initiatives in place to improve the sales trends of the Barnes & Noble retail business.

Secondly, Amazon enjoys strong network effects because it holds the largest market share in the e-book market. Consumers who own Amazon's Kindles are more likely to buy e-books from Amazon, and not Barnes & Noble or Nook, because of the differences in e-book format (*.mobi versus *.epub).

Therefore, Barnes & Noble faces an uphill battle in trying to replace Amazon as the king of e-books. Instead, it makes sense for Barnes & Noble to focus on its strengths in physical stores, as indicated by its decision to spin-off the Nook business.

One publisher that relies less on Amazon
Unlike most other trade book publishers, Scholastic, the largest children's books publisher in the world, has little dependence on book sales from Amazon and bricks & mortar stores operated by big boys like Barnes & Noble. For the nine months ended Feb. 28, 2014, the retail channel accounted for only 22% of Scholastic's year-to-date revenue, with the remaining sales contributed by school-based book clubs and book fairs.

The bulk of Scholastic's books are either sold via book clubs where teachers aggregate the students' orders or at week-long book fairs where parents accompany their children in the book browsing experience.

The numbers validate Scholastic's success and dominance in the book club and book fair sales channels. Approximately 62% of all elementary school teachers who received promotional materials from Scholastic in fiscal 2013 participated in the book clubs; nine in 10 schools which organized a Scholastic Book Fair in fiscal 2012 did a follow-up in fiscal 2013.

Furthermore, the penetration rate of e-books is much lower in the children's books category. E-books represented only 11% of children's book sales in 2013, compared to a 27% share for adult e-books during the same period. As a result, Scholastic is less susceptible to unfavorable contract pricing terms from guys like Amazon.

Foolish final thoughts
In the ongoing tug-of-war between Amazon and other publishers, I fear that Amazon will lose in the long run by alienating more book publishers with its tough stance. Instead I favor Barnes & Noble and Scholastic as my top picks in the books market. Barnes & Noble should benefit from the 'saturated' e-book market; Scholastic has greater bargaining power with distributors and retailers because of its unique sales channels.

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