Is Amazon shifting its Core Value Proposition from price to speed?

Two weeks ago, Amazon announced that it intends to build and open its first distribution center in Illinois. Currently, Amazon fulfills many orders to Illinois, including Chicago, from a distribution center in Indiana and others further away. Having a distribution center in Illinois would enable Amazon to provide next-day or even same-day delivery to Chicago customers. However, Amazon also agreed to collect sales tax from Illinois residents as a condition of opening a local distribution center; that effectively represents a 6.25% to 9.75% price increase, depending on the customer, municipality and product category.

Amazon's decision to open a distribution center near Chicago aligns with its recent decisions to open centers near other big cities, including Boston, Charlotte, Los Angeles, Milwaukee and New York Metro (all of which have been announced since September,) and collect sales taxes in those states. In addition, earlier today, Amazon announced an agreement with Hachette to sell its print books and eBooks, after months of public squabbling. The terms of the deal between the two companies are confidential, but both companies have confirmed that Hachette will have the ability to set its own prices for eBooks. That's in line with the agreement that Amazon reached with Simon & Schuster last month, which also gave that publisher the right to set eBook prices.

One other data point, this one anecdotal, is that I recently purchased some food products from Amazon. The company is moving aggressively into grocery sales and delivery with its AmazonFresh service in San Francisco, metro Los Angeles and Seattle. For customers in other areas, Amazon recently launched a service called Amazon Prime Pantry, which enables Amazon Prime members to order a limited selection of non-perishable items for a flat fee of $5.99 with 3-4 business day delivery. That also represents a price increase for Prime customers, who pay nothing for 2-day delivery of other products. I ordered one of the grocery products that didn't require Prime Pantry shipping, but I paid $17.99 for a product that I subsequently purchased for $4.79 from a local supermarket. You can safely assume that much of the price difference went for the "free" shipping.

So, we have multiple points of evidence that Amazon is willing to let its effective consumer prices increase. If that's true, it's a dramatic shift in the company's strategy, which has been to underprice its competition, much like Walmart's now-abandoned "Always the Low Price" strategy. However, if Amazon is willing to no longer be the low-price vendor, what's the tradeoff? Amazon's recent flurry of announcements suggests that it's speed of delivery, and possibly, the ability to provide same-day grocery delivery to the largest metropolitan markets. Amazon is signalling that it intends to offer next-day delivery to perhaps 90% of the continental U.S., and same-day delivery in as many as the 50 largest cities.

I discussed my hypothesis with one of my former clients, and he made a very important point: Anyone can offer the lowest price as long as they're willing to take losses; price is never an effective long-term differentiator. On the other hand, same-day delivery is a powerful differentiator, because it requires massive capital and labor investments that few competitors are willing or able to make. Amazon is making the investments to give it a long-term competitive advantage over not only brick & mortar retailers, but also quasi-competitors like Google that don't have logistics as a core competency. In summary, Amazon is taking some of the money that it's been using to subsidize below-cost sales to consumers and shifting it to capital investments in and labor costs for distribution centers.

Netflix jumps into the movie production business

Many people in the movie and television businesses have believed that given Netflix's success with original television series, it was only a matter of time before the company would begin producing movies. Those beliefs have been confirmed in a big way: Last week, Netflix announced that it has partnered with The Weinstein Company and IMAX to produce a sequel to "Crouching Tiger, Hidden Dragon" called "Crouching Tiger, Hidden Dragon: The Green Legend," and today, Netflix announced a four-picture production deal with Adam Sandler and his Happy Madison production company.

The terms of the deals aren't public knowledge, but some of the plans have been revealed: In the "Green Legend" deal, IMAX was brought in to distribute the film to IMAX theaters. IMAX develops the cameras, projectors, screens and processing software for its various formats, but its theaters are actually owned and operated by other parties, and a number of those parties in the U.S. are very unhappy. The four largest theater circuits in the U.S., Regal, AMC, Carmike and Cinemark, have said that they won't show the sequel. Cineplex in Canada and Cineworld in Europe have also refused to show it. That doesn't completely eliminate IMAX as a viable outlet for the movie, because there are many IMAX theaters operated by museums and public institutions, and smaller theater chains with IMAX theaters may decide to show it.

It's not clear whether Netflix changed its strategy overnight or whether it had already expected the theater chains to react the way they did, but in today's announcement, Netflix said that none of the four movies to be produced by Adam Sandler will be shown in theaters. In addition, they also made clear that none of the movies that Adam Sandler or Happy Madison are already committed to for other producers or distributors are included in the four films.

No one should be surprised that big theater chains won't show Netflix's films--they've pushed back against major studio day-and-date Video-on-Demand (VOD) tests (the movie is released in theaters and on VOD on the same day,) starting with Universal's "Tower Heist" in 2011. By and large, the big studios have backed off of day-and-date VOD, but they're aggressively testing shorter windows between some movies' theatrical release and their availability on VOD. Smaller independent studios such as Magnolia Pictures have adopted day-and-date VOD releases. 2929, parent company of Magnolia, also owns Landmark Theaters, which has 50 theaters in 21 markets, so Magnolia is guaranteed of theatrical distribution in many major cities, no matter what other theater chains decide.

It's likely that Netflix is structuring its movie production deals with the expectation of no domestic theatrical revenues. Whatever theatrical distribution Netflix gets will be promotional, not a significant revenue generator. Over time, if Netflix's movies prove very popular, the big theater chains may be forced to start bidding for the right to show them in their markets. However, for now, the safest move for Netflix is to budget movie production in line with VOD revenues.

Earlier today, The Verge reported on Adam Sandler's deal with Netflix, and wrote:

Under the deal, Sandler removes the burden of risk. Netflix will solely fund the films, taking full responsibility for providing investment — and securing additional investment — off Sandler's Happy Madison Productions. Though Netflix will be the sole financier, the films will still have their $40 million to $80 million budgets. Sandler's payments are a large chunk of his films' budgets. He reportedly receives $15 million and over per film as an actor, and can make an additional $5 million as the producer, which explains how Grown Ups 2, a comedy with a handful of special effects, reportedly cost $80 million. On top of all that cash, it's likely Sandler and his production company will make an additional, undisclosed lump sum of money simply by signing the deal. Netflix decline to provide comment to The New York Times on the specifics of the agreement.

It's inconceivable to me that they would agree to pay production costs anywhere near $40 to $80 million or $15 million per picture for Sandler's acting, especially since Sandler's last several movies have bombed in the U.S. Netflix probably has a "back-end" deal with Sandler that pays him additional compensation if the movies reach or exceed performance targets, such as the number or percentage of subscribers who watch them. As the Verge article points out, Sandler laces his films with product placements, which can defray some production costs, or put money into his pocket. That might be enough to enable Sandler to, say, produce a film for $25 million, get $10 million in product placement funds, deliver the movie to Netflix for $20 million and put $5 million before tax into his pocket.

Netflix may be the first VOD company that will underwrite major motion pictures for its own distribution, but it almost certainly won't be the last. I expect Amazon to follow suit, and possibly Redbox. (Update, October 4, 2014: TechCrunch reported today that Redbox will shut down its streaming service on Tuesday, October 7.  That makes it much less likely that the company will get into original production.) SoftBank, the owner of Sprint in the U.S, SoftBank Mobile in Japan and the single largest shareholder of China's Alibaba, just invested $250 million for 10% of Legendary Entertainment, with options to invest a total of $750 million more between now and the end of 2018. Legendary, whose movies are co-financed, marketed and distributed by Universal, could produce movies for SoftBank and Alibaba should either company decide to distribute its own original titles.

An approach for funding independent films...via Netflix

The business and process of funding, making and distributing motion pictures is going through changes at least as wrenching as those caused by the rise of television after the Second World War:

• Technology has changed everything from movie production to theater projection. You can buy a camera that will give you images that stand up quite nicely in a movie theater for the same price as a big screen TV from a few years ago. Editing and color correction that once required hundreds of thousands of dollars of equipment can now be done on a PC that you buy from Amazon. The only company that still makes motion picture film is Kodak, and they're still in the business only because the big U.S. motion picture distributors agreed to buy a minimum quantity of film per year. Film is almost completely phased out as a delivery medium for theaters; it's been replaced by digital projection.
• International revenues from movies are starting to exceed domestic revenues. In particular, China has become the single biggest and most important international movie market. Dialogue-heavy movies tend not to do well in China and some other markets, so the major studios have shifted their emphasis to expensive, special effects-heavy movies like Marvel's superhero series.
• The shift in emphasis from plot-driven to action-driven titles has dramatically decreased the amount of funding available for smaller, more literate movies that were once the "bread and butter" of the major studios. There are still a few producers who make these kinds of movies (Megan Ellison's Annapurna Pictures is a good example,) but by and large, the major studios acquire these titles for their prestige and award-winning possibilities, not with the expectation that they'll make much money.
• Most of the major studios have shut down their independent divisions, or as in the case of Universal's Focus Features, have radically reorganized them to fit better with the studios' new international emphasis.
• Streaming and Video-on-Demand have largely supplanted, although not totally replaced, DVDs and Blu-Ray discs for home video distribution. The studio revenues from streaming and VOD are significantly less than what they made from physical media, but consumer preferences (a shift back to movie rental after years of purchasing DVDs) have forced the studios to adapt.

All of this means that if you make small, independent movies, it's getting harder and harder to get them funded and onto movie screens. Note that I didn't say "get them distributed." It's easier than ever to get independent movies into consumers' homes, with Netflix being by far the biggest outlet, while Amazon, Apple iTunes, Crackle, Epix, Google Play, Hulu Plus, Redbox Instant, Sony Unlimited Video, VHX, Vudu, Xbox Video, Yekra, YouTube Movies and others also stream movies to consumers. Some of these distributors selectively license titles, while others are open to anyone.

For independent producers, the problem isn't finding distribution--it's making money. Let's take a movie that costs $1 million to produce (including post-production.) You send the movie to Netflix, but they offer you only $1,300 for the rights plus a bonus based on the number of times your movie is watched. Apple's iTunes and Amazon won't pay anything upfront, but iTunes will sell your movie for a 30% commission, and Amazon will take a 15% commission. Unless your movie is very popular, none of the three will do any promotion for you, and the promotion they will do is limited to preferred placement of your movie on their websites and apps. That means that you've got to budget a significant amount of money for promotion, which may include:

• Submissions to film festivals
• "Four-walling" (renting) theaters to get a theatrical release and reviews
• A social media outreach campaign
• If you happen to have a well-known actor or two in the cast, queries to radio stations, local and national daytime news shows, daytime and nighttime talk shows, syndicated daily entertainment shows and celebrity/entertainment magazines.

There's no single rule of thumb that says how much you should budget for your promotional campaign, but for a $1 million movie, the very least that you should expect to spend is $100,000. If you've got a lot of well-known actors and a strong pitch, you could end up spending $1 million or even more (but in this case that's good news, because it means that you're getting lots of coverage.)

So, let's say that all-in, you've got $1.25 million in the movie and promotion. You've got to get back at least that $1.25 million just to break even, and you and your investors would certainly like more. Let's take a simple case: You price the movie at $10, and you sell 60% of your total sales through Apple and the remaining 40% through Amazon. To break even, you need to sell a little under 165,000 copies. 165,000 is a high but not completely unreasonable number if your promotional campaign is successful. However, you have to raise the $1.25 million at the very beginning of the project in the hope that you can sell 165,000 or more copies at the end.

There may be another model, at least for some distributors and filmmakers. Netflix has built a very successful business using an "all you can eat" subscription model. With its recent price hike, Netflix charges $8.99 per month in the U.S. The company has 48 million subscribers worldwide as of their last financial quarter. The cost of the infrastructure and bandwidth to serve those customers is factored into the $8.99 price.

Netflix could create a second tier--call it "Netflix Premiere"--that would offer exclusive new movies 30 to 90 days before they're available through any other outlet, for an additional $5/month. If 10% of Netflix's subscribers sign up for the Premiere service, that would be an extra $24 million of gross revenue each month--largely incremental revenue, because the infrastructure and bandwidth are already paid for. A hefty portion of that $24 million could be used to fund new independent films. If Netflix reserved 70% of the revenue for film production, that would result in $16.8 million that the company could use to fund films each month. To a studio, $16.8 million is chump change, but to independent filmmakers, that could represent two or more complete films.

Netflix could distribute the money in two ways:

• It could be an investor in a film (for example, funding half the film while other investors and distributors fund the remaining 50%.)
• It could fund the entire cost of the film, and own the film outright when it's complete.

Netflix would have the exclusive first distribution window in either case, as a condition of the producers accepting its funding. It's very unlikely that any film funded by Netflix would get domestic theatrical distribution because of the first-showing restriction, but there's a good chance that at least some of the films would be picked up by other streaming and VOD distributors. There might be some opportunities for hotel and airline distribution as well, not to mention international distribution in markets where Netflix either doesn't do business or doesn't exercise its first-showing right.

For the first year or two, Netflix would have to underwrite the Premiere service, acquiring and showing movies until its subscriber base covers its costs. After that, however, the Premiere program could underwrite at least a dozen independent films a year, and potentially many more. This approach certainly won't fix the independent film funding problem, but it will put a dent in it, and if it's successful, it'll encourage other companies to launch similar programs.

What's really behind the decline in brick & mortar bookstores?

This morning, Bloomberg Television covered yesterday's resignation of Barnes & Noble CEO William Lynch and subsequent management reorganization. Bloomberg showed a bar graph of the decline in the number of bookstores in the U.S., and said that Amazon was responsible for the decline. Yes, Amazon played a part, but there are other reasons that are at least as important:

• The decline in the number of bookstores began in the 1980s, when Barnes & Noble's and Borders's superstores decimated independent booksellers.
• U.S. book sales started declining years before the 2007 introduction of Amazon's Kindle and the 2008 Great Recession. People are simply spending less time reading books.
• eBooks from Amazon and other retailers have cannibalized sales of print books. In other words, eBook sales haven't increased total U.S. book sales revenues--they've only slowed the rate of decline.

So, you've got three factors responsible for the decline in the number of bookstores:

1. Price competition, which was used by Barnes & Noble and Borders to kill off a large part of the U.S. bookstore industry even before Amazon was founded in 1995 (but which Amazon has certainly used to its advantage.)
2. Declining book sales, which pressures all booksellers but puts the most pressure on retailers that don't have other product lines to fall back on for revenue.
3. eBooks, which generally aren't sold in brick & mortar bookstores (although they could be.)

The New York Times takes yet another dump on Amazon

The New York Times' David Streitfeld is at it again. Last FridayThursday, the Times published an article written by Streitfeld that charges that Amazon is using its "monopoly" on book sales to increase prices. The bottom line was that Streitfeld claimed, using completely anecdotal evidence, that Amazon is increasing prices on some academic and small-press print titles; eBook prices are unaffected. How many titles are affected, and the average price increase, either in dollars or percentage, Streitfeld didn't say. He lists price changes for less than ten out of several million titles.

Even if Streitfeld is correct, and Amazon is generally increasing prices on academic and small-press print books, there are at least two reasons why they'd do so that have absolutely nothing to do with abuse of Amazon's market share:

1. The company is compensating for the costs of stocking slower-moving titles. Unlike eBooks, print books take up warehouse space, and have to be physically picked from shelves, packaged and shipped. A slow-selling title takes up space that could be used for a faster-selling title or a completely different type of merchandise. That space has a cost, and the cost is allocated on a per-copy-sold basis, whether or not Amazon passes it on to consumers. Amazon may simply be passing that cost onto consumers in the form of lower discounts.
2. For the reason stated above, Amazon may be considering not stocking some of these low-selling titles and instead buying them from distributors as orders are received, which would increase its costs. (This was the way that Amazon first started business.) By raising prices now, Amazon can gauge the impact on demand and change course if needed.

One other point: If you prefer not to buy an academic or small-press title from Amazon, you can always get it from Barnes & Noble or an independent bookseller. If they don't have it in stock, they can order it for you from Ingram, Baker & Taylor or an academic distributor. However, I can almost guarantee you that you'll pay the publisher's list price.

Now, just three days laterThe following day, Streitfeld and the Times came back with another article that makes an even more ridiculous allegation: Amazon's pricing model makes it impossible for customers to determine the "true" price of its books. He says that book prices will be "determined by demand and perhaps by whim." I thought that we lived in an free economy where supply and demand determines prices, and that the law of demand is a good thing. Apparently, according to Mr. Streitfeld, I'm wrong. Consumers should accept whatever prices are set by vendors and buy their goods and services, no matter what the price. Silly me.

Streitfeld also claims that Amazon's pricing policies are now "a radioactive topic with some vendors." For that claim, he uses two publishers as examples: The University of Chicago, which refused to answer because its pricing policies are proprietary, and Melville House, which has had a long and very public adversarial relationship with Amazon. Streitfeld suggests that the University of Chicago Press's refusal to discuss the subject is because of fear of retaliation, but it could equally be due to the fact that most companies that sell through distribution don't discuss their pricing policies. For example, Apple is happy to discuss the retail prices for its devices, but ask it how much it charges Best Buy for those products, Best Buy's retail markup on their wholesale cost, or its reaction to Best Buy's pricing policies, and all you'll get is a stony silence. In addition, discussing pricing can be seen as signalling, which can be of benefit to competitors and can also be used to fix prices. But, apparently, Mr. Streitfeld didn't think that those alternate explanations were plausible.

Let's go back to Streitfeld's original argument, that consumers are unable to determine the "true" price of books sold by Amazon. In my experience, Amazon always shows the suggested list price set by publishers for both print books and eBooks, as well as its price and the discount (if any.) Shipping costs are clearly visible when you place the order, and can be adjusted based on speed of service. (Amazon Prime members generally pay nothing for shipping if they're willing to accept two business day service.) Even sales taxes are fairly simple from the consumer's point of view: If you live in a state where Amazon collects sales tax, Amazon will calculate and add the tax to the order. If Amazon doesn't collect taxes in your state, they don't add them to your bill, and it's up to you to determine whether or not your state requires you to pay the sales tax separately. How does any of this obscure the "true" price of books? I know what the publisher has set as its suggested list price, what Amazon charges, the discount off the list price, the shipping cost and (in some states) the sales tax.

I'm going to use two terms that reporters and editors don't like to see, especially in relationship to themselves: In my opinion, David Streitfeld is a hack. There is absolutely no way to read his articles as anything other than what they are: Hatchet jobs on Amazon. Even when he does manage to speak to someone at Amazon, he turns their response into a reinforcement of his argument. I'm not even sure what Mr. Streitfeld's job is at the New York Times. Is he a reporter? If he is, his articles fail any reasonable test of objectivity, and should never make it to print. Is he the Times' columnist in charge of dumping on Amazon? If so, he's doing a great job--but his column should be on the editorial page or in the Op-Ed section, not in an area of the paper where readers expect hard news.

Hulu: Here we go again

You may recall that in June of last year, Hulu put itself up for sale, in part because of strategic disagreements between joint venture partners Disney and News Corp. (NBCUniversal, the third partner in Hulu, is prevented from taking an active management role as part of the terms of Comcast's deal to acquire NBCUniversal.) In October, Hulu's owners cancelled the sale because of "disappointingly low offers." That didn't solve the strategic differences between the partners, however. Today, All Things Digital reported that Guggenheim Partners, Yahoo and Amazon, possibly among others, are considering making offers to acquire Hulu--even though the partners haven't announced that it's for sale. The smell of blood in the water is just too strong.

I'll keep this brief: The reason that the offers for Hulu were disappointingly low last year was that the partners were unwilling to offer Hulu's buyers long-term access to their content. Exactly the same issue will arise if Hulu is put up for sale again. Hulu is effectively worthless without its content. With the exception of Guggenheim Partners, all of the potential bidders already have their own video infrastructure, players and apps. There was a time when Hulu's player was head and shoulders above anyone else's, but that's simply not the case anymore.

The purchase price of Hulu will have to include three to five years' of the partners' content, along with assurances that their content will continue to be available after that time at a price that Hulu's buyer can afford. If the content isn't there, any potential deal will fall apart.

This could turn into the Mergers & Acquisitions equivalent of Lucy pulling the football away from Charlie Brown at the last minute every year. Fox Sports could broadcast "Who Wants To Buy Hulu?"--just put Cleatus the robot into an Armani pinstripe suit, give the play-by-play to Fox Business, and you're all set. For now, all we can do is sit back and watch the action.

ROI: The Innovation Killer

Why is it that established companies seem to have so much trouble with responding to (or developing their own) innovative products and services? Why have so many companies, both big and small, seemingly given up on solving big problems, and are instead happy to make incremental improvements to existing products? One big reason, in my opinion, is the focus in American business on Return on Investment, or ROI. Return on Investment is a measure of how much money, measured as a percentage, a given investment will return over time. The money comes from cost savings, increased sales, or both. Companies evaluate investments against a target Rate of Return that they set. If a proposed investment is expected to meet or exceed the company's Rate of Return, the company makes the investment; otherwise, it doesn't.

It's fairly straightforward to calculate the expected ROI for a new product or capital investment that's very similar to products that you (or others) already sell, or capital investments that you (or others) have already made. If you're Proctor & Gamble and you're considering introducing a new flavor of Crest toothpaste, you have a huge database of historical information about how much it cost to develop new toothpaste flavors, put them into production and market them, and how well they sold over time. If you're Amazon and you're considering building three new warehouses, you know with great accuracy how much it cost to build similar warehouses in the past and how long it took to break even on those investments.

On the other hand, consider what IBM had to deal with when it decided to launch its own personal computer in 1981. Its experience with building mainframe computers was useless in projecting the costs of developing, manufacturing and marketing a personal computer. The personal computers that had sold to date were intended for hobbyists, which was a very small market. IBM had very little information with which to calculate the ROI for its personal computer.

The more innovative a product is, the more it represents a discontinuity (a break from previous technologies, goods and services,) the less reliable are its Return on Investment calculations. To reduce risk, most companies will assign such investments a relatively low ROI. Then, when they compare the ROI with the company's target Rate of Return, they'll kill the project if the ROI is below the Rate of Return. Company managers can guarantee that the project will be killed by deliberately putting conditions on the ROI calculation that will force it to be below the Rate of Return.

Big companies innovate by accepting projects that have risky ROI calculations, or by ignoring the ROI analysis altogether. Bell Labs was able to invent the transistor because there was no requirement that John Bardeen, Walter Brattain and William Shockley work on projects that would generate a predictable amount of revenue in a predictable time. Texas Instruments and Fairchild Semiconductor invented the integrated circuit in parallel, not because they knew what the ROI would be, but because they believed that the opportunity would be tremendous. IBM's decision to move ahead with its PC despite the company's ROI requirements led to market leadership for nearly two decades. On the other hand, Xerox's Palo Alto Research Center invented laser printers, Ethernet and graphical user interfaces but ended up seeing its inventions commercialized by others.

Companies that hold every project to a strict Return on Investment calculation are likely to create only incremental improvements to existing products and processes--lots of "singles and doubles." Companies that are willing to ignore ROI in search of a greater goal are the ones that at least have a chance for true innovation--the "home runs" that can define, or redefine, an industry.

Penguin Random House: The Aftermath

Earlier this week, Pearson and Bertelsmann confirmed that they intend to merge Penguin and all of Random House except for its German-language business into a new joint venture, to be named Penguin Random House. (No Random Penguin or Penguin House for us.) Shortly before the deal was announced, word leaked out that News Corp. was considering making an offer to acquire Penguin, but the terms of the Pearson-Bertelsmann deal mean that Pearson can't consider any other offer.

I believe that, three to five years from now, the publishing industry will look much like the recording industry does today, with the Big 6 becoming the Big 3. In fact, it was Bertelsmann's experience in its joint venture with Sony Music that's said by some to be the reason that the company insisted on having a majority interest in its joint venture with Pearson. Its joint venture with Sony was 50:50, and differences in objectives and strategies between the two companies eventually led Bertelsmann to sell its recorded music business to Sony.

If the publishing industry looks like the recording business in a few years, here's a preview of the likely winners and losers:

• Publisher employees: The biggest reason for publisher consolidation is cost reduction. Penguin and Random House, and other consolidating publishers after them, will get rid of redundant distribution facilities and most of the people who work in them. In addition, they'll consolidate cross-imprint functions, such as sales, marketing, copy editing, production and design. That will put a lot of talented professionals on the street, and with fewer big publishers, there will be fewer places for them to look for work.
• Authors: Despite what Penguin and Random House have said, it's inevitable that they, and other consolidating publishers, will reorganize their imprints. Some imprints will be discontinued, and their authors will be moved to other imprints or dropped. The same thing will happen to the editors at the imprints--many will be laid off.
  
  Author acquisition will be dramatically affected. The Big 3 recording companies have all but discontinued their formal A&R (Artists & Repertoire) operations that sent people into the boondocks in order to find new artists. Their equivalents in publishing are acquisitions editors, and many of them will find themselves without jobs. The big publishers will increasingly focus on successful self-publishers as their "farm teams", and will pay big money to poach bestselling authors from each other. For their part, bestselling authors will have less loyalty to publishers, because many of their editors will be gone.
• Retailers: Some industry pundits have speculated that consolidation of the top publishers would give them more clout with retailers such as Amazon and Barnes & Noble. If the recording business is any indicator, they're wrong. Just as with books, the music retailing business consolidated, and highly influential retailers such as Tower Records, Musicland, Wherehouse and Virgin Music are gone (Virgin has closed its U.S. stores but still operates in other countries.) Music retailing in the U.S. is dominated by Apple, and the consolidation of the Big 6 recording companies into the Big 3 has given the surviving record companies little or no additional leverage with Apple or Walmart.
  
  It's unlikely that mergers between the Big 6 publishers will give them any more negotiating power with Amazon, Apple, Barnes & Noble or Kobo. The publishers will continue to depend on the retailers for the vast majority of their revenue, and the U.S. Justice Department will be watching over their shoulders in order to prevent more shenanigans like organized price-fixing.
• Independent Publishers: Independents will actually be helped by publisher consolidation, for several reasons. First, many talented publishing professionals who ordinarily wouldn't have considered working for smaller publishers, or working as freelancers, will become available to independents. Second, some of those professionals will set up their own independent publishing companies. Third, the authors that are shed from the rosters of the consolidating publishers will become available to the independents. Fourth, authors who might have been discovered and developed by the top publishers will instead go to independents. Fifth, with fewer titles coming from the big publishers, retailers will have more shelf space (real or virtual) to devote to independents.
• Self-Publishers: The big publishers will increasingly recruit successful self-publishers to fill their rosters and compensate for the loss of acquisitions editors. The success of the 50 Shades trilogy has eliminated any remaining stigma from self-publishing authors. Big publishers now know that success as a self-publisher is a very strong indicator of marketability--and it eliminates the cost of spending years to develop a promising author.
• Agents: Consolidation of the Big 6 will spell problems for literary agents. They'll have fewer authors on the rosters of the top publishers, and thus, fewer opportunities to earn commissions from big advances and royalty payments. They'll have to devote more of their time to independent publishers, which generally pay lower advances and generate lower royalties for their clients. And, they'll have to compete with other agents to represent successful self-publishers, meaning that they'll have to accept lower commissions.
• Consultants: Publishing consultants who have spent their entire careers in the publishing industry are going to find it hard to adjust to publisher consolidation. Consultants with contracts with two publishers that consolidate into one will have one of their two contracts cancelled, and the surviving contract will be closely scrutinized. (I saw this happen first-hand as the IPTV industry went through massive consolidation starting in 2008.) Publishing consultants will have to shift their focus to independent publishers, which have much smaller budgets than the Big 6.

In short, independent publishers are about the only group that will be a clear winner from publisher consolidation, followed by successful self-publishers. Everyone else will end up either neutral or a loser as a result of consolidation. 

Amazon & Apple: Is their proxy war getting hotter?

Earlier today, according to Reuters, Walmart notified its store managers that the company would no longer carry Amazon's Kindle eReaders and tablets once its existing inventory and committed purchases run out. Walmart confirmed its decision with Reuters, but didn't specify the reason(s). In May, Target announced that it would no longer carry Kindles, and like Walmart, it never made an official public statement about the reason. However, CNN noted that Target had just been authorized by Apple to begin selling iPads, and that it planned to add Apple "mini-stores" within 25 of its locations.

There are two reasons being cited by observers as to why Walmart might have decided to drop Kindles:

1. Amazon may not have offered Walmart a sufficient discount, or
2. Walmart may see Amazon as an increasingly large competitor for general merchandise sales, and doesn't want to support a competitor any longer.

Both of these reasons make sense, and either one of them may be true, but let's sideline that discussion for a bit.

At Publishers Lunch Deluxe, Michael Cader reported on Apple's efforts to get evidence from Amazon for its defense in the government's eBook price-fixing case. According to Cader, Apple has been trying to compel the Justice Department to turn over the transcripts of interviews with 14 Amazon managers and executives. Those interviews weren't taken under oath. The Justice Department argued that the interviews are protected work product, and aren't subject to release. However, Justice has given Apple the names of everyone at Amazon who was interviewed, and said that Apple could take depositions directly from those people. In addition, the Justice Department has released all of its email communications with Amazon and all of the documents and data it received from Amazon during its investigation.

Apparently, Apple took up the Justice Department on its idea, and filed subpoenas to force the 14 Amazon employees to give depositions. Then, last Friday, September 14th, Amazon filed a motion in Seattle Federal court to quash the subpoenas, on the grounds that Amazon isn't a party to the litigation. This week, Apple filed a motion with Judge Denise Cote, who's in charge of all of the U.S. cases related to eBook price-fixing, to move Amazon's motion from Seattle to her court. Judge Cote is now considering Apple's motion.

I don't know that much about the law regarding who can and can't be compelled to provide depositions and discovery documents. What I do know is that if Apple does eventually get the right to enforce its subpoenas, Amazon is going to want to put strict limits in place to prevent any confidential information that's not directly related to the price-fixing case from being revealed to Apple.

That brings me back to the title of this post, and to my first point. Clearly, Apple and Amazon are competing in more areas, and in the U.S., Amazon is currently the only serious competitor to Apple in tablets, based on sales. Apple is widely rumored to be planning to announce a smaller iPad next month. Target dropped Amazon shortly after signing a deal to carry Apple's iPads, and now, a month before the smaller iPad's expected release, Walmart has also dropped Amazon's Kindles. Does that mean that Apple might have made Walmart's getting the small iPad conditional on dropping Amazon? It's certainly possible, but rather than getting into legally murky waters, Apple could have required Walmart to give its products a certain amount and type of display space--a very common condition in retail distribution deals. Walmart would have to get that space from somewhere, and "independently decided" (wink, wink, nudge, nudge) to take it from Amazon. Another perfectly legal option would be if Apple offered Walmart co-op funds if it did certain things (for example, PC manufacturers get reimbursed for part of their advertising costs by Intel if they include that four-note musical theme at the end of their commercials.) These payments amount to a discount--and if Target is already getting them, Walmart would be at a competitive disadvantage if it didn't get them as well.

All of this adds up to "shadows on the wall" suggesting a proxy war between Apple and Amazon:

• Amazon is using the Justice Department as a proxy against Apple to get agency terms and Most Favored Nation clauses terminated, and
• Apple is using Target and Walmart as proxies to hinder Amazon's ability to sell Kindles in stores.

If this "proxy war" model is correct, I'd expect Best Buy to be the next retailer to drop Kindles. Apple has dedicated sales space in most Best Buy stores, and a lot of leverage over the retailer. In addition, Amazon is a strong competitor to Best Buy, so there's plenty of reasons for Best Buy to stop selling Kindles.

You may say that this is all paranoia, and you may be right, but I've spent enough time in high tech to know that everything that's happened so far is right out of the Silicon Valley playbook. 

Bogus reviews and how to spot them

About a week ago, The New York Times wrote an article about someone who sold bogus positive book reviews that he posted under a variety of identities on Amazon, and presumably, other websites. His company lasted only a few months until it was "outed" by a disgruntled author who didn't like the review of her book that the company posted. The Times used this one company, and one piece of research, to insinuate that there's a torrent of fake book reviews on Amazon, and that all four and five star reviews should be considered to be fake unless proven otherwise.

The Times not only drew a sweeping conclusion from relatively scant evidence, but it also "buried the lede": The problem of fake reviews on the Internet pervades every product category, not just books. It also discounted the fact that fake reviews can be both positive and negative. I chalk up the Times' article to lazy reporting and sloppy editing, but there's a very real problem with fake reviews.

(Update, September 8, 2012: It does appear that Amazon is full of fake book reviews, but according to The Guardian, the practice isn't limited to self-published authors. Author Jeremy Duns figured out that best-selling crime author R.J. Ellory was posting breathtakingly positive reviews of his own books under the pseudonyms "Jelly Bean" and "Nicodemus Jones," and was trashing competing authors with 1-star reviews, including Stuart MacBride and Mark Billingham. Ellory has since apologized, but I suspect that the only thing he's really sorry for was getting caught. The Guardian's article also notes other examples of best-selling authors getting caught giving themselves positive reviews, and in some cases, trashing their competitors. Amazon is going to lose a huge amount of credibility unless it comes up with a way to confirm the identities of reviewers. Publishers could also add clauses to their contracts that prohibit writers from posting reviews under any name other than their own or paying third parties to post reviews.)

It's important to keep in mind that reviews are inherently going to be more heavily distributed toward very positive and very negative ratings, because people are more motivated to review things that they're very happy or unhappy about. Think about going out for dinner to a modestly-priced restaurant and getting an "okay" meal at the price you expected. You're unlikely to write a review about that "meh" experience. On the other hand, what if you get one of the best meals you've ever eaten, or what if the food is bad, the service is worse and the night ends with the waiter spilling a hot cup of coffee in your lap? Either way, you're much more likely to write a review, and the review is likely to be very positive in the former case and very negative in the latter one. So don't automatically assume that great or terrible reviews are fakes.

There's been some research published on how to spot fake reviews. For example, MIT's Technology Review reported that researchers at the State University of New York at Stony Brook used the TripAdvisor site to come up with rules for identifying fake reviews. They started by assembling a group of "likely valid" reviewers--they'd written at least ten reviews, each review was more than a day or two apart, and their ratings didn't deviate too far from the average ratings for all hotels.

The researchers then compared reviews from its "likely valid" group with those of one-time reviewers to see if the one-time reviewers gave a significantly higher number of five-star ratings. They also looked at the ratio of high to low ratings given by different groups of reviewers, as well as sudden bursts of reviews (multiple reviews posted over a few days) that might indicate a deliberate marketing campaign. Then, they compared their results with a previous study they'd conducted, in which they hired people to write fake positive reviews, so that they could identify tell-tale clues such as use of too many superlatives. The researchers found that they could identify fake TripAdvisor reviews "in the wild" around 72% of the time.

The SUNY Stony Brook research focused on fake positive reviews, but a couple of years ago, Consumer Reports' The Consumerist website asked its readers for suggestions on how to spot both positive and negative fake reviews, and they came up with 30 "tells". Here are a few:

• The reviewer only has a single review on the site.
• There's little or no information about the reviewer in their site profile.
• You can't find any information about the reviewer on other sites, such as LinkedIn.
• The reviewer uses a pseudonym that has more than three numbers at the end.
• Multiple reviews, either very positive or very negative, show up about the same subject in a very short period of time (a day, or a few days.)
• The wording of multiple reviews is very similar.
• The review uses the "official" name of the product or service. If it keeps using the official name over and over, it may be an attempt to game search engines.
• There are no details, just a broad statement that the subject is great or terrible.
• They use "marketing speak"--no one would write conversationally the way that the review is written.
• There's a "conversion story"--the reviewer thought that they would hate the product or service, but then they tried it, and now they love it.
• If the subject has multiple locations (such as a chain store or restaurant), the exact same review can be found for multiple locations.
• The review is very negative about the subject and strongly recommends a competitor by name.
• There's a link to the subject's website, or a third party's website, in the review.
• The spelling and grammar in the review is poor--it suggests that the review may have been written by an offshore review mill.

Reviews can save you a lot of money and aggravation, but you have to look for obvious signs of fakery. A fake review can be worse than having no review at all.

Apple accuses author of naming the eRetailer that she dare not name

Apple's never had much love for that pesky First Amendment, and The Digital Reader reports that the company has now banned an eBook from its iBookstore simply because it mentions Amazon. Here's a summary:

Author Holly Lisle was asked to release her series of eBook lessons on writing in Apple's iBookstore, which she did. Everything went swimmingly until she reached Lesson 6, which teaches authors how to do research in order to identify other genres in which to sell their books. As part of the lesson, she included an example with links to Amazon's website. Apple rejected the eBook on the basis of the links to Amazon (something that Apple's done in the past,) and Lisle edited the eBook and replaced the links to Amazon with links to her own site. Then, she resubmitted the eBook, and Apple rejected it again, this time because it simply mentioned Amazon. (To be completely accurate, Apple rejected the resubmitted version because it claims that Lisle didn't remove the links to Amazon, even though she actually did remove them and has uploaded the new version of the eBook without the links multiple times.)

It's not unusual for eBookstores to delete, or fail to approve, eBooks due to plagiarism or because they reproduce public domain content that's already available in the bookstore in multiple forms. However, Apple appears to be only eRetailer that refuses to carry eBooks that even mention competitors. Lisle claims that Apple's actions aren't censorship because Apple isn't a government entity, but it's a distinction without a real difference. If, instead of having 10% market share, Apple had 90% market share and engaged in this behavior, it would be de facto censorship.

Update, August 2, 2012: Apple has apologized to Holly Lisle and has reinstated her Lesson 6, including the links to Amazon. However, the decision to allow Lisle to sell her eBook should be seen more as a response to negative PR than as any change in Apple's policy of banning eBooks with links to competitors.

Amazon misses on both revenues and profits, but the stock is up

According to Bloomberg, Amazon reported its Q2 financials after the close of the market today. Gross revenues were $12.8 billion, just short of the consensus analyst estimate of $12.9 billion but still up 29% year-over-year. Net income, however, was only $7 million, or $0.01/share, compared with $191 million or $0.41/share a year ago, and below the $0.03/share forecast by analysts.

The company claims that the decline in profits was due to big investments in distribution centers, but another factor was likely to be declines in sales of the Kindle Fire and Kindle eReaders. Analyst Mark Harding estimates that Amazon sold only 670,000 Kindle Fires in Q2 due to customers' expectations of an updated model (or models) later this year.

Amazon expects a Q3 loss of $50 million to $350 million compared to analyst expectations of a profit of $119.6 million, on sales of $12.9 billion to $14.3 billion, vs. analyst expectations of $14.1 billion. The company has built eight new fulfillment centers this year and plans to build ten more before the end of the year, and much of that expense will be loaded into Q3.

Amazon's stock closed at $220.01, and is currently priced at $222.80 in after-hours trading.

NAPCO/InfoTrends eBook Publisher Survey

The July/August edition of Book Business Magazine has the results of a survey of 261 publishers (including 145 book publishers) done in May by InfoTrends and the North American Publishing Company (Book Business' parent) about their adoption of digital media and approach to digital production and distribution. Some of the results are surprising; here's a summary:

• PDF was the format of choice for 76% of the book publishers, followed by EPUB, with 68%.
• The top priority for eBook production and distribution at the book publishers was improving the overall user experience, cited by 60.3% of respondents, followed by improving overall design and typography (54.9%) and incorporating embedded rich media (44.4%). Only 20.6% planned to add search capabilities, and features such as embedded social media and sharing capabilities; improving footnotes and references functionality; and enabling reader annotations and highlighting were all named by less than 20% of publishers.
• The Amazon Kindle was the most popular device that book publishers use to test their eBooks, cited by 39.7% of respondents, followed by Apple's iOS devices (34.9%), Barnes & Noble's Nook (25.4%) and Amazon's Kindle Fire (22.2%).
• Surprisingly, 30.2% of respondents said that they don't test or tune their eBooks for specific mobile devices, which may explain why so many eBooks look so bad on mobile devices, and 13.5% of respondents don't know which devices (if any) their company tests eBooks on.

Simba Information: Waterstones' deal with Amazon will be "...one of the biggest screw-ups in the history of book retail"

Book Business has an interview with Simba Information Senior Analyst Michael Norris, whose company just published its Trends in Trade Book Retailing study. Norris reiterates something that I've been saying for a while: eBooks aren't growing the publishing market--they're just cannibalizing print sales. Further, print sales are falling faster than eBook sales are growing, so at best, eBooks are slowing the market's overall rate of decline.

Norris says that Barnes & Noble's relative success in the eBook business has a great deal to do with its stores, and with its promotion of Nook hardware and accessories in those stores. He's puzzled by B&N's decision to break its Nook business away from the rest of the company--and even more puzzled by Waterstones' decision to partner with Amazon for Kindle eReaders and tablets. Norris compared Waterstones' deal to Borders' disastrous decision to outsource its online eBookstore to Amazon, and said "...I’ve really got to hand it to companies like Amazon, they know how to kill a competitor and make it look like suicide." He added, "It’s going to be one of the biggest screw-ups in the history of book retail."

When asked what book retailers that sell eBooks can do, Norris said "I urge every retailer who does sell ebooks to buy one of their own ebooks and then buy the same or similar ebook from Amazon, then think...about what kind of experience is going to make people come back. "

New York Magazine publishes first eBook through Byliner

According to the Nieman Journalism Lab, New York Magazine has published its first eBook, a compilation of columns and articles from the past five years as selected by readers through the nymag.com Most Popular Stories feature. They've partnered with Byliner, which does publish original work but is primarily a discovery engine for content from established writers on the web. The new eBook, "New York Magazine's Most Popular," will initially be sold through Apple's iBooks for $7.99, and through Amazon and Barnes & Noble shortly after. Revenues will be split evenly between New York Magazine and Byliner. Individual authors within the anthology will be paid a "courtesy fee," and Byliner will also sell individual articles, for which the authors will get a cut of revenues.

Target to offer Livrada's eBook gift cards

PaidContent reports that Livrada, a Los Angeles-based startup, will sell gift cards for bestselling eBooks in Target stores' electronics sections, starting July 15th. Customers will purchase a gift card for a specific title, such as Fifty Shades of Grey. The recipient of the gift card goes to Livrada's website and activates the card, and then chooses whether to get the eBooks for Kindle or Nook. Livrada purchases the eBook from Amazon or Barnes & Noble (other platforms will be supported by the end of the year,) and delivers it to the recipient's eReader, tablet or computer.

Livrada gets marketing fees from the publishers of the eBooks, a portion of the purchase price from Target, and affiliate fees from Amazon and Barnes & Noble. There's no word on whether Livrada marks up the price of the eBooks. The question is whether enough consumers will buy the gift cards to make it into a viable business. At this point, there are only six titles available; Livrada is working to get more titles, publishers and platforms.

Who's winning and losing due to the shift to eBooks?

In my last post, I wrote that eBooks aren't expanding the market for books in general. However, even if eBooks are, overall, simply shifting money from one bucket to another, there are definite winners and losers:

Winners:

• Amazon: The company sells the most popular eReaders and more eBooks than anyone else in the U.S. (although a lot of those sales are unprofitable.) Amazon's dominance in the eBook market scared five of the six biggest publishers into (according to the U.S. Justice Department and more than 30 states) illegal price-fixing in order to take away Amazon's price advantage.
• Barnes & Noble: In the U.S., the bookseller is Amazon's only serious competitor for both eBooks and eReaders. Barnes and Noble has between 25% and 30% of the U.S. eBook market.
• Kobo: The company is Amazon's primary eBook and eReader competitor outside the U.S. It's recovered from the failure of Borders and Borders' licensees (at least, outside the U.S.) Now that it's owned by Rakuten, it has both the financial resources it needs and a natural advantage in Asia.
• Major publishers: Even though eBooks are shifting money around rather than increasing overall sales, publishers are earning more money on each sale, because eBooks have no printing, binding, shipping, warehousing or return processing costs.
• Self-publishers: eBooks have opened up the market to both writers who couldn't find publishers or agents, and writers who've been previously published but didn't earn much money. Royalty rates on self-published eBooks are much higher than those from major publishers, so writers can sell fewer copies at lower prices and still make more money.
• Consumers: Even though the Big 6 publishers have raised the prices of their eBooks under agency pricing, in most cases their eBooks are still less expensive than print. Self-published eBooks are dramatically less expensive than equivalent print titles. In addition, eReaders and tablets are far more convenient for consumers than carrying around multiple print books.

Losers:

• Independent booksellers: Few independent booksellers have successful online eBook businesses, and none of them have the same ease of ordering and delivery that Amazon and Barnes & Noble have. The American Booksellers Association inadvertently tied itself to the "albatross" of eRetailers, Google. which has since given notice that it plans to cancel its distribution agreements with independent booksellers. Whether independents will ever have a significant share of the U.S. eBook business depends almost entirely on who the ABA decides to partner with next.
• Small publishers: Small publishers that are still focused on print are tied very directly to the fate of retail booksellers. They need shelf space in order to build awareness and sales of their books.

Too early to tell:

• Apple: With no more than 10% of the U.S. eBook market and even less internationally, Apple's jump into the eBook business has largely been a bust, plus it's become entangled in Federal, state and private price-fixing lawsuits. Competitors such as Kobo are gaining share more quickly in international markets. Apple may ultimately decide that eBooks are more of a problem than they're worth, and settle for taking 30% of sales from other booksellers.
• Sony: At one time, Sony was the undisputed leader in the eReader market, but a series of missteps have left it an also-ran, even in its original strongholds of Japan and the U.S. Sony can turn things around by aggressively pursuing partnerships with booksellers outside the U.S. and Canada.

None of these judgments are set in stone: Barnes & Noble's partnership with Microsoft could help it build an international business, or its slowly-sinking retail bookstores could bring down the entire enterprise. Major publishers could fail to transition to digital-first strategies and end up with costs that are much too high for their revenues. Independent booksellers could find the right partner and become a viable competitor for eBook and eReader sales. Small publishers could start producing far more eBooks and become more visible in online eBookstores. Apple's rumored new "iPad mini" could be the perfect tablet for reading eBooks and could drive sales of many more titles.

A race to the top, or to the bottom?

In the last few weeks, announcements and rumors have been flying about technology leaders launching new mobile computing products:

• Microsoft jumped into the tablet business with its Surface tablets for Windows RT and Windows 8.
• Google announced its Nexus 7 tablet, built by Asus.
• Amazon is rumored to be announcing a replacement for the current Kindle Fire in late July or early August.
• That was followed a couple of days ago by rumors from reliable sources that Apple plans to announce  a 7" to 8" iPad in September or October.
• Yesterday, Bloomberg broke a story that Amazon is working on a smartphone to be built by Foxconn, and is trying to acquire patents in order to protect itself from the widespread litigation between smartphone and software vendors.

Assuming that all the rumors are true, it means that Amazon, Apple, Google and Microsoft will be competing directly against each other with tablets and (with the exception of Microsoft) smartphones. The margins on mobile devices are very low--only Apple has figured out how to make solid margins on its hardware. Samsung is making money because it manufactures so much of its own products, and it sells so many of them. No one other than Apple and Samsung makes money on smartphones. As for tablets, Apple makes excellent margins, but according to the latest hardware cost breakdowns, Google is just about breaking even on the Nexus 7, while Amazon is making a small gross margin on its Kindle Fire.

If Apple jumps into the 7" tablet market, will it compete with Amazon and Google on price, or will it add features that they don't have, such as 4G support, in order to command a higher price? How does Amazon expect to differentiate its smartphones from the pack of Android models? When Microsoft's Surface tablets make it to market, will they be competitive?

With everyone cloning everyone else and making incremental improvements, are we nearing the point where there are no clear lines of differentiation for anyone? If:

• Everyone has access to the same components, 
• Everyone's trying take advantage of whatever gaps have been left by their competitors until they get filled, and
• Android Jelly Bean's user experience is finally competitive with iOS and Windows RT,

Doesn't that mean that competition will inevitably come down to the number of apps available, customers' investments in libraries of apps (which affects switching costs) and price? That's a market that looks very much like personal computers.

More details about the rumored updated Kindle Fire

The China Times has some details about the rumored next-generation Kindle Fire:

• The next-generation Kindle Fire will be announced either at the end of this month or in early August. 
• It'll still be priced at $199, will have a metal chassis instead of plastic, and the display will come from LG Displays and Panasonic. 
• The screen will be higher resolution than the current model. 
• It may have a camera, which the current model lacks, but the translation that discusses this feature is very confusing. 
• Quanta, which builds the current model and will also build the new one, has received an initial order for two million units. 
• Heavy shipments of components for the new model started in June. 

There are no details on the processor, memory, graphics, etc., but I wouldn't be surprised to see them be very similar to the Google Nexus 7.

Amazon Publishing likely to acquire Dorchester Publishing

At Digital Book World, Richard Curtis writes that Amazon is the "stalking horse" bidder to acquire Dorchester Publishing in an auction to be completed on August 15th. Amazon has committed to pay all outstanding back royalties owed to Dorchester's authors and agents as of May 31st if it wins the auction. Curtis writes that it's unlikely that any other company will outbid Amazon, given that Dorchester has been on the market for some time, without any real interest from buyers.