Simon & Schuster revenues up 3%, but operating income down 47% in Q2

The Wall Street Journal reports that CBS issued its Q2 financial results yesterday, including Simon & Schuster. The publisher's revenues increased by 3% year-over-year to $189 million, with a 44% increase in eBook sales offsetting a decline in print sales. eBooks now represent 21% of Simon & Schuster's revenues, and the company expects eBook sales to increase slightly less than 30% for the full year. Operating income before depreciation and amortization was $9 million vs. $19 million in the previous year, down 47%, for a profit margin of 4.8%. The company says that profits were affected by the proposed settlement of eBook litigation with the Justice Department and states.

The problem isn't agency pricing, it's Most Favored Nation clauses

PaidContent writes about a letter written by American Booksellers Association president Oren Teicher, protesting the proposed eBook price-fixing settlement between the U.S. Justice Department and Hachette, Harper Collins and Simon & Schuster. In his letter, Teicher writes that the publishers shouldn't be prohibited from using Agency pricing, saying that the loss of the agency model would “significantly discourage new entry, and will lead to the departure from the market of a sizable number of the independent bookstores that are currently selling e-books." In an earlier letter to the Justice Department, Barnes & Noble made a similar request, with similar arguments.

The problem with these arguments is, as Jane Litte wrote on the "Dear Author" blog, that agency pricing is meaningless without Most Favored Nation (MFN) clauses in place with all the major book resellers. Apple's MFN clause requires publishers to insure that Apple can always sell their eBooks at a price no higher than the lowest price offered by any other reseller. The combination of Agency pricing and MFN is necessary in order to make this work.

As Teicher's letter points out, the Justice Department doesn't claim that Agency pricing is illegal. In fact, the settlement with the three publishers expressly permits Agency pricing with some restrictions. What it forbids, for five years, are MFN clauses. So what, exactly, is Teicher asking for? It sounds as though he wants the publishers to be able to implement Agency pricing with no exceptions. No reseller would have the ability to discount for sales or special events. Resellers couldn't negotiate with the publishers--the entire pricing scheme would be "take it or leave it." In other words, he wants industry-wide MFN in practice, without individual MFN clauses.

In any event, given that the ABA has lost its eBook eCommerce partner (Google) and hasn't come up with a replacement, Mr. Teicher's arguments are largely moot.

It's On: U.S. Justice Department sues Apple and five publishers for eBook price-fixing, settles with three of the publishers

The long-rumored eBook price-fixing lawsuit against Apple and five of the Big 6 publishers (Hachette, HarperCollins, Macmillan, Penguin and Simon & Schuster) was filed in Federal court in New York today by the U.S. Justice Department. In addition, the Attorneys General from Texas, Connecticut, Ohio and Pennsylvania are filing their own lawsuits today in Federal court in Texas. Here's a summary of U.S. Attorney General Eric Holder's remarks:

• Hachette, HarperCollins and Simon & Schuster agreed to a settlement, which must be reviewed by the court, with the following terms: 
• The publishers will go back to the wholesale model and allow retailers to set their own prices for eBooks.  Update: Publishers Lunch Direct has clarified the situation (and given the actual verbiage in the settlement, I use the word "clarified" advisedly.) The three publishers will be allowed to continue to offer agency contracts, and they can use variable commissions and discounts to encourage resellers to limit their discounting of eBooks to consumers. However, they can't prohibit resellers from offering discounts. Publishers Lunch Direct claims that this clause prohibits resellers from selling eBooks below the retail price less commission set by the publishers, but I don't read it that way: Resellers can sell eBooks at any price they choose and take as much of a loss as they want. In addition, resellers can refuse to purchase on agency terms, but publishers can refuse to sell to them.
• They will terminate their "Most Favored Nation" agreements with Apple, Amazon, Barnes & Noble and other eBook retailers. 
• They're prohibited from placing constraints on resellers' ability to offer discounts on eBooks for two years. 
• They're prohibited from conspiring or sharing competitively sensitive information with their competitors for five years. 
• They must implement a strong antitrust compliance program. 
• Justice charges that the defendants held regular, near-quarterly meetings to discuss confidential business and competitive matters as part of a conspiracy to raise, fix and stabilize retail prices. 
• They also mutually agreed to seize pricing authority from resellers, agreed to pay Apple a 30% commission on eBooks sold through the iBookstore (and to impose the same 30% on other resellers,) and used most-favored-nation provisions to guarantee that no reseller could sell their eBooks at a price lower than Apple's. 
• According to the statement, "...one CEO allegedly went so far as to encourage an e-book retailer to punish another publisher for not engaging in these illegal practices." 
• Acting Assistant Attorney General Sharis A. Pozen quoted from the complaint as follows: "One executive said that, 'the goal is less to compete with Amazon as to force it to accept a price level higher than 9.99.' And yet another said, 'we’ve always known that unless other publishers follow us, there’s no chance of success in getting Amazon to change its pricing practices.' Our complaint also quotes Apple’s then-CEO Steve Jobs as saying, 'the customer pays a little more, but that’s what you [he’s referring to the publishers here] want anyway.' As you can see, we allege that these executives knew full well what they were doing. That is, taking steps to make sure the prices consumers paid for e-books were higher." 

Apple: Don Quixote de Cupertino?

Update, April 11, 2012: Bloomberg is reporting that the U.S. Justice Department filed suit this morning against Apple, Hachette, HarperCollins, Macmillan, Penguin and Simon & Schuster for eBook price-fixing; Hachette, HarperCollins and Simon & Schuster settled with the Government.

Bloomberg reported that Apple, Penguin and Macmillan are unlikely to agree to a settlement with the U.S. Justice Department over eBook price-fixing accusations, and are preparing to go to court. The three other publishers in the case, Hachette, HarperCollins and Simon & Schuster, are said to be very close to agreeing to a settlement with the Justice Department.

Regular readers of my blog know my opinion on the subject: There's very strong evidence, even if circumstantial at this point, that the publishers imposed agency terms on all of their resellers at almost exactly the same time, including the exact same commission rate, and that all of them threatened to stop supplying eBooks to any reseller who refused to agree. Apple's precise role in the scheme isn't clear, but it's known from Steve Jobs' own words that Apple proposed the scheme to the publishers and knew that it included the part about refusing to sell eBooks to any reseller (including Amazon) that didn't agree.

Apple may believe that it didn't coordinate the actions of the publishers (or that it's covered its tracks well enough that the Justice Department can't prove that it did coordinate their actions.) It may also not want to agree to a settlement for fear of its impact on the civil price-fixing case underway in New York. However, in my opinion, Apple is taking a huge risk by not settling the case before it goes to court.

As it looks now, Hachette, HarperCollins and Simon & Schuster are close to a settlement. If they settle, they'll enter into what's called a consent decree, which doesn't require them to assume guilt for the charges. They'll be required to change their business practices, possibly pay a fine, and agree to court supervision for a limited period of time. The pain and reputational damage will be over quickly. For Apple, Penguin and Macmillan, however, their senior executives are in for months of depositions, they'll be required to provide many thousands of documents as part of the discovery process, and the court trials and appeals will likely take years to play out.

In addition, the Justice Department will be able to compel Hachette, HarperCollins and Simon & Schuster to testify against the other three companies. They'll have immunity as a result of their settlement, and they'll have no reason to protect their competitors or Apple. This is a standard part of most price-fixing cases: One or more defendants cut early deals with the Justice Department and gain immunity, and then they provide evidence against the other players in the price-fixing scheme.

The worst possible outcome for Apple would be for it to lose in court, even if it eventually wins on appeal. All they have to do is look at Microsoft to witness the damage that could be done. That case was eventually settled with a consent decree, but Microsoft was under court supervision for ten years. The company could no longer pursue the aggressive tactics that it had used in the past to suppress competition. Most importantly, it became a convicted monopolist, which changed both the public's perception of the company and the stakes for any future litigation. (When Bill Gates eventually passes away, stories about his philanthropy will have to share time with the videos of his depositions.) The press was no longer afraid of retaliation by Microsoft's public relations department for running negative stories, and Microsoft lost control of its messages.

Apple is unafraid of litigation, as witness its myriad lawsuits against Android licensees. In Walter Isaacson's biography, Steve Jobs clearly saw Android as not only a theft of Apple's intellectual property by Google, but a personal betrayal by Google Chairman Eric Schmidt, who served on Apple's board of directors for years. Jobs swore that he would spend Apple's entire cash horde, if necessary, waging "thermonuclear war" on Google and Android.

Unfortunately for Apple, its cases against Samsung, HTC and Motorola have been far from the "slam-dunks" that Jobs thought they would be. Apple has estranged perhaps the most important component supplier for its mobile products, Samsung, and it's being forced to bring alternative vendors up to its quality and deliverability standards. For example, Apple had planned to launch the new iPad with three LCD vendors, LG, Samsung and Sharp, but only Samsung was able to meet Apple's quality requirements and ship in the necessary quantities in time for the launch. In addition, some of Apple's own patents are being challenged and could be invalidated.

Apple, like Don Quixote in Cervantes' novel, enjoys its battles. Unlike Quixote, however, Apple's opponents fight back, and are likely to hurt Apple much more than Apple hurts them.