Amazon's Battle With Hachette Has Negatively Impacted Income, But Those Costs Are Temporary

Jul.30.14 | About:, Inc. (AMZN)


Amazon has temporarily reduced sales in a lucrative business.

The negative publicity is unwarranted.

If Amazon is successful, that business may become more lucrative.

Sam Walton was a visionary; he was one of the greatest businessmen in American history. He once said, "There is only one boss: the customer. And he can fire everybody in the company from the chairman on down, simply by spending his money somewhere else." History has supported his view. Sam Walton believed in driving prices down as low as possible. The vision of low prices, rather than high ones, has often been at odds with short-term returns. In a world focused on returns by the quarter, higher prices create higher net income. The long-term cost of customer attrition does not show up in the incoming statement for years. Higher margins and higher revenues from the remaining customers can disguise a loss of individual customers in many industries. Growth through raising prices without offering new values to the consumer is not sustainable.

Amazon (NASDAQ:AMZN) has taken over the role of Sam Walton for this decade. Investors are frequently upset by Amazon missing earnings projections. Despite substantial revenue growth (23% quarter-over-quarter), Amazon still posted an operating loss. Investors clamor for higher prices and better margins, but it won't happen. The enormous growth Amazon has experienced reflects a desire to focus on the customer. There has been plenty of bad publicity, and the latest battle with Hachette has drawn in hundreds of authors. The company has been delaying shipments of books, and has encouraged customers that are eager for those books to buy from competitors. This is a long-term focus on the industry, and that is where Amazon and Hachette do not see eye to eye. In the interim, Amazon has offered to give 100% of the proceeds to the authors. It also offered to pay the authors the normal fee and donate the entire remaining amount to a literacy charity.

This sector of the business has operational leverage, but the variable costs can be construed in different ways. The way it chooses to report the income doesn't change how much income the company receives. If Amazon reports the entire revenue from the sale, it looks like it has variable costs regarding the payment to the author and the publishing company. Is it really reasonable to look at the transaction that way? All 3 entities are dealing with operational leverage. The cost to create the book is not affected. Amazon incurs the cost of processing the transaction and any related overhead expenses, such as responding to customer service requests. Amazon doesn't really eat those costs, even if it passes on the revenues to the other parties. Effectively, Amazon is serving as a sales person and obtaining a commission off each book sold.

The great thing about that role as a sales person, when all entities have operational leverage, is that the goals should be closely aligned. The goals aren't aligned; Hachette is still involved in physical books. That competing product provides Hachette with an incentive to view e-books as potentially cannibalizing its traditional book sales.

When considering Amazon's role in the process as a commissioned sales platform, the reduction in sales is a direct reduction in income. The business of having a computer process an e-book sale without human interaction is very attractive. It is worth fighting with Hachette to get the right deal in place, but how would Amazon be able to capitalize and amortize those costs? If Amazon expenses the costs as incurred, it may make current earnings worse and future earnings better.

What is Amazon arguing for? Many critics say it is about the percent of the revenues that go to each party. However, digging deeper, it appears that the argument encompasses the fundamental question of: "How much should e-books cost the consumer"? One author has lambasted his customers referring to them as "Entitled". Amazon has argued that customers want e-books to cost less than $10. Hachette, it appears, would like to price books at $14.99. Not all authors are opposed to the price cut; Hugh Howey argues in favor of Amazon's $9.99 structure. Like Sam Walton, Amazon is arguing for lower prices. The lower prices have been a driving factor in bringing more customers to Amazon.

If Amazon succeeds, the industry may become more attractive. There is a term in economics: deadweight loss. It refers to a lost opportunity to have a transaction that would have been beneficial for both parties. The idea is simple: If a potential customer wishes to purchase something for more than the cost incurred by the seller, then both the customer and the seller would gain from the exchange. If that sale does not happen, both the customer and the seller have missed out.

The opposite side of that issue is discriminatory pricing. If each consumer could be charged the absolute maximum they would pay, then the company could easily sell to every consumer that was willing to pay at least one cent more than the cost of production. That isn't a feasible solution, since there are several issues with discriminatory pricing. Therefore, the company has to figure out what price will maximize its profits. In the case of Amazon, it needs to maximize its commission revenues. Ignoring transaction costs, selling 10 books for $5 each would be the same as 5 books for $10 each, or even 50 books for $1 each. Hachette has a more vested interest in keeping the traditional book formats alive. As e-books become cheaper, traditional books are less appealing to consumers. Amazon is also involved in selling physical copies of books, but it isn't treating it as a long-term venture. If e-book sales displace Amazon's physical sales, then it does incur opportunity costs. However, the long-term economics suggest that the cost of printing and mailing physical books can't compete with online publishing.

If Amazon is successful, its role may become more lucrative. Even if it failed to achieve a higher percentage of the gross revenue, Amazon may be correct about the direction of the industry; lower prices are the future. Traditional book publishing requires editing, printing, binding, and distribution. In the new market for e-books, the editing is still important, but an editor can perform that work. If the author so chooses, they could use an editor that works for part of their royalty rather than a flat payment. The rest of the services are not needed. If customers genuinely want those services, they'll need to pay more for hard copies. The digital copy should be cheaper; it is substantially cheaper to produce.

Should the author genuinely care how much people pay to read their book? Does it really help them to have a higher price? Does it change how many hours of their life they spent working the book? From our vantage point, it seems they should be concerned about their net earnings, not about their price per unit. The same could be said about Amazon's role. The only one left out in the cold is Hachette, which remains vested in the dying industry of physical print. It isn't a case of profit margins, as explained in this slide by Michael Sullivan. It is a case of protecting a role in a dying industry. Without the large monetary costs to bring a book to market, the retailer and author have little need for a middleman. There are always companies that resist change. It wasn't all that long ago that a company, Apple, suggested selling individual songs for $1 online, instead of physical CDs for $15. Clearly, it was possible to transfer a file and deal with the billing overheads for less than a dollar. It did it when piracy was rocking the music world and customers were upset by the high costs of CDs. Think authors are getting paid by every reader right now? Go search The Pirate Bay. Go check out your local library. We've been down this road before, and we saw how the story ended.

Disclosure: All information in this article is the opinion of the author. Sources are deemed reliable but not guaranteed. Forward looking statements contain projections that are uncertain. Before investing in any security, you should speak with a financial advisor that understands your risk and return objectives. The author does not directly own Amazon, but does have long positions in index or mutual funds with long exposure to large cap U.S. corporations. The author does have an Amazon Prime membership and does make use of the local library, rather than purchasing either traditional books or e-books.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.