Apple's Commission Strategy Could Squeeze Amazon

 |  Includes: AAPL, AMZN
by: William Haynes

Rumors swirl about an Apple event this month. According to All Things Digital, Apple will be holding "an important — but not large-scale — event" in New York later this month. Consensus is that the event will not feature hardware but instead will focus on digital media, possibly encompassing the iBookstore and iTunes U. Steve Jobs was passionate about education, and talked to his biographer about revolutionizing textbook publishing. So an education focus seems plausible.

Rumors of this event prompt me to write about another possible move by Apple that could have a big impact on the landscape for digital media and on competitors, particularly Amazon. Apple is leading in the tablet space with iPad2, but Amazon is finally giving them a competitor, though in a slightly different segment (the smaller and low priced Kindle Fire that uses a '"forked" version of Google's Android OS).

Apparently, the Fire has sold well this holiday season, probably taking some buyers from Apple, though exact numbers are hard to come by. However, Amazon's go-to-market strategy for the Fire (and other Kindles) has relied on the razor blade model (sell the razor cheap and the blades expensive). In this case the Kindle Fire is sold at a slight loss, but the digital media to fill it is sold at a 30% profit margin.

The only problem with Amazon's strategy is what happens if a competitor starts selling cheaper razor blades. And a better (if more expensive) razor. Apple fought hard to set up an agency pricing system for books (similar to how it sells apps and possibly music and video) with a 30% commission. Amazon was forced to go along with this. This commission has been called the "Jobs Tax," perhaps unfairly, given that most other media distributors charged and still charge higher commissions. In any case, Apple has stated that it aims to run the iTunes store at break even. As the volume increases, it seems as though it could have room to reduce its commission.

How likely is this to happen? In an interview last year, Rupert Murdoch gave a hint that the iTunes 30% commision might decrease after the first year for his iPad publication The Daily:

Cavuto: I want to ask you, how much are you making on that? Because it’s $0.99, but typically, typically Apple takes a third.

Murdoch: That’s correct.

Cavuto: Now, is it taking a third here?

Murdoch: At least the first year, yes. We’ll be getting $0.70.

Cavuto: All right. But it goes—so you say at least the first year. It goes down after that?

Murdoch: We—no. Up, we hope.

Cavuto: But down for Apple.

Murdoch: That’s subject to negotiation.

I'd emphasize the "at least the first year" phrase. At the very least, this implies to me that Apple gave assurances to Murdoch that they are willing to revisit negotiations on the commission level.

Apple would have several options if it did want to change the commission level. First, it could simply reduce the commission to 20% or even 15%. That would be the simplest thing to do, and Apple likes simplicity. Or it could do something that might keep income from iTunes more in line with expenses, which is to charge a fixed cost ($0.10) to cover credit card processing fees plus a variable fee to cover server and transmission costs. Visa quotes minimum fees of about $0.05 + 1.6% for small transactions, and Apple could probably negotiate that amount lower. On the other hand, Apple presumably has fairly large fixed costs in administering 200 million credit card numbers. So $0.10 plus 10% would to my mind be the lowest it would go. However, if it does anything with commissions, I think it is more likely that Apple will reduce from 30% to 20%, and then bide its time to go lower.

What would the implications be if Apple does pursue a low commission strategy? Clearly, it will hurt Amazon, whose profit margin has been hovering in the (very) low single digits, and at 0.7% for the most recent quarter. If Amazon keeps its digital commission at 30%, it will likely gradually lose publishers. And Apple could even reduce retail prices by 10%, which Amazon will not countenance for very long. Either way, Amazon will be hurt. And every Kindle it sells will make their situation worse, unless it increases Kindle prices. Apple would also improve its competitive position versus other OS platforms, including "official" Android and Microsoft/Nokia's Windows Phone.

At the same time, Apple will mollify the sometimes testy publishers it deals with, and lessen (though not abolish) pressure from anti-trust agencies around the world.

The best thing about this strategy is that it is just the first step. Even if Amazon responds by cutting its commission to 20%, it will never know when Apple will turn the screws again by ratcheting down commissions to 15% or even lower. It will be very hard for Amazon to sell its razors at a loss if it cannot be sure how much it can sell the blades for.

As Apple's digital sales increase, its ability to lower commissions improves. And Apple becomes a more desirable partner for all kinds of publishers - think about the a la carte TV subscription rumors, and how a 20% commission would look to the Hollywood studios compared to the 50% or greater markup that cable networks charge.

I doubt that changes in commission will be announced at the upcoming event, but I think it could happen this year, and may do severe damage to Amazon's strategy. Apple may even want to wait for a few more quarters to allow Amazon plenty of Kindles at a loss, before springing the trap.

Disclosure: I am long AAPL.