The Book World Vs. Amazon

| About: Amazon.com, Inc. (AMZN)

When Amazon (NASDAQ:AMZN) was founded in 1994, the book market was antiquated. But that was the nature of the business. Books take up a lot of space, and even the biggest brick and mortar stores can only hold so many titles. And stores typically relied on walk-in customers to move those titles.

So it was no mistake that Amazon targeted the book market. By cutting out the middle man (the distributor or retailer), Amazon connected readers with publishers. And because a book isn't ordered until it's actually purchased by the consumer, it doesn't have the constraints of stocking physical supply, so it can 'hold' millions of titles.

And then in 2007 Amazon released the Kindle ... and took a 90% stake in the eBook market. Amazon used its discounting power to dominate the market by dropping prices to $9.99 per book. Amazon was perfectly willing to forgo a profit to grab a bigger share of the market. And it was perfectly willing to use its market power to corner publishers into giving better terms. And it worked … not only does Amazon dominate eBooks, but a brick and mortar store selling printed books at $25 has a hard time standing up against it.

Novelist Richard Russo put it best: "When you sell books at a loss, by the millions, to corner the market, you're not interested in competing … you're interested in burying your competitors and then burying the shovel".

Amazon had the eBook market in a stranglehold. So when Apple (NASDAQ:AAPL) introduced the iPad in 2010, it came up with a new pricing model for selling books. The company made a deal with five publishers to sell books on the iBookstore through the "agency model": publishers set the sale price ($12.99 and $14.99), and Apple would get a 30% cut. This differed from Amazon's wholesale pricing model, where it bought books from publishers at a discount and then had full control over prices.

The Justice Department took notice. But rather than looking at the 800 pound gorilla in the book market, it took aim at Apple and the five publishers.

The Justice Department filed an antitrust suit accusing Apple and the five publishing houses of colluding to fix prices in an attempt to undermine Amazon. Three of the publishers, HarperCollins, Simon & Schuster and Hachette, settled immediately. Apple and the two remaining publishers are willing to fight it out in court.

According to Apple, "the launch of the iBookstore in 2010 fostered innovation and competition, breaking Amazon's monopolistic grip on the publishing industry". Apple's iBookstore opened the door for more players, including some independent stores, to enter the eBook market. And since then, Amazon's hold on the market has narrowed to 60%.

What the Justice Department has managed to do is give Amazon room to tighten its grip and regain power over the market. This couldn't have worked out better for Amazon.

Granted, Apple's 'agency model' deal drove the price of eBooks up, and with Amazon, readers paid a lower price. But that lower price has its own costs … there are potential consequences to giving Amazon too much control in dictating prices. It's great if we can buy books at a low price … but pricing books too low makes it hard for publishers to meet their costs.

Regardless of the outcome of the suit, this is already a victory for Amazon and a loss for the publishing world.

And the stakes are high. Ebook reading is growing … and 70% of eBook readers buy their books on Amazon (according to O'Reilly Media) … and those readers might stick with Amazon. Because most eBooks must be read on a proprietary device (Amazon books are read on a Kindle, and Barnes & Noble (NYSE:BKS) books are read on a Nook), the larger a consumer's library, the less likely they are to switch to another retailer. And the more likely that the Justice Department just allowed Amazon to consolidate its monolithic grasp.

Amazon is a giant online retailer of everything. The company has better than 160 million active users and accounts for 20% of online sales in the U.S. Not bad. But I wrote a while back that Amazon needs to be careful about managing its image. I think that is still true. And I wrote that I wouldn't buy Amazon. That is also still true.

Amazon may have found an unintentional ally in the Justice Department, but that doesn't translate to a reason to buy. Shares may be up year-to-date, but they have held a long-term sell signal since last December.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.