The Nook Peacock Play: A Cartoon For A Complicated Story

| About: Barnes & (BKS)

As an homage to Bob Kohn's clever, albeit unsuccessful, cartoon amicus brief, I've made this article about the e-book industry a cartoon as well.

Last week I wrote an article concerning the e-book lawsuit, taking the contrarian view that the ultimate beneficiary of this lawsuit may be Barnes and Noble (NYSE:BKS). As I predicted in my Instablog, the decision came last week. Judge Denise Cote, in a 45 page ruling, approved the settlement.

My original thesis, that Amazon (NASDAQ:AMZN) will not be able to offer the same prices they did two years ago, is still in play. But I will now more fully explain how, even though they argued against it, this decision benefits Barnes and Noble. If they act quickly, Barnes and Noble is uniquely positioned to capitalize on this industry shaking event.

A Leadership Vacuum

The settlement calls for the three settling publishers, Hachette, Harper Collins, and Simon and Schuster to terminate their current e-book contracts with Apple (NASDAQ:AAPL) within seven days, and any other e-book distribution contract as soon as possible beginning thirty days after the approval of the settlement.

The publishers will then negotiate new contracts under the following conditions:

1. No "Agency Pricing"- the practice of the publisher dictating the sale price to the retailer- for two years.

2. No "Most Favored Nation" clauses - which allow retailers to automatically price match competitors at the publisher's expense- are forbidden for five years.

These unique contractual obligations are designed to force the publishers to adopt an entirely new business model for e-books. Because the settling publishers, and the two other publisher defendants still fighting in court, would constitute a critical mass within the industry, it is likely that the new business model and contracts will become a template for all other publishers as well.

What the settlement does NOT do, is actually write the new contracts.

We're back at square one, folks. The rules for the entire e-book market - and by extension the e-reader and tablet market - are about to be renegotiated.

And Apple will not be spearheading the negotiations. The "agency" business model promoted by, and presumably favoring, Apple has been declared illegal by the government. It will not come back.

Furthermore, Amazon will not be spearheading the negotiations. The public comment period was overwhelming negative on both the settlement and on Amazon. Businesses and individuals throughout the publishing supply chain defended Apple and the publishers on the basis that Amazon's "wholesale" was worse. The "wholesale" business model promoted by, and presumably favoring, Amazon has been declared wholly unacceptable and potentially illegal by the industry itself. It will not come back, either.

The publishing companies themselves have been enjoined in order to prevent collusion- they can't talk to each other. So the publishers will not have the collective bargaining power to promote a new business model favoring themselves.

And that leaves Barnes and Noble. The only major player in the e-book industry that has kept their nose clean enough that the government is still permitting them to discuss a new business model, but has not lost the goodwill with the rest of the supply chain that will be needed to actually effect any change. Barnes and Noble is in a unique bargaining positioned to promote a new business model in their own favor.

The "Long Tail" becomes the "Peacock"?

One really odd thing about the proposed settlement is that it includes a clause expressly permitting publishers to do something they have never done before.

From Judge Cote's Ruling:

"The Settling Defendants... may enter into contracts with e-book retailers that prevent the retailer from selling a Settling Defendant's e-books at a cumulative loss over the course of one year. See id. at § VI.B."

Basically, publishers can't prevent e-book retailers from selling individual titles at a loss, but they CAN prevent retailers from using outside funding to do so.

This is simply unprecedented. To get an idea of how this impacts the industry you need some background on how bookselling works.

Booksellers such as Amazon, Barnes and Noble, Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) have traditionally sold bestsellers such as "The Hunger Games" and the Steve Jobs autobiography at a loss. They do this because these are the titles that customers are most likely to compare prices on. Once a merchant has a customer in the door (or using their e-book format) the customer can be then sold a "long tail" of less popular titles. Publishers don't like this because they don't always get a cut of that "long tail"- the profitable add-on sales may be titles from the publishers own back list, or it may be a title from another publisher, an independent author, or even non-book merchandise.

But this clause would change that. If Amazon wants to discount, say, the Steve Jobs biography published by Simon and Schuster, they must fund that discount by selling other Simon and Schuster titles at a profit. Instead of one "long tail", each e-bookstore must grow multiple, separate tail for each publisher. A Peacock!

Barnes and Noble doesn't have the deepest pockets, but they do have the most experience marketing traditional publishing backlists. Thus, they would have a competitive advantage if the "peacock" model were to become industry standard.

A Little Tit for Tat

There's only one problem with the "peacock" model. There's no reason for e-bookstores to agree to it! Barnes and Noble opposed the clause themselves in their amicus brief, complaining that it would be burdensome to comply with such a program.

The government's response was that the settling publishers had requested the ability to make such a request, and that it was their responsibility to bargain for it. In other words, it is reasonable to expect that the publishers will offer the retailers some incentive to participate.

Another clause in the settlement tells us what that incentive may be:

"The Settling Defendants may compensate retailers for promotional services that they provide to publishers or consumers, see id. at § VI.A"

This is a reference to what the industry refers to as "co-op", or publishers offering bookstores kickback money in exchange for better placement on store shelves or on the website. Oddly enough, this has always been a hush-hush practice as it was presumably illegal. But apparently it isn't as the Department of Justice is actually encouraging it.

So, in exchange for adopting the peacock model, Barnes and Noble can ask for co-op payments to help pay the rent, to expand the website, or even to subsidize loss-leader hardware sales. It's a win-win. With $7 billion in annual sales, the publishers have an incentive to keep Barnes and Noble in business anyways. Barnes and Noble wouldn't mind the "peacock" model all that much as it isn't all that different from what they're currently doing.

The Peacock Expands

Ultimately, though, the "peacock" model would be most beneficial for the publishers if they can convince Amazon, Apple, and Google to adopt it as well. The only way to do that is to make the subsidies enviably large in the short term.

For example, they could give nooks away free, a full $100 subsidy. The New York Times already did this.

(Breaking News! I went to to look for the link to back up the NYT statement and found Reader's Digest is actually doing this right now. That was fast. I better hurry up with the rest of the article!)

In the long term the big tech companies will want in on this. To compete with the subsidized model, they'll be willing to "peacock" as well. Since the publishing companies don't have infinite amounts of cash, this will mean less money will be available for direct nook subsidies. But that's okay - it will force everyone to play the game Barnes and Noble is the best at playing.

Go Long BKS Now

I can't guarantee management will take advantage of this situation. But the CEO William Lynch showed he can be a pretty savvy negotiator in recent deals with Microsoft (NASDAQ:MSFT) and Liberty Media (NASDAQ:LMCA). I think there's a good chance they'll spin this to their advantage as well, either by doing what I just described or something a bit more creative.

Disclosure: I am long BKS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short AMZN