This is a report from our premium subscription research service The Internet Analyst. The Internet Analyst is currently in beta, with a formal launch coming towards the end of 2009. To sign up for a free beta trial, please submit your name and email address here.
Wall Street can’t help itself.
With all the buzz around e-readers, analysts expect big numbers out of hardware sales and e-book consumption. While hardware sales may experience huge growth in the coming years, we believe many underestimate the losses companies like Amazon will need to weather before selling e-books becomes a meaningfully profitable business.
Currently companies like Amazon lose about $2 for every e-book (we discuss this below). So, if it sells one million e-books the company loses about $2 million.
Analysts keep one-upping each other with forecasts of profits in 2012-2014. What they aren’t telling you is that this will require publishers to radically reduce the prices at which they are selling e-book licenses.
Will this happen?
It should. Publishers should move to a high-volume model where they sell more units for less. But “should” is very different from “will.”
In any event, in order for the e-reader market to thrive publishers must lower their wholesale prices so that distributors can turn a reasonable profit. We believe that if the price is lowered enough publishers may earn less per unit, but could ultimately earn more in overall revenue and profit through a greater number of sales. This, of course, benefits the e-book distributors as well.
Book publishers will likely be the largest supplier to e-readers, though we believe ultimately consumers will read magazines and newspapers on the devices and even listen to music. As a result, it’s important to understand how book publishers will be impacted and whether or not they will contribute to the transition to digital or fight it.
We believe that at first publishers will fight the trend by standing firm on wholesale prices that lead to a loss for most e-book distributors, but over time will be driven to lower prices and adjust their business models to maintain profit margins.
SOMETHING’S GOT TO GIVE
Amazon accounts for about half of US e-reader sales currently and is losing money selling e-books. Here is how:
- Book publishers are standing their ground on wholesales prices – selling books at about $12 to distributors regardless of if it is a print copy or digital copy.
- Amazon sells them for $9.99, losing about $2 per sale.
Clearly companies like Amazon have to start selling e-books at print retail prices or book publishers will have to lower their wholesale prices. We think it will be the latter.
WE BELIEVE MOST OF THE MONEY IS TO BE MADE IN CONTENT SALES
Margins on e-reader hardware sales are currently low – gross profit margins are in the 20% range before costs like marketing and overhead are even taken into account. E-Book sales on the other hand can generate high margins depending on the wholesale price charged to distributors. We believe that book publishers can sell e-books to distributors at a wholesale price that enables each party to turn a decent profit (we go into this in detail below). As a result, we see the shift to the sale of e-books going like this:
- Consumers force publishers to sell e-books by buying e-reader devices and an increasing number of e-books. However, most will not pay the higher print title price for an e-book.
- A price battle occurs between publishers and e-book distributors as both try to promote and sell e-books while still turning a profit (this is already happening).
- Over time publishers will generate less revenue from selling e-books, but profit margins could even improve somewhat.
- At this point e-books will be sold for less on both a wholesale and retail level, netting both distributors and publishers profits. Authors will inevitably make less money.
CONSUMERS WILL DRIVE THE TREND
We believe book buyers will start to buy an increasing amount of their books online, causing the negotiating leverage in determining wholesale prices for e-books to shift toward the distributors. We see a few drivers to this trend:
- The less than half of US citizens that read books are educated with high incomes, a profile that matches most early-adopters that would be interested in a new device.
- 2/3 of book buyers are below the age of 55, indicating they are likely technologically sophisticated.
- More people are buying and finding books online, which would support the next step – buying and reading digital books distributed and promoted online. For example, 30% of Generation X buy their books online and 21% of book buyers became aware of a book through online promotion, according to the 2008 US Book Consumer Demographics and Buying behaviours Report.
In addition, as e-readers become more sophisticated with better graphics and technology there will likely be an increasing number of features that make reading e-books preferable to print books for many readers.
PUBLISHERS CAN ADJUST TO SALES BEING DRIVEN BY E-BOOKS AND STILL MAINTAIN CURRENT MARGINS
Currently, we estimate book publishers generate net profit margins of about 10% per book release. This does not leave a lot of wiggle room for price adjustment, which is likely why most are standing firm on wholesale pricing. However, book publishers can turn a profit from selling e-books. For example:
- We estimate over 50% of a book release’s costs (not counting returns) come from manufacturing/shipping and royalties to authors.
- Manufacturing/shipping costs will become nominal if all books are sold digitally.
- Authors will make less in royalties (typically 10% of retail)
Below is an example of a P&L for a typical print versus digital release:
Publishers should be able to sell e-books to distributors like Amazon at $5 and still maintain the profit margins they enjoyed on print book sales. In turn, distributors like Amazon should be able to sell e-books at the current $9-$10 price and still enjoy a healthy profit.
The bad news for authors is that their royalties will decrease since they are based off of retail sales price.
The Bottom Line: Like most traditional media industries, book publishers have a large legacy print business to maintain while they figure out the transition to digital. As a result, we believe in the short-term e-books will be a money loser for distributors since book publishers won’t want to cannibalise their print sales with much cheaper e-books on the market. However, over the long-term we expect prices to come down, publishers to adjust, and the growing e-reader market to drive incremental profits for both distributors and publishers.
NOW WATCH: Briefing videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.