Amazon's Road to Profitability: Toll Booths on Your Road to Readers

Though mentioned here back in May, some recent strong-arm tactics by Amazon UK have been picked up by the New York Times, which is referring to the removal of the "Buy Now" button as "the literary equivalent of a nuclear option for rebellious publishers who balk at its demands":

“Amazon seems each year to go from one publisher to another, making increasing demands in order to achieve richer terms at our expense and sometimes at yours,” Mr. Hutchinson said in the letter. “If this continued, it would not be long before Amazon got virtually all of the revenue that is presently shared between author, publisher, retailer, printer and other parties."

This kind of aggression from Amazon is becoming commonplace, but it’s worth a step back to try and understand the broader strategic context that might underlie these moves.

While many fear that Amazon is maneuvering to become a publisher, I disagree; Amazon isn’t trying to become a publisher — they are trying to become the toll booth that every publisher (and I use the term loosely) must go through to get to readers. The ferocity with which they’ve pursued this strategy lately suggests they feel tremendous pressure to improve their profitability. (Current operating margins are around 4.5%.)

Why would they squeeze publishers on discounts? Because online discount book retailing is just not a very profitable business. As Jason Epstein notes in Book Business: Publishing Past, Present and Future, the numbers underlying Amazon’s book business just don’t add up:

At first it appeared that The Reader’s Catalog would become a worldwide bookstore without walls offering an enormous range of titles, eventually in all languages: in effect what has become. But I had miscalculated: I expected that the catalog could operate profitably on the 40-percent margin between what we paid the wholesaler and what we charged the customer together with the shipping and handling charges that the customer also paid. I was wrong. Though we shipped orders as soon as books arrived in our warehouse from the wholesaler, the handling costs, clerical salaries, and computer and credit card charges were more than I had budgeted for. I expected that as the business grew these costs as a percentage of sales would decline. Instead, as we added more staff to handle increased sales, I found that our margin would be insufficient no matter how the business grew even though we had the advantage of immediate payment from our customers and thirty days to pay our supplier and were increasingly ordering books directly from publishers at greater discounts.

Epstein goes on to explain the root cause of the margin problem:

The problem was not a matter of size. It was structural. Though we kept no inventories, had no retail premises, or salespeople and received payment in advance, a $25 or $30 average order simply did not produce enough margin to cover the cost of handling it and never would no matter how big the business became, for the more we grew the more infrastructure we would need to serve our expanding customer base.

What does this mean for Amazon? It means that they cannot achieve the kind of profitably investors are looking for through operational effectiveness. When it comes to their core bookselling business, low operational costs alone are insufficient — they need higher gross margins (through discounting concessions from publishers).

How does removing the "Buy" button fit into this? Note that Amazon is only pursuing this in markets where it’s a major player — in other words, in markets where much of the traffic from publishers to readers passes through its toll booth. When they put up a detour sign and force that traffic through a less reliable and more questionable part of town (the Amazon marketplace), at least in the short term that certainly hurts the publishers more than it hurts Amazon.

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