Digital dilemma: Amazon pushes to package up more profit

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In late April, Amazon.com Inc. invited a group of journalists to its Seattle headquarters, in part so they could listen to Marie Force talk about her amazing new life.

In the romance novel industry, Ms. Force is a superstar. Her prolific bibliography, much of it self-published, has resulted in some 2.5 million copies sold. So financially rewarding is her career as an author that she recently quit her day job, hired her own staff and bought a new Mercedes.

Mostly, Ms. Force talked at length about an Amazon tool called Kindle Direct Publishing. In essence, KDP is a digital e-book service that allows authors to side-step the traditional publishing process by acting as their own publishers. Even though she currently has contracts with several traditional publishing houses, Ms. Force makes no secret of the fact that she is largely unimpressed with the services they provide. She says her relationship with them is one of necessity, at least until she can find some other way to get her books on the shelves at Target and other large retailers.

"It hasn't happened yet, and when it does, I will have no further use for traditional publishing."

Amazon's relationship with the traditional gatekeepers of the content it sells – publishers, record companies, movie studios – has never been straightforward. On one hand, the world's most powerful online retailer relies on those companies for the bulk of its digital media offerings – one of the fastest-growing product categories in its catalogue. But at the same time, Amazon is under growing pressure to finally start turning its massive customer base into equally massive profits. That means, in turn, that the retailer is under similar pressure to squeeze its content partners even harder for lower prices.

Or perhaps, if that doesn't work, side-step them entirely. In a myriad of industries, from music to movies to books to the very basic business of selling things, Amazon is simultaneously playing nice with the giants of the old guard even as it goes about creating the tools, services and market conditions that may one day render them irrelevant.

Device gambit

Behind a glass case in the lobby of Day 1 North (an Amazon campus building named after a quip by company founder Jeff Bezos that it's still "day one" on the Internet, an atmosphere ripe for innovation) there's a copy of the very first book Amazon ever sold. It's a a computer modelling and programming text called Fluid Concepts and Creative Analogies.

Twenty years ago, Amazon began life as a seller of physical books. Over time, the company grew to become the world's biggest digital storefront, shipping everything from baby strollers to hot sauce.

But more recently, much of Amazon's sales growth has come from digital, rather than physical items – everything from e-books to movies to music to mobile applications. Indeed, the company has spent billions on three lines of hardware (e-readers, tablets and, this year, a new set-top box called Fire TV) designed not to make money, but to facilitate the consumption of content.

"We price our devices effectively to break even," said Dave Limp, vice-president of Amazon Kindle devices. "We want to make money when our customers use our devices, not when they buy our devices."

In many ways, the strategy has worked. According to David Naggar, vice-president of Kindle, customers who purchased a Kindle e-reader or downloaded the Kindle reader app on another device bought on average four times as many books from Amazon as they did in the 12-month period prior.

Amazon's fundamental appeal to consumers has always been predicated primarily on two factors – speed and price. The company has invested heavily in building its capacity to speed up shipments, in large part by building countless fulfilment centres around the globe. Indeed, the company has become so good at getting products to consumers quickly that it can now realistically aim for same-day delivery on many of its products.

But on the issue of price, Amazon needs help. The company already demands the lowest prices possible from its publishing partners, but a combination of low sales prices and massive investment in its shipping infrastructure means that, in many cases, Amazon's profit margins are almost non-existent.

So while Amazon continues to expand its product offerings at a brisk clip, profit remains elusive.

"Amazon is really, really convenient and also very cheap, and this is why they are as sort of monolithic as they are,' said Laura Miller, a New York-based author and publishing industry observer. "But they're not very profitable and it's not very clear how long they can sustain that."

For years, investors were inclined to let Amazon generate minuscule profit, as the company continued to reinvest in what has become perhaps the most powerful and expansive Web-based store on the planet. But as of late, Amazon's inability to make money has started to affect its perceived worth.

Late last month, the company reported earnings for the March quarter that were largely in line with analyst expectations. But its small operating profit of just $146-million (U.S.), as well guidance for an operating loss in the coming quarter, sent the company's stock down almost 10 per cent on the day. Indeed, Amazon shares today trade at about $100 less than the $400 highs they reached at the beginning of this year – as BGC Financial analyst Colin Gillis puts it, "the stock is trading as if investor patience has come to an end."

For the better part of 20 years, Amazon has commanded one of the loftiest price-to-earnings ratios of any public company in the world – despite not generating much profit. Instead, the company has grown by leaps and bounds in almost every other way. Its campus dominates much of downtown Seattle's north end. More people work for Amazon today than its neighbour, 20 kilometres to the west, Redmond-based Microsoft Corp.

But if investor patience has in fact run out, as the reaction to the company's last quarterly earnings may suggest, then Amazon will find itself under even more pressure to squeeze better margins from its content partners. And for a company as notoriously combative as Amazon, that process can sometimes get ugly.

Messy disputes

Earlier this month, Hachette Book Group (HBG), one of the smaller of the major publishing houses in North America, found that its books were taking an unusually long time to ship through Amazon.

Normally, customers could expect the retail giant to have many of Hachette's titles on their doorstep within a couple of days. Instead, the wait times were closer to four weeks – and in the meantime, Amazon suggested they purchase similar titles from other publishers, which would be delivered much quicker.

"We are satisfying all of Amazon's orders promptly, and notifying them constantly of forthcoming publicity events and of out-of-stock situations on their website," a Hachette spokesperson said in a statement. "Amazon is holding minimal stock and restocking some of HBG's books slowly, causing 'available 2-4 weeks' messages, for reasons of their own."

Amazon's disputes with book publishers have been well-documented and often messy. Four years ago, during a dispute with the publishing house Macmillan over e-book prices, the online retailer simply removed a user's ability to purchase Macmillan titles from the Amazon website – a tactic that can have immediate and profound financial repercussions for the publisher, especially given that Amazon controls somewhere between a third and half of the book market in the U.S.

At stake in the Hachette dispute is not only the publisher's own sales, but also Amazon's ability to muscle better terms out of its publishing partners. Both companies are caught up in a bitter fight over e-book pricing terms, with Amazon trying to get the lowest prices possible from the publisher to boost its anemic profit margins. An Amazon spokeswoman refused to comment on the matter.

According to some observers, part of the acrimony between Amazon and some of its content partners is likely a result of culture.

"Jeff Bezos admires people who are disagreeable and love debate and like to fight," said John-Kurt Pliniussen, an associate professor at the Queen's School of Business.

"If that's the way the people are, and they're hired for those skills, you can just imagine how they do business with other companies – it's going to be like that."

But beyond the headline disputes, Amazon is starting to employ a strategy that has the potential to affect traditional content gatekeepers much more significantly than the occasional passive-aggressive broadside.

Quite simply, Amazon is starting to create the content itself.

Going direct

Listening to an Amazon executive describe KDP, the company's self-publishing service, it's hard not to think of it as a direct competitor to traditional publishing houses.

"If you want to be published by a publisher and if they'll buy your rights and publish your books, that's great, and we're very happy to sell those books," said Kindle executive Mr. Naggar. "If you decide that you want to control your own rights, decide what your cover looks like, earn a 70-per-cent royalty, be available globally instantly, KDP is now available to you as well."

(Asked whether Amazon makes more money every time it sells a KDP book, compared with books delivered by a traditional publisher, an Amazon spokeswoman refused to comment).

The book industry may be the most immediate example of an area where Amazon is starting to – at least in some cases – replace the traditional middleman, but it is not the only one. The company also runs a service called CreateSpace, which allows musicians and movie makers to self-publish their work and sell it on-demand – in physical form – through Amazon.

"Historically ... [if] you want to make an album, well you're going to have to do a minimum run of CDs or DVDs or books of some minimum value," said Bill Carr, vice-president of music and video at Amazon. "But the ability to print on-demand or burn on-demand is a meaningful innovation, a meaningful way of solving that problem."

So far, CreateSpace has been responsible for only a small portion of Amazon's overall media offerings. But the company has taken the strategy one step further by launching its own production company. Amazon Studios, announced last year, is currently producing five original TV shows, following the lead of digital media companies such as Netflix.

Amazon's ongoing effort to act as middleman in the creation of almost every sort of digital content has also, more recently, seen the company expand into newer fields. Amazon AppStream, a cloud-based service, allows app developers to run complex or processor-intensive applications remotely, taking advantage of Amazon's massive cloud computing infrastructure. In effect, the service is part of a group of offerings through which the company hopes to do for app developers what its self-publishing tools have done for authors.

Taken in sum, Amazon's myriad expansions mean the company is positioned as a potential gatekeeper in virtually every major area of digital content. As such, should investors continue losing patience with the company's financial results, Amazon's acrimonious disputes over pricing and profit margins may begin to be felt by more than just a few publishing houses.

"I remember seeing [an illustration] of Jeff Bezos a while back," Mr. Pliniussen said. "He had six arms, he was smiling and each hand was holding a different product group.

"Now it may be more appropriate for him to have 18 arms."