Department Of Justice Bites At Apple

By Stephen D. Simpson, CFA | March 12, 2012 AAA

Price fixing allegations aren't anything new; investors can usually count on seeing a few threats lobbed at this or that industry every year. What's unusual in this case is that a form of digital media, often seen as the dragon slayer of entrenched controlled prices, is in the center of the fight. What's even more unusual is that Apple, a company often credited for spot-on sense of its customers' sentiments, is involved as well.

SEE: Antitrust Defined

A Warning Shot from the DOJ

The U.S. Department of Justice has recently warned Apple, as well as five traditional large publishing houses, that it intends to pursue a suit alleging antitrust/price-fixing behavior in the e-book market.

What this case ultimately boils down to is the allegation that these companies have essentially forced Amazon and other retailers to raise their prices on e-books. While Amazon has generally preferred to use a wholesale pricing model (where it decides the final price and the margin it wants), publishers have forced the company in many cases to adopt an agency model - a model where the publishers set the price and give a fixed percentage over to the retailer.

Certainly there is anecdotal evidence to support the accusation. E-book prices have been on a steady upward march; where e-books often used to be substantially cheaper than the physical versions, that gap has in many cases evaporated completely. While Amazon used to limit e-book prices to $9.99 in most cases, a squabble with Macmillan ultimately ended with Amazon raising the prices on those books to a range of $12.99 to $14.99.

Publishers Have Everything at Stake
It's not too hard to see why publishing houses want to take a firm hand with pricing. Simon & Schuster (owned by CBS), Hachette, Pearson's Penguin and News Corp's HarperCollins all saw what happened to the music industry when digital distribution took all the power out of the labels' hands.

Piracy has clearly had a major negative impact on the music industry, but so too has the ability to buy individual songs for, well, a song. Music labels used to be able to sell entire records for $10-plus and buyers just had to accept the fact that they were buying songs they didn't necessarily want or like in order to get the ones they did. Now buyers can just buy the songs they want for a buck apiece from online stores such as Apple's iTunes.

With production costs not falling nearly so fast, record labels have seen their profits disappear and several well-known labels have closed up shop as a result, and now it's the turn for the publishers.

A year ago, e-book sales were more than one-quarter of industry sales and that percentage is increasing at an accelerating rate. That makes the pricing, and profits, of e-books even more important. What's more, book publishers should be very much afraid of the possibility that textbook publishing "jumps the fence" and goes the e-route as well; those ridiculously over-priced textbooks are a gold mine for publishers, and one they can ill-afford to see devalued by cut-rate e-book pricing.

Apple's Role
It may seem a little strange that Apple is even involved in this squabble. After all, it's basically the same boat as Amazon - it makes a reader and sells content. Apple's involved because it has chosen to cooperate with the publishers; Apple introduced an agency model where the publishers set the prices and Apple got a 30% fee at a time when Amazon was still pushing its wholesaling model.

Ultimately, the threat to Amazon is pretty clear - if it doesn't play ball with the publishers, the publishers will take their books to more compliant retailers (like Apple) and Amazon won't have anything to sell. Maybe Amazon is a beloved online retailer, but the fact is that nobody shops at stores that do not sell what they want to buy.

For Apple, it would seem to be a no-lose proposition. Either Amazon plays hardball and risks losing titles to Apple, or Amazon gives in and they both collect very profitable fees with little threat of a price war.

The Bottom Line
So, how much of this really matters to investors in the end?

For starters, investors in publishing and media companies cannot afford not to watch these developments. The fights over who controls the signals (the content) and who sets the pricing is going to decide where the profits flow in the future. These fights may also take the industry in entirely new directions; while e-books cost very little to produce, publishers need those profits (they would argue) to promote writers, pay advances and otherwise survive in a world where reading is not what it used to be.

For Amazon, this is a battle about just how much independence the company can exercise in running its business. There has long been a delicate balancing act between suppliers and retailers (not just in publishing), and if suppliers think they can force retailers' hands when it comes to pricing, the e-commerce model could be in for some changes. Amazon is accustomed to being a game-changer, moving the power more towards the distributors and authors, but that could be up in the air if the DOJ fails to make its case.

Last, and by no means least, is Apple. Operationally, there may not be all that much at stake. The problem for Apple, though, is the value of its brand and its corporate image. Apple traffics heavily in its reputation as a "cool" company that really "gets" its customers. Well, if those customers come to believe that Apple is partially responsible for them having to pay more for e-books, that reputation may be at risk and Apple may find that it has to compete on the basis of features and value - a game it arguably cannot win in the long run, versus Samsung, HTC and others.

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