Why Amazon Cannot Afford To Lose The eBook Wars To Apple

“One defends when his strength is inadequate, he attacks when it is abundant.”—Sun Tzu, The Art of War

The Apple iPad isn’t even available yet, but already it is forcing Amazon to respond in a variety of ways to protect its competing Kindle eBook business. Amazon just snapped up a touchscreen technology startup, presumably to update the already ancient-looking Kindle. Emboldened book publishers are pushing back on Amazon’s $9.99 pricing now that they can sell the same eBooks on the iPad for $14.99, and Amazon is capitulating. And the Kindle team at Amazon, which once had an arrogant approach towards publishers when it was the only game in town, is now bending over backwards to solicit their loyalty, says one editor at a publishing company who has noticed the change in tone.

The coming battle between Apple and Amazon will occur on many fronts, but place where Apple can really hurt Amazon is on pricing. Just as Apple initially did with 99-cent songs on iTunes, Amazon imposed a uniform $9.99 price on bestsellers in the Kindle Store.  A single price helps to establish markets for new product categories, especially when that price is at a discount to the physical alternative.  While the 99-cent strategy worked well for Apple in digital music, in books Apple doing a jujitsu move on Amazon by allowing publishers to have more control over the pricing. Now Macmillan is demanding that Amazon sell its eBooks for $14.99, and News Corp’s Rupert Murdoch is making similar grumblings about  HarperCollins.

Even before the Macmillan dustup, on the day of the iPad launch Steve Jobs predicted (in this video with the Wall Street Journal‘s Walt Mossberg that Kindle and iPad “prices will be the same. . . . The publishers are actually withholding books from Amazon because they are not happy with it.”  And voilà!  All of Macmillan’s books disappeared from Amazon, to the great joy of Barnes & Noble. The books will be back soon at the higher price, but the pressure from other publishers to follow suit is already growing.

Simply by allowing a $14.99 price on the iPad, Steve Jobs destroyed Amazon’s $9.99 price advantage.  At first glance, it might seem that Amazon will actually come out the winner here, since it was losing money on each $9.99 bestseller and now will be making money on those.  For instance, it currently pays publishers 50 percent of the list price for bestsellers, which is typically $28.  Thus it loses about $4 on each Kindle bestseller. Under the new agreement with Macmillan, it will pay 70 percent of the new list price of $13 to $15 and pocket about $4 on each sale. Forced to make a trade-off, book publishers prefer to make less on each digital book under the new iTunes economics and keep the list price higher in order to protect sales of physical books.

As counter-intuitive as it may seem, Amazon is actually not the winner because it just lost pricing power to the book publishers. Citi analyst Mark Mahaney explained why in a note earlier this week:

This one is counter-intuitive. Typically, people think of pricing power as the ability to raise prices. With AMZN, it’s the ability to lower prices and to compete on Price, Selection & Convenience. If Amazon is forced to do away with $9.99 pricing on all best-sellers (which typically account for 5% of book retailers’ sales), it will be less able to compete effectively with other eBook retailers.

The economics of eBooks for Amazon just changed.  It was willing to take the loss on that 5 percent of sales to win customer loyalty, bring them into the Kindle Store, and buy other titles at a profit.  It was a loss leader.  Just like Amazon loses money on free shipping or Amazon Prime, it chose to lose money on bestsellers to gains loyalty and market share.

Mahaney estimates that Amazon will sell 3.5 million Kindles this year and 100 million eBooks.  He estimates total Kindle hardware and eBook sales (assuming the $9,99 price) to come to $1.9 billion, or 5 percent of Amazon’s estimated total revenue for 2010.  If Amazon can’t hold the line on the $9.99 price, it will be harder to sell 100 million eBooks and there might also be less demand for Kindles. (The ability to buy new books at a steep discount is one of the Kindle’s main appeals). Every million Kindles Amazon doesn’t sell will result in a 1 percent reduction in Amazon’s total estimated revenue for 2010.  (Barclays analyst Douglas Anmuth estimates only 3 million Kindle sales this year). Will the iPad dampen sales of the Kindle and its eBooks, and by how much?

Amazon cannot afford to lose this war.  Not so much because of the potential revenue impact this year, but because as digital books become more popular they will become a bigger part of Amazon’s business than of Apple’s.  What we are seeing is a fight over who, if anyone, will get to be the iTunes of eBooks. Amazon holds that position today, but book publishers saw how iTunes emasculated the music industry and don’t want to repeat that experience.  Perhaps nobody understands that better than Steve Jobs, which is why he is now playing a different game.