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The grand unified theory of Nook

October 03, 2011 – Comments (6) | RELATED TICKERS: BKS , AMZN , LCAPA

Barnes and Noble, of course, of course!

For those of you (like me) that are too yound to remember, that was the tagline for the 70's commercials that helped Leonard Riggio start his empire.  It's also, IMHO, the best, albeit surprising, answer for the question "Who will win the Tablet Wars?".

Are you crazy?  Why? How? The debt! You might ask.  Well, slow down, buckaroo, that's a lot of questions.  The last one isn't even a question.  But I'll go ahead and answer all four.

Are you crazy? ------------------------------------------------------------------------------------------------

That's the easy one, sure I am.

Why?-----------------------------------------------------------------------------------------------------------

That's a bit trickier.  But basically, Barnes and Noble has three secret weapons; the agency model, the epub standard, and the fact that Amazon has too many direct competitors.

For those unaware, the agency model is the business model selected by the large publishing companies in North America and England in which all ebook prices are set by the publisher rather than the competitor's.  Consequently, ebooks are the unique digital media product in which high margins are actually maintained.  As such, the razor-and blade model can be applied to tablets backed by a strong ebookstore.  This business model doesn't work with mp3's, streaming video, apps, streaming video games etc. because competitive pressures and low barriers to entry drive the profit margins on those products far too low to subsidize hardware products.  In fact, most of those digital products end up subsidizing the hardware purchases or subscription plans rather than the other way around.  ONLY agency model protected ebooks are suitable blades.   Keep that in mind.

So the winner of the tablet race is Amazon? Then.  Well, probably not, for two reasons.

The most significant is the epub standard.  The epub standard (specifically ADE) is the e-book format used by almost all ereaders, other.  Amazon Kindle's share of the ereader market is somewhere between 50-60% worldwide, depending on who you ask, and dropping due to the number of competitors.  The remaining 40-60% is pretty much all epub.  In the U.S., about half of the epub market is nook, the remainder of the US market and the entire international market is distributed among multiple smaller competitors. As the ereader market shifts into the tablet market, the weaker and less dedicated ereader makers will start to drop out of the market, and the users will look to transfer t heir library to another device.  Since the Nook natively reads the existing ebook files, and the Kindle does not- these users will break strongly in favor of the nook.  This is the Geoff Moore "Gorilla Game" advantage.

 The other reason is that Amazon is an unsuitable platform. A lot of analysts and commenters think Amazon's mp3, cloud, and streaming video services give them an edge in the tablet battle.  I just think they simply scare off valuable developers.  Remember, without margins protected by the agency model, these services do NOT significantly contribute to Amazon's ability to subsidize their tablet.  But they DO give competing media services such as Netflix, Gamestop, and Sirius satelite radio (more on these names later) an incentive to favor the competition with their own applications.

On a related note, Amazon's reputation as the "Wal-mart" of ecommerce hurts their ability to compete for distribution.  The actual Walmart.com, as well as Overstock.com, and Books-a-million carry the nook to the exclusion of the Kindle.  In fact, if you search for Kindle at those websites, you are directed to the nook!  As of today, Target is now distributing the nook.  Other than Amazon itself, I believe only Office Depot (LOL) and the AT&T stores carry the Kindle and not the nook.  And Amazon actually carries the nook in their 3P market!

That's nice in theory, But How?-------------------------------------------------------------------------------------------

Here's where the research comes in.  Barnes and Noble can't compete head to head with Amazon on pricing at the moment due to cash discrepancies.  Luckily, they don't have to.  They can zig when Amazon expects them to zag.  Where are they zigging?  To the following places:

1.  Video Games!  

http://techcrunch.com/2011/09/12/gamestop-has-an-android-tablet-on-the-way/

Gamestop is partnering with a "hardware developer" to produce an android tablet of their own.  Gamestop is a Barnes and Noble spinoff, Len Riggio sits on the board of both companies.  Case closed. 

Whoops! The Kindle Fire is not equiped with a streaming video game service.

2.  Europe!

http://paidcontent.org/article/419-uks-waterstones-to-wade-into-the-e-reader-market-with-kindle-killer/

Waterstone's, England's answer to BKS, is coming out with an ereader and tablet too!  And the "template" is the nook.  I read this as the ereader IS the nook.  Particularly given that in an interview last year, William Lynch leaked that Barnes and Noble would be expanding into Europe, not in the "next six months", but definitely in "three years"

http://www.thebookseller.com/profile/bn-lynchpin.html

Not just the UK, either, but France and Germany as well!  Incidentally- Gamestop has locations in all those places as well.

D'oh the Kindle Fire isn't available in Europe.

3.  Mirasol!

 http://www.the-digital-reader.com/2011/09/23/barnes-noble-to-launch-2-new-nookcolors-this-year/

Barnes and Noble will have three nook units for sale this year.  The base model, the color model, and... a mysterious third tablet priced at $350.  Why would they need to raise the price?

Well, for the last several years Qualcomm has been developing a full-color, full-video, version of the epaper technology know as Mirasol.  And everyone was SURE it would be in the next Kindle. And everyone was SURE it would be groundbreaking.  But it wasn't in the Kindle.  Not this year, at least.

So what,- did Qualcomm just give up?

Of course not.  In fact, Cheryl Goodman, the spokesperson for Qualcomm has recently verified that Mirasol WILL be on the market in time for the holidays anyways, with several production partners.

http://goodereader.com/blog/electronic-readers/qualcomm-talks-about-future-of-mirasol-based-screen-technology/

So I ask again- what could the $350 tablet be? 

This is Clayton Christnesen's Innovator's Dillemma- Amazon listened to their own over-enthusiastic press and launched a traditional LCD tablet, when they had access to and may have even preferred to launch something more disruptive. Leaving the innovation to smaller, less established firms.

But... the debt, the stores....................................................................................................................

I understand the theoretical concern.  But liquidity concerns are frequently overblown.  The Kindle Fire verifies the Nook business model has merit and cash can be easy to come by if your business model appears to work.

Look at my other profile:

http://my.fool.com/profile/Distressedstar/activity.aspx?source=iersitlnk0000002

Here, I only pick low current ratio companies, and I pick them because they have low current ratios with no due dilligence whatsoever.  It's an all-star portfolio.

The stores are still paying for themselves with 2-300K to spare.  It's not enough to fully finance the nook, but it shouldn't drag them down.

So how does Barnes and Noble get the cash to compete with Amazon. 

1.  From the developers: John Malone just took a big stake in the company.  He owns Sirius, he owns Liberty Starz! which until recently was Netflix's largest content supplier.  Not only do they have cash from that deal, but if those services were to offer nook color apps that would make them more competitive with the Kindle.  And those services could possibly even offer free trials of their service to nook color owners that would effectively lower the price of the nook.  Why would Netflix/ Sirius want to do that?  Simple- this tactic would cost the media services nothing up front while hooking new owners on their service, in an ecosystem where they don't have to compete directly with Apple, Amazon, or Google.

2. From their customers:  Last year, shortly before cutting the price of the original nook by $50, BKS offered them at $250 with a $50 gift card.  They could use this tactic again if they do not have the cash on hand to directly sell tablets at a loss.  As an added bonus- this actually reduces the amount of sales tax owed since the transaction is wrung-up as a $200 taxed purcase + a $50 tax-free gift card to be used on tax free ebooks.

3.  From their distributers:  In the notes to BKS financial statements, we find this:

"The Company also pays certain vendors who distribute NOOK™ a commission on the content sales sold through that device. The Company accounts for these transactions as a reduction in the sales price of the NOOK™ based on historical trends of content sales and a liability is established for the estimated commission expected to be paid over the life of the product. The Company recognizes revenue of the content at the point of sale of the content."

In other words, when Barnes and Noble doesn't have the cash to simply subsidize a purchase upfront- they can just finance the subsidy by getting a partner retailer to sell at a loss and compensating them from the resulting ebook revenue stream.

 Thus, $99 nook touches are already available on Overstock:

http://www.overstock.com/Electronics/Barnes-Noble-NOOK-The-Simple-Touch-Reader-Refurbished/6198991/product.html?TID=D:HPAD_1

I got a nook color there for $160 even the week before the Kindle Fire was announced.  Today they are $180.  Already beating Amazon.

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How crazy is that?