A Long Winter

While 2008 ended on a disappointing and even discouraging note for many in the book industry, the outlook for the new year is even bleaker. One-time adjustments by retailers and underlying shifts in the structure of the book industry will make 2009 the worst year for publishing in decades, and could lead to long-term fundamental changes in the business.

For much of 2008, the industry focused its attention on the viability of the struggling Borders, but Barnes & Noble faces many of the very same issues: high fixed costs (store rents and staff wages), thin margins and flat or declining same-store sales. As Amazon continues to grow, it will take market share away from traditional retailers, turning marginally profitable outlets into money losers; the current economic crisis will only accentuate the decline. The problem of declining individual-store profitability becomes particularly acute when long-term leases are up for renewal, as will be the case for many expansion-era stores in the next few years. Management may be forced to choose between relocating to a cheaper, less attractive site (where lower rent costs may not offset falling revenues) and abandoning an area altogether. The retail landscape could begin to change dramatically in 2009 and beyond, with the reduced network of stores reinforcing readers' recent tendency to browse and buy online. Even an unlikely merger of Borders and Barnes & Noble would not resolve this structural problem.

In addition to the agony of store closings, bookstore chains will increasingly struggle to finance inventories. The likely dearth of bank loans and bond market funding will cause chains to rely even more heavily on returns to finance purchases, at least for the first part of the year. In effect, publishers will become bankers without the prospect of a bailout. Initial orders for new titles will be cut further, shelf lives of slow-moving titles will be shortened and return rates probably will spike to unprecedented levels in the first half of 2009.

Bookstore chains will attempt to make publishers share their pain by demanding more favorable discounts, additional payments for front-of-store placements and significantly longer payment terms. With cash flow concerns paramount, the existing tension between retailers and publishers will escalate.

Loss Leaders

One of the few stocks to survive the recent crash relatively unscathed has been Wal-Mart, and for a very simple reason: in a recession shoppers become extremely price-sensitive. Mass merchandisers like Wal-Mart and Costco have come to occupy an anomalous position in the book world. By treating books as loss leaders and using steep discounts to create a generalized perception of value (few other products carry a manufacturer's recommended price and lend themselves to loss-leader merchandising as well as books), they have become vital in building initial distribution for bestsellers. Although high return rates (often over 40%) make this the least profitable channel for publishers, in the current recession this avenue will probably take market share away from traditional book retailers, further increasing the leverage giant mass merchandisers enjoy in determining initial laydown levels (a risk borne entirely by publishers) and payment terms.

Publishers have had the opposite experience with Amazon. The fastest-growing retail sector for publishers, it has also been the most profitable because of systemically low return rates (well under 10%). At this point there is no reason to expect that Amazon's annual growth of 10%—20% will not continue for the next few years. What does this mean for Amazon's position relative to publishers? The most amazing aspect of Amazon's treatment of publishers to date has been its relative restraint: negotiations on terms of sale generally fit the bluster-but-compromise pattern characteristic of the industry, and thus far Jeff Bezos has largely resisted the temptation to follow the example of the Riggio brothers and become a publisher himself. The question is whether the Kindle can serve as an instrument to change the familiar rules of engagement.

The secrecy that has surrounded every aspect of the Kindle since its introduction should give publishers reason to worry. What is Amazon actually up to? Clearly, Bezos is looking to build customer loyalty. And the Kindle provides a platform to experiment with new forms of readership, new ways to promote books and make reading recommendations, and new pricing models. The deepening direct-marketing relationship between readers and Amazon raises the specter of disintermediation for booksellers, and a radical rethinking of established book pricing patterns.

There is no reason why prices for e-books, with marginal costs much lower than print books, should parallel pricing on hardcover or even trade paperback editions. E-book pricing flexibility could, over time, lead retailers to try pricing p-books differently. For example, demand-driven pricing would charge more for fast-selling titles (why should the first million copies of a new J.K. Rowling book be priced at the same level as the next million copies?) and substantially less for slow-moving titles (an expansion of the old remainder-in-place concept). Opening up the Pandora's box of pricing, however, could also result in a major change in the relative profit shares of authors, retailers and publishers, and if online retailers demand a larger share of the pie, publishers' margins will come under increasing pressure.

The natural reaction of publishers to a downturn is to cut payroll and titles. These savings measures, however, may not be sufficient to offset lower sales, the likely surge in returns and the greater costs of financing inventories through extended payment terms that may come in 2009. The one-time charges for severance, higher returns provisions, inventory write-downs and adjustments to reserves for over-guarantee writeoffs will be painful for publishers, but the more troubling questions are whether retailers can renegotiate terms of sale to achieve a permanent rollback in publishers' operating margins, and whether existing book pricing models will come under attack. These changes could generate pressure for a new round of consolidation among the big publishers, while driving some smaller publishers out of business (financing will be especially hard to raise for independent publishers) or into partnership with the larger houses. Given the current state of the economy and credit markets, the valuation of publishers is likely to drop in 2009, making some companies attractive acquisition targets.

Despite the drive to cut costs, the market for advances for celebrity books shows few signs of abating in 2009. Publishers will likely continue to overbid for potential bestsellers, justifying their offers on marginal contribution from outdated sales projection models. This means bad news for other writers, as the willingness of publishers to invest time and money in developing new projects and of retailers to risk stockpiling unknown authors may drop precipitously. These are not encouraging developments for an industry that has had an admirable track record to date in discovering new talent and fostering a diversity of expression. Under these circumstances, some writers may be willing to try an e-book-only first publication or even to establish a direct relationship with a retailer such as Amazon, thereby undermining the exclusive role of publishers in the long run.

Even if consumer spending bounces back in 2010, the shift to online buying at the expense of bricks-and-mortar stores—and the pressure on publisher profitability—will continue. The success of the Kindle, moreover, is likely to cause Sony, Apple and even Google to reevaluate their approaches to e-books. An expanding array of e-reading opportunities will invite price experimentation among competitors, and the price for books in the public domain could rapidly approach zero, causing more profit headaches for publishers.

With the recession accelerating changes that are already taking place in the market, the world after 2009 will likely begin to look very different for book publishers, and a likely return to the relative security of the last decade may be wishful thinking.