On the face of it, the stakes in Apple Inc. (NASDAQ:AAPL)‘s ebook trial may not seem very big. During the trial, Apple Inc. (NASDAQ:AAPL) executive Keith Moerer claimed that Apple has 20% of the U.S. ebook market. That market was estimated to be worth about $1.4 billion, which means that Apple makes about $280 million a year, small compared to total iTunes revenue. In contrast, Amazon.com, Inc. (NASDAQ:AMZN) is estimated to have about 50% of the U.S. market. In fact, the consequences for Apple of losing the trial may extend well beyond iBooks.
Why the complaint?
After reading through the government complaint and some of its evidence, I’ve started to worry that Apple may have miscalculated in this case, and that the stakes are higher than just ebooks and the price Apple Inc. (NASDAQ:AAPL) charges for them. In order to explain my concern, let me back up a moment and provide a capsule summary of the case for those who may not have been following it closely.
In the Department of Justice (DOJ) complaint, Apple Inc. (NASDAQ:AAPL) is alleged to have violated Section 1 of the Sherman Antitrust Act (SAA) by conspiring with numerous book publishers to set the price of ebooks well above its competitor Amazon. As Apple prepared to launch the iPad in 2010, Apple persuaded the major book publishers in the U.S. to sign contracts with it to publish through iBooks, which featured prominently in Steve Jobs’ introduction of the iPad.
These contracts specified that Apple would serve as the book publishers’ agent (the so called agency model) and sell the ebooks at a price set by the publishers, with Apple Inc. (NASDAQ:AAPL) taking a 30% fee. The agency model was a departure from the wholesale model under which the book publishers had operated in selling both hardcopy and electronic books. The publishers sold books at a wholesale price, and then it was up to the retailer to decide on the retail price.
The wholesale price model had started to break down for ebooks as Amazon achieved great success with the Kindle, introduced in 2007. Amazon was selling many ebooks at $9.99, below the wholesale price paid to the publishers.
Publishers’ conspiracy
Why should the publishers care? Two reasons. First, the publishers were concerned that the steeply discounted ebooks were cannibalizing sales of physical books. Second, the publishers were concerned that consumers would become so accustomed to Amazon.com, Inc. (NASDAQ:AMZN)‘s ebook pricing that it would become the norm and Amazon would begin to demand lower wholesale ebook prices rather than continue to take a loss.
The DOJ concludes in their complaint that the publishers had formed a conspiracy by late 2009 to “do something about Amazon” and fix prices at a more acceptable level. There’s little doubt that this conspiracy existed, since all of the publishers have already settled with the government, although the settlements didn’t require admission of wrongdoing. The publishers just had to refrain from trying to fix prices in the future.
The DOJ alleges that Apple Inc. (NASDAQ:AAPL) proposed the agency model specifically to address the publishers’ concerns about Amazon, as well as ensure that iBooks would be profitable from the beginning. Crucial to the government’s case is the role of a so-called “most favored nation” (MFN) clause in the Apple contracts. This clause would allow Apple to lower the price of any ebook to match that of a competitor such as Amazon. The government claims that MFN was intended to compel publishers to either withhold ebooks from Amazon.com, Inc. (NASDAQ:AMZN) or force Amazon to accept the agency model as well, since publishers would lose serious money if Amazon continued to sell steeply discounted ebooks at $9.99.
The presiding Judge, Denise Cote will decide the case in this non-jury trial, based on whether she believes the government’s view or Apple’s. Apple’s defense rests largely on a claim that it proposed the agency model based on its iTunes experience. It was just business as usual for Apple.
Eddy Cue, now in charge of all Internet services, proposed the MFN provision, and has defended it as simply a way for Apple to defend itself against Amazon, and not as a tool to enforce price fixing. Perhaps Apple, in its rush to bring a full plate of services with the iPad, walked into the middle of something it didn’t fully understand.
The consequences of losing the case
I wouldn’t pretend to understand the legal issues well enough to predict the outcome of the case, but I have to say that the signs aren’t good. Judge Cote expressed the opinion at the outset of the case that Apple would probably lose. Plus there are numerous email exchanges between Apple executives and various publishers that seem very damning. Sure, it’s mostly circumstantial, but the government doesn’t have to prove its claims “beyond a reasonable doubt” for a civil antitrust case.
The concern I have about Apple’s losing the case is not in its immediate impacts. If Apple loses, it signs some form of judgment agreeing to play nice from now on, and coughs up some money to cover the government’s legal expenses. Apple will of course, appeal, would could defer any final judgment for another year.
The problem with Apple Inc. (NASDAQ:AAPL) losing is its “business as usual” defense. If Apple’s iTunes business practices served as a model for iBooks, and these practices were found to be anticompetitive, this opens the door to a wide ranging DOJ investigation into iTunes pricing, especially Apple’s relationships with music and video content providers. Since Apple makes about $4 billion a quarter from iTunes, now the business stakes are much higher.
iTunes pricing has uncomfortable parallels with what happened with iBooks. Once again, Apple’s agency model has produced virtually uniform pricing for digital music and video content across the industry. Every song’s a buck, wherever you go on the Internet. Most videos are released at the same time and have the same pricing, whether for rental or purchase. The only area where there seems to be genuine price competition is in apps, because here the developers do set their own prices and do compete on price.
If Apple were a normal company, the announcement of further DOJ investigations would not have much impact on its share price. Look how many times Google has been investigated. But Apple isn’t a normal company, and with its abnormally high short interest, the Apple bears will have a field day in the media. Apple Inc. (NASDAQ:AAPL)‘s Fall product announcements are starting to look like the light at the end of a very long, dark tunnel.
The article The Consequences of Apple Losing its Ebook Trial originally appeared on Fool.com and is written by Mark Hibben.
Mark Hibben has a position in Apple. The Motley Fool recommends Amazon.com and Apple. The Motley Fool owns shares of Amazon.com and Apple. Mark is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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