eReaders and the Danger of a Price War

This is a guest post from Zack Urlocker, former EVP of Products at MySQL.

Last week, Barnes & Noble announced they would cut the price on their wireless Nook eReader, from $259 to $199 ($149 for a new WiFi-only edition.)  Many thought this was a good opportunity for the third place contender to gain market share.  But within a few hours Amazon beat Barnes & Noble’s price by $10, marking down the Kindle 2 to a mere $189.

As The New York Times notes:

The price cuts were made as manufacturers of e-readers faced a mounting threat from Apple’s iPad. Even though it is far more expensive than the e-readers, the iPad, which starts at $500, performs a range of functions with a versatile, colorful display that contrasts sharply with the static, monochrome screen of e-book readers. Apple said it sold more than two million iPads in the two months since the tablet’s introduction….Analysts had expected the prices of e-readers would gradually fall because of the natural decline in component costs and the increased profitability of e-books themselves.

The price cuts should add further momentum to what, despite incursions by the iPad, has been a growing market for dedicated e-reading devices. Amazon and its rivals are on pace to sell 6.6 million e-reading devices this year, up from 3.1 million in 2009, according to Forrester.

If Amazon, Barnes & Noble, Sony et al. manage to sell six million eReaders this year, that would be impressive growth for a category that has been lackluster to date.  Amazon has never broken out sales of it’s Kindle line, but by all appearances it’s the leading standalone eReader and likely has sold a couple of million units in its three-year history.

In comparison, Apple has sold more than three million iPads in its first 80 days. And they’re expanding into nine more countries next month.  Analysts are predicting that the iPad could sell between five and 10 million units this year, which blows Amazon’s Kindle out of the water.  And unlike Amazon, Apple actually makes money with its iPad since its costs are around $260 for the $499 entry-level product and margins improve on the higher-end units.

Amazon and Barnes & Noble were willing to sell eReaders at a loss even before this recent price cut.  The ePaper screen itself costs far more than a color LCD display and if you add in the other components and manufacturing costs, they’re spending real money to subsidize the purchase of these devices.  Until recently, Amazon was also losing money on the sale of many bestselling eBooks, paying royalties to authors that were several dollars higher than the standard $9.99 best-seller price.  With recent re-negotiations (and raised prices on ebooks), they now stand to make money on more eBooks than previously, which improves the situation.

But it’s worth considering a few questions:

• Will price cuts making any difference competing against the iPad?
• Or does it just increase the burn of a money-losing business?
• Why is Apple’s iPad business profitable and Amazon’s Kindle isn’t?
• If you could chose to be in either business, which would you choose?
• And what does all this have to do with open source?

The key point here is that price is just one part of a disruptive strategy.  No doubt, part of the success of MySQL, Red Hat, JBoss, Alfresco, Zimbra, Pentaho, Revolution Analytics et al., comes from delivering 90 percent of the benefit for 10 percent of the price of incumbents. The trick is do to do in a manner that is profitable but that incumbents cannot respond to because of their higher cost of operations.  (And remember, most open source users don’t pay anything!)

Self-Inflicted Disruption?

The widespread distribution of open source over the Internet means vendors don’t have ongoing costs associated with free users.

Contrast this with Amazon, Barnes & Noble et al. who now have to run unprofitable hardware businesses and make up for them with follow-on sales of eBooks, much like console vendors do with add-on games. Amazon, and especially Barnes & Noble, may soon regret starting a price war that hurts their profitability and ultimately doesn’t require any response from Apple, the market leader.

In a classic disruption play, the market entrant attacks a new, underserved market that is profitable for them, but would be unprofitable for the incumbent given its larger cost structure.  In this case, Barnes & Noble and Amazon are doing the opposite: they’re inflicting the money-losing operation on their own investors.

At some point Amazon and Barnes & Noble may find that the best way out of a hole is to stop digging and they’ll get out of the hardware business completely.

The same phenomena is starting to creep into many so-called “freemium” Software-as-a-Service (SaaS) businesses.  In some segments, there are so many startups competing that there may be a comparable battle for free users that takes attention and resources away from the money-making add-ons.  Unlike open-source software, free users in a SaaS model still cost money to service.  So if you don’t build a compelling value-add proposition for paying customers, you can find yourself winning the war and running out of money, especially as Google and Microsoft start making further inroads into Cloud / SaaS offerings.

This is one of the dangers of relying on price alone as a disruptor: there’s no limit to the amount of money that can be lost in building an unprofitable, make-it-up-in-volume business.

The key point is to remember that price isn’t the only factor driving buyer decision-making. Many people use open-source software because it’s a better fit than traditional proprietary systems for certain classes of applications. For example, MySQL has a stronghold in web applications, business intelligence, telecommunications, SMB and bundled or embedded OEM applications.

In these areas, MySQL competes not just on price, but on fit: in these scenarios MySQL runs more efficiently and with less complexity than the big guys.  And it is in these use cases that most of MySQL’s revenues are generated.

As long as there is a slice of the overall market that is willing to pay for additional products and services, then you can build a sustainable business on a freemium or open source model.  But you need to make sure you invest to build the differentiated offering alongside your free product.

Zack Urlocker is an investor, advisor and board member to several startup software companies in SaaS and Open Source. He was previously the EVP of Products at MySQL responsible for Engineering and Marketing. He built the MySQL Enterprise subscription strategy and product line. MySQL was sold to Sun for $1 billion and is now part of Oracle Corporation. He is also a marathon runner, blues guitarist and occasional yak whisperer. When not whispering sweet nothings to yaks, he blogs at The Open Force.

Further information:

• Amazon: Kindle $189
• New York Times: In Price Wars, eReaders go below $200
• WSJ: Apple iPad Off to Fast Start; iPad Outselling Mac
• Ars Technica: iPad Components Estimated at $260