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It was just about two years ago that I appeared on a panel at a meeting of agents with, among others, Macmillan CEO John Sargent and Sargent made the point that maintaining ebook pricing and margins was one of the critical challenges facing publishers. Ebook sales were still hovering around one percent of the business. Or maybe two. Nowhere near five. Sargent was prescient.

It was about six months ago that I did a couple of posts on direct marketing techniques. I engaged a publishing friend named Neal Goff, whose background is mostly outside of trade books, to help me with those. I had him walk me through some fundamentals because I didn’t know them and, I feared, neither did the trade houses that were now — because of agency — required to set prices on their own books without the requisite expertise.

It was only last week that Random House announced it was shifting to agency pricing and I said I hoped they would be more ambitious about experimentation with price than their competitors in the arena had been.

All of these thoughts came together for me when I read this post on CNET that has two real wake-up calls in it for the big publishers.

One they are increasingly aware of: very cheap ebooks are selling very well and, with at least two major bestseller lists (The New York Times and USA Today) now counting ebook sales in units for their rankings, there is a real threat that the established business at established price points could be chased from the biggest market-maker there is. (It is important to note that the Times and USA Today methodologies are still a bit opaque and it is not clear how lower-price books are weighted. Some clear successes in the low-price realm haven’t shown up yet.)

The other point is more subtle. Individuals and little publishers are fiddling with price in ways to maximize bestseller positioning and revenues. The rules are complicated. Both Amazon and Barnes & Noble have programs that reward pricing above $2.99 by paying higher royalties. But it would certainly appear that there are many consumers who are limiting their shopping for ebooks to those that cost 99 cents or below. So some authors have learned that cutting their price increases unit sales to put them on a bestseller list, then raising their price results in more revenue. Apparently one very useful strategy for revenue maximization is to shuttle between prices.

The point that “cutting price boosts sales” isn’t exactly surprising, and it also isn’t exactly news. J.A. Konrath, perhaps the first established author to really start raking in shekels self-publishing through Amazon, has been experimenting with pricing and proving this point for a long time. Konrath’s data was charted for clarity by blogger Dave Slusher a few months ago. Konrath’s work and Slusher’s analysis of it further emphasizes the central point Neal Goff made to us. Experimentation matters. (Neal called it “testing.”)

Another author has demonstrated that cutting price is important, and promoting lower prices is also important.

Although I have heard one major publishing CEO suggest that the house is doing some fiddling with pricing, there was no suggestion there of controlled and monitored experimentation. And I believe it is safe to say, without doing any research, that no major publisher is doing that on a consistent and persistent basis, let alone algorithmically-programmed price management such as the major ebook retailers almost certainly do.

There is another hugely ironic point buried in the CNET story. It is built around the work of an author named Christopher Smith, who has mastered the shuttle-pricing technique. Turns out Smith has a new fan named Stephen King. King, of course, has not only published successfully with major houses for decades, he was one of the first great ebook experimenters around the turn of the century when he tried to do author-direct publishing of ebooks before there was a market. King’s blurb for Smith has been very helpful to the lesser-known, lower-priced author.

Might Smith return the favor for King by teaching him the revenue-maximization techniques he’s developed so King can get back into the self-publishing experimentation game? I think that possibility encapsulates the major publishers’ biggest nightmare. Publishers are going to have a devil of a time defending their 25% royalty rate into the future, which just feels intuitively unfair to authors. They can get away with it for the time being because print sales still matter. But they won’t for long and if publishers don’t use their scale to do a better job managing dynamic pricing to extract the maximum revenue from ebook sales than an author might do on his or her own, the challenge of retaining their top talent will become even more difficult.

There is a reasonable suggestion that publishers should be making in a hurry about bestseller lists in the ebook era. In print, books are separated by format (hardcover, trade paperback, mass-market) by The Times and identified by format by USA Today  so that apples-to-apples comparisons are possible for consumers. It is really a stacked deck to rank on unit sales alone any book at 99 cents and Ken Follett’s bestseller “Fall of Giants”  at $19.99. Format in print creates a reasonable proxy for price. I think price-tiered bestseller lists would be a stretch, but going to the movie studio “box office” concept would not. Publishers, while they still have clout as advertisers in media that promote bestseller lists, should suggest a “units times price” ranking as one that provides a more useful comparison for many consumers.

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Sometimes, and it would seem quite often these days, the future comes faster than you expected it.

Followers of this blog, and of my speeches before there was a blog (this one’s from 2001!), know I’ve long been expecting ebook reading to supplant print book reading for many people. I’ve been wrong about the timing. (Ten years ago I’d have expected to be where we are now three or four years ago.) I’ve been wrong about whether a dedicated device for reading would make much of difference. (I read so comfortably on a phone, and before that on a PDA, that I figured few would want yet another device for reading only.) And I’m rethinking my expectations around enhanced ebooks and the utility of social reading.

But it has seemed clear to me for a long time that ebooks offered compelling advantages over print — portability, ease of purchase, and a lower cost basis that must inexorably lead to lower prices — that would increasingly sway many of the inevitably growing number of people who had a readable handheld screen in reach most of the time. And my long experience dealing with bookstore economics made it clear to me that the consequent sales subtraction from brick-and-mortar stores would lead to closures, which would lead to longer travel times for customers to get to the stores, which in turn would drive more people to purchase print or digital books online. And that would lead to more closures. This is a virtuous circle if you’re in the ebook business or sell print online. Or if you want to see Americans consume less gasoline.

It is a vicious cycle — a death spiral — if you’re a bookstore.

Michael Cader of Publishers Lunch reported (you have to subscribe to use the links) that BookScan numbers show a drop in unit sales of printed books of 4.4 % from 2009 to 2010. But don’t take that number to any bank. It is already out of date. Cader did a further analysis of more recent BookScan data shortly thereafter showing that print book sales have dropped by over 15% compared to the prior year over the first six weeks of 2011! And the share of print sold online keeps rising, so that almost certainly means that print sales in stores has fallen even faster. Could print sales in stores have dropped 20% or 25% from a year ago? They certainly could!

Sales of iPads, Kindles, and Nooks exceeded most expectations for Christmas 2010. Dominique Raccah, the head of independent publisher Sourcebook, a company with a diverse trade list, reported on her blog that dollar sales at her company in January were 35% digital!

No wonder she says, “We may well be at the tipping point. I suspect that we’re going to see some dramatic reassessment when publishers look at their numbers at the end of the first quarter, 2011.”

I have heard the argument from very smart people that ebook adoption will plateau at some point. Since it has been doubling or more for the past three years and was often placed in the mid-teens for new fiction and narrative non-fiction by the last quarter of 2010, we know that it can’t continue to double for the next three years without exceeding 100%. Nonetheless, predictions that ebook sales would achieve 50% in the next five years and that bookstore shelf space would drop by 50% in the next five years — which is what I thought would be the case — seemed pretty aggressive six months ago.

They don’t seem aggressive anymore.

The Borders share of the publishers’ revenue is estimated to be about 8%. They could be 10% or 12% of brick-and-mortar. So if Borders were to completely disappear tomorrow (and they aren’t about to do that) and even if every book they sold in their stores were somehow purchased at somebody else’s store (which won’t happen), the reduction of book sales in stores is so large that all the other stores would still, collectively, be looking at a substantial year-on-year sales decline.

All this means that 2011 that is going to be a real “fasten your seat belts” year for publishers. And Raccah is right that publishers are going to be a bit stunned at what they see when they look at their numbers for the first quarter of this year.

One impact that sophisticated publishers are well aware of but that is not obvious to the untrained eye is that as sales go down, returns percentages, inevitably and inexorably, go up. When a publisher calculates a returns percentage for any period — a week, a month, a quarter, or a year — they are measuring the returns received and credited in that period against the sales made in that period. But the returns actually come from the sales made in prior periods; even in the worst of situations, very few books are returned less than three months following their purchase.

So what’s happening right now is that shipments out are being depressed — no or very little Borders and diminished expectations everywhere else — while returns are rising because they’re coming back from orders placed against the higher expectations of the past six to 12 months. That means that the net sales numbers being created right now — shipments out minus returns — might, for many, be a disappointment verging on devastation.

And returns percentages aren’t the only percentages that are going to be troubling. Two others that publishers look at are also going to get more challenging.

The percentage of a book’s print price that is constituted by the “unit cost of manufacture” is one. The unit cost is extremely run-sensitive. If you’re printing fewer books and if you have to hold the line on retail prices (both of which will almost certainly be true), the percentage of revenue spent on creating the print books is going to rise.

The second trouble spot is that publishers like to think about the cost of “fixed overheads” as a percentage. Many publishers still follow the unwise practice of putting a percentage calculation of overhead into their unit cost calculations for every book. But if sales volume falls faster than overheads can be reduced, that percentage rises too. And you can’t fire your way to rapid overhead reductions very effectively. Shedding staff is often an illusion anyway; we keep hearing about freelancers getting work because publishers have fired the staff that used to do it. But, besides that, warehouse and office space costs and systems investments don’t rise or drop with volume (which is exactly why it is a logical error to calculate them as a percentage of revenue!) Publishers who are using a percent figure for overhead to calculate their margins on each title they acquire to sell are going to find those numbers need to be reconsidered as well.

While Barnes & Noble will be feeling the margin pain of all brick-and-mortar booksellers, they are, no doubt, also very well aware of their growing importance to all publishers in an upcoming Borders-less (or less-Borders) world. B&N will almost certainly be looking for better trading terms and publishers will almost certainly feel the weakness in their negotiating position dealing with those requests. And that’s aside from the fact that publishers really and truly want a healthy Barnes & Noble maintaining its ability to show their wares to the public.

So sales are going down, returns are going up, the cost of goods is going up, margins from sales are going down, and right-sizing overheads is going to be an accelerating problem. The good news is that ebook sales are rising and the margins from them — at least for now — have been pretty well preserved.

But the first significant sign that ebook prices are going to tumble has arrived with the news that 99 cent ebooks are now beginning to appear on the mainstream media’s ebook and combined bestsellers lists which come from The New York Times and USA Today. This creates some nasty problems. It puts previously unknown authors selling 99 cent books before the public as bestseller creators. And it encourages the established publishers to cut prices to register unit sales to get on those lists themselves.

At the very least, I’d expect publishers to start asking The Times and USA Today to consider the total revenue a book generates at retail (price times units) when creating the lists, not base them on unit sales alone. Since the established publishers buy a lot more ads than the 99-cent-book authors do, we should expect them to, at least, get a hearing.

Publishers are going to be scrambling to keep their business profitable and having second thoughts about many of their most time-honored practices in the weeks to come.

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Kindle is certainly engendering a lot of confusion by billboarding the downloads of free ebooks as “sales.” That paradoxical scorekeeping was the lead for an article by Motoko Rich in The New York Times on Saturday that quoted a lot of people, some apparently disagreeing with each other, but none of them necessarily wrong.

There really are three separate questions to consider, which get elided in these conversations.

1. What is the impact of giving away ebooks as a promotional device, either to boost the word of mouth on the book being given away or to promote an author’s other titles?

2. What is the potential impact on the industry overall of ubiquitous giveaways of ebooks that would apparently have commercial value?

3. When ebooks are given away, how should that sale be “scored” in any measurement of the book’s popularity?

The answer to the first question appears, anecdotally but just about universally, to be that giving ebooks away boosts sales of that title and related titles. Rich’s piece sites numerous publishers attesting to that. She apparently found no publisher that is skeptical about whether giveaway promotions work or has seen the tactic fail. And that would confirm my experience: I don’t know of one.

But as we’ve noted before, this effect could change over time. We’re still in a period where ebooks are not an acceptable format to most book readers. That means the benefits of giving them away is not confined to the word-of-mouth from the recipients, it can result in a print book purchase by the very person you gave it to! As ebook reading becomes more popular, particularly if we go to a DRM-free universe, the impact of cannibalization from giveaways could grow dramatically from what it is now.

The second question is what is apparently paramount to David Young of Hachette (as quoted in the Rich piece) and is influencing the policies described at Penguin. As more and more ebooks are given away, it offers a wider array of choice to people who prefer to select from the free offerings and just never pay. For the last 15 years of his life, my father, Len Shatzkin, refused to buy anything except remainders. He shopped from several mail order catalogs and, if he was in a bookstore, shopped at the bargain tables. His position was that if publishers were going to be dumb enough to reliably give the books away six months or a year later, he’d just wait and choose his reading from among what had been marked down. With free ebook marketing the way it is today, sometimes you don’t even have to wait!

And that’s obviously what was on Young’s mind when he said the tactic was “illogical.” It is illogical if you take a long-term, industry-health view of the situation. It is totally logical if you’re trying for short-term advantage to break a new book or build a particular author, as most of the other authors and publishers were trying to say.

There was a long comment string on the HarperStudio blog about this question six or eight months ago. I said at the time that I figured that if these giveaways kept spreading, one of our more industrious web entrepreneurs would create an ebooksforfree.com site which would be a consumer directory to “free” offers at various publishers and web retailers, title by title.

It’s a classic Tragedy of the Commons. Each person giving away ebooks succeeds in their intentions to boost their sales, but everybody will pay for the overgrazing in the end.

The third question is a tricky one. It is worth noting that the App Store makes it very easy to for the consumer to decide whether to shop the free apps or the priced apps. I think Amazon is hurting themselves by not at least sorting their bestseller pages that way. And they don’t. Amazon says the Kindle bestseller listings change every hour: I just checked the Top 10 and found one 25 cent book, one book at a substantial price (higher than $9.99), and eight free. Some of the eight free were self-promoters like the lead in Rich’s story; some were public domain; some were multi-book authors from established publishers. But only one of the Top 10 was elected with votes paid for with dollars from the Kindle clientele, which is what I think most people looking at “best sellers” would be looking for.

This raises a question I don’t know the answer to and my way to do the research will be to see if somebody with knowledge posts a comment. Kindle reports to the USA Today Bestseller List. This is, as far as I know, the only reflection of ebook popularity in the public domain. It would be interesting to know if USA Today has a standard for that reporting. Of course, most of the “weight” of the USA Today list, quite properly, would be print sales so whatever Kindle reports might not move the needle much. Most sales today are still print sales. But we’re headed for a crazy world if the concept of what “sold best” is expanded to include what people were willing to take for free.

On the other hand, if you try to separate free from paid, you will still face the question of where to draw the line. If publishers sell a $20 hardcover as a $5 ebook, should those units count equally in determining bestseller status? How about a dollar? How about a penny?

A tip of the hat here to my sometimes colleague Brian O’Leary of Magellan Media, who hinted at what I have said at length in this piece in his brief turn in Rich’s article. Brian has done extensive research that tends to confirm what Rich’s interviews and my anecdotal information suggest: that giving away ebooks boost sales in the present marketplace. But Brian managed to bridge the enthusiasm of the giveaway marketers and the incredulity expressed by David Young with his observation that there was a risk that free reading could eventually “supplant paid reading.”

And that wouldn’t really be good for anybody.

This is absolutely the last post you will see promoting Digital Book World 2010, which is on this Tuesday and Wednesday at the New York Sheraton and which is turning out to exceed my fondest hopes when we started out planning it this summer. But we have a panel on the very subject of this post called “Ebook challenges: competing with free and getting the timing right.” Brian O’Leary is moderating, and the panelists include agent Robert Gottlieb of the Trident Group; marketing director Mindy Stockfield of Hyperion (which published Chris Anderson’s book “Free”); ebook retailer Kobo’s VP Michael Tamblyn, and Steve Ross, who has been a publisher at both Random House and HarperCollins. There’s another panel on “Ebook pricing: what should they cost and why?” which includes the head of Penguin’s ebook publishing efforts, Tim McCall.  I enjoy having The New York Times stamp the topics we selected last August as “current” 72 hours before our show begins, even if just implicitly.

If you like this blog, I know you’ll enjoy Digital Book World. I hope to see you there.

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