The Nook of Doom

Barnes & Noble’s new e-reader could kill its business

Amazon’s success with the Kindle is a virtuous cycle of cost reduction. As it converts customers from visiting the Web site to buy a book (and then waiting for the mail) to picking up the Kindle for both functions, Amazon gains margin at every turn.

At B&N, there’s a different story. In the center is BN.com, the lackluster e-commerce site. In the world of online bookselling, BN.com is an afterthought, a product of pride more than a return on investment. Lacking brand loyalty and meaningful market share, BN.com doesn’t have the critical mass to launch the Nook well. To be fair, Lynch recognizes this without having to admit to it. At the press conference, he emphasized two features of the Nook that would compensate for the company’s online weakness, by leveraging the firm’s strength in physical stores.

Although the Nook won’t land until the end of November, Lynch showed off large in-store displays that the company will use to push the new device. B&N figures that with 700-plus superstores and more than 600 college stores manned by “40,000 passionate booksellers,” they’ll have plenty of evangelists to play catch-up to the Kindle.

More than that, the Nook has some snazzy features designed to generate store traffic. Much has been made of the book-sharing feature, but a bigger deal is the Wi-Fi embedded in the Nook. Nook owners—would they be Nookies?—will get extra benefits by bringing their device to a B&N store. They’ll be able to browse inside a book for up to an hour on each title, and the stores will give Nookies access to exclusive content. B&N emphasizes the presence of its booksellers as an added advantage to deciding which book is right for the customer.

At first glance, it seems like a brilliant work-around for the BN.com problem. Lynch made it clear to CNBC that the company sees the book business moving away from stores. The Nook hedges that bet by moving firmly toward e-commerce but also giving Nookies reason to come back to the store. But it also opens Barnes & Noble up to a nightmare scenario.

Think about those 700-plus superstores. They’re very expensive to run, and sales are falling. In thecompany’s earnings release from earlier this month, we learned that same-store sales are down 4 percent during a nine-week period in late summer. B&N expects same-store sales to continue to decline 2 percent to 4 percent for the rest of fiscal 2010, which ends that May.

The positive news that sales at BarnesAndNoble.com increased by 8 percent seems to validate the Nook strategy. But when you take a closer look at the numbers provided for the nine-week period ending Oct. 3, you begin to see the real problem. Superstore sales dropped approximately $20 million, or 3 percent, to wind up at $665 million for those nine weeks. At the same time, online sales rose 8 percent, from about $84 million to $91 million. In other words, $6 million in online sales is replacing less than one-third of the $20 million overall sales decline. Barnes & Noble is shoveling hard—but the hole still gets deeper.

For newspapers, the problem comes from a differential in ad rates. In books, there’s the price issue that that has blown up everywhere in the business. Amazon has established the idea of $9.99 e-books, especially for best-sellers. Publishers have maintained their wholesale price above $9.99 to stop this. On the most heavily trafficked titles, BN.com will have to spend money to keep up the $9.99 price point. But Amazon has mountains of cash from its other businesses to support this; B&N does not. The physical stores don’t generate enough profit for that. Meanwhile, those stores are getting beat up by Wal-Mart (WMT), Target (TGT), and Amazon (AMZN) as they establish a $9 price for the biggest best-selling titles.

Barnes & Noble (BKS) held a slick press event earlier this week to announce its new Nook digital reader. William Lynch, president of online business, was justifiably pleased as he stood cradling the cute arrival. But even though the Nook offers improvements that trounce the Kindle, it is hard not to see the device as a doomsday machine that could destroy B&N’s beleaguered business.

Here’s the problem: Barnes & Noble sells books, but it’s not in the same business as Amazon. The Kindle improves Amazon’s (AMZN) business in every way. The Nook will put pressure on a structural weakness in B&N’s business plan, toppling a flailing operation.

The Big A is an Internet retailer. The Kindle builds on the firm’s strong brand loyalty and refines the bookselling process that its customers already find appealing. (In this week’s earnings announcement, Amazon named Kindle its top product across the site in both unit and dollar sales.) As sales shift to the Kindle, the infrastructure of Amazon’s business, like servers and warehouses, can be diverted toward other items, like electronics and cloud-computing services. Barnes & Noble does something very different. It owns physical stores that it must stock and restock, man with employees, and send people to.

Fine, you say, just wait until those Nooks start kicking in this December. But that’s where the problem will accelerate. The Nook seems designed to cannibalize sales without freeing up the costs of keeping stores.

Amazon claims that e-book readers buy three times as many books once they convert to the Kindle. That’s great for Amazon because they get three times the number of units without any increase in fulfillment or freight costs. The more sales they shift to the Kindle from Amazon.com, the more money they make. That’s true even if each book brings in half the revenue. For Amazon, profit-per-customer will rise in this scenario. Over at Barnes & Noble, profit-per-customer will fall.

The more successful the Nook gets, the more damage it will do. Let’s say B&N’s plan works. Nook owners make more frequent trips to stores and buy more books. Let’s hope Nookies buy three times as many books because B&N will need the unit sales bump to keep revenue static on low-priced e-books. (With those crazy e-book discounts, it’s more like three times just to tread water.) Unless Barnes & Noble has a whole new product line to roll out into stores, the Nookies can only purchase magazines and illustrated books to improve B&N sales.

In an orderly world where change takes place incrementally, the Nook might be a smart long-term strategy to shift Barnes & Noble’s base from physical stores to e-readers. But we don’t live in that world. The book business has shifted into hyper-space with dramatic change taking place within a compressed time frame.

As the Nook eats away at B&N’s business, the firm will have to move quickly to find a white knight. Since the Nook boosts the idea that reading is social, the best use of its Wi-Fi features would be driving Nookies to places with a broader footprint and a greater opportunity for incremental revenue. Like Starbucks (SBUX). A deal that trades traffic for access would work in everyone’s favor and buy B&N time to shrink its bookstore business. But it will have to be a huge footprint. B&N’s online sales will need to double each year until 2012 to replace bookstore revenue. Otherwise, the doomsday Nook scenario will end with a bang, not a whimper.