The publishing company Penguin-Random House is an excellent example of poor alignment between a company’s business and operating models.
Penguin-Random House, a firm with 3.3 billion Euros in sales, creates value by providing enjoyable books for a variety of readers at an affordable price.[i] Penguin-Random House is a major player in a publishing industry that is facing the collapse of its traditional distribution model. Independent bookstores are disappearing, with the total number of independent bookstores decreasing by over 50% since 1995. The U.S.’s second largest brick and mortar bookstore chain, Borders, closed its doors four years ago. Amazon is now the largest player in the book market, and electronic books sales are increasing rapidly. E-books now represent 43% of sales, and are the largest driver of Penguin Random-House’s profits. In hard cover sales, Penguin Random-House captures 49% of the retail price, in e-books, it captures 70% of the retail price.[ii]
Penguin-Random House’s operating model has not kept up with this shift to electronic distribution. Specifically, its process for evaluating and selecting from various author’s book proposals hasn’t changed. Traditionally, Penguin-Random House’s competitive advantage was an ability to hit a relatively high percentage of “home runs.” The publisher sifted through thousands of submissions, selecting the most commercially viable for editing, printing, and distribution of bookstores. Despite this rigorous screening process, seven of ten published books still lost money.[iii] However, Penguin-Random House’s famed marketing and public relations capabilities turbo charged sales from the successes, more than covering the costs of the failures. The effect of this competitive advantage was a smaller relative percentage of unprofitable SKUs, and larger sales on profitable SKUs, increasing overall profits compared to its competitors. These outsized profits on unproven authors provided funding for Penguin-Random House to pay large advances to established authors and celebrities with preexisting audiences, ensuring a steady stream of predictable revenue.
The shift to electronic books eliminates the need for this risk averse operating model. Without the cost of physically printing and shipping books, the only downside to a poorly selling e-book is the cost of editing. Cycle times would drop, as the average e-book takes one month to hit the electronic book shelves, versus over a year for hard copies. Penguin-Random House’s current tight screening of potential authors leads to “false negatives” where potential block busters are turned down, leaving money on the table. For example, then Penguin Books famously passed on Harry Potter and the Philosopher’s Stone because of the word count and the belief that “Children’s books don’t sell.”
If Penguin-Random House fails to shift to a looser screening of unproven authors for e-book publishing, especially in the romance and science fiction genres, it will continue to lose authors. Already, more than half of debut authors earning $100,000 or more from book sales are self-publishing.[iv] As these new self-publishing authors become the established authors of tomorrow, they will have little incentive to shift to Penguin-Random House, as their margins are better self-publishing, offsetting the author’s lower overall sales. Additionally, Penguin-Random House’s value added for marketing will be relatively minor, as these authors will be able to communicate to their audience via email lists and social media. This will dry up the talent pipeline for Penguin-Random House, ultimately forcing it to offer significantly larger advances to poach authors, or leading it to partner with e-book publishers like Amazon, to publish hard copies of Amazon authors for a minimal profit margin.
One way Penguin-Random House could align its business and operating models is by releasing e-books from new authors, after screening for a minimal level of writing, under the name of one of its subsidiaries. For these releases, authors would receive no advance, only a percentage of sales. While most books would languish in obscurity, Penguin-Random House could use e-book sales to determine which books to publish in hard cover. Just a Threadless used the wisdom of crowds to source t-shirt designs, Penguin-Random House could use the market to identify the next Harry Potter.