Price Wars are Part of this Firm’s Plan

In a bid to steal some thunder in the burgeoning market for handheld electronic readers, Barnes & Noble (NYSE: BKS) announced this week that it will cut prices on its Nook e-reader. Bad move. Rival (Nasdaq: AMZN) was waiting for such a development, and quickly offered up its own price cuts for its Kindle 2. Falling prices and rising market share are part of Amazon’s long-term playbook, and many past rivals have been bloodied by trying to compete with Amazon’s global scale.

At first blush, this is a real win for consumers. For those who don’t want to pay the $500 to $700 for Apple’s (Nasdaq: AAPL) iPad, the new $200 price point for the Nook and the Kindle 2 should prove enticing. These firms know that they won’t make much money on these devices, but they do offer the chance to build a loyal customer base for many years to come. That’s just what Apple did with iTunes nearly a decade ago.

Of course, both Barnes & Noble and Amazon should see sales of their readers rise at a solid clip this year, though it’s safe to assume that Amazon will retain its hefty lead. That’s because in several respects, Amazon’s Kindle 2 comes out ahead in terms of usability, and if history is any guide, the company will make sure that Barnes & Noble is always saddled with a slightly inferior offering.

Both devices look and feel the same, but the Kindle 2 can be used internationally, supports more formats, is opening up to third-party application developers, and offers thousands more book titles. Amazon recently changed its relationship with book publishers, and will now earn roughly $2.50 for every title sold. As many Kindle readers have noticed, this policy has involved a mark-up to more than $10 from less than $10 for many titles. Similar relationships are being pursued with newspaper and magazine publishers.

To be sure, this whole segment is still less than 10% of each firm’s revenue base. And to some extent it will cannibalize existing book sales. But for Amazon, that’s OK. As with all of its market development efforts, Amazon simply wants to patiently build a very strong moat around this business, perhaps to the point where Barnes & Noble looks to exit the market.

Seemingly Expensive

This price war comes at a time when investors have lost their enthusiasm for Amazon. Shares have fallen -20% since late April amid concerns that the stock looked pricey and that torrid growth can’t be sustained. The stock may look expensive, trading at 40 times next year’s earnings, even after the recent pullback, but free cash flow is actually twice as high as net income. So shares are trading at a more reasonable 20 times that multiple.

And even as investors fret that Amazon is too big to keep growing quickly, it’s worth noting that sales will probably rise another +35% this year, and another +25% in 2011. The market opportunities are hardly saturated: Amazon controls only 10% of the U.S. e-commerce market, which itself controls a paltry 3.8% of the total retail market. Thanks to steady margin gains, the bottom line is expected to grow at an even faster pace.

CEO Jeff Bezos recently ran through a wide range of growth drivers at the company’s annual meeting, including new online categories, further international expansion, and a much more aggressive push into cloud computing, or the delivery of hosted services on demand over the Internet. Amazon is also testing the waters once again on grocery deliveries, which could prove to be a large market. All of these initiatives may dampen earnings in the near-term, but set the stage for the next round of margin gains once those investments are completed.

Amazon is sitting on more than $6 billion in cash, and generating another $3 billion in cash flow every year. If shares keep falling from current levels, management may look to do a first-ever share buyback. Or perhaps a newly-issued dividend could be offered. The company has so many organic growth prospects that acquisitions make little sense at this point.

Action to Take –> Every few years, investors start to question whether this growth machine is running out of gas. And every time, the company goes on to develop yet more legs to growth. Shares are out of favor recently, which could make this a good time to pounce.