Another Milestone in the Apple/Amazon War

Following a flat return in the market yesterday, U.S. stocks are marginally higher on Tuesday morning, with the benchmark S&P 500 and the narrower Dow Jones Industrial Average up 0.13% and 0.11%, respectively, at 10:18 a.m. EDT. Between the threat of growing conflicts in Iraq and Ukraine and the start of the Federal Reserve's two-day monetary policy meeting, it's perhaps understandable if traders are hesitant to make large bets. In company-specific news, the world's most valuable company, Apple   has agreed to settle (for an undisclosed amount) a civil class action suit alleging the iPhone maker fixed the prices of e-books. The settlement is another milestone in the transformation of the digital media landscape, in which a few large players, including Apple and rival , are vying to create a dominant platform to distribute content.

Amazon was the dominant distributor of e-books when Apple opened its iBookstore and launched the iPad in 2010: the Internet superstore controlled 90% of e-book sales. That power irked the major publishers that did not have the muscle to sell books to consumers directly and were forced to watch Amazon set the e-book price point at $9.99.

Amazon is relentless in pushing down prices on the products it sells and is comfortable earnings razor-thin margins. In the case of e-books, Amazon was happy to operate on a wholesale model, paying the publishers $10 per book, thus breaking even when it sold them on to consumers.

The Justice Department alleged that Apple saw an opportunity to take market share from Amazon by advancing a different model to five major publishers. In the "agency model," publishers would be free to set the retail price and Apple would take a 30% cut. Once that model was introduced, several publishers renegotiated their arrangement with Amazon along similar lines. The ultimate result: higher profits for the publishers and higher prices for consumers.

There is no question that Amazon is laser-focused on lowering prices. Publisher Hachette has accused the Seattle e-commerce giant of delaying the availability of its titles as a contract negotiating tactic.

As a loyal and highly satisfied Amazon customer, it's difficult for me to criticize the company for its drive for lower prices. As a financial journalist, however, I wonder whether it is touching up against (or overstepping) the limits of its business model: Wall Street has been willing to give the stock the benefit of the doubt so far, but the company's current operating cash flow does not justify the stock price.

As far as Apple goes, it waded into an e-book market in which Amazon was dominant and has successfully taken market share (Amazon's market share is now roughly two-thirds). Can Amazon pull off the same trick? On Sunday, The New York Times reported that Amazon may launch a smartphone at an event tomorrow in Seattle. Apple probably feels its iPhone franchise is secure (at least from the threat of Amazon), but this industry is hard to predict -- stranger things have happened.

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Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool recommends and Apple. The Motley Fool owns shares of and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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