Barnes & Noble's Kodak snap

Business Spectator

The Barnes & Noble announcement last week that it was considering selling or spinning off its electronic reader business neatly illustrates the near-impossible dilemma confronting legacy businesses in an increasingly digitised world.

Barnes & Noble's Nook business is second only to Amazon in the e-book sector in the US. Barnes & Noble, the biggest of the bricks-and-mortar book sellers in the US after the demise of Borders, established the business only two years ago.

The disclosure that it might separate Nook from its physical business shocked the market, which has seen Nook as the group's growth business and perhaps its future. If sold or spun out, the distancing of Nook from the bricks-and-mortar chain would exaggerate the existing large question mark over the future of that business.

Why would Barnes & Noble even consider shedding Nook? The question goes to the heart of the conundrum being confronted by those industries – music, books, media and retail more generally – on the receiving end of the first onslaught of the digital revolution.

There are two broad strategies for dominant traditional players to respond to the threat from new digital rivals. They can protect their legacy cash flows until they eventually die or they can try to transition their businesses across the digital divide, much as the newspaper businesses or Telstra's Sensis division are now trying to do.

Kodak is a good example of the former. Overwhelmed by the impact of digital photography on its once globally dominant film business, whether by active choice or because it couldn't adapt its business model and thinking quickly enough, Kodak ended up milking its legacy cash flows and margins until it has reached the point where it is now on the verge of bankruptcy.

With Nook, Barnes & Noble has been trying to create symbiotic footholds in both the old and new worlds and a potential transition path from the old to the new.

The accelerating nature of the structural shift towards all things digital, however, means that the legacy high-margin profits have been dwindling even as the capital required and the losses entailed in building a digital business in the face of aggressive tactics from Amazon have been escalating.

Amazon – like many of the successful new digital businesses – has continued to invest in building scale and dominance rather than near-term profitability, which complicates the position of would-be old world challengers trying to balance a declining level of profitability against investments in loss-making and low-margin growth.

Another problem for traditional businesses is that even if they are successful in creating new digital models, they accelerate the cannibalisation of their still high-margin legacy businesses by the new low-margin platforms.

It doesn't help the position of the traditional players that they face different market expectations than their purely digital competitors. They are measured by their profitability, whereas profits are secondary to growth rates for the digital aggressors.

The Barnes & Noble announcement appears to be a concession to that market reality, with the company believing that a distancing of the digital business could unlock shareholder value, given that digital businesses are valued differently, and attract higher valuations, than legacy businesses. It would also mean that someone else, or the market, would take on the task of supplying Nook's capital and funding its losses.

There are obvious parallels between Barnes & Noble's predicament and that faced by media businesses and retailers and, more recently in this market, Sensis.

Sensis had done a better-than-expected job of staving off the impact of the new environment on its directories business and milking the high-margin legacy cash flows, but it was taken aback last year by an abrupt implosion in its revenues.

Its response to the digital threat – an attempt to radically transform its business model which does involve sacrificing margin – was, with hindsight, belated and inevitably disruptive. The business is now shedding revenue at a percentage rate that is expected to be in the high teens.

The quandary for those business directly threatened by the tide of digitisation is that there is no established model or pathway they can follow to successfully transition their businesses across the digital divide while retaining legacy margins and profits. There will be many more ‘Kodak moments' for incumbents as the digital environment continues to expand.