Earlier this month rumors circulated that Microsoft was looking at purchasing the Nook business (in which it already owns a stake) from Barnes and Noble.  I wrote about the deal a year ago, so you might want to review that piece for more background information.  While we haven’t heard anything since the initial rumor I did want to comment on what might be the motivation of the two parties, and on some of the commentary that occurred when the rumor surfaced.

Barnes and Noble (BN) has no business being in the Tablet hardware business.  Let me explain.  BN’s primary competitor in Tablets is Amazon.  Amazon sells Tablets as loss leaders (or at best, break-even) to support sales of media where they have an extensive and well-loved ecosystem.  Of course they have the e-books that made the Kindle so successful.  But they also have reasonably well-established video and music offerings.  And, of course, as the world’s largest electronic mall they have shopping.  The Kindle Fire exists to be the world’s best front-end to all those services.  The only established media offering that BN has is e-books.  So BN has to price its Tablets competitively with Amazon, but lacks the revenue sources that support doing so.

One can argue that BN must compete with the Kindle Fire and that the correct path is to continue to build out its offerings in other media in order to do so.  The problem is that this takes deep pockets and quite a bit of time.  BN has neither.  One quick solution would be to buy leadership in streaming video, for example.  Netflix has a market cap of about $13 Billion.  BN?  About $1.3 Billion.  So buying leadership isn’t happening.  Even buying a smaller but relevant player (like Hulu) is likely out of their reach.  It’s almost impossible to imagine BN continuing to compete in Tablets since they have no realistic path to profitability.

Of course BN does have an option.  With Amazon “in it to win it” in Tablets and Apple (anti-trust issues aside) making progress in adding e-books to its own infrastructure the question for other Tablet-makers is “What about us?”.  BN, as the only player with an e-book offering comparable to Amazon’s, can and should focus on being an arms merchant to the non-Amazon non-Apple Tablet makers.  Microsoft’s original investment in Nook Media LLC (NM) is an example of a non-Amazon non-Apple player looking to protect it from relying on major competitors for e-book experiences and infrastructure.

So why might Microsoft seek to acquire full control over the Nook?  Well, first of all even assuming that “where there’s smoke there’s fire” and that Microsoft is looking to acquire something from BN we don’t know exactly what they are looking to acquire.  Is it just the hardware business?  Is it the entire e-book hardware, software, and media service offering?  Does it include the college bookstores?  Etc.  In other words, it might not match the exact boundaries of the NM subsidiary that BN created to take the original Microsoft investment.

You can find some of my thoughts in last November’s speculation on a Microsoft 7″ Tablet.  That piece, while dated, talks about the need for Microsoft to offer more content-consumption oriented Tablets.  And to do so at more competitive price points.  In other words, to produce a competitor to the Kindle Fire family.  So Microsoft, with its deep pockets and Xbox Video and Music services, must and almost certainly will compete in exactly the space that BN is being forced to abandon.

What Microsoft needs is e-books and, more importantly, to be part of a family that offers a clear and desirable growth path from pure e-readers.  While the original minority investment should, in theory, offer all of this the reality is that such joint ventures frequently fail to deliver the goods.  And with the majority owner of the joint venture under financial pressure, it seems even more likely that Microsoft would have trouble getting what it wants when it wants it without gaining full (or at least majority) control.  So for Microsoft the natural progression of things would be to finish the job.

At this point let me interject one diversion.  I have heard the real crown in the jewel here is BN’s college book business.  I do not discount that this was, or could be, the real reason Microsoft got into bed with BN.  At the very least it could have been the tipping point in any “build vs. buy” analysis.  This makes any speculation about a deal much more complicated, so I will ignore it for now.

What I wonder about is what is left for BN should Microsoft acquire Nook Media LLC?  Is it just a book retailer?  Is that a sustainable business, even for a company that is essentially the last chain standing?  Could something in a deal make this a palatable option for BN?

BN has about 1300 retail outlets split almost evenly between its traditional stores and college bookstores.  I walked into my local BN yesterday and found that right in the center is a large “store within a store” for the Nook.  What happens to that space if Microsoft acquires the Nook business?  Does BN put back in the bookshelves and expand the inventory in each store?  Could the future of that space be the key to a deal?

Economics must force BN to reduce real-estate and inventory costs associated with the sale of physical books.  Meanwhile, Microsoft is struggling with the limited reach of its small set of retail stores.  One part of a deal, perhaps even the key to the deal, could be to turn the existing Nook retail space in BN stores into specialty Microsoft Stores.  They could either be things that Microsoft operated under real-estate leases with BN, or that BN itself operated.  In the latter case they would perhaps be part of a strategy that BN pursued to add consumer electronics retailing to the book business.  BN as a Best Buy competitor is either the dumbest or smartest thing I’ve ever suggested!

Microsoft could quickly grow its retail presence to 700 to 1400 locations as part of a deal with BN.  That is mind-blowing and, yes, highly speculative.  But it makes sense.  Microsoft goes from distribution laggard to leader (at least in the U.S.).  BN gets cost reduction on its physical store real-estate costs, or establishes a new retail business to supplement physical book selling.  Win-win, at least on paper.  In reality I have trouble seeing Microsoft profitably operating that many domestic locations or BN changing its stripes.  But the bricks and mortar world is where the interests of these two parties in doing a deal diverge, or converge.

Some have speculated that BN selling Nook to Microsoft is good for Apple, Amazon, and Google but I really don’t see that.  BN as an independent but toothless Tablet competitor is the best scenario for Apple and Amazon, and gives Google leverage while it grows Play adoption for e-books.  BN as a non-competing supplier of e-reader software is the best case scenario for Google Android ecosystem players such as Samsung who need a name brand alternative to the Kindle reader software.  Put all of this under Microsoft’s control and Apple and Amazon face a deep-pocketed competitor who is putting the final touches on its ability to make their lives miserable.   And while Microsoft would continue to support non-Microsoft platforms, as it has with Skype, Google and the Android ecosystem would lose leverage and partnering opportunities.

I wouldn’t be surprised to see Microsoft either acquire or take a majority stake in Nook Media LLC.  Nor would I be surprised if the rumor was no more than that.  I also wouldn’t be surprised if any deal was for a subset of NM.  Whatever the structural outcome what interests me is how Nook, Surface, Microsoft’s retail ambitions, and BN’s survival all come together.  Something substantial is likely to happen in this space later this year.  We’ll just have to wait to see how it plays out.