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The latest news is that Amazon.com (NASDAQ:AMZN) might launch a free smartphone. Not just free as in "subsidized", of those there are many already, but "free" in the sense of "costing zero", zilch, nada, unsubsidized.

While I believe that this doesn't really stand that much of a chance of seeing the daylight, the articles reporting it already go on a trip saying how Amazon.com will make it back on content and whatnot. The Kool Aid flows freely among the believers in Jones … I mean, Jeff Bezos.

Given this belief, I think it might be useful to establish just how likely it is for a free smartphone to pay for itself. To do this, I'll draw from Apple's (NASDAQ:AAPL) experience, since we do have some published numbers on iTunes, which more or less translate into the best case of what one might expect from Amazon.com.

A foreword

The tale of "we'll sell the device at cost and make it up on content" is not new for Amazon.com. This was the tale that accompanied the launch of the original Kindle Fire back in 2011. During 2011 Amazon.com had earnings of $1.37 per share. Right now, 2 years down the road, Amazon.com no longer has earnings (on a TTM basis).

So we already know that selling devices at cost to profit on content didn't exactly set the Amazon.com world on fire (not that anybody cares). Obviously, giving away devices to then make money on content is much, much harder than selling devices at cost to then make money on content. But let us try to see what the Apple numbers imply.

The free smartphone

The first thing to remember regarding Apple's numbers, is that the iTunes sales in any given quarter depend not just on devices sold in that quarter, but also on the entire installed base of devices sold before that quarter. Still, recently-sold devices usually consume more than older devices. But to make things better for Amazon.com, I'll actually relate the devices sold in a given year, to iTunes revenues in that same year. Let us see what happened in the 12 months to October 31 2012 (Source: 10-K; AppleInsider.com).

As we can see, in that year Apple had iTunes revenues of $17.9 billion, and sold 218.5 million iOS devices capable of buying content from iTunes. Remember, those iTunes revenues also include revenues from devices that were sold previously but we're going to ignore that and think that these were only for the devices sold that year. Now, this means that the iTunes revenue per iOS device sold was $81.9. The gross margin on those revenues is around 30%, so only $24.6 in gross margin per device sold. And then iTunes also has a good many other costs so that it can run, including data centers, curation of the content, credit card charges, etc. It's thus no surprise that Tim Cook says iTunes is run for breakeven.

On top of this, one should remember that Apple's customers are "higher end", so they consume more content than the regular customer. This is borne in statistics showing that Apple devices are used much more often for navigating the web, ecommerce, etc when compared to their market share of installed devices.

So if anything, Amazon.com is likely to get less than the $24.6 in gross margin per device per year in content gross margin. Which leads us to question, exactly how many years would Amazon.com have to expect those devices to exist, just to recoup its initial investment even if it had no cost below gross margins (as well as no financing costs)? For a $246 phone, that would be 10 years. How did a phone back in 2003 look like? It looked like this:

(click to enlarge)

That's how 2013's phones will look like in 2023. How many people would still be using them?

Conclusion

Even optimistic math using Apple's tremendous iTunes experience shows that there is not enough margin in content to pay for a free -- and cheap - smartphone. Those thinking otherwise are basically daydreaming.

At the very least, if Amazon.com does go ahead with the free smartphone, it won't represent an investment in the future -- it will just represent the admission that 2014 earnings won't show up, either. Much like it happened in 2011, 2012 and 2013.

Source: Just How Reasonable Is A Free Amazon Smartphone? Apple Provides The Answer