Why Amazon's Fire Phone Had To Be Expensive, And May Be Unsellable

| About: Amazon.com, Inc. (AMZN)


Amazon needed to make a magical phone or discount heavily to compete with Apple and Samsung. It did neither.

The argument for a subsidized phone is available: it is designed to push high-value sales through Amazon's channels. Amazon has more potential here than Apple or Google.

Amazon didn't subsidize because it can't. It could cost billions, and the sales it would generate are themselves hardly profitable.

A just-OK phone at full price makes little sense now. Amazon must have planned to subsidize, and bailed as its stock sank, and forecasts for coming quarters went south.

The Amazon (NASDAQ:AMZN) Fire smartphone has arrived to mixed, but mostly quizzical reviews. The quick dissections which are a Web staple have been performed. The comparison charts, mostly to the Apple (NASDAQ:AAPL) iPhone 5s and the Samsung Galaxy S5, have been compiled. Unboxing videos will soon litter YouTube.

I'm not going to do the feature blow-by-blow here. I'm interested in the economics of the launch, for the consumer and for Amazon. Mostly, I'm interested in what the product's introduction really tells us about the economics of Amazon.

Lots of business writers have weighed in on the Fire's pricing: $649 without a contract, right up there with the Apple and Samsung flagship phones. This defied all expectations. Amazon was supposed to enter the market with a competitive phone at a bargain price. They could do this, the argument went, because more than their competitors' phones, the Fire phone would pay for itself on the back end, with massive new revenue streams from all the product purchasing Fire users would be doing from - who else? - Amazon. In fact, this was supposed to be the very reason for Amazon to try and break into the phone duopoly to begin with.

What's the toughest business in the world to crack? De Beers' diamond monopoly, circa 1960? Consider how hard it is to challenge Apple and Samsung in the smartphone space today. Forget market share - think profits. According to Canaccord Genuity data, as reported by AppleInsider, the two companies took a remarkable 109% of feature phone/smartphone operating profits in Q313. Wait, what? That means - yes, everyone else put together is losing money. (Sony (NYSE:SNE) led the also-rans with a 0% share. I guess that's something. Actually, it's nothing.)

You need to have the brass of a Jeff Bezos to wade into those waters. And, everyone assumed, you need to have an ace up your sleeve. If the phone he'd brought on stage last week had some serious magic to it that would have done it. But the clear consensus is, it didn't. A few nice flourishes at best, to go with a few glaring deficits. (And Apple will unveil its next big thing in just a couple of months.)

Bezos needed something else, and the consensus was, pricing strategy would be it. After all, smartphones are mature; everyone can build one now. What differentiates Amazon is its stunning core competency: its warehouses, distribution and mind-share. Those are leveragable. Make a phone that ramps up purchases for the core Amazon business, and the phone doesn't need to pay for itself. So you can get huge market-share by massively undercutting on price with a phone that doesn't have to be better - just good enough. Then watch the profits accrue to the larger business.

And yes, the Fire is heavily freighted with tools and integrations that support shopping. Read what the NYT has to say about it, specifically, shopping on Amazon. Although this wasn't spoken aloud at the roll-out, it was clear to analysts immediately that the phone will make it simple to shop in a store, collect a price-tag image, and get a better offer from Amazon. And then place that offer. All while enjoying the air conditioning at Target (NYSE:TGT).

Apple and Google (NASDAQ:GOOG) also have integrated sales programs built into their phones. Samsung doesn't benefit from this nearly as much as Apple does, of course, because Apple owns its own ecosystem. Apple invented this market, based on iTunes and the App Store and one of the world's great credit card databases. Still, Apple is all about taking 30% cuts off low-cost, digital goods, like songs and apps. They don't sell Nike shoes or Oakley sunglasses or most of the thousands upon thousands of products Amazon does, at full retail. Generating sales through the phone should mean far more to Amazon than it ever could to Apple or Google. In theory, they should be able to go the razor route, giving away the handles and selling the blades.

But Amazon isn't going this route, and the analysts on Wall St. and in the Valley are scratching their heads. Why didn't Amazon pursue this strategy, and how are they planning to win market share going head-to-head? I admit, I can't answer the second question. I can't even offer a hint. It's such a mystery, I have to imagine this wasn't the original plan. I think the phone was developed to be marketed the way it was expected to be by outsiders - and then it couldn't be, so Amazon is making the best of it. And that's where the analysis gets interesting.

What stopped Amazon from low-balling the Fire phone? Short answer: I don't think they can afford it.

Start with some very rough numbers. Instead of $649, what would the Fire price need to be to win major share, based on price? I'm going to say $349, to get the critical mass they need, despite the entrenched duopoly, restriction to AT&T (NYSE:T), lack of access to a major app store and other later-mover disadvantages. What's the wholesale hit to Amazon to reach that price? I'm guessing $200 per phone. How many phones would that move? This is tricky. Worldwide smartphone sales will cross a billion in 2014, maybe 1.2B. That includes much lower cost models in parts of the world. Apple sold 44 million in Q2 alone. So let's say Amazon could produce 25 million sales in its first year with a heavily discounted phone. Great - but the subsidy amounts to five billion dollars. Even if you don't like my assumptions, the number is still going to be huge.

OK, so a $5B investment. Amazon has been pouring money into itself relentlessly for years. This sounds just like what they'd do. (I can't prove it, but I think it's what they wanted to do with the Fire phone.) Why not do it? The answer is, they'll never make it back. And just maybe, the board is finally putting its foot down. Losing 25% of your market cap in three months can do that to a board.

What boost to sales would it take to recover that five billion? Depends on the profitability of the sales operation. So how profitable is Amazon? You know as well as I do - it's not. Amazon does not make money; it makes promises. Shareholders have been driving it higher for years, on the promise of future profits. Always future. Amazon doesn't lose money - but it doesn't make any either.

But wait. Something new - the company's Q214 projection is for a GAAP loss as big as $455 million. That's what helped to tank the stock.

So what's going on in the guts of the company? Would a big boost to sales produce leverage for better results - or just more money-losing sales? (Reminds me of the old joke: "I lose money on every sale, but I make up for it in volume.")

It could be otherwise. Amazon could have made the Fire attractive enough that it will sell, and generate ancillary product sales. And that could start a virtuous cycle. A few analysts think so - here's Adam Hartung in Forbes.

In short, I believe Amazon abandoned its plan to market a low-cost Fire phone for some combination of these reasons:

1. No faith they could get sufficient share, regardless of price

2. No faith that the phones will generate the necessary volume of Amazon purchases

3. No faith the additional purchases will actually be profitable

4. No faith the additional profits will pay for the subsidies, at least within a reasonable time frame

5. Fear of weakening the balance sheet with the subsidies

The result is a worst-of-all worlds scenario: a phone that is at best just competitive, going up against deeply entrenched competitors without a pricing advantage. Suddenly, Robin Chan's task at BlackBerry (NASDAQ:BBRY) doesn't seem like the most daunting Smartphone sales job any more.

Disclosure: The author is long AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.