Amazon's Problem: What If Tablets Don't Sell Lots Of Content?

| About:, Inc. (AMZN)

So far, Amazon's (NASDAQ:AMZN) launch of the new Kindle line-up this past Thursday has been very well received. Amazon showcased an even broader range of devices than some people expected. In addition to a new basic Kindle and an updated Kindle Fire, Amazon also introduced the Kindle Paperwhite (which seems to replace the Kindle Touch), a 7" Kindle Fire HD, an 8.9" Kindle Fire HD, and an 8.9" Kindle Fire HD with 4G LTE connectivity. These products span a price range of $69-$599 (you'll have to pay an extra $15 to opt out of "special offers": ads on the lock screen and one corner of the home page). While Amazon offered one tablet for the 2011 holiday season, the company will now have a basic $159 7" Kindle Fire, a $199 7" Kindle Fire HD, a $299 8.9" Kindle Fire HD, and a $499 8.9" Kindle Fire HD LTE (with memory upgrade options on most models).

As expected, these tablets are all priced very competitively. Between low prices and a wider variety of specifications, Amazon is clearly hoping to challenge all of the main competitors in the tablet/e-reader space: particularly Apple's (NASDAQ:AAPL) iPad, Google's (NASDAQ:GOOG) Nexus 7, Barnes & Noble's (NYSE:BKS) Nook family of products, and the upcoming Microsoft (NASDAQ:MSFT) Surface. With the 8.9" LTE tablet, Amazon is trying to compete with Apple on performance rather than price.

By contrast, the 7" models (which are expected to move in much higher volume) appear to be priced at or below cost. It is still too early to know the exact production cost of the basic Kindle Fire or the 7" Kindle Fire HD. However, based on the teardown analyses of the first generation Kindle Fire and the Nexus 7, we can get pretty good guesses. While the original Kindle Fire had an estimated build cost of $202 upon release, that was down to $140 in July. Nevertheless, with the new model featuring several hardware upgrades, Amazon will lose money on the hardware at the new price of $159. (There is much less room this time for component costs to drop.) The Kindle Fire HD is very similar to the Nexus 7 16GB model, boasting an upgraded screen and speakers but fewer sensors. Its component bill probably comes in very close to IHS iSuppli's $159.25 estimate for the Nexus 7 16 GB version. Adding in development, manufacturing, marketing, and distribution costs, the Fire HD probably sells slightly below cost.

Amazon's game plan in the tablet market is to sell its own tablets at or below cost in order to drive future purchases of media (e-books, music, movies, etc.) through the Amazon ecosystem. Amazon CEO Jeff Bezos endorsed this view of Amazon's business model in this widely-cited comment: "We want to make money when people use our devices, not when they buy our devices." Most market-watchers seem incredibly enthusiastic about this model (though there are exceptions). One Seeking Alpha author recently raved about the disruptive potential of Amazon's operating model vis-a-vis Apple, Microsoft, and Barnes & Noble. The vast majority of analyst comments following Amazon's event were enthusiastic about the new devices as well. While some analysts noted that margins will be slim or non-existent, the consensus appears to be that Amazon will be rewarded with high-margin digital media sales in the future.

The big hitch in this equation is whether or not sales of Kindle tablets will drive enough sales of media to justify the likely losses on the hardware. On this score, I think Wall Street is far too complacent. Amazon does not release statistics about media purchases by Kindle Fire users, but the company's overall results in recent quarters are not particularly promising. At this point, there is not enough data to be sure of the Kindle Fire's impact on Amazon media sales. However, the following are some suggestive data points.

First, domestic media sales growth and international media sales growth remain similar year-to-date. (All data from the most recent 10-Q) The first generation Kindle Fire was only available in the U.S., so in theory it should have boosted media sales in the U.S. but not internationally. However, media sales in the international segment increased by 17% year over year in 1HFY12 (adjusted for currency fluctuations), which is identical to the 17% growth in North American media sales.

Second, the growth rate in North American media sales of 17% was below the prior year's 19% first-half growth rate. In other words, even though Amazon had put roughly 5 million Kindle Fires into consumers' hands by early 2012, this did not prevent a decline in the growth rate of media sales. In general, media sales are growing significantly below the company's average growth rate.

Third, while Amazon's management is clearly committed to the current strategy (selling devices at or below cost to drive future digital content sales), discussion of digital sales figures was virtually absent from the most recent earnings call. This stands in stark contrast to the frequent mentions of digital media success on the Q4 call back in January. If digital media had continued to show strong sales trends in Q2, management would likely have mentioned this fact on the earnings call. This is far from conclusive evidence, but it is at least suggestive.

Perhaps Amazon's gamble on subsidized hardware and future content sales will work out well for the company and shareholders in the end. However, with over $1 billion in Kindle Fire sales over the past year, Amazon should be looking to generate hundreds of millions of dollars in incremental content sales (or more). The available sales numbers do not suggest this level of success. While Amazon says (truthfully, in my opinion) that it does not want or need users to be on a short "upgrade cycle," the fast moving nature of the tablet world today makes the upgrade cycle a fact of life. In two years, you won't see many original Kindle Fires in use, because there will be tablets available at $150 or less that run circles around the original Fire. Amazon therefore does not have a long "device lifetime" to drive profits. If the company has to sell a subsidized tablet every year to keep users within the ecosystem, it's going to be hard to fill the gap with content sales. Furthermore, Amazon's competitors will not stand still. Apple will likely release an iPad Mini this fall, which could cut into Amazon's tablet market share. Moreover, I would not be surprised to see Google drop the price of the Nexus 7 prior to the holiday season (particularly if it seems to be losing sales to the Kindle Fire).

At 2X sales and more than 100X forward earnings, is priced for perfection today. Investors do not fully appreciate the downside risk of Amazon's tablet strategy. Until the company can really show revenue acceleration in media sales, I would advise a dose of healthy skepticism on this point. If Kindle Fire users do not buy much incremental content, or if their digital content purchases cannibalize physical purchases from Amazon, then Amazon will be hard pressed to meet Wall Street's aggressive earnings targets. Considering the company's current lofty valuation, that makes the Amazon a sell or short.

Disclosure: I am short AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.