It's a big week in the tech world, with Apple (NASDAQ:AAPL) expected to unveil the iPhone 5 on Wednesday morning, and the first two versions of the new Amazon (NASDAQ:AMZN) Kindle Fire lineup shipping on Friday. Right now, the mobile ecosystem race increasingly seems to be dominated by three players: the aforementioned Apple and Amazon, along with Google (NASDAQ:GOOG). (Microsoft (NASDAQ:MSFT) is also trying to up its game in tablets and smartphones with the Windows 8/Windows RT/Windows Phone 8 launch this fall.)
Interestingly enough, Apple is the only one of these three mobile leaders to sell its hardware at a profit. Google has already shown in the smartphone business that it can give its Android OS away for free and make it up in ad revenue and app sales. With the Nexus 7, Google is now selling its own-branded hardware at roughly breakeven. Amazon, by contrast, does not have as much of a track record. With the new Kindle Fire lineup likely to lose a few dollars up front on each device sale (as I have discussed before), it's critical for the company to make a tidy profit on (incremental) content sales to Kindle Fire owners.
Amazon's plan for driving content sales appears to be ultra-competitive pricing and offering a mix of a la carte and subscription pricing. With respect to the first strategy, Amazon promptly began to drop e-book prices again following last week's e-book judgment. With Prime Instant Video and the Kindle Lending Library, Amazon hopes to drive gains in its $79/year Amazon Prime subscription service. As Amazon CEO Jeff Bezos recently recounted to AllThingsD, Prime was originally a fast/free shipping program, but the company decided to expand it to digital content because of the overall transition away from physical media.
Perhaps Amazon can manage the digital transition better than Netflix (NASDAQ:NFLX) did. Back in late 2010 and early 2011, the investment community was impressed with Netflix's success at moving from a DVD by mail model to an internet streaming model. The problem was that Netflix found it impossible to offer the added value of streaming without charging extra for customers who also wanted physical DVDs. When Netflix tried to raise prices and separate the services, things quickly went south.
Amazon's problem is slightly different. While Netflix was only in the subscription business, Amazon is also in the content sales business. By encouraging customers to buy a Kindle Fire and sign up for Amazon Prime (if they haven't already done so), Amazon will drive adoption of Prime Instant Video and the Kindle Lending Library. But those libraries include a vast amount of content that Amazon also tries to sell a la carte. Now, there's nothing wrong with selling a la carte to some customers and by subscription to others. But the people likely to adopt the Kindle Fire and Prime service are (for the most part) already big Amazon customers.
Amazon is thus giving these customers (at a flat rate of $79/year) items which they would have bought separately in the past. Moreover, some would have paid the $79 for Prime anyway, in order to get faster shipping on those items. With Amazon's low content prices, e-books, MP3s, and videos that are only offered a la carte also come at very low margins. As Amazon puts more Kindles and Kindle Fires into its best customers' hands, surely they will move to more digital consumption, and reduce their purchases of physical media from Amazon. Meanwhile, the company keeps adding fulfillment centers at a rapid pace. With so much stuff priced free (with a Prime subscription) or just above cost in digital form, it's hard to see where the profit's coming from. (In the AllThingsD interview cited earlier, Jeff Bezos admitted that Amazon's content deals for Prime subscribers are very expensive.)
This all goes to Amazon's key problem: not only will Amazon's Kindle Fire strategy hurt the company's bottom line today, it will also pressure revenue growth going forward. As I discussed at length earlier this month, this is critical for investors because Amazon is valued on a revenue multiple today. Amazon's P/E will become important when revenue growth slows down noticeably (below 20%), but probably not before then. However, Amazon's decision to offer lots of content at a low $79 annual price will cannibalize a la carte sales of those products. Selling e-books and MP3/video downloads at lower prices than physical books, CDs, and DVDs will also pressure the top line. While margins might be slightly better, they are not nearly enough to turn Amazon into a value stock as its revenue growth decelerates. Perhaps Jeff Bezos really can induce people to spend more on content with an easy-to-use online interface. Amazon's anemic revenue growth in the "media" category suggests otherwise. As Amazon works to promote digital media consumption, it may well be giving away with one hand what it is taking with the other.
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.