Amazon's Fire Phone - Flop Phone, Brilliant Strategy?

| About:, Inc. (AMZN)
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Amazon's Fire Phone exists solely to provide a gateway to its Prime service.

The phone's price and specs are not uniquely differentiated enough to appeal to non-fanboys.

Lack of access to Google Play store will prove to be an inhibitor for mainstream customers.

On June 18, Amazon (NASDAQ:AMZN) launched its first smartphone, the Fire, as an AT&T exclusive. The phone costs $199.99 for the 32 GB version with a two-year contract, which is on par with other top of the line smartphones, the iPhone 5S (16 GB) and priced $100 above the 16 GB Galaxy S5 and the Nokia Lumia 1520. Its other specifications - 4.7" HD display, 13 MP camera, 2 GB RAM and 2.2 GHz quad-core processor - are at or below par with these phones.

Jeff Bezos is fond of saying that he sees opportunity in other companies' margins, and I am surprised that the phone is not that competitive from a price point perspective.

The major feature of the phone that has been heavily touted is the "Dynamic Perspective", which is supposed to open up a new class of immersive apps and games, and allow for one-handed navigation. Time will tell if this is a real innovation or mere gimmickry.

More importantly, mainstream consumers will not be able to access the Google Play store (without rooting the device and potentially voiding the warranty). Amazon for obvious reasons would like to sell all content through the Amazon app store. The Amazon app store has tripled in size from last year and now contains 240,000 apps. However, this is barely a fraction of the Apps on iOS and Google Play (1.2 Million) as of June. As a result, I believe that customers who have substantially invested in either of these ecosystems will not be interested in the Fire Phone. Even new customers will hesitate to buy the phone if it does not run the key apps they are interested in - witness the struggles of the Windows Phones, in spite of their great hardware and imaging capabilities.

Due to these factors, I believe that the Fire phone will not be a hit in terms of sales. However, I think Amazon does not plan for that either. The Fire phone is squarely designed to bring in customers to its $99/year Prime subscription service by offering a year for free. Amazon continues to add value to the subscription, recently adding access to over a million songs through Prime music. A Prime subscriber tends to be very sticky, and Amazon sees a significant increase in purchasing behavior and transactions once they onboard a customer to the service.

Amazon is betting that a large portion of its customers, once they try a year of Prime membership for free, will see enough value in the service to stay on. It obviously has great analytics on the customer lifecycle and value of Prime customers relative to others, and is willing to invest to bring them into the fold. It will then be able to spread the (largely fixed) cost of content acquisition over a larger user base, as well as benefit from the increased gross margin derived from customers moving a larger portion of their purchases to Amazon to benefit from free two-day shipping. Once the marginal cost of shipping becomes zero after paying the subscription, Amazon's 1-click ordering process becomes much more attractive than visiting the grocery store.

The US smartphone market has around 160 million subscribers. For every 1 million units of the Fire phone (less than 1% of the market), assuming a 25% incremental attach rate to Prime, means an additional 250,000 Prime subscribers. If you assume an average check of $500/year from Amazon, at 20% gross margins, this would yield $200 in incremental gross margin per customer ($100 from the subscription and $100 from shopping). By this rough math, 1 million units would bring in $50 million of incremental gross margin per year to Amazon. As long as Amazon continues to add value to the service and maintain its retention numbers, every succeeding year of phone sales just adds to the base of Prime customers and gross margins.

I wrote earlier that Amazon still has significant growth opportunities ahead of it - based on my analysis above, the launch of the Fire phone is another brilliant move from Bezos to tie everything around Prime. He is not looking for millions of people to buy his phone - just enough that attach to his service.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: I am short AMZN puts.