The Biggest Question About the Kindle Fire HD

Amazon's (Nasdaq: AMZN  ) new line of Kindle tablets were announced recently, and reviews across the Internet gave the company two thumbs up. According to fellow Fool Evan Niu, Apple (Nasdaq: AAPL  ) better watch its back and, frankly, I don't disagree.

What intrigued me about the announcement, though, was the company's strategy to continue subsidizing devices in hopes of making the money up on the back end. Jeff Bezos sold the original Kindle below cost to get into the market, which made sense at the time, but even these new devices won't make Amazon a profit unless users buy things on them.

The notion of only making a profit only if customers use the product is admirable, but is it wise? Apple makes a profit every time you buy an app, a song, or a movie on its devices, but it also makes a profit on every device that is sold. And it's a hefty profit at that. So can Amazon make money on these devices by making it up on the back end? I did some back-of-the-envelope calculations to get an idea.

How much do you spend on apps and books?
Since Amazon is cryptic about how much it makes from apps, movies, e-books, or anything else it may sell on the Kindle, I used the best comparisons -- the iPad and iPhone. Here's how I came up with a rough estimate for monthly revenue and profit that Amazon can expect from the Kindle.

First, I looked at how much revenue Apple generated from iTunes, the App Store, and the iBookstore. The company reported revenue of $2.06 billion in the most recent quarter for these items, including some accessories, which will skew the number slightly higher; but, because it's the best-reported number, and it will increase the numerator and help make the case for Amazon, I'll go with it.

Now, how many iPads and iPhones are floating around out there to generate that revenue? I assumed that devices sold in the last two years would be active, so I used iPhone and iPad sales from the calendar second quarter of 2010 through calendar first quarter 2012. The total came out to 166,901,000 iPhones and 67,084,000 iPads, for a grand total of 234 million devices. This doesn't account for new devices but, again, it should lower the denominator, helping the case for Amazon.

Now, if we divide the revenue generated by three, we get average monthly revenue of $686.7 million, divided by 234 million devices, which brings us to average monthly revenue per user of $2.93. Now, take Apple's 30% cut of developer revenue, and we get a revenue of $0.88 per month per user (not including infrastructure or overhead costs).

Making money on the Kindle Fire
If my assumptions above are correct, there isn't a lot of money to be made on the Kindle Fire HD, but there are reasons to think that the Kindle Fire HD will make more money for Amazon. Kindle users are book readers, and books are generally more expensive than apps that sell well in Apple's App Store.

Earlier this year, RBC Capital estimated that each Kindle Fire generated $136 in additional revenue for Amazon. If we assume a two-year estimated life, that's about $5.67 per month, or about a $1.70 profit. RBC also estimated that Amazon lost about $18 on each Fire it sold, when including marketing and free shipping. These estimates may be in the right ballpark for the new devices and, if they are, it doesn't make the device a moneymaker for Amazon. Amazon, like Apple, takes a similar 30% of sales -- meaning it makes about $40.80 in additional revenue for each device after the initial sale, leaving just over $20 of potential profit.

What I haven't included is advertising revenue from Kindle ads. I don't have good estimates for what this revenue would be, but it will likely add a few dollars to Amazon's case at the very least.

Even if we assumed a slight loss in manufacturing costs for new devices, and nearly $6 per month in recurring revenue, Amazon is going to be lucky to make a profit on the new Kindle Fire HD when accounting for costs like the cloud, and other infrastructure costs.

Crushing the competition
Amazon has created  a device that will likely be a winner in the tablet market. Google's (Nasdaq: GOOG  ) Nexus 7 doesn't have as much memory for the same cost, the iPad is more expensive and, therefore, less compelling for many consumers, the Microsoft (Nasdaq: MSFT  ) Surface tablet follows a number of flops for the tech giant in the mobile space, and Barnes & Noble's (NYSE: BKS  ) Nook looks dead in the water.

If Amazon is able to take a big share of the tablet space, then what? Tablets don't exactly require brand loyalty and, with quality increasing, I think it's safe to say that consumers won't require a new device every year or two. I'm just wondering how a dominant position in tablets helps make Amazon money.

The bottom line matters
For years, Amazon has been building a business that's more about making sales than making profits. The company's margins are down since the first Kindle Fire was released, and I have no doubt that they'll be down again once this product is released. The company's model of making money on the back end just doesn't lend itself to making money the way Apple's does, and that's why I'm negative on the stock. Until Amazon can prove its model can make a significant profit, I'll stay bearish. Even in the short-term, it's left me feeling like the curmudgeon that just doesn't understand this newfangled business model.

For an extremely in-depth look at Amazon, you should check out our premium report on the stock. It comes with a year of updates, so find out more by clicking here.

Fool contributor Travis Hoium is short Amazon and manages an account that owns shares of Apple. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings, or follow his CAPS picks at TMFFlushDraw.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 21, 2012, at 11:19 PM, Shelly2884 wrote:

    I share your concern on the Amazon back end strategy but maybe for a slightly different reason. Apple's IPAD is a higher priced item sold to people who both have more money, more sophisticated and are more willing to work in a virtual world. I say this because they are buying the best and plan on using the IPADS which mean they will invest in Apps and similar. The Amazon products are cheap. They are targeting those with less money and who are not as committed to virtual. Therefore the level of buying from the Amazon targeted customers will be significantly lower then those with the IPAD. Also, its probable that many of the Amazon customers who buy their less costly tablets, probably would have bought whatever they are going to buy from Amazon anyway. I have not seen any proof that just because they have the Amazon product will create a new buying stream. This loss leader will in my opinion just be a loss.

  • Report this Comment On September 22, 2012, at 12:10 AM, JokerJoey wrote:

    And eventually if they lose enough you'll see it eat away at the rest of the operations, lowering their grosses there and eventually exposing the emperor for what it is: naked. So watch out. Amazon trading at the multiple it does makes no sense whatsoever when Apple is trading at just 15, give or take. When the iPad mini debuts next month, that will likely spell doom for the Kindle. Also, with target and Wal-Mart rebelling and turfing Amazon products, it's not too far a stretch to see that many retailers are getting fed up with Amazon's approach to market penetration.

  • Report this Comment On September 22, 2012, at 4:15 AM, H3D wrote:

    "The notion of only making a profit only if customers use the product is admirable, but is it wise? "

    It's not admirable, it's forced.

    Amazon have no choice.

    They could not sell the device at a profit.

    And the probably won't make a profit even with content purchases.

    But the alternative is to lose the content market.

    Amazon is not making a bold move. Amazon is fighting for its life.

    Shame they got greedy. Expecting to have Kindle app on, for example, Apple devices, and then closing their own devices then closing their own devices to those other vendors was just bad mannered.

  • Report this Comment On September 22, 2012, at 8:37 AM, lucasmonger wrote:

    I think the best headline I've seen for the iPhone applies to iPads also. Apple products are Rolexes in a sea of Timexes. Alas, $499 for an iPad is very affordable compared to the price of a real Rolex.

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