Amazon's Kindle Strategy Is Finally Working!

Has Amazon's strategy of selling Kindle devices at or below cost reached a "tipping point"?

Feb 9, 2014 at 11:30AM
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Amazon.com (NASDAQ:AMZN) popularized the e-reader, and in the past few years, it has also helped drive the widespread adoption of cheap tablets. Whereas most of the early iPad competitors such as the Motorola Xoom and BlackBerry (NASDAQ: BBRY) PlayBook were priced at parity with the iPad and sold terribly as a result, Amazon chose to drive sales volume through low pricing.

Amazon's strategy was simple -- it wanted to make money when people used its products, not when they bought them. Amazon typically prices its Kindle e-readers and Kindle Fire tablets at or slightly below cost. By tightly integrating the devices with Amazon's online store, Amazon hopes to make money by selling lots of e-books, music, movies, and other stuff to Kindle and Kindle Fire users over time.

However, until recently, the strategy looked like a bust. While Amazon's e-readers and tablets were popular, the company's media sales growth was lackluster. More recently, though, Amazon's media sales growth has picked up again in North America. This suggests that the Kindle strategy is finally succeeding.

A flawed strategy?
A year or two ago, it was hard to find much evidence that Amazon's Kindle strategy was working as expected. In 2011, Amazon's media sales in North America grew 16%. That fall, Amazon launched the first-generation Kindle Fire tablet in the U.S., and it sold fairly well.

Theoretically, that should have boosted media sales in 2012, as Kindle Fire owners started to use their tablets to buy things like e-books and movies. Nevertheless, Amazon's North American media sales rose just 15% in 2012, slightly below the 2011 rate and well below the growth rate of most of Amazon's other segments.

As recently as the middle of last year, Amazon's North American media sales growth continued its deceleration. In the first half of 2013, North American media sales grew 15%, down from a 17% growth rate in the first half of 2012.

Media sales accelerate again
However, the tide began to turn in Q3, when year-over-year growth ticked up from 15% in 2012 to 18% in 2013. The turnaround was complete last quarter, when Amazon grew North American media sales by 21% year-over-year, up from a growth rate of just 13% in Q4 of 2012. The last time the growth rate reached 21% was Q3 of 2011 -- ironically enough, the quarter before the Kindle Fire went on sale.

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The Kindle Fire may be behind the reacceleration of Amazon's media sales growth.

While media sales were once Amazon's main business, the category's importance has receded in recent years because of the rapid growth of the "electronics and general merchandise" category. Last quarter, electronics and general merchandise accounted for three times as much sales volume as media in North America. Still, with electronics and general merchandise growth slowing down, the acceleration of media sales is a welcome sign for Amazon shareholders.

Why it matters
The law of large numbers has started to affect most aspects of Amazon.com's business. The company already controls a significant chunk of the market in most of the key segments where it competes. Moreover, it has already driven its weakest competitors out of business. As a result, growing revenue by 20%-30% every year is becoming increasingly difficult.

While two quarters of faster growth in North American media sales does not quite make a trend, it's the best evidence yet that Amazon's Kindle strategy is gaining traction. It's pretty hard to overcome the law of large numbers, so any acceleration in sales growth is noteworthy.

This is also good news for Amazon's international business. Within the international segment, media sales growth has slowed to a crawl recently, increasing just 1% in 2013, or 7% excluding exchange rate fluctuations.

However, Amazon CFO Tom Szkutak stated last month that digital media sales growth is picking up outside the U.S. -- it's just a small part of the business right now. As digital sales start to overtake physical-media sales, the total growth rate may reaccelerate.

Foolish bottom line
Amazon's Kindle e-readers and Kindle Fire tablets represent an important part of the company's long-term strategy. By selling these devices at attractive prices -- typically at or below cost -- Amazon.com hopes to lock users into the Amazon "ecosystem." This allows the company to make money over time by selling other items through those devices, particularly digital content.

Until recently, it was hard to be sure this strategy was succeeding. Amazon appeared to be selling plenty of Kindles and Kindle Fires, but media sales growth remained steady.

However, in the past two quarters, Amazon has seen a new round of accelerating media sales growth in North America. This suggests that Amazon's quest for long-term dominance in the market for books, music, and movies is back on track.

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Adam Levine-Weinberg owns shares of BlackBerry and is short shares of Amazon.com. The Motley Fool recommends and owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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