Amazon Stock: How Much Smartphone Upside Is There?

Amazon plays its Prime business awfully close to the chest, which leaves investors no choice but to speculate on the economics. Can Amazon's new smartphone help drive Prime subscriptions?

Jun 15, 2014 at 8:00AM

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Source: Amazon.

Investors are now just three days away from Amazon.com's (NASDAQ:AMZN) smartphone unveiling. Amazon will be extremely late to the smartphone market compared with its entrenched rivals. Given the intense competition, what would success look like for Amazon? How much financial upside would there be?

A numbers game
There were about 1 billion smartphone units shipped globally in 2013. If Amazon were able to grab 1% of that base, then that would translate into 10 million units. Considering the current state of the smartphone market, I would consider 1% market share a success.

Pricing remains largely unknown, but if we consider Amazon's historical strategy of selling hardware at or near cost, then we can make some educated guesses. The bill of materials for a mid-range smartphone is typically around $225. Then we have to factor in marketing and distribution costs. It's doubtful that Amazon is seeking a direct operating profit, but it probably wants to at least cover these expenses in order to be operating breakeven.

Amazon is using a new type of facial recognition sensor, but it's unclear how much that might add to component costs. Let's entertain a possible pricing range of $250 to $300. At 10 million units, that translates into $2.5 billion to $3 billion in revenue, or 3% to 4% of Amazon's current trailing-12-month revenue base. Amazon's core e-commerce business is growing at a much faster clip (23% last quarter), so 3% to 4% in incremental sales is by no means a game changer.

Prime numbers
The most likely strategy that Amazon is pursuing is to use a smartphone to help sell Prime subscriptions. The number of Prime members that Amazon currently has is one of its most closely guarded secrets. There are numerous third-party estimates, but Amazon did say in December that it has "tens of millions of members worldwide," which has led investors to peg the figure at 20 million.

At the new $99 price point, that represents $2 billion in subscription revenue. Of course, the real value in Prime members is that the free expedited shipping gets people 1-Click buying to their hearts' content. Amazon's smartphone could help retain those members as well as sell Prime to new members.

If half of the 10 million in aforementioned hypothetical unit sales were to new members, Amazon could potentially add 5 million new Prime members. That's $500 million in incremental subscription revenue, in addition to the likely increase in e-commerce spending. As you can see, the ecosystem effects start to add up pretty quickly.

To subsidize or not to subsidize
Another unknown is whether Amazon will pursue subsidy pricing. While installment plans are on the rise domestically, the majority of smartphone buyers still prefer subsidized prices. Subsidies do come with strings attached, and carriers typically demand co-branding and bloatware privileges. However, in return they offer vastly greater scale with marketing, sales, and retail distribution.

If Amazon does indeed launch some type of Prime Data offering, where it covers data fees related to its new Prime Music service, Amazon would have a strong bargaining chip in subsidy negotiations. Amazon may not like having carriers act as middlemen between itself and customers, but that's simply how business gets done in the smartphone industry. After a subsidy, Amazon's phone could easily be free. But Amazon could be on the hook for ongoing data fees under this scenario, bleeding out slowly over time.

Again, Prime is very likely the endgame here. Since Amazon obscures the actual underlying economics of Prime in a blanket of mystery covered in a veil of secrecy, it's difficult to accurately quantify how much upside a smartphone represents. As a result, investors have to speculate hypothetical numbers, because Amazon doesn't give us much of a choice.

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Evan Niu, CFA, has options on 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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