Seven years ago, Amazon.com (NASDAQ:AMZN) entered the hardware business with the original Kindle. Since then, Amazon's hardware pricing strategy has evolved to the point where the company sells devices at cost in order to profit on content and services later on.
It's a textbook example of the classic razor-and-blades model, and one that Amazon has become quite good at. The mantra that Jeff Bezos now regularly recites is that Amazon doesn't want to make money when customers buy its devices -- it wants to make money when customers use its devices.
Since Amazon has such vast e-commerce and digital content ecosystems, it can afford to sell hardware at cost while OEMs lacking these ecosystems have no choice but to pursue up-front gross margins. With the Fire Phone that was introduced this week, Amazon is doing something decidedly un-Amazon: It wants to make money up front.
Amazon wants to make money when you buy a Fire Phone
Priced at $650 unsubsidized or $200 on contract, Amazon is positioning the Fire Phone as a direct competitor to Apple's (NASDAQ:AAPL) iPhone 5s, along with other flagship devices. The Fire Phone offers more storage than the iPhone 5s at that price point, but there are other areas where the Fire Phone lags Apple's high-end phone. More importantly, Amazon will absolutely be generating a gross profit at $650. This marks a significant departure from Amazon's historical hardware pricing strategy.
Amazon has spent years developing this phone, and you might think that it wants to recoup those R&D dollars. However, even that would also be out of character. Amazon has never been afraid to bleed out massive sums of money when it enters new markets in the name of aggressive competition.
Consider how Amazon pummeled Diapers.com parent company Quidsi into submission in 2010. After initially spurning Amazon's acquisition offer, Amazon's competing Amazon Mom service pulled out the big guns, offering a plethora of aggressive discounts combined with expedited shipping (courtesy of Prime, of course). Quidsi execs calculated that Amazon would lose $100 million in three months just selling diapers. It simply couldn't compete, so it sold. The rest is history.
What's more important: diapers or smartphones?
If Amazon was willing to lose over $100 million in diapers, why shouldn't it be just as willing to absorb development and marketing costs to enter the smartphone market? Why wouldn't it price the Fire Phone near cost like it has done with so many other devices?
Even though the promotional offer of 12 months of Prime effectively reduces the price by $100, that should even be more reason for Amazon to price the Fire Phone aggressively. It should be trying to get the Fire Phone into as many hands as possible, as the Fire Phone's primary purpose is to push Prime subscriptions and make buying random stuff on Amazon even easier than it already is. A lower price point would lead to more subscriptions that are highly likely to renew. At yesterday's event to introduce his company's smartphone, Bezos suggested that Prime's retention rates are remarkably high, comparing it to a bucket that doesn't leak.
It's very possible it only costs Amazon around $300 to build the Fire Phone, before marketing and distribution costs come into play. That could have also made the device free on contract after carrier subsidies. Amazon should be as aggressive in the smartphone market as it was in the diaper market.
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Evan Niu, CFA owns shares of Apple and has the following options: short January 2015 $280 puts on Amazon.com and long January 2015 $250 puts on Amazon.com. The Motley Fool recommends and owns shares of Amazon.com and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.