Why the Fire Phone Is Destined to Be a Failure

Last Wednesday, Amazon.com (AMZN 1.49%) unveiled the Kindle Fire Phone. It has a 3-D-like viewing perspective, tie-ins to Amazon shopping, and unlimited cloud storage, and it comes with a year of Amazon Prime. 

And it's destined to be a failure. Or, at the very least, irrelevant. 

While analysts will pontificate over whether it's an "iPhone killer," it's not even in the same league as Apple's (AAPL 0.51%) device. Well, except for the bizarre decision to price it at the same level as the iPhone. It's also late to the market, and exclusive to only one carrier in the United States. 

With the Fire smartphone going against what made Amazon so successful in so many markets, what is Jeff Bezos thinking?

Image source: Getty Images.

The smartphone market is largely settled
In an interview with The New York Times, Bezos was asked the question on everyone's mind. Was Amazon too late to unveiling a phone?

New York Times: But are you too late into this market?

Jeff Bezos: I think in the whole evolution of this, we're still pretty early. I don't want to judge before all the facts are in, but I think this wireless thing is going to be big.

If we go back in time just five, six, seven years, we're talking about different players -- Nokia, BlackBerry, and others. Things change very rapidly in this area.

I have a hard time accepting that even Jeff Bezos believes himself saying that. If anyone realizes the power of reacting quickly to fast growing markets, it's Jeff Bezos.

In 1994, Bezos quit a well-paying job on Wall Street to found Amazon. Upon quitting, he packed up all of his belongings and headed out to begin his new company. At the time he didn't even know what city he'd wind up in -- later settling in the Seattle area. He just knew the Internet was a unique opportunity and he couldn't afford to wait.

For a man who has acted so decisively when seeing huge opportunities. Bezos is conspicuously late on the smartphone front. Sure, no one can be at the forefront of every trend. But Amazon is really late to this party. 

Relative to past consumer technologies, smartphones are a young market in terms of how long they've been on the market. The PC market grew from about 1 million sold per year in 1980 to a bit over 350 million at their peak in 2011. Smartphones, by contrast, were at about 122 million in sales in 2007 when the iPhone was released and sold around a billion units last year. 

While the PC plodded along, growing relatively consistently over the past 30 years, the smartphone packed all that growth into a much shorter timeframe. It took one-fifth of the time and became a market three times as large. We're early in mobile only when you compare the time it has existed relative to PCs. But we're extremely late when you see how quickly the technology reached saturation points in most markets. This was the most rapid evolution in technology history. 

Data compliments of Gartner.

Bezos' answer to The New York Times is right: This mobile thing is going to be big. Too bad the facts are already in. They're in that chart right there, and they say Jeff Bezos and Amazon are going to be irrelevant. 

An optimist could look at that chart and note that smartphones sales are still rising extremely rapidly. In 2013, IDC estimated that smartphone shipments rose 39%. While smartphone growth is expected to slow in the years ahead, IDC still expects shipment growth to come in at an impressive 19.3%. 

The problem is that growth is coming from areas where the phone literally isn't sold. The highest growth in the past year came from markets like China, and in the years ahead it'll come from markets like India. Amazon's phone announcement ignored any international sales. It's being sold as part of an exclusive agreement with AT&T (NYSE: T). In the United States, smartphone growth rates are expected to slip into the single digits this year. 

When the phone is finally launched internationally, it'll face tough challenges finding large numbers of buyers. A major part of the phone's appeal is integration to Amazon's Prime services, where the company continues adding media offerings. The problem is, these offerings aren't always available in other markets Amazon operates in. Its Instant Video selection, which is similar to Netflix, is currently available in only four countries -- the U.S., the U.K., Germany, and Japan -- and its new Prime Music service is available only in America. 

Then there's also the fact that Amazon is more of an American phenomenon than other tech companies are. Online's share of retailing stands at about 11.6% in the United States versus a Europe average of 7.2%. Amazon still collects about 60% of its revenue from North America, a higher concentration than most high-tech peers. Online retailing is also strong in markets such as China, but Amazon is still a small player in that country. Its market share of online business-to-consumer retail was estimated at just about 2% last year. 

What is success?
So the phone is going to see minimal sales and be largely limited to the United States, but you might say Amazon doesn't need to sell tens of millions, or even 5 million, to be successful. It just needs to further entrench itself with its best customers. 

Looking at global market share numbers, it looks as if Android will continue building on its market-share lead in the coming years. 

Worldwide Smartphone Sales to End Users 

Source: Gartner. Units in thousands.

Yet the actual competitive dynamics at play in the smartphone world are far more complex than this market-share chart. At the high end -- roughly defined as phones costing $400 or more off contract -- Apple holds a much more dominant position. In launch periods after new iPhones are released, the iPhone's market share moves past 40% in America on all smartphones, and even higher on high-end devices. In Japan, researcher Kantar estimated that the iPhone hit 69% of all smartphone sales last December.  

The smartphone market is largely in a period of stasis. Apple is dominant in more expensive devices and wealthier countries where smartphones are sold on contract, while Android has huge market share in all other smartphone spaces. Neither has "won," but both are pursuing vastly different strategies and have a strong grip on vastly different market segments. 

Amazon's approach could be similarly nuanced. The company needn't compete for huge sums of total market share but instead aim for a portion of their most valuable customers. 

I understand the logic behind this strategy, and the selling points on the Fire Phone lend to it. For example, the phone comes with a "Firefly" button that lets you "scan" the world around you. While the feature could scan a movie you're watching to identify it -- pretty neat, huh? -- its main use is scanning a product to seamlessly bring up an Amazon page where consumers can then purchase it. It's the next evolution in reducing the frictions between the virtual side of e-commerce, and buying physical items. The phone also comes with a year of free Amazon Prime, which offers free two-day shipping. 

Amazon's Firefly in action, recognizing a street sign to pull up information on the company. 

In that sense, the Fire Phone is the world's most clever shopping cart. 

A recent study from researcher RBC shows why Amazon wants to continue swelling the ranks of Amazon customers. In the study, they found that the average Prime customer spends $538 a year, compared with about $320 for a non-Prime member. Now imagine giving your best customers a phone that makes shopping at your store even easier and puts your services right at their fingertips. Using such a strategy, Fire Phone buyers become a new, better class of Amazon customers. 

A few problems with this strategy
But I'm far from sold on this approach. 

Let's say there are about 20 million Amazon Prime subscribers (Amazon hasn't disclosed this number, only revealing "tens of millions"). Now, let's say 10% of them buy a Fire Phone. That's actually a pretty generous figure when you consider most people in the United States already have a smartphone and the Fire Phone is available at only one of the country's four major carriers. Finally, let's assume each one of those Fire owners spends double the average Prime user on average, or about $1,000 a year. 

The math would be pretty simple: 2 million phones multiplied by an additional $500 a year is a billion more in revenue. With Amazon slated to pull in about $91 billion this year, that'd be roughly 1% of its revenue. 

However, there are a few flaws in these assumptions. First off, while Amazon Prime buyers spend more money, it's also a program their best customers self-select into. That is to say, if you're willing to spend $100 a year for a service that heavily features cheaper shipping, you're probably already spending more than the average customer. In RBC's own data, 39% of Prime subscribers said they hadn't spent more since joining the service. Even if Amazon later announces that Fire Phone users spend twice as much as an average Prime user, they might have spent that amount regardless of whether they own an Amazon phone or not, as the Fire Phone will naturally appeal to a sliver of Amazon's best customers who already spend more than the average.

Second, why does Amazon need a phone to make this strategy work? Its iOS app already includes a feature named "Flow" that allows scanning of real-world objects, much like Firefly. The Amazon phone has a dedicated button called Firefly, which encourages shopping. That's a feature that can't be replicated on an iPhone or Android app. Yet it's questionable whether the company's phone will drive more shopping relative to continually adding features to their Apple and Android apps, which already have huge user bases. 

Facebook Home in action.

Facebook (META 0.14%) famously introduced its own user interface for Android devices named Facebook Home. Phones based on Facebook Home never took off because users didn't want Facebook at the center of the phone. Facebook took a gamble on the phone, but it wasn't a gamble the company needed. Research from Betaworks shows that 68% of users have a Facebook app not just installed on their phone, but on their home screen. Likewise, Amazon's best customers probably already have Amazon's services prominently featured on their phone. 

Facebook discovered that creating a "Facebook Phone" wasn't worth the trouble. Amazon's Fire Phone looks to be following in the same path. Its a big jump from being a favored app to having users who want a phone built around your services. 

Why so expensive?
I was at the Amazon press conference when the original Kindle Fire was announced. Writing shortly after the announcement, my article led with the tablet's most important feature. 

If you take one thing away from the unveiling of Amazon.com's new tablet, it should be this: When Jeff Bezos unveiled the price at today's press conference, the person sitting next to me gasped.

Only $199 for that sharp-looking of a tablet?

While the tablet market is now flooded with cheaper tablets that are high in quality, it's important to remember that at the time of the Kindle's unveiling, they didn't exist. Most tablets were competing with the iPad in the $500 price range. The biggest selling point of the Kindle Fire was that it was cheap. 

The Kindle Fire got out to a rapid start. In its first quarter on sale, the tablet captured 14% of the tablet market, putting Amazon second behind only the iPad. But success breeds imitators, and as tablets such as the Nexus 7 hit the market in the $200 price range, the Kindle Fire began losing momentum. Researcher IDC estimated the Kindle Fire's share of the tablet market at just 1.9% last quarter. 

The natural conclusion is that people like the Kindle's price a lot more than they like its integration with Amazon services. Amazon doesn't hide from this fact. Watch this Kindle commercial. What's the punchline? The Kindle Fire is cheaper than the iPad. 

Competing on price has long been Amazon's hallmark, so it's remarkable that the Fire Phone is one of the more expensive phones on the market. It starts at $199 on contract, or $649 off it. That's the same starting price as the iPhone. 

Why would the company run away from its historical pricing strategy with the Fire Phone?

One of the key reasons is probably the bizarre pricing structure of the U.S. smartphone market. While an iPhone 5s really starts at $649, most users purchase it on a contract that cuts the immediate price they're paying down to $199. This contract pricing structure encourages users to buy high-end phones. After all, your carrier might give you a phone for free that cost the carrier $200, but then you've only managed to get the carrier to "eat" $200 in costs. It's a much better deal to buy that iPhone when your carrier eats $450 of the costs. In the United States and other markets with cell-phone contracts, competing on price is very difficult. 

For years, the press wondered how Amazon could attempt to break through this pricing structure. We have the answer now: Amazon didn't. 

It's a curious move. When asked about the expensive pricing, Bezos said the following to The New York Times.

New York Times: I was surprised that you weren't competing on price so aggressively. This is essentially the same price as rival devices.

Jeff Bezos: Well, it's 32 gigabytes instead of 16, which is a big deal. So don't forget that small fact! And it has Prime -- for new or existing members, you get 12 months free.

But it's a really premium phone. We've packed a lot of hardware, a lot of expensive materials into the phone.

The question is, why charge for the phone at all? Was the Kindle Fire not a premium tablet? Amazon decided to price that cheaply relative to the market. Most high-end phones have materials -- casing, processor, manufacture, etc. -- that add up to being in the $200 range. Even with the extra cameras and sensors required for the Fire Phone's 3-D viewing perspective, the Fire Phone itself probably costs less than $250 to make. 

If Amazon's strategy is to sell the phone to its best customers who probably already take advantage of Prime's features, why include a year of Prime at all? Why not make the phone free on contract -- or about $400 off contract -- to make it even more attractive to Amazon power users?

If Amazon's goal is to sell the phone to new users -- and hook them into Amazon's services with the offer for a year of Prime -- then why did they limit themselves to just one wireless carrier that covers less than one-third of Americans?

Just what is Amazon's strategy? 

Even Amazon doesn't believe in the Fire Phone
I believe the answers to this question lie in one simple fact: Building and marketing smartphones is expensive, and even Amazon can only tolerate so much lost money. 

When you build a smartphone, you don't need to just market to consumers; you also need to get wireless carriers like AT&T and Verizon to promote your product. Just look at Samsung, which in the past year spent about $12.4 billion on marketing, the vast majority of which was on advertising and sales promotions with wireless carriers. 

The expenses around not just promoting a phone, but also researching and developing them, is what leads to companies that sell tens of millions of phones yet sometimes incurring billions' worth of losses even though their phones are sold for far more than the materials inside them. 

Amazon has traditionally eschewed expensive television marketing spots. In fact, it only recently began advertising to promote the Kindle e-reader and Kindle Fire tablet. The company has passed on marketing precisely because marketing is so expensive that it would prohibit the company from undercutting competitors' costs. 

Yet advertising in the device space is a necessity. Samsung can spend billions on advertising because it has such wide appeal across markets. This is where the limited appeal of Amazon's phone becomes problematic. If Amazon is intending on selling the phone to a narrow audience of Amazon customers, the sales volume of the phone just won't be large enough to justify the costs of a national advertising campaign. 

That's probably the reason the phone is exclusive with AT&T. Think for a moment what exactly Amazon gets for that exclusive arrangement. Customers of its phone don't get any special data packages. The phone isn't subsidized any differently from a similar phone from Samsung or Apple. Amazon seemingly gets little to no benefits for limiting itself to just one carrier. 

That is until you realize that AT&T can promote the phone. Carriers like exclusives to create a differentiator to drive potential new customers to their stores. In exchange for exclusivity, what Amazon gets in return is being able to cut back on costs associated with promoting the phone. AT&T will do the heavy lifting there. 

At the end of the day, if Amazon believes the Fire Phone could compete strongly in the market, it would have wanted a broader reach, for the phone to be accessible to most Americans. Amazon chose AT&T to limit its risks and costs launching a phone. It's important to remember that Amazon keeps just a sliver of profitability to appease Wall Street. Last year, that profitability was just $274 million on sales of $74 billion. The costs of promoting a phone could have risked pushing Amazon back into the red, so it chose a less risky path. 

The simple fact is that even Amazon doesn't really believe in the Fire Phone. Otherwise, it would have acted more decisively to make the phone cheaper and more widely available. 

The good news: it doesn't matter
There are a few good pieces of news to come out of the Fire Phone for Amazon investors. First off, it will never publicly be regarded as a massive failure. 

At least not as far as the media is concerned. Most companies report sales of products on a quarterly basis. The ability of product sales to either beat or miss Wall Street's expectations creates a rallying point for the media. A weak quarter of iPad sales leads to hundreds of articles questioning whether the tablet market is dying. A strong quarter of iPhone sales leads to an equal number of stories wondering questions like "Is Apple back?"

Amazon never allows the media to control this narrative, because it never releases numbers on any new products. The original Kindle e-reader? Never disclosed. Specific revenues from cloud computing? Not discussed. Sales from the Kindle Fire tablet? Nary a peep.

Instead, Amazon issues press releases that often describe sales in vague terms such as "millions sold," or "our most popular product ever," or "sales up 250% over the same period last year." Of course, we don't know how many millions were sold, what constitutes the most popular product ever, or how many products were sold last year to know if such an increase is really a big deal. 

Amazon is a master of releasing charts with no Y-axis. It's a cheap trick meant to fit whatever it wants the media to believe. At some point, we might hear about "millions of Fire Phones shipped" or its being "among Amazon's most popular products ever." What we'll never see are definitive numbers to quantify how popular the phone is. 

Then there's also the matter of how irrelevant the Fire Phone is to Amazon's total business. Wall Street has Amazon pegged to grow revenues all the way up to $183 billion by 2018. Almost all that growth comes from retail operations, with the cloud computing division kicking in growth on top. In the grand scheme of things, its phone ambitions are irrelevant to its business. Since Facebook announced its failed Facebook Home overlay last year, its stock is up an astounding 163%. Far bigger issues drive its success. While I believe the Fire Phone is destined for failure, I've also considered buying Amazon's stock for wholly different reasons. 

In three years, when a dusty Fire Phone box falls in an AT&T warehouse, will it make a noise?