Any willingness on Amazon's part to take a loss on the new tablet shouldn't be that surprising. It's all about locking up customers for the long run.
commentary While the Kindle Fire's dramatically low price may seem revolutionary, Amazon is actually taking its cues from a well-worn playbook.
Industry analysts, blogs, and even our own site cooed at the $199 price point of Amazon's freshly unveiled tablet. The company is using price as the hook, even if it loses money on each unit.
But before you sing Amazon's praises for breaking new ground, you should realize that undercutting the competition to drive adoption is far from a new strategy. In reality, Amazon and the Kindle Fire is only the latest example of a company willing to take an upfront hit to ensure a profit down the line. The good news for Amazon: the tactic often pays off.
"The Kindle is about other Amazon services gaining customer traction," said William Ho, an analyst at Current Analysis. "You can also think of it as subsidizing the hardware and getting the return on services and content."
The strategy follows the classic shaver and razor model: sell a cheap shaver--likely at a loss--to a customer, and make it up when they go back to buy replacement razor blades.
At $199, the Kindle Fire makes for one expensive shaver. But essentially, that's what it is. Piper Jaffray analyst Gene Munster estimates that Amazon will take a $50 loss on each tablet.
Amazon is banking on the fact that once you have your Kindle Fire, you're going to want to fill it with videos, music, and of course, digital books. While the details aren't out yet, most believe the device will be a closed system that will direct you to Amazon for your media needs.
"It's not part of a money-losing war for share, but rather the expectation that the tie-in to apps, movies, books, and services such as Prime will make the device profitable," said Ross Rubin, an analyst at NPD.
Amazon offers Prime, which is a premium membership to the online retailer, for $79 a year. The membership includes free two-day shipping on products, as well as unlimited streaming of videos from a library of television shows and movies.
If you look around, you'll probably find something that a company sold to you at a loss, everything from the cellphone in your pocket to the PlayStation 3 in your home entertainment center.
The wireless industry is perhaps the most apt example of the model. A wireless carrier will subsidize the cost of a phone, which could sell from anywhere between $500 and $700 by itself, so it only costs $200 when bundled with a two-year service contract. As the customer goes through the contract, the carrier recoups its loss and ultimately generates a profit.
That's why companies such as AT&T and Verizon Wireless will take a big hit if they have a quarter with an extraordinarily high number of new iPhone activations. Sprint Nextel CEO Dan Hesse has said he would gladly take the near-term financial pain if it meant adding a few more quality contract customers.
Cable providers offer free cable set-top boxes, modems, and Wi-Fi routers--sometimes at a cost of several hundred dollars--if it means you end up paying a regular monthly fee. Hewlett-Packard's highly profitable printer business hinges on cheap printers but expensive ink refills.
"It is the same general idea--lower the barriers for adoption by dropping the price, and the revenue will follow over time," said Jonathan Chaplin, an analyst at Credit Suisse.
One tough industry
One of the most dramatic examples is the video game industry, where its largest players are willing to endure years of losses to establish a beachhead. The idea is to set up a broad base of users and to make up the revenue through the sale of video games.
When Microsoft was attempting to break into the business with its original Xbox in 2001, it had to take a hefty loss with each unit. Then-Merrill Lynch analyst Henry Blodget estimated that Microsoft would take a $125 hit on each unit and wouldn't make money for the first three years.
Microsoft, however, stuck to its guns, and the strategy worked. Microsoft is considered a major player alongside Sony and Nintendo. Sony took a hit with its PlayStation 3 initially because of the high cost of the included Blu-Ray player, which at that point was considered a luxury item by itself. It continued to lose money on each unit as it cut prices to remain competitive with the Xbox 360 and the Wii.
But even the video game industry can tolerate only so many losses. The players have largely agreed to hold back a new generation of hardware in the hopes of preserving the profits of the older system for a few more years. They've instead opted to extend the life of their current systems with motion-sensing add-ons like the Xbox Kinect and PlayStation Move.
"Nintendo really shook things up with the Wii because it went with less expensive components and was profitable on the hardware much earlier than usual for a game console," said Jon Erenson, an analyst at Gartner.
Tablet market still open
What Amazon has done is taken the strategy and deployed it on to the tablet market. Despite an increasing number of companies coming out with their own tablet, it's a segment that's ripe for this kind of pricing scheme.
Apple had set the bar at $500 for its lowest end iPad. It's a price point that other tablet manufacturers have struggled to get to. But the Kindle Fire brings the bar dramatically lower, and as I wrote yesterday, it's not a level easily attained by hardware companies who make money wholly on the product they sell.
• Amazon unveils Kindle Fire tablet for $199
• Amazon unveils trio of Kindle e-ink readers
• Amazon lights a Fire with its Kindle tablet (photos)
While some believe the $199 price point will make the Kindle Fire an iPad killer, that's unlikely to happen. Curiously, Apple employs the opposite strategy in pushing its products. It uses inexpensive songs, podcasts, videos, and apps to drive device sales, where it enjoys a healthy profit margin. And it's done so with unprecedented success.
Which isn't to say that the Kindle Fire won't be a hit itself. Amazon has an opportunity to break open the tablet market, drawing in customers who never would have considered one before.
That's a small price for Amazon to pay.