Where the Fire Phone sits in Amazon’s strategy

on June 19, 2014
Reading Time: 6 minutes

In the run-up to Amazon’s Fire Phone announcement, and especially as it was announced, I saw a wide range of responses from bloggers and others that seemed to fundamentally misunderstand where the Fire Phone sits in Amazon’s strategy. So I thought I’d have a go at explaining where I think it sits, based on my understanding of where Amazon makes its money.

The first critical thing is to understand the relationship between Prime and e-commerce in Amazon’s strategy. Some people seem to think everything Amazon does is to drive Prime memberships but that’s actually backwards. Prime memberships are a means to an end and not an end in themselves. Prime memberships bring in $99 a year in revenue, but they likely cost Amazon much more than that. Just providing the Netflix-like Prime Instant Video feature probably costs $50-60 per active user per year. Now, add the quasi-Spotify Prime Music service Amazon announced last week and it’s likely spending another $2-3 per month or $20-30 per year there. For Kindle owners, there’s the Kindle Lending Library as part of Prime too, which has a cost of its own that’s harder to quantify. Now look at shipping, which Amazon subsidizes to the extent its net cost of shipping (i.e. shipping revenue including part of Prime revenue minus shipping costs) is equivalent to its entire marketing budget:

 

Amazon shipping and marketing costsPrime is likely a loss leader on the pure basis of what Amazon charges for it minus the direct costs from just Prime Instant Video, Prime Music and shipping. That’s key to understanding where Prime sits in Amazon’s strategy: it is not, itself, a money maker. In fact, it was losing so much money Amazon recently had to increase the price from $79 to $99 to better cover the costs of all the freebies it’s now throwing in.

Of course, Prime doesn’t end there – the free shipping drives two sorts of behaviors:

  • People buy more stuff, because the net cost is more competitive when shipping is free – the obvious effect
  • People also buy more stuff because of the psychological effect of having paid for something and wanting to realize as much value from it as possible.

It works, too. As RBC Capital Markets demonstrated in a report a few days ago, Prime subscribers spend significantly more than non-Prime subscribers:

amazon-prime-spending-chart

Look at the amounts involved. On an annualized basis, over 90% of Prime members are spending upwards of $100 per year, over 80% of them are spending over $200 per year, and well over half are spending over $400 per year. That’s far more than they’re spending on Prime, which of course is loss-making as we saw above. So that’s the real value of Prime: it drives sales of other goods and services from Amazon.

Now think about where the Fire Phone fits within that strategy: the answer is simple:

  • The primary objective is to drive that difference between Prime using (and now Fire Phone-using) customers and non-Prime customers even higher
  • A secondary objective is to drive more Prime membership, hence the free annual membership Amazon is giving away with the phone. Without this deal, it’s very likely 100% of the people buying the phone would be existing Prime customers, and this deal (which is apparently temporary and promotional) may drive that down to 90% or so.

The fundamental role of the Fire Phone, though, is this: to serve as the obvious choice of phones for what I call “Amazon people” just as the iPhone was the obvious phone for Apple people, and Android devices are natural choices for Google people. By Amazon, Apple and Google “people” what I mean is those people who identify with those brands so strongly they have invested significantly in those ecosystems, and strongly prefer new products and services from those companies more so than from the others. These customers likely already have Kindles, Kindle Fires and Fire TVs in many cases, and the smartphone is a natural extension of those things.

Once in their hands, of course, the Fire Phone will serve to significantly reduce the friction involved in seeing a desired object and buying it from your mobile device. As I said in a piece last week:

Imagine what’s possible when Amazon controls the whole smartphone experience: a dedicated app on the homescreen (perhaps even triggered by a hardware button) which launches an app for quickly adding things to your Amazon wish list or cart, via barcode or image capture and OCR. The friction involved in translating a real-world discovery of an appealing product into an Amazon purchase would be greatly reduced.

That is, of course, exactly what Amazon did announce today, and the Firefly features went even further than I suggested by recognizing all kinds of objects (and it is, indeed, triggered by a dedicated hardware button).

That’s the role of the Fire Phone: to cement the relationship Amazon’s users have with the company and to ultimately drive more sales in Amazon’s core business, which is e-commerce. It gives it a much better stronghold in the emerging m-commerce market and allows Amazon to go from a useful showrooming solution to a mobile buying solution with these users. Of course, it only makes sense Amazon would extend many of these features to other devices too through Firefly apps on iOS and Android proper, and I imagine we may well see that emerge in the coming months.

What the Fire Phone isn’t, and was never going to be, is an attempt by Amazon to achieve world domination in smartphones. It isn’t intended to sell tens of millions of devices, and it isn’t intended to make Amazon tons of money from device sales. With distribution limited to just AT&T in the US today, it’s a given it won’t achieve that level of sales. With the target market best thought of as a fraction of the US Prime base, it’s clear it will be a significant achievement if Amazon sells 1-2 million phones in the first year.

Which brings us to the price. At similar levels to premium smartphones such as the iPhone 5S and Samsung Galaxy S5, the Fire Phone is not the disruptive entry into the smartphone market many were hoping for from Amazon. So why did it price the phone at such a high level? I was as surprised by anyone Amazon didn’t subsidize it heavily or find some other way to disrupt the business model for buying phones, but in hindsight there are at least two good reasons.

Firstly, phones aren’t content consumption devices to anything like the extent e-readers and tablets are. Kindles exist solely to read Amazon ebooks, and as such Amazon can afford to subsidize them, because they know these devices are effectively just storefronts for ebooks. The Kindle Fire tablets are consumption devices, but they’re also far more open than Kindles, and consumers can use whatever content services they want on them, even though they’re Amazon-centric. As such, the subsidy on these devices is smaller. The Fire TV is similar to tablets, and is subsidized at a similar level as a result. Smartphones are the least content-centric device Amazon has launched, and even though Amazon’s content applications and services will be front and center, they’ll mostly be those Amazon bundles into Prime anyway, meaning there will be very little additional revenue from content bought through these devices. Yes, the hope is – as outlined above – Amazon will sell more goods to these customers because of the Firefly feature, but that’s a much less proven business case. It’s entirely possible many customers will never use it. As such, Amazon can’t afford to subsidize it in the same way as its other devices.

Secondly, smartphones are a very different product category from any of the others Amazon makes, in that very few people pay full price for them. This was one of the biggest boons for Apple when it began offering the iPhone – carriers paid for roughly two thirds of the price, and AT&T is doing the same for the Fire Phone, reducing the nominal $650 price to $200 on a 2-year contract. As such, Amazon doesn’t need to subsidize it, because AT&T will. On the other hand, AT&T also offers (and perhaps Amazon will in time too) an option to pay for the device in monthly installments, at $27 a pop. As this data from CIRP shows, consumers are terrible at calculating the true cost of owning a device when they pay for it this way. So perhaps Amazon’s calculus was it didn’t matter as much what the nominal price was because no one will ever see it.

The big question now is whether the strategic rationale behind the Fire Phone – which is solid in theory – will play out in practice. The irony is Amazon likely doesn’t know, and we will likely never know, because Amazon doesn’t ever share any concrete data on how any of its devices sell. If the phone is still being sold a year from now, and especially if it gets a successor, then we’ll know it has done its job for Amazon. If it gets quietly discontinued, then it will have failed. Interestingly, the premium price takes a lot of the risk out of the equation – at those prices, margins on the device itself could be decent if it sells any sort of decent number.