Kindle Challenge to IPad Narrows Amazon Margins

Amazon.com Inc. (AMZN)’s profit margins, already at a five-year low last quarter, are set to narrow next year as the world’s largest online retailer sells its new tablet computer for half the price of the iPad.

Kindle Fire 300x200 Kindle Challenge to IPad Narrows Amazon MarginsThe Kindle Fire will go on sale next month for as little as $199, compared with $499 for the cheapest tablet from Apple Inc. (AAPL) The lower price will help Amazon sell 4.5 million Kindle Fires in the fourth quarter, according to Barclays Plc, topping the 3.3 million units Apple reported for iPad’s debut quarter. It also means Seattle-based Amazon loses about $10 on each tablet, according to IHS Inc.

“It is possible that in 2012 you’ll have a quarter with negative operating margins,” said Ben Schachter, an analyst at Macquarie Capital in New York. “That typically is a disaster scenario. It’s phenomenal to have this revenue growth, but at some point you want to see them make money on it.”

Chief Executive Officer Jeff Bezos is counting on sales of music, books, movies and merchandise on the tablet to make up for money lost on the device. The Kindle Fire, available Nov. 15, has a 7-inch display, smaller than the iPad’s 9.7-inch screen, Amazon said at a Sept. 28 event in New York. The device will run on Google Inc.’s Android software, have a dual-core processor and offer Wi-Fi connectivity, the company said.

Apple Challenge

Amazon is trying to parlay its leadership in e-commerce to grab a piece of a market that Cambridge, Massachusetts-based Forrester Research Inc. predicts will grow 51 percent a year through 2015. While tablets from companies such as Hewlett- Packard Co. and Research In Motion Ltd. have failed to erode Apple’s dominance in the market, Amazon may be the first to pose a meaningful sales challenge to the iPad, Brian Blair, an analyst at Wedge Partners Corp. in New York, said the day of the Kindle Fire’s unveiling.

Still, selling the device at a loss means Amazon’s margins could fall below zero percent, weighing on the company’s stock price, Macquarie’s Schachter said. Amazon’s 2 percent operating margin in the second quarter was the lowest since the third quarter of 2006, according to data compiled by Bloomberg. They may have narrowed to 1.3 percent in the third quarter, which ended in September, analysts surveyed by Bloomberg project.

Investors’ focus on Amazon’s revenue growth has so far diverted attention from the decline in profitability, Schachter said.

Sales, Share Gains

Sales rose 51 percent in the second quarter from a year earlier, the biggest jump since at least 2002, and analysts predict revenue will rise 43 percent this year, according to data compiled by Bloomberg.

Amazon shares fell 1.1 percent to $243.93 at 9:37 a.m. New York time. The stock has gained 37 percent this year before today. It is projected to rise 1 percent over the next 12 months, compared with an anticipated 20 percent increase for Apple, according to Bloomberg data.

Mary Osako, an Amazon spokeswoman, didn’t respond to requests for comment.

Amazon spends about $210 to make each Kindle Fire, while the iPad 2 costs Cupertino, California-based Apple about $333, IHS estimates.

Amazon will have to rely on content sales on the Kindle Fire to make the tablet profitable, said Kerry Rice, an analyst at Needham & Co. in San Francisco. He estimates Amazon will sell 2 million to 4 million Kindle Fires this year.

Media, Merchandise

“Amazon is coming at it as, ‘We’re a media company, and we need to put this in the market to drive sales of our media,’” Rice said. “What this device does for Amazon is drive the consumption of media in whatever form possible. They pay once for a movie, and if they sell it a million times, that margin increases.”

A Kindle Fire user would have to spend about $500 on media and merchandise through the device, on purchases of items with 2 percent to 4 percent margins, to make up for Amazon’s loss on the tablet itself, estimates Scot Wingo, chief executive officer of Channel Advisor Corp.The Morrisville, North Carolina-based company consults on Web strategies for more than 3,000 businesses, including Amazon third-party sellers.

Wingo expects Amazon to sell about 5 million tablets in the fourth quarter, bringing pressure on margins for the first six months of sales.

Adding Prime Users

Margins may widen in the next few years, a result of Amazon’s switch to a so-called agency model to sell books, which means the company reports 100 percent profit and lower revenue on each purchase, Schachter said. Instead of selling a book for $10 and booking the entire amount as revenue, then paying publishers $7 — a 30 percent gross margin — the company only reports the $3 in revenue, he said.

Amazon is offering Kindle Fire buyers a 30-day free trial of Amazon Prime, the company’s $79-a-year membership service that includes streaming video and free two-day shipping, something that may bring in more net income, Wingo said.

While Prime members represent about 8 percent of users, they spend four times as much as other customers, according to ChannelAdvisor. The Kindle Fire could draw 10 million more Prime members, Wingo said.

“You go to Costco or BJ’s, you buy the membership and you want to shop there enough to make up the cost,” he said. “Once you join Prime, it just becomes second nature. You stop going to Target every Wednesday.”

Investors’ Patience

Revenue from digital content on Kindles will surpass hardware sales from the device in 2013, Barclays analyst DiClemente estimates. He projects that the Kindle Fire and content sales through the tablet will account for 5.1 percent of Amazon’s 2012 revenue.

Investors may not continue to overlook the narrower margins if Amazon doesn’t find a way to squeeze more profit from its lower-priced items, Schachter said.

Increases in capital expenditures and marketing must be countered by profit from higher-margin digital offerings such as books, music and movies, he said. Amazon can also leverage its ability to sell consumers items like clothes and cat food, in addition to digital media products, to woo customers from Apple, he said.

“Scale does not necessarily beget margin expansion,” Barclays’s DiClemente said in an interview. “The sentiment from investors is that in the near-term, revenue growth is more important than margins. If and when revenue growth starts to slow down, the narrative on Amazon’s financial story will switch to margins.”

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