On Free Kindle

It appears, at least to Farhad Manjoo, Kindle is going to be free. He writes in recent Slate colum,

I can’t tell you when this will happen. But it will happen. Mark my words: The Kindle will be free.

Let us not delve into how he arrived at such a certainty couched as a measured statement with uncertainties.  Let us take his word for it and look at what it would mean to Amazon’s profits. According to Manjoo, who seems to have a window into Amazon decision maker’s mind and their business strategy,

First, why? Well, that’s easy—because Amazon’s long-term goal is to make money from selling content and general merchandise, not by peddling its own devices.

The case in point is the low-end $79 Kindle that will be free. So what kind of money should Amazon make by selling content and general merchandise by not peddling its device? Let us be aggressive and assume that this low-end Kindle is going to be great to sell general merchandise and not just content.

Again according to Manjoo, Amazon makes no profit on these devices or may be even losing money. Let us say they are indeed selling $79 Kindles at their marginal cost.

Say by making the Kindle free, they sell 20 million of them.

Cost? $1.58B for 20 million units. Just to stay where there are with current gross margin, they have to gain gross margin(not sales) of $1.58B from content and merchandise sales.  To put that in perspective, Amazon’s 2011 gross margin is $10.8B from sales of $48B. At its 22.4% gross margin, this $1.58B means $7B in sales.

And this $7B  sales will all have to be incremental new sales, sales that are made possible only because of the free Kindles. Sales that would have any way happened, because customers do shop even without free Kindle, cannot be counted towards these numbers.

On a per Kindle basis that means every free Kindle user must spend additional $350, above and beyond what they are already spending with Amazon. How likely is that scenario? Say amazon now has 100 million shoppers, its current revenue of $47B means, each shopper spends an average of $470 per year. Can a free kindle somehow add $175 per year (assuming device lifetime of 2 years) to this $470?

Now this is just the simplest of the math. You can see how unfavorable it gets when you add in lost profit from those who buy other Kindle models and Kindle Fire switching to free version.

On the flip side, say if Amazon were able to sell 5 million of the $79 Kindles. As per our marginal cost assumption they are no costs. If Amazon were able to generate the same $175/y in incremental sales from these 5 million customers that is $875 million in new sales and $196 million in new profit – not just the profit they had to make stay at same place but something that actually moves the needle.

Why wouldn’t they do that? If somehow a free Kindle buyer could be coaxed to spend $350 more why is not possible with the one that bought Kindle for $79?

I don’t have the window into Amazon’s strategic mind or the data they are looking at.May be you should ask Manjoo.  Amazon has said before, “economics don’t work for a free Kindle”. That appears as a bluff to Manjoo.

What appears like a bluff to us outsiders may really be the result of strategy guys doing their job – evaluating all possible paths ahead of them and making choices with constraints.

That is the difference between writing something based on one’s wishful thinking and having to make decisions that affects shareholder value.