Amazon Kindle Fire May Be More Profitable Than Expected

Amazon.com, Inc. (NASDAQ:AMZN) began shipping its much-anticipated Kindle Fire tablet Nov.14, a day earlier than its original Nov.15 shipping date. There are some assumptions that Amazon is selling its tablet for a loss at $199, but it doesn't appear to be the case considering the long-term aspects of the device.

However, a Wall Street analyst has said that Amazon's Kindle Fire tablet may be more profitable than expected and the latest prediction could boost Amazon shares.

According to data released by iSuppli, the manufacturing cost per Kindle Fire unit is approximately $202. RBC Capital Markets estimate an additional $10 in marketing costs per unit and $5 in shipping cost per unit (to be conservative), bringing the total cost of one Kindle Fire to $216.70. At selling price of $199, Amazon generates an operating loss of roughly $18 per unit (-8.9 percent profit margin).

RBC Capital Markets conducted a proprietary survey of 216 Kindle Fire owners to get a better early understanding of what users are doing with the new tablets and gain an insight around Amazon's potential revenue and profit from these devices from hardware, software, digital and physical goods.

One high level conclusion is that Kindle Fire unit economics are likely to be more favorable than consensus expectations, based primarily on frequency of digital goods purchases, the brokerage said

Our assumption is that AMZN could sell 3m-4m Kindle Fire units in 4Q, and that those units are accretive to company-average operating margin within the first six months of ownership. Our analysis below assigns a cumulative lifetime operating income per unit of $136, with a cumulative operating margin of over 20%, analyst Ross Sandler wrote in a note to clients.

Let's see how these works out. Based on RBC survey results, the brokerage estimates that the average Kindle Fire owner purchases 5 e-books per quarter, which could prove to be conservative. Amazon accounts for e-book sales using the agency and merchant models, but for this illustration, RBC assumes all are under the agency model.

Assuming the average selling price e-book is $9.99 and Amazon keeps 30 percent as a commission, the company would generate $15 per quarter in high margin revenue and RBC estimate a 70 operating margin (from net revenue to operating income) per e-book.

In addition, Sandler expects that the average Kindle Fire owner purchases 3 paid apps per quarter, which could prove conservative based on early attach rates. With regards to expenses, the analyst estimates Amazon pays on average about 70 percent revenue share to app publishers, in addition to roughly $0.25 per app in operating expenses. Based on RBC's assumptions, each paid app would generate around a 20 percent operating margin.

In addition to digital goods, the survey results suggest the initial Kindle Fire sale should create other cross-selling opportunities, most notably Prime memberships and physical goods sales. The survey also showed that 42 percent of Kindle Fire owners are Amazon Prime members and 46 percent either don't know they get a free trial with their Kindle, or have already chosen not to renew.

The cost of a Prime membership is $79.99, hence applying an 8 percent attach rate (probability of conversion) and the $20 in revenue recognition per quarter, Amazon likely generates $1.60 in incremental Prime membership revenue per Kindle Fire owner per quarter.

Sandler said the initial sale of a Kindle Fire results in an operating loss of $17.70. On average, Amazon will break even on a Kindle Fire unit in less than five months, accounting only for direct digital good purchases.

In the first year following the sale of a Kindle Fire, the analyst estimate that Amazon will generate $33.56 in operating income (9.1 percent margin), including the sale of digital goods and incremental Prime memberships and physical goods. In year 2 and year 3, Sandler estimate that Amazon will generate $51.26 in revenue from digital goods and incremental sales. This translates to a three year cumulative operating income $136.09 per Kindle Fire unit and life-time operating margin of 21 percent - well above company average.