Making the amazon kindle case study

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©2014 by the Kellogg School of Management at Northwestern University. This case was developed with support from the June 2010 graduates of the Executive MBA Program (EMP-78). This case was prepared by Professor Mohanbir Sawhney and Joseph R. Owens, PhD, and Pallavi Goodman. Cases are developed solely as the basis for class discussion. Some facts in the case have been altered for classroom discussion purposes. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. To order copies or request permission to reproduce materials, call 847.491.5400 or e-mail cases@kellogg.northwestern.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Kellogg Case Publishing.

REVISED APRIL 25, 2014

MOHANBIR SAWHNEY, JOSEPH R. OWENS, AND PALLAVI GOODMAN 5-413-751

Kindle Fire: Amazon’s Heated Battle for the Tablet Market

In January 2012, as Jeff Bezos reflected on the early sales success of Amazon’s Kindle Fire device, he was oddly troubled. In a little over three months, Amazon had sold nearly 5 million Kindle Fires and had captured half of the non-Apple tablet market share. Worldwide sales of e- books since the introduction of the Kindle product line had grown from less than 1 percent of all books sold to 15 percent in 2012. But Bezos was not ready to call it a success yet.

As he anticipated Apple’s imminent announcement of the third-generation iPad and its entry into the textbook market, Bezos knew he would have to refine his strategy for the Kindle Fire. In addition to Apple, new entrants such as Samsung, Motorola, and Google were beginning to enter the tablet market. Furthermore, Amazon’s long-time competitor in the E Ink1–based e-readers, Barnes & Noble, was now selling a device nearly identical to the Kindle Fire called the Nook. Bezos had told investors that the Kindle Fire was the key to Amazon’s future in the hardware space. The markets seemed to agree. Amazon stock had dropped $40 since the launch of the Kindle Fire. Analysts were concerned about the Kindle product line’s economics because Amazon was selling the hardware at cost, betting that content and commerce revenues would make up for the hardware price subsidy.

Bezos was wrestling with several issues with the Kindle Fire strategy. How should Amazon modify the positioning of the device in response to the new entrants in the tablet market since its launch? What was the most promising target market for the Kindle Fire, and how should it be positioned against competing products? How could Amazon turn the sales success of the Kindle Fire into business success? Would revenues and profits from commerce and content justify selling the hardware at cost? What were the likely responses of the competition?

History of Amazon

In 1999 Amazon accomplished its founding mission of becoming the world’s largest online bookstore. Two years later it turned its first profit. By 2011, just fifteen years after the company

1 E Ink was a specific proprietary type of electronic paper manufactured by E Ink Corporation and commonly used in mobile devices such as e-readers.

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started out of Jeff Bezos’s 400-square-foot garage, Amazon had 25 million square feet of warehouse space, reported $50 billion in revenues, and controlled 10 percent of the North American e-commerce market (Exhibit 1 and Exhibit 2). Competitors struggled to transition from brick-and-mortar–based businesses, but Amazon had repeatedly been at the forefront in the e-commerce market. From its pioneering use of user-based reviews for product comparisons to its development of 1-Click® ordering on its website, Amazon had continued to innovate. The company’s marketplace for third-party vendors, introduced in 1999, helped grow its selection rapidly.

Bezos’s 2010 annual letter to shareholders touted that “invention is in [Amazon’s] DNA” and that the long-term interests of its shareholders were perfectly aligned with the needs and wants of its customers. This focus on the long-term, however, with repeated innovation and thrusts into new markets, had created tension with the short-term interests of investors. The $45 fall in stock value between Q3 2011 and mid-Q1 2012 illustrated this tension between Amazon’s visionary investments and public market investors (Exhibit 3). Investors were doubtful of the margins Amazon would attain on the new streams of revenue that it was betting would flow through its new devices.

When Amazon began offering its spare server computing power and storage space as a service in 2006, the cloud-based information technology services field was still nascent. Under the rapidly expanding Amazon Web Services (AWS) division, Amazon rolled out its Elastic Compute Cloud (EC2) platform and the Simple Storage Service (S3). AWS was expected to make up just 3 percent of Amazon’s revenues by 2012, but AWS revenues were expected to almost triple in the following three years. Amazon called its “service-oriented architecture” the “fundamental building abstraction” for all Amazon technologies.2

This focus on internal technology development had led to significant benefits for customers. Through the widely popular Amazon Prime express shipping subscription service, the company had built a customer base that was motivated to always shop at Amazon.com first before they went elsewhere. This service, which for an annual fee of $79 provided two-day express shipping on most items sold directly by Amazon, was made possible by the company’s logistics innovations. Through its marketplace partners, Amazon had outsourced its long-tail3 offerings while lowering its overhead. Without the technical advancements that made the logistical infrastructure run smoothly, customers would not have embraced these partners as a seamless extension of the Amazon brand. Additionally, the advanced algorithms driving the popular product recommendations that were integrated into every product page relied on sophisticated management of the underlying data infrastructure.

Amazon, since its founding, had a strong history of investing in emerging opportunities years ahead of revenues or profitability. It took the company six years to become profitable primarily because of its commitment to innovation. It was this commitment to innovation that drove Bezos to found the Lab126 hardware development group, which developed, in extreme secrecy, the future of e-commerce: the first successful e-reader, the Kindle.

2 Amazon.com, 2010 Letter to Shareholders. 3 Long tail, a term popularized by Chris Anderson in The Long Tail: Why the Future of Business Is Selling Less of More (New York: Hyperion, 2006), describes the retail strategy of selling a large number of unique items in relatively small quantities while selling fewer popular items in large quantities. Underpinning this strategy is the belief that the sum of many small markets is worth as much, if not more, than a few large markets.

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The Emergence of E-Readers

Although the attractive prospect of reading long-form texts digitally had led to many e- readers coming to market over the years, e-books had remained a niche curiosity. The original “killer app,” the paper book, remained largely unchallenged until the advent of E Ink technology in 1997, which made reading possible in any light condition and with minimal power usage. The new crop of e-readers was born.

In 2007 the market leader was the Sony Reader. It could hold a library of up to one hundred books and was sold for $299–$399, depending on the accessory bundle. More than 10,000 titles were available for purchase at 75 to 85 percent of the retail price of a physical book. However, the Sony Reader was clunky to use and difficult to load content onto. Even the simple act of page-turning was slow and difficult to manage one-handed.

For more than a decade, various competitors offered iterations on this basic business model, and had sold a combined 400,000 units by the end of 2007. The Iliad by iRex, larger than the Sony Reader, was sold for $799 and could adequately display full-sized PDF files but had similar drawbacks in content acquisition for customers. Many early adopters also used the tiny screens of a variety of personal digital assistant devices such as the Palm III and V, as well as early- generation iPhones, to read e-books. Critics cited the slow and clunky operation and general poor usability of early e-readers as book replacements as well as the inadequate e-book distribution and promotion model as reasons that the e-book had yet to jump the chasm on the innovation curve.

The Amazon Kindle

In a highly successful product launch, Amazon introduced its own e-reader, the Kindle, in November 2007. The Kindle featured a QWERTY keyboard, an onboard dictionary, and access to Wikipedia. It had memory sufficient for two hundred titles, which was expandable via an SD card. Its grayscale, passively lit screen sipped battery and thus could last for more than a week. The stark white, 10.3-ounce device with a 6-inch E Ink screen was, at first glance, similar to competitors’ offerings. Under the hood, though, lay Whispernet, an EVDO cellular antenna with prepaid Sprint service that enabled wireless content delivery. At several points during the Kindle’s development, Bezos sent engineers back to the drawing board to make Whispernet work seamlessly. Bezos knew the key differentiator for the Kindle would be the capability for customers to discover, purchase, and sync content quickly and easily wherever they happened to be—sans computer.

The first-generation Kindle was priced competitively at $399. In addition to the more than 100,000 e-books offered by Amazon, customers could purchase subscriptions to nineteen newspapers (for $5 to $14 per month), sixteen magazines (for $1.25 to $3.49 per month), and hundreds of blogs (for $0.99 per month) that would self-update wirelessly. Customers were also provided with an e-mail address specific to their device that could be used to load and convert DOC and PDF file formats for viewing on the Kindle. This service cost 15 cents per megabyte.

Prior to the Kindle’s release, Amazon sent its representatives to knock on doors and cajole the major book publishers to digitize their offerings for its new e-reader. By bringing the publishers onboard, Amazon hoped to simplify the digital rights management (DRM) issues that

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were slowing the move toward electronic distribution of books. The company succeeded in convincing all of the “Big Six” publishers to rapidly accelerate their e-book development and to offer their content through the Amazon e-bookstore. Amazon subsequently shocked these publishers by subsidizing the price of new titles, many of which were offered at $9.99. This aggressive content pricing model, co-announced with the product launch, helped the first- generation Kindle sell out in the first three hours.

When Amazon started the development of its first-generation Kindle in 2006, the entire e- book market was only $3 million and less than 1 percent of all book sales in the United States. But both e-book reader device sales and revenues for e-book readers were projected to grow substantially in the ensuing years (Exhibit 4). Five years later, Amazon’s revenues from e-books were estimated to have topped $1 billion. Amazon had likely (it does not publicly release these metrics) sold a cumulative 30 million Kindle units.

As the Kindle product line evolved, Amazon continued to enhance the user experience, mostly by improving navigational features such as page-turn speed, battery life, and screen resolution, and by reducing the device’s weight and width (Exhibit 5). To expand the use cases for the Kindle product line, Amazon developed a larger version of the device. The $549 Kindle DX featured a 10-inch screen, making it the ideal e-reader for displaying figures and tables from textbooks or business documents.

As the e-reader market matured, price pressure on the devices slowly grew. Prior competitors such as Sony, iRex, and Hanlin released updated, cheaper devices, but importantly Barnes & Noble (B&N) jumped into the field as well (Exhibit 6). Each generation of the Kindle had focused on improving the user experience, lowering the cost, and growing the general adoption of Amazon e-books and other Amazon content. However, the newer entrants forced Amazon to begin to discount its devices considerably (Exhibit 7).

Amazon used its installed base4 of Kindle owners to push higher volumes of e-books, which had significantly lower distribution costs compared to physical books. The company’s profit per title fell from $13 for a new-release hardcover to a mere $3, but the increase in volume compensated for this loss. Given that the gross margin on each Kindle device was barely 5 percent and that the margin for each e-book was 20 to 30 percent, the Kindle devices were arguably a tool for getting the Amazon ecosystem of content into the hands of the customer.

With each e-book purchased from Amazon, customers were further committing themselves to the Amazon ecosystem, a completely unheard-of benefit in the traditional print space, where customers had complete independence in choosing a retailer. Bezos shrewdly knew that this lucrative customer base needed to be locked in before a competitor, such as B&N, could do the same.

4 Installed base refers to the total number of operating systems or products actually in use (i.e., that customers have installed), as opposed to market share, which only measures units sold. Analysts view the installed base as a more reliable measure of a platform’s popularity. See http://en.wikipedia.org/wiki/Installed_base (accessed January 16, 2014).

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E-Book Ecosystems

The advent of e-books meant that the traditional methods of book publishing and selling had to adapt to the digital platform. Book distributors began to develop entire ecosystems around the content, publication, and delivery of e-books. E-booksellers had to forge relationships with major publishers to make e-books available and added to their online portfolios. They developed proprietary platforms to adapt to this digital transition, which meant that competing platforms and ecosystems were controlled by the major players—primarily Amazon, followed by Apple and to a lesser extent, Google eBookstore and Barnes & Noble. However, the existence of competing e- book formats meant that digital books did not gain broad popularity until Amazon launched the Kindle e-reader. E-books could be purchased on the Amazon website or directly through the Kindle device via a 3G or Wi-Fi connection for e-book delivery. Amazon’s proprietary system was developed initially for its Kindle devices but was later adapted to the world of applications (apps) to encourage a cross-platform reading experience. Not only could books be read on the Kindle but e-books purchased on Amazon could now be read on different platforms, for instance, on iPads and iPhones, personal computers, and Android devices. (By contrast, books purchased from Apple could only be read on Apple devices.) To protect its ecosystem, however, Amazon made it difficult for books purchased outside of Amazon to be accessed on the Kindle device or through Kindle apps.

When Amazon started selling $9.99 e-books in 2007, the major book publishers were not happy to see the erosion of the agency-based pricing model they had enjoyed for more than a century. When approached by B&N in 2008 and Apple in 2009 to develop e-books for their new tablets, book publishers were eager to reassert their favored agency-based pricing model. B&N and Apple, as new entrants into the e-book market, were willing to cede pricing control back to the publishers in order to rapidly gain access to large content libraries for their devices. This move later forced Amazon to follow suit for e-book pricing in late 2009, though these actions launched several anti-trust, price-fixing lawsuits against the publishers and Apple. Consumer expectation of e-book pricing had shifted, however. For most popular titles, e-book prices remained at $9.99 ($13.99 for new releases), a far cry from the old $26 price of a hardcover book.

An area of contention among e-booksellers was competition for content sales through apps on smartphones, third-party e-readers, and computers. Amazon, Sony, Google, and B&N sold e- books through their own branded apps on all the major platforms (Exhibit 8). These apps reduced the switching costs for customers by making the DRM-protected content they purchased from a given retailer available on all their mobile devices and computers.

In July 2011 Apple announced that it would remove all applications from its App Store that did not use Apple’s “in-app purchase” platform. Critically, this platform directed a 30 percent cut of all sales to Apple. Apple’s change in policy set the stage for its announcement of its cross- platform iBooks App bundled with the iOS 5 release in October 2011. Apple’s counter-stroke was an attempt to lock out sales by competitors on its devices and to simultaneously offer its own partners’ content in their place.

Barnes & Noble E-Readers

In October 2009 B&N launched its Nook product line. The Nook, an E Ink e-reader similar to the Kindle, was B&N’s attempt to capitalize on Amazon’s success in e-books. The Nook featured

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a 6-inch E Ink screen, a seven-day battery life, Google’s Android operating system, native PDF support, and wireless access to the B&N e-bookstore through prepaid AT&T cellular service.

B&N tried to undercut the Amazon Kindle 2 (then priced at $359) by pricing the Nook at $259. A price war ensued. Second-generation Kindles fell from $359 in early 2009 to $259 after the Nook’s launch. As the two largest U.S. booksellers vied for the leading position, e-reader prices fell to less than $200 in 2010 and then to less than $100 in 2011 (for the simplest low-end devices from each product line). During this three-year period, sales of e-readers grew from less than 1 million units per year to more than 8 million in the United States. Both B&N and Amazon were focused on getting their customers to build their digital libraries as quickly as possible.

In contrast to Sony and other early Kindle competitors, B&N copied Amazon’s entire e- reader/e-book business model. B&N saw the writing on the wall and knew that its traditional book retailer business model was in major decline. It secured e-book deals with its publisher business partners, outsourced the development of the Nook’s hardware and firmware, and began a major push to drive Nook sales to the forefront of its physical as well as online stores. Employee retention and compensation metrics were amended to focus on Nook sales per shift, and company profits were divided into two categories: digital (profitable and growing for 2011) and traditional (unprofitable for 2011).