Why Every E-Commerce Company Will End Up Making Hardware

They have no other choice

"I've had failures at Amazon that cost hundreds of millions of dollars. You might remember Pets.com or Kozmo," Amazon CEO Jeff Bezos said in an interview last week, comparing this year's Fire Phone to two famous flops of the 2000 dot-com bubble.

In its 20 years, Amazon has upended more than one market. Its online shopping model forced retail giants such as Walmart and Best Buy to slow their global expansion and change how they run their businesses just to survive. Its AWS cloud computing business is still growing 100% a year, eight years after launch, and tech giants such as Google and Microsoft have had to chase it on Amazon's terms. And of the countless efforts to digitize books, Kindle is the only one actually replacing paper books and putting publishers out of business. These achievements have made Bezos the most celebrated business leader since Steve Jobs.

But Amazon's first push into smartphones has failed. Last quarter's earnings report showed the Fire Phone cost Amazon US$170 million. According to an analysis by The Guardian, the Fire Phone may have sold only 30,000 units before its price cut, fewer even than Luo Yonghao's Smartisan.

The iPhone 5s, released a year earlier, looks like a more premium product than the Fire Phone

The failure is no surprise. Both the Fire Phone's price and its headline features were flawed, as we suspected when it was announced. But this is not the end of Amazon's phone. Even as he admitted the first-generation product had failed, Bezos said it was only the beginning: "People like to focus on the failures... but you have to understand that making big bets is very hard. If you want to take risks, you need to experiment. And if it's an experiment, you can't know in advance whether it will work."

Over the past 10 years, Lab 126, Amazon's product development team in Silicon Valley, has grown from a little over 10 people to more than a thousand. Created to build an e-book reader, the team now works mainly on Android software and hardware. In Silicon Valley, a thousand salaries add up: the starting pay for a senior software engineer there already topped US$160,000 a year last year. Staff costs alone run Lab 126 more than US$100 million a year.

Amazon never touched PCs in the desktop era. So why would an online retailer whose ultimate goal is to build the "Everything Store" now pour huge sums into hardware? I believe it has no choice.

What is broken is not the phone but the future of digital consumption

Amazon's sales rise every year while its profits hover around zero, year after year, and the company runs on a logic of its own. As Benedict Evans, a partner at the well-known Silicon Valley venture capital firm Andreessen Horowitz, put it in an earlier article:

"Amazon keeps creating new business lines. At first, like any new business, they lose money. But Amazon doesn't turn them profitable by pressing some 'magic button.' They just keep growing and keep adjusting, like any business... In other words, Amazon is a large collection of different e-commerce startups built on the same platform."

At Amazon, the money earned by mature businesses subsidizes new ones. And Amazon, which started by selling books, does best in media: books, CDs, DVDs and games. According to figures the US Census Bureau released last year, these are also the retail categories with the highest share of online sales, 25% of the total. That figure does not even include what has already gone digital, such as e-books, online video and mobile games.

But as mobile devices and the internet spread, books, music, games, TV series and videos are all abandoning paper and discs and moving entirely online. The most important pillar supporting Amazon's new businesses will sooner or later disappear.

Against this background, Amazon has, since 2004, made a series of attempts to disrupt itself: Kindle e-books to replace book sales, the Amazon MP3 and Prime Music services to replace music sales, and the Instant Video and Prime Video services to replace sales of movie and TV discs. The most successful is Kindle, which is gradually replacing paper books. The other digital content businesses have not done as well.

The bet is far bigger than US$170 million

Amazon has staked far more than the US$170 million it wrote down on the Fire Phone. Like other video sites, it now pays to make its own TV series. Figures from the market research firm BTIG show that Amazon's total spending on producing TV series will exceed US$500 million. Add the cost of buying TV and film rights, and Amazon may have spent more than US$1.5 billion on video content over the past year.

Meanwhile, to promote its online music service, Amazon also spends more than US$100 million a year on licensing.

Add Twitch, the game-streaming site Amazon bought for US$970 million a few months ago after outbidding Google, and Amazon's spending on digital content this year already exceeds US$2.5 billion. That still leaves out Kindle and Amazon's game development team.

All this cash burning sets Amazon's profit growth in sharp contrast to Google's and Microsoft's:

Over the past year, as Google and Microsoft have pushed harder into cloud computing, the three companies have started a price war. Constant losses make it hard for Amazon's AWS to compete on price with two cash-rich rivals. The head of AWS has said publicly that cloud computing will become Amazon's biggest business; now the losses on digital content are already threatening its future.

Fire is an entry point Amazon cannot do without

Some analysts argue that Amazon should not fight a hardware war at all, but should focus on content and sell it through Apple's and Google's platforms. But that road was closed four years ago.

In 2010, Apple changed its payment rules. Every company selling digital content through an iOS app had to use Apple's App Store payment system and hand Apple 30% of the revenue. That covered books, music, video and even news.

For Amazon, which itself pays for content rights, giving up 30% means no profit. Once Apple's new policy took effect, Amazon removed the store from its Kindle app. Since then, all its digital content can be bought only on the web.

Google's own Android app store, the Google Play Store, takes exactly the same cut: 30% of any app sale or in-app purchase of digital goods.

That is why Amazon stripped every Google service out of Android to build its own Fire OS, then launched the Fire tablet, the Fire TV and the Fire Phone one after another.

For Amazon, Fire is an entry point, one that Apple and Google cannot touch.

Why did the Fire Phone fail?

After using it for three weeks, we see several main reasons the Fire Phone failed.

1. "A product that isn't high-end, at a high-end price"

When he launched the Kindle Fire HD tablet in 2012, Bezos coined a widely quoted line: "premium products at non-premium prices."

Low prices have always been Amazon's hardware strategy. From the Kindle reader to the Fire tablet, prices have kept falling:

But two years later, the Fire Phone arrived at the same premium price as the iPhone:

Samsung's recent rapid decline shows that, as cheap competitors multiply, it is getting harder for an Android phone to sell at an iPhone price. When the Fire Phone set such a price, we expected a breakthrough in hardware or software.

2. Hardware with nothing distinctive about it

Undistinguished hardware is an Amazon tradition. Even the Kindle reader, which ignited the e-reading market, innovated mainly in content and business model: it coaxed publishers into digitizing tens of thousands of books before launch, and in an era when Wi-Fi was scarce, it made buying books easy over free 3G. The Kindle's own hardware design and software clearly lagged behind the smartphones and tablets of its day.

The Fire Phone inherits the Kindle's design weaknesses. Pick it up, and your first impression is how ordinary it is. Neither its looks nor its specs stand out, and it is a quarter heavier than the iPhone 6, which has the same screen size. To be fair, it does not even look more premium than Chinese smartphones of the same period that cost under 2,000 yuan.

Worse, it offers no meaningful innovation in software or services either.

3. Overly complex technology for a feature nobody uses

"Glasses-free 3D," or what Amazon calls "Dynamic Perspective," was the Fire Phone's biggest selling gimmick at launch. Using four infrared cameras on the front, the phone tracks the position of your face and adjusts the picture on the screen to create a 3D-like effect.

But once you have the phone in hand, you find that its 3D simply means that elements on the screen tilt when you tilt the phone. It reminds me only of the iPhone motion-sensing games that were briefly popular in 2008, yes, the ones where you tip the iPhone to roll a little ball around, and that nobody plays anymore.

The lock screen that shifts as you move your head or hand is the only part of "Dynamic Perspective" that looks like fun

At the launch event, Bezos spent a long time explaining how hard "Dynamic Perspective" was to develop, but users care about results, not features. For "Dynamic Perspective," the Fire Phone carries four extra cameras, only to do what an accelerometer and a gyroscope can already do.

Another so-called innovation is "Firefly." Press the dedicated button on the left side of the phone, and the Fire Phone uses its camera and microphone to identify things around you and takes you straight to an Amazon shopping page.

At launch, Firefly was seen as the feature that would make the Fire Phone a gateway to shopping. But in our tests, QDaily found it could not even recognize Amazon's own Kindle reader. It is worse than the Google Goggles app, which Google released long ago and which few people use.

4. Not enough content

Amazon's books, music and video are widely credited for the decent sales of the Kindle reader and the Fire tablet. On the phone, the situation is reversed.

For a smartphone, the most important content is apps. Every service and every piece of content is delivered through them. But the Amazon Appstore preinstalled on the Fire Phone does not offer nearly enough. According to the latest figures Amazon released this year, the Amazon Appstore has fewer than 300,000 apps. Apple's and Google's stores passed one million long ago.

It is hard to list exactly what Amazon's app store lacks, because apart from games, it lacks almost everything.

5. Limited sales channels

As the seventh most-visited website in the world, amazon.com draws 168 million visitors a month in the US alone. Add Amazon's sites in other regions, and hundreds of millions of people visit Amazon's stores every month.

But the Fire Phone did not make full use of this traffic. At launch, it was sold only in the US, and only through a single carrier.

Price cuts alone may not fix the problem

The first-generation Fire Phone has now been cut to US$449 (about 2,780 yuan), and has been on promotion at US$199 (about 1,232 yuan) and then US$225 (about 1,393 yuan). But even if Amazon fixes every problem above and regains the price advantage its Fire tablets enjoy, its prospects remain uncertain.

When the Kindle Fire tablet launched in 2011, it cost US$199, 40% of the iPad's price at the time and far below the Android tablets of Chinese makers such as Huawei. Soon after launch, Amazon briefly became the world's second-largest tablet maker, behind only Apple.

But set the Fire tablet's sales against its prices and you find that as soon as Amazon stops cutting prices, sales fall. For the past two quarters, Amazon has dropped out of the top five. In its place are PC makers such as Lenovo and Asus, along with a flood of cheap "others."

The phone price war is even fiercer. Now that every Chinese maker has realized it cannot become Apple and has turned to copying Xiaomi, mainstream Android phones sell for less than 2,000 yuan. Even Samsung, which long dominated the Android market, has been dragged down by "the Xiaomis". The next Fire Phone will have to face these rivals too.

Because of piracy, Chinese e-commerce companies skipped the era of selling music, movie and game discs entirely. But judging by how Alibaba, the biggest of them, is buying rights, negotiating co-productions and launching Yulebao, they do not want to miss content consumption in the digital era. So who will control the entry point to digital consumption in China?