Game-Change Potential for Amazon's Kindle Fire

Ending months of anticipation,  Amazon (AMZN) formally unveiled its tablet computer device, the Kindle Fire, at a press conference Wednesday. Much as Amazon.com has been a disruptive force for brick-and-mortar retailers, we believe the Kindle Fire tablet has game-changing potential for digital media distribution and represents a credible challenger to  Apple (AAPL) for market share in this category.

The new device, which will retail for $199 and start shipping Nov. 15, features a 7-inch full-color LCD touch screen, dual-core processor, free cloud storage for digital content purchased, wireless synchronizing through Whispersync technology, and Amazon's new cloud-enhanced Silk web browser, which promises faster web browsing. Kindle Fire users will also receive a free month of Amazon Prime, which should augment Amazon's existing general merchandise sales.

There is no change to our $235 fair value estimate based on this announcement, as we have already assumed 35% annual growth rates for Amazon over the next three years, including 45% growth in the electronics and other general merchandise category and high-teens growth in media sales. Still, it is difficult to forecast Kindle Fire sales with a high degree of certainty, given the rapidly evolving nature of the tablet computer category, and there are several potential sources of upside to our base-case assumptions.

Even before the announcement of the Kindle Fire, we liked Amazon's chances to compete in the digital media world, given its sizable customer base (144 million active users as of June), which has been growing at more than 20% during the past six quarters, and the potential for the symbiotic hardware/software platform. Also important is Amazon's ability to sell the tablet as a loss leader, meaning the company will sell the product below cost in anticipation of making up profits through higher-margin digital content sales. With Amazon.com increasingly becoming the starting point for online sales and a large audience already accustomed to downloading books through previous versions of the Kindle, we believe the company has an opportunity to accelerate digital media sales, given its sizable breadth of content offerings and competitive digital media price points, which will also drive operating margins higher. Amazon's digital content offering includes licensing agreements with  CBS (CBS), Fox , NBCUniversal (CMCSA),  Sony (SNE), and  Warner Brothers , a wide selection of Android (GOOG) apps and games, and exclusive content agreements with several digital magazine and comic book publishers, which compares favorably with Apple's library.

While we aren't expecting Amazon to supplant Apple's dominance in digital media, we believe it could develop into a formidable player, given its expansive customer base, vast content offerings, and achievable price point ($199 compared with a $499 entry price point for the iPad and $249 for  Barnes & Noble's  Nook Color).

According to technology market research firm Gartner, tablet computer sales to end users are expected to reach 63.6 million units worldwide in 2011, with Apple accounting for 73% of the total market. We don't expect Apple will give up its commanding lead anytime soon, but we expect Amazon to rapidly grow into the number-two player in this market in relatively short order. In fact, we wouldn't be surprised to see 4 million-5 million Kindle Fire units sold during the fourth quarter (representing $800 million-$1 billion in incremental revenue, before including any digital media attachment sales), or about half of the 9 million iPad units sold between April and June.

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