Room for Two in the Tablet War

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Amazon ignited a tablet war this week by announcing the Kindle Fire.

I'm here today with R.J. Hottovy, he is the director of consumer research, and Michael Holt, he is a senior analyst at Morningstar, to take a closer look at the tablet space and see what impact the Fire could have on it.

Gentlemen, thanks for joining me today.

R.J. Hottovy: Thank you.

Michael Holt: Thanks for having us.

Glaser: So, R.J., could we talk a little bit first about the Fire. Can you give us an overview of the product and what you think its near-term potential is?

Hottovy: Sure, absolutely, I think this really has game-changing potential in the tablet space. It's a seven-inch touch screen, dual processing, tablet computing device. It really is a compelling product. And thing that surprised us most, I think, was the price point on this. It's $199, which is actually a little bit lower than what we are looking for. I think the combination of this low price point, the content offering that Amazon has, and its already expansive customer base is over 144 million users make this the first serious entrant we've seen in this space to compete with Apple for market share.

Glaser: So, looking at Apple, then, are they running scared from this? Does this really put a big pressure on the iPad's real monopoly on the tablet space right now?

Holt: It is the first legitimate challenger to the iPad, but it's directly in line with what we've been expecting in the tablet market. We've never seen this as a monopoly. We've seen it evolving much like the smartphone market has where there is a strong number two and possibly room for three or four players.

Glaser: So, there are really still maybe more questions and answers when it comes to whose going to win this, but I guess content is another big question here. R.J. mentioned that Amazon's content is a big reason why they want to get this tablet out there. How do you see these relationships with the media companies playing out and does this hardware really matter for those relationships.

Hottovy: Really, the thing that's compelling from our standpoint and in terms of this tablet launch is that Amazon can launch this as a loss leader. They're not going be making any money on the tablet itself. It's all about the content sales, and they already have relationships in place with all the major media companies, the streaming video through it. It really is just more of a customer acquisition tool. So, as you get your Kindle Fire, you're going to be out there going to Amazon's site picking up digital media products and at the same time probably checking out other Amazon.com selections. It really is consistent with our take that Amazon is going to be the clear market share winner in the retail space for several years to come.

We're estimating about 30% top-line growth for the company over the next five years and a lot of that's coming at the share of bricks-and-mortar retailers, especially in commoditized industries. And I think this is really what we're going to see as a result here. I think it's got all the right partnerships in place, media content, it's got a handful of compelling apps. I think this is going to be a really interesting product, and I do expect it to sell very well.

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Glaser: So, this seems like it's a slightly different strategy than Apple, then, because the iPad I don't believe is actually sold as a loss leader, but they are also trying to move that media. Do you think Apple is going to be able to really continue with that, or are they going to have to cut the price of the iPad do you think in order to stay competitive?

Holt: I don't think they'll have to cut it right away. They are going to see how this thing evolves. And the important thing to remember is Apple has a strong lead here. They've got a strong established base in smartphones and that's a natural user base that's going to gravitate towards the iPad versus the Kindle Fire. And the thing is, these aren't perfect substitutes. [The Kindle Fire has] a smaller screen. It's not as fancy technology. It's got some bells and whistles that are missing. It's almost the Toyota to Apple's Lexus. They are targeting different market segments here.

Glaser: So, let's talk about some other potential players in the tablet space. If you look at someone like Research in Motion with their Playbook or with Samsung or some of the other Android tablet markers, what's their response to this? Are they going to be able to get into that number three slot?

Holt. Well I think what we've seen so far is that nobody can compete with Apple at the $499 price point; that's for sure. And that's what is making Amazon's strategy so compelling.

So, a lot of these other guys are going to have to figure out a way to either get down to that price point at this smaller form factor or to figure out a different way to be competitive with Apple, and that's where the big question mark is. Nobody has figured out how to solve that problem.

Glaser: Then we we'll have to wait for Microsoft next year to see exactly what their tablet looks like as well?

Holt: Absolutely. We can never count out the giant from Redmond, because they have such a strong user base already.

Glaser: So R.J., when you look through the holiday season and you look at Amazon, what are the key metrics that you are going to keep an eye on? Is it the actual media sales? Is it the actual sales of the tablet? When can we actually be able to say this has had the impact that we think that it might? Is it something that's going to be near term or medium or long term?

Hottovy: I think there are a couple of things. I think the first thing we'll be looking at is actual unit sales here, and we are actually projecting between 4 million and 5 million Kindle Fires to be sold in the fourth quarter alone, which is approximately half of the run rate that we saw with the iPad from the months of April through June. So, I think it's going to make a splash in the market right away.

I think the key thing, though, that we will be watching for is media sales actually from Amazon, to see what kind of secondary effect we really have here. Because that's really what's going to make the story compelling, if Amazon can drive margins out of this business. It's always been known as the low-cost leader. If it actually can add a margin growth story to this investment story, it will be quite compelling.

Glaser: When we look at the stocks today, do we see value in either Amazon or Apple for investing today?

Hottovy: Amazon right now, our fair value estimate is $235, and it's approximately 55 times earnings, which does look a little bit steep, but if you strip out the investments they are making in their cloud computing business, their infrastructure, their distribution centers, and also factor in about $4 per share in cash that they have on hand at the end of June, it looks a lot more reasonable at 20 to 25 times, and given that we do see this as a clear market share winner, if it were to dip down in the $200 range, we'd be looking at this one.

Glaser: And how about Apple shares?

Holt: Well, our fair value estimate for Apple is $530, so with it trading just about $400, we see plenty of upside for investors, and given their massive earnings power in the next 12 months, we see that as a pretty reasonable multiple at 13 times or 10 times net of cash.

Glaser: So it sounds like there is plenty of room for both players in the industry.

Hottovy: Absolutely.

Glaser: All right. Thanks so much for talking with me today.

Holt: Thank you.

Hottovy: Thank you.

Glaser: For Morningstar, I am Jeremy Glaser.