Here’s how Amazon can disrupt the smartphone business and take both Apple + Google to school

The rumor mill is heating up on Amazon’s plans to enter the smartphone business — a fiercely competitive market currently dominated by Apple’s iPhone franchise and Google’s Android platform. Despite massive investments, Microsoft has so far failed to make inroads as a third platform, so Amazon will have to pull off some very impressive work on many fronts to have any shot at success.

Amazon is famously tight-lipped about their plans — my office sits in the middle of the Amazon campus and I haven’t been able to pry anything out of my friends on the inside (not for lack of trying) — but I’ve been thinking a lot about how Amazon can succeed by creating a “third way” in the mobile business.

It won’t be easy, but I think there’s a way for Amazon to do something entirely different — and incredibly disruptive — to the way consumers think about their phone.

First, let’s review the current situation:

In five short years Apple has crushed the legacy mobile business and now commands nearly 75% of handset industry profits with just 9% global market share. Apple has pulled this off through tight vertical integration — controlling everything from the device and OS to the media (via iTunes) and apps (through the Apple App Store) that run on it.

Google has — until recently — run a completely different play, licensing the Android operating system and running an Android appstore, but allowing device makers and carriers to pick and choose their level of Google integration and support (while offering incentives and sweeteners behind the scenes to get bigger partners to play ball). That has made Android the leading smartphone OS worldwide, but with weaker controls — and much lower margins — for Google’s mobile business.

But Android market share has begun to flatten out, driving Google (or so it appears) to reconsider their open strategy. They just unveiled a slick Google-branded 7″ tablet, the Nexus 7,  and have begun to consolidate their music, media and apps offerings under the Play brand, all signals of a move to a more Apple-like unified hardware / OS / media experience.

It’s not yet clear  whether Google will deploy their $12B acquisition of Motorola Mobility as anything more than a tool in the ongoing mobile patent wars — the Nexus 7 was built by Asus, not Google’s own hardware arm — but they’re already deeper in the hardware business than anyone ever expected them to be, and it wouldn’t surprise me to see Motorola’s device-building capacity brought to bear on behalf of Google’s vertical integration efforts.

Amazon’s Kindle Fire launch sent a clear message to both Apple and Google that Amazon is playing to win in this new, vertically integrated mobile device / OS / media war.

By “forking” Google’s open-source Android OS for the Fire, Amazon put some very aggressive kung fu on Google, leveraging Google’s massive investment in mobile software to bootstrap themselves into a directly competitive position. This move burned any chance of collaboration with Google and put Amazon on a direct collision course with the two current leaders in the smartphone battle.

But as is now becoming clear, Kindle Fire was just a warmup for the real fight.

Tablets may be grabbing a big chunk of consumers’ entertainment and e-commerce time, but the smartphone — the always-on / always with you device — is still the big prize in mobile. Amazon is now clearly aiming for a piece of the pie currently dominated by iPhones and Android devices.

So what is Amazon’s secret weapon in the smartphone battle? I’m betting it will be Jeff Bezos’ favorite play: miniscule margins + massive patience.

Apple makes most of their money from the consumer at the time of device purchase; their media and app businesses are low-margin service lines that feed and sustain their high-margin device sales. Apple’s massive investments in supply chain optimization and proprietary hardware innovation allow them to maintain device margins while staying competitive on price.

Barring a major shift in strategy and execution, Google is in the eyeballs business. Android is a massive cost center that allows Google to retain its dominant position in the digital ad business as consumer and business attention shifts (rapidly) from web to mobile. Google’s model requires hundreds of millions of daily users to feed the low-conversion / low-yield models of search and display advertising.

Amazon is in the consumer transactions business, and nobody understands that business better than Jeff Bezos. You may think of Amazon as an online bookstore, or even an online Walmart, but what they’re really shooting for is 100% share of consumer wallet — whether you’re buying books, or clothing, or digital goods, or even local services, they want you to make Amazon your shopping platform of record.

Mobile devices are becoming the default interface to the world of consumer spending, and Amazon can’t afford to give either Apple or Google control over that little pane of glass.

How will Amazon attack this problem?

Whenever Amazon wants to own something, they find out a way to do it cheaper than anyone else. Not better, but always good enough. And if anyone ever gets close enough to be a threat… they lower prices, and keep on lowering them until no one dares to follow.

They way they see it, if they hold on to that customer relationship long enough, they’ll always make up the lost margin in customer lifetime value. And the more things they can find to sell to those same customers, the richer that lifetime value equation starts to look.

So what does this strategy look like in the smartphone business?

Google tried this scorched earth policy with Android, but in doing so they lost control of the ecosystem — as the Amazon fork demonstrated so forcefully. Amazon needs to find a way to give a lot away — more than anyone else in the market — while holding on to their crown jewel, the purchase funnel and customer transaction.

We’ve seen glimmers of Amazon’s mobile strategy already:

• By pricing Kindle Fire at BOM they quickly became the best-selling Android tablet on the market, betting that they’d make up the lost margin in increased share of wallet over time.
• Experiments with ad-supported Kindles have allowed Amazon to test the waters for other types of hardware subsidies that boost lifetime value while keeping retail hardware prices low.