Budget Tablets: Is the Game Worth the Candle?

In the past month, the budget tablet segment experienced a new round of price cuts by major manufacturers. Barnes & Noble initiated this new price war as the company dramatically slashed the prices of its soon-to-be-discontinued Nook HD and Nook HD+ tablets to clear inventory. Other vendors such as Amazon.com and Hewlett-Packard have followed suit with more modest price reductions.

Margins are already very thin for tablets, with the exception of Apple's iPad. The most recent round of price cuts could mean that the vendors are selling these tablets at a loss to gain market share.

At some point, investors could reasonably wonder whether there is any point to competing in this market. The non-Apple tablet market has already become fully commoditized, with relatively unknown Chinese vendors offering tablets with specifications equal to the top Android tablets at very low price points. There may be strategic reasons for major American tech companies to keep selling budget Android tablets. However, as an investor, I'm skeptical about the benefits of this strategy in light of the difficulty of merely breaking even in the low-cost tablet market.

A new price war
Around Father's Day, Barnes & Noble initiated massive price cuts for its Nook HD and Nook HD+ tablets. The Nook HD price dropped from $199 to $129, while the Nook HD+ price dropped from $269 all the way to $149. While this is theoretically a "limited-time offer," it's been running for more than three weeks now.

Barnes & Noble's Nook HD tablet. Source: Barnes & Noble.

Moreover, when Barnes & Noble reported quarterly and annual earnings late last month, the company announced that it was planning to phase out Nook tablets. Instead, the company will focus on producing its own e-readers and partnering with other companies for tablets. Clearly, management realized that it was impossible to sell tablets at a profit in the crowded Android market, and apparently the company wasn't selling enough incremental content to justify the Nook division's notable hardware losses.

With Barnes & Noble significantly undercutting other vendors' prices, competitors eventually felt compelled to respond. Amazon cut the price of its Kindle Fire HD 7-inch tablet from $199 to $169, while HP lowered the price of its recently released Slate 7 (its first major push into the Android tablet market) from $169 to $139.

Losing money
Research firm IHS iSuppli estimated last November that the Kindle Fire HD cost approximately $174 to manufacture. That estimate includes the costs of manufacturing, but not any software/licensing costs or logistics costs (i.e., getting the tablet from the factory in Asia into your hands). Based on that cost estimate, it seemed plausible that Amazon was breaking even on the Kindle Fire HD hardware.

Component prices tend to decrease over time, meaning that Amazon's manufacturing cost is probably a little less than $174 today. Still, it's unlikely that costs have declined so far in eight months that Amazon could break even at a $169 price point.

By extension, while HP's Slate 7 uses cheaper components than the Kindle Fire HD in some cases, it seems unlikely that HP could earn a profit at the current $139 price. After all, even Amazon's low-end Kindle Fire (which is a fairly comparable device) sells for $159.

Is it worth it?
For Hewlett-Packard, it's pretty hard to justify building a tablet that probably loses money (or at best breaks even) while helping cannibalize the company's PC business. Perhaps there's some value to pushing HP Android tablets to make a statement that HP is not just a "Windows" company. It could potentially smooth the road for an entry into the Android smartphone market. However, profit could be just as elusive there as in the tablet market.

Amazon and Barnes & Noble have the "excuse" that selling tablets at or slightly below cost can drive consumer loyalty and future content sales that justify the initial investment. However, as my colleague Demitrios Kalogeropoulos recently noted, content sales growth has been slowing at both Amazon and Barnes & Noble despite these investments. This trend calls the "tablets drive lots of content sales" strategy into question.

Barnes & Noble has already called it quits in the Android tablet market. HP and Amazon also need to think long and hard about whether the potential long-term benefits of competing in this market outweigh the upfront losses. With irrational pricing as the order of the day, it seems increasingly unlikely that Android tablet vendors will prosper.

Learn more
Android tablet vendors may be hard-pressed to earn a dollar, but Apple has had no such problem with its iPads. In fact, Apple has a history of cranking out revolutionary products that capture the public's imagination ... and then creatively destroying them with something better. Read about the future of Apple in the free report "Apple Will Destroy Its Greatest Product." Can Apple profitably disrupt its own iPhones and iPads? Find out by clicking here.

The article Budget Tablets: Is the Game Worth the Candle? originally appeared on Fool.com.

Fool contributor Adam Levine-Weinberg owns shares of Apple and Hewlett-Packard, is long January 2015 $390 calls on Apple, and is short shares of Amazon.com. The Motley Fool recommends and owns shares of Amazon.com and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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