Two weeks ago the Wall Street Journal confirmed earlier reports that Amazon plans to launch a tablet this fall. It’s rumored that it will have a 9-inch screen and run an Android operating system.

On the surface this looks like a terrible idea. Since the launch of Apple’s iPad last year, tech titans including Samsung, HP, Motorola, and Research in Motion have all fast-followed with their own tablets, but the outcomes have been uniformly disappointing – John Gruber at Daring Fireball estimated that, even including Nook Color e-readers, the iPad’s share of the category is in the ~95% range. As Marco Arment put it, “[t]here really isn’t much of a tablet market. There’s an iPad market.” It’s widely agreed that Apple has the best tablet OS, form factor, and specs, plus the most apps and the strongest brand. It’s believed that Apple also has a cost advantage (due to early investments in suppliers’ production facilities), enabling entry level iPad pricing that none of the other major players have been able to beat.

So trying to enter this market as the 14th or so player doesn’t sound like a smart move for Amazon. Unlike the aforementioned hardware makers, it could easily sit this game out. Or could it?

Crazy Like a Fox

Amazon is a retailer that, despite its ever-growing “A to Z” product offering, still makes 40% of its revenue – and even more of its profit – by selling software and content, like books, movies, music, and games. This media, not physical goods, is still Amazon’s selling focus. Don’t believe me? Check out the department list at the left side of its home page – right now it reads:

• Unlimited Instant Videos
• MP3s & Cloud Player
• Amazon Cloud Drive
• Kindle
• Appstore for Android
• Digital Games & Software
• Audible Audiobooks
• Books
• Movies, Music & Games
• Electronics & Computers <- Finally, ten items down, the actual physical stuff!
• Home, Garden & Tools
• Grocery, Health & Beauty
• Toys, Kids & Baby
• Clothing, Shoes & Jewelry
• Sports & Outdoors
• Automotive & Industrial

It’s often been said that Apple makes money selling devices, and uses its software and content (e.g., iTunes) to drive those sales. Amazon does the reverse. Being the content-retailer of choice is so important to them that they designed and marketed an intuitive e-reader, the Kindle, just to ensure they’d own the e-book space. (A side note: crucial to Amazon’s success here was the realization that, in the digital media retailing world, “purchasing” and “consuming” activities would converge in a single device.) Even with a beautiful piece of hardware, Amazon was clearly tempted to view it as a mere complement for their true aim (selling digital media) in a razor-and-blade strategy. Which is exactly what Amazon’s been doing: rapidly dropping Kindle prices to get devices in the hands of as many users as possible (the ad-supported version is now only $114 and, in a sense, the Kindle app in every mobile store is essentially a free version of the device). This strategy shares elements with the idea of commoditizing your complements – in both cases, a cheaper complement (e-reader) helps you sell your money-maker (e-books).

In the meantime, of course, Apple has launched its own iBooks app and store on its iOS devices, a credible second-runner to Kindle. In theory, Apple doesn’t need to have its own content stores on its devices – if customers decide they like using the Kindle app for e-books (or, say, the Netflix app for movies), that would still help Apple sell iPads and iPhones. But Apple knows that providing its own proprietary, well designed content stores and formats will increase user stickiness and earn them a nice pile of cash on the side. So Amazon built a device to help them sell e-books and Apple built an e-bookstore to help them sell devices.

In an alternate universe, a fragile peace could have emerged between Apple and Amazon, with each holding a knife against the other (a strategic phenomenon known as spheres of influence). But unfortunately for Amazon, the Kindle was only a minor threat to Apple’s ability to use e-reading to sell devices, while Apple’s “knife” was and is much bigger. Apple recently announced it has sold 222 million iOS devices, all of which have iTunes (movies and songs), the App Store (software and games), and now the iBookstore. In other words, the sheer speed of Apple’s success in selling devices has made its threat a reality: it’s already become a dominant software and content retailer.

This position has emboldened Apple to muscle Amazon around a bit. This week, Apple began enforcing an earlier threat to take a 30% cut of every publisher sale made through an iOS app (like Kindle), as well as disallowing in-app buttons that took readers out of the App Store to make a duty-free purchase. Unable to cope with such a burden, Amazon – as well as Barnes & Noble, Borders, Google, and purveyors of other types of content like Rhapsody – removed the stores from their apps on Monday.

While users can still use Apple’s mobile browser Safari to access the Kindle store and download content, this is obviously a huge blow to Amazon’s ability to retail content. Controversy aside, Apple clearly knew that most digital retailers would choose to close up shop rather than pay such huge fees. A lot of pundits have missed this point – Apple isn’t trying to make money by taxing iOS users’ purchases in other companies’ stores. It’s trying to be the only good store in town (a la iTunes), and it’s doing it by crippling Amazon’s ability to have a store on the turf Apple owns. Amazon and the other companies aren’t revolting, they’re getting run out of town.

This is why Amazon can’t sit the tablet game out. To sum up, they’re basically looking at four facts that, combined, spell big trouble for them:

1. Selling digital content and software is extremely important to Amazon.
2. People want to buy (and consume) digital media on highly functional mobile devices (i.e., smartphones and tablets).
3. Apple reigns supreme in those product categories.
4. Apple’s aggressively preventing Amazon from selling digital media on Apple devices.

The only link in that chain that Amazon feels it can attack with any chance of success is #3.

And in This Corner…

The good news for Amazon is that, because it’s aiming to put devices in people’s hands primarily to enable selling them content and software, it doesn’t have to adopt the same “me-too” strategy that’s so dismally failed the other hardware manufacturers. One big key to success is a low price: a Retrovo study indicated that this was a huge selling point to potential tablet customers, and that a price in the $250-400 range could garner significant share relative to iPads at $500-830.

Is a price that low even possible? That depends on two things – first, Amazon would have to keep costs to a bare minimum. There’s plenty of signs that’s exactly what it’s doing – from outsourcing manufacturing to a large, experienced Asian producer (possibly Samsung), to using a simpler, smaller touchscreen, to forgoing cameras. It could also save money by using lower-cost processors and chips and having less flash memory storage. But another part of keeping the price down is relinquishing device profitability. Unlike the huge margins sought by Apple, Amazon can adopt the razor-and-blade strategy (possibly even accepting a loss on each tablet sale) and try to make it up on subsequent revenue from the digital media users buy on the device. Through a combination of these two tactics, I bet Amazon could price a tablet below $300.

The second big key to success, however, is the right user experience and capabilities. Some, such as MG Siegler, doubt whether customers would even want a stripped-down tablet from Amazon. But I believe it has an opportunity here to capitalize on its strengths and create the ideal content discovery and consumption device, rather than the ultra-flexible machine Apple’s designed. Imagine a tablet perfectly designed to find, buy, and consume books, newspapers and magazines (via the Kindle app), audiobooks (via Audible), music (via a rebranded Amazon MP3 and Cloud Player), movies and shows (via Amazon Instant), games, and other software (via the Appstore for Android). Running the Android Honeycomb OS, the tablet could tightly integrate these features in a simple interface with Amazon’s Cloud Drive for storage and syncing, Amazon’s excellent loyalty program Prime (with perhaps a free year’s membership), and an improved recommendation engine for discovery. General tablet functionality like web browsing, email, and social media would be key secondary features, while more advanced apps and capabilities – perhaps including 3G service – might be absent altogether. In many ways it might resemble a better-packaged Nook Color.

Could Amazon pull this off? Despite not yet having a tablet, Amazon’s brand is strong enough that a majority of potential tablet customers would consider buying it based on name alone. If Amazon nailed the pricing and user experience described above and added some brilliant marketing, I think it could be the first non-iPad tablet to sell in the multi-millions. That’s not the whole battle, though – Amazon would still have to convert enough digital media purchases to make it all worthwhile. Here’s where Amazon’s strengths in retail, pricing, and loyalty could really pay off. Amazon also just signed up 100 newspapers and magazines to deliver full-color issues to subscribers in the Kindle app, a sign that content creators still have faith in Amazon’s experience in selling and delivering digital media.

Ready for War

Any way you slice it, Amazon is making a huge bet by entering the tablet market. I don’t think anyone realizes how high the stakes are for them, and thus for Apple too. On the one hand, Amazon’s success with the Kindle, combined with CEO Jeff Bezos’ strategic direction (and the inevitable feeling of having one’s back against the wall) bodes well for an Amazon tablet. On the other hand, selling an Amazon tablet means convincing consumers not to buy the most successful consumer product ever. The last thing I would tell a company that spends half its energy battling Walmart would be that it should start spending the other half going toe-to-toe with Apple.

But Amazon is gritting its teeth and marching onto the field. The clouds have gathered. Get ready for a rumble.