Amazon: A tale of two tablets

September 28, 2011, 9:00 AM UTC

[UPDATE: Bloomberg News reports that Amazon’s new Kindle is indeed called Fire and will retail for $199. The tablet reportedly sports a 7-inch color screen but lacks a camera or microphone. The device will have onboard Wi-Fi but no 3G.]

FORTUNE — For months, analysts and technology pundits have been expecting Amazon to release a tablet capable of going toe-to-toe with Apple’s dominant iPad. With its massive e-commerce reach, robust ebook sales and rapidly expanding Kindle business, Amazon would succeed where others — like Hewlett-Packard and Research in Motion — failed miserably. Turns out, the long-awaited announcement may not be anything of the sort.

Unconfirmed reports from popular technology blogs TechCrunch and GDGT paint a very different picture. Both sites claim that, later today, the technology giant will unveil a next-generation Kindle. But instead of the long awaited uber-tablet, Amazon (AMZN) may be readying a stop-gap measure it can have out the door in time for the holidays. Dubbed the Kindle Fire, the device is thought to sport a 7-inch color touch screen and run a modified version of Google’s (GOOG) Android operating system. The unit’s design has reportedly been outsourced to Quanta, a company responsible for the design of BlackBerry’s (RIMM) much-maligned PlayBook. If true, the move would mark an about-face for the company, which has relied upon the Cupertino-based hardware division Lab126 for Kindle development.

Amazon is at a crossroads. It can either create a full-featured tablet designed to take on the iPad or, alternatively, build an incremental device aimed at guarding its market share and not letting another quarter go by without a color unit. The former tactic has much higher stakes, bringing with it a costly investment and raising analyst and consumer expectations. If, instead, Amazon does unveil a less ambitious model, it shouldn’t come as much of a surprise given the company’s past moves. The company has shown time and again it’s more than willing to course-correct.

Today’s Kindle is radically different than the model introduced in November 2007. The first Kindle donned a boxy form factor with sharply angled keys and buttons. After the shape received mixed reviews, Amazon’s Lab 126 — led by ex-Apple (AAPL) vice president Gregg Zehr — churned out a friendlier set of designs.

The company has also shifted gears on pricing. The original Kindle retailed for $399, but thanks to competition from Barnes & Noble’s (BKS) Nook and decreased manufacturing costs, the Kindle now starts at $114 for a basic WiFi version with ads. The same goes for book pricing. Until last year, Amazon called the shots: it bought books at wholesale and set the prices. Increasing pressure from the iPad and its iBookstore however caused Amazon to shift over to a so-called “agency model,” where book publishers set the price. “They’re selling the hardware at a loss, and they are making some money on the ebooks,” explains BGC Financial analyst Colin Gillis. (Amazon does not publicly disclose detailed numbers for Kindle sales.)

But perhaps nothing better exemplifies Amazon’s willingness to change than the adoption of a color backlit display, something the Kindle Fire is almost certain to have. For years, Bezos has championed the black-and-white e-ink screens found in the Kindle and publicly brushed off the success of the tablet. “It’s really a different product category,” he told Fortune last year. Last fall, the company blasted the iPad’s readability in a TV ad pitting the two devices side-by-side. Still, even Bezos can’t ignore the iPad’s success.

At stake is an ever more complicated market for tablets and reading devices. Citigroup’s (C) Mark Mahaney estimates Amazon will sell 17.5 million devices this year and a whopping 26 million in 2012. That would, according to Maganey, generate generate $6.1 billion for the company, or almost 10% of overall sales. Of course, the iPad currently dominates the tablet market with at least 68% market share, according to the Massachusetts-based consulting group IDC. Gartner Research expects the iPad to sell nearly 47 million units this year and overall tablet sales to increase year-over-year through 2015. Meanwhile, Gartner predicts overall growth in the e-reader category, which Amazon dominates with 52% market share, to generally slow down during the same time frame. In other words, which market Amazon’s Kindle Fire is intended for exactly could have dramatic consequences for its bottom line.

Of course, nothing will be certain until Amazon takes the wraps off the new device. One near certainty: it will offer deeper integration with the various services Amazon has built over the years, from Android apps to movie streaming and music downloads. Whichever market the device plays in, it will have to be a compelling enough upgrade to move current, devoted Kindle owners to upgrade. Another certainty? Amazon’s announcement today won’t be its last. The company has shown it’ll move aggressively to stay ahead — even if that means changing course.