Misguided Government Attacks on Amazon.com and How to Play Them

May.16.11 | About: Amazon.com, Inc. (AMZN)

About one-fifth of the people are against everything all the time.
-Robert F. Kennedy

On several levels, I find the flap over Amazon.com (AMZN) and sales tax indicative of a pervasive societal cluelessness, reflected frequently by our state governments. I will not go over the particulars of the conflict; several other sources have done a fine job, including Seeking Alpha and a recent state-by-state look over at TheStreet.com.

Here's a quick and dirty summary. As it stands, online retailers do not have to collect sales tax from customers if the customer resides in a state where the retailer does not have a physical presence. Some states that impose sales taxes require residents to pay a sales or use tax directly to their state tax board at the end of the year for all applicable purchases not taxed at the time of transaction. This law is about as relevant and enforceable as other laws that have been on the books since the beginning of time, such as no spitting on the sidewalk or wearing a hat in a government building.

Some states have had success making claims that Amazon.com Associates in their state constitute a physical presence for the online retailer. Governments have generated some traction with this approach, prompting Amazon.com to drop the Associates program in several states. Amazon Associates enter into a marketing agreement with Amazon.com. They're not employees. They're not even a formal extension of the company. Contending they constitute a physical presence in a state where Amazon.com does not have direct operations rings as little more than disingenuous.

What happens with the Amazon.com sales tax issue could bring enormous implications for investors. And not just the ones who hold shares of AMZN. Other Internet firms could be impacted. In addition, the state-by-state outcomes and any changes to federal, state and local law and standing Supreme Court rulings could impact state and local budgets. Of course, fiscal health at the state and local level can directly affect personal income, consumer spending, the housing market, unemployment rates, and, subsequently, the stock market.

After I discuss several important facets of the issue - some of which I have seen little, if anything, written about - I will offer ways that investors, with or without a postion in AMZN, can play the potential incremental and final outcomes.

Politics Impacts Markets

The day-to-day news that flows on this issue amounts to noise. It's more useful and instructive to view it through a philosophical and political lens. This approach helps investors looking at the prospects of AMZN as a long-term investment, not just a stock that gyrates on the basis of the story (or headline) of the day.

By going after Amazon.com and having the nerve to even bring up a consumer's "obligation" to pay a sales/use tax, state legislators serve injustice and display their ineptitude to constituents by shifting focus from their own problem of fiscal mismanagement. They need to create a bad guy. And, more so, a solution to the financial problems marring their states; problems they, themselves, could have prevented. The easy answer - go after the man at the top as well as the little guy. Create anger. Generate confusion. It's the American political way.

The following two excerpts - the first from a February 2011 California Legislative Analyst's Office report to the chair of the State Assembly Revenue and Taxation Committee and the second from a February 2011 letter from Amazon.com VP of Global Public Policy Paul Misener to a member of California's tax arm, the Board of Equalization (BOE) - help support what I perceive to be a misguided cash grab, fueled by a lack of political will and little, if any, foresight. I focus on California because, as a resident since 1999, I know it better than other states.
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Government Ignores Root Causes

Although I am sure local residents can come up with their own provincial illustrations, the following points may or may not apply outside of California. Even when factoring in a recent glimmer of hope, California has done little to sustainably address its now $15 billion budget deficit. Failure to collect sales tax from Amazon.com or from the state's residents does not suddenly fuel what years of mismanagement and accounting gimmicks created. A disdain for taxes, which took meaningful hold in the 1970s, deserves a lion's share of the blame.

When California voters passed Proposition 13 ("Prop 13") in 1978, they effectively started the state's financial struggles. Prop 13 not only limits property taxes paid; it also constrains the state legislature's and the voting publics' ability to implement taxes, even ones that would fund vital services such as police, fire, and public education.

Warren Buffet waxed now-famously about Prop 13 in a 2004 response he penned to a Wall Street Journal article written about him:

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Click here for source

Outside of small add-ons that result from bond initiatives passed by voters, California counties can charge property tax equal to no more than one percent of the assessed value of a home. If you lived in your home when Prop 13 became law, state assessors rolled your property's value back to its 1975-76 level. Regardless of when you purchase a home in California, the assessed value of your property cannot increase, on an annual basis, by more than California's CPI or 2%, whichever is less, nor can the property tax you pay exceed 1%, bond indebtedness notwithstanding. This voter-approved initiative drained, and continues to drain, California's coffers, prompting obvious negative impacts on the state's finances and services. Less-publicized Prop 13 consequences, however, have just as significant of an impact.

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Source: California Constitution

Robert Kennedy, who was murdered in California on June 5, 1968, had more political will in his index finger than any politician who has ever set foot in the state since that fateful day. I bring up RFK because, after reading and viewing hours upon hours of work about the man, I could easily envision him having stepped up years ago with more than lip service about the failure of Prop 13.

It takes political guts to stand up against the super-majority provisions in Prop 13 with regard to tax increases (Ironically, Prop 13 received less than two-thirds of the vote when it passed in 1978). By tying the hands of lawmakers and citizens, Prop 13 makes Canada's most conservative province, Alberta, look progressive relative to supposedly "liberal" California. The state could take in hundreds of millions of dollars, if not billions more than the $1.1 billion it claims it loses thanks to non-payment of sales/use taxes.

Prop 13 represents just one "root cause" of California's budget conundrums. Surely, other states have major issues they ignore and mismanage as public officials single out Amazon.com and their state's citizens as primary contributors to a mess they fail to assume proper responsibility for creating. It's the classic case of looking to politically-easy targets as opposed to politically-unpopular ones. It's not that California residents, for instance, want to pay sales tax on online and mail order purchases. The state can frame the issue as a big corporation exploiting a loophole - always a hot button - when no such loophole even exists.

Failure to Understand Competition and Economic Impacts

While it's unlikely that anybody can, with enough confidence for my liking, quantify the economic consequences of potential outcomes to the Amazon.com sales tax issue, I think several things are clear.

First, the notion that Amazon.com has an unfair competitive advantage against a state's brick-and-mortar retailers is comical. Punishing Amazon.com for taking advantage of (and following) the law of the land amounts to changing the rules of the game in progress. Detractors like to point out Amazon.com's admission that it structured its business model around the tax issue as some sort of mea culpa indicating shadiness or wrongdoing. Of course, they took advantage of tax laws when building their business. It's no different than a business locating a brick-and-mortar outlet in an area with more favorable tax or land use laws.

By essentially penalizing Amazon for its own foresight and subsequent success, states effectively devalue innovation. They should laud Amazon.com for what it's been able to do for the nation as whole, economically as well as culturally. Just as states would be wise to make it easier for Intel (NASDAQ:INTC) to locate future operations in the U.S. and for Apple (NASDAQ:AAPL) to build on thousands of square feet of land in places like North Carolina, they should create hospitable environments for Amazon Associates as well as real estate and functionings directly related to Amazon.com. Texas dropped the ball in this regard. And California appears on the verge of doing the same.

As Amazon.com notes in the above-referenced letter to California politicians, the state could see a net loss to its general fund if it plays hardball with Amazon.com, forcing the company to end its Associates program in the state. Clearly, they'll lose the income taxes these self-employed individuals pay. It's not a reach at all to think that some Amazon Associates will simply move and set up shop elsewhere.

If you're making a nice living in California selling books, for instance, via Amazon.com, why would you not consider leaving the state for a less-populated and less-expensive outpost? For some people, it will be a no-brainer. And, no matter how this shakes out, California will likely be left with less income tax from the jettisoned Associates. If current Supreme Court precedent stands, they'll continue receiving no piece of the pie from Amazon.com's massive retail sales unless, of course, they decide to turn the screws on their own citizens for the nonpayment of user taxes.

This amounts to little more than a cash grab. As usual, there's no principle involved. Until Amazon cemented itself as the major player in retail, governments largely ignored the issue of mail order/online sales tax collection and the enforcement of user tax laws. All of a sudden, it comes down to a matter of fairness. Not only is the political dog and pony show transparent, but it threatens small business more than it threatens Amazon, who can and will move nimbly to mitigate any financial impacts. Why would a small business want to secure customers beyond state lines by harnessing the power of the Internet when this is the thanks it gets from government for growing?

Playing It With Puts

As somebody who is quite bullish on AMZN, I fully recognize several things. The stock has been on a torrid run of late. And, even more importantly, as inane as this sales tax issue is, it could do some damage to longs. That much said, even the most negative outcomes on the sales tax issue do not warrant investors abandoning long positions in AMZN.

I agree with Amazon.com CEO Jeff Bezos, the tax issue should, and likely will, be dealt with at the federal level. Ultimately, I think the Supreme Court will need to revisit the issue. Bringing it to this level provides the best chance to take politics and state budget deficit concerns out of the decision-making process. If I have faith in any part of the American system, I have faith in the Supreme Court. Any overhaul of the federal tax code - even if dealt with primarily in Congress - will likely benefit Amazon.com in some areas and hurt them in others. At the end of the day, one way, as opposed to 50 possible ways, of doing things makes a world of sense and brings true, or, at least a higher degree of fairness to the matter.

The impact - even if it's "bad" - will probably not be worse than the impact of, say, a quarterly EPS miss. AMZN will get hit, maybe even stay down for a while, and then resume whatever move it was going to make originally based on Amazon.com's execution of its overall business. Many investors underestimate the power of the platforms and the synergies between platforms that Amazon.com has created. They've barely started their push into streaming, the cloud, and gadgets. Therefore, I think we're only on the eve of Amazon's dominance. Amazon is big enough to swallow whatever hiccups come its way.

Despite my positive outlook, I fully realize the need to protect yourself or simply make a play on the possibility this thing crushes or significantly hampers Amazon.com going forward. If you're long AMZN, this might be a good time to buy one protective put for every 100 shares of the stock you own.

If you own AMZN stock, it might make sense to take some profits anyway if you've profited handsomely with the move past $200. A protective put helps calm fears that AMZN could decrease substantially in value on noise or on hard news, such as unfavorable resolutions to the tax issue.

If, for example, you bought the AMZN May $190 put on Friday, it would have cost you about $37, excluding commission charges. The cost of a June put with the same strike price ran about $273. Owning one of these puts gives you the right to sell 100 shares of AMZN at $190 on or before options expiration day, regardless of AMZN's market price. If disaster strikes this week with the stock, and it plummets, losing 20% of its value (which would bring it to around $160), you could exercise your option and sell 100 shares of AMZN at $190. Of course, you could buy in-the-money puts, but the cost of buying that insurance comes at a higher price.

These scenarios represent good deals and make the cost of insurance look like a smart investment. You could also close out your put position, for a profit or loss, prior to expiration. As for the shares you hold long, you can ride out the bumps and, if you remain long-term bullish, buy more on weakness.

If you think Amazon.com will eventually get hurt on the sales tax front, but you're not decidedly bearish, you could buy a longer-dated put and keep it in your back pocket. This approach is akin to buying what many options traders call a lottery ticket. Buying an out-of-the-money put generally involves a relatively small outlay of capital, particularly on contracts that do not expire for several months (these expirations give events time to unfold) and are deep out-of-the-money. If the worst happens and the bottom falls out of the stock, you profit nicely. If you're wrong, you took a chance but did not break the bank.

When governments, politics and the stock market cross paths, you have to take note and be ready for anything. At this point, nobody can predict with any level of certainty what will happen with Amazon.com, the states, the feds, and sales tax collection. Many of us have strong opinions, but few of us are likely to end up being "right." It is tough to argue, however, against protecting yourself, at least to some extent, against the possibility that your long position goes south on bad news.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Author may initiate a long or short position in AMZN or APPL at any time.