Sales Taxes Will Not Kill Amazon's Bottom Line, But They Still Hurt

May.11.12 | About: Amazon.com, Inc. (AMZN)

There is a pervasive misconception with regard to the impact paying of state sales taxes will have on Amazon (NASDAQ:AMZN). Multiple comments and articles have made statements decrying the payment of sales taxes as the beginning of the end for AMZN's profitability.

State sales taxes don't work like that.

The sales tax is applied at the end of the transaction, based on the selling price of the item. The profit made off the product is not affected by the addition of a sales tax. It definitely has an impact on the buyer of the item, as it increases the total purchase price, but for Amazon, the profit per item stays the same.

AMZN claims a profit when it can buy a good and then sell the same good to you for more than they paid for it. As such the profit for each item is determined by the price they can sell it for minus the cost to purchase, store and deliver the item to the customer.

If they make their 1.5% margins on a $100 item, they get to claim the $1.50 as profit.

If the customer has to pay 5% sales tax on the item, Amazon still gets their $1.50 profit on the item but the customer now has to pay $105 for the same item. AMZN's gross profit does not change.

Depending on how Sales tax is recorded on their balance sheet, they might even be able to claim the additional revenue from the customer as top line growth. If this happens, margins would contract but the market is choosing to ignore AMZN's constantly decreasing margins, so that doesn't really come into play.

Real Impact of State Sales Taxes

While the gross profit per item does not change with the payment of State sales taxes, AMZN could still suffer from their adoption.

As more states require Amazon to pay sales taxes on purchases, top line growth should feel the pressure even if gross profit remains the same. The increase in final purchase price evens the playing field for the competition that already pays these taxes and it also directly impacts the volume of sales from their regular customers. If there a 5% increase in price for any given item this will lead to a certain decrease in purchasing volume. Maybe not a matching 5% decrease, but it certainly won't help or motivate increased purchases through Amazon.

High end electronics and other such large purchases are regularly routed through Amazon due to the ability to avoid paying the sales tax on these big ticket items. Take out that inherent discount to Amazon orders and the competition starts to look extremely attractive.

Let's compare one example item and see how the competition stacks up for large electronics.

Amazon vs. Best Buy (NYSE:BBY) for a Large Screen Sony LED TV. Fight!

Example item is a Sony (NYSE:SNE) Bravia 65" 3D HDTV

  • Best Buy Price: $5499.98
  • Amazon Price: $5498.00

A whopping $1.98 savings on a $5k+ purchase excluding taxes and delivery.

But wait, factoring in sales tax, that savings turns into solid triple digits. Using California as an example with a 7.25% sales tax rate, purchasing through Amazon saves us over $400. Now that is definitely justification for making such purchases through Amazon!

What this experiment shows us is that prices on these large purchases are extremely competitive. The brick and mortar retailer is more than able to compete on sticker price but Amazon currently has a clear pricing advantage with the avoidance of sales taxes. Take that away and brick and mortar holds a much better hand in the retail poker game.

Without the tax advantage, suddenly Best Buy.com and Wal-Mart.com (NYSE:WMT) can actually undercut Amazon's prices to leverage their superior operating margins and steal market share. Amazon's primary competition would now have room to innovate and compete where before they were playing in a rigged game.

There is also the continued threat of smaller online distributors that would be able to continue to avoid paying sales taxes. They would be able to take away additional market share as the deal seeking vultures move to a new spot for the best deal. Once you factor in an average 5% sales tax as a price advantage that Amazon would be losing, the competition should be sharpening their knives for the upcoming market share carving party.

Can Amazon Adapt?

Well that is the big question, is it not?

Amazon could lower prices to account for the price increase seen by the customer. We have not seen that in the states they are already paying sales taxes in, so I don't see that coming to pass.

In my opinion, top line growth will be negatively impacted by the paying of sales taxes, especially in their largest markets. Amazon purchasers in California and Texas will both start seeing sales tax charges by the end of this year. As that spreads through the market place, Amazon's competition will be making every effort to capitalize on the removal of this tax advantage. There are already brick and mortar stores offering to match online prices. That trend should pick up more industry wide adoption. We have already seen that sticker price comparisons are already competitive on the big purchases, so competition for the high margin high revenue purchases will come at Amazon from multiple directions.

Barring further degradation of Amazon's margins to eliminate the customer price impact, I don't see any alternative other than top line growth taking a hit, especially on their higher margin large ticket purchases. A lot of those purchases are currently being made by looking at the item in Best Buy or HHGregg (NYSE:HGG) and then ordering it on Amazon to avoid paying sales taxes. Take away the sales tax advantage from Amazon and the convenience and instant gratification that brick & mortar offers will start working in Best Buy and friends' favor again.

The Amazon Fairy Tale

AMZN, the stock, is a story writ large in the markets, a fairy tale if you will. It stars the great CEO Bezos that has a "plan" calling for ever increasing top line growth without regards to margins or earnings that will lead to a mystical, magical place called "Increased Margins Land". It is quite the fanciful tale, with large investments and loss leaders galore. As with most story stocks many believe in them until the story stops.

The whole crux of the AMZN story lives and dies by the infinite growth of the top line. It has little to no earnings, disappearing profit margins but since Revenues continue to increase, the story lives on. The payment of State sales taxes, while it may leave gross profits per item alone, could bring an end to the story of never ending top line growth.

Paulo Santos has gone over the valuation and declining operating metrics in great detail (Take a look, there are quite the plethora of them) and done a lot better than I would be able to, so I won't delve into any of that.

What I recommend doing is wait, watch the price action and start to consider short plays. If AMZN moves up to its 52 week high, I plan on starting a short position and riding it up if need be. Story stocks rarely have a happy ending, but I'm not going to rush in front of a moving train. This has the potential for the same sort of implosion that we saw in Netflix (NASDAQ:NFLX) and Green Mountain Coffee Roasters (NASDAQ:GMCR) when the story got called into question, but the hard part, as always, is predicting when the music will stop.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in AMZN over the next 72 hours.