Amazon Is Still Strong, but the Challenges Mount

Once again, Amazon (AMZN) reported some seriously high-wattage earnings and sales in its most recent quarterly statement. The online retail giant's net profit of $299 million, or 66 cents a share, handily beat Wall Street estimates, and revenues climbed 46% from last year to $7.13 billion.

But this time, Amazon's next-quarter guidance wasn't quite what analysts were hoping for, and share prices have dropped as a result. This attitude from Wall Street, frankly, puzzles me. While the good times are likely to last and Amazon will remain profitable at least for the remainder of 2010, its fortunes won't be as sky-high as the last two quarters -- and the reasons are patently obvious.

Staying Dominant in a Saturated Market

The first quarter for Amazon ended on March 31, which also heralded the end of the fiscal year. Just three days later, Apple (AAPL) added another little gadget to its army of sleek technological devices. Perhaps you've heard of the iPad? It has sold more than 500,000 units since its April 3 launch, and that number will only climb once the 3G model arrives in stores by April 30. It may not be the magical, revolutionary device as Apple touts, but it is spurring interest in (and additional sales of) e-books, such that exponential growth of e-book sales should remain so until market share hits double-digit territory.

But when it comes to the devices that consumers will be reading these books on, it's a different story.The e-reader market is close to the saturation point. Barnes & Noble (BKS) is trying to pump up sales of its the Nook by selling it in Best Buy and running TV commercials. A new company, Kakai, wants to zero in on the student market, a golden opportunity that Amazon, with its oversized Kindle DX, has more or less missed. Canadian-based Kobois ready with its inexpensively-priced device. Plastic Logic's QUE is probably too late (and way too expensive) to launch at all. And on and on. Amazon will dutifully create a next-gen Kindle -- likely with color and a touchscreen -- but expecting to maintain the 80% to 90% market share the company had at the beginning of the year is a sucker's bet.

As I've said before, what will help keep Amazon a robust player in the e-reading market will be its strategy of putting its applications on every device, maintaining its one-click shopping and having the biggest e-bookstore. The Kindle e-reader is a Trojan horse for turning as many books as possible into Kindle books, priced the way they like. Amazon has had to step back a bit from the latter point, thanks to big publishers (with the exception of Random House) forcing them to switch from the wholesale model to the agency model, where the retailer takes a 30% cut of the e-book list price. But the more customers Amazon can reach through various sales conduits like apps for the iPad, Blackberry and other devices, the better -- because a smaller slice of a larger pie is still big money.

A Taxing Situation

Of course, Amazon wants to hang onto as much of the money they are raking in, but cash-strapped states want their cut, too. North Carolina, Rhode Island and Colorado are among a growing number of states battling with Amazon to get the online retailer to collect sales taxes from affiliate-based sales, as DailyFinance reported in March. Amazon has responded by ending affiliate programs -- in which website owners get a commission on any product bought through an Amazon link -- in those states, with the exception of New York, due to an ongoing court case.

That has not stopped North Carolina from pursuing its sales-tax collection goals. According to a lawsuit Amazon filed on Monday,the state has asked Amazon to disclose the names and addresses of consumers who have made purchases so it can bill them for unpaid taxes. Amazon, however, says that complying with the state's requirements would violate their customers' privacy.North Carolina's Department of Revenue struck back on Wednesday, calling Amazon's accusations "misleading." The state said their request was for "general information" -- transactions with out-of-state retailers, including the purchaser's name, address and the item's purchase price -- something they request routinely from all sorts of businesses.

The law appears to be on Amazon's side with respect to privacy. In 2007, a Wisconsin judge struck down federal prosecutors' attempts to get Amazon to identify thousands of customers' buying habits as part of a tax evasion case, ruling that "the subpoena is troubling because it permits the government to peek into the reading habits of specific individuals without their prior knowledge or permission." But that still doesn't solve the tax conundrum North Carolina and other states face: online retailers like Amazon have been exploiting old legal rulings that allow them to sidestep sales tax collection. And even if Amazon and North Carolina can come to a mutually beneficial agreement on both privacy and sales tax, the state shouldn't count on a huge income bounce, as Rhode Island found out to its chagrin.

In other words, Amazon's tactics may facilitate tax cheats, but the states' changing their laws may not bring in the money they hoped for. Amazon also has other tax-related headaches to deal with, in large part because of the new agency model. Basically, when a retailer acts as an agent - as Amazon will now do, taking a 30% cut from e-book sales right off the top - it becomes critical to determine whether they have what's called "nexus" (or responsibility) to collect, report, and remit sales tax. Right now, there is no consensus, state by state, as to whether the retailer is responsible for collecting sales tax or if the publisher must do so, which makes things rather complicated. At the moment, Amazon will collect tax for New York, Washington, Kentucky and North Dakota, while Simon & Schuster (CBS) and HarperCollins (NWS) will collect far more widely - all but 5 and all but 13 states, respectively.

With the expected complications of figuring out who should collect sales tax in which state, Amazon's financial burden just got worse -- a problem that is only exacerbated further by the higher e-book list price customers will now see for some of their favorite bestsellers. Add up all of these wrinkles and no wonder Amazon has tempered its second quarter earnings guidance -- and will likely do the same for the remainder of its fiscal year.