Tax Doomsday Is Coming for Amazon

On Tuesday, (AMZN) shocked and dismayed its shareholders. Reporting earnings for the final quarter of 2011, Amazon admitted that despite 35% sales growth, profitability had headed in the entirely wrong direction. Operating profit margins got cut in half, while net profits were down 57%. The culprit: massive spending on a number of initiatives -- everything from building new warehouses, to subsidizing "Prime" membership, to selling Kindles at a loss -- which decimated the company's profit margin.

Investors are now wondering whether all the investment Amazon has been doing lately is worth the cost. If the whole idea behind Amazon is that it's supposed to be a virtual store, free of the fixed costs of ordinary retailers, then why spend money building warehouses? Why invent the Kindle Fire, if all Amazon intends to do with the thing is sell it below cost?

Fans of the company will tell you this is all part of Amazon's grand plan, to invest and accept low profit margins today, in order to set the stage for monster revenue growth and fatter profit margins tomorrow. And that is the plan ... in part. But the truth is actually bigger than that.

The truth is that unless makes the investments it's making today, its business could be in serious trouble within just a couple of years.

What Makes Amazon Great

It's true that Amazon has a big advantage in not operating physical stores. It also has great customer service, superior search and interface, and any number of other advantages.

Perhaps its biggest advantage, though, is that it's become the Walmart (WMT) of online shopping, offering "always low prices" to the Internet shopping masses -- prices often superior to what its bricks-and-mortar rivals can offer.

But key to Amazon's ability to beat the competition on price is the fact that current law permits Amazon to avoid charging sales tax on most of its sales, only collecting tax on sales to states where it maintains a "physical presence."

But maybe not for long.

States Are Sick of the Tax Dodge

Across the nation, dozens of states are struggling with budget deficits, and looking to Amazon's sales success as a partial solution to their problems. A movement's afoot to require the e-tailer to begin collecting taxes for the states, removing one of its biggest advantages over the competition.

So how does Amazon prepare for its date with "tax doomsday"?

  • It steadily expands the list of goods it will ship to you, starting with books and now going all the way through nonperishable groceries, all sold at cut-rate prices.

  • It offers $79 "all you can eat" shipping on these goods through Amazon Prime (with analysts postulating it loses $11 annually per membership).

  • It gives away free streaming of movies and television shows, a la Netflix (NFLX) as part of that service.

  • It offers 15% discounts for "subscribe and save" shopping.

  • And finally, it invents a line of Kindle devices that it sells to customers at an estimated loss of $10 to $15 apiece on just hardware costs alone.

Indeed, it sometimes seems like every new idea Amazon has dreamed up in recent years has been calculated to more efficiently and consistently lose money for the company. And now the company warns that it may lose as much as $200 million in the current quarter as a result. It's enough to make an investor shout: "This is crazy! Is this any way to run a business?"

Crazy Like a Fox

Actually, yes. In fact, it's precisely what Amazon must do if it's to survive tax doomsday.

You see, the day's not far off when Amazon won't be able to offer the lowest prices anymore. Just last month, the company struck a deal with the state of Indiana. The Hoosier State would not ask Amazon to collect sales taxes on goods delivered to in-state shoppers for two years ... but on Jan. 1, 2014, Amazon will begin collecting sales tax.

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This deal was significant because historically, Indiana has traded tax favors for warehouse jobs. (Last summer, the company announced its latest, 900,000-square-foot distribution center would be built near Indianapolis.) If Amazon is coming to an agreement with Indiana, though, the writing's on the wall. The sales tax exemption is going away.

Assuming other states follow Indiana's example (as California already has), Amazon has perhaps two years left to "train" shoppers to shop its site. Ideally, Amazon wants customers to do this automatically through subscribe and save features, or as part of the company's Kindle ecosystem. If that doesn't work, Amazon will at least want to make switching to another retailer inconvenient, entailing worse product selection and the loss of Prime privileges such as free shipping and free streaming movies.

In short, Amazon has good reason to lose money today. It has to -- or else it will lose customers tomorrow.

Motley Fool contributor Rich Smith does not own shares of any company mentioned above. The Motley Fool owns shares of Walmart Stores and Motley Fool newsletter services have recommended buying shares of Netflix,, and Walmart Stores. Motley Fool newsletter services have recommended creating a diagonal call position in Walmart Stores.

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