Is Amazon Losing its Competitive Advantage?

By Chad Henage - May 4, 2012 | Tickers: AMZN, BBY, WMT | 0 Comments

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I recently read an article by Evan Niu of The Motley Fool, saying that Amazon.com (NASDAQ: AMZN) cut a deal with the State of Texas to collect sales taxes beginning July 1, 2012. Some of his comments about this settlement made sense, others worried me that he was looking past some real issues that will face the king of online retailing. It's not having to collect taxes that will change the dynamic of Amazon, but the amount of investment needed to make more settlements work, that may be a big problem.

In the agreement with the State of Texas, part of the settlement was the company agreed to, “certain commitments related to capital investment and job creation in the state...”. Further, the Texas State Comptroller Susan Combs said that building out facilities, while settling with state tax collectors seems to be “part of Amazon's long-term strategic plan.” These are words that should ring heavy in every Amazon shareholder's ear. Evan saw this as a net positive as he said, “...as Amazon builds out its distribution infrastructure...that it should continue to improve shipping times and costs to customers and see additional operating efficiencies.” He further expanded this idea, and said that the company might be able to pass along cost savings to customers and possibly even make Amazon Prime even cheaper. While this sounds good on the surface, there are some very real consequences of an expanded presence.

Today Amazon collects taxes in 5 states. Within the next 4 years the company will be collecting taxes in 7 more. This is just the beginning. There is no way that tax hungry states are going to sit by and let billions in taxes just pass by. I predict that within the next few years, Amazon will be collecting sales tax in at least the 48 contiguous states. If Amazon's settlement with Texas is the blueprint, then Amazon is about to become a very different company. Imagine this, as Amazon settles with each state, the company makes infrastructure and job creation commitments to avoid a cash payment of uncollected sales taxes. What does this mean for the company? Two things, more employees and more capital expenditures. To get an idea of how this could impact Amazon longer term, we have to examine the company's margins versus their competition.

In the last three years, Amazon's gross margin has average 22.4%. In that same timeframe, Walmart's (NYSE: WMT) gross margin has averaged 25%. In the same three year timeframe, Best Buy (NYSE: BBY) the much maligned retailer that Amazon is supposedly putting out of business, has a gross margin of 24.75%. So while Amazon is clearly growing faster, the company's gross margin is lower. Why does this matter? If Amazon has lower margins with less employees and less fixed costs, what happens if those two dynamics change?

The issue that I have with Evan's thinking in his article is, he assumes that additional infrastructure spending equals cost efficiencies. While that is true to a certain extent, it changes the game when it comes to Amazon's inherent advantage of being an online retailer without as much overhead. The reason that Amazon has been successful is, the company can in theory offer lower prices than traditional retailers because of lower overhead. Let's compare sales per employee at Amazon, Walmart, and Best Buy to see how this works:

Clearly Amazon sells more per employee than their two bricks-and-mortar counterparts. However, what if this Texas deal is the start of a hiring binge that Amazon would be required to undertake? The company is expected to create about 2,500 jobs over the next four years in the state. This would bring Amazon's headcount to about 58,400, however 38 more states could have similar commitments. Even if Amazon only hired 1,500 people per state that would bring Amazon's headcount up to 115,500 employees. This is a huge difference from the 56,000 today. These additional employees create additional fixed expenses. This doesn't even speak to the fact that in theory Amazon would need to spend money in the other 38 states to expand the company's infrastructure in the way of additional warehouses. This means additional fixed costs in the way of buildings, taxes, insurance, etc. In short, this starts to sound like Amazon is going to have a lot bigger physical presence than they do now.

Bottom line, I'm sure Amazon will continue to grow. I'm sure that the company will continue to be the primary online shopping destination. I'm not so sure that the pricing gap that appears today will continue. As Amazon is forced to hire more people and spend more on infrastructure, sure the service will improve, but to what extent? If I order from Amazon and get my shipment in 1 or 2 days versus 3 or 4 days is this enough of an incremental improvement that it's worth the thousands of jobs and the billions of dollars in infrastructure spending? These additional costs will shrink Amazon's already smaller margins. That is more important to investors than the impact of collecting sales taxes would ever have.

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