Introduction...2. Market Pricing...4. Walmart in the Internet Age...7. Amazon s Ubiquity to Profitability Profit Matters...

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2 TABLE OF CONTENTS Introduction Market Pricing Walmart in the Internet Age Amazon s Ubiquity to Profitability Profit Matters Investment Structure Conclusion Appendix Bibliography

3 INTRODUCTION When asked to choose between Amazon and Walmart for an investment we had to hold for no less than ten years our prejudices had to be constrained. As students in our late 20 s and early 30 s we have each grown an affinity towards Amazon and their innovative and self-disruptive approach to business. Professors have admired them, students hope to work for them and the market has rallied behind them. Our partiality was no less strengthened in being able to purchase absorbently priced textbooks at deep discounts year after year for the past several years. To make our decision we sidelined our preferences and focused on the macro fundamentals. Given the constraints of a ten-year investment time horizon, we believe Walmart (WMT) to be a more suitable investment than Amazon (AMZN). We used primary macro fundamentals to arrive at our decision and chose a moderate risk profile to add context to our decision making process. Taking into consideration our risk profile we were able to forecast the two companies investment returns and associated risks and position them against our moderate expected return. The main topics of discussion revolved around market pricing of the two companies, Walmart being able to compete in the internet age, potential pro s and con s of Amazon s ubiquity in the marketplace, why profitability matters in distinguishing between the two companies, and our proposed investment structure. Paralleling the main topics we evaluated Walmart and Amazon by focusing on their respective business models, management focus and financials. In doing so, we were able to develop a better understanding of Walmart and Amazon s similarities and 2

4 dissimilarities. Once these distinctions were made we then looked at market trends for guidance as to how the companies risk and returns might be affected over the future tenyear period. While assessing risks, we looked for areas of exposed weaknesses or potential trending headwinds, we contemplated how we might mitigate those risks, and took into account MD&A discussion on future developments. We also developed our own strategies that might assist earnings growth for Walmart. While assessing returns we followed a similar approach to our due diligence process on risk assessment. For return analysis, we gathered data on potential tailwinds and forecasts found in MD&A and management interviews. Taking into account historical performance and growth trends we also projected earnings forward for five years to develop a sense of worst, base, and best-case scenarios. Walmart and Amazon are influential in both business markets and governmental regulation. Macro factors had to be used to gauge the companies, as they are both extreme cases in their own right. We concluded that Walmart has a clear path to returns and have chosen Walmart for our ten-year investment hold. 3

5 MARKET PRICING On the surface, Amazon and Walmart are both large and successful companies competing in the retail industry. Upon closer inspection, these two companies could not be more different. Walmart focuses on big box, brick and mortar retail chains while Amazon is the one stop shop for online consumers. Walmart s business model focuses on cost bargaining and low cost purchasing so that savings can be passed onto their customers. Amazon s business model revolves around efficiency, innovation and their ability to test new and risky projects. Profits generated by Walmart are passed onto investors through a dividend and Amazon s potential profits are invested back into the company to further revenue growth. The market has clearly included Amazon s revenue growth and gain in market into their share price. That s why, as of November 6th, 2015 close, Amazon had a market capitalization of $ billion compared to Walmart s $ billion. This is all despite the fact that Amazon has had dismal profits, if any, over the past several years. To determine whether or not the market has mispriced Amazon or Walmart, we calculated the intrinsic values of both companies and compared those values to the current stock price. The intrinsic value was calculated using a discounted free cash flow model (see Appendix for detailed methodology and scenario projections). The current price for Amazon and Walmart is $ and $58.80 respectively. Our model shows that Walmart is the wiser investment and is currently underpriced by the market. See graph below comparing our model to the current closing price as of Nov 6th,

6 To account for various assumptions in the industry over the next ten years, we discounted the cash flows of each company under three separate scenarios. The high growth model assumes a strong market growth rate for the duration of our time horizon and both are able to continually growth their market share. The low growth model still assumes a strong online retail market growth rate but a shrinkage in the traditional retail market. Both companies are not able to grab as large of a share in the market. The base growth model is what we perceive as a likely scenario that balances out all the positive and negative factors. If Walmart s revenue grows at 2%, roughly the same rate as the long term US GDP growth rate, Amazon will need 20.8% annual revenue growth over the next 10 years to match that of Walmart s. Our range for Amazon s growth is between 5.86% and 20.77%. Additionally, we do not believe the current premium for Amazon s stock price is justified. Amazon s revenue growth is a major reason that investors have faith in Amazon s business model. Their revenue growth projections are very difficult to predict due to their 5

7 R&D spending and how that translates to top-line revenue growth. Their new products and services continue to create new markets and expand Amazon s hold in the existing ones. The data required to understand the effectiveness of Amazon s R&D spending is not available to the public. However looking at the ratio between the yearly revenue increase and previous year s R&D expense, we can gauge investor sentiment on Amazon s valuation. We believe that as revenue growth slows down in relationship to R&D expense, investors will start to doubt whether Amazon s innovations are contributing to revenue growth and would want operating profits to fall to the bottom line. As this ratio approaches 1, we predict a stagnation of Amazon s stock price. At a ratio of 0.8, we predict a substantial dip in Amazon s stock price. 6

8 WALMART IN THE INTERNET AGE While Walmart is the better investment, it still has risks. Walmart must take a number of actions to effectively compete in the Internet Age. In order to compete effectively with online competitors such as Amazon, Walmart must focus on delivering an excellent experience for customers shopping online. One way it can do this is by focusing on fast and efficient shipping of products to customers that purchase goods online. Walmart s U.S. stores alone provide them with a unique advantage in the number of stores it could use as possible distribution centers. Walmart currently utilizes 158 dedicated distribution centers and only a handful of stores for distribution, but it could look to leverage more of its Walmart supercenters and discount stores to deliver goods to customers 1. By leveraging their stores as distribution centers, Walmart could reduce shipping time, as well as lower shipping costs. Similar to Amazon s courier delivery model, Walmart could also look to leverage its existing vehicle fleet (while also expanding the number of vehicles) to guarantee same day and/or hourly delivery to customers. Another area of focus is payment. Walmart should consider making the process easier for those customers that would like the convenience of shopping online without a credit card. Currently a quarter of Walmart s customers do not possess a bank account or credit card. 2 63% of Millennials do not have credit cards 3. Walmart has targeted this large

9 customer base with its, Pay with Cash, online feature, where online customers can pay for their order with cash in store. While this is a great feature, the option isn t prominently displayed or marketed very well. By increasing marketing of this feature through online and traditional mediums (TV, radio, print, etc.) Walmart can attract more online shoppers to purchase goods. Walmart s online store does not need to directly compete with Amazon. It just needs to boost the Walmart brand and draw more people to their stores. Creating a product/service eco-system would be a great way to do this. Walmart should look at creating an interconnected ecosystem between its product and service offerings. One potential area that could benefit from an interconnected ecosystem is the area of digital media streaming. Walmart currently owns the Vudu streaming service, which streams to a number of devices such as Sony s Playstation 4, the Microsoft Xbox One, Apple s ipad, and Roku set top boxes 4. Much like what Amazon has done with its Kindle book services and Apple has done with it s itunes services, Walmart should continue to offer the Vudu service on these different devices, but also look at creating a proprietary device, under a separate brand, that takes advantage of this service. By creating a low cost, media player that focuses on streaming Vudu content, Walmart can push sales of its own proprietary device in-stores and online, while still selling devices from other providers that carry the Vudu application. In addition to making improvements internally to shore up its e-commerce business, Walmart should consider forming strategic partnerships with other firms to

10 improve its online business. One of the areas in which Walmart is looking to grow is in the area of online produce sales. Walmart is currently offering a service in a few markets where individuals can pick up their groceries through a drive-thru (or in some select markets, can have these groceries delivered directly to one s home) 5. Much like Target has done with Instacart, a startup delivery service, Walmart can look at outsourcing a delivery service through another provider. Rather than try and spend expensive time and money trying to do this in-house, Walmart could outsource these tasks to startups or established companies skilled in these particular disciplines, while Walmart focuses on other areas of growth. While there are a number of areas that Walmart can improve in order to become more competitive in the online age, Walmart leadership is invested in the idea of putting forth the resources to become a competitive force in e-commerce. Walmart currently plans on spending $2 billion dollars in the next two fiscal years, to shore up their e- commerce business 6. This is a good start and we believe they should invest more, up to 2% of their revenue, to allow them compete with online retailers. More importantly, we believe in the ability of the executive team to make these changes happen. Given their commitment to success, their large brick and mortar infrastructure, and consistent in-store customer base, Walmart has the potential to thrive in the online age

11 AMAZON S UBIQUITY TO PROFITABILITY Amazon s ubiquity, as defined by the array of offerings the company continues to develop, is ever growing. A quick glance at their 10K and MD&A and you ll notice that beyond Amazon s merchandise sales they offer services such as, fulfillment, publishing, digital content subscriptions, advertising, co-branded credit cards and their fast growing Amazon Web Services. Breaking down this ubiquity, through the lens of business model, management focus and financials we were able to draw strong connections to profitability but were not able to draw a clear timeline as to when that profitability will start flowing to the bottom line. Strictly taking into account Amazon's business model we would agree that they can turn a profit. Their potential to scale profitability is present as Amazon has attractive gross margins. Primarily connecting third party distributors to consumers, they maintain low levels of physical capital and most of their platforms are user facing internet based applications which are easy to scale. Their profit margins are in the 20% range (similar to that of Walmart) amidst major spending in R&D, Technology and Content as it's referred to by Amazon, totaling $9.2 Billion in Amazon is successfully servicing a broad range of industries. This diversification de-risks a singular industry/ segment downturn and ties Amazon s success closer to systematic risk instead of unsystematic risk. Furthermore, these separate offerings are operating within Amazon's ecosystem, which create internal efficiencies by nature. 10

12 Evaluating Amazon s ubiquity through a management focus also makes a case for strong profitability. Despite the long list of companies like Airbnb, Lyft, Sears, Yahoo, and so on, who have recently pulled executives from Amazon, Amazon s management team is still very strong. Despite many articles in the recent press exemplifying strenuous internal working conditions, Amazon's flow of top tier human capital persists. CEO and Founder, Jeff Bezos, alone de-risks investor fears though simply being present. It is worth noting that if he were to be replaced over our ten year investment period there would be concern. As far as the financials, Amazon s ubiquity to profitability becomes slightly more unclear. Deciphering between profitable and non-profitable offerings is held under wraps. Viewing Amazon s financials, one doesn't get a clear sense of how the company is doing or what the company is doing. Because of this, we believe there is a major risk involved in investing. Net income has been lackluster to say the least but there has been a very strong growth in revenue, which is being continuously reinvested. Operating cash flow is growing which is important to note but at the end of the day, sitting in the seat of the investor, one would want to see profits growing. Amazon can clearly turn profits if they needed to. The question for us isn't, Will Amazon be able to convert ubiquity into profitability? but rather, When will they turn ubiquity into profits? and we can't answer that. Because of this risk, and the additional risk associated with a ten-year investment constraint, we do not see Amazon as an appropriate investment. 11

13 PROFIT MATTERS Profit matters. Profit is the reason we chose Walmart. If we based our investment on the premise of profitability, then we would have picked Amazon. Amazon has demonstrated profitability, and an efficient allocation of resources on its initial investments, however it has not generated a profit. Profits are important for a company such as Amazon, since it allows them to grow while also attracting investors. While companies might not focus on profit and concentrate instead on market share and growing their customer base during their early years, established market share leaders such as Amazon are expected to eventually produce a profit. In the past, analysts and investor groups have bought into Amazon because of its fast-paced revenue growth. While investor confidence has been positive in the past due to large revenue gains year over year, overall revenue growth has fallen as of late. When looking at dollars spent on technology and content versus revenue generated, we can see that Amazon is spending a large amount of money on technology and content, and every year each dollar spent on is generating less and less revenue. When we look at Walmart, we can see that they are generating a profit and producing a steady stream of revenue growth year after year. In conclusion, we believe that profitability only matters to a degree. After analyzing both companies and doing extensive research, we believe that it is important to distinguish between profitability and profit and for established companies such as Walmart and Amazon to generate a profit. 12

14 INVESTMENT STRUCTURE Due to Walmart s relative low-risk and high return on investment, we decided on a 50% leverage investment structure throughout the ten-year period. This allows us to take advantage of the low borrowing rates while simultaneously increasing potential gains. We chose not to exercise flexibility offered in other investment structures, such as options, primarily due to the ten-year time horizon. We felt that over ten years peaks and troughs would level off for a smooth and steady return we could sleep well with. If we were to have chosen, Amazon we may have included options in order to hedge some of the risk. However, we felt that taking a leveraged long position on Walmart stock would be a suitable and appropriate selection for a moderate risk portfolio. CONCLUSION Given the task of selecting between Walmart and Amazon for a decade long investment we decided to choose Walmart. The consistency not just in Walmart s profitability but pure profit, their dividends, and their business model were all a plus. Walmart has stood strong against disruption for decades and has robust revenue growth despite some fluctuations along the way. Walmart's physical footprint and cash flow allow it a world of opportunities only limited by shareholders. Amazon, similar to that of a ship on its maiden voyage, has an ideal staff and superior technology, the ship is cutting through the waters of its competitors but has yet to declare a destination. We want to know when and in which facet of their network will 13

15 they start transferring top line growth to bottom line profits. It s even possible that taking profits isn't in their business model. Without any insight into Amazon's destination we don't feel comfortable investing with a time constraint of ten years and have chosen Walmart due to the overall clarity of its operations. 14

16 APPENDIX A: Discounted Free Cash Flow Detailed Methodology To determine the range of intrinsic values of each company, we broke up each company by its significant or substantially relevant segments. These segments were different enough to warrant different growth rates projections. For Amazon, these segments were North American Retail, International Retail, and Amazon Web Services (AWS). While AWS is a relatively small part of the Amazon business, its rapid growth rates make this segment very relevant to our model. For Walmart, the segments are Walmart North America and Walmart International. The revenue generated by these different segments was available in the respective company s financial statements. The market growth for each specific segment is broken out and the company s market share growth for the company in that segment is forecasted using available data. We used best judgment, expertise from faculty, and background experience to account for missing data. The two growth rates combine to provide the range of likely growth rates for the next five years. See below for the revenue growth projections. Amazon Revenue Growth Projections (First 5 Years) Segment Market Size Growth Amazon Market Share Growth Low Growth Rate Base Growth Rate High Growth Rate North American Web Retail 10-13% (Mintel) (5)-5% 5% 15% 18% International Web Retail Amazon Web Services 12-15% (8)-2% 4% 8% 17% 25-33% 0-10% 25% 35% 43% Walmart Revenue Growth Projections (First 5 Years) Segment Market Size Growth Walmart Market Share Growth Low Growth Rate Base Growth Rate High Growth Rate Walmart US 1-2% (2)-2% -1% 1% 4% Walmart International 2-3% (4)-3% -2% 3% 6% Due to the different characteristics and operations of the two companies, the models were slightly different. We assumed Walmart would experience stable growth after year five and used terminal projections for year six and onwards. The stable growth 15

17 assumption for Amazon would not occur until year ten. For the period between years five and ten, we assumed a growth rate of 10%. To determine the free cash flow (FCF), we used the following equation: EBIT for Walmart was calculated similarly using a fixed ratio to revenue. Amazon s EBIT ratio fluctuates greatly from year to year. Amazon s R&D were added back into EBIT since the results from R&D would help generate additional revenue in future time periods. R&D expenses were projected using a fixed ratio to revenue. Depreciation & Amortization was forecasted using the a fixed ratio to revenue averaged from the past 3 years. Capital expenditures ratio to revenue for Amazon was calculated similarly. Walmart s capital expenditures ratio, due to anticipated additional investments based on our recommendations stated in the body of this paper, was increased by 2% of revenue in addition to the past 3 year average ratio to revenue. Net working capital was calculated by subtracting current liability from current assets, both of which were also forecasted using a fix ratio to revenue. To discount the free cash flow to present value, we used the weighted average cost of capital (WACC) as the discount rate. We used the following equation to determine WACC: Both equity and debt were forecasted using a fixed ratio to revenue. Tax rate was assumed to be 35%. The cost of debt was obtained from each company's balance sheet. We used the following formula to determine the cost of equity: The risk free rate of 2.4% and market risk rate of 5.5% were the average rates reported in a 2015 survey of risk free rate and market risk rate for the US. (Fernandez) We used unlevered beta as a measure of unsystematic risk: The forecasted beta used in our model is the average levered beta from the past three years. The intrinsic value was calculated using the following formula: 16

18 APPENDIX B: Amazon Low Growth Rate Scenario 17

19 APPENDIX C: Amazon Base Growth Rate Scenario 18

20 APPENDIX D: Amazon Best Growth Rate Scenario 19

21 APPENDIX E: Walmart Low Growth Rate Scenario 20

22 APPENDIX F: Walmart Base Growth Rate Scenario 21

23 APPENDIX G: Walmart High Growth Rate Scenario 22

24 BIBLIOGRAPHY Amazon s 40 Million Prime Members Spending $1,500 a Year on Average. Geekwire. Web. Jan 27, 2015 Amazon vs Walmart Revenues and Profits Revenues and Profits. Web. 24 Oct Columbus, Louis. "By 2018, 62% Of CRM Will Be Cloud-Based, And The Cloud Computing Market Will Reach $127.5B." Forbes. Forbes Magazine, 20 June Web. Evans, Benedict. Why Amazon Has No Profit (And Why it Works). 5 Sept Evans, Edward. Are Profit and Profitability the Same Thing? University of Florida Executive Summary Online Shopping US. Mintel. 25 Jun Fernandez, Pablo. Discount Rate used for 41 countries in 2015: a survey. April 23, 2015 Hartung, Adam. Bigger Is Not Always Better - Why Amazon Is Worth More Than Walmart. Forbes Online. 25 Jul. 15 Intelligence Unit. The Economist. Web. 26 May 2015 Kelleher, Kevin. This Is Why Amazon Is Dominating Walmart Now. Time Online, 18 Sept Less Amazing Than Amazon. The Economist. Web. 1 Feb "Our Business." Our Business. N.p., n.d. Web. 09 Nov Skowronski, Jeanine. "Survey: More Millennials Say No to Credit Cards Bankrate.com." Survey: More Millennials Say No to Credit Cards Bankrate.com. N.p., n.d. Web. 05 Nov Three Stocks Advancing the Services Sector. The Street, Inc Web. 3 Nov "Walmart Announces "Pay with Cash" for Online Purchases." N.p., n.d. Web. 26 April "Walmart." Help Link Page. N.p., n.d. Web. 05 Nov

25 "Wal-Mart Will Spend Nearly $2 Billion in Web Improvements over Two Years." Wal- Mart Will Spend Nearly $2 Billion in Web Improvements over Two Years. N.p., 14 Oct Web. What is The Difference Between Profitability and Profit? Investopedia Worstall, Tim. The Internal Economics Of Amazon's No Profits Growth Model. Forbes Online, 7 Sept "VUDU - Shop VUDU." VUDU - Shop VUDU. N.p., n.d. Web. 06 Nov