THE ECONOMIST INVESTMENT CASE STUDY COMPETITION …

[Pages:20]THE ECONOMIST INVESTMENT CASE STUDY COMPETITION 2015

Amazon vs Walmart

Team: InvesGo

Emory University Goizueta Business School Arjun Agarwala (Class of 2016) Vibhu Katiyar (Class of 2016) Rohan Singh (Class of 2016)

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Table of Contents

1. ABSTRACT............................................................................................................................................ 3 2. BUSINESS MODELS ............................................................................................................................ 4

2.1. Walmart ............................................................................................................................................ 4 2.2. Amazon ............................................................................................................................................ 4 3. THE ULTIMATE RETAIL WAR.......................................................................................................... 5 3.1. Why Walmart Stock is Attractive .................................................................................................... 5 3.2. Elusive Profitability Remains a Concern for Amazon ..................................................................... 6 3.3. Future of Retail Industry ? Who is Better Prepared? ....................................................................... 7 4. WALMART: FINANCIALS AND COMPARABLES.......................................................................... 9 4.1. Relative Pricing .............................................................................................................................. 10 4.2. Profit Margins ................................................................................................................................ 11 4.3. Performance and Coverage Ratios ................................................................................................. 11 4.4. Share Repurchase ........................................................................................................................... 12 4.5. Earnings and Dividend Projections ................................................................................................ 13 4.6. Stock Valuation .............................................................................................................................. 14 5. INVESTMENT STRATEGY ............................................................................................................... 14 6. RISK CONSIDERATIONS.................................................................................................................. 15 7. APPENDIX........................................................................................................................................... 16 REFERENCES ......................................................................................................................................... 19

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1. ABSTRACT Over a 10-year investment horizon, Walmart stocks will provide greater value than Amazon through consistent dividend payouts and steady share price appreciation, leveraging the company's existing retail model and renewed focus towards e-commerce.

Walmart has a 40-year history of increasing dividend payouts with a dividend yield of 3.03% at the current price. Walmart's P/E ratio, currently at 12.27, is extremely attractive and has ranged between 13.3 and 18.2 for the past decade. This signals that Walmart is currently selling at an `everyday low price', which we believe is a reasonable entry point for long-term investors.

A reasonable entry point, however, does not eliminate a possible volatility in stock prices in the shortterm. Walmart's plan to invest $2.5B in employees and $2B in e-commerce over the next two years will negatively impact earnings. Earnings will also be impacted by capital expenditures of over $23B for store improvements. However, post 2018, these investments are estimated to yield significant returns and enable the firm to reward investors. Walmart possesses the necessary infrastructure, capital, customer reach, buyer's power, and a focused management team to evolve and expand the firm into a model that combines brick-and-mortar stores with a robust e-commerce platform. Walmart's scale and price competitiveness will further ease the firm's transition into this omni-channel model.

Amazon's story has been one of unparalleled success, with the firm going from strength-to-strength over the past two decades. Its current ace-in-the-hole, Amazon Web Services, is estimated to grow from $7B today to $46B by 2020 [1]. However, despite the firm's impressive growth over the past few years, investment plans in international markets, and expansion of offerings by launching services such as Prime Now and Logistics, its bottom-line has never been an attractive proposition from an investment perspective. Amazon's belief in "failing fast" has driven investment in several products and services, such as the Fire Phone and Amazon Destinations, which have not yielded expected returns. The launch

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of programs such as Prime Now, where the firm may not earn any returns in the near future, further reduces the viability of Amazon as a 10-year investment opportunity.

2. BUSINESS MODELS 2.1. Walmart Walmart is a discount retailing company that operates retail stores, supercenters, warehouse clubs, Sam's club, and websites ? and . It has over 11,400 retail units in 27 countries and e-commerce websites in 11 countries. It operates as Walmart in the U.S. and Puerto Rico, Walmex in Mexico, Asda in the UK, Seiyu in Japan and Best Price in India. [2]

Walmart, the world's largest retailer and employer, has taken over half a century to become the largest company in the world based on almost half a trillion dollars in revenues. Over the decades, Walmart has consistently outperformed other retailers in both profitability and growth. It has been able to generate consistent profits and pay increasing dividends through efficiency in purchasing, distribution and store operations.

Doug McMillon, current President and CEO of Walmart, leads a strong management team to deliver Walmart's mission of "saving people money so they can live better." Under his leadership, Walmart is bringing together its stores, logistics network and e-commerce capabilities to empower customers to shop "whenever, wherever and however" they want. [3]

2.2. Amazon Amazon is the world's largest online retailer, with extensive operations in North America and is now increasing global presence. The marketplace includes websites such as , amazon.co.uk, amazon.de, amazon.co.jp and amazon.in. [4]

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Amazon started as an online book retailer but rapidly diversified into a host of other product categories. Today its business model has several moving parts. It maintains inventory and sells products with a mark-up directly through its online store and also provides a platform to third-party retailers while charging a small commission. Additionally, Amazon offers a subscription based model through its Prime service as well as a small electronics product line. Finally, Amazon provides cloud infrastructure to enterprise customers through Amazon Web Services. The firm has expanded its Prime offerings to include content such as music, videos and web series, while also investing in Amazon Logistics, a division aiming to reduce its dependence on UPS and FedEx.

Jeff Bezos founded in 1994 and is the CEO and Chairman of the Board. The company's mission is "to be the Earth's most customer-centric company." Since going public in 1997, Bezos has believed that if Amazon grows revenues, the stock will take care of itself. [5]

3. THE ULTIMATE RETAIL WAR 3.1. Why Walmart Stock is Attractive The current dilemma faced by investors about Walmart is due to a short-term focus on the firm's ability to generate profits and adapt in a changing retail environment. The recently issued negative guidance by Walmart highlighted low revenue growth, higher operating costs and increasing capital expenditures. A $1 increase in the firm's minimum wage in July and an expected additional $1 increase, which would bring minimum wages to $10 in February 2016, will increase expenses by $1.2B and $1.5B in FY2016 and FY2017, respectively. In addition to capital expenditures of $23.4B to improve stores, the firm plans a $2B investment in e-commerce over the next two years. The guidance led to widespread disappointment among investors. Skeptical about Walmart's future as a low-cost brick-and-mortar retailer, investors reacted by selling their positions causing the stock to lose 40% of its value over the past year. Despite this, Walmart's strong fundamentals and balance sheet, coupled with a long-term

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strategy well laid out by the management, enable it to become a compelling opportunity for a 10-year investment horizon. The existing pessimism allows value investors to buy a premium dividend paying stock at an attractive price. [6]

3.2. Elusive Profitability Remains a Concern for Amazon Amazon has been very successful in gaining market share in the US and other markets, such as the UK and India. Despite recently completing its 20th anniversary, Amazon still focusses on maintaining a startup culture. The firm has been investing aggressively in growth by raising debt and utilizing retained earnings, without focusing much on profits and thus has not released dividends since its inception. This culture, while necessary to maintain its innovative edge, has also resulted in several loss making investments. Uncertainty in the profitability of their different ventures is enhanced by Amazon's refusal to release concrete numbers on segment subscribers, costs and revenues. 2015 marked a surprise with AWS revenue being listed separately from US and International streams. To justify the current market price, Amazon needs to increase margins. However, the most feasible strategy to facilitate this would be to eventually increase prices, a difficult proposition in the retail business, where price competitiveness drives purchases.

Currently, the business that provides maximum margins is Amazon Web Services, Amazon's cloud computing segment. AWS is growing at a rapid pace and is expected to generate $7B in sales for FY2015 at a 25% margin. Analysts expect this revenue to grow to almost $46B by 2020 [1]. However, the presence of traditional players such as Microsoft, Dell and Salesforce and the entry of firms such as Google, IBM, and Oracle into the cloud space, point to an increasingly competitive industry with shrinking margins. [7]

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3.3. Future of Retail Industry ? Who is Better Prepared? Despite the proliferation of e-commerce, traditional brick-and-mortar stores will continue to be the preferred channel for many households for the next decade, in both the US and emerging markets. Stores provide consumers a sensory experience allowing them to touch and feel products, immerse in brand experiences, and engage with sales associates. Online purchases are also affected by the presence of stores, in other words, the source of value creation (product awareness) is now de-coupled from the place of value capture (sales transaction) [8]. The launch of Amazon Books, a physical book-store, also supports the strength of the omni-channel model, suggesting that revenues from such a model might exceed analysts' expectations.

Walmart already has a significant advantage over Amazon in the physical realm. With approximately 4,700 stores in the US, 90% of the American population lives within 15 miles of a Walmart store [9]. 7,000 international stores also provide Walmart a substantial reach in other countries. Thus, the focus for Walmart becomes improving its online platform and delivering better customer experience, and the firm has embarked on an ambitious turnaround plan in a bid to improve sales, operations and customer service. Aggressive investments in the e-commerce platform, coupled with large capital availability and a well-established brand name, allow Walmart to replicate Amazon's model, with potentially lower costs, and consequently lower prices for customers.

Walmart's $2B e-commerce investment, focusing on integrating its online selection with stores, offers them an even-footing with Amazon in the long-run. The recent test launch of a Walmart loyalty program similar to Prime, albeit one costing $50 per year [10] as compared to Prime's $99 per year charge, highlights Walmart's focus on replicating some of Amazon's strategies. Walmart's lower subscription cost will rapidly attract new customers and may even cause some Prime members with insignificant

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annual purchases to switch loyalties. Walmart will also be able to leverage its existing infrastructure and technical capabilities to scale at a brisk pace.

Walmart retains the ability to repurpose existing stores into potential distribution center-cum-store hybrids that would reduce operational costs. This would give customers the ability to shop online or at a store or even order online and pick up at stores, which could also handle online returns. Walmart's vast trucking fleet and distribution channel provide it close proximity to customers, which eventually might facilitate one-day or even faster delivery of products and allow the firm to compete against Amazon Prime, Prime Now, Pantry and Fresh. In comparison, Amazon has just over 50 distribution centers in the US. It has struggled to make profits due to the relatively high cost of one- and two-day shipping. This disadvantage will necessitate capital expenditures over the next decade on Amazon's behalf, to match Walmart's strong network, further shrinking Amazon's earnings. Thus, while Walmart does not necessarily have to replicate Amazon's model, Amazon may need to transform itself to the omnichannel Walmart model, requiring significant investment in the coming years.

Walmart's plan of raising minimum wage constitutes 75% of the announced earnings reduction over the next two years [11]. However, this step, along with store improvements will boost employee morale, reduce turnover and provide improved in-store customer experience. Additionally, Walmart recently started providing managers with tablets and mobile devices [12] to leverage real-time analytics and enable the firm to realize higher operational efficiencies. On the other hand, workforce culture has been one of the criticisms of Amazon of late [13] and despite preventive measures, turnover rate continues to remain high, reducing efficiency and increasing costs attributed to training and severance packages.

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