A Financial and Strategic Analysis of Amazon.com Inc.

A Financial and Strategic Analysis of Inc.

MBA 298: Management Project Instructor: Dr. K.C. Chen Student: Thomas Eble Date: 01 December 2015

Table of Contents

1. Introduction .............................................................................................................................1 2. ............................................................................................................................2

2.1. Amazon's Business Model ................................................................................................3 2.2. Amazon's Industry and Competition.................................................................................4 3. The Financial Model ...............................................................................................................6 3.1. Introduction to Financial Modeling...................................................................................6 3.2. Step-by-Step Guide to develop a Financial Model............................................................8

3.2.1. Estimating Revenues ..............................................................................................11 3.2.2. Estimating COGS and SG&A ................................................................................15 3.2.3. Estimating Financing Costs and Income Tax Expense...........................................22 3.2.4. Modeling the Balance Sheet based on the Income Statement ................................26 3.2.5. Estimating CapEx and Finalizing the Financial Statements...................................29 3.3. Some Technical Notes on the Input Sheets .....................................................................33 3.4. Some Technical Notes on the Estimate Sheets................................................................34 4. Enterprise Value Multiples ..................................................................................................37 4.1. Introduction to Relative Valuation Models .....................................................................37 4.2. Enterprise Value vs. Equity Value ..................................................................................40 4.3. Basic vs. Diluted Shares Outstanding..............................................................................43 4.4. Valuation Metrics and Multiples .....................................................................................46 5. Public Comparable Company Analysis ..............................................................................49 5.1. Our Valuation Approaches ..............................................................................................49 5.2. Introduction to Public Comparable Company Analysis ..................................................51 5.3. Finding Comparable Companies .....................................................................................52

5.4. Some Technical Notes .....................................................................................................53 5.5. Looking at Amazon's Numbers.......................................................................................55 6. Precedent Transactions Analysis .........................................................................................59 6.1. Introduction to Precedent Transactions Analysis ............................................................59 6.2. Finding Comparable Transactions...................................................................................59 6.3. Some Technical Notes .....................................................................................................61 6.4. Looking at Amazon's Numbers.......................................................................................63 7. Cost of Equity and WACC ...................................................................................................65 7.1. Cost of Equity - Risk-Free Rate and Market Risk Premium ...........................................65 7.2. Cost of Equity - Systematic Risk (Beta)..........................................................................66 7.3. WACC - Cost of Debt .....................................................................................................71 7.4. WACC - Market Value Weights and Calculation ...........................................................72 8. Discounted Cash Flow Analysis ...........................................................................................73 8.1. In Theory - The Enterprise Discounted Cash Flow Model .............................................73 8.2. In Practice - Which DCF Model should be used? ...........................................................76 8.3. Unlevered Free Cash Flow - Operating Assumptions .....................................................79 8.4. Unlevered Free Cash Flow - Calculation Methodology..................................................80 8.5. Continuing Value and Present Value Calculations..........................................................81 8.6. Implied Price per Share and Sensitivity Analysis ...........................................................84 9. Conclusion..............................................................................................................................87 10. References ..............................................................................................................................89 11. Appendices .............................................................................................................................94 11.1. Tables and Charts.........................................................................................................95 11.2. Financial Model Quick Steps.....................................................................................105 11.3. Amazon's Strategic Analysis .....................................................................................110

1. Introduction

The intention of this paper is to analyze the stock of Inc., subsequently simply called Amazon, from an investor's point of view. In doing so, we will perform a comprehensive financial analysis, by first building a detailed operating model to forecast Amazon's future financial statements, and then valuing its stock using several methods, including public company comparables, precedent transactions, and discounted cash flow analysis. Based on this, we will then issue a recommendation to either buy, hold, or sell the stock. However, to yield meaningful results, any financial analysis should be accompanied by a strategic analysis, which studies a company's business models and competitive advantages, as well as the macroeconomic environment, industry fundamentals, and competitors to assess the potential for future revenue growth and profitability. Due to the limited scope of this paper, the focus lies on the financial analysis with only a brief strategic analysis in the beginning to provide the reader with some basic background information on Amazon. For further reference, a detailed strategic analysis is provided in the Appendix.

Also, to enable the reader to fully understand the structure and methodology of the paper, several key points should be mentioned beforehand. To begin with, after this introduction and a brief strategic overview of Amazon, the paper will be split into two parts: The first part deals with building Amazon's financial model, whereas the second part deals with valuing Amazon's stock, based on the inputs from the financial model. Next, in the interest of simplification, theoretical concepts will mainly but not exclusively be based on four carefully selected sources: Kaplan's (2013 and 2014) books to prepare for the Chartered Financial Analyst (CFA) designation, which provide basic explanations and more conceptual knowledge. Damodaran's (2012) and Koller, Goedhart and Wessels' (2010) books on investment valuation, which provide more detailed explanations that are widely used by practitioners and academics. And finally, Pignataro's (2013) book on financial modeling, which provides a hands-on step-by-step guide to financial modeling.

Based on these theoretical concepts, we also aim to provide a practical approach to business valuation, as all too often there is a huge gap between what theory suggests to do and what equity

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analysts actually do in practice. To achieve this, we will analyze and compare equity research reports for Amazon from Deutsche Bank Markets Research (2014), Jefferies Equity Research (2014), and UBS Global Research (2014). Additionally, where appropriate, we will use a complete MS Excel valuation spreadsheet of IBM Inc., provided by Deutsche Bank Markets Research (2011). In the light of practical application, the models developed and utilized throughout this report should further be viewed as first-pass models, which intend to illustrate basic concepts instead of going down to the smallest details.

Regarding the financial data used throughout this report, it should be noted that in a professional setting one would most likely not use public sources like Yahoo Finance or Morningstar, even though they typically provide credible information. Instead, financial data providers like Bloomberg, Reuters, or Factset would be used to gather more accurate, standardized, and timely data on markets and companies in an efficient manner. Lastly, regarding the writing style of this paper we adopted the approach that investment banks commonly use in their equity research reports. More precisely, from a grammatical perspective they use the first-person plural to explain their house view with phrases like "we think" or "it is our expectation", for example.

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This section will take a closer look at Amazon's business model and the industries it operates in to provide some background for the following two main parts of this report. As will be discussed more detailed in later sections, the strategic analyses briefly summarized in this section are key inputs for the following financial model and valuation methods. However, they are also extremely time-consuming and require considerable experience, especially with regard to industry fundamentals and overall business dynamics. Therefore, unless otherwise noted, this section will mostly draw on professional reports from S&P Capital IQ (2015), Morningstar (2015b), Value Line (2015), as well as Amazon's (2015) latest annual report. For further reference, a more detailed strategic analysis of Amazon is provided in the appendix of this report. While we will primarily focus on insights from the above mentioned sources, we highly recommend using the information contained in the appendix to complement the analysis.

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2.1. Amazon's Business Model

To start with, was founded by current CEO and Chairman Jeffrey P. Bezos in 1994, and is among the world's highest-grossing online retailers with $89 billion in revenue in 2014. The company is headquartered in Seattle, Washington, and is listed on the NASDAQ Global Select Market under the symbol "AMZN" since its initial public offering in 1997. In 1995, Amazon opened its virtual doors to become "Earth's Biggest Bookstore" and "Earth's Most Customer-Centric Company". Starting with books, the company has since then expanded into a broad range of product categories including consumer electronics, media, digital downloads, shoes and apparel, health and beauty, kids and baby, home and garden, as well as auto and industrial. Also, outside the United States, Amazon meanwhile operates in Canada, the United Kingdom, Germany, France, Italy, Spain, Japan, China, Mexico, India, Brazil, Australia, and the Netherlands.

Besides expanding its online retail business in terms of additional categories and geographies, Amazon also broadened its range of products and services to not only serve consumers but also sellers, enterprises, and content creators. Regarding consumer products, for example, the company also manufactures electronic devices including the so-called Kindle e-readers, Fire tablets, Fire TVs, Echo, and Fire phones. Additionally, Amazon offers a service called Amazon Prime, which is an annual membership program that includes free shipping, streaming of movies and TV episodes, as well as borrowing e-books for Kindle devices. Overall, the company focuses on a vast selection, lowest prices, and outstanding customer experience by providing easy-to-use functionality, fast and reliable fulfillment, and timely customer service. For example, key features of Amazon's retail websites include personalized recommendations, customer reviews, secure payment mechanisms, detailed product information, wedding and baby registries, customer wish lists, and content preview of many books.

On top of that, through its Merchant and Amazon Marketplace programs, the company allows third-party sellers to offer their products on Amazon's retail websites or on their own websites, and to fulfill orders through Amazon's fulfillment service. In doing so, the company earns either fixed fees, revenue share fees, or per-unit activity fees. Similarly, the company serves enterprises through Amazon Web Services (AWS), which offers a variety of cloud computing, database, and

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analytics services for any type or size of business. Lastly, Amazon serves authors and independent publishers through Kindle Direct Publishing and Amazon Publishing, as well as musicians, filmmakers, or app developers through various programs that allow them to publish and sell content.

Amazon manages its operations primarily on a geographic basis, with its two major segments being North America and International. As of 2014, the former accounted for 62% of net sales (60% in 2013), whereas the latter accounted for 38% of net sales (40% in 2013). Since both segments provide similar products and services, they are further subdivided into media products, electronics and other general merchandise (EGM), and other products. Looking at the numbers, media products represented 25% of net sales in 2014 (29% in 2013), electronics and other general merchandise (EGM) composed 68% of net sales (66%), and other products accounted for 7% of net sales (5%). Additionally, Amazon's business is strongly affected by seasonality, which results in higher sales volume during the fourth quarter, which ends December 31. More precisely, the company reported 33%, 34%, and 35% of annual revenues in 4Q for the years 2012, 2013, and 2014, respectively.

2.2. Amazon's Industry and Competition

As stated in its latest annual report, Amazon's (2015, p. 3) business model is based on four principles: "Customer obsession rather than competitor focus, passion for invention, commitment to operational excellence, and long-term thinking." By building on these principles, Amazon has developed a range of sustainable competitive advantages and became one of the most disruptive forces in the retailing industry. In fact, Amazon played a major role in the structural shift away from traditional brick-and-mortar retailing, especially in commoditized categories with low switching costs for consumers and intense price competition. While well-known companies like Borders, Linens `N Things, or Circuit City already left the industry, names like Barnes & Noble, RadioShack, or Office Depot struggle to match up with Amazon. This trend is further intensified by consolidation among mass merchants like Wal-Mart and direct-to-consumer sales by companies like Apple, for example. However, Amazon still faces intense competition from a variety of players in its rapidly evolving industries. Among them are not only physical retailers and other online retailers, but also companies that manufacture consumer electronics, companies

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that provide cloud computing and data storage, companies that provide e-commerce services like website development, fulfillment, and payment processing, as well as web search engines, comparison shopping websites, publishers, and other media companies.

To defend and further extend its market position, Amazon identifies selection, price, and convenience as the major competitive factors for its retail business, as well as quality, speed, and reliability, for its seller and enterprise services. In fact, Amazon's strong brand recognition has come to reflects exactly these attributes, which is a rare combination among retailers that combined with its continued efforts to enhance customer experience represents one of Amazon's major competitive advantages. On top of that, it is the low-cost operation of its online platform that allows the company to charge lower prices and strengthen its competitive position. More precisely, its fulfillment and distribution network is more cost effective and also easier to scale than having a large physical presence like traditional retailers. Additionally, Amazon has cost advantages from current U.S. tax laws, where online retailers only have to collect sales taxes in states where they maintain a physical presence. Another unique advantage over competitors is a so-called network effect, which essentially is a result of Amazon's low prices, vast selection and user-friendly interface. These attract millions of customers, which in turn either attract other merchants to the Amazon platform or encourage wholesalers and manufacturers selling directly to Amazon. This effect is further intensified through additional services including Amazon Prime, customer reviews and product recommendations, as well as an expanded selection of both physical products and digital content.

Looking at Amazon's growth potential, from 2010 to 2014 the company generated a constant average growth rate (CAGR) of 32% in revenues. Other key top-line metrics, including active users (21% CAGR from 2010 to 2014), total physical and digital units sold (36% CAGR from 2010 to 2014), and third-party units sold (46% CAGR from 2010 to 2014) continue to outpace global e-commerce trends, which indicates that the company also gained market share. Over the next several years, the independent market research company Forrester Research (see Section 11.3 in Appendix) predicts a 9% CAGR of e-commerce sales in the United States, growing from $294 billion in 2014 to $414 billion in 2018. On top of that, internationally growing internet usage provides additional opportunities for e-commerce sales abroad, especially in emerging but also in developed markets. For example, Forrester Research estimated a 11% CAGR of European

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