WALMART VS AMAZON Economist 2016 Investment Case Competition sponsored by RealVision

Transcription

1 WALMART VS AMAZON Economist 2016 Investment Case Competition sponsored by RealVision Abstract Over the next 10 years Walmart stock will outperform Amazon because: Combining brick-and-mortar with e-commerce is a winning strategy: Although the growth of e-commerce is impressive, brick-and-mortar stores still account for 90% of retail revenues. Walmart is better positioned as an omni-channel retailer given its global store network and strong online presence. Early entry in China will pay dividends as country s middle class booms: The growth of the Chinese middle class will alter global consumption trends in the next decade. Walmart has been laying the foundation to meet this demand and is accelerating expansion in China. Earnings, not dreams, drive value: Walmart has proven it can deliver long-term profitable growth. Comprehensive strategy and operational excellence will continue to provide above average profitability. Strong balance sheet and robust free cash flow provide low cost capital to support growth: Relatively low debt insulates Walmart from rising rates. Undervalued stock will provide most value to shareholders: Conservative DCF model shows the market is significantly mispricing Walmart s stock. Cole Buckley, Pete DeFina and Lindsay Root

2 Table of Contents Walmart vs Amazon... 2 Industry Summary... 2 Company Overviews... 3 Amazon... 3 Walmart... 4 Market Position & Analysis... 5 Walmart is positioned to become the leading omni-channel retailer... 5 Walmart is able to capture growth in Asian middle class... 7 Walmart s global network provides competitive advantage... 9 Financial analysis Walmart has above average profitability and a strong history of profitable growth Walmart s conservative capital structure makes it easy to raise capital and reduces impact of rising rates Valuation P/OIPS Discounted Free Cash Flow Conclusion Works Cited

3 Walmart vs Amazon Amazon and Walmart have become ubiquitous, household names in the US and for good reason: both of these companies have revolutionized the way in which we shop. Amazon offers a convenient experience, and an ever-expanding selection of products whereas Walmart has a wide network of store locations and famously low prices. As investments, these companies highlight the dichotomous nature of the retail industry brick-and-mortar vs e-commerce; high growth vs steady growth; US vs International; actual vs market expectations. To coalesce these stark differences, we will first summarize the industry and these companies, followed by an analysis of market position and financials, and finally an analysis of the firm valuation, all of which point to Walmart as the clear investment over the next 10 years. Investment decision: Buy WMT Industry Summary For the ease of comparison, we ve grouped both Amazon and Walmart into retail, however, the industry forces that drive each of these companies are distinctly different and the firm that is best able to leverage these forces will ultimately make a better investment for the next 10 years. 2

4 Table 1: Industry Summary 1 Industry E-commerce and Online Auctions in the US Warehouse Clubs & Supercenters in the US Department Stores in the US Key Drivers Life cycle stage: Per capita disposable income Number of mobile internet connections Percentage of services conducted online World price of crude oil Growth Mature Decline Concentration Level: Low HHI 250 High HHI 5,000 High HHI 2,000 Technology Change: Barriers to Entry: High Medium Medium Low High Medium Threats High reliance on shipping companies (FedEx, UPS, etc.). Operating profits limited when oil prices are high. Membership (like Prime) limits ability to pass higher costs onto customers. Gas stations generate large portion of industry revenue. E-commerce sites are better positioned due to low overhead costs, offering lower prices and wider inventories. Opportunities Disposable income levels determine quantity and quality of online purchases Integrate in-store and online for personalized customer experience Company Overviews Amazon Amazon.com, founded in 1994 by current CEO Jeff Bezos, is the largest internet-based retailed in the US. They maintain three different operating segments: North America, International, and 1 (IBIS World, 2015) 3

5 Web Services. In Q2 of 2015, Amazon reported $23 billion in sales of which North America represented 60%, International 32%, and Web Services 8%. 2 Amazon currently sells over 300 million products in a variety of categories. Its retail operation encompasses many different business models Amazon Retail, Amazon Marketplace, and Amazon Web Services. In Amazon Retail, the company purchases and takes possession of inventory in which it stores in one of its 74 3 distribution centers in the US. In Amazon Marketplace, third party sellers are able to list items on Amazon s website and the seller pays a fee to Amazon. Amazon Web Services is cloud-computing platform providing services like online storage and virtual servers. 4 Walmart Walmart, founded in 1962 by Sam Walton, was the world s largest company by revenue 5. Its operating segments include Sam s Club, Walmart US, and International. In Q2 of 2015, Walmart reported $119 billion in sales of which Walmart US represented 62%, International 26% and Sam s Club 12%. 6 Sales are generated predominantly through one of its 11,526 stores throughout the globe. Walmart also generates sales through its website Walmart.com, however less than 3% of sales are generated online. 7 Evolving to compete in the digital space, Walmart is moving from a traditional brick-and-mortar retail store to an omni-channel model which includes online sales. 8 Table2: Selected Company Metrics 9 Company Name Walmart (WMT) Amazon (AMZN) Employees 2.2 Million 154,000 Shareholders 250,000 2,744 2 (Amazon, 2015) 3 (MWPVL, 2015) 4 (Amazon, 2015) 5 (Fortune, 2015) 6 (Walmart, 2015) 7 (Forbes, 2015) 8 (Walmart, 2015) 9 (Mergent Online, 2015) 4

6 Market Cap $187 Billion $307 Billion Revenue 486 Billion Billion Net Income 15.5 Billion 328 Million Dividend 1.95 N/A Dividend Yield 3.33% N/A Share Price $58 $655 Market Position & Analysis Walmart is positioned to become the leading omni-channel retailer Retailers have realized that the future of retail is offering goods and services through tightly integrated digital and physical channels. A 2014 study by A.T. Kearney found that a majority of customers prefer online shopping for product discovery and delivery, and physical stores for product testing and returns. 10 In fact, two-thirds of the customers purchasing online use a physical store either before or after the transaction. 11 The tradeoff in customer preferences between online and physical stores is driving an increasing amount of retailers to adopt an omni-channel model. Successful online retailers such as Microsoft and Athleta are now opening brick-and-mortar locations as part of a blended retail strategy. On the other hand, traditional brick-and-mortar retailers are making large investments to improve its online presence. Walmart CEO Doug McMillon said I want us to stop talking about digital and physical retail as if they re two separate things, the customer doesn t think of it that way, and we can t either. McMillon went on to discuss Walmart s plans to heavily invest in its vision of seamless integration between digital and physical shopping. Online sales currently make up only a small 10 (A.T. Kearney, 2014) 11 (A.T. Kearney, 2015) 5

7 percentage of Walmart s total revenues, however with $12 billion in e-commerce sales in 2015 it is already one of the largest online retailers in the world. 12 Indeed, Walmart has incredible upside potential in online retailing if it can successfully execute its omni-channel strategy. In 2015 the global e-commerce market was estimated to be $1.5 trillion which is forecast to grow at an average of 15% for the next 3 years. 13 Despite this high growth rate, in 2019 e- commerce sales will still only account 12.4% or $3.5 trillion of total retail sales of $28.5 trillion (see Figure 1). 14 Figure 1: Global Retail and E-commerce Sales Forecast in Trillions 15 11% 10% 12% 13% 14% 15% 16% % 7% % 17% 93% 91% 90% 89% 88% 87% 86% 85% 84% 83% 83% Brick-and-mortar Retail e-commerce sales Total As of 2014, China represents a $400 billion e-commerce market and is forecast to grow at more than 20% over the next few years (see Figure 2). The drivers for this growth include China s large population, growing internet penetration, and increase in disposable income with the forecasted rise of the middle class. 12 (Market Realist, 2015) 13 (emarketer, 2015) 14 Ibid 15 (emarketer, 2015) 6

8 Figure 2: China Internet Penetration and Number of Users % 51% 53% 56% 59% 62% 65% % 1,016 72% 1,071 76% 1,130 80% # of users in millions % population Walmart is able to capture growth in Asian middle class The growth in the Asian middle class will completely change the trajectory of retail sales. US consumption drives US and the global economy, especially since the recent trend in savings has resulted in US consumption growing faster than the US GDP. 17 Representing $10 trillion, US consumption accounts for under one-fifth of the world economy. This massive consumer base is propped up by the US large middle class. However, this trend is shifting as the middle class is growing rapidly in populous countries around the globe, most notably, Asia. In 2000, China s middle class represented 2% of the world s population and just 10 years later, it represented 9%. 18 China s consumers have the potential to drive global demand, particularly in the next 10 years (see Table 3). Table 3: Percent change in size of middle class by region 19 Region Asia Pacific 25.10% 12.56% Sub-Saharan Africa 0.02% -0.42% Middle East & North Africa -0.61% -0.33% Central & South America -2.08% -0.77% North America -8.07% -4.41% Europe % -6.64% 16 Ibid 17 (Bureau of Economic Analysis, 2015) 18 (Brookings Institute, 2010) 19 IBID 7

9 Additionally, Chinese consumers are avid shoppers. In a 2007 survey, Chinese respondents indicated that they spend 9.8 hours per week shopping, whereas the typical American only spends 3.6 hours. 20 More than 40% of survey respondents also stated that shopping was their favorite activity. Given these sentiments, and the fact that half of China is still not connected to the internet, Walmart is better positioned to capitalize on these trends than Amazon. In contrast to its position in the US, Amazon must compete for market share with Alibaba and JD.com in China. Current research estimates that Amazon occupies less than 1.5% of the market share and is losing $600 million a year. 21 Earlier this year, Amazon quietly opened a store on competitor Alibaba s Tmall platform, a site for authentic brands, in order to access Chinese customers since it has not had much success via its own website Amazon.cn. This does not bode well for the ubiquity nor profitability of Amazon in China. Whereas Amazon is struggling for a foothold in the Chinese market, Walmart is enjoying modest, albeit slow, growth in China. Since entering the market in 1996 with two stores, it rapidly expanded to 279 stores by 2010, however, Walmart did face some challenges as particular low performing stores were forced to close. 22 Despite rising debt and total liabilities up from 76% in 2013 to close to 80% currently, Walmart was able to improve profits and margins over the same period indicating that the firm is able to rein in costs. 23 "Our aim is to become an integral part of China's economy," said CEO Doug McMillon. "China is a top priority." 24 Despite setbacks, Walmart has pledged to open 115 new stores by 2017, bringing 20 (McKinsey & Company, 2007) 21 (Fortune, 2015) 22 (Wall Street Journal, 2015) 23 (Reuters, 2015) 24 (Reuters, 2015) 8

10 the total to 530 stores in China. 25 In 2011, sales in China accounts for about 2% or $7.5 billion of Walmart s annual revenues, but sales in China have risen over the last decade while sales in the US continues to shrink. 26 Furthermore, Walmart is positioning itself to offer greater e-commerce flexibility to its Chinese customers by partnering with local company, Yihaodian. Walmart just recently bought out the company s founders, signaling that Walmart is gearing up for an investment into its Chinese omni-channel model. China s online retail sales rose 49% to $440 billion 27 and with Walmart s ownership in Yihaodian, Walmart hopes to expand its inconsequential 1% market share. With China as the largest opportunity for growth for both Amazon and Walmart, it is clear that Walmart is much better positioned. Walmart s global network provides competitive advantage Since the opening of its first international location in 1991, Walmart has been steadily increasing its global presence. Currently, it operates 6,290 international store locations. Walmart is well established in developed countries and is now focusing on growing store count in the fastest growing economies. Five of Walmart s international regions are forecast to outpace global average growth in the next 10 years. Each of these regions has seen store count rise by more than 25% in the last 5 years. Of particular interest are India and Africa, where it has been difficult for US retailers to gain a strong foothold. Walmart has made steady progress in these regions through a series of acquisitions. Despite the challenges of doing business in emerging economies, Walmart is planning continued expansion. By 2020, it will add 50 new stores in India and 90 stores in Africa. 25 (Wall Street Journal, 2015) 26 (The Atlanic, 2015) 27 (CCTV America, 2015) 28 (AFK Insider, 2014) 29 (The Street, 2015) 9

11 Figure GDP Growth Rate of Walmart Key Regions and Store Count 30 Financial analysis Walmart has above average profitability and a strong history of profitable growth Walmart is well known for its ability to create profits by leveraging scale and operational excellence. Table 2 demonstrates that Walmart is above average in all key measures of profitability. Of particular note is Return on Equity. Walmart operates with less leverage than its competitors and as a result is able to generate high Return on Equity. Table 4: Profitability Metrics for top 4 brick-and-mortar retailers + Amazon 31 Profitability Walmart Amazon Brick- and- Mortar Average Costco Carrefour Target Gross Profit Margin(TTM) 24.3% 31.3% 23.0% 13.0% 23.0% 31.0% Operating Profit Margin(TTM) 5.4% 0.8% 3.3% 3.3% 2.8% 7.6% Return on Assets(TTM) 7.8% -0.4% 2.3% 2.3% 2.7% 1.8% Return on Equity(TTM) 19.7% -1.7% 7.2% 7.2% 13.6% 5.4% 30 (Walmart, 2015) 31 (Mergent Online, 2015) 10

12 Walmart s profitability is not just a recent occurrence. Gross profit margin (Gross Profit/Total Revenues) has been steadily increasing for more than two decades; proving that Walmart can balance everyday low pricing with its tremendous purchasing power (see Figure 4). Figure 4: Walmart Annual Gross Profit Margin 32 26% 25% 24% 23% 22% 21% 20% Walmart s conservative capital structure makes it easy to raise capital and reduces impact of rising rates Walmart has used profits to pay down its debt and achieve a conservative capital structure. 60% of Walmart s assets are financed through debt, compared to 78% for Amazon and 68% for brick-and-mortar competitors. 33 This relatively low debt to equity ratio is a characteristic of family-owned businesses which view debt as a constraint. 34 The relatively low debt ratio and high interest coverage ratio have earned Walmart a high credit rating and low cost of borrowing. Moody s gives Walmart an investment grade rating of Aa2, significantly higher than Amazon and other key competitors. The benefit of Walmart s conservative capital structure is its ability to issue future debt at a lower cost than industry peers. 32 (Mergent Online, 2015) 33 (Mergent Online, 2015) 34 (Harvard Business Review, 2012) 11

13 Another benefit of Walmart s relatively low amount of debt is it helps to insulate them from the shock of rising interest rates. A forecast consensus prepared by the Wall Street Journal shows interest rates rising dramatically throughout 2016 and Firms such as Amazon, with high leverage and low operating margins will be significantly burdened by debt service in an environment of rapidly rising interest rates. Valuation Our valuation of Walmart is based on two approaches: using Price (P) to Operating Income Per Share (OI) multiple, and a Discounted Free Cash Flow (DFCF) valuation. Price/Operating Income Per Share The P/OI ratio was selected to remove inconsistencies in valuations that can result from high growth rates and/or depressed or negative net earnings, characteristic of many pure play e- commerce retailers. Specifically, this valuation metric was selected over a net earnings valuation metric, such as Price to Earnings (P/E) ratios, in order to eliminate any bias created by deductions of interest, depreciation, and or amortization. Also, because of the different growth rates traditional brick-and-mortar retail and e-commerce segments, fixed asset capital expenditures (CAPEX) and their financing are also varied across the retail industry. For example, e-commerce is a relatively high growth segment, exhibiting relatively high average CAPEX, (AMZN CAPEX as % of Sales = 8.8%; WMT CAPEX as % of Sales = 2.5%) and depreciation, which can depress net earnings and bias valuation estimates based on e-commerce net earnings. Similarly, diverse financing methods and interest deductions create net earningsbased valuation biases. 35 (Wall Street Journal, 2015) 12

14 Figure 5: Price/Operating Income 180x 160x 152.7x 140x 120x 100x 80x 60x 40x 20x 58.1x 40.4x 31.1x 26.2x 25.5x 19.9x 14.5x 10.0x 7.8x 0x AMZN BABA BIDU TGT OSTK GOOG COST EBAY AAPL WMT Using Walmart s current share price (close price $58.61 as at Nov. 6, 2015) and trailing twelve month operating income (as at Jul,. 30, 2015), we calculated Walmart s P/OI ratio to be 7.8x which is closer to its brick-and-mortar rivals than to e-commerce pure plays, yet lower than all Table 5: Retail Industry Comparable Firms Retail Industry Comparable Firms Comparables Weighting of Comp Ratios Company (Ticker) P/OIPS Sales ($Billion) Weight (Sales) Weighted Average AMZN 152.7x $ % BABA 58.1x % BIDU 40.4x % TGT 31.1x % OSTK 26.2x % GOOG 25.5x % 26.1x COST 19.9x % EBAY 14.5x % AAPL 10.0x % WMT 7.8x % major competitors in the retail industry 36. In order to better reflect Walmart s true current share price, a weighted average (by sales) of all comparable P/OI ratios was calculated (26.1x), indicating a current share price of $67.40, 15% higher than the current market price. 36 (Yahoo Finance, 2015) 13

15 Table 6: Price/Operating Income Per Share P/OIPS Valuation P/OI 26.1x Enterprise Value $634,924,825,970 Net Debt 416,341,000,000 Equity 218,583,825,970 Total Diluted Shares Equity Value Per Share 3,243,000, Discounted Free Cash Flow The discounted free cash flow valuation method was selected to provide a business-driven valuation method, to complement the market-driven P/OI valuation. This is a credible valuation method since it allows the incorporation of expected growth in both sales channels and profit margins. A free cash flow growth rate of 3.0%, in line with global GDP growth, was applied to Walmart s free cash flow over the 5 year discounted cash flow valuation. Table 7: Weighted Average Cost of Capital Weighted Average Cost of Capital Cost of Equity (r e ) 7.12% Risk-free rate (r f ) 3.09% Market Risk Premium 6.01% Beta After-tax Cost of Debt 2.85% Cost of Debt (r d ) 4.39% Tax rate (t) 35.00% Debt Weight (W d ) 13.73% Equity Weight (W e ) 86.27% WACC 5.46% 14

16 Table 8: Discounted Free Cash Flow Model Discounted Free Cash Flow Model WACC 5.46% Growth Rate of FCF after % Present Value of Free Cash Flow $ 92,775,515,775 Present Value of Terminal Value 591,471,343,253 NPV (Enterprise Value) $ 684,246,859,028 Net Debt (416,341,000,000) Equity 267,905,859,028 Total Diluted Shares Oustanding 3,243,000,000 Equity Value Per Share Also, risk and time were measured by this valuation method by the use of a risk-adjusted weighted average cost of capital (WACC) for Walmart. This valuation yielded an indication of value at $82.61 per share, 41% more than the current market share price of Walmart. Both of the market-derived P/OI valuation and the firm-derived valuations signal that Walmart has been underpriced by the market for the following reasons: 1. Significant growth opportunities in the e-commerce segment 2. Significant international growth opportunities, especially in China in both brick-andmortar and e-commerce channels 3. Distribution infrastructure and exceptional supply chain management that create economies of scale and scope 4. Sound management and focused strategy as an omni-channel retailer These factors are expected to catalyze growth across all segments for Walmart, especially in e-commerce where the segment s growth rate is expected to outstrip the more stabilized brick-and-mortar growth rate. As indicated, Walmart s annual online sales increased by 15

17 approximately 22% in its most recent fiscal year, a trend that is expected to continue to drive sales up. 37 Conclusion Given that the expected trends in the greater retail industry are expected to fuel rapid expansion of the e-commerce channel and stabilized growth in the brick-and-mortar channel, Walmart s omni-channel model and strategy are expected to provide the retail giant with substantial growth opportunities. Moreover, Walmart s existing footprint in China and presence globally allow the firm to capitalize on future demographic changes given the rise of China s middle class. In line with these drivers and as evidenced above, Walmart s intrinsic value is greater than its current market value, further indicating that Walmart is the superior investment choice. 37 (New York Times, 2015) 16

18 Works Cited A.T. Kearney. (2014). On Solid Ground: Brick and Mortar Is the Foundation of Omnichannel Retailing. Retrieved from ce-e40c-450d-97bb-884b017f4cd7 A.T. Kearney. (2015). Global Retail E-Commerce Keeps On Clicking. Retrieved from /asset_publisher/87xbennhpz3d/content/global-retail-e-commerce-keeps-onclicking/10192?_101_instance_87xbennhpz3d_redirect=%2fconsumerproducts-retail%2fe-commerce-index AFK Insider. (2014). Sub-Saharan Africa Is Walmart s New Battleground. Retrieved from Amazon. (2015). Retrieved from Amazon. (2015). 10Q 2nd Quarter Brookings Institute. (2010). The New Global Middle Class:. Retrieved from class%20kharas/03_china_middle_class_kharas.pdf Bureau of Economic Analysis. (2015). CCTV America. (2015). Walmart expands its scale in China in face of sales decline. Retrieved from emarketer. (2015). Retail Sales Worldwide Will Top $22 Trillion This Year. Retrieved from Retail Sales Worldwide Will Top $22 Trillion This Year - See more at: Forbes. (2015). As Walmart Forecast Dips, Is It Also Losing The Low-Price Battle To Amazon? Retrieved from Fortune. (2015). 500 Largest Companies. Retrieved from Fortune. (2015). Humbled Amazon turns to rival Alibaba for help in China. Retrieved from Harvard Business Review. (2012). What you Can Learn From Family Business. Retrieved from IBIS World. (2015). Market Realist. (2015). Inherent Risks and Rewards in Walmart s E-Commerce Business. Retrieved from McKinsey & Company. (2007). The Consumer Trap: Retailers Need to Adapt to Entice Fickle Chinese Shoppers into Their Stores. Mergent Online. (2015). MWPVL. (2015). Amazon Global Fulfillment Center Network. Retrieved from New York Times. (2015). Walmart, Lagging in Online Sales, Is Strengthening E-Commerce. Retrieved from 17

19 Reuters. (2015). Rare store sales data highlights Wal-Mart's China challenge. Retrieved from Reuters. (2015). Wal-Mart to expand China store network by nearly a third after growth stalls. Retrieved from The Atlanic. (2015). How Walmart Is Changing China. Retrieved from The Street. (2015). Wal-Mart Renews India Wholesale Expansion, Plans 50 New Stores by Retrieved from Wall Street Journal. (2015). Econ Forecast. Retrieved from Wall Street Journal. (2015). Wal-Mart Says It Will Go Slow in China. Retrieved from Walmart. (2015). 10Q 2nd Quarter Yahoo Finance. (2015). Yahoo Finance. Retrieved from 18