Decision 2025

Amazon - positioned to be a superior investment over the next decade.

Team: Bluejays

Bob Mills

Reed Janousek

Anthony Cerasoli

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To complete this case our team used Google Docs to collaborate, iPads to research, transcribed

10Ks on laptops in Starbucks and ultimately a 20 page paper materialized despite us having met

for all of three hours in person. 10 years ago this effort would have had us locked in the library

for the full 10 days. In 10Y the PESTEL environment surrounding a company can shift so

dramatically an industry can literally disappear. With that in mind we approached with caution

the notion of developing a relevant 10Y recommendation for two extremely different companies.

THE FINANCIALS

Because the Walmart business model and strategy produces stable transparent financial

statements we chose the Dividend Discount Model methodology to value Walmart. The ten year

time frame incorporated the recently announced investment in e-commerce and people with the

subsequent expected rebound in earnings. Amazon was valued using a sum-of-the-parts

approach with EV/EBITDA as the multiple. By splitting Amazon into North America,

International and Amazon Web Services (AWS), forecasting EBITDA and applying comp-based

multiples we were able to derive an enterprise value. After backing out net debt we arrived at a

market cap that could be translated into a share price.

We believe that Amazon will deliver a higher 10 year holding period return. Our financial

models suggest Amazon will return 23.4% annualized versus 10.0% for Walmart. Recently their

equity values have sharply diverged. Amazon spiked on the success of AWS while a

deceleration in Walmart earnings followed by a 3Q15 surprise has sent its stock spiraling.

Pricing each as of 10/26, and using our methodology, we believe that Walmart is currently

mispriced by the market. With Walmart at $58.40 and our calculated fair value at $70.83

Walmart is trading at a 17.5% discount. Pricing Amazon at $602.30 and using our SOTP

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approach we calculated fair value to be $546.89 putting Amazon at a 10.1% premium. That

Walmart is more mispriced is no surprise given recent guidance that the company will see a near

term reduction in EPS as it invests for the future. Juxtapose this against Amazon which has

introduced a business line (AWS) believed to be capable of producing mid-double digit top-line

revenue growth. Given the relative performance metrics and frequency upon which equity

investing is judged it is understandable why asset managers would sell Walmart and bid up

Amazon.

Taking for granted that modeling equities with a 10Y horizon introduces a near inappropriate

amount of model risk we sought qualitative validation of our numbers. We thought deeply about

the core competencies of each company, the challenge of providing a unique customer

experience and which company can better diversify and surround the consumer. Our strategic

analysis confirmed our belief that the Amazon model will deliver superior results.

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LEVERAGING CORE COMPETENCIES

Amazon’s organization is better suited to dynamically apply their resources and core

competencies to the external environment, allowing them to build and sustain a competitive

advantage in the markets they choose to serve

When comparing Amazon and Walmart, many resource and core competency similarities exist.

Both have extensive distribution infrastructure, world class logistics capabilities, a deep expertise

in IT/analytics and commitment to their customers. The strengths of these resources and core

competencies are relevant and well documented, but it is Amazon’s ability to dynamically apply

and even reconfigure its resource base that makes it the better investment.

To establish context, let’s discuss the organization’s respective mission statements:

Amazon: “Our vision is to be earth's most customer centric company; to build a place where

people can come to find and discover anything they might want to buy online”1

Walmart: “Saving people money so they can live better”2

Amazon’s mission states that it is centered on delivering the best customer experience, while

Walmart’s is focused on the value of low prices. Although the difference is subtle, in practice

the gap is wide as Amazon’s mission provides for a higher growth ceiling. Said casually,

Amazon is less concerned than Walmart about what products, services, or even channels are part

of their revenue stream. A specific example, AWS, can demonstrate this concept.

A decade after Amazon launched their e-commerce business, they realized they needed an IT

infrastructure to allow the employees designing the customer experience (application engineers)

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to be decoupled from the people providing the necessary technology. The result was a highly

scalable web service that with a few customer-focused additions was marketable to others with a

similar need. AWS is now Amazon’s fastest growing and most profitable segment.

What created the environment that birthed AWS? Amazon has a unique atmosphere where their

resources, core competencies, and mission create innovation. Their resources provided the assets

for AWS – IT infrastructure and expertise. Their core competencies around customer service

provided the leverage and momentum to move the initiative forward. Their mission played an

active role in fostering a culture that encouraged experimentation, but more importantly didn’t

act as a barrier in bridging the idea with the market. Subsequently, Amazon reconfigured their

resources to gain a competitive advantage in the marketplace.

This ability to build, leverage, and reconfigure core competencies into sustainable competitive

advantages exemplifies why Amazon is positioned to succeed in a rapidly changing external

environment. Examples include:

o Amazon Restaurant - leverages their customer experience competency and grows their

delivery infrastructure.

o Amazon Fresh - higher margin business - leverages their distribution network and

excellent customer experience and service.

o Twitch - positions them at the forefront of the online gaming frontier (Twitch accounted

for 2% of global Internet traffic in 2014)3. Broadens product line and strengthens IT core

competency.

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Amazon’s online model provides for basic but powerful advantages over a traditional retailer

like Walmart and we believe two will drive performance in the next decade. First, while both

organizations face a global execution challenge, Amazon is better positioned and organized for

success. Their online model with third party marketplace enables them to partner globally with

any vendor and any local logistics company and leverage their brand and first class customer

service to grow their business. It’s unlikely Walmart can execute a similar global strategy given

their current capabilities. Second, Amazon’s online model provides the framework to create a

virtuous network effect. A new customer for Amazon generates a larger incremental benefit than

a new customer at Walmart, as their products and services are integrated underneath one

customer-centric mission umbrella. For Walmart to be successful in challenging Amazon they

must surround the customer the way Amazon has. A single Amazon customer can run their

small business through AWS, game on Twitch, store their music on Amazon Cloud and last

minute shop on Christmas Eve. Currently, Walmart.com offers low prices on products with in-

store pick-up. The two companies aren’t in different leagues in e-commerce, they are playing

different games.

When we step back and review the dynamic capabilities of both organizations, it is important to

consider the external environment. The strength of Amazon is that it is relentlessly searching the

external environment for opportunities to deploy its core competencies on behalf of the

consumer which better positions it for growth independent of the evolution of the external

environment during the next decade.

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CUSTOMER EXPERIENCE

Amazon has developed a significant lead in delivering a world class customer experience. This

first mover advantage is more likely to be enhanced and expanded than relinquished during our

investment window.

One need look no further than Craig’s List as proof that the consumption experience has

dramatically changed. To grow share in a crowded retail market corporations must differentiate

themselves; and in a world of unlimited choice, customer experience (CX) is becoming the

deciding factor driving where individuals spend their dollars. CX is the interaction between an

organization and a customer over the duration of a relationship and includes the customer's

attraction, awareness, discovery, cultivation, advocacy and purchase and use of a service or

product4. ForeSee, a specialist in CX analytics, produced a survey in 2013 which generated an

experience index. Of 100 corporations Amazon scored 1st, Walmart 97th. Within retail and

apparel brands AMZN was 1st, Walmart 21st (last). 5 The ideal CX in consumer retail is easy,

provides choice, is convenient and anticipates customer needs. Both Walmart and Amazon have

utilized their core competencies to provide a unique customer experience betting their

investments will protect their competitive advantage. The question is which CX will “win” the

next decade.

As a function of their mission statement, Walmart bet correctly that consumers would value the

opportunity to one-stop shop at the lowest prices. They delivered by developing core

competencies in logistics and the utilization of technology to enhance operational efficiencies.

As scale developed driven by intelligent internal organization and strategic location growth

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Walmart strengthened pricing power with suppliers and raised the barriers of entry for

competition because of their massive investment in fulfillment. This strategy has delivered on

average 21% annual sales growth the past 45 years.6 Amazon, also as a function of their mission

statement, bet that customers valued a CX focused on low cost and wide selection, but deepened

that experience significantly. The operation of a virtual supercenter allows Amazon to offer

massive product selection – approximately 250 million SKUs (US site) versus the approximately

178 thousand in the average supercenter and 5 million on Walmart.com. To respond to the

convenience of the Walmart experience, Amazon developed a similar core competency in

logistics and IT driven operational efficiency, but focused on the added convenience of home

delivery. Jeff Bezos’ focus on delivering a positive CX has made the product less important and

the consumption experience (on Amazon.com) the primary provider of value. They’ve delivered

continual customer-centric innovations such as one-click shopping, pioneered meaningful

customer reviews, RSS feeds to track price changes, Prime Now and more. Monitoring items in

your shopping cart, remembering past purchases, and serving as your digital library has made

Amazon a personal consumption assistant and actually generated a high switching cost. That

relentless customer-centric focus has been critical to the success of AWS. Delivering simple and

helpful IT support to start-ups and small to mid-size corporations (the anti-Nick Burns7) has

generated lifetime customer loyalty and has delivered unparalleled growth in sales.

The question becomes will Walmart’s investment in e-commerce and people challenge the CX

that drives the remarkable sales growth of Amazon. The virtual supercenter will always win on

selection and the ease of online search capabilities. Amazon has same day home delivery for

those “must haves” that could force a customer to a physical store. Walmart can’t compete with

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Amazon in this competency because Amazon organized to optimize last mile delivery while

Walmart organized to optimize delivery to out of town distribution centers which served as hubs

for multiple supercenters. Culturally Amazon has perfected the delivery of features born from an

outside-in perspective and these innovations have served to continually enhance CX. Walmart

took a singularly focused, and in retrospect too narrow, outside-in approach that the customer

simply wants the lowest price. The investment in Walmart.com, people and cleaner supercenters

represent a renewed focus on the Walmart CX but we view this as defensive in nature. We do

believe Walmart has a CX driven opportunity with their neighborhood markets capable of

driving above average sales growth in the grocery sub-market over the next decade.

The challenge for Walmart is they must spend to enhance their CX while placating investors.

Amazon has no such constraints; it is expected to continually re-invest earnings to bring its

unique customer-centric sales engine to new markets. This raises the question does profitability

matter and is the Amazon model one that can be simultaneously everywhere but only capable of

breaking even? In 2015 profitability does not matter for Amazon, in fact their valuation is based

on the expectation that their investment in capex will continue to deliver explosive sales growth.

The drop in capex that would deliver higher net income would drive a revaluation of the growth

portion of Amazon’s value and drive a significant (de) revaluation of the stock price.

Profitability will ultimately matter but Amazon will be afforded expansive breathing room by

investors to fully exploit all the potential revenue streams. Amazon strategy has been executed

in two parts. First obtain scale in distribution and sales as the low cost leader while

differentiating yourself via a first class customer experience. Second, test consumer willingness

to pay for the experience provided and expand margin. A successful micro test case of this

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strategy was the increase in Prime membership from $79 to $99 which was received well by

consumers.

Amazon has earned its honor as the best CX provider and has the capability and vision to

leverage this underlying competency into new products and services that will drive above

average growth. Amazon is defining what a world-class CX is; Walmart is following.

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PRODUCT DIVERSIFICATION AND INTEGRATION

Amazon’s diversification of products (retail, media and web services) are well-positioned to

capture future market opportunities. Amazon will integrate their diverse products and generate

value for businesses and advertisers while continuing to provide a seamless user experience for

customers that will allow them to “own the home” as well as provide the backbone for the

Internet of Things (IoT) revolution.

Amazon and Walmart are frequently viewed as direct competitors, which is true in the retail

arena, but Amazon has leveraged its customer centric core competencies and become a major

player in very diverse markets. As Walmart develops its e-commerce platforms to compete with

Amazon in retail, Amazon continually looks for new emerging markets. This approach has

Amazon competing with the top technology companies in the world and they are well-positioned

to generate sales (and profit) in the upcoming decade.

Amazon has diversified into three primary areas: retail, media and web services. All areas are

positioned to be successful, but AWS is proving to be a profit machine. AWS provides

businesses with a suite of IT services such as networking and databases, cloud-computing and

advanced analytics. The on-demand, pay-as-you-go model has served as a launching ground for

numerous notable start-up companies such as Airbnb, Yelp and Spotify and has also expanded to

large companies such as Intuit, Nike and Johnson & Johnson. AWS now has over a million

active customers and is rapidly growing, posting $1.8 billion in revenue in Q2 2015, up 81%

from the prior year⁸. The next big opportunity for AWS is the shift toward the Internet of Things

(IoT).

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IoT revolves around connecting devices and leveraging data. Sensors are now imbedded in

millions of products such as cars, thermostats and multiple wearable devices. These devices

work effectively at gathering data, but each lacks the ability to store, aggregate and process the

information. The true value of IoT from both a consumer and business perspective is analyzing

and leveraging data. Cloud-based services such as AWS provide the back-end support for all of

these devices. Amazon recently launched an IoT platform that will store, analyze, and develop

machine learning based on the information sensors collect. As more devices become digitized

and connected, Amazon sits at the crossroads to capitalize on a growing market and growing

revenue stream.

Another revenue-generating opportunity for Amazon is to integrate its three diverse markets and

“own the home”. Amazon revolutionized the shopping experience with one-click purchases and

two-day free shipping through Prime. Amazon is now connecting this retail market with a web

service approach. Amazon recently launched Echo, which is a voice command device that

leverages cloud technology and controls smart devices. Echo can also order items directly from

Amazon through voice requests. Although not fully integrated with all smart devices, Amazon is

once again on the frontier of a new market. The final piece that allows Amazon to “own the

home” is media. Amazon offers Prime Video that allows users to stream thousands of movies

and television series. As discussed above, the 2014 acquisition of Twitch puts Amazon in a

position to capture the television and gaming market. The combination of these three markets

identifies a very near future (in such instances already occurring today) where Amazon will be

integrated through multiple channels of the home. Individuals will control lights and appliances

through voice activated systems. Television, internet and retail will converge. Individuals will

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stream content and when advertisements appear will be able to make purchases in real-time

through voice activated requests. These retail items will then appear on the doorstep within

hours or a single day. Amazon will touch customers through multiple outlets, countering

customer power and making switching costs even higher. “Owning the home” has the potential

to increase retail sales, expand cloud-based uses, generate advertising dollars through television,

and ultimately continue to drive Amazon’s growth and profitability over the next 10 years.

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Recommendation

We’ve made the financial and strategic case for a 10 year investment in Amazon. The last

question is how to express our view. We explored many options. Is there a total return swap

whereby we could lock in Walmart’s high current dividend and finance downside protection for

our Amazon long position? Amazon debt maturing in 2034 is trading 180 to UST for a yield of

4.49% which underperforms Walmart. Ultimately, being from Omaha, home of the oracle, since

we believe in the Amazon model and buy and hold is good enough for Warren Buffett our

recommendation is:

Long Amazon Equity.

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Endnotes

(1) AMZN mission statement – found in Investor Relations section – amazon.com

(2) WMT mission and values – WMT website.

(3) http://blog.twitch.tv/2014/02/twitch-community-4th-in-peak-us-internet-traffic/

(4) The wiki definition is “Customer experience (CX) is the product of an interaction between an

organization and a customer over the duration of their relationship. This interaction includes

a customer's attraction, awareness, discovery, cultivation, advocacy and purchase and use of

a service.[1] It is measured by the individual's experience during all points of contact against

the individual's expectations.” Wiki Definition

(5) http://www.foresee.com - The Foresee Experience Index (FXI) Top 100 Brands Edition

2013.

(6) As stated at studentofvalue.com/walmart

(7) SNL reference to Jimmy Fallon’s terrible IT tech guy character – if you got it I’m impressed!

(8) Amazon Q2 2015 Earnings Release

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Value Notes

• Investment on e-commerce and people in FY15 & FY16 pulls down EPS with recovery

in FY19

• Dividends increase in FY16, FY17 & FY18 at reduced rate primarily for marketing

purposes until recovering in FY19 when EPS has rebounded.

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The Physical versus Virtual Super Center

We acknowledge the example may be a stretch but the scale of selection is incredible.

Omaha Walmart Super

Center located on 168th

& Maple. The average

supercenter is 178,000

square feet and offers

150,000 SKU’s.

Assuming this is an

average super center

that is 1.19 square feet

per product.

Assuming the super

center offered the

5,000,000 SKUs offered

on Walmart.com the

same ratio would

require an expansion,

and likely upset the

neighbors.

At 1.19 products per

square foot Amazon’s

250,000,000 SKUs on

the US site would cover

nearly the entire city of

Omaha.