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Amazon vs. Walmart:

A Tale of Two Disrupters

EconoMIIS Team:

Hesham AlSaati

Thomas Gilmore

Michael Mahoney

Middlebury Institute of International Studies at Monterey

November 9, 2015

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Table of Contents

Introduction – 3

Which Stock is Mispriced and Why? – 4

What changes must Walmart make to compete in the internet age? – 10

Will Amazon be able to turn ubiquity into profitability – 12

Does profitability matter – 13

Conclusion – 15

Appendices – 16

Bibliography - 22

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INTRODUCTION

1a. Walmart vs Amazon: Which stock would you choose to invest in if you couldn’t sell it

for a decade, and why?

The comparison of Amazon and Walmart is a tale of two disrupters, each having rocked

the world of retail in their own way: while Walmart disrupted the “Mom & Pop” paradigm and

brought affordable chain retail to the countryside, Amazon bucked the “Mom & Pop” bookshop

and took away the cost of shipping.

Amazon is an innovator; it excites us with its ideas and ambitions. Walmart is our trusty

standby, impressing us with its sheer magnitude and economy. Amazon excites us with its

spectacular growth in the US and abroad. Our weekday evenings are spent watching Amazon

Prime movies, and our recycling bins are often littered with Amazon Prime shipping boxes.

And yet we find Walmart to be the more attractive investment option. Looking at

fundamentals, market sentiment, and viable predictions for the changes in technology and the

world over the next ten years, Walmart stood out as the clear winner and we would thus choose

to hang onto Walmart stock for ten years if given the choice.

Over the next several pages, we’ll show you why.

1b. 2025: Looking to the future

To begin to predict the companies’ futures, we had to first take a look at the future of the

world in 2025. And what we saw in our crystal ball: drones.

We looked at four emerging technologies with the strongest potential to impact the retail

sphere – self-driving cars, 3D printing, robotics and drones. Self-driving cars will become

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commonplace on our streets with the potential to disrupt current logistical supply chains. Ever

cheaper 3D printing systems will make the creation of items simpler on both small and large

scales. Robotics will increasingly integrate into the background of businesses across the board.

Last but not least, drones will represent a faster way to transport products bypassing crowded

thoroughfares. Robotics plays a significant role for both companies by effectively increasing

output and efficiency - by pushing out more products per minute and bringing down staff costs.

Having investigated all of these technologies, we find that due to strong interest and meaningful

impact on fulfillment capabilities, drones will be the one new technology to have a major impact

on e-commerce in the next 10 years. Based on current technology with a drone flight radius of

10-miles, drones will prove to be more beneficial to Walmart than Amazon, given that 90% of

US population is located near a Walmart store 1. As drones are rolled out into a fulfillment role,

Walmart can use its current retail locations as hybrid retail space fulfillment centers, maximizing

their service coverage.

2. Which stock is mispriced, and why?

Based on a thorough fundamental valuation for both Amazon and Walmart financials,

along with the market’s current and future trends, we find that both stocks are mispriced in

different ways, for different, compelling reasons.

Our fundamental valuation2 and analysis for both firms clearly assess the value of their

assets and revenues, unclouded by the extraneous influences and breadth of opinions on the

value of Amazon’s stocks. Our analysis for both companies took into account capitalization of

R&D (of the utmost importance to Amazon, which invests so heavily in its R&D) and operating

1 Leeb, Stephen. Wal-Mart Fattens Up On Poor America With 25% Of U.S. Grocery Sales. Forbes. 20 May 2013 2 Damodaran, Aswath. Fundamental Valuation Model.

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leases, and valuation of executive stock options. Of note, we capitalized operating leases and

R&D; a current debt ratio of 3.9% raising to 7.5% in the stable growth period (in line with the

current industry standard); a risk premium for equity of 5.5%; a beta value of 1.5 for the high

growth period and 1.2 for the stable growth period, which we find reasonable given Amazon’s

higher volatility on the market. Lastly, we performed a real options analysis for both companies

to incorporate drone delivery systems into their operations using the Black Scholes model.

Potential growth for each company took into account the current state of drone technology, the

cost of drones, and the companies’ unique positioning and ability to capitalize on this new

opportunity. Amazon would be able to squeeze out their large third-party logistics cost, while

Walmart will be able to fulfill same-day delivery and grocery etc.

2a. Amazon

We have tested Amazon on various models. First, a high-growth model assuming that

they are a startup firm 3. Although the high-growth model yielded a positive share price, we feel

that it does not realistically reflect the intrinsic value of Amazon’s stock as the model bases

future value largely on the assumption that the current stock price is correct. Given our

fundamental analysis we find the disparity not realistic. We were curious to find out how

investment analysts Gurufocus reached such a pessimistic value on Amazon’s stock 4. When we

remove capitalization for R&D from our model, we reach that same number of $10. Another

consideration for Amazon stock is that many investors currently view it as a momentum stock.5

As succinctly put by Aswath Damodaran, "Once stocks become a momentum play, intrinsic

3 High-growth model is unfounded for Amazon (this model only makes sense when dealing with a start-up). 4 Gurufocus Amazon stock Analysis. (Valued at $10). 8 Nov 2015 5 3 Reasons Why Amazon (AMZN) is a Great Momentum Stock. Zacks. 16 Sept 2015.

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value goes out the window," and with a loss of intrinsic value the market ceases to be an efficient

means of valuing the stock. With all in mind, we found the fundamental stock price for Amazon

(including capitalized R&D and operating leases) to be $185.63 - approximately 71% less than

its current stock price of $659 (as of 11/8/15).

Figure 1: Amazon Market price vs. current FCFF value and FCFF value plus Drone

Real Option.

To account for future technological changes in the retail industry over the next decade,

we took the further step to add a real option (using the Black Scholes model) for drone delivery

technology which both Amazon and Walmart have expressed interest in 6 7, and calculated a

present value for the drones’ estimated future value to the company. Adding this real option

6 Layne, Nathan. Walmart Seeks to Test Drones for Home Delivery, Pickup. Reuters. 27 Oct. 2015. 7 Wattles, Jackie. Jeff Bezos: Amazon Drones Will Be ‘As Common as Seeing the Mail Truck’.

CNN Money. 16 Aug 2015.

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value to Amazon’s fundamental stock price, we see the value per share increase by $37, to

$222.63. Although a proportionately large jump, this is still a gap of $436.37 between this rate

and the current stock price of $659.

2b. Walmart

On the other hand, we have Walmart. As a company more mature in its growth cycle, we

used the following considerations in the fundamentals valuation: we capitalized operating leases

(significant to a company with as strong a property footprint as Walmart) and R&D; a current

debt ratio of 18.9% 8; a risk premium rate of 5.5% 9; a beta value of 1 10.

With these figures considered, we find the fundamental stock price to be $81.94 -

approximately 39% more than the current stock price of $58.80 (as of 11/6/15). Adding in the

real option for drones, the total stock price jumps up to $91.94.

8 Walmart’s current ratio and near the industry average for a mature retail company 9 A survey of academic economists gives an average range of 5-5.5% for a 30-year horizon. CFO’s estimate the

premium to be 3.8% over T-bonds. 10 Beta on par with market (reasonable given Walmart’s historic stable growth)

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Figure 2: Walmart Market price vs. current FCFF value and FCFF value plus Drone

Real Option.

And how do we explain Amazon’s breathtaking overvaluation, vis-a-vis Walmart’s

notable undervaluation? For both companies, we see a combination of external forces and strong

investor sentiment at play.

For Amazon, the key market driver for their stock price is investor sentiment. According

to Baker and Wurgler (2007), Amazon is particularly ripe for investor sentiment: “In particular,

stocks of low capitalization, younger, unprofitable, high-volatility, non-dividend paying, growth

companies or stocks of firms in financial distress are likely to be disproportionately sensitive to

broad waves of investor sentiment” 11. Visionary CEO Jeff Bezos has long been credited for

creating incredible excitement for his ideas, stating “If you decide that you’re going to do only

11 Baker, Malcolm and Jeffrey Wurgler. Investor Sentiment in the Stock Market. Journal of Economic Perspectives.

Spring 2007.

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the things that are going to work, then you are going to leave a lot of opportunity on the table.”

This underlying excitement, along with the fact that the company outperformed analysts’

expectations in the first three quarters of 2015 (despite hiccups with the failure of the Amazon

Fire Phone, for example), can be seen as a key driver driving up demand and price for their

stock.

However, the company is, in fact, older and further along the corporate growth trajectory

than a typical start-up. So although these qualities may be expected of a young start-up

company, it could be problematic to apply these qualities as signs of strength in a company of

Amazon’s age.

For Walmart, we see a combination of external forces keeping the price low. Ongoing

external challenges, including a slump in sales due to increased retail competition, and external

forces such as the stock market shock in China (which accounts for $2 billion of Walmart

revenues and a large proportion of their supplies) helped precipitate a decline in company’s

revenues throughout the year. The company’s stock was at an historical high of $90 per share in

January 2015. Yet more recently, in mid-October an announcement that the company would

raise its minimum wage to $10/hour for some 600,000 employees caused their stock to drop an

additional 10%, reaching a low it hadn’t seen since 1988 12. These setbacks have caused the

stock to drop well below its proper value, but have also had the impact of having Walmart jump

into action, expanding on their online commerce and uncharacteristically taking bigger risks on

new innovations – actions which, we believe, will situate it for future growth. As such, we find

the Walmart stock – which we firmly believe to be valued below its fundamental worth – to be

the more appealing investment option.

12 Layne, Nathan and Sruthi Ramakrishnan. Walmart Warns on Profit, Stock has Steepest Decline in 25 Years.

Reuters. 14 Oct 2015.

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I. What changes must Walmart make to compete in the internet age?

In order to compete more effectively in the internet age, Walmart needs to be proactive

rather than reactive in their e-commerce offerings, finding ways to meet the bar set by the

competition and also innovate in ways to give them an edge in the increasingly competitive

landscape.

Walmart’s global presence still position it as a leader, yet the company needs to be

increasingly wary of the noted decline of customer traffic in traditional brick-and-mortar retail

spaces and the increase of online shopping traffic. A forward-looking Forbes article proclaimed

how a “hyper-connected world” has influenced consumer behaviors and expectations, forcing

retailers to adapt to those changes or become obsolete 13. Walmart specifically has been accused

of being a laggard, trailing behind the competition in its innovation and technology 14. By

looking at recent acquisitions of Walmart Labs and an annual budget of $1.5-$2 billion on R&D,

the company has evidently acknowledged the importance of this industry shift towards online

retail and has begun laying the groundwork to grow in this new space. In recent years, the

company added Kevin Systrom (Founder of Instagram) and Marissa Mayer (CEO, Yahoo!) onto

the board of directors, with Mr. Systrom in particular charged with leading “the company’s

overall vision and strategy” 15. Walmart’s omnipresence serves different demographics, more

potential from a global middle class expanding to the east 16, and a current base serving a vast

populous of unbanked consumers (excluded from the growth of e-commerce). We have seen

13 Thau, Barbara. A Look at the Retail Model of the Future. Forbes. 10 Feb. 2015. 14 Nash, Kim. Walmart to Pour $2 Billion into E-Commerce Over Next Two Years. Wall Street Journal Blog. 14

Oct. 2015. 15 Walmart website. (“Board of Directors”) 16 Kharas, Homi and Geoffrey Gertz. The New Global Middle Class: A Cross-Over from West to East. Wolfensohn

Center for Development at Brookings.

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trends from both companies providing financial intermediary services 17, an additional growth

opportunity for Walmart given their widespread physical presence. By creating seamless

integration between their online and brick-and-mortar offerings, improving services such as one

day shipping, turning into subscription-based revenue sources such as consistent online grocery

sales, it is safe to note that Walmart can capitalize for growth in omni-directions.

The company is also making attempts to add value to their customers’ online shopping

experiences, releasing innovations including online grocery shopping and “Shipping Pass”, an

online ordering model which allows members to join for $50/year and enjoy free three-day

shipping (reminiscent of Amazon Prime).

As Amazon has raised the bar for online deliveries, promising speedy, free two-day

shipping to its Prime members, Walmart will clearly have to meet consumers’ rising expectations

of its online retailers and, at the very least, provide shipping options as good as the competition,

if they are to compete in this space.

Particularly as the Millennial generation gains more buying power and the Baby Boomers

age, we find it likely that both populations will increasingly move towards the online shopping

space and social media integration 18 .

In a similar vein, we believe the store can meet its emerging market customers in the

technological space they inhabit, and put special emphasis on building a strong, user-friendly

mobile ordering platform. In China, for example, the smartphone penetration rate is currently

43% and set to grow - so ensuring that their Chinese customers have a seamless mobile ordering

offering now could help their business grow alongside this important trend.

17 Carter, Dougherty. Keep Wal-Mart Out of Some Financial Services, Bankers Ask. 7 May 2013. 18 Carr, Austin. Why Facebook, Twitter and Pinterest Have Embraced the Buy Button. Fast Company. Sept. 2015.

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The results of these recent efforts remain to be seen. But so long as the company remains

open minded to internet growth and continues to invest in its new Silicon Valley innovation arm,

we believe they stand a good chance of succeeding in this realm.

II. Will Amazon be able to turn ubiquity into profitability?

Per their vision statement, Amazon “seeks to be Earth’s most customer-centric company

for four primary customer sets: consumers, sellers, enterprises, and content creators” 19.

Although such grand promises of growth and increased ubiquity are great for stoking corporate

growth and investor sentiment, we find it unlikely that the company will be able to turn ubiquity

into profitability within ten years.

Although the company has shown remarkable growth in recent years, continuing to direct

funds into its R&D (figure 3, Appendix) and becoming more and more omnipresent, looking

behind the curtain shows us that the true results of the company’s ventures have been mixed.

Although certain projects, such as Cloud services, have grown, several of their technology

ventures, such as the Fire Phone, were considered failures20, while other projects such as the

Amazon Register and the Daily Deal were quietly closed in recent months21. Amazon’s attempts

to make Kindle a household name is offset by their lack of transparency regarding sales figures.

Most compellingly, although Prime membership grew by 53% in 201422, we find that the

company has been losing billions of dollars on the shipping fees associated with the program23.

19 Amazon website 20 CIaccia, Chris. Why Amazon’s Fire Phone Turned Out to Be Such a Disaster. The Street. 27 Aug. 2015. 21 Del Rey, Jason. Amazon Kills Two Businesses: Local Daily Deals and its Square Competitor. Recode. 30 Oct.

2015. 22 Soper, Taylor. Amazon Prime Memberships Grow 53% in 2014, Despite $20 Price Hike. Geekwire. 29 Jan.

2015. 23 Mangalindan, JP. Inside Amazon Prime. Fortune. 3 Feb. 2015.

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Furthermore, as we have discussed earlier, we estimate a huge amount of the current

stock price is based on investor sentiment. If the company tampers with its R&D spending,

directing funds back to other areas in order to boost profits, they risk tampering with this

sentiment - leading to a potentially precipitous drop in the stock price.

As the competitive landscape of online marketing broadens domestically, it will be harder

for Amazon to cash in on their growing ubiquity. As established retail competitors such as

Walmart and Target take bold steps to overhaul their online presence, they are predicted to bite

into Amazon’s current online dominance. Amazon will face similar competitive issues

internationally as well, particularly in China and India where Alibaba and FlipKart have the

lion’s share of online retail market, respectively2425.

Technology could hold the key for profitability for Amazon. The introduction of robotics

to their fulfillment centers would allow them to streamline the distribution process, and thus

reclaim a portion of the $2 billion per year spent on fulfillment center salaries. As well,

advancement into shipping - with drones, for example - could help the company recoup some of

its staggering losses on its shipping fees. However, given the current state of drone technologies

- which have a maximum carrying capacity of 5 pounds of cargo - and the hesitation of the FAA

to approve such technology for commercial use, we predict it will not be able to make a

significant impact within ten years.

III. Does profitability matter?

In a word: yes.

24 Burkitt, Laurie. Wal-Mart Says It Will Go Slow in China. The Wall Street Journal. 29 Apr 2015. 25 AFP. India's multi-billion dollar e-commerce battle between Amazon, Flipkart and Snapdeal heats up. India

Times. 5 Aug 2015.

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Conventional business wisdom states that profitability is necessary for a company’s long-

term viability - it provides necessary funds for the company to use for R&D, growth, or

dividends to shareholders, allowing it to expand sustainably over time. Businesses which do not

prove to be profitable prove to be unsustainable in the long run.26

Amazon has, of course, flouted this convention by continuing to grow while remaining

unprofitable for years after its inception. However, as their business performance has beaten

expectations, they have been able to continue along their growth trajectory with the support of

their investors and a strong stock price.

However, ubiquity has its limits, particularly in a regulatory sense. Although some have

predicted that Amazon will turn its uniquity into profits by, essentially, taking over the market

and raising prices to more profitable levels, such a manoeuvre would undoubtedly put it at risk

for clashing with anti-trust laws27.

As well, additional wisdom tells us that investors are willing to invest in businesses so

long as they believe they will eventually gain a profitable return on their investment. Or, in the

words of one McKinsey study, “Investors reward R&D spending only if companies are expected

to create value from it.”28 This wisdom, in hand with Jeff Bezos’ recent guarantee that his

company would turn profitable after the 2015 holiday season29, leads us to believe that the time

may soon come for Amazon’s investors to demand monetary value from their investment -

hinting that profitability may soon matter to Amazon after all.

26 What is More Important for a Business, Profitability or Growth? Investopedia. 27 Damodaran, Aswath. If You Build It (Revenues), They (Profits) Will Come: Amazon’s Field of Dreams! Musings

on Markets. 29 Oct. 2014. 28McKinsey & Co. Do Fundamentals Really Drive the Stock Market? 29 Soper, Spencer. Amazon CEO Jeff Bezos Promises Wall Street a Profit. Bloomberg LP. 22 Oct 2015.

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IV. CONCLUSION: How would you structure your investment in your chosen company?

We see the 10-year mandate as looking long-term in scope, and we would thus keep our

stock with Walmart for (at least) the ten-year period. Based on our fundamentals analysis, we

believe that the stock is currently undervalued - and this, along with the promising steps Walmart

is taking to reinvigorate its e-commerce, as well as its broad scale - lead us to believe that the

stock price will rebound in time and lead to sustainable profits for the investor in ten years.

We further feel confident in this selection when we consider potential risk for both

companies in the future, specifically when we look at the potential threat of cybersecurity.

While Walmart could certainly be damaged by a breach in security (a la Target), a breach in

cybersecurity for Amazon could be truly staggering: with a business model built entirely online,

such reputational damage could be irrecoverable for the company.

Walmart is an economy, it grows like an economy, it is stable because it is large, and the

market will ultimately reflect its true value.

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APPENDICES

Figure #: Growth rate and projected EBIT for Amazon and Walmart over the 10 year period.

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Figure 3: Amazon.com acquisitions since inception by category

Figure 4: Projected costs for implementation of drone logistics.

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Figure 5: Projected added value of drone option to Amazon over 10 year period.

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Size of the Middle Class, Regions

(millions of people and global share)

From:Homi Kharas and Geoffrey Gertz - The New Global Middle Class: A Cross-Over from West to East -

Wolfensohn Center for Development at Brookings

Figure 6: Projected added value of drone option to Walmart over 10 year period.

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Amazon FCFF

Amazon Valuation

Walmart FCFF

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Walmart Valuation

Model

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Bibliography

AFP. India's Multi-Billion Dollar E-commerce Battle Between Amazon, Flipkart and Snapdeal

Heats Up. India Times. 5 Aug 2015.

Amazon website. www.amazon.com.

Baker, Malcolm and Jeffrey Wurgler. Investor Sentiment in the Stock Market. Journal of

Economic Perspectives. Spring 2007. (pp 129–151)

Burkitt, Laurie. Wal-Mart Says It Will Go Slow in China. The Wall Street Journal. 29 Apr 2015.

Carter, Dougherty. Keep Wal-Mart Out of Some Financial Services, Bankers Ask. 7 May 2013.

Ciaccia, Chris. Why Amazon’s Fire Phone Turned Out to Be Such a Disaster. The Street.

27 Aug. 2015.

Damodaran, Aswath. If You Build It (Revenues), They (Profits) Will Come: Amazon’s Field of

Dreams! Musings on Markets. 29 Oct. 2014.

Damodaran, Aswath. Fundamental Valuation Model.

Del Rey, Jason. Amazon Kills Two Businesses: Local Daily Deals and its Square

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Competitor. Recode. 30 Oct. 2015.

Gurufocus Amazon stock Analysis. (Valued at $10). 8 Nov 2015

Investopedia. What is More Important for a Business, Profitability or Growth?

Kharas, Homi and Geoffrey Gertz. The New Global Middle Class: A Cross-Over from West to

East. Wolfensohn Center for Development at Brookings

Layne, Nathan. Walmart Seeks to Test Drones for Home Delivery, Pickup. Reuters.

27 Oct. 2015.

Layne, Nathan and Sruthi Ramakrishnan. Walmart Warns on Profit, Stock has Steepest Decline

in 25 Years. Reuters. 14 Oct 2015.

Leeb, Stephen. Wal-Mart Fattens Up On Poor America With 25% Of U.S. Grocery Sales.

Forbes.

20 May 2013.

Mangalindan, JP. Inside Amazon Prime. Fortune. 3 Feb. 2015.

McKinsey & Co. Do Fundamentals Really Drive the Stock Market?

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Soper, Spencer. Amazon CEO Jeff Bezos Promises Wall Street a Profit. Bloomberg LP. 22 Oct.

2015.

Soper, Taylor. Amazon Prime Memberships Grow 53% in 2014, Despite $20 Price

Hike. Geekwire. 29 Jan. 2015.

Thau, Barbara. A Look at the Retail Model of the Future. Forbes. 10 Feb. 2015.

Walmart website. (“Board of Directors”)

Wattles, Jackie. Jeff Bezos: Amazon Drones Will Be ‘As Common as Seeing the Mail Truck’.

CNN Money. 16 Aug 2015.

3 Reasons Why Amazon (AMZN) is a Great Momentum Stock. Zacks. 16 Sept. 2015.