REAL VISION INVESTMENT CASE STUDY - Case Study Competition 2016 - The Economist
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REAL VISION INVESTMENT CASE STUDY Case Study Competition 2016 Walmart vs Amazon: Which stock would you choose to invest in if you couldn’t sell it for a decade, and why? ABSTRACT: This report presents our findings regarding the choice between Walmart and Amazon in terms of the investment into a stock held for a decade. We computed two alternative scenarios: projected dividend stream and projected stock price. In the first case, we found that Walmart is likely to distribute more dividends than Amazon. In the second case, we found Amazon to experience greater price appreciation over the same period. To establish comparability, we developed synthetic competitors for Walmart and Amazon. This enabled and apples-to-apples comparison across product categories. After combining the two scenarios, we found that investment in Walmart is likely to yield 12% more return/dollar than an equivalent investment in Amazon. Participants: Li, Hao; Tian, Muhan; Ligorio, Andre Castle Point on Hudson, Hoboken, New Jersey 07030 www.stevens.edu
TABLE OF CONTENTS Contents Introduction ______________________________________________________________________________________________ 1 Companies background __________________________________________________________________________________ 3 Future forecast____________________________________________________________________________________________ 7 Conclusion ______________________________________________________________________________________________ 15 Appendix 1 - Assumptions _____________________________________________________________________________ 17 Appendix 2 - Tables ____________________________________________________________________________________ 17 Contact Information ___________________________________________________ Error! Bookmark not defined. Company Information _________________________________________________ Error! Bookmark not defined.
INTRODUCTION Introduction This study investigates the relative returns from long-term investment into Walmart and Amazon. The question about comparability is difficult for two primary reasons. First, the product categories of both the companies are significantly different. Second, while the stock price of Walmart is influenced by its income stream and (and the associated dividends), the stock price of Amazon has been largely shaped by its revenues (as well as the rapid growth in revenues). We addressed these challenges by relying on three distinct approaches. They include the development of synthetic competitors and identifying the performance of each firm relative to this competitor across all major product categories, projecting the income stream of the two companies into the future, and forecasting the market price of the stock. Our findings show that compared to their synthetic competitor, Amazon is expected to perform significantly better than Walmart in terms of the revenues, Walmart is projected to perform relatively better in terms of the profitability. We also found that historically, the price of Walmart and Amazon’s stock has been closely associated with their revenues. Thus, due to its accelerated revenues the historical trends suggest that Amazon will experience significantly higher appreciation in price relative to Walmart. However, when we take into account the projected income (and therefore dividend) stream, even after excluding the aberrations in Amazon’s income, we find that Walmart stock is likely to generate significantly larger revenues. Integrating the price appreciation and dividend streams, we find that an investment in Page 1
INTRODUCTION Walmart is likely to yield 37% return while the investment in Amazon is likely to yield 25% return. The comparison suggests that Walmart stock will lead to 12% more return on investment than Amazon. Page 2
COMPANY BACKGROUND Company background WALMART Walmart Stores, Inc. (Walmart) is an American multinational retail corporation that operates a chain of discount department stores and warehouse stores. Headquartered in Bentonville, Arkansas, United States, it was founded in 1962 by Sam Walton and incorporated in 1969. It employs 2.2 million staff in 28 countries over 11,000 stores, and 1.4 million of the employees are in America. The company was first quoted on the New York Stock Exchange in 1972 and rose from a regional to a national giant. It is also one of the world’s most valuable companies by market value, [1] and is also the largest grocery retailer in the U.S. In view of the excellent performance in the past forty years, Walmart not only focuses on retail business, but also wholesale and international business. Now Walmart has three main parts of their business, Walmart U. S., Walmart International and Sam’s Club. However, in recent years, the revenue of Walmart decreased with the rise of e-commerce, such as Amazon, EBay and Best Buy. The e-commerce stole the revenue from Walmart and Walmart decided to develop its own e-commerce to provide customers online retailing for Walmart, Sam’s Club, ASDA and all other international brands. It is a tendency to shop online which brings lower prices and more convenience, and obviously, Walmart knows that, so in the past few years they spent an enormous amount of money to build and improve their online shop. The following figure illustrates Walmart’s revenues across all the major product categories. We have alos listed all of their leading competitors in each category: Page 3
COMPANY BACKGROUND AMAZON Amazon.com, Inc. is an American electronic commerce and cloud computing company with headquarters in Seattle, Washington. It is the largest Internet-based retailer in the United States. It started as an online bookstore, later providing cloud infrastructure services and becoming the world’s largest provider. Now Amazon sells almost everything with separate retail websites in 17 countries and offers international shipping to many other countries for some of its products. The company also produces consumer electronics – notably, Amazon Kindle e-book reader, Fire tablets, Fire TV and Fire Phone. In 2015, Amazon surpassed Walmart as the most valuable retailer in the United States by market capitalization. We have to admit that Amazon rose miraculously in the past 5 years. It switched from selling books to selling a wider range of commodities which marked its aggressive transition from a book seller to an ecommerce retailer. However, with the continuing increase in revenue, the net income of Amazon remains stable and low, an unusual result which means the company’s profitability has remained low in the years since it was built. The reason is that the CEO Jeff Bezos’s view is clear: keep investing, because to take profit out of the business would be to waste opportunity. The following figure illustrates Amazon’s revenues across all the major product categories. We have also listed all of their leading competitors in each category: Page 4
COMPANY BACKGROUND Page 5
COMPANY BACKGROUND Page 6
FUTURE FORECAST Future forecast METHODOLOGY As the product category-wise distributions indicate, there are significant differences between Walmart and Amazon in terms of the source of their revenues. These differences suggest that the market outlook of Walmart is likely to be different than the outlook for Amazon. The two firms are not completely comparable. This requires some way to establish and apples-to-apples comparison whereby the performance of Walmart is compared to a synthetic competitor with similar revenue streams (i.e. product categories) and the performance of Amazon to its own synthetic competitor. The relative distance of each firm from its synthetic competitor can help establish the extent to which they are exceeding or falling behind the benchmark performance. The following section elaborates the competitive landscapes and the development of the synthetic competitor. COMPETITIVE LANDSCAPE To develop a firm that is completely identical in terms of its sources of revenues, we averaged the performance of the top three competitors for Walmart and Amazon shown earlier. Once the average performance was established for each category, we created a weighted average of the competition based on the proportion of revenues from each category. The resulting performance represents a benchmark for Walmart (across its five major categories) and Amazon (across its ten major categories). Thus, the performance of the synethetic competitor identifies how good each firm is performing relative to their industry benchmark. While we Page 7
FUTURE FORECAST
have measured several performance variables, to keep the analysis simple we focus on revenues
and income in the subsequent sections.
The following table provides the comparison of Walmart and Amazon with their synthetic
competitor (identified as ‘benchmark’) for the year 2015.
Walmart
Ratio Synthetic Walmart
Revenue $90,598.56 $486,651.00
Net Income $2,558.00 $16,363.00
Assets $48,302.47 $203,706.00
ROA 4.35% 8.01%
ROE 12.96% 20.76%
Profit Margin 3.47% 3.36%
Cash Conversion
4.78 12.14
Cycle
Inventory turnover 14.09 8.11
Asset Turnover 2.37 2.38
Amazon
Ratio Synthetic Amazon
Revenue $ 128,121.88 $ 88,988.00
Net Income $ 11,647.35 $ (241.00)
Assets $ 94,596.81 $ 54,505.00
ROA 2.67% -0.51%
ROE 24.83% -2.35%
Profit Margin 6.01% -0.27%
Cash Conversion Cycle 38.32 (24.90)
Inventory turnover 16.61 7.99
Asset Turnover 1.59 1.88
These tables illustrate that Walmart has a superior performance to its industry benchmark and
its synthetic competitor indicates the company's superiority in most of the performance
Page 8FUTURE FORECAST measures, however, Amazon’s comparison with its industry benchmark indicates that the company's revenues and particularly the net income is significantly inferior. EVOLUTION OF COMPETITIVE LANDSCAPE Next, we projected the expected future behavior of each firm (Walmart and Amazon) as well as of their synthetic competitors. In the case of the firm, we relied on their historical performance to forecast the future performance. This is consistent with the idea of ‘path dependency’ which suggests that firms are constrained by their historical choices and their future actions will be not too different from their history. However, historical projections are unlikely to be realistic for the industry benchmark. This is because the synthetic competitor represents several firms that are quite distinct in their historical performances and aggregation is likely to increase the potential of errors. We therefore used a third-party. We obtained the industry forecasts (at the product category level) from IBISWORLD, a market research company. To build the forecast for Walmart and Amazon from the historical data, we projected their revenue and income trends for 10 years into the future based on the data from the 10 years. We limited the historical basis to the last 10 years to ensure we only take into account the performance considerations associated with the recent choices of each of the firms. We used a linear forecasting model which showed an R-sq of 0.97 and 0.91 for Walmart and Amazon, respectively. Although we found the R-sq to be somewhat higher in the case of the polynomial model, we used the linear model for simplicity. Page 9
FUTURE FORECAST Page 10
FUTURE FORECAST The figures shows that Walmart is currently performing at a revenue of 5.36 times its benchmark competitor and with a net income that is 6.41 times. By 2025, the forecast suggests that Walmart's revenue will be 6.4 times with a net income that would be 7.12 times the synthetic competitor. However, this scenario is quite different for Amazon. The company's Page 11
FUTURE FORECAST revenue in 2015 is 70% of its synthetic competitor and the net income is $2.4 millions negative in contrast to $11.6 billion for the synthetic competitor. By 2025, the forecast for Amazon's revenue suggests a value that is 2.6 times the synthetic competitor but with a net income that is expected to be 13% to the industry benchmark. The apples-to-apples comparison suggests that Walmart is a significantly better choice than Amazon in terms of the performance outcomes by 2025. PROJECTED INCOME STREAM Next, we compared the projected returns from investments. We treat these returns to be a reflection of the dividends distributed by each of the firm, and for simplicity, assume that both Walmart and Amazon will distribute 100% of their future profits. Building on our forecasts for the net incomes over the next 10 years, we divided them with the number of shares outstanding and to identify the expected divided per share. This value was discounted by the current interest rate (approximated at 3%). The result shows that a single share is likely to experience a gross dividend yield of $32.65 for Walmart and $16.9 from Amazon. Taking into account the prices of their stocks, we forecast the gains to be 41.51% and 3.55%, respectively. PROJECTED STOCK PRICE While stock prices are closely associated with investors’ expectations of revenues, we checked and found that historical correlation between net income and stock price has been 0.82 for Page 12
FUTURE FORECAST Walmart and -0.5 for Amazon. In contrast, the historical correlation between the revenues and stock prices have been 0.9 for Walmart and 0.99 for Amazon (based on Pearson correlation). This suggests that projected revenues may be a useful reference to predict the changes in the stock prices for each firm into the future. Page 13
FUTURE FORECAST Extrapolating the projected revenue with the historical correlation to identify future stock prices shows that the price of a Walmart stock is likely to be $94.01 and for Amazon it will be $799.60. This suggests an appreciation of almost 22% relative to the price of Walmart’s stock ($73.36 – average for 2015) and an appreciation of 62% for Amazon compared to its current stock price ($476.93 – average for 2015). This shows that continuing with investors’ optimism, Amazon is likely to yield greater returns for investors keen to sell their stock in 10 years. Page 14
CONCLUSION Conclusion We conclude that: Which of the two companies is the market mispricing and why? Our analysis suggests that the Amazon is highly mispriced. In particular, Amazon’s prices are reflective of its revenues rather than its income. Furthermore, investment in Amazon will be profitable in terms of the appreciation in prices rather than the fundamental deliverables expected from the company. What changes must Walmart make in order to effectively compete in the internet age? Although Based on our product category analysis, we find that Walmart has to focus more on retaining its market postion across all categories and persisting with its income to revenue ratio. We don’t believe simply copying Amazon’s online model will be an attractive market proposition for Walmart, because they don’t appear to have a positive effect on the fundamentals. Will Amazon be able to convert ubiquity into profitability? Given its current market position, we do not believe Amazon has a demonstrable plan to profit. Page 15
CONCLUSION Does profitability matter? Why? As we show, it does to some extent. However, both profitability and price appreciation should be kept in perspective. How would you structure your investment into your chosen company? The 130 - 30 strategy is remarkably popular among mutual funds and hedge funds. We plan to short sell the stocks of the synthetic competitor of Walmart, up to 30% of our portfolio value, whilst buy and hold the Walmart stock with 130 percent of our fund. Based on our previous analysis and calculation, Walmart in the future decade is expected to outperform its synthetic competitor, which is a accordingly designed pool of rival companies. All the pooled companies weigh their revenue share. So we structure our short portfolio by the weight of each company of Walmart’s synthetic competitor. By structuring our investment with the 130 - 30 strategy, we expect to generate an impressive return from Walmart stock, and to seek for potential opportunity of arbitraging the fail of the synthetic company. Page 16
APPENDIX 1 - ASSUMPTIONS
Appendix 1 - Assumptions
1. The market will face no major economic shock in the future decade and the investment
environment will stay healthy.
2. The management structure and business of both Walmart and Amazon will remain
steady. We also assume that Walmart and Amazon will retain their current category
structure for the next decade.
3. The synthetic competitor represents the average performance of the top 3 companies
within the industry. We assume that these competitors will either remain on the top or
will be replaced by firms that have a comparable performance. The top 3 companies of
the industry are determined based on the revenues. The weight of each constituent
company is based on its revenue weight which has been adjusted by the weight of the
product categories.
4. The industry growth rate are based on the forecasts from IBISWorld.
5. The current and forecasted stock prices are all year-end closing prices.
6. The future market reaction (or stock price) will remain tightly correlated with
companies’ revenue.
7. The number of shares outstanding will remain constant, i.d., no stock split or repurchase
will happen in the future.
8. All net incomes in the future will be paid out as dividends.
Page 17APPENDIX 1 - ASSUMPTIONS
9. The current discount rate (estimated at 3%) is used to discount all future prices to the
current value.
Page 18APPENDIX 2 – TABLES
Appendix 2 – Tables
IBISWorld data: Industry trends
SUPERMARKETS & GROCERY STORES
Growth
Year Revenue $ million %
2016 591,338.80 0.7
2017 598,161.40 1.2
2018 602,566.90 0.7
2019 607,071.90 0.7
2020 612,568.90 0.9
2021 618,017.30 0.9
PHARMACIES & DRUG STORES
Growth
Year Revenue $ million %
2016 271,488.80 3.2
2017 277,518.00 2.2
2018 284,342.60 2.5
2019 294,150.20 3.4
2020 303,748.00 3.3
2021 313,033.80 3.1
HOME IMPROVEMENT STORES
Growth
Year Revenue $ million %
2016 168,889.30 4.7
2017 178,875.90 5.9
2018 187,703.80 4.9
2019 198,056.30 5.5
2020 210,576.70 6.3
2021 220,561.20 4.7
Page 19APPENDIX 2 – TABLES
DEPARTMENT STORES
Growth
Year Revenue $ million %
2016 156,875.70 -4.4
2017 152,479.60 -2.8
2018 149,066.20 -2.2
2019 145,579.30 -2.3
2020 143,492.90 -1.4
2021 140,617.80 -2
CONSUMER ELECTRONICS STORES
Growth
Year Revenue $ million %
2016 80,195.10 0.6
2017 80,810.20 0.8
2018 81,621.90 1
2019 82,574.50 1.2
2020 82,963.20 0.5
2021 83,640.20 0.8
WAREHOUSE CLUBS & SUPERCENTERS
Growth
Year Revenue $ million %
2016 470923.9 4.8
2017 482602.8 2.5
2018 492303.2 2
2019 499441.6 1.5
2020 506933.2 1.5
2021 512509.4 1.1
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