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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