FNCE 4P03 - Final Report

Chris Tringham - 3650140 Matt Urbanski - 3573854 Maria Ivanova - 3686011 Ryan Sheriff - 4165593

Cash Flow Analysis In 2009 Amazon reported large increases in cash flows from operations. YOY percentage growth increased from 20% in 2008 to 94% in 2009. Free Cash Flows, calculated using CFO minus CFI figures, also increased dramatically from $498M to $956M in 2009, a 94% improvement. Conversion to a direct cash flow statement gives insight into how this happened. Comparison of YOY cash collections show that Amazon has increased its collections from customers over the last three years. Of these collections, the primary factor has been an increase in Unearned Revenues. The large increase in cash flow is also augmented by the trend in YOY Cash Payments to Suppliers. The company has decreased its payment ratio the past three years, reflecting a controlling of supplier payments. The payment of income taxes also decreased in 2009 as deferred tax payments rose to $81M. The total effect of these working capital management decisions is an increase in cash flows of $793 Million, accounting for 52% of the total change. Competitor Comparison For comparison purposes we selected eBay and Barnes & Noble as a benchmark for Amazon's performance. In 2009 49% of Amazon sales were generated by media, which primarily consists books and music. As the largest retailer of books, Barnes & Noble, is the best candidate for comparison for this part of Amazon's revenue. Amazon generates all of its revenues from online sales, making eBay a good proxy for Internet spending comparison. The common size income statement provides some valuable insight into the differences between these companies. Amazon's cost structure is much closer to Barnes & Noble than eBay, considering the high COGS portion. eBay eliminates these costs because it facilitates the transfer rather than delivering the actual products. We can also notice that Amazon's lack of retail stores allows it to undercut Barnes & Noble on price, while at the same time maintaining a higher net income margin. We computed the compound annual growth rates (CAGR) for these three firms, given the importance growth plays in valuation. Both Amazon and eBay have achieved EPS CAGR during the last 5 years of almost 25%, while Barnes & Noble has shown a

modest growth of about 2%. The decline in profitability at Barnes & Noble has been triggered by cheaper online alternatives, less overall demand for books, and increased costs to maintain its physical retail stores. Amazon's P/E ratio as of December 31,2009 was 66, compared with eBay and Barnes & Noble who have P/E ratios of 13. Incorporating the growth rates shows that Amazon's PEG ratio is 2.66, while eBay's is only 0.54. This large gap suggests that Amazon is overvalued and eBay is undervalued. We believe that the high PEG ratio reflects the market's expectation that margin expansion will accelerate in the future. Ratio Analysis Amazon's operating cycle has remained steady at roughly 46 days since 2006, however its cash cycle has increased from -14 days to -32 days. Clearly, Amazon has begun to exert increased pressure on it's suppliers to extend the time allowed for payment. The Altman Z-score we calculated for Amazon was 1.81 is surprisingly low. given their minimal long-term debt figures. We suspect that Amazon's relatively large total assets skew these ratios lower than their competitors. More than 50% of total assets are cash and short-term investments, which suggests that this score is not the best measurement of risk of bankruptcy in this situation. When comparing Amazon to their competitors, the largest discrepancy occurs with the ratio of Retained Earnings/Total Assets. As previously stated, Amazon has a very large total asset value, furthermore they have relatively small values for retained earnings (116 million for 2009, and negative values for preceding years). This information leads to a T2 value which is less than 1% (0.0084), compared to T2 values of 0.6357 and 0.33 for eBay and Barnes & Noble respectively. This dramatically low T2 value has greatly reduced the overall Z-score, and yields a result that is borderline with bankruptcy prediction. Non-recurring Items

Amazon generates nearly 50% of its sales from international sources, which suggests that a large portion of its profit is exposed to currency fluctuations. Amazon does not engage in any hedging strategy and its earnings are adjusted accordingly. In 2009 Amazon acquired online shoe retailer Zappos for approximately $1.2 Billion in shares. This was a large investment that boosted revenue immediately, but diluted EPS. In response, Amazon has approved a $2 Billion share repurchase plan for 2010 to mitigate the issuance of the 10 Million shares used in the acquisition. Adjustments Amazon, eBay and Barnes & Noble only use FIFO. However, we found that Wal-Mart used LIFO and reported no change in LIFO reserve during 2009. This low inflation environment meant that no adjustment needed to be made to Amazon's COGS to consider the effects of using a LIFO method. Amazon does not offer financing to its customers, therefore bad debt expense is a minor feature that arises primarily from deposits they make with suppliers. Industry Outlook Our outlook for the internet retail industry is positive. In 2009, the S&P Internet Retail Index outperformed by a large margin, increasing 161% compared to a 24% advance in the S&P 1500. Although fragmented between a number of large and midcap companies, the industry as a whole has growth potential. From a macroeconomic viewpoint, consumer discretionary spending will continue to be a primary factor. Standard & Poor’s notes that American personal spending decreased 0.6% in 2009, but is projecting growth of 2.2% in 2010. Wage growth is expected to remain flat throughout 2010 but is expected to increase modestly thereafter as unemployment rates ease. From an industry perspective, we think online retailers offer a strong combination of convenience, selection, information and value compared to brick and mortar retailers. Currently, only 6% of total US retail sales were e-commerce transactions, however Standard & Poor's anticipate this figure increasing to 10% by 2013, totalling $229 billion.

Du-Pont Analysis Amazon's ROE has significantly decreased since 2005 from the highest of 145.93% to 17.16% in 2009. The company's profit margins are stable since 2005, ranging between 5% and 4%. The decline can be explained by the significant drop in the leverage of the firm(Assets/Equity) from 15.02 in 2005 to 2.63 in 2009. Their equity compared to assets increased significantly in recent years, leading to a lower Equity Multiplier. eBay's ROE is following a quite different trend. It has been steadily increasing for the past 5 years from lowest at 10.77% in 2005 to highest of 17.33% in 2009. From the decomposition of the ROE, we can clearly see the reasons for the opposite movement of ROE compared to Amazon. Although eBay's tax burden and interest burden increase, and their margins have slightly decreased since 2005, the asset turnover and the equity multiplier have both improved over time. Barnes and Noble's ROE follows a similar path as the one for eBay, by slightly increasing for the past 5 years. The situation in Barnes and Noble is similar to that in eBay with respect to their increased Asset turnover and Leverage, which are the main determinants of the increasing trend of ROE. Although, their tax burden increased slightly, it was counteracted by a similar decrease in the interest burden. Barnes and Noble kept their margins relatively stable during the years, ranging from highest of 5% to the recent lowest of 3%. Sales Forecast Amazon has a very seasonal operating cycle with a huge fourth quarter to reflect the holiday shopping season. We ran a regression on a quarterly basis to account for this trend. The regression was then extended into 2010 for a sales forecast:Q1 sales of $6.28B, Q2 sales of $6.14B, Q3 sales of $6.46B, and Q4 sales of $8.8B. Amazon's guidance for Q1 was $6.4B-$6.7B, showing that our forecast was relatively close to managements expectations. Target Price

Calculating a target price for Amazon based on past performance is a difficult task given the immense future growth that is expected. Using an average P/E ratio for their competitors results in a target price of $26.70, which clearly doesn't reflect their future profitability. The discounted cash flow based on the sustainable growth model results in a more viable target price of $198.83. The huge disparity between these figures shows the difficulty associated with a rapidly growing young company which has doubled EPS during the past 2 years. We used SGR as the growth rate. We believe that the most important contributor to determining Amazon's value in the future is their ability to grow profit margins. Revenue growth will begin to decline and they will become dependent on generating economies of scale by optimizing distribution and inventory control. Based on CAPM the cost of equity for Amazon is 18.4%; with an historical Beta of 1.7 and a market return of 11%. However Amazon's ROE and CAGR of EPS are greater than 20%. Therefore, in the discounted dividend growth model we would have a negative discount factor. The problem is determining an appropriate longterm terminal growth rate given the lack of historical comparisons with a similar business model. Recommendation Amazon's current valuation reflects an expectation of dramatic EPS growth and the potential for a large dividend, given the abundant free cash flow generation. However, we are concerned that Amazon has not exhibited regular increases in margins. Expansion of operating margins will be very important in sustaining 20%+ earnings growth as revenue growth tapers off. Our forecast for 2010 is revenue of $27.7 Billion. The trailing net margin trend suggests that net margin will be 4%, which results in income attributable to shareholders of $1.1 Billion or $2.46 per share. This is a forward P/E ratio of 58, and seems very high for a company likely to only grow EPS by 20% YOY. We therefore rate this stock a SELL. A better value would be a PEG ratio of 2, which would result in a target price of $98.40, 33% lower than the current $145 price.

Amazon's net margins are comparable with Wal-mart, yet the internet is supposed to lead to huge costs advantages. In order to justify their current valuation Amazon would need to double margins at the very least, we believe this is highly unlikely.

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