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  1. Amazon.com Valuation Exercise 15.402 Finance Theory II Prof. Kevin Rock 5/10/01

  2. Contributors

  3. Agenda • Background: 1999 Analysis • Market Analysis: 1999-present • Financial Analysis • Forward Looking

  4. Market Analysis Market Analysis Financial Analysis Financial Analysis Background Background Forward Looking Forward Looking Background: 1999 Analysis A brief overview of the “ Amazon.com Valuation Exercise” submitted by 15.434 on December 8, 1999 • 1999 Valuation • Historical Analysis • Holdings Profile • Valuation of Internet Companies

  5. Market Analysis Market Analysis Financial Analysis Financial Analysis Background Background Forward Looking Forward Looking 1999 Valuation • Key Assumptions • Growing market share to 24% of a market growing at 8% per year • Gross margins grow to 25% while marketing falls to 8% of Sales • Capex and Depreciation offset (not true in 1999) • Growth in free cash flows of 5% after 2010 • Weighted Average Cost of Capital • Comparables: Borders, Barnes & Noble and Wal-Mart • Amazon.com Beta = 1.47 • WACC = 17%

  6. Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Forward Looking Forward Looking Forward Looking 1999 Valuation (cont’d) • Results of the Analysis • Share Price = $18.20 per share (b = 1.47) • Range: $27.50 per share (b = 1) to $6.80 per share (b = 3) • Key Insights • Increased gross margins and shrinking marketing & selling expenses are key drivers of long-term value • Free Cash Flows projected to be positive starting in 2003

  7. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Historical Analysis Expansion of Price/Revenue Multiple

  8. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Historical Analysis (cont’d) • IPO date: May 15, 1997 • Price per share: $1.50 (adjusted for stock splits) • Invested in other Internet retailers • drugstore.com, gear.com, pets.com, etc. • Analyst forecasts are rosy • $17B sales of on-line merchants in 1999 • Web sales to consumers $108B in 2003 • Sales growth is 59% CAGR

  9. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Holdings Profile • Insiders held 60% of the stock • The remaining 74 million shares (float) traded • Janus funds = 22% of the float • Short interest = 22% of float • 56% of the float was actively traded • Average daily volume 12.9 million shares • Excluding Janus, and short shares, Amazon’s shareholder base turned over every 6 days! • A stock with huge interest and very small float led to large volatility and BIG price swings!

  10. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Valuation of Internet Companies • Usually estimated using comparables • P/E * estimated earnings • P/S • Breakup Value • Most stocks are overvalued • “Nifty Fifty” study • Value = current operating value + value of all future growth opportunities • 1999 Study of 20 internet companies concluded valuation implies a growth rate of 80%! • Indeed, high P/S ratios led to overvaluation

  11. Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Forward Looking Forward Looking Forward Looking Market Analysis

  12. Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Forward Looking Forward Looking Forward Looking Wall Street Sentiment JP Morgan: Initiates coverage of Amazon.com with a "BUY" rating and a 12-month price target of $160 Lehman: “..investors should stay away from the company's bonds because the extreme credit risk facing the company has not been properly taken into account.” Merrill: “We believe that [AMZN] will go down less and recover faster if a (first quarter) pullback occurs” GS: “We continue to believe that our four holiday favorites: ... Amazon.com Inc. (AMZN), ... will continue to be well-positioned to maintain or increase their leadership positions."

  13. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Wall Street Sentiment (cont’d) US Bancorp Piper Jaffray, 3/2001 Amazon: Our sister kissing Buy Rating reflects our extreme caution in a difficult economic environment, while still recognizing the company’s enormous long term potential Buy.com: We are discontinuing coverage of Buy.com. Our most recent rating was neutral and most recent suitability rating was speculative Barnes and Nobel.com: We are encouraged by B&N progress…we continue to believe BNBN has a viable business long term given the strength of its brand SG Cowen, 5/2001 Goldman Sachs, 4/2001

  14. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Comparables: Stock Performance Legend: AMZN: Amazon; BNBN: Barnes And Noble; BUYX: Buy.com; EFTD: FTD.com Source: http://finance.yahoo.com/

  15. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Comparables: Stock Profile Source: http://finance.yahoo.com/

  16. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Institutional Holdings 35,000,000 Institutional Holdings This Qtr 30,000,000 Last Qtr Large institutional shareholders have continued to accumulate shares, others are mostly flat to rising. 2 Qtrs Ago 25,000,000 3 Qtrs Ago 20,000,000 15,000,000 10,000,000 5,000,000 0 FMR CORP CITIGROUP INC TCW GROUP INC LEGG MASON INC JOHO CAPITAL LLC STATE STREET CORP JANUS CAPITAL CORP VANGUARD GROUP INC BRINSON PARTNERS INC/IL LINCOLN CAPITAL MANAGEMENT CO MUNDER CAPITAL MANAGEMENT /ADV MORGAN STANLEY DEAN WITTER & CO BARCLAYS GLOBAL INVESTORS NA /CA/ AMERINDO INVESTMENT ADVISORS INC OLD MUTUAL ASSET MANAGERS UK LTD STATE TREASURER STATE OF MICHIGAN TIAA CREF INVESTMENT MANAGEMENT LLC HELLMAN JORDAN MANAGEMENT CO INC /MA/ DRESDNER RCM GLOBAL INVESTORS LLC /CA... CALIFORNIA PUBLIC EMPLOYEES RETIREME..

  17. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Top Insiders and Institutions (as of March 31, 2001) Institutional Holdings (cont’d) 359.2 million shares outstanding 60% owned by insiders 40% owned by institutions *All share data in thousands

  18. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Insider Trading Director John Doerr Sells most of stock Bezos Bezos + Friends TransCosmos Bezos

  19. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking What the FY 2000 Numbers Show... Amazon Financials • Revenue growth slowing • From 298% (’98), 122% (’99), 30%(2000) • Expanding revenue base limits growth rate • Business conditions - Market maturity - General slowdown in consumer spending • $1.6B net loss • $500M equity losses (permanent and temporary) • $860M operating loss (before interest and other)

  20. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Comparables: Financials Amazon.com Financial Performance Rev Growth: 22% GM Growth: 26% OM Growth: -15% NI Growth: 24% Ratios P/E: NA P/S: 2.23 P/B: NA B&N.com Financial Performance Rev Growth: 38% GM Growth: 21% OM Growth: -164% NI Growth: -4% Ratios P/E: NA P/S: 0.96 P/B: 3.31 Buy.com Financial Performance Rev Growth:NA GM Growth:7% OM Growth: -17% NI Growth: NA Ratios P/E: NA P/S: 0.09 P/B: 0.78 FTD.com Financial Performance Rev Growth: 38% GM Growth:30% OM Growth: 7% NI Growth: NA Ratios P/E: NA P/S: 2.41 P/B: 23.23 Source: Bloomberg, Financial performance figures are expressed in percentage terms to compare the relative over last calendar year

  21. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Flawed Business Model? • Sales: $1.00 • COGS (0.76) Gross profit 0.24 • Marketing (0.22) • Technology & content (0.10) • SGA (0.04) • Amortization (0.12) • Impairment (0.18) • Net interest expense (0.04) • Unrealized gain/loss (0.05) • Loss per $1 revenue: ($0.51) (Based on FY 2000 Operating Results)

  22. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking 1999 Valuation Revisited • Good valuation but several incorrect assumptions • Massive capital expenditures (supply chain, warehousing, etc.) vs. forecast of equal CAPEX and depreciation • Operating expenses nearly 200% higher than forecast • Lower gross margins than forecast • Led to lower FCFs than forecast suggested • However, valuation said $18.20/share and the most recent closing price was $17.56/share. • So, if you bought the 1999 valuation…

  23. Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking 1999 Valuation Revisited (cont’d) Short the Stock or Buy a Put (Put Strike at $80, $10 Option Price)

  24. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking 1999 Valuation Revisited (cont’d) Other Strategies • 2:1 Reverse Hedge (Buy 2 Calls, Short 1 Share) • 1:2 Hedge (Long 1 Share, Buy 2 Puts) • Bottom Straddle (Buy 1 Put, Buy 1 Call) • Protect yourself against the upside • Why? The valuation showed massive overvaluation. Save the option costs and just short the stock!!!

  25. Market Analysis Financial Analysis Background Forward Looking Financial Analysis

  26. Market Analysis Financial Analysis Background Forward Looking Turnover Control • Accounts receivable turnover has been constant at approximately 1-3 days • Accounts payable turnover has averaged 60 days • Over 50% of COGS financed w/ accts payable • 1Q ‘01 - suppliers receive (request?) faster payments (45 days) • Inventory turnover has decreased due to Amazon’s move from “just in time” to “leveled” inventory • Reduced delays in filling customer orders • More products carried in stock

  27. Market Analysis Financial Analysis Background Forward Looking Operating Cycle • Leveled inventory and decreased days payable have adversely impacted the operating cycle

  28. Market Analysis Financial Analysis Background Forward Looking Profitability • Return on assets has been consistently negative • Amazon has lost approximately 12 cents for each dollar tied up in the business

  29. Market Analysis Financial Analysis Background Forward Looking Short-term Liquidity • Current and acid test ratios have declinedsignificantly, indicating potentialdifficulties in meeting current obligations

  30. Market Analysis Financial Analysis Background Forward Looking Long-term Solvency • Debt to assets ratio of greater than one is a concern for long-term solvency • Suggests that future capital needs will be funded through equity – are the markets open?

  31. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Assumptions: U.S. Books, Music, Video • Revenue: • Industry CAGR growth = 32% (from Jupiter) • AMZN market share declines from 47% in 2000 to 28% in 2005 • Gross Margin % constant at 2000 level of 24.6% • Operating expenses grow at two-thirds sales growth rate (historically consistent with AMZN operating expense growth)

  32. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking DCF Assumptions: U.S. Early Stage • Consumer Electronics and Home Products combined CAGR = 59% (Jupiter study ) • Assume AMZN growth matches industry CAGR • Gross margins: 21% (from CE retailer Best Buy) • Toysrus.com partner revenue growth = 27% (Jupiter projections for online Toys category) • Assume AMZN growth matches industry CAGR • Other ACN (partner revenue) = 88% of toysrus.com revenue • Operating expenses grow at two-thirds sales growth rate

  33. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Strategic Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Assumptions: International • Revenue growth by segment • United Kingdom – Books/Music/Video Industry CAGR 59% FY2001 declining to 20% FY2004-FY2006 (from Jupiter) • Germany – B/M/V Industry CAGR 54% FY2001 declining to 18% FY2004-FY2006 (from Jupiter) • France - B/M/V Industry CAGR 87% FY2001 declining to 31% FY2004-FY2006 (from Jupiter) • Japan - FY2000 AMZN sales grown by projected increase in Japan online spending • AMZN market share remains at 35% of total international market

  34. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Assumptions: International (cont’d) • Gross Margin constant at 21% (conservative and lower than U.S. B/M/V) • International operating expense growth modeled after U.S. expense growth (e.g. 2003 Int’l op. exp. % = 1999 U.S. op. exp. %)

  35. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Other Assumptions • Net WC grows at 61% of sales growth rate based on historical Net WC growth. • Tax rate = 0% through 2004 due to NOLs; 40% after 2004 • Capital expenditures in 2001 fall to 35% of 2000 CapEx level (due to current warehouse overcapacity); after 2001 growth in single digits. CapEx is calculated assuming: • Net PP&E decreases by 10% per year • Depreciation constant at 2000 level • Terminal value: cash flows grow at 5% after 2005

  36. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking DCF Model Assumptions

  37. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Projected Cash Flows

  38. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking WACC - Determination of Beta Average unlevered Beta = 0.92 Average levered Beta = 1.24

  39. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Amazon’s WACC Cost of debt before tax = 15.9% Tax rate = 40% Beta = 2.55 = Amazon’s current beta Beta = 1.25 = Average beta of the comparables, levered for Amazon Beta = 1.47 = beta in December 1999

  40. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Valuation using DCF

  41. Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Market Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Financial Analysis Background Background Background Background Background Background Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Forward Looking Valuation using Price/Sales Average Price/sales excluding min and max= 1.7  Value per share is = $13.29 The difference with DCF proves that the market is still very optimistic about Amazon

  42. Market Analysis Market Analysis Financial Analysis Financial Analysis Background Background Forward Looking Forward Looking Forward Looking

  43. Market Analysis Financial Analysis Background Forward Looking Future: Makings of a Winner • The Space • E-tailing • Brokerages • On-line Auctions • The Losers • Insufficient demand • Higher costs • Negative profits • The Winners • First mover advantage • Superior customer service • Strong name brand

  44. Market Analysis Financial Analysis Background Forward Looking E-tailing: Profit Reigns Supreme • The Story: • “Virtual” stores face reality that retailing involves real goods and real costs • Many face the reality of negative profits • The Casualties: • Kozmo (.com) Inc. – liquidation was delivered to its’ door • NY State of Mind: model only works in dense urban areas • New orders = more hires to deliver more goods = higher costs • Pets.com – only the singing puppet remains • Not a natural e-tailing market: Is it convenient to wait days to get dog food that sells down the street? $82.5 million said “yes” in the 1998 IPO • Negative gross margin in every quarter of operation said “no” • Webvan – needs to order some cash flow from the bread aisle • Cash flows indicate a fast transition from start-up to liquidation • From Dec99 to Dec00 (millions): • CFO: (59) to (263), CFI: (641) to 247.5, CFF: 746 to (4.3)

  45. Market Analysis Financial Analysis Background Forward Looking E-tailing: Winning mix • Natural e-tailing market and product • Commodities (Flowers, DVD’s, not luxury goods) that customers can wait a few days to receive. Remember shipping charges (No Dog Food)! • Operational efficiency: ROA isn’t virtual • Leverage assets across business lines and channels • Exceptional user interface and customer service • Just because its online doesn’t make it convenient • Generate repeat customers through a great experience, not fancy web sites. • A brand that pays off: • If you’re losing money on every sale, you can’t make it up in volume • Forget the Super bowl ads • Current examples:Lands’ End, Staples, FTD

  46. Market Analysis Financial Analysis Background Forward Looking Online Brokerages • The Story: Trading at the speed of the net • Increased competition from traditional brokerage houses • Revenue growth through increased trading volume from existing customers and new customers is difficult to achieve in current market • Major players: • E-Trade • Current competitive advantage: leading brand name, proprietary technology • Growth opportunity: expanded products and service offerings—on-line and off-line brokerage and banking services, access to IPO • Datek Online and Ameritrade • Current competitive advantage: low cost trading, relatively well-known name, advanced technology • Challenges: Hard to grow business in low volume market condition, maybe targets for acquisition

  47. Market Analysis Financial Analysis Background Forward Looking Online Auction • The story: • Competitive advantage: Internet is the largest auction site • More and more people and business are going on line • Auction house collecting fees, but do not carry inventory or ship products • Auction sites attract even more business in a slow economy • The winning player: • E-Bay • First-mover advantage: world’s largest and most popular person-to-person online trading community—has customer loyalty • Low cost and scalable business model • Established infrastructure

  48. Market Analysis Financial Analysis Background Forward Looking ISPs • Definition: company that provides access to the internet. In addition to serving individuals, they also serve companies, providing a direct connection from the company’s networks to the internet. • Winners: AOL, Earthlink • Losers: Free internet access providers, small players • Large subscriber base permits economies of scale that allow ISPs to increase e-commerce revenues and improve margins • High marketing & customer acquisition costs • High churn rates increase volatility in revenues • Broadband driving growth rates • Alliances with cable companies and computer manufacturers drive growth

  49. Market Analysis Financial Analysis Background Forward Looking Portal: One-stop Shop • What is a portal: • Offers broad array of resources and services • Successful portals: • Useful services - partnerships, free e-mails, search engine • Large consumer base • Ability to generate advertising revenue • Example: Yahoo - first pure content web site to generate profit • Failed portals: • Not enough useful service • Not enough customer base • Example: Go.com, Sloanspace

  50. Market Analysis Financial Analysis Background Forward Looking Other Net Models • Drkoop.com’s downfall • Failed alliances with partners (AOL, Go.com, etc.) • Unable to build brand • Acquisitions did not provide positive net return