Dear Stock Market…

Dear Stock Market,

I need you to pull your head out of your ass.

You are paying record valuations.

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But in the face of the identical earnings deterioration we saw heading into the financial crisis.

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The growth you are pricing in simply cannot be realized.  Real incomes are the same level they were in 1990.

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But the real S&P price level is 3x higher today.

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What’s that?  Population growth is the key to earnings growth you say, because we know credit and welfare are beyond sustainable levels at all time record highs?  The problem with that is population growth is at 100 year lows.

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And so if Income, Population, Credit and Welfare have flatlined for the foreseeable future (which is clearly showing up in the collapsing current earnings growth rates) from whence is the record growth being priced into the market going to be realized?  Robots or Refugees?

Signed,

Dead Money.

Which is the Better Buy – Amazon or Walmart?

In January I began teaching Applied Financial Modeling at Marquette University.  Part of the curriculum was to discuss real time real world markets.  As such, we began each class with a review and discussion of market pro perspectives and discussed viewpoints from various financial media outlets.  I pressed the importance of collaboration, drawing ideas and concepts from others but to ensure the viewpoints and arguments we use to draw our own conclusions are balanced.  While the bullish case is the predominant case as it is the paid objective of mainstream economists and bank strategists, Zerohedge is a great balancer of mainstream perspective.

And so I introduced the students to Zerohedge as part of the curriculum.  At the beginning of the course I reached out to Zerohedge with an idea.  I had planned that the final exam would take the form of a take home project whereby each student would be tasked with some analytical problem.  My proposal to Zerohedge was to publish the best final report.  Zerohedge responded with an immediate “Absolutely”.

Now a little context of the course.  Typically this is a heavy text book laden DCF curriculum.  However, from my time in banking I found that college grads seriously lacked the ability to think critically and to problem solve, or in other words lacked an ability to analyze.  And so I didn’t use a textbook and this brought great apprehension to most of my students who have grown up through an educational system that is laser focused on scoring well on standardized testing as a means to secure school funding.  These students have been trained to disregard the concept of learning in lieu of scoring well on a test.  Memorization and regurgitation is what they know.

The first half of the semester was spent learning the basic concepts of growth, risk, time value and cash flows.  I drafted all lecture notes and distributed to the class.  The second half of the semester I stopped drafting notes and because there was no textbook this forced the students to focus on what was being discussed.  The second half of the course was spent applying the concepts of analysis to real world data.  In effect, the concept of applied financial modeling is not DCF or any other specific formulaic model but the application of data in a useful and meaningful way toward some objective.  This requires a deep understanding of the inter-relatedness of all stimuli within the context of risk, growth and cash flow.

While my students had some fairly grave concerns about the class structure they came around and in the end I believe (by way of their evaluations of the course) to really appreciate having developed the skill of analysis, critical thinking and problem solving rather than just plugging and chugging in some preformed DCF models.

The winning final report was done by Leo Martinic, a junior and not surprisingly Leo is a member of the AIM program, a student run investment group led by Business Faculty, David Krause.  This group manages about $2M of the school’s endowment fund.    The assignment was one question: Which is the better buy – Amazon or Walmart?  Below is the analysis presented by Leo Martinic.

FINA 4360                                                                                                                 Leo Martinic

Final Paper

Overview

Amazon.com, Inc. (AMZN) and Wal-Mart Store, Inc. (WMT) is the classic example of old versus new school. Both firms sell just about everything imaginable, but how they go about making those sales is completely different. Amazon offers retail products solely online along with a myriad of technological services such as movie streaming. Amazon prides itself on getting a customer’s product to them as fast as possible and offers “Amazon Prime”, the firm’s two-day shipping service for an annual fee of $99. Walmart is the typical “brick-and-mortar” retail store, featured in almost every small town to large city in the U.S., along with a presence internationally. Walmart does offer an online segment, but does not have the internet pedigree Amazon possesses. Walmart just came out with their own two-day shipping service to combat Amazon, called “ShippingPass” for an annual fee of $49. As Amazon has plowed massive amounts of capital back into the business to generate growth, Walmart has continued to open stores while adopting a consolidation approach by creating “Supercenters”, resulting in increased total square footage. With these drastically different strategies for retail in the 21st century, only one question remains: As an investor, is Amazon or Walmart the better buy?

A Look into Amazon

Amazon’s revenues have soared since its inception, generating YoY growth of 20.2%, 19.5%, and 21.9% for 2015, 2014, and 2013. Estimates for 2016 are even better, sitting at 24.7%. This staggering revenue growth is due to CEO Jeff Bezo’s dedication to massive capital expenditures and a current no dividend policy, averaging about $4.7 billion spent on capital expenditures per year over the past three fiscal years. The capital expenditures have increased operating margins 943% in 2015 and 761% over the LTM. Although the huge plowback of cash into the business has generated corresponding growth, it does not come without potential risk. It is no guarantee that the large capital expenditures heading into the future will yield Amazon’s historical growth rate. The ever-present risk with such large capital expenditures is the fact that if it does not pay off by generating top line results or cost efficiencies, then it is effectively flushing money down the drain that could have otherwise been paid back to investors. This is something Amazon and investors need to consider.

The organic growth is great, but operating expenses have grown 27.1%, 33.5%, and 35.8% for 2015, 2014, and 2013 along with similar, but not as severe, increases in COGS. The brunt of these hikes in cost are due to the increasing cost of shipping. In fact, the firm has been losing money on the shipping aspect of “Amazon Prime”. In 2015, Amazon charged $6.5 billion for shipping and ended up spending $11.5 billion, resulting in a shortfall of $5 billion. The shipping cost issue needs addressing if margins are going to improve. An issue with Amazon’s huge growth is that it has only yielded break-even bottom line results. It seems as if investors are infatuated with the staggering growth, but are not worried about current profit generation given Amazon is trading at a current P/E of 295.93 and the firm’s P/E has reached as high as 537 over the past year.

Management has continually stated their current focus is on free cash flow, which they expect to generate a significant bottom line result when the growth phase scales back. The belief is that the massive capital expenditures will have set a foundation for revenues to continue their climb while the focus shifts toward cost efficiency. The promise of cash flow finally came to fruition in 2015, as Amazon generated $7.33 billion in free cash flow yielding a 276% increase over the prior year. Analysts believe this is the turning point for Amazon and expect these staggering numbers to continue, starting with the top line and filtering to the bottom line.

One worrisome fact with Amazon is that total debt has also increased at a similar rate as just about every one of the firm’s glowing statistics, increasing at a 58.6% CAGR over the past five years. With Amazon we have massive revenue growth, high debt and expenses, slim to no margins (other than gross margin!), and no true profit (as of yet). As I was sifting through Amazon’s SEC filings, I found an 8-K worth noting from February. Amazon’s board of directors authorized a $5 billion share buyback plan, which I believe indicates that management is weary about earnings growth and will resort to considerable buybacks to inflate the stock price heading into the future. The buyback could be a signal that the growth story is nearing its end and this authorization could be a back-pocket option to hold up the stock price along with distributing cash with which the firm cannot find another productive use. The counter argument is that if substantial negative interest rates permeate over to the U.S., then Amazon would rather hold their own stock than lose money by sitting on idle cash.

A Look into Walmart

Walmart is a completely different story. Walmart’s revenue growth has slowly deteriorated from 11.8% in 2007 to -0.7% in 2016. This deterioration is signalling the world is moving away from the “brick-and-mortar” provided by Walmart and more towards the currently preferable online shopping. And perhaps more alarming the growth deterioration may be signalling that consumption could actually be in decline.. With the decrease in revenue growth, Walmart has seen its operating income, pretax income, and net income decrease 12.6%, 14.2%, and 10.2% respectively from 2015 to 2016. This is the first time Walmart has seen such a pullback in their historically superb results. Walmart’s workforce also received a substantial wage hike of around $1.5 billion, which is bound to increase notably in the future.

Walmart’s P/E sits at 14.71, not far off from its five-year average of 14.83. It is obvious that Amazon and its online-only platform has eaten into Walmart’s grip on the retail sector. With the fall in performance, Walmart continues to pay a 2.95% dividend yield amounting to a $6.3 billion payout for 2016. The firm only carries $8.7 billion in cash on its balance sheet, so as cash flows begin to descend Walmart’s ability to fund a high dividend payout will be questionable at best. Cash dividend coverage has decreased from 6.39 in 1999 to 2.33 today, including an alarming 10.3% drop from 2015 to 2016 alone. Walmart will continue to run into trouble generating the cash necessary to pay their high dividend and soon enough the firm will have to borrow in order to continue to satisfy shareholders.

With no growth, Walmart will have to adjust in order to combat Amazon for the crown of the retail sector. Walmart is the perfect case of how investors are looking for immediate gratification, whether through stock price appreciation or through dividends. Such a strategy ignores the fact that Walmart is being forced to cannibalize itself from the inside out by trading future growth to satisfy investor hunger today. In addition, Walmart has slowly bought back shares since the turn of the century. In 2000, Walmart had 4.4 billion shares outstanding in contrast to the 3.1 billion outstanding today. The firm has decreased its outstanding shares about 1-4% every year, while repurchasing 7.1% in 2011 alone. I view this as management’s attempt to artificially prop up the stock price along with maintaining ratios as results have plateaued and begin their inauspicious descent. It also takes significant cash to maintain these repurchases again a form of economic cannibalization..

Up to this point I seem to be forecasting a disastrous spiral into irrelevance for Walmart, but let me be clear that the firm is not going away any time soon. Walmart has about 4.8x the annual revenue of Amazon and the firm’s accessibility around the world is unmatched. Also of similar importance, Walmart is a good risk averse investment for those who depend on large dividends from blue chip companies as annual income. However it is my opinion that these very things that make Walmart a risk averse asset in the short term could spell trouble further out; decreasing cash flows, waning profitability, breached competitive advantage, a high dividend payout to appease shareholders, and the continuous eating of shares to prop up the stock price all portray Walmart’s imminent cash problem for the future.

Conclusion

Overall, I think the better buy is Amazon, but not for the reasons you might think. Personally, I do not believe Amazon’s future lies with their online retail, but rather the firm’s AWS (Amazon Web Services) subsidiary. With strong growth prospects for their AWS segment, my DCF came to a price target of $924.34 per share for Amazon. Amazon is an incredible growth story with endless potential in a world where people demand to get products quickly without any real effort, but the firm’s core online retail business has not made money.

The business idea is terrific, but in order for Amazon to make money they need to raise the annual “Amazon Prime” fee well above $99. The issue is that price increases will steer customers away, so Amazon needs to make a choice. Should they continue their low priced “Amazon Prime” to increase their customer base and revenues while making no profit? Or should they increase prices, which will drive away some customers but will result in profit generation?  The question is whether Bezos can slash costs, most notably shipping costs, while maintaining a high quality and expedited shipping process.

As of now, that seems more like a pipe dream than a reality.  However, this past week, Amazon entered into a partnership with Atlas Air in order to add twenty Boeing airplanes to its operations, so it is not for a lack of trying. Amazon’s core business reminds me of the tech bubble of 1999-2000. Amazon’s P/E of 295.93 is nothing short of crazy and already prices in projected best case success for the firm. The reality is that Amazon has been operating for 22 years and their core business still cannot generate a profit. The core business’ inability to generate a profit will catch up with the firm and its stock price unless they adapt. The laws of finance can be bent, but they will not break. Fortunately for Amazon I believe the fundamental growth prospects from high investment has and will continue to produce ground breaking innovation resulting in realized growth.

If Amazon is going to generate a substantial profit, it will be realized through their promising AWS subsidiary. This may sound contradictory, as I said Amazon reminds me of the tech bubble, but here I am championing their “tech” segment.

Techcrunch  Source: Techcrunch

However, the situation is quite different. Amazon’s AWS segment has posted increasing profits and is well ahead of the competition in the cloud computing industry. From Amazon’s website, “Amazon Web Services (AWS) is a secure cloud services platform, offering compute power, database storage, content delivery and other functionality to help businesses scale and grow”. The segment is posting a bigger operating income than Amazon’s core business.

Seekingalpha

Source: Seekingalpha.com

AWS accounts for about 8% of the firm’s revenue but over half of their profitability in the first quarter of 2016. Businesses are buying into AWS faster than any other cloud-computing firm in the industry. Netflix delivers its streaming capabilities through AWS; Healthcare.gov runs partly through the service, and music giant Spotify is built on the service as well, just to name a few. Amazon even engineered a custom cloud for the CIA and other intelligence agencies in order to share information. It is apparent that AWS has quietly become a vastly important service.

MKM

Source: MKM Partners

In this table we see that Amazon’s AWS is witnessing the best of both worlds that it cannot quite find within its core business, which is tremendous growth in revenues along with profit generation. The operating margin is in line with the industry while swiftly increasing market share at an unmatched pace. Overall, I believe AWS is the future for Amazon. All businesses need cloud computing to operate in the 21st century. Businesses contemplating making the switch seem to flock to AWS in droves. Deutsche Bank recently stated that if AWS were a standalone business, it could easily be valued at around $160 billion.

Walmart had its success in the past, but the decrease in revenues and overall financial performance in 2016 foreshadow what will be a slow descent from atop the retail pedestal. My DCF resulted in a price target of $65.03 for Walmart. With tremendous growth and profitability in AWS, Amazon essentially buys itself time to figure out how to iron out their core online retail business to generate profitability. If Amazon does continue its burst onto the retail scene and finally improve margins, Walmart will have to adjust its strategies or cash flows will erode while the firm continues to spend huge amounts of cash on dividends and share buybacks, effectively leading the firm into self-cannibalism. So if I had $700 sitting around, I would much rather have one share of Amazon than ten shares of Walmart.

References

http://www.businessinsider.com/aws-estimated-to-be-worth-160-billion-2015-11

http://www.businessinsider.com/amazon-aws-growth-rate-is-far-outpacing-other-enterprise-vendors-2015-12

http://www.theatlantic.com/technology/archive/2014/07/the-details-about-the-cias-deal-with-amazon/374632/

http://www.theatlantic.com/technology/archive/2015/04/the-unbelievable-power-of-amazon-web-services/391281/

http://www.infoworld.com/article/2609809/cloud-computing/why-amazon-web-services-rules-the-cloud.html

http://finance.yahoo.com/news/wal-mart-sharpens-amazon-attack-134701833.html

https://aws.amazon.com/what-is-aws/

 

Red Cross Pension Chasing Yield into Minefields

I happened to be going through the Red Cross audited financials this morning (this is not typical morning reading for me but I’m doing some due diligence on another matter).  Under the Notes to Financials I came across the organization’s pension assets breakdown and what I found was a bit shocking. Screen Shot 2016-05-25 at 7.20.52 AM More than half of the organization’s pension assets are level 3 assets.  For those not up to speed on the level 3 assets here is the definition from Wikinvest.

“Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include certain private equity investments, certain residential and commercial mortgage related assets (including loans, securities and derivatives), and long-dated or complex derivatives including certain foreign stock exchanges, foreign options and long dated options on gas and power). Level 3 assets trade infrequently, as a result there are not many reliable market prices for them. Valuations of these assets are typically based on management assumptions or expectations.”

Now I’m not an expert in ERISA regulations but I was surprised to see this allocation mix for the Red Cross pension assets.  My (limited) understanding is there are fairly strict guidelines and limitations on what portion of overall assets can be allocated to high risk investments; level 3 assets representing the highest risk on the risk continuum. However, as a portfolio manager one is under pressure to generate sufficient yield to sustain cash outflows (obligations) of the pension.   While historically PM’s could achieve 7% returns with quality corporate paper and Treasuries, today that is simply a pipe dream.  Currently the US 10 yr is at all time lows and has continued to decline since 2007, now yielding around 1.8%.  As interest rates declined from 2007 we can see the allocation shift from safe to risky assets by the Red Cross pension. Screen Shot 2016-05-25 at 8.21.24 AM Between 2007 and 2008 the Red Cross pension went from 14% of assets allocated to level 3 assets (nonmarketable & MBS) up to 28%.  By June 2009 they had lost 25% of total assets, which meant they had 75% of the assets to generate the same obligations but with interest moving to 0%.  The end result is the chase for yield with 53% of assets today being allocated to level 3 assets.  Why?  Because the obligations of the pension are essentially fixed but the returns are floating with Fed policy deteriorating risk adjusted returns.  And so it’s not really a matter of choice but a mathematical necessity for the PM’s managing the pension to look toward riskier assets for that same 7% return. And so we see how the Fed policies are directly responsible for ballooning the systemic risk in the financial and socioeconomic landscape.  Not just pensions but actual individual retirees are facing the very same dilemma.  That is, the cost to live is not something most have much control over.  And so because retirees had baked in a 5% to 7% return on their nest egg they must achieve that annual return.  This means for those lucky enough to still have a nest egg after the last two bubble crashes they are forced to venture further out onto the risk continuum.  Risk adjusted returns have deteriorated into negative territory in Europe (it’s the only way an investor would accept a loss going into an investment i.e. negative rates) and we are very close to that here in the US. But there must be some upside to the ZIRP policies to offset the almost unmanageable amount of resultant risk, right?  I mean these policies are meant to help the average American not hurt them, correct?? Screen Shot 2016-05-25 at 8.55.57 AM The above chart actually shows a decline in weekly earnings of the American worker. The next chart, however, shows just where the policies’ upside landed. Screen Shot 2015-11-06 at 8.46.47 AM Banks benefited most with 400% growth in income, followed by nonfinancial corporations with 280% growth in income but again with no benefit to the American working class incomes. So while risk to the entire system has ballooned by way of forcing pensioners (and all savers) to chase yield into the darkness as a result of the Fed’s policies over the past 8 years there has been absolutely no benefit to the American worker.  However, banks and corporations have reaped significant rewards.  And so I ask the PhD economists who have so gregariously supported the performance of the Fed for the past 8 years to explain just how these policies have helped the American people?  And Zandi, stating you don’t believe the data is not an argument suitable to a PhD.