WHEN Ocado came to the market in July 2010, to some (its investors) it was a great opportunity to buy into a growth online market with a unique business model and amazing technology. The company had been going for ten years and was just about to break through the tipping point, which would lead profits and returns to rise exponentially, augmented by the building of a second warehouse in the Midlands and justifying an even higher valuation. However, to some commentators – myself included – it was best summed up by the jokey phrase “Ocado begins with an O, ends with an O and is worth O”. We simply could not see how Ocado could ever generate a proper return on capital.
We felt then – and still do – that the economics of home delivery of food just don’t stack up. Gross margins are low and costs are high, with the cost of the last ten yards being particularly painful.
The fact that only Tesco has ever made money online in food (and this with its much greater scale and a larger customer base) and that some operators such as M&S and Morrison are not even trading online, tells its own story. However, the bulls won the argument and the shares successfully floated at 180p, albeit at lower levels than had been earlier anticipated.
A year on and the shares languish at 118p, so what has changed? What has changed is that there have been significant downgrades to every line in the profit and loss statement – most damagingly to long-term forecasts – and major changes to debt projections. Yesterday’s third quarter sales announcement brought even more downgrades and this to a year that only has just over two months to run.
To be fair, the company believes that once its capacity constraints unwind and its new £210m warehouse opens, its economics will be transformed. We too expect the economics to change, but for the worse. We expect customer orders to underperform expectations and that the fall in average basket size will accelerate, as Ocado delivers to more and more customers outside the M25.
If we are right, then the shares have much further to fall. Why? Because of the double whammy effect that lower profits and more realistic valuation metrics will have upon the share price.
Concerning the latter, right now, the shares are being supported by a nonsensical belief that they deserve to trade on a par with Amazon. This is just plain wrong. Ocado is neither doing anything new – home delivery of food has been around since Victorian times – nor is it unique. Value Ocado in line with the food retail average on enterprise value-to-sales ratio and the shares more than halve again.
We don’t think that a marginally profitable distributor of Waitrose’s products (and 150 Ocado own-label products) deserves to trade at a premium to Sainsbury, or any of the other food retailers.
Philip Dorgan works as a retail analyst for Panmure Gordon.