Ocado’s online shopping promise has too high a price tag

“Prediction is very difficult, especially if it’s about the future” is a line often attributed to Nobel-prize winning physicist Niels Bohr. But when it comes to the long-term impact of coronavirus on consumer behaviour, the stock market seems to disagree.

In the US, companies such as Zoom, Peloton and Amazon have outperformed local indices as investors bet on a homebound future for white-collar employees. In the less tech-weighted UK market, attention has focused on names such as Flutter, the £18bn online bookmaker, and £16bn grocery-technology company Ocado.

The latter’s performance has been particularly breathtaking, as the “Microsoft of retail” has risen 66 per cent year to date, versus a drop of 18 per cent for the FTSE 100. Once London’s most shorted stock, Ocado’s rally has led to almost total capitulation from bears, with its short interest now so low that no investor has reported a negative position since early July.

Investor giddiness, however, has pushed Ocado’s valuation to heights that would make even the most online of online retailers blush. Its enterprise value now stands at 8 times its sales over the past 12 months, according to S&P Global data, compared with 5.3 times for Amazon and 3.4 times for Berlin-based HelloFresh.

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The company’s story, on the surface, makes sense. As both an online grocer and a provider of fulfilment technology to third parties, Ocado should be uniquely positioned to take advantage of the recently accelerated trend towards home food delivery.

Yet step back from the company’s blue-sky rhetoric of a potential £2.8tn in sales in addressable key markets, or chief executive and co-founder Timothy Steiner’s claim on a recent conference call that “75 per cent to 80 per cent of the market” could come online, and the narrative gets cloudier.

Take Ocado’s half-year results, announced last week, in which the company talked about “unprecedented and sustained” demand due to the pandemic. Working backwards from the numbers, Jefferies estimates that revenues in its UK grocery business — a joint venture with Marks and Spencer — rose 45 per cent in the second quarter. Yet Tesco’s online sales were up 49 per cent in the quarter through to May, while Sainsbury’s digital sales increased 87 per cent in the three months to end-June. This suggests, says Jefferies, that Ocado lost “ample share of the UK online market” during lockdown. UBS data analysing app downloads suggest a similar trend.

Some of that loss can be attributed to Ocado refusing orders from new customers as demand intensified during panic shopping in March. But it also underlines the benefits of existing scale — Tesco and the other big-box retailers are able to reach customers in remote areas due to their vast network of stores. Ocado remains a largely urban proposition.

Bulls on the stock say that global partnerships are the future of the company. So far Ocado has signed deals to build 58 “customer fulfilment centres” (or CFCs) for grocers such as Krogers in the US, Canada’s Sobeys and Groupe Casino in France. These deals deliver Ocado’s software, robotics and delivery knowhow in return for an annual licence fee set at a percentage of the CFC’s expected sales.

There are two problems with that model. The first is there is little clarity over each CFC’s real long-term economics. That is in part because the business line has yet to mature — just two locations in France and Canada have opened so far — and also because Ocado has been reluctant to share details with investors of the terms of its deals.

The second issue is that Ocado is on the hook for building out a lot of the infrastructure for its partners — a requirement that carries a cash cost of £30m per CFC over a three-year period, net of upfront fees. The company’s £2.3bn in cash, bolstered by £1bn debt-and-equity raising in June, should suffice for its current growth plans but does not leave much room for error.

Analysts are split on Ocado, with 40 per cent rating the stock “hold”. Yet most agree that further capital increases will be required. Berenberg, which is bullish, believes the company requires at least 180-odd CFC deals to justify its heady valuation. Bears such as Exane BNP Paribas say Ocado will require 330 CFC deals in total — six times the number today — for the current market cap to make sense.

And even the bulls could be growing slightly weary.

In 2010, Goldman Sachs’ first report on Ocado spoke of its “fundamentally different business model” and its “structural and cost advantages” versus the competition. Because of this, the investment bank reasoned, Ocado would generate free cash flow by 2012.

Ten years and £1.6bn of extra capital later, the business is still no closer to delivering on that promise.

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