Sell Ocado (OCDO) at 146p

A report from the IPO experts at AllNewIssues.com

In early July the IPO experts at AllNewIssues.com published a detailed review of the supposed "hot" float of the year, the online food retailer Ocado. Following their analysis they advised that investors sell Ocado shares. Since the first day of dealings the shares have plunged from the IPO placing price of 180p to just 146p.

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Background: After months of speculation about its plans to go public Ocado finally listed on the Main Market of the London Stock Exchange on 26th July, raising £200 million at 180p per share. The placing price was well below the initial 200p - 280p valuation which the firm was originally looking for. Since the first day of dealings the shares have tumbled and are currently trading at 146p and valuing the business at £807.65 million.

Operations: Ocado is an online food retailer which sells more than 20,000 different products via its website, www.ocado.com. It prides itself on the quality and affordability of its products which are individually delivered within one hour slots chosen by customers. Ocado earns revenues on the basis of online sales (net of VAT and promotions), delivery fees and from advertising services provided to suppliers on its website. At present the group has over 240,000 active customers (those who have shopped within the last 12 weeks) and can process over 100,000 orders per week.

Nearly all of the products sold by the company are obtained via a sourcing arrangement with John-Lewis-owned supermarket chain Waitrose, which gives it access to the upmarket retailer's own-label and third party-branded products. The deal, which was recently extended until September 2020, enables Ocado to benefit from Waitrose's purchasing power and its established buying operations and supply chain systems. At present the majority of Ocado's sales are of general grocery items but it also sells a small non-food range of toys, magazines, homeware and fresh flowers.

The firm's single, centralised distribution centre (or Customer Fulfillment Centre in Ocado-speak) is a state of the art, 295,000 square feet warehouse located in Hatfield, which can handle 1 million items a day and 105,000 orders per week. To support this Ocado also uses a network of small warehouses (spokes) around the country which are primarily used to store delivery vans and to boost its ability to fulfil deliveries in promising areas.

Business Development: £45 million of the net proceeds from the £200 million placing will be used to repay the group's debts, with the remainder being used to invest in expansion. This would involve increasing capacity at its existing distribution centre from 105,000 to 180,000 orders per week and to develop and build its network. Finally, Ocado also hopes to use placing funds, as well as £197 million in debt facilities available on admission, to purchase the property and equipment for a second distribution centre in order to facilitate the next phase of its growth ambitions.

Financials: The firm has a good top line growth record, with revenues rising by 47% to £402 million over the three years to the 2009 year-end. Business has been very brisk indeed since the 2009 year end with group turnover over the 24 weeks to 16th May 2010 30% ahead of the previous year at £245.6 million. Notably, EBITDA over the half-year soared by 181% on the corresponding period to £8 million (87% of underlying earnings achieved over the entire 2009 financial year). This top-line growth on improving margins helped the business narrow pre-tax losses by 47.1% to £6.7 million. However, Ocado has never delivered a pre-tax profit in 10 years of trading.

As at 16th May 2010, the company had net debt of approximately £110.2 million, net current liabilities of £62.9 million and net liabilities of £36.9 million. We also note that Ocado had approximately £270 million of unused tax losses as at the end of the 2009 financial year which may be written-off against future profits.

Assessment: While it is true that the company is the only pure play online food retailer it is by no means the dominant business in online retailing. In the 12 months to February 2010, Tesco achieved online sales of £1.7 billion (dwarfing Ocado's 2009 turnover of £402 million), while both Sainsburys and Asda having reported significantly higher online sales of over £500 million. What's more is that all of its competitors named above are major FTSE 100 companies (or in ASDA's case owned by Walmart - one of the world's largest companies), which all boast impressive track records of earnings growth, dividends and a valuable property portfolio.

Another threat to the business is that from 1st January 2011 Waitrose will be able to offer its WaitroseDeliver service within the Greater London area (the area bounded by the M25 motorway). This new competitive pressure (which comes from its key supplier) is a major concern as 50% of the group's total sales are earned in this area. If Waitrose decides to further its presence in the market it may choose to end its supply agreement with Ocado. This will cause major problems for the company as Ocado only has a tiny range of its own-brands and relies on Waitrose's brands for the bulk of its sales.

Investor sentiment took a sharp turn for the worse after Ocado published its prospectus, with many commentators speaking about a return to dotcom era valuations. We agree with the consensus opinion that it is absolutely ludicrous for a company that has never reported a profit (even after investing £341 million), and still requires major long-term capital expenditure, to have expected to be valued at up to £1.1 billion. Analysts at Ambrian and Collins Stewart issued damning notes on the IPO, stating that a reduction in Ocado's valuation to approximately £500 million would be required to make the shares attractive in their eyes.

While we must give credit to Ocado's management for using all their banking experience and contacts to achieve a great valuation for themselves, we can see no value in the shares. At 146p they are still a SELL.

Key Data
Epic: OCDO
Market: Full List
Spread: 146p - 147.75p

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