Ocado shares have further to fall

Ocado's shares have fallen heavily since the firm's flotation. But that doesn't mean they're worth buying, says Matthew Partridge. They've got a lot further to fall yet.

Facebook is probably the most high profile technology IPO bust, but the saga of Ocado comes a close second. When the online shopping firm went public in June 2010, we advised against buying into it. Even before full trading began, the IPO price had to be slashed.

Yet thanks to a slick PR operation the shares initially did very well. By February 2011, they had surged to 259p, an increase of 40% from the first day of conditional trading.

But this proved to be the high point. By the start of this year they had gone down to 54p - a fall of nearly 80%. While they then briefly rallied for a time this year, they are still only 64p - well below their flotation price.

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Normally, such a fall would suggest that they might be oversold. However, in this case, we think they are still expensive. Ocado's sales growth is slowing and it's very hard to see any upside for the company from here.

The basic problem is that Ocado's business model is flawed, as my colleague Phil Oakley has pointed out in the past. Selling and delivering groceries over the internet is popular with consumers, but it isn't very profitable. Ocado has had to spend vast amounts of money on warehouses and sorting centres. At the same time, the incremental margins on each extra good sold are tiny.

The supermarkets have experience and their own distribution chains. However, even they are finding it hard to make a profit. Indeed, retail expert Clive Black thinks it costs £20 for them to bag and transport the typical order, much more than customers pay at the moment.

The problem for Ocado is that the supermarkets seem willing to offer online services as a loss leader. Tesco, Asda, Sainsbury and even Waitrose, who Ocado sources many of its goods from (although Ocado is building up its own label brand), offer online shopping. Morrison's and Marks & Spencer are also thinking about jumping in.

And it seems clear that Ocado's sales are starting to hit their ceiling. While the company enjoyed 21% annual growth from 2007 to 2009, the latest figures show this has slowed to single digits. Ocado blamed the Jubilee and the Olympics. There is evidence that they did have some impact on online sales, as people watched TV, rather than browsing online. However, even if Ocado does manage to get sales up, it is not expected to make any profits until 2014 at the earliest.

Ocado is no takeover target

Some experts have suggested that Ocado could end up being a takeover target. However, it's hard to see what a buyer would get out of it. The firm makes no profit, so the only things of value are its hard assets - its vans and sorting centre. After you take away liabilities, the total net assets of Ocado are only £173m. In contrast, its market capitalisation is £351m. This means that it would be much cheaper to replicate the firm's operation by starting from scratch.

It's also hard to see who would want to buy. The supermarkets already have storage facilities, and it's hard to see Amazon, which has made tentative moves into the food market, launching a bid unless the price goes down drastically.

An even bigger worry is that Ocado's financial situation looks vulnerable. Philip Dorgan, analyst at broker Panmure Gordon, thinks that "we are at the beginning of the end game for Ocado. Standing alone with a pile of debt and falling market share isn't sustainable."

Dorgan points out that current cash consumption puts the firm at risk of breaching its covenants. These are the agreements it has made with its creditors, not to let debts get above a certain level in relation to its EBITDA (cash profits).

If the covenants are broken, its creditors would be able to call in their loans.At the very least, Ocado might be forced to sell assets, which would make it even less attractive to potential suitors. Ocado denies that it is in danger of breaching its covenants, but the fact that the issue is even being raised is hardly confidence-inspiring.

Dorgan points out that even Ocado's management admits that its lack of cash is stopping the firm from offering the voucher discounts needed to keep the customer base growing.

So, given the problems it's facing, it is clear that Ocado's shares are overpriced. Panmure Gordon has a price target of 50p. In the worst case scenario, says the broker, the share price could plunge in half to the net asset value (NAV)of 33p.

In short, we wouldn't touch the shares. And if you're feeling adventurous you could short them via a spread bet. Do understand that this is risky, particularly as stocks in precarious situations like this can often rally sharply as well as fall hard so make sure you have your stop losses in place and don't risk more than you can afford to lose.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri