Nobody expected Ocado to make a profit in 2011, so today's announcement that it didn't shouldn't come as a surprise.
The trouble is, we don't think Ocado will ever make huge profits. And that means you shouldn't go near the shares.
Here's why.
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Grocery delivery businesses struggle to make money
The first big issue is that Ocado is trying to do something that Tesco, Sainsbury's and Asda have all failed to do: make meaningful profits from delivering food to its customers. Morrisons doesn't even bother offering this service.
It's not hard to see why it's so tough to make money in this business. It has lots of fixed costs in the form of labour picking and sorting orders and driving delivery vans and assets such as warehouses and vans. You need to sell a lot of food and deliver it very efficiently to make money. This is not easy when you may have to drive miles between deliveries.
In short, big food retailers see online ordering and home delivery as a defensive tactic to stop their customers going elsewhere. So why does Ocado think it can actually make good money at this business?
Growth markets don't always equate to investment riches
In answer to that, Ocado points to the huge growth potential of the UK online grocery market - the Institute of Grocery Distribution is predicting that it will be worth £11bn by 2016.
However, in response, we'd argue that airline traffic has been growing for decades and the industry has delivered large cumulative losses to their shareholders. Why? Too much competition.
To make attractive returns for investors, a company has to do something that others can't copy. They can only do this if they have limited competition. That's not the case in UK food retailing. Competition is intense, and is likely to become more so, especially given the woes of current industry leader Tesco (which has just seen its market share drop below 30%, and so is even more likely to come out fighting).
To succeed in a competitive market, a company needs to be the lowest-cost operator. Does Ocado have a genuine cost advantage over its much bigger rivals? If not, then what is Ocado's source of competitive advantage?
The Waitrose factor is waning
The key attraction of Ocado is that it delivers Waitrose food. Waitrose is a big hit with middle-class Britain as shown by its rising market share. However, Ocado isn't Waitrose it just delivers its goods. And the company's stranglehold on this is diminishing.
Since June 2011, Waitrose.com has been able to compete with Ocado within London's M25 area arguably the area with the most affluent customers. Surely it is only a matter of time before London customers currently using Ocado start to receive their weekly groceries from Waitrose.com.
The other significant issue is that Waitrose can end its current UK distribution agreement with Ocado in 2017. Ocado points to its growing number of own-label products, but we doubt it can create a really strong stand-alone brand.
The numbers don't stack up
How else can Ocado make reasonable returns for its investors? Management points to the potential profits growth that would come from selling more groceries on a fixed-cost basis. This is known as operating leverage if your costs grow far more slowly than your sales, then your profits can rise very quickly after you've established yourself.
But let's have a look at the evidence. In 2011, Ocado grew its average number of customer orders per week by 18.6% to 110,219 with sales increasing by £82m. But trading profits only increased by £2.9m a marginal return on sales of just 3.5%. This is not the kind of leverage that suggests Ocado's business model is working.
Some analysts believe that Ocado might be a takeover target: Marks & Spencer, Amazon and Morrisons have all been touted as possible buyers. We think this is unlikely for two reasons.
Firstly, the online grocery market is not attractive as we've mentioned. Secondly, any buyer who is also a rival of Waitrose would have to pay Waitrose £40m in compensation to buy Ocado that's quite a big deterrent. Even the existence of large unused tax losses may not tempt buyers as a business has to be profitable before they can be used.
Ocado shares still look overvalued
Of the 13 analysts surveyed by Bloomberg, five say, 'buy', four 'hold' and four 'sell'. The average price target is 87.9p 5% above the current share price. Consensus forecasts are for pre-tax profits of £4m in 2012 rising to £6.5m in 2013 putting the shares on a 2013 price/earnings (PE) ratioof 52.5 times (based on a share price of 84p and earnings per share forecast of 1.6p).
This looks a rich valuation to us, particularly given a stretched UK consumer and the threat to Ocado's income from its promise to match Tesco prices on around 7,000 items.
Looking at Ocado's balance sheet, its net asset value per share is 31p. Given the challenges facing its business model we struggle to see why any rational investor would pay more than this for the shares. Sell.
