In December 2020, my colleague Matthew Partridge suggested in MoneyWeek magazine that adventurous investors might consider shorting the Ocado (LSE: OCDO) share price (or at least avoiding or selling out of the stock) due to its excessive valuation and growing operational challenges. This call was right on the money (quite literally). Since then, the stock has fallen more than 60%.
The FTSE 100 retailer was one of the big winners of the coronavirus pandemic, but the company has not been able to sustain its performance. In its latest trading update, the group announced that sales fell 8% in the two months to the end of April, compared with a 5.7% decline in the previous three months. Management now expects sales growth of less than 5% for the current financial year, compared with an earlier forecast for 10%.
Even the company’s joint venture with Marks & Spencer (LSE: MKS) is not helping the online grocer navigate the current retail environment. The cost-of-living crisis combined with a “return to more normal consumer behaviours as restrictions have ended,” is driving a shift away from online shopping.
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Still, there's more to the story here than just the cost of living crisis and reopening of the UK economy.
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Ocado is facing several big challenges
Ocado is really two different businesses. Both of these are currently having to deal with some major challenges.
Ocado Retail, the online grocer jointly owned with M&S, is poorly positioned for a tough economic climate. According to the consumer magazine Which?, Ocado is the second-most expensive traditional supermarket after Waitrose, judged on a basket of 63 groceries.
In an environment where consumers are watching every penny, that puts the group at a disadvantage to other retailers. It’s no wonder the value of the average basket has fallen by 9% compared to a year ago.
Still, at least this side of the business is earning a profit. Retail earnings before interest, tax, depreciation and amortisation (Ebitda) totalled £150m for fiscal 2021.
The other side of the business, the logistics technology side, is still bleeding red ink. Ocado is selling its robotics and automation technology around the world. Demand is high for these systems and it has only increased after the pandemic exposed the weaknesses of a human-backed fulfilment system.
The group has inked deals with major retailers to roll out 48 customer fulfilment centres (CFCs) by 2035. This could increase the share of revenues from the ‘International Solutions' segment from 2% to 16% (at the high end) by 2026 according to projections.
While these CFCs could become a major revenue generator for the group by the end of the decade, (customers will pay capacity-linked fees when they’re in operation) the high cost of getting them up and running is weighing on Ocado’s bottom line.
Capital spending has quadrupled since 2018 and could rise even further this year. Last year, spending totalled £680m as the corporation ramped up spending ahead of what has been described as a “crunch year” in 2022. By the end of this year the group will be managing 12 live CFCs, up from four at the start of the year. A further 19 are in various stages of construction.
Capital requirements are growing and so are losses
Since its IPO in 2010, Ocado has been burning through cash as it pursues its aggressive growth plans, and the company has returned to the market this week for yet another capital infusion.
The company has raised £575m through a share placing to fund its expansion plans and invest in innovation. City analysts had been expecting the firm to tap investors for more cash at some point in 2022, but the scale of the fundraising seems to have caught some off guard.
Indeed, Shore Capital analyst Clive Black notes that the placing “reflects material cash burn and concerns about liquidity.” It comes as Fitch, the credit rating agency, downgraded Ocado’s outlook to negative on Monday, citing a slower forecast for its international tech operations to turn profitable.
Ocado has always been a jam tomorrow type business. It has haemorrhaged cash since its IPO and struggled to build real value for shareholders. While the company’s technology is clearly in demand, if the group cannot make any returns on its investments, it’s going to struggle to win over the market.
Investors also need to take Ocaod’s legal battles into consideration. It is having to fend off claims from Norway-based Autostore, which believes its grid-based technology forms the basis of Ocado’s CFC platforms. The two corporations have been battling it out in the courts for years with not much to show for it. And the bills are mounting with Ocado forking out over £28m on legal fees in 2021 alone. On that basis I don’t think it’s unreasonable to suggest that some of the recent cash call will be earmarked for lawyers fees.
Taking all of the above into account, it’s clear to me why the market has turned its back on the Ocado share price. The stock is down 46% this year and I doubt market sentiment is going to change any time soon.
Refinitiv analyst estimates have the company losing £310m in 2022 and £242m by 2023. Even the most optimistic analyst projections don’t have profits arriving until the end of the decade at the earliest.
In the meantime, the group is going to have to continue to tap investors for funding to support its capital spending and legal battles. Despite the firm’s technological prowess, investors might want to sit this one out.
