These two shares are better bets on online retail than

Online retail is a big, sexy growth area in 2014. The market in the UK alone is expected to grow 18% this year to £107bn.

So it’s no surprise that an online retailer of washing machines and white goods, AO World (LSE: AO), recently decided to cash in and float on the stock market.

It listed on Wednesday. The shares soared 33% on their first day of trading.

That’s not the craziest thing to happen in the current market. But it’s still pretty exuberant. Frankly, there’s no way I’m investing at the current price.

But AO isn’t the only game in town. There are other ways to play the online retail boom…

AO World’s valuation is insanely high

Before I highlight some alternative online retail plays, let’s look at AO in a bit more detail.

First up, I should say that AO World looks to be a great company. I bought my last washing machine from the website and I was very happy with the whole process. No complaints from me on that score.

What’s more, there’s plenty of room for growth. Currently, 34% of domestic appliance sales in the UK are sold online. AO has 24% of that online market. I’m confident that online sales will continue to grow quickly, so I think AO could easily double its sales over the next three years. The company also hopes to expand in Germany.

The problem is that all of the good news is reflected in the share price. Plus a hell of a lot of hope.

AO closed last night at 367p, which values the company at £1.55bn. Yet its revenue last year was just £276m.

Now you could argue it’s unfair to look at past figures. After all, AO is growing fast.

But looking forward, AO is trading on a multiple of 90 times its forecast ebitda for 2015. Wow! That’s astonishingly high.

The important point about ebitda is that it is a measure of profit much loved by young companies that aren’t making any money using more conventional profit figures.

So we’re actually being kind to AO here by looking at ebitda, rather than less generous forms of profit. Yet the company is still on a multiple of 90! The equivalent figures for rival online retailers, Ocado (LSE: OCDO) and Asos (LSE:ASC) are 35 and 49 respectively. And I think both of those companies are over-valued too.

The only way that AO can justify its current valuation is if it becomes the dominant white goods retailer in the UK, beating off competition from Dixons, Amazon and others. On top of that, AO must also build strong positions in several other countries. And whilst doing this, it also needs to maintain a decent margin.

It’s not going to happen. The competition is too strong.

And I suspect that AO’s founder, John Roberts, doesn’t think it’s going to happen either. He sold some of his shares this week and raised £86m. (Admittedly, he has retained a 28% stake in the business.)

Two stocks that look like better bets than AO World

So what about the alternatives?

Well, I’ve already said that Ocado and Asos both look too expensive to me. Sadly, there aren’t any other pure online retail businesses on the London stock market. Not that I’ve spotted anyway.

That means we have to look at traditional retailers who have built strong online businesses.

The two most obvious are Tesco (LSE: TSCO) and Next (LSE: NXT). With large store networks, both companies are well-placed to benefit from the latest retail trend – ‘click and collect.’

Tesco revealed this week that its online business has now moved into the black and made a £127m profit last year. That’s very encouraging. The company arguably also looks cheap now on a price/earnings ratio  of ten. Given a choice of buying shares in Tesco or AO, I’d go for Tesco.

But as I can choose any share on the stock market, I’m not going to buy shares in Tesco. Not at the current price anyway. I’m put off by the company’s serious problems in the ‘bricks and mortar’ world. I think it’s going to be a while before Tesco turns itself around.

I’m much more positive on Next, in which I own shares. Online sales have grown fast here and now comprise roughly 45% of total sales. The company is no longer cheap, but it will probably still repay patient investors. It looks well placed to benefit from continued growth in online retail.

I have one final alternative: Amazon (Nasdaq:AMZN), another company in which I own shares.

I know, I know, the valuation looks even crazier than AO’s at first glance. (The p/e ratio is over 500). At the current price, this is a very risky play.

That said, just remember that Amazon is the clear granddaddy of online retail, and it’s consistently grown market share through very aggressive pricing. What’s more, it’s invested in other areas such as cloud computing services, and these other businesses are becoming increasingly valuable.

The day will come when Amazon will feel that it can start to raise its margins. When that happens, Amazon may not look so expensive after all.

So if you want to get exposure to online retail, Next is probably the best medium-risk play, while Amazon is a high-risk play with the potential to surprise many folk.

• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.

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  • Jonathan Tedd

    Yet more advice to buy shops! I want engineering, high value high skill stuff with a fat order book. Or IT.

    Food retailers are probably a good buy, they are a cartel more or less.

  • Ed Bowsher

    Hi Jonathan,

    If you don’t want to invest in shops, fair enough. For what you’re looking for, Rolls Royce could be a good bet. We’ve covered the company recently in the magazine:

    Unfortunately, the above piece is behind a paywall – only for MoneyWeek subscribers. But if you take out a free trial to MoneyWeek, you’ll be able to read the article then.

    Moving onto food retail, I’m bearish right now. All of the big chains are stuck with large store estates which are going to deliver lower returns as online retail grows. And there’s also increasing competition from unlisted rivals such as Aldi, Lidl and Waitrose.