Ocado Group – Dropping shoes
All,
Please find our unchanged analysis here.
Instead of a profit warning, in July Ocado Retail gave us a new CEO but today's Q3 trading statement from the JV with Marks and Spencer gave us the inevitable warning. We put the Retail results and lowered guidance in the context of the wider group, pick out the trends for the JV and decide whether/when/if we wish to position ourselves in Ocado.
Warning only impacts UK JV:
- Short-term cost issues at Ocado Retail will not impact group investment in the Technology business. Ocado group had £1.6bn of cash on the balance sheet at H122. Our 2022 forecast year-end cash on hand was £1.27bn and is now £1.2bn. Our model now moves from £7m to -£34m in EBITDA for FY22
- Management wouldn’t guide for 2023, but we expect H123 will be softer than we had previously anticipated as cost headwinds continue to work through the system. We would expect these headwinds to lower in H223.
- We will update our model once we have full figures for the group (we should get headline numbers with the Q4 trading update in December). In answer to a question management said that Ocado Group/M&S are both in a position to provide temporary liquidity to Retail if a bridge was needed but that this was not expected. The bond documents contain a £350m carve out for Permitted Investments which could be utilised for Ocado to provide its share of any temporary liquidity facility if it was needed.
- The Retail business is over 50% of our group valuation so we are not dismissing the cost headwinds impact. However, we are not trimming the valuation of Retail yet as we see our DCF assumptions as conservative and expect the cost headwinds as being recovered. In the longer term, 1) the impact of higher costs will eventually be recovered via higher consumer prices; 2) Centralised distribution will give online retailers a structural cost advantage over bricks and mortar.
Soft demand and cost headwinds in H2:
- Ocado retail is running at c360k orders a week vs a capacity of 600k, the need to keep ramping up orders is going to keep marketing expenses high in the near-term (acknowledged by management).
- Food costs are up 7% vs last year. Customers are also choosing cheaper options within their basket (e.g. mince instead of steak). As M&S is a premium grocery product the potential for clients to trade down (to say Aldi/Lidl) is higher. Also, the current pressure on EBITDA margins will remain for another few quarters. Much of the pressure has come in H2 and is likely to weigh on H1 next near.
- Q3 sales at Ocado Retail were 2.7% up vs the previous year and “stronger” growth is expected in Q4. However, the 8% fall in H1 means FY sales are likely to be down slightly. Previous guidance was for a 10% increase. The improvement from H1 is down to customer additions which drove weekly orders fulfilled up 11% which has substantially erased the poor start to the year.
- The group expects the JV to reach break-even EBITDA for the FY (to November). This implies EBITDA losses in H2 of around £40m. Previous guidance was for low single-digit EBITDA margins. The cost increases are heavily weighted towards H2. Our estimates are for £30m in cost headwinds in H2 that would wipe out the £30m of EBITDA we had previously forecast. There may be some cost recovery in H2 but we expect that to be used utilised in higher SG&A as Ocado increases marketing spend to support pricing.
- Management provided some detail on the cost headwinds faced by Retail which will total £14m a quarter before any government assistance.
- Electricity: costs have gone from £10m a year in 2021 to £30m now. This is mostly in H2 so the annualised figure will be closer to £40m. This equates to £7.5m a quarter.
- Fuel: risen from £18m to £22m or £1m a quarter
- Dry Ice: Normally the annual cost is £2.5m, current pricing is £20m - £30m a year.
Investment Considerations:
- Taking into account the headwinds in retail and potential spill-overs into the technology business, we still think 13% or 60p/£ (for the 27s) is a more appropriate level for the SUNs. But we’re not Alice and this isn’t (quite) wonderland. investors are covered 55-60p/£ by the value of the retail business and so the bonds should resist further downward pressure and we may get involved at a higher value. While we are not getting paid on the paper however and the market is volatile, we are holding off on buying all that volatility - if only for tactical reasons.
- The rest is the potential value of the international business, and we would need a return of 15% (with no significant debt ahead). Blending our RRRs for the two businesses we get 13%. This poor set of Retail results could see the bonds pull back a few points and as our medium-term thesis continues to hold, we will be seeking to get involved if pricing widens sufficiently. Of the three issues, we prefer the lowest priced, highest duration 27s to take advantage of some beta.
I look forward to discussing this with you all
Aengus
T: +44 203 744 7055
www.sarria.co.uk