Ocado (OTCPK:OCDDY), (OTCPK:OCDGF) has been in the news quite a bit over the past few months, between the boom in home grocery shopping during the pandemic, a tie-up with Marks and Spencer and its ongoing expansion. My thesis about the company is that it is valued by the market like a tech company, but in fact its business model and capex requirements mean it is more akin to a logistics company. While the valuation basis can subsist as long as it is seen as a tech company, I see it as overvalued.

The Key Valuation Challenge: What Kind of Company is Ocado?

The Ocado story has been gracing the news for a long time now, with a couple of decades of business in the U.K. already behind it at this point.

In the beginning, the idea was that Ocado was going to be an online supermarket, a bit like Fresh Direct was in the United States. Fairly fast, the business model shifted towards being an online fulfiller. It would still be branded Ocado, but rather than having to build a brand from scratch, it would partner with a known grocery purveyor whose brand it could leverage to build customer trust and loyalty. That was Waitrose, and after many years it recently changed to Marks & Spencer (OTCQX:MAKSF). The model evolved again, towards using such a business as proof of concept for being an automated online grocery purveyor. So, for example, any number of supermarkets would be able to work with Ocado to enable their online operations.

The evolution has cut to the heart of the investment case for the company. After its heady start amidst the dot-com days, this quickly shifted to the less frothy seeming business of being a supermarket, in which case valuation benchmarks might include other supermarkets. As the company has shifted further towards positioning itself as a tech expert, it has been more logical to value it in line with benchmark tech companies, which of course usually come with higher valuation multiples than supermarkets.

The Shopping Business Continues Well

The company set up a JV with Marks and Spencer for its U.K. retailing business. That allowed it to reduce its own stake in the business and scoop up a total consideration of up to up to £750m, which I think was a better deal for Ocado than it was for M&S.

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In line with a 2020 surge in online grocery shopping in the U.K. (which I covered in COVID-19 Means Supermarket Sales Increase, But Flat Profits: Analyzing Tesco’s Results) it recently reported strong comparative results, with retail revenue up 52% year on year. Basket sizes have been falling from their COVID-19 peaks but remain higher than the pre-pandemic run rate, at an average £141. The company also said that customers have responded positively to the switch from Waitrose to Marks and Sparks, noting that the weighting of M&S products is higher than it was for Waitrose and that it has increased the average basket size by around five items, although personally I wouldn’t draw conclusions from that this early on in the life of the M&S stocking. M&S has more products in the store than Waitrose did and the initial uplift – which may also relate to the ongoing pandemic shopping trends – could be indicative of future trends, or could just reflect an early stocking up period by M&S enthusiasts. More time is needed to tell.

The Proof Points for Ocado’s Rise as a Tech Name

The company has signed up an increasing number of international clients for its offering. It has nine clients with combined revenue of £210 billion. These include Kroger (U.S.) (KR), which Gary Bourgeault discussed here, Groupe Casino (France), Sobeys (Canada), Morrisons (U.K.) (OTCPK:MRWSF), and Bon Preu (Spain). These are big names and clearly the Ocado proposition is compelling to compete at this level.

In its first half to the end of May, billings to such clients were up 58% to £73.7 million. It is expected that the revenue will continue to show significant increase in years to come as the model is proven and rolls out to more retailers.

So far, so good. It took two decades to reach that point, but fair enough. The question for the investment case is not so much about revenue, though, as about costs and scaleability. What enables tech companies to be valuable is the idea that development costs may be high, but the add on cost per user is low. So, with a strong network effect, it is possible to add a lot of users without significantly expanding the cost base, making profit margins high and (perhaps) justifying lofty valuation multiples.

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Ocado’s business isn’t quite like that. Running an online grocery fulfilment business requires vast, expensive infrastructure which isn’t scaleable, in the form of warehouses, vehicles and robots. By serving multiple clients it could have an efficiency benefit, but nonetheless the scaleability benefit just doesn’t work in the same way, even if it could do for the software component of the operation.

That hasn’t held Amazon back (AMZN), one may argue. But the crucial difference is that Amazon holds the relationship with the end user. So cross-selling becomes easier and the cost of the fixed infrastructure is amortised over a much wider range of purchases. That doesn’t apply for Ocado. Ocado is simply a tehnology vendor and provider to a customer such as Kroger – the Kroger customer’s relationship remains with Kroger, not Ocado.

While Ocado did turn a profit in 2015 and again the following year, its history is generally one of losses. Last year’s loss was £211.8 million, equivalent to EPS of -29.4p. in the half year to the end of May, the company had net current assets of £973 million. It went on to raise £1 billion of capital shortly afterwards, including a £657 million share issue. That points to the fact that this is a business model which eats capital hungrily. Consider this line from its half year results, which relates to full-year expenditure:

Total capital expenditure for the Group is expected to be around £600 million with the majority of the increase reflecting the additional capital to meet the needs of our Solutions customers’ growth in the UK and internationally

In other words, almost all of the share issue raise will go to building and fitting out distribution centres the company needs. The more it grows, the more it will need – and so the capex roundabout will continue. Meanwhile, profits remain elusive.

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Ocado’s Valuation Looks Extreme

At the moment, the company is valued at around £17 billion. That is just a little less than its leading North American customer, Kroger. But whereas Kroger reported $1.6 billion in earnings in its most recent year – and that was at the low end of its recent earnings range – Ocado registered yet another loss, as it has for most of its history. At £212 million, it was much bigger than in the preceding years. There are no earnings on which to base a p/e ratio. But the price is now approaching 10x sales, which for a company whose sales have only grown 59% in the past five years looks excessive. The share price chart tells its own story for this lossmaking company.

Source: Google Finance

Outlook: Ocado is Overvalued but Could Get More Overvalued

I think Ocado is overvalued because it is primarily a logistics company, with a near two decade history of losses and sizable capex needs. I don’t think it’s a tech company.

However, its valuation has always, even before it was a listed company, reflected the story of it being a futuristic tech company, not a supermarket or logistics business. So, while I think it is overvalued, the story has legs and the market likes it. I would not be surprised if the overvaluation continues, and the share price continues to increase. That, however, is mere speculation to me, not a solid investment case.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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