Ocado still delivers food for thought

The online grocer has had a rollercoaster ride since its flotation last year, and it still divides opinion. James Thompson reports

It has been quite a ride for Ocado's investors since it floated amid a flood of City and press scrutiny in July 2010. The online grocer basked in the glow of making its maiden quarterly pre-tax profit last year, defied the December snow to deliver 27 per cent sales growth over Christmas and completed a deal with Carrefour, the world's second biggest retailer by sales, to sell its French products to UK customers.

But it has also suffered "growing pains" that have forced Ocado to add extra capacity to its huge, highly automated warehouse in Hatfield, Hertfordshire, to keep up with demand until it opens a second customer fulfilment centre (CFC) in North Warwickshire at the end of next year.

The ebb and flows in its fortunes – despite its sales continuing to grow at more than 20 per cent in every financial statement since flotation – have been reflected in the volatility of its shares. After diving to an all-time low of 123.5p last October, the online grocer surged to a high of 285p in February. Yesterday, its shares fell by 2.1p, or 1.1 per cent, to 187p, a sliver above the float price of 180p on 21 July.

What has also not changed much is that Ocado continues to strongly divide opinion among City analysts. However, the nuance of the debate around Ocado has changed recently.

More focus has centred on the capacity constraints at its existing CFC, which Ocado again mentioned alongside its half-year results on 27 June. Jonathan Pritchard, an analyst at Oriel Securities, said: "They could have flagged that [constraints] up an awful lot earlier in the process." However, Andrew Bracey, the finance director of Ocado, said it raised the issue November when it became aware of it.

To address these capacity constraints, Ocado has allocated £85m of investment to extend its delivery capabilities at the Hatfield CFC to as many as 180,000 orders a week, compared with a peak of 124,000 recently. Mr Bracey said: "We would like to grow north of 25 per cent or higher and until that capital expenditure goes in we cannot grow as fast as we want. It is a supply side issue, not demand side." The Hatfield CFC was intended to process orders of only about £500m but with this new investment Ocado reckons it can do £1bn a year. Andy Wade, an analyst at Numis Securities, says the "capacity constraints" should only be an issue in the "short term" for Ocado until it completes its second CFC at the Birch Coppice Business Park in Dordon in late 2012 at a cost of £210m.

He says: "Having to upgrade and improve it [existing CFC] whilst working at full capacity will be a bit of a challenge." That said, Numis forecasts that Ocado will deliver a maiden pre-tax profit of £6m for the year to November 2011 and £9m for the following year.

However, other areas are causing concerns in the City. Mr Pritchard says: "I think the biggest disappointment is that the sales growth has slowed in the last quarter and a bit. That has really surprised the market." Ocado grew sales by 20.8 per cent to £296.7m for the 24 weeks to 15 May, but this compared with 24.7 per cent in the first quarter and 29 per cent last year.

Certainly, Philip Dorgan, an analyst at Panmure Gordon, has long-term concerns about the level of profits Ocado's dedicated warehouse-picking model can deliver.

"I don't think it is going to make enough profits to justify the current share price. Food retailing is a low margin industry and online retailing is difficult to make money out of. It has fierce competitors who are also trading online," he says. While Tesco has three dot.com-only stores, or dark stores, and Asda has two to serve densely-populated areas, these two, Sainsbury's and Waitrose largely operate a lower-cost pick-from-store model.

Waitrose has often been cited as a key threat to Ocado, particularly since the supermarket chain has been able to deliver from any of its shops inside the M25 from July, as its non-compete agreement expired. This was part of a 10-year sourcing deal signed between Ocado and Waitrose last year.

Oriel's Mr Pritchard says Waitrose's free delivery for customers could eventually become a "very, very material issue" for Ocado and one that could eat into its earnings before interest, tax, depreciation and amortisation (Ebitda) margin. But Mr Bracey says free delivery "makes sense" for Waitrose, as it is trying to get customers to try its service. But, he adds, this becomes "more economically difficult" when an online grocer delivers between 120,000 and 140,000 orders a week.

In fact, a number of analysts believe there is enough growth for all the major players in the online grocery market, where sales are expected to double to £9.9bn by 2015.

Indeed, one said the fact that Tesco's average online grocery basket jumped beyond £100 last year demonstrated the widespread demand for groceries over the internet. For Ocado, the core argument behind its path to profitability was highlighted when it increased its margin on underlying earnings by 48 per cent to 4.8 per cent, which helped it deliver a half-year pre-tax profits of £200,000. As long as its fixed costs do not jump and sales continue to grow at current similar rates, the days of Ocado being labelled "the loss-making online grocer" should soon be over.

Mr Bracey says: "There is a significant upward trajectory in our profitability."

However, among City analysts, Ocado continues to be the Marmite of grocery retailing. Ultimately, the proof will be in growing pre-tax profits. But one year from its IPO, Numis' Mr Wade says: "The long-term potential is at least as good – if not better – as when they floated."

Ocado in a basket

*Sales up 20.8 per cent to £296.7m for the 24 weeks to 15 May. Its underlying earnings rose 78.7 per cent to £14.3m.

* More than 6 million individual items are picked at Ocado's warehouse, which is the size of nine football pitches. It process 124,000 orders a week.

*Ocado made 18 deliveries on its first day in 2002; last Friday, it was making 18 per minute.

*Ocado now delivers to 70 per cent of UK households – as far south as Dorset coast and as far north as Hull.

*Founded by three Goldman Sachs bankers, Ocado employs 5,000 staff.