Where next for Ocado shares?

• Ocado shares have climbed to new highs during the coronavirus pandemic as consumers shift to online grocery shopping and on expectations that more retailers will adopt its automated warehouse technology
• One unwelcome consequence of the shift online is that larger traditional supermarkets have quickly expanded their digital offering, and the likes of Tesco and Sainsbury's are now growing online sales at a faster rate than Ocado
• But Ocado’s technology means its online operations are more profitable than rivals, and the firm is expecting earnings from its grocery business to soar over 70% this year
• Ocado has not signed a new partner for its automated warehouse technology for a year, but it is still burning through cash developing CFCs around the world and is likely to need more cash in the future

Has the rally in Ocado shares gone too far?

Ocado shares have rallied by 92% since the start of 2020, making it the best performer in the FTSE 100.

The meteoric rise has pushed Ocado’s valuation from under £9.3 billion at the beginning of the year to over £18 billion today. This has been driven by increased demand for online grocery shopping, naturally benefiting the UK’s only purely online grocer, and expectations that the shift online will prompt more retailers to adopt Ocado’s automated warehouse technology.

Tech stocks have managed to thrive in the current climate as people and businesses adopt more digital services whilst people work from home. The fact Ocado is one of a very small handful of major tech stocks listed in London has contributed to the rally this year as investors seek to buy into the increased demand for technology, and Ocado’s share price has even outperformed the biggest US tech giants like Amazon (up 66%) and Netflix (up 47%).

But why is Ocado worth nearly £9 billion more than the start of the year? Well, Ocado’s grocery business is going from strength-to-strength and it has opened some of the first CFCs for its partners - but is this worth the extra value investors have slapped on the company this year?

Is Ocado losing market share in online groceries?

As the only purely online grocer in the UK, Ocado should be in prime position to capitalise as Brits embrace online grocery shopping this year.

Ocado delivered 345,000 orders per week on average in the third quarter to the end of August, up just 20,000 from the 325,000 weekly orders shifted in 2019.

That compares poorly to the traditional supermarkets that have been forced to up their online services this year. For example, Tesco is now offering 1.5 million weekly online slots to customers compared to 600,000 before the pandemic, and says online sales account for around 16% of total sales compared to just 9% beforehand. Meanwhile, Sainsbury’s was delivering around 370,000 orders per week but has increased that to over 650,000, and says around half of all online orders are placed by new customers.

Revenue from Ocado’s grocery business was up 52% in the third quarter (Q3), marking a significant acceleration from the 27% growth reported in the first half (H1). That has also benefitted from the swap over to Marks & Spencer's from Waitrose at the start of September, with its new partner encouraging larger basket sizes among Ocado customers. Still, this strong growth has lagged larger counterparts. Tesco’s online sales were up 69% in the six months to 29 August, while Sainsbury’s booked a 75% rise in the three months to 27 June.

Morrisons, the first company to begin using Ocado’s automated warehouse technology, has also reported strong online growth this year and has increased capacity five fold, but notably it hasn’t relied on Ocado to expand but focused on developing new distribution channels with the likes of Amazon and Deliveroo.

This suggests Ocado could be losing out in the online market to traditional supermarkets, although a recent upgrade to its guidance suggests growth could have accelerated markedly since its most recent update. This year has played into Ocado’s online model. Yet it has also forced larger incumbent players to take action and pushed them into a market that they were only taking baby steps toward before. Their size means they have been able to quickly scale up their online capacity. Ocado intends to increase capacity by 40% through to 2021, but that will still significantly lag its rivals.

The trump card that Ocado holds over traditional supermarkets is that its technology-led operations are more profitable. Traditional supermarkets are determined to offer products at the same price online as they are in store, even though online orders come with major additional costs, like that of the picker that collects your order and the delivery driver and van to get it to your door.

The economics of online groceries remains unclear as none of the major supermarkets break out the profit (or, more likely, losses) they make shipping goods directly to customer’s doors. Still, most of them have said they will report broadly flat profits this year despite seeing a surge in demand, suggesting they are still to tinker with the economics.

Meanwhile, Ocado recently upgraded its guidance for annual Earnings before interest, tax, depreciation and amortisation (Ebitda) from its grocery business, which will now be ‘over’ £60 million – a 72% rise from last year’s £35 million and a huge uplift from the previous target of £40 million.

Where next for Ocado’s Solutions business?

Ocado’s Solutions business is where the company’s true value lies. The fact Ocado’s valuation is now double that of Sainsbury’s and Morrisons combined despite holding just 1.8% of the UK grocery market demonstrates the value is being assigned to Ocado’s technology and not its grocery business. Ocado has been pedalling its technology for years but it took some time for it to be adopted by major retailers around the world. Ocado has so far signed up nine partners:

It has been a year since Ocado signed up a new partner, meaning it is yet to prove there is increased demand for its technology as a result of the shifts caused by the pandemic. It has, however, managed to expand work with existing partners like Kroger, which has committed to three more customer fulfilment centres (CFCs) as well as its first mini-CFC.

Ocado has also developed new tech to improve the efficiency of new and existing sites, like its third-generation robot arm that picks orders twice as fast as the previous model. It also announced it is spending $312 million to acquire two robotics companies, stating this will grow annual revenues next year by £30 million accompanied with a ‘small negative impact’ on Ebitda.

Still, the absence of new deals may be a blessing in disguise. Ocado’s business model means it has to fork out the money needed to build the CFCs for its customers in return for annual fees and a slice of sales in the future. This means Ocado has to spend a lot of money upfront but doesn’t generate a return until much later on, once the CFC is established and has matured.

This places a huge burden on cashflow. To put the task into perspective, Ocado is thought to be developing around 50 CFCs around the world at present and each one is thought to cost around £30 million over a three year period.

Ocado is therefore burning through cash as the majority of CFCs still being built. Ocado spent £260 million in capital expenditure and generated just £76.7 million in operating cashflow in the last financial year. This year, it intends to spend a staggering £600 million in capex as it builds out more CFCs, and analysts forecast it will continue to burn through hundreds of millions of pounds over the next two years.

Despite these costs, Ocado has said it is still looking to sign up new partners, which it admits would ‘negatively impact short-term profit’. This means Ocado is willing to burn through the cash if it means it can expand its top line and ensure its technology is seen as the go-to solution for retailers looking to move online around the world.

Still, the opportunity among its nine existing partners is huge on its own. Together, they boast annual revenue of £210 billion and Ocado believes it could generate anywhere between £3.5 billion to a whopping £26.3 billion in fees from these nine partners alone depending on the level of online penetration in their markets.

Will Ocado need more cash?

Ocado has raised over £1.6 billion in the current financial year - £950 million from the bond markets and £657 million in equity. Ocado said it would use the funds to ‘sign more clients, build more CFCs, build CFCs faster and invest in innovation to ensure the Ocado platform stays at the forefront in the sector.’

This has bolstered the balance sheet and gives Ocado over £1.3 billion in cash. Minus the debt and it has £196 million, meaning it is part of the minority of FTSE 100 stocks that have more cash than debt right now. Notably, Ocado has said its two new acquisitions ‘will have no financial impact in the current financial year’.

Still, it is almost inevitable that Ocado will need to raise more cash over the coming years to develop more CFCs and it is not clear how many it will need to tip the scales and make it a self-sustaining operation, nor justify its current lofty valuation.

Are Ocado shares overvalued?

The shifts being caused by the pandemic is undoubtedly going in Ocado’s favour. The growth story remains the same as it was before, it’s just that investors hope that the pandemic will accelerate demand for Ocado’s services. The recent upgrade to its earnings guidance has provided confidence that the pandemic is causing a long-lasting and sustainable uptick in demand for the company. However, the push being made by traditional supermarkets is still a concern, as is the fact it hasn’t signed any major new deals for its automated warehouses.

While Ocado is certainly worth more now than it was at the start of the year, it is still difficult to justify its lofty valuation. Right now, much of the momentum is being provided by the grocery division, but the tipping point for Ocado will come from its Solutions unit, when its existing CFC sites generate enough income to fund new CFCs to make the company self-sustaining.

Ocado has plenty of work to do building out CFCs for its existing partners and it has just enough cash to cover the costs of the ones currently in development, but it would need to raise more cash to build more. This means investors should prepare to be tapped for a lot of cash over the coming years. Brokers are divided on Ocado, but the average target price of £19.80 suggests Ocado is now overvalued considering it currently trades at £23.50.

How to trade Ocado shares

There are different ways to gain exposure to Ocado shares.

You can speculate on the Ocado share price with financial derivatives like CFDs, without taking ownership of the underlying shares. You can speculate on the Ocado share price rising by going long or falling by going short. You’ll also be able to open a position with leverage, which will grant you full market exposure for a small initial deposit.

Alternatively, you can invest in Ocado shares, which means you’ll be taking direct ownership of them. This’ll make you a company shareholder, so you’ll be eligible to receive dividends and have voting rights in company decisions. Notably, Ocado is yet to pay a dividend and is unlikely to pay one any time soon.