Where next for Ocado and M&S shares as they launch online grocery venture?

Ocado switches to M&S from Waitrose

Ocado will start to stock goods from Marks & Spencer (M&S) at the start of September as the pair embark on a new venture that they hope can build ‘the UK’s leading online grocery business’.

The two companies initially struck the deal early last year and formalised the terms of their 50:50 joint venture in August 2019. However, customers will only be able to access M&S goods through the Ocado site from the start of September because Ocado had to wait for its existing sourcing arrangement with Waitrose to end. Waitrose, arguably M&S’s main rival, is channelling its efforts back to its own website after Ocado decided to ditch it as a partner.

What to expect from the Ocado-M&S venture

The venture, which will trade under Ocado.com, aims to combine the recognised quality of M&S food with Ocado’s strengths in automation and fulfilment. Ocado will expand its product offering, with M&S to supply over 6500 products compared to the 4000 provided by Waitrose.

It will also give it another chance to deploy its automated fulfilment centres. For M&S, which up to now has had virtually zero online presence, the venture thrusts it into the fastest-growing channel of the grocery market.

The service will initially be available to about three-quarters of all UK households. The pair will be hoping the 12 million-plus M&S shoppers will embrace the online service and that it can retain as many Ocado shoppers that had become accustomed to Waitrose as possible.

How much is the Ocado-M&S venture worth?

M&S acquired 50% of Ocado’s online grocery business for a total consideration of up to £750 million. M&S paid £562.5 million upfront and will pay up to a further £187.5 million over five years dependent on how the venture performs. M&S funded the deal by raising equity under a £600 million rights issue.

Read more about how M&S suspends dividend amid coronavirus crisis

This has given the new venture a starting valuation of £1.5 billion.

The pair said the venture would have made £1.46 billion in revenue in the year to 2 December 2018, and earnings before interest, tax, depreciation and amortisation (ebitda) of £34.2 million. The significant acceleration in online grocery shopping amid the coronavirus crisis suggests the venture’s income and earnings could improve as it launches in September.

Although any earnings from the venture will be equally split, Ocado will receive additional income from the fees the venture will pay to its solutions business that is responsible for licensing out and managing its automated warehouse technology to retailers around the world.

What does it mean for M&S?

M&S has been in trouble for years and the coronavirus pandemic has only exacerbated its problems. The company’s revenue has managed to steadily grow but its profits have been hammered.

Although its newer stores are larger and better located, the majority of its outlets are down high streets and shopping centres where footfall has plummeted during lockdown. The fact M&S has no way of selling its food online meant it has been unable to offset any weakness in-store until now.

M&S is in the third year of its latest turnaround programme that involves closing down its older, poorly positioned stores and building out its network of newer out-of-town stores, including its Food Halls that are capable of stocking a wider range of products.

But investors are yet to be convinced that the company is on the right path. The Ocado deal has done little to stem the dramatic fall in M&S shares in recent years, having more than halved in value since the partnership was announced in February 2019.

M&S said it was axing 7000 jobs earlier this month in what is one of the biggest cuts in the UK retail sector yet, building on another 950 jobs lost a month ago. It is drastically trying to cut costs after revealing adjusted pretax profits plunged to their lowest level in three decades in the most recent financial year. The coronavirus meant the outlook was equally grim.

‘From a financial point of view, the 2020-2021 year is likely to be a lost year. Although we have taken drastic measures to secure cash flow and maximise sales, it is inevitable we will emerge with more debt than we had planned and make losses for a large part of the year,’ M&S chairman Archie Norman conceded.

M&S is hoping the food business, which accounts for the majority of revenue and around half of its earnings alongside its clothing and homewares division, can propel the company’s recovery by shifting online. M&S is currently a bit-player in the grocery market, but it does boast superior margins over most of its rivals, while Ocado is one of the only companies to have demonstrated it can deliver groceries to customer’s doors profitably by reducing labour and relying on automation.

This suggests the pair can profitably capitalise on the accelerated move to online shopping at a time when most others are having to subsidise deliveries and are losing money on each order. This is why increased demand during the pandemic has not translated into higher earnings for most supermarkets, because so many customers have stopped making profitable in-store purchases and started making loss-making orders online.

M&S admitted its previous attempts to enter the online grocery market on its own were unsuccessful. It said the cost of developing its own technology like Ocado’s would have taken too long and been too risky, and said the traditional way of using staff to pick orders, replenish stock and deliver baskets to the customer’s door was ‘uneconomic’. Utilising Ocado’s technology means it has a ‘profitable, scalable presence in online grocery’ that has the ability to become the largest player in the market.

Ocado is currently thought to be the second largest player in online groceries with around 15% market share, but Tesco is still thought to be the largest with around double that share. But Ocado is by far the fastest-growing online grocer and the latest data from Kantar Worldpanel showed Ocado was the only one not to experience a slowdown in online sales during the 12 weeks to 18 August. M&S will also be hoping to not only provide an online service for its own customers but to capitalise on a rare opportunity to poach customers from Waitrose that have become comfortable using Ocado’s online platform.

M&S may have to balance volumes against margins

M&S is hoping Ocado can boost the amount of products it sells and attract a wider audience, but there are fears that this tactic could hurt the company’s superior margins. M&S’s older stores are too small to stock a full range of goods, so the online service will bring its full suite of products to the masses. M&S hopes this will encourage shoppers to buy more products, and that it can become a viable choice for those looking to do a full weekly shop and shrug its image as a pricey and convenient option for commuters and city dwellers.

This will be a major concern for Ocado too. Under the Waitrose deal, the average Ocado shopper spent over £100 on each order but the average M&S customer currently spends less than £15 per order. As a result, M&S is taking action to ensure it is accessible to a wider audience, such as introducing a new ‘remarkable value’ campaign that has cut the price on everyday essentials, such as bread, to attract customers.

This has prompted fears that M&S’s margin will deteriorate as volumes increase, which will do little to help a company that has seen its profits evaporate over the last five years.

What does it mean for Ocado?

Ocado enters the new deal on a much stronger footing than M&S. As the largest online-only grocer, it has naturally benefitted from the accelerated adoption of online shopping this year. It is growing at a faster pace than the traditional Big Four – Tesco, Sainsbury's, Asda and Morrisons – and it hopes that M&S will bring millions of customers to Ocado.com, and that a wider range of goods of equal quality and similar price can also poach existing customers that are at risk of moving to Waitrose.

One of the main risks Ocado faces is losing existing customers that are loyal to Waitrose, or that M&S simply doesn’t attract the same volume of customers as Waitrose – which holds a larger share of the overall grocery market than M&S.

However, the deal is not all about groceries for Ocado. It represents a major step in its evolution to a tech company that develops and licenses out automated warehouses and logistical services rather than flogging food and drink online. Ocado had full control and responsibility over the online grocery outfit under the deal with Waitrose, which didn’t have a stake in the venture and only supplied goods.

Now, with M&S having bought half the business and the pair establishing an independent board, Ocado has more time to concentrate on its solutions business (although senior positions of the board will be held by management from both companies). This is even demonstrated by the fact Ocado used the money raised from M&S to fund the construction of more warehouses it is building on behalf of retailers around the world.

Still, groceries is big business for Ocado and the main driver of the business – for now. It generated over £1 billion of revenue in the six months to the end of May 2020 and £45.7 million in ebitda, compared to the £322 million revenue and heavy losses from its Solutions business.

There is an added sweetener for Ocado. It will receive additional fees for supplying its technology to the grocery business on top of its 50% share of any earnings the venture makes. Ocado has said its Solutions unit will earn £50 million in annual ebitda from the venture. This will make it one of the solutions division’s largest partners and it is expected to order capacity the equivalent of eight fulfilment centres over the next 12 years.

How important will the venture be for M&S and Ocado?

M&S and Ocado have been on very different paths up until this point. One has been stuck in the past, failed to keep up with the modern world, and has constantly disappointed shareholders for years. The other has been pioneering the tech underpinning the future of online retail, has become a vital partner for some of the world’s largest retailers (not just grocers), and delighted shareholders after seeing its share price more than double since the lows seen in March.

This is further demonstrated by the fact M&S shares have continued to plunge since raising the equity needed to fund the deal while Ocado shares have continued to soar higher even after it raised £650 million in equity to accelerate its growth plans. Ocado is capitalising at a time when M&S is figuring out a way to survive.

The deal is both important and sensible for both parties. M&S has found a fast-track lane to go online and saved itself a lot of time and energy by securing arguably the best partner in the business rather than trying to develop its own online operation. Considering M&S would have had to start from scratch, it would have been far too costly and time-consuming for a company in M&S’s position to build its own capabilities.

Ocado has found a way to expand its product range and a way to instantly tap into M&S’s 12 million customers while simultaneously finding a major new customer for its solutions business. It also represents the first step away from groceries (having sold half the business) and a reallocation of capital into the Solutions business, which is where the long-term future of Ocado lies.

The success of the venture is integral for both companies, but M&S will be more reliant on it than its partner. Ocado still relies on its grocery arm to help bring in the cash needed to fund the pricey warehouses for its partners, but it is ultimately focused on the technology side of the business and adding new deals with more major retailers. As for M&S, it is relying on this venture to turn it into a mainstream supermarket that can compete, and even get ahead, of the traditional supermarkets.

How to trade Ocado and M&S shares

The share prices of Ocado and M&S have been heading in opposite directions this year. Ocado shares have risen 132% since the lows in March and is one of the only stocks not to have experienced a sharp coronavirus-induced fall. M&S shares, meanwhile, have been in steady decline since 2015 and have lost 40% of their value since the start of this year alone.

Read more about the best supermarket stocks to watch in 2020

The performance of the new venture will be a major driver behind the share prices of both companies going forward, although arguably more so for M&S than Ocado. For example, M&S only has its troubled store network and the new online operation to rely on, whereas Ocado could offset any weakness in groceries by striking new deals for its Solutions business.

Still, the fact Ocado shares have soared so high this year begs the question about how high it can go. It broke through its target price set by brokers in early May and the gap between its share price and target price has only widened in recent weeks. This has led brokers to place an average Hold recommendation on the stock.

Read more: How to buy and short Ocado shares

On the other hand, the dramatic fall in the M&S share price means most brokers believe the stock has been undervalued since January and that there is upside to the current share price. There is currently an average Buy recommendation on the stock.

_{(Source: Reuters)}

You can go long or short on Ocado or M&S shares with us, using CFDs:

1. Open an account with IG and log in to our trading platform
2. Type ‘Ocado’ or ‘Marks & Spencer’ in the search bar and select it
3. Choose your position size
4. Click on ‘Buy’ to go long, or ‘Sell’ to go short in the deal ticket
5. Confirm the trade