Ocado share price soars after striking transformational deal: has it finally delivered

Ocado shares spiked to reach an all-time high after striking the biggest deal yet for its technology platform with US retailer Kroger. It has been a long wait for those that have stuck by the company, but has Ocado finally delivered for shareholders?

Joshua Warner @JoshWarner_IG
Analyst, London

Publication date : 2018-05-22T14:32:46+0100

Source: Bloomberg

‘The scale and economics of this agreement are totally different to our other deals,’ – Ocado finance director Duncan Tatton-Brown.

Scepticism has shrouded Ocado since the company joined the London Stock Exchange (LSE) in 2010. The company has struggled to mount any serious challenge in the UK grocery market, and currently has about 580,000 active customers to represent just a 1.2% share (up just 0.1% from a year ago). Since Ocado shifted its strategy toward its technology in 2015, it has failed to convince investors that it could successfully roll-out and monetise it.

Ocado’s unique technology centres on its end-to-end system that can be used by online retailers to manage their supply chain. This is coupled with purpose-built warehouses, or ‘customer fulfilment centres’ (CFCs), combining both software and hardware to create a largely automated distribution centre.

Ocado builds centres on behalf of clients and, when built, the company then charges ongoing fees for servicing and consultancy work. It then earns revenue based on the gross value of the goods that go through the centres, income rising when its client’s does.

Learn more about how a Sainsbury’s and Asda’s merger will shake up the UK grocery market

The company has managed to sign a string of deals for its Ocado Smart Platform and CFCs over the past seven months, and has now unveiled the biggest deal to date. While a deal with Kroger, one of the world’s largest grocers and the market leader in the US, was on the cards and anticipated by shareholders the agreement is massive compared to what anyone expected. Previous deals have seen clients take a more gradual approach to Ocado’s offering, taking one CFC before committing to others, but Kroger has demonstrated confidence in the firm by committing to at least 20 CFCs, eclipsing all the other deals Ocado has secured so far.

The Kroger deal is a transformative moment for Ocado, but the firm still has some way to go. It will now have to prove it can deliver the deals it has signed and move toward sustainable profitability. So what does the deal mean for Ocado, and where is the company heading next?

Ocado strikes major deal with US retailer Kroger

‘As we work through the terms of the services agreement with Kroger in the coming months, we will be preparing the business for a transformative relationship which will reshape the food retailing industry in the US in the years to come,’ – Ocado chief executive and co-founder Tim Steiner.

Ocado has struck a deal to open a swathe of new CFCs across the US, which will then be used by Kroger to manage its distribution operations using the Ocado Smart Platform. The multiple sites will be managed under a centralised model and will be automated.

The financial details of the deal still need to be ironed out and whilst the deal clearly outweighs the others it has signed with other clients, Ocado shareholders will still be eager to find out just how valuable the partnership is to the business and, more importantly, when that value will start to trickle through to its financial results.

Ocado Group strikes biggest partnership yet with Kroger: the details of the deal

Kroger and Ocado are to identify 20 CFCs over the first three years of the deal
Work on where the first three sites will be located has already started and should be complete by sometime in 2018
Kroger will pay monthly exclusivity and consultancy fees to Ocado
The pair will sign an overall services agreement to facilitate the phased approach to developing new CFCs across the US, based on standard terms for Ocado’s platform
Kroger will pay compensation to Ocado if it fails to commit to the 20 CFCs targeted

Kroger purchases 5% stake in Ocado Group as part of major partnership

The other major element of the agreement will see Kroger take a 5% stake in Ocado. Kroger will purchase 33.1 million new Ocado shares for £183 million, implying a value of £5.52 per share. That price roughly matches the price of Ocado shares before the partnership was announced, meaning Kroger will automatically see the value of its stake in Ocado rise if it pays that price following the spike in Ocado shares since the deal was unveiled.

Ocado share price climbs to all-time high after Kroger deal

During its earlier days when it was more focused on its online grocery delivery operation, Ocado shares struggled to gain ground. By late November 2017 Ocado shares were standing at 238.7p before starting its journey upwards after unveiling the deal with Groupe Casino.

The Ocado share price found further ground as each new deal was announced and prior to unveiling the Kroger deal, shares had closed at £5.54. Shares then spiked to an all-time high of £9.97 on the day of the announcement, before dropping back down to close at £7.96. Shares have since found stability above the £8 mark, and the company could see itself become part of the FTSE 100 at the next quarterly review.

Ocado chart

Ocado now has partnerships in the US, UK, Canada and Sweden

Kroger is not the first company to opt for Ocado’s Smart Platform but it is by far the biggest. Ocado’s first deal was signed with UK supermarket chain Morrisons in 2013 before being extended in 2016. More recently, Ocado struck a deal with French retailer Groupe Casino last November, Canadian grocer Sobeys in January, and Swedish grocery chain ICA Group at the start of this month.

The increased flow of deals signed since late last year shows that momentum was gaining traction even before Ocado added Kroger to its list of clients. Now, because the Kroger partnership is substantially bigger than the other agreements, Ocado is now proving it can not only deliver more deals than it has in recent years, but better quality and more valuable ones.

Kroger secures exclusivity over Ocado system but has to earn it

Kroger will be only company in the US that will be able to use Ocado’s platform for grocery and food distribution, as it has secured exclusivity under the deal with the UK firm. This is because Ocado believes Kroger, which generates about $122 billion in annual sales, is ‘best-positioned to win in US grocery’, and therefore has ended talks with other US retailers.

That suggests Ocado certainly had the potential to sign other deals with US firms, but that the deal with Kroger was so valuable that it eclipsed anything that was being proposed by other potential new clients. One of the reasons there is so much hype over the Kroger deal is because it places Ocado’s system at the heart of the US grocery market, which is a far bigger market than that of the UK, Canada, and Sweden. But Ocado has now put all its American eggs into one basket, and must rely on Kroger’s growth to propel its own growth in the country.

Having said that, Kroger will have to work to retain that exclusivity and Ocado has ensured that it will be able to sell to other US firms if Kroger was to falter in some way. The US firm will have to pay Ocado monthly exclusivity fees and Kroger will lose its exclusive right to Ocado’s platform should it fail to commit to the 20 CFCs within the next three years.

In the longer term, Kroger will have to meet targets based on its market share to keep its exclusivity, or order an agreed number of new CFCs each year – ensuring that Ocado is only cutting itself off from the rest of the US market whilst Kroger generates growth in some form or another, whether that be in sales or expanding its network of Ocado centres.

How did Ocado Group perform in early 2018?

Retail revenue continued to increase in the early stages of the current financial year, rising just shy of 12% despite being held back by poor weather conditions that also hit the wider grocery and retail market.

The amount of orders through Ocado.com, Fetch, Sizzle and Fabled has continued to grow after rising over 11% in the first stage of this year, but the value of each order has fallen further, declining as shoppers placed fewer items in their basket, offsetting the lift in the average value of each basket that was spurred on by inflation.

Ocado financial performance in the 13 weeks to…

	28 February 2016	26 February 2017	4 March 2018
Retail revenue	£311.60	£352.40	£363.40
Average orders per week	216,000	252,000	280,000
Average order size	£112.63	£110.85	£110.45
Cash and cash equivalents	£38.30*	£41.20	£259.70
External borrowings	£66.50*	£130.20	£285.20

^{(*Cash and borrowings as of Feb 21, 2016), (revenue, cash and borrowings all in millions).}

The growth in retail revenue in the first quarter (Q1) of the year was broadly in line with that delivered in the final stages of last year, and Ocado said it operated at full capacity for most of the period before the bad weather disrupted its operations in the final week. Still, Steiner said the company took nearly 300,000 orders over the last week of the quarter, ‘often in the most trying conditions’.

What to expect from Ocado earnings in 2018

Ocado Group expects revenue for the full year to be 10% to 15% higher than the last financial year. That would see revenue climb to around £1.44 billion to £1.55 billion.

Ocado has not given precise guidance for earnings before interest, tax, depreciation and amortisation (EBITDA), but said it would reflect the fixed costs of its CFC in Erith, south-east London, which will come online in the middle of this year as the company’s fourth CFC (and the largest one to be developed to date). However, Ocado is expecting EBITDA to ‘improve significantly’ from 2019 onwards.

Ocado has budgeted around £210 million in capital expenditure for this year as it builds capacity and invests further in its platform, up from just over £160 million in the last financial year.

Analysts are still expecting losses from Ocado over the coming years, but earnings and revenue are to continue rising over the next two years, according to the company-compiled consensus:

Ocado’s recent earnings and analyst forecasts for next two years

(Millions)	52 weeks 2016	52 weeks 2017	53 weeks 2017	2018 con	2019 con
Retail revenue	£1170	£1310	£1350	£1490	£1490
EBITDA	£84.3	£84.3	£86	£87.1	£105.4
Pre-tax profit/loss	£12.1	(£0.5)	£1	(£17.5)	(£1.3)

When will Ocado next publish its earnings?

Ocado Group will release its interim results covering the first half of its 2018 financial year on 10 July.

What is the financial impact on Ocado Group from the Kroger deal?

Ocado has said the deal with Kroger will have a neutral impact on earnings in the current financial year. Although the company expects to sign the deal with the US giant on broadly the same terms as agreed with Groupe Casino, Sobeys and ICA Group, Ocado is hoping to lower the amount of upfront funds it needs to build and develop the CFCs in return for discounting the ongoing and monthly fees that it will charge Kroger.

Each new CFC sees cash outflow reach a peak of about £30 million when it starts to install all the equipment, according to previous deals that Ocado has struck. That would suggest £90 million is needed for the initial three sites and £600 million for all 20, unless Ocado finds a way to lower the intensity of spending. The fact that Kroger has committed to a string of new CFCs means Ocado will hope costs decline as more CFCs are brought online for Kroger, as it benefits from a centralised model. This is compared to previous deals, which has seen partners agree to singular units before committing to more CFCs.

Ocado had just shy of £260 million in cash at the end of Q1 after raising £143 million through a placing conducted in February, but funding requirements will be better defined once the details of the Kroger deal have been ironed out. In addition, Ocado’s cash position will be boosted by the cash it will receive from Kroger’s investment in the company. Still, Tatton-Brown has not ruled out asking shareholders for more funds, stating that ‘even if we do (raise equity), shareholders have shown in the past that they are willing to support us’.

While those that bought in under the placing in February snapped up Ocado shares at what is now the bargain price of 455p, anyone looking to buy in under any future potential fundraising will have to pay a substantially higher price.

Investors in Ocado’s share placing cheer as short-positions backfire

The Kroger deal may be the well-earned reward that many patient shareholders have waited for, but for those that bet against the company, convinced Ocado couldn’t get its platform off the ground, the Kroger deal has spelt disaster for their short positions.

Those cheering the deal include those investors that snapped up Ocado shares in the February placing. Three institutional shareholders purchased substantial stakes in Ocado. The London & Amsterdam Trust bought 6.2 million shares for £28.2 million, The Capital Group Co bought 5.8 million for £26.4 million and Apple III, part of Rausing Jorn, bought 3.4 million shares for £15.5 million. The three are currently the biggest shareholders in Ocado.

Top ten shareholders in Ocado Group

	Shares (millions)	% stake
Capital Group Company	82.2	12.93%
Rausing Jorn (Apple III)	72.4	11.39%
London & Amsterdam Trust Company	70	11.01%
Lansdowne Partners	43	6.77%
Vanguard Group	31.7	4.99%
Massachusetts Mutual Life Insurance	29.4	4.63%
Baillie Gifford & Co	20.4	3.21%
UBS	20.1	3.16%
Exor SA	17.6	2.76%

^{(Source: Bloomberg, as of 21/05/2018, holdings may be held in multiple portfolios)}

The shares purchased by the three biggest shareholders and others under the February placing are not far from doubling in value as Ocado shares find new highs.

Ocado Group has long been a favourite with those seeking short positions, and the firm is currently number 16 on the list of most shorted UK-listed stock.

Most shorted UK stocks

	Market value of short position	Stake held by holders	No. of holders
Carillion	—	13.99%	12
Debenhams	£38.5 million	13.87%	8
Greencore Group	£150.3 million	13.69%	13
Pets at Home Group	£104.5 million	13.48%	9
Marks & Spencer	£556.4 million	11.74%	10
GVC Holdings	£658.9 million	11.73%	13
Restaurant Group	£71.4 million	11.65%	9
Aggreko	£196.7 million	10.49%	8
Sainsbury's	£648.2 million	9.66%	9
Ultra Electronics Holdings	£102.8 million	9.16%	8
Anglo American	£2.16 billion	9%	7
IQE	£83.4 million	8.99%	6
AA	£73 million	8.78%	8
Greene King	£128.4 million	7.57%	7
Ocado Group	£365.6 million	7.19%	7
Morrisons	£421.4 million	7.03%	8
Telit Communications	£13.5 million	6.94%	3
Provident Financial	£108.8 million	6.72%	7
RPC Group	£216.3 million	6.55%	9

^{(Source: Bloomberg, as of 21/05/2018. Market value as of last closing price)}

Notably, Ocado’s first partner (Morrisons) is also one of the most shorted stocks in the UK, as is food and clothing retailer Marks & Spencer (M&S). The boost to Ocado’s share price has seen the company’s market cap overtake that of M&S and its valuation now hot on the heels of Morrisons.

Still, there are some that hold large short positions on Ocado Group:

Short positions held on Ocado Group

	Market value of short	Stake held
GMT Capital Corp	£96.1 million	1.89%
Kairos Investment Management	£76.8 million	1.51%
Marshall Wace	£50.9 million	1%
Parvus Asset Management Europe	£43.7 million	0.86%
Hunt Lane Capital	£36.6 million	0.72%
UBS Asset Management UK	£31 million	0.61%
Blackrock Institutional Trust	£30.5 million	0.60%

^{(Source: Bloomberg, as of 21/05/2018. Market value as of last closing price)}

Conclusion: Ocado is starting to deliver, but is not out of the woods yet

The Kroger deal will go far in silencing those that have long-criticised Ocado and doubted its ability to turn from online grocer to technology provider, but the company now has the huge task of actually rolling-out the partnership over the next three years.

While the rate and quality of the deals Ocado is securing can only be seen as positive, every new agreement mounts pressure on Ocado’s finances, due to the intensity of capital needed to get centres up and running and the delay in generating income from them.

Ocado has proven there is demand for its technology. Now it has to prove it is profitable.

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