Commentators love to hate Ocado Group PLC (LSE:OCDO, Financial). Many say the stock is overvalued, doesn’t have enough capacity and has no sign of net profits. They say the company missed a golden opportunity during the lockdowns, has executed poorly on operations and that the stock is only in the FTSE 100 because interest rates are practically zero.
I’m not one to dismiss the other point of view. The best investors spend lots of time looking for problems in any investment thesis. Some of the arguments against Ocado have some validity, and I definitely understand not wanting to own shares of a company that's not profitable yet. It’s just a question of how you are looking at things, and what the future holds for the company.
On valuation, certain metrics look expensive. But then, technology stocks do tend to have higher valuations because of the growth potential on offer. Amazon.com Inc. (AMZN, Financial), for example, had a price-earnings ratio of more than 100 for the longest time, and yet the stock kept going up, with earnings eventually beginning to catch up to the high valuation. For Ocado, the GF Value chart shows the stock as fairly priced - for me, that’s a good starting point.
On capacity, Ocado is ramping up, and its retail joint venture with Marks & Spencer (LSE:MKS, Financial) is Ocado’s touchpoint with the UK consumer. This business did quite well during lockdowns, as seen by sales growing by just over a third last year as the average basket size and active customer numbers rose. This was partly an open goal thanks to the pandemic, and critics said Ocado should have done better, as new visitors couldn’t place orders as its website and capacity for grocery delivery could not meet demand early in the pandemic when people did not want to do in-person shopping. To be fair, among all the grocers in the UK, only Tesco (TESO, Financial) was able to ramp up to meet demand. This was a black swan event, and most companies were not able to pivot quickly enough. However, consumers are more comfortable with online shopping now, which plays to Ocado’s advantage in the longer term.
However, the real value of Ocado isn’t in book selling; the company's future growth potential comes from its back end systems, not the customer facing grocery delivery. Ocado provides solutions and logistics businesses, which provide software and automation for grocery delivery, which it calls the Ocado Smart Platform, or OSP. It uses this itself in the UK with Marks & Spencer, but internationally, it licences this technology to a range of large national grocery chains, and this is the main growth opportunity for Ocado. It’s also an asset-light business as the grocery chains have ownership of the physical assets. So, commentators highlighting the problems with Ocado’s own warehouses or capacity growth in the UK are missing the point. While Ocado is classified as a "Consumer Staples" stock by FTSE, in reality, it’s trying to turn itself into more of a technology or systems provider.
This brings me to the reason why Ocado is losing money. In fact, Ocado has positive Ebitda and operating cash flow. The negative cashflow in the first half of 2021 was due to a high amount of capital expenditure and business acquisition spend. We are not talking about a mature company or industry where we should expect a cash cow. This is a relatively new industry, and Ocado is a first mover and innovator in this industry amid its home market. Thus, I think we should allow the company to make investments for the future.
New business for the OSP requires some cash investment up front. While the construction of warehouses is borne by clients, the cost of the software and automation technology is Ocado’s. The solutions offering charges clients an upfront fee and a continuing fee based upon delivered sales capacity, said to be about 3% and 5%, respectively. So right now, we are still in the J-curve period, where the infrastructure spend is outpacing the revenue collection.
Right now, Ocado has six customer fulfilment centers live in the UK and four in international markets. It also has a strong committed pipeline of 56 across eight markets beyond 2022.
I am comfortable with Ocado’s financial strength, as it has a strong Altman Z-Score of just over 5 and a stable Piotroski F-Score of 5 out of 9 (but I'm definitely not saying Ocado is a value stock). Revenue per share is good and is seeing consistent growth.
Another reason I hold this stock is because my portfolio is value-heavy with many “old economy” type positions. I try to be style agnostic and have a diversification of characteristics in my portfolio. I want to own some high growth potential to hedge against the old economy cash cows. There are not too many very exciting innovative growth stories in the UK. Wise plc (LSE:WISE, Financial) is one (which I own and I wrote about here) and Ocado is probably the main other one. Growth guru James Anderson of Baillie Gifford (Trades, Portfolio) said earlier in the year:
“I still struggle to see, with the probable exception of Ocado, companies with the same level of ambition [as the big technology players of Silicon Valley].”
The shares may be down 20% in the last year, as pandemic winners have been rotated out of, but in the bigger picture, Ocado is still in a bull market. The shares are now trading for just over 18 pounds ($24) each. They were trading for just ÂŁ5 in 2018 and under ÂŁ1 in 2012.
The argument to sell now and buy back cheaper later, on the basis that interest rates might rise and growth stocks will fall hard, reminds me of the exchange between Elmer Harwood and Mr. Partridge in Reminiscences of a Stock Operator:
“My dear boy,” said old Partridge, in great distress “my dear boy, if I sold that stock now I’d lose my position; and then where would I be?”
It’s like if you sold Amazon.com in 2000, would you have really bought it back in 2001? I believe I’ll hold Ocado for a long time and focus on their strategy and customer acquisition for the time being.
