The Business Model – How does it work?

Ocado is the UK’s leading online grocery business. It’s more commonly known for delivering groceries to customers doors. And this does remain the primary source of revenue. But it has recently begun to evolve.

Today, Ocado utilises advanced robotics and machine learning to automate its warehouses (fulfilment centres) and distribution methods. Using the Ocado Smart Platform (OSP), its growing list of partners can seamlessly scale up their online grocery businesses in a cost-efficient manner. The list includes companies like Morrisons, Kroger, and Coles.

Beyond grocery delivery and warehouse automation, the company has also been heavily investing in long-term ventures within the field of robotics and vertical farming.

Industry:Retail (Groceries)
Analyst:Zaven Boyrazian
Cog Score:77 / 100
Last Updated:17th May 2021
Date Added:17th May 2021
Price Added:1,959p

Revenue & Cost Drivers – How is the money flowing in and out?

Ocado generates income from its two divisions.

Ocado Retail

This segment is responsible for the sale of online groceries and serves individual shoppers directly. Customers sign in to Ocado’s website, select which groceries they want to buy and then a few days later, the goods arrive on their doorstep.

Beyond selling its own products, the business has long since had an established relationship with UK supermarket Waitrose. Sadly after working together for 20 years, this partnership came to an end in August 2020. But this decision was made back in 2019, and the management team was prepared for it. In its place, Marks & Spencer (M&S) has entered into a 50/50 joint venture and paid £750m for it.

Under this new agreement, Ocado shoppers can now purchase M&S branded products on Ocado’s website. And based on the latest trading update, it seems customers are embracing the new relationship. On average, 25% of a customer’s basket contained an M&S branded product.

Online grocery shopping has slowly been rising in popularity over the years. But in 2020, due to lockdown restrictions caused by the pandemic, the online channel of UK grocery shopping doubled from 7% to 14%. Naturally, this created a favourable environment for Ocado to operate in. So I’m not surprised to see the divisions revenue grow by 35% to just under £2.2bn.

There are some valid concerns from investors regarding whether this performance can be maintained going forward. After all, as lockdown restrictions begin to ease, people will likely return to the more traditional trip down to the local shop. But according to several surveys, around 82% of UK shoppers who tried ordering their groceries online in 2020 would likely continue to use it even after the pandemic has ended.

This segment was the core business model of Ocado for many years. And arguably, it still is today since it generated about 94% of total revenue last year. But the management team is actually refocusing the business to its second source of income.

Ocado Solutions

This segment is still relatively early in its development cycle but holds the potential to launch the business into a period of super growth. At least that’s what I think. It generates revenue in two ways. The first is charging UK supermarkets for the use of its delivery network and infrastructure. Currently, the list of companies includes M&S, Morrisons and of course, Ocado Retail.

The second and, in my opinion, the more exciting method of revenue generation comes from the Ocado Smart Platform (OSP). OSP is a mixture of expert personnel, software, and robotics that automate the processing, storage, and packaging of groceries purchased online. Supermarkets pay a recurring fee during their agreed contract (which usually lasts up to two years before renewal) to deploy the platform for their own operations.

There are eight large scale supermarkets subscribed to OSP (excluding Ocado Retail), mostcannot of which are based internationally. The list includes Groupe Casino (France), Kroger (US), Coles (Australia), Sobeys (Canada), ICA Gruppen (Sweden), Aeon (Japan), Bon Preu (Spain), and finally Morrisons (UK).

Overall this division achieved a 13.6% revenue growth last year. This obviously isn’t as exciting as the 35% growth of Ocado Retail. However, if I isolate the income received through fees alone, the division grew by 52%!

Looking at the business as a whole, it achieved record sales in 2020. But despite this, it remains unprofitable, which certainly adds a level of risk.

Taking a closer look at the underlying profits, Ocado Retail surged by 265% from £41m in 2019 to £149m in 2020. However, Ocado Solutions didn’t fare as well. In fact, the division saw its profits drop by 38.4% and 51.7% for its UK and International operations, respectively.

The lacklustre performance appears to be mainly attributable to the significant investments made in expanding its fulfilment centres, increasing the OSP capacity. In 2021, an additional three facilities are expected to become operational. Given that the reduced profitability is being caused by increased investment rather than operational problems, I am not overly concerned. But I will be keeping a close eye on whether these new facilities are brought on-line as scheduled and how much value they start creating.

Fundamentals – How do the financial statements look?

As Ocado accelerates its international expansion with the construction of new fulfilment centres, the firm has been taking on a considerable amount of debt. Based on the latest figures, the balance sheet has a total of £1.4bn of loans and equivalents.

Given the lack of profitability, this does add some solvency risks. However, it seems that a large portion of the raised capital has yet to be spent. As such, the company is currently flooded with cash providing an enormous level of liquidity. In fact, the current ratio is now sitting around 4.8.

Therefore, I don’t see Ocado running into any immediate financial troubles. However, because this cash is sourced from loans and the issuance of shares, it is ultimately a non-sustainable resource that cannot be relied upon over the long term. I’ll be watching closely to see whether the management team announces plans to repay its obligations and buy back shares once stable profitability has been achieved.

The high level of liquidity is undoubtedly a good sign. However, I wonder whether this capital can be better used than collecting virtually no interest in a bank account. Ocado is actively investing in a wide range of ventures that range from robotics to vertical farming. The latter seems quite exciting to be given the forecasted scale of the agricultural technology market over the next ten years.

But so far, looking at the return on invested capital (ROIC), none of these ventures has managed to create any substantial value. As a reminder, ROIC is the percentage gain on each Pound invested by the business.

In 2020, the ROIC was positive, suggesting the creation of value. However, upon closer inspection, this is not actually the case. Why? Because the firm’s operating profit is being inflated by income generated through non-core operations. Specifically, these profits are made from advertising on its website and minor rental agreements on some of its properties.

Removing the influence of this income reveals that the ROIC is still firmly within the red. Although it did see some improvement last year.

I will be keeping an eye on how the ROIC behaves throughout 2021. Many of Ocado’s ventures are long-term investments, so I’m not expecting a substantial increase this year. But over the next few years, I’d want to see these returns improve. Otherwise, it may indicate the management team is not able to successfully identify lucrative investment opportunities.

Competitive Advantages – Why will it beat its rivals?

While Ocado Retail remains the dominant part of the business, the firm is mainly competing with traditional supermarkets. But there are a few other grocery delivery services like Instacart to contend with. The firm doesn’t appear to have any vast economic moat beyond the convenience provided to customers by ordering groceries online. It does offer thousands of different products. But so do other online grocery retailers. And as more supermarkets enter the online space, I believe the existing advantages will continue to wither.

This process has already begun to happen. For example, Waitrose has just partnered up with Deliveroo to offer their online customers the ability to receive groceries within a minimum of 20 minutes!

However, Ocado Solutions does show signs of a growing moat. Beyond the continual efficiency improvements made to OSP, there appears to be the start of the formation of switching costs. As businesses become more dependent on Ocado’s automated technology, the cost of shifting to their own solution or adopting that of a rival is rising. This also grants the firm a bit of pricing power at the same time.

What’s more, with each additional subscriber to the service, Ocado naturally generates more cash flow. This can then be re-invested into expanding its capacity, which, in turn, builds a stronger value proposition for more businesses to join OSP, thus repeating the cycle. In other words, a network effect.

Overall, the competitive moat of Ocado is widening but remains relatively narrow at this stage. And it likely will stay that way so long as the firm remains reliant on Ocado Retail as its primary revenue driver. At least, that’s what I think.

Risk Profiling – What are the potential weaknesses?

Least Concern

  • Ocado’s automation technology is not the only one available on the market. If rival firms innovate new methods that lead to higher efficiency for businesses, it could begin to lose customers.
  • The business operates on an international scale which exposes it to fluctuating exchange rates. The use of forward contracts can mitigate this impact, but large swings in currency prices can adversely affect profits.

Growing Concern

  • Some of the equipment used in the firm’s warehouses are sourced from a single supplier. Any delay in or supply chain disruption could negatively impact product availability and reliability. This, in turn, would result in delays in payments from its customers leading to potential revenue loss.
  • Different countries have different regulatory requirements surrounding the storage of groceries. If Ocado is unable to comply with these rules, it would likely suffer hefty fines and potentially lose customers and partners.
  • The firm is continually reinvesting its Customer Fulfilment Centres to expand operating capacity OSP. However, any delays in this process may give the impression that Ocado is not reliable and may lead to reputational damage.

Serious Threat

  • Due to the heavy reliance on technology, any cybersecurity breach could have a major impact on the business’s operations. Beyond any interruptions to service, the exposure of customer data would likely result in significant reputational damage as well as potential legal expenses.
  • The biggest selling point of Ocado’s Smart Platform is the ability to provide a highly efficient online grocery selling solution for businesses. Should it fail to deliver results expected by customers or not be as cost-effective as promised, it’s unlikely that subscription contracts will be renewed.

Valuation & Forecast – What does the future hold?

Valuing an unprofitable business in the middle of a strategic shift is quite tricky. But assuming the company can maintain its current level of revenue growth and make Ocado Solutions the core operation of the business within the next five years, my unprofitable project income model has estimated that the intrinsic value of the share price lies around 2,108p. Comparing this to the current share price of 1,959p indicates the stock may be undervalued.

But those are some lofty assumptions. And historical performance is not an accurate indicator of what the future might hold. If any slowdown in growth were to occur, it would likely have a significant adverse effect on the Ocado share price.

However, if it can meet these expectations, then I believe its share price is capable of considerable growth. Let me explain why. Using the management team’s projected capturable market size, there is an estimated range of £3.5bn to £26.25bn in potential OSP fees. These figures are dependent on the level of online penetration of the grocery retail sector, spanning from 10% to 75%.

A 75% penetration does seem a little optimistic over the next couple of years. But over the long term, I do think it’s plausible. Today, around £242bn of grocery shopping is done online worldwide. That’s about an average 8.4% level of penetration of the £2.8tr market size. This means that even if penetration doesn’t increase, Ocado still has a potential £3bn to capture. Comparing this to the £124m of fee income from 2020 leaves an enormous amount of room to grow.

What’s the score?

With e-commerce becoming a more prominent portion of global spending, Ocado offers a promising solution for businesses and individuals to get their groceries. At least that’s what I think.

Currently, the company is still very much an online retailer. And the transition towards a robotic agricultural automation business will likely take many years before becoming the dominant source of revenue.

But suppose it is successful in expanding the reach of its OSP, and the online penetration of grocery shopping continues to rise. In that case, I believe Ocado could become a leader in this market.

77 / 100

Zaven Boyrazian does not own shares in Ocado Group. Reasonable steps have been taken to ensure the accuracy of the information at the time of publishing. The views and expressions within this analysis are the opinions of the author. It has not taken into account the circumstances of any specific individual, and does not constitute personal advice or a personal recommendation for any individual; neither should it be solely relied upon by any individual when making an investment decision. The Money Cog has a disclosure policy.