Ocado Group OCDO LN
March 26, 2019 - 10:20am EST by
Shakalu
2019 2020
Price: 13.00 EPS -0.06 -0.03
Shares Out. (in M): 692 P/E N/M N/M
Market Cap (in $M): 12,000 P/FCF N/M N/M
Net Debt (in $M): -66 EBIT 0 0
TEV ($): 11,934 TEV/EBIT N/M N/M

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Description

 

Thesis Summary: Ocado is a UK-based logistics tech company specialising in online grocery retailing. Over the last 19 years the company has developed a solutions platform that allows grocery orders placed online to be processed, picked and delivered in a fast, accurate and profitable way. Prior to signing its first international deals, market perception of the company had been negative for years as investors attached a negative value to Ocado’s IP. Over the last 18 months Ocado has signed several lucrative licensing deals with large retailers in X countries (Krogers, ICA, Casino, Coles, etc), which has rerated the stock from a low base. Despite the move in share price, we believe Ocado is only at the beginning of its growth trajectory driven by a combination of the scaling of its solutions platform through international partnerships (present and future), increasing online penetration of the grocery market globally and various other market opportunities.

 

Company Overview:

 

History and background

 

Ocado is the world’s largest dedicated online grocery retailer and solutions provider. The company was founded in 2000 effectively as Waitrose’s online business, as in November of the same year it entered into its first branding and sourcing arrangement with Waitrose. The UK market at the time was and still is an oligopoly with under 10 major players capturing nearly all of the market. Among these major players, Waitrose differentiates itself with its premium product offering while its online offering through its partnership with Ocado allowed it to become a first-player in what has since become a much bigger market – online grocery retail.

Ocado’s partnership with Waitrose together with the deal it struck with Morrisons in 2013, allowed it to develop a fully automated grocery picking and packing warehouse model over the span of a decade. As part of its buildout of the first Customer Fulfilment Centre (CFC) in Hatfield, Ocado developed bespoke systems and processes, avoiding the need to use off-the-shelf software packages and solutions that would have constrained its ability to reach the needed levels of complexity and efficiency for a profitable large-scale online grocery operation.

Grocery retail market and online segment dynamics

A look at how most other grocers have chosen to solve the online grocery challenge points to Ocado’s high differentiation and unique offering.

Grocers typically operate on very low margins, usually in the range of 1-4%. This means that unless under pressure, investing in an online offering is not on top of most grocers’ agenda. This explains why most grocers, in their attempt to develop an online offering, have invested in the least capital-intensive models e.g. in-store picking.

While providing a short-term solution to the loss of customers to grocers with an online offering, the potential for in-store picking to satisfy long-term demand while maintaining grocers’ already low margins is very limited. First of all, each store typically has a capacity of just ~1,000 orders per week, inherently limiting the ability of any in-store picking model to meet higher levels of demand. In addition, the reliance of this model on manual labour to pick customers’ orders inherently limits its efficiency in terms of the fully loaded picking rate (total number of items picked divided by total labour hours) to a range of 75-100 items an hour, which compares to 182 at Ocado’s newest CFCs. Furthermore, in-store picking is only suitable for certain types of stores, as the inventory and range of assortment available in small stores isn’t large enough to operate an online offering. Small stores’ isles are too narrow for efficient picking and there is no space for buffering orders in the backroom. Large crowded stores aren’t suitable to serve as a basis for an online operation either given the inevitable competition for produce between pickers and regular customers and the resulting deterioration of the in-store customer experience.

Ocado’s online grocery model, on the other hand, manages to completely overhaul the grocery picking and packing system. While from a customer’s point of view the action of going to a physical store for a bi-weekly or weekly stock-up adds little value given the largely homogenous/fixed nature of the basket bought each week, from the grocer’s point of view fulfilling these orders is a very complicated operation. This is due to the varying size, shape, fragility, shelf-life and temperature needs of each product, particularly in the fresh category. It is the Herculean nature of this task that makes Ocado’s achievement to date a true feat.

Ocado’s technology over the years

Ocado’s first-generation of CFCs – CFC1 and CFC2, are based on linear conveyor systems with zone picking. Automated conveyors route customer totes down different aisles to pick stations, where pickers select from adjacent “shelves” which are automatically replenished from inbound goods which are decanted and stored in high racking. CFC1 was able to achieve a “units per total warehouse labour hour” (UPH) rate of 150. However, CFC2’s improvements to layout, hardware and the use of automated storage and retrieval systems for slow moving ambient SKUs have increased the UPH to 175. This first generation of CFCs has reached a combined EBITDA margin of 10.1% (after including delivery costs).

In its second-generation CFCs (CFC3 and CFC4), Ocado has developed an altogether different model of operation – the Hive concept. Unlike the previously linear nature of the operation, the Hive relies on robots (automated guided vehicles) moving across a grid which sits on top of a storage array – lifting and lowering totes containing customer orders or inventory to locations within a three-dimensional grid. 

 

https://www.youtube.com/watch?v=iogFXDWqDak

 

https://www.bbc.co.uk/news/av/business-38897417/the-ocado-warehouse-run-by-robots

 

The robots store products in the Hive (either the ambient or the chilled section), which they will then dig for and pick up upon the execution of an order – carrying the needed goods to the picking station where pickers pick the items from the product tote and place them in a customer order tote. Once a customer order is ready for delivery the bots will store them within the Hive before the order needs to be dispatched, when the bots will retrieve the orders from the Hive to be loaded onto the delivery trucks.

 

The benefits of the Hive system can be summarized as follows:

 

  • The 3D structure of the Hive means that Ocado can begin CFC build-outs with small initial capacity and therefore smaller capex outlay while not compromising on the range of SKUs offered
    • Increases in capacity are easy to implement given that the grid can simply be extended together with more bots being added
  • Linear nature of the first-generation CFCs meant that it took much longer to put together a typical 50 SKU order than it does in the case of the Hive, with the former taking 150 minutes per order and the latter as little as 5-10 minutes
  • Greater resilience of Hive system in case of a malfunction of any part of the picking and packing ecosystem, with bots being easily replaceable and substitutable (this is in contrast to the critical nature of each part of a linear picking and packing process, where failure of any part of the chain causes a whole conveyor line to grind to a halt)

 

Thus, in addition to having an operational model which completely overhauls and automates the store-based picking operation, Ocado has managed to also greatly improve on its own initial offering by relentlessly innovating and improving upon its own technology.

Market perception of the company over the years

 

In Ocado’s early years as a public company its reinvestment of at least £50M per year of its free cash flow into further automation and development of the picking and packing process as part of its Ocado Solutions business,  weighed down on its share price as the market failed to perceive the highly valuable nature of the solution it had developed, its highly transferrable nature and scalability across the globe. This market perception was reinforced by Ocado’s failure to get an international deal through its Ocado Solutions platform by its initially targeted deadline of the end of 2015, instead signing its first major international deal in November 2017 (with Casino in France).

 

The large increase in the company’s share price since the signing of the Casino deal reflects the partial realization by investors of the coveted nature of the technology and intellectual property developed by Ocado. However, in our view, the company’s share price today only partially reflects its value given the platform-like nature of its Solutions business which is not only highly transferrable across different retailers, type of product and geographies but is also the best in class and unrivalled by any other grocer or online grocery delivery service provider in the world.

 

Therefore, the good performance of the stock over the past year doesn’t in the least indicate full or even substantial reflection of the total value of the company in its stock price. This is because the recent share price increase is coming from a low base that persisted throughout the company’s pre-2018 history, which was caused by the ascription of negative value to the company’s IP – an attitude which still persists given the early stage of development of Ocado’s partnerships, which are still in their capex phase, and Ocado’s inability to book revenues in connection with these partnerships that it derives in the form of license fees upon signing and fees running up to the launch of CFCs due to IFRS 15 rules.

 

We therefore believe that the recent share price appreciation is a small move in the bigger picture that is the scalability of Ocado’s solutions and its direct relevance to many issues faced by online retailer grocers.

 

 Business Segments

 

Ocado operates in 2 business segments:

 

  • Ocado Retail is mainly comprised of the Ocado.com webshop which provides a range of 54,000 SKUs including groceries and household items from Ocado’s own private label offering, the private label offering of Waitrose (to be replaced by M&S in September 2020) and some CPG branded products sourced either in conjunction with Waitrose or directly by the company
    • Ocado Retail includes the company’s Customer Fulfillment Centers (CFC), spoke networks and end-to-end logistics platform
    • This business segment operates as any grocer but with an overhauled operational model; this means that like any retailer it earns its profits from a combination of the markup on goods sold, membership payments from its Smart Pass program for frequent customers and delivery fees for certain orders below its free delivery threshold 

 

  • Ocado Solutions, on the other hand, concentrates on monetizing the company’s IP and know-how on a global scale; Ocado Smart Platform (OSP) is the end-to-end solution for operating online in the grocery market developed by the Group, which the company leverages to become the e-commerce solutions partner of choice for leading retailers globally looking to launch and develop their online operations
    • This segment includes Ocado’s partnerships with Morrisons in the UK, Group Casino in France, ICA Group in Sweden, Bon Preu in Catalonia - Spain, Sobeys in Canada, Coles in Australia and Kroger in the US
    • The profitability of this segment of the business is derived from the upfront fees that international customers pay upon the signing of a deal with OSP, fees paid during the development phase and ongoing fees linked to the utilization of capacity within a given CFC
    • Ocado’s customers usually pay for the CFC sites, the building, their servicing with adequate electricity and other utilities, while Ocado takes ownership of and pays for all the equipment, robots and technology

 

Investment Thesis:

Ocado’s proprietary state-of-the art solution to online grocery services

Ocado has tackled the concerns that have held back penetration rates in the online grocery segment to date. Some of the reasons that the shift to online in the grocery segment has been slow are customers’ concerns about freshness, the possibility of substitutions when ordering online, the difficulty of arranging a delivery and the costs associated with delivery services.

  • Freshness of groceries in traditional online delivery services is impacted by two major factors:
    • The lengthened supply chain that leads to the customer’s door
    • Traditional retailers rely on retail distribution centers which are the first stop for groceries being delivered by suppliers. It is from these retail distribution centers that groceries are delivered to stores or semi-automated dark stores from where the online delivery occurs. This means that traditional online grocery services lengthen the journey of fresh produce, as it spends more time in warehouses and rather than being directly picked up by the consumer has to undergo an additional journey before reaching the consumer.
  • The last-mile delivery of the groceries
    • The fragile nature of fresh produce makes last-mile delivery particularly difficult to execute without damage to the products. Fresh produce often needs to be carefully packaged and refrigerated on its way to the consumer, making this journey particularly expensive as evidenced by the high delivery costs discussed below. Therefore, suboptimal delivery methods (i.e. lack of refrigeration, too much physical impact to produce from road journey etc.) can substantially jeopardize the value of the online grocery offering.


  • Substitutions are an issue because grocers are lacking technology to accurately track their inventory in real-time. This results in ~15% of products listed on US online grocery services being out of stock at any given time (~double the rate in stores) resulting in low levels of picking accuracy resulting in a high level of substitutions and inevitably customer dissatisfaction. A recent WSJ article on the topic summarizes the issue perfectly (https://www.wsj.com/articles/amazon-to-whole-foods-online-delivery-customers-were-out-of-celery-hows-kale-11553425200?mod=searchresults&page=1&pos=2):

“Many grocers don’t have technology that can readily track inventory in real-time. That means items listed as available online often aren’t in the nearest stores filling a delivery order, leading employees to make their best guess or rely on computer recommendations that can suggest unsuitable substitutions. …

There are a number of reasons why many online grocery services struggle to offer substitutions customers want. Shoppers typically depend on suggestions from online tools, and algorithms can make mistakes or suggest inappropriate alternatives. Services that rely on gig-economy workers who pick items off store shelves can exacerbate the selection problem, since many aren’t food experts and juggle many orders a day. Grocery consultants say.

Mishandling substitutions is expensive for retailers, as it often leads to refunds or a replacement item that is pricier than the original. Refunding incorrect items decreases an online order’s profitability by 1% to 2% on average, according to research by McKinsey & Co. The problem can be particularly bad with promotions, angering suppliers when their products are swapped out for a rival’s”.

  • Home delivery of groceries costs an average of $10 per order, however customers’ limited willingness to pay for convenience means that grocers only get reimbursed an average of $8 per order. However, unless this average charge of $8 per order is reduced substantially, the penetration by the online segment of the wider grocery retail market will remain limited, preventing the benefits of superior economics which arise from denser delivery.
    • While busy and well-earning urban dwellers may be willing to pay for convenience, suburban residents accustomed to long car journeys as part of everyday life are unlikely to take up online purchases of groceries unless delivery costs are substantially reduced

Below is a summary of how exactly Ocado has tackled all of these issues:

  1. Ocado’s disintermediation of the traditional supermarket supply chain has meant that it is able to guarantee the provision of products which are fresher than those found at a supermarket, reaching Ocado ~24 hours earlier than they would a physical supermarket.

Traditional supermarkets operate through a large network of retail distribution centers (RDC) where suppliers deliver groceries. It is then from these RDCs that the products are delivered to supermarkets. Ocado, on the other hand, has the groceries delivered by suppliers directly to its CFCs. It is then from the CFCs themselves that the products are delivered to the customers, after a stopover at a spoke for 2/3 of deliveries where the goods are re-distributed to smaller vans. This system implies that Ocado has less buffer stock, minimizes the time its product spends in warehouses and maximizes the speed of delivery from the source. The result is that Ocado can guarantee that 2/3 of the code life of a product will be spent in the customer’s refrigerator, something that traditional supermarkets are simply unable to do.

2.                   The highly automated process within the CFCs themselves, ensuring less human interference in the handling of products and therefore reduced human error, together with higher rotation of stock due to a shorter supply chain, reduces wastage/shrinkage costs to ~0.8% of net sales vs. traditional retailers’ shrinkage cost of 2-3% of sales. This not only impacts Ocado’s bottom line, but also contributes to products’ greater freshness when delivered to customers, given reduced handling of fresh produce by workers.

 

3.                   The high level of automation in Ocado’s operating model together with its 100% online model also means that Ocado has high visibility of its available and inbound stock, and any pending customer orders. This translates to a superior ability to notify customers of the availability of its products for specific delivery slots, thus reducing the number of orders in any year that have substitutions to <1%.

4.                   It is this very same operating model which allows Ocado to operate at such a cost advantage to physical supermarkets as to make the delivery of groceries at low costs to customers economically viable. Ocado’s cost advantages can be broadly broken down as follows:

Disintermediation of the RDC network: the RDC model costs retailers ~2-5% of sales and Ocado is able to eliminate ~90% of these through its shorter supply chain

High automation: Ocado’s first generation CFCs – CFC1 in Hatfield and CFC2 in Dordon, use conveyor systems to route customer totes down aisles to pick stations, with pickers (human labour) selecting from adjacent shelves which are themselves automatically replenished with inbound goods, decanted and stored in high racking; Ocado’s second generation CFCs – CFC3 in Andover and CFC4 in Erith, are even more technologically advanced – operated through a Hive system where robots decant products from suppliers into totes, dig for a required SKU, carry a product tote to the pick station, carry completed customer orders to storage and then retrieve the customer totes ahead of loading a van for its route; this state of the art proprietary technology and end-to-end highly automated process allows Ocado to save on a lot of labour costs which amount to as much as ~9% of sales for traditional retailers vs 0.7% at Ocado

Reduced waste costs: as already mentioned above, this highly automated process reduces costs related to shrinkage/waste from the ~3% of sales at traditional retailers to ~0.8%

Lower property occupancy costs: Ocado’s pure-play online business model means that it doesn’t require a whole network of retail space for physical shops; instead Ocado uses warehouse space on light industrial land, which is considerably cheaper; this also impacts expenditure on utilities due to extensive chilling and electricity needs in retail locations of grocers; traditional retailers’ spending on the property and utilities amounts to 6-8% of sales vs. <2% for Ocado

Media and other income benefits: Ocado also benefits from the income it derives from the sale of advertising space and targeted promotions on its online platform to Fast Moving Consumer Goods (FMCG) suppliers; this segment amounted to ~4% of sales in 2018 and has been a structural tailwind to gross margins over the years, especially with the increased use of Ocado’s mobile channel where pricing for advertising is higher

 

These cost advantages amount to ~19-23% of sales and allow Ocado to accommodate last-mile delivery costs which amount to ~11% of sales, without having to charge customers too much for the service. This is in addition to costs relating to its CFCs which stand at ~8% of sales. As a result, Ocado is able to offer efficient delivery within 1-hour time slots – ensuring convenience for the consumer for a reasonable delivery charge - averaging £1.50 in the UK with certain deliveries above £75 and deliveries to SmartPass subscribers being free.

It is the very fact that Ocado has completely reconfigured the operations of a traditional retailer in developing its online grocery solution that makes its offering highly attractive and greatly superior to solutions of competitors.

 

Kroger deal and further optionality from international deals

The success of the Ocado Solutions segment of the Group points to the fact that rather than a simple online retail grocer, Ocado is a technology, logistics and software company, with know-how and IP in the optimization of grocery supply-chains unparalleled by anyone in the world. This is likely to drive further deals with international supermarket chains as the moves that some have already made in partnering with Ocado are likely to kickstart defensive moves by competitors to also create an online offering, thus further driving the online penetration of the grocery retail market of that particular geographic area. This trend has already been witnessed in relation to Amazon’s entry into the online grocery segment with Amazon Fresh, Amazon Pantry as well as Whole Foods’ online offering, as US grocery retailers have rapidly accelerated their investment in online capabilities in response.

The Kroger deal is the most expansive international deal that Ocado has signed to date, with plans to build 20 CFCs over the next 3 years. Given the size of the US grocery retail market where Kroger is the 2nd largest player with a 7.17% market share as of 2016 and sales of $122Bn in 2017, this deal is likely to be the primary revenue generator for Ocado in the medium-term. Besides driving strong top-line growth for Ocado, this deal is also likely to result in improved economics for Ocado’s Solutions Platform.

  • Capital efficiency

Ocado’s partnership with Kroger is particularly notable among its international deals given the companies’ agreement to build 20 CFCs over the next couple of years – an operation of a scale that Ocado hasn’t undertaken to date. The scale of the Kroger deal is likely to drive profitability to a new level.

The build-out is likely to further improve the capex/sales ratio of the new facilities given its unprecedented scale vs the very gradual build-out of only 4 CFCs in the UK that has taken place to date. More specifically the scale of the build-out will allow for better procurement of the mechanic handling equipment (MHE) which includes the robots which operate the Hive, the aluminum railing/grid along which they travel and the pick stations, likely to result in dramatically improved economics for Ocado’s partnership with Kroger in the form of greater capital efficiency. These improved capex dynamics could already be seen in CFC4 (Erith) where the MHE capex/sales ratio dropped to 10% from the 13% ratio in CFC3 (Andover), and the total capex/sales ratio dropped to 19% from the 21% in CFC3. This opportunity for further capital efficiency will further be helped by the modular nature of Ocado’s second-generation Hive CFCs, allowing smaller scale build-outs to still be economically viable, thus allowing for a quicker return on  investment.

The superior economics created by large scale procurement combined with Ocado’s negative working capital model, provide for attractive returns on invested capital (ROIC), with the fourth CFC at Erith already achieving a ROIC of over 50%.

  • Opportunity for exponential growth in market with low penetration

However, the international partnerships story is about more than mere capital efficiency, as most of the markets where Ocado has signed partners and particularly the US, have yet to experience even the first leg of growth in online grocery sales - experienced in the UK over the past several years. Kroger’s strong position in the US market combined with its plans for a prompt launch of the online offering on a massive scale in a market with online penetration of the grocery market as low as ~1.5% is promising for Ocado. More specifically, we expect Ocado to enable Kroger to develop a delivery to home solution, which given Kroger’s large market share bodes well for the fees that Ocado will be able to derive from its ongoing capacity fees.

  • Further optionality from deploying Ocado Solutions in Kroger’s internal supply chain

There is further optionality from Kroger implementing Ocado’s solution for replenishing its own stores, as this could allow Kroger to reduce the number of regional distribution centers it uses as a midpoint between its suppliers and its retail stores, shifting capacity to Ocado’s CFCs instead. This would allow Kroger to improve the margins of its core business while allowing Ocado to maximize the flow of goods through the CFCs which would also require higher capacities, thus allowing Ocado to reap higher annual capacity fees from Kroger. It has been reported that Kroger is already considering implementing Ocado’s solutions for supplying its Walgreens concessions.

Furthermore, Ocado’s ability to build-out capacity in a modular way and thus to start operations with small capacity before fully scaling a CFC, will allow Kroger to penetrate regions of the country where it may not have operated to date, which it will be particularly incentivized to do given that an online grocery offering like Ocado’s is likely to attract customers away from other grocers. This is likely to be the case even in those regions where grocers already have their own online offerings due to Ocado’s superior operations and cost structure which translates into better customer service with cheaper delivery fees, while maintaining a profitable business.

 

Superiority of proposition and operations to that of competitors

It is important to note that Ocado’s above described solutions to key issues surrounding the online buying and delivery of groceries stand out from those adopted by competitors such as Instacart, Peapod and some supermarkets, not only allowing it to create a superior customer experience but also allowing it to do this profitably, for reasons already described above. Here we will focus on alternative models adopted by competitors and the reasons why they don’t match up to Ocado’s offering.

  • Instacart

Third-party delivery companies currently handle ~50% of the online grocery market. Instacart is the largest independent third-party grocery delivery provider, with estimated sales of ~$2Bn in 2017.

Partnering with Instacart allows supermarkets to offer their customers delivery services. However, while Ocado manages to completely overhaul the supplier to customer chain of travel of grocery products, thus saving costs amounting to ~19-23% of sales to then be able to invest in automating the order and delivering it to the customer at low or no cost to the customer while still remaining profitable, Instacart leaves grocery retailers’ operating model intact instead acting as an intermediary - buying from a physical supermarket on behalf of the customer. The company allows shoppers to order groceries from supermarkets that have signed up in the particular area, and sends gig economy workers to pick up and deliver the orders. In the case of partner supermarkets, Instacart offers their products at no markup on its platform, while marking up the products of non-partner supermarkets by on average 15%. In addition, it charges customers delivery fees in the range of $3.99-9.99 or fees of $99-149 per annum for membership which allows free delivery on orders above $35.

From the customer’s point of view, this model of grocery delivery results in substantially higher prices from the combination of higher product prices (in the case of non-partner supermarkets) and high delivery fees. In addition, the freshness of products is not comparable to Ocado's offering.

Grocers pay these third-party delivery companies an average fee of 10-25% on each order, making their online grocery offering a money-losing operation. In addition, from supermarkets’ point of view, this strategy is risky in the long-run given that they lose control over the quality of the service provided to the customer while at the same time getting blamed for any shortfalls in quality of service. In addition, retailers lose valuable customer data.

Instacart itself is unprofitable (when administrative expenses are accounted for), putting in doubt the sustainability of its business model. While to date the company has benefitted from large uptake of its services by US consumers, this success is largely the result of a lack of viable alternatives. Ocado’s superior customer proposition as well as its superior proposition for partners, is likely to significantly stall if not completely eradicate Instacart’s progress to date. It is important to note that Kroger itself has been using Instacart as a temporary solution to its lack of an online offering before the build-out of Ocado’s CFCs.

The contrast in the operational model of an Instacart-type vs. Ocado, results in the former being easily disruptable by the latter, as Ocado enables retailers to develop in-house online delivery solutions allowing them to retain control over the quality of service to the customers and the data derived from their purchases, while providing an online offering profitably and with potential cost benefits to its existing internal supply chain and physical infrastructure.

  • In-house solutions

Grocers tend to opt for one of two options in developing their online grocery operations in-house – manual picking and packing from physical stores or semi-automated operations in dark stores.

As already briefly discussed above, the manual picking and packing from physical stores is highly problematic given the already low profit margins of supermarkets – in the range of 1-4%, which means that such a “cost-plus” model which effectively develops an add-on delivery service while leaving the basis of the operating business intact, inevitably reduces the profitability of the retailer, while also potentially negatively affecting the shopping experience of the regular customer who now has to compete for products with the pickers, a problem exacerbated with grocers’ struggle to accurately track their inventory real-time.

The “cost-plus” nature of this model is revealed by the extensive investments that grocers have had to undertake in order to implement it, including “reconfiguring their stores, installing coolers for delivery orders, creating dedicated checkout lanes for online-order shoppers and redesigning backrooms and parking lots”(https://www.wsj.com/articles/consumers-love-food-delivery-restaurants-and-grocers-hate-it-11552107610?mod=searchresults&page=1&pos=18).

Semi-automated dark stores while potentially achieving margins comparable to physical stores by separating the operations of the physical stores from the online segment of a grocer, nevertheless also underperform in terms of profitability. This is because the largely fixed cost base of store-based grocery retailing (72% of costs fixed vs. 28% variable) makes traditional grocers highly vulnerable to channel shifts from offline to online grocery shopping. This is because while dark stores manage to somewhat overhaul the online segment of grocers, they still leave the legacy store-based part of the business intact. This is in stark contrast to Ocado’s development of an end-to-end solution which takes out a large part of these fixed costs from grocers’ operating models, allowing not only the operation of a profitable online operation but also having the potential for replacing fulfilment of products to physical stores, something that is likely to be implemented in the M&S JV and Kroger deal.

In addition to the fulfillment of online grocery orders being logistically and financially cumbersome for grocers, they also face the challenge of solving the delivery problem, the extensive costs of which have already been set out above.

  • Further examples of unsuccessful ventures

Peapod and parent company Ahold Delhaize’s combined online grocery offering is a hybrid between the manual picking and packing and semi-automated dark stores described above. Peapod’s operations while conducted from warehouses which are separate from Ahold’s physical stores, are highly labour intensive and equivalent to the labour undertaken by pickers in physical stores. This means that Ahold’s online offering also operates on a “cost-plus” basis, as the system of physical stores is once again left intact, heavily hampering the grocer’s profitability. This explains why Peapod is only profitable in a handful of the markets it operates in.

The lack of traction that Amazon’s roll-out of Amazon Pantry and Amazon Fresh has had and its announcement of entry into the physical grocery business itself is just another sign of just how much it takes to establish a sustainable and profitable online operation, with its lack of success once again being largely attributable to the lack of automation in its warehouses and the non-transferability of its management and delivery of non-fresh items to fresh items.

All this points to the extraordinary nature of Ocado’s technology both in its ability from a practical standpoint to manage fresh produce as well as its ability to do so profitably. This is a testament to Ocado’s position as a technology, logistics and software company rather than merely a grocer, as evidenced by its employment of 1,300 technology employees and over 500 engineers.

 

Further penetration of UK market and consequent margin expansion

  • Online to form larger portion of grocery market

We expect considerable growth in the UK business going forward. As of 2017, the penetration by online of the wider grocery sector was only ~7% in the UK, which although the 3rd highest rate in the world after South Korea which has online grocery penetration of ~10% and Japan with ~7% penetration, is still considerably below online penetration rates in other product markets. Online retail penetration in the electricals, music and video segments in the UK, for example, are closer to 45-50% while online penetration of the clothing & footwear market is ~25%. This makes the grocery sector the anomaly and points to its likely growth as a percentage of the wider grocery retail market in coming years, as evidenced by the vast differential in the growth rates of the total grocery market – growing at low single digits, and the online grocery segment – growing in the mid to high teens in the UK.

Further evidence for the fact that the online grocery market is only going to grow in the future is that so far it has been supply that has been the constraint on demand rather than the other way around, as Ocado has been managing demand through its limited provision of delivery time-slots. It is this supply-led nature of the market that has allowed all incremental capacity to be fully utilized. This points to the existence of strong latent demand for online grocery shopping and the likelihood of its future growth.

Ocado is still at the early stages of an inflection point in the growth of the online grocery market, as Ocado has 721,000 customers in a UK market comprised of 27M households, and its revenue of ~£1.5Bn in its Retail segment is a small fraction of the £200Bn UK food and grocery market vs. Tesco’s £38.5Bn and Sainsbury’s £28Bn.

  • Better capital efficiency and delivery economics due to further penetration of UK market

 

It is important to note that further penetration of the UK grocery market is only part of the growth story of the UK part of the business, as greater penetration with the consequent higher sales volumes that will pass through Ocado will considerably improve the economics of its operations. While Ocado has managed to break the correlation between scale and efficiency in Andover - its 3rd CFC, allowing  for further expansions through modular facilities, operating at a larger scale would nevertheless still improve its margins through greater capital efficiency. But above all the benefit of larger sales volumes in the UK would be derived from better delivery economics. Higher demand in Ocado’s existing catchment areas increases the density of customer orders, allowing them to continuously improve the efficiency of routing through the use of complex algorithms, ultimately resulting in a higher number of deliveries per van per week. In 2018, deliveries per van per week rose 6.6% to 194, a figure that has consistently grown alongside sales/volume growth over the past years.

  • Improvement on Waitrose deal with M&S JV

 

Ocado’s JV with M&S makes the future of the UK story even more promising while also strengthening the financial position of the overall business. The upfront payment of £562.5M by M&S to Ocado for 50% of its Retail operations and the deferred consideration of £187.5M, strengthens Ocado’s balance sheet position ensuring that the company is well funded to deliver the 23 CFCs signed by Casino, Sobeys, ICA and Kroger, any other potential international partners in the future and the 8 CFCs planned with M&S in the UK over the next 12 years.

 

In addition, the JV structure with M&S is superior to Ocado’s current tie-up with Waitrose due to its better alignment of incentives between the two grocers, as both will benefit from the optimization of Ocado.com’s product/SKU offering, removing the inevitable push-and-pull that arose from the Waitrose agreement, where Ocado was limited in its ability to expand its private label offering (restricted to 20% in the earlier years, later rising to 30%). In addition, Ocado up until recently had to pay Waitrose sourcing fees which amounted to as much as a £15M drag on Ocado’s EBITDA (and would’ve amounted to £20M in 2019) arising from fees that Ocado had to pay whenever it sourced branded products from CPG companies directly rather than together with Waitrose.

 

Moreover, the M&S JV contributes to the further monetization of Ocado’s Solutions Platform, providing a >£50M annual income stream for the business segment’s provision of its solutions and technology to the JV. OSP’s provision of services to the JV also creates potential for the deployment of the platform’s state-of-the-art automated solutions in M&S’s own supply chain (something Kroger is considering for supplying its Walgreen’s concessions) creating further optionality in the agreement.

 

  • Addressing concerns about M&S JV

 

However, Ocado’s ability to continue to provide a wide range of SKU’s through the M&S agreement is worth a closer look given the market’s division on this issue.

 

Ocado’s current offering spans 54,000 SKUs, and 65% of Ocado’s annual sales come from branded products, with 40% being branded products sourced through Waitrose and the remaining 25% sourced by Ocado directly (for which it pays the sourcing fee to Waitrose). Thus, the market concern is that the termination of the Waitrose agreement may substantially reduce Ocado’s branded product offering given M&S’s limited branded product offering. The JV structure of the agreement together with the removal of sourcing fees penalizing Ocado for expanding its branded product offering, however, mean that Ocado will have more leeway in developing relationships with CPG companies allowing the maintenance of the majority of this branded SKU range and its further expansion. Ocado’s existing direct relationships with some of these CPG suppliers through its direct sourcing efforts over the years as well as its provision of advertising space on its online and mobile platforms puts it in a strong position to replace the branded SKUs that it previously obtained through Waitrose and continue expanding this range. Moreover, Ocado’s development into a UK household name and a “supermarket” in its own right, means that CPG suppliers themselves are likely to be incentivized to maintain direct relationships with the online retailer.

 

The loss of the private label offering of Waitrose, on the other hand, will be fully compensated by M&S’s own private label offering. Of the 54,000 SKUs currently offered, 4,000 are Waitrose private label. M&S plans to replace at least that many and potentially add more private label SKUs, and has stated that on 3,400 of those private label goods, M&S’s products are 4% cheaper than those offered by Waitrose, with M&S planning to invest in the pricing of other SKUs over coming months.

 

Thus, the M&S JV will ensure just as rich and expansive a range of inventory in the form of >50,000 SKUs.

 

  • Symbiosis between M&S ‘ready-to-eat’ and Zoom

 

Further areas of optionality are likely to be the symbiosis between Ocado’s Zoom offering (described below) and M&S’s wide range of ready-to-eat products (its ‘eat now’ proposition), making a Deliveroo/Uber Eats type offering likely, as Zoom is scaled with the opening of more micro fulfilment centers.

 

 

Immediacy – Ocado Zoom

 

The above described growth in the online grocery market in the UK, however, is only one dimension of the UK/Ocado Retail growth story. Ocado’s entry into the “Immediacy” online grocery market is likely to be a game changer for the Group. In 2018, Ocado reported average orders per week of 296,000 and an active customer base of 721,000, which equates to ~20-22 orders per customer per year. Together with an average order size of £106.85 this points to the fact that Ocado’s main market to date has been in the larger basket segment i.e. the 42% of the UK grocery retail market which is the weekly/bi-weekly stock-up. The remaining 58% of the UK grocery retail market is comprised of “top up” shopping, defined as shopping for baskets <£60.

 

Ocado has started trialing an immediacy service – Ocado Zoom, from March of this year in West London. The service will provide delivery within 60 minutes, of shopping baskets of <£60 in value and offer 10,000+ SKUs (vs ~1,000 SKUs in the average convenience store). The company explains the economics behind the offering as underpinned by the adaptation of Ocado’s unique supply chain model used for its Ocado.com webshop for the Zoom service, with products going from CFCs directly to a micro automated fulfillment facility, instead of going to a spoke or directly to a consumer. In addition, clever software will allow Ocado to replenish the micro fulfillment centers very cheaply and efficiently in small batches of daily deliveries, allowing them to carry a large range of SKUs in a small site ensuring freshness and immediacy.

 

Apart from the efficiency of the supply chain leading up to the micro fulfillment center, the economics of this offering will be supported by the density of demand around any particular micro fulfillment center. Since Ocado envisages delivery from these facilities by third party couriers, with one or two deliveries being made on a journey within a 4-5km radius of the center, for the economics of this undertaking to make sense Ocado needs to be able to generate sufficient demand from a particular micro fulfilment center within a limited radius. Thus, the company will be identifying areas with rich density to ensure that the demand for the service is indeed there before building a micro fulfillment center.

 

This new offering will enable Ocado to penetrate an altogether different part of the UK grocery market both increasing the number of its customers and further penetrating the grocery shopping of those who already shop with Ocado for their larger weekly/biweekly baskets. Furthermore, convenience (i.e. the immediacy segment) is one of the few segments of the UK grocery market that is still growing and is not facing pressures from the discount segment, making entry of the segment particularly attractive.

 

 

Expansion into general merchandise

 

Expanding its operations to the delivery of general merchandise - whether additional household items or clothes, would be a natural development for Ocado. This is because the logistics that goes behind the management and delivery of non-fresh items is nowhere near as complicated and doesn’t required the same level of technological advancement as does the delivery of groceries, and any such endeavor could be carried out within its existing technological infrastructure (barring capacity constraints) given the fact that Ocado already has a small general merchandise offering as part of Ocado.com and Fetch.com – its pet store.

 

The potential for any such undertaking is more likely following the M&S JV, given M&S’s expansive general merchandise offering which will provide Ocado with a way to materially expand its offering in an altogether different addressable market which it has barely monetized to date. M&S’s general merchandise offering is likely to be highly complementary to Ocado’s overall customer proposition as many of M&S’s clothes and home products are sold at a low price-point meaning that they are viewed by consumers as disposable and are therefore easily purchased online.

 

Ocado could also penetrate this market through partnerships with such companies as Primark (Associated British Foods) creating CFCs that would solely cater to the delivery of general merchandise. Such partnerships could also potentially have better economics as the expenditure requirements would be less demanding given the lack of need for separate chilled and ambient sections as well as automated pickers with such technology as to ensure a lack of damage to fragile produce, as pickers using suction cups could often suffice in a general merchandise operation.

 

 

Continued development of IP and state of the art technology

 

The company’s continued commitment to developing IP and proprietary technology creates optionality from further improvements to the efficiency of its end-to-end grocery supply chain solution and consequent further attractiveness and monetization of the Ocado Smart Platform.

 

One such ongoing development is robotic picking and packing of groceries which would constitute a very notable technological advancement given the non-uniform size, shape, rigidity and fragility of fresh groceries and therefore the need for any robotic arm carrying out the task to mimic the capabilities of the human hand while using advanced vision systems.

 

Ocado has also developed what is called OSPick – a system designed to pick a range of groceries within the CFCs using a simple suction cup mounted on an articulated robot arm, with an intelligent vision system that can pick a wide range of products without prior knowledge of the items presented to it.

 

Ocado’s R&D activities in the space of physical infrastructure and robotics will drive further efficiency in its existing and future CFCs by further reducing the need for labour and all the risks associated with having humans employed at CFCs. Yet in addition to the greater efficiency that such developments will drive, such technological advancements are likely to be revenue drivers in themselves, making them more than a way to minimize costs. This is particularly likely given the recent announcement of Ocado’s JV with M&S which marks Ocado’s shift to the OSP segment of its business and likely greater future concentration on monetizing its IP and state of the art supply solutions, making advances in R&D all the more important in driving Ocado’s future value.

 

Ocado’s advanced software capabilities must also be stressed. The recent announcement of a deal with Coles includes not only the build-out of CFCs but also a front-end solution for their in-store picking solution which operates in more rural areas of Australia. While not a significant fee and value driver for the company, a partner’s decision to use Ocado’s solution rather than their in-house software from prior operation of the online grocery offering, points to Ocado’s superiority in consumer-facing aspects of its operations as well i.e. its highly functional front-end websites providing efficient basket building capabilities as well as accuracy of information about inventory/availability. Ocado’s expertise in building front-end solutions has played a role in its earning of a reputation for industry-leading customer levels.

 

In the context of its international partnerships, Ocado’s software solution can act as bait – a starting point for a relationship that may develop to become much more comprehensive, as the low level of fees (<1% of sales) that this solution is sold for as well as its high quality attracts many traditional retailers struggling with their in-house software capabilities. Such a front-end only solution creates the perfect starting-point for Ocado to then take over the whole operation of the online grocery services of the partner in question.

 

A mere look at the kind of personnel/cadres Ocado employs speaks to the importance and centrality of R&D to the company’s business model and customer proposition, with Ocado employing 1,300 technology employees and over 500 engineers.

 

 

Monetizing data

 

What is also overlooked by the investor community is the treasure trove of data that Ocado collects upon each customer order. Not only does this data and its analysis allow Ocado to understand consumption patterns and thereby make its offering highly relevant to the needs of the modern consumer, Ocado uses this data to personalize the journey of each customer on the site as Ocado segments its customers to be able to offer them different items in different areas of the site, customize searches, promotions and the checkout walk. Ocado’s ability to use this data to “suggest” products to customers is of great value at a time when more than half of its orders are coming from the mobile channel and therefore a smaller screen, giving Ocado immense power in shaping the customer’s final basket.

 

The importance of enabling the customer to build a basket quickly and efficiently mustn’t be underestimated. Websites which have poor navigability, aren’t intuitive and don’t consider customers’ previously exhibited preferences tend to dissuade the customer from subsequent use. If the experience of shopping online ends up being as time-consuming as going to the store, the customer proposition of online grocery retail is significantly reduced. Thus, online grocers’ ability to suggest products to customers not only based on their exact prior product purchases but also according to a categorization of customers as bargain-shoppers, health conscious or premium shoppers will majorly affect the grocer’s value in the customer’s eyes.

 

The improved functionality of Ocado’s customer-facing interface has been one of the drivers of topline growth in recent years, with Ocado’s ability to provide relevant suggestions and maximize its margin whenever it is suggesting one product out of a range offered by a number of competitors e.g. in the case of ingredient suggestions for a recipe as part of a meal planning exercise, forming an important part of this.

 

Valuation

 

We take a sum of the parts approach to the valuation given the different earning models of the two business segments – Ocado Retail and Ocado Solutions.

 

At a steady state – once the Ocado/M&S build-out of 8 additional CFCs is completed, CFC3 is rebuilt and all the CFCs are operating at full capacity (the 8 additional CFCs will be the size of CFC3 in Andover), we’d expect the EBITDA of Ocado Retail to be ~£550M, based on an EBITDA margin of 10% - a level already achieved at Ocado’s first generation CFCs.

 

 

Ocado Retail Revenue capacity (£M) EBITDA margin EBITDA (£M)
Ocado CFC1 1,000 10% 100
Ocado CFC2 x 50% 600 10% 60
Ocado CFC3 350 10% 35
Ocado CFC4 x 67% 800 10% 80
Ocado CFC 5 - 12 2,800 10% 280
Total 5,200   555

 


We also project a steady state EBTIDA from OSP - Ocado Solutions, after the build out of all CFCs for signed on international partners, with an assumption for the percentage of turnover for each retailer that will move online and the consequent total capacity managed by Ocado for its international partners. We assume 10% online penetration for Bon Preu given that it’s lack of concentration in urban centers and 5% penetration for Coles given that it already has an in-house store-pick solution which it will continue to operate, with an assumption of a steady state online penetration of 15% for the remaining partners given the 7% penetration already achieved in the UK and the likely further growth of this figure as online grocery sales growth outpaces the general grocery market’s growth. We estimate a 4% capacity fee charged by Ocado on all these partnerships and 1% recurring costs of managing this capacity provision, which results in ~£670M of steady state EBITDA.

 

International deals Revenue (£M) % Online Revenue capacity Fee as % of capacity Costs as % of capacity EBITDA (£M)
CFC2 x 50% (Ocado + Morrisons JV) 600 100% 600 5%   30
CFC4 x 23% (Morrisons) 400 100% 400 4% 1% 12
Bon Preu  1,000 10% 100 4% 1% 3
Casino  17,000 15% 2,550 4% 1% 77
Sobey's 14,000 15% 2,100 4% 1% 63
ICA 8,500 15% 1,275 4% 1% 38
Kroger 92,500 15% 13,875 4% 1% 416
Coles 21,000 5% 1,050 4% 1% 32
Total 133,000   19,900     670

 

To determine an appropriate EV/EBITDA multiple we take as peers online delivery companies of both food and general merchandise. It is key to recognize that Ocado’s peers aren’t physical supermarket chains, as the core of Ocado’s business is fundamentally very different – being much more concentrated on the development of technological solutions to logistics issues in the supplier to customer transportation/delivery of fresh produce and general merchandise. This is particularly the case following the Ocado/M&S JV which will shift Ocado even more towards the Solutions part of its business, as it sheds management of the site and servicing of CFCs, instead only concentrating on the technology that they house.

Thus, taking a peer group of online delivery companies we see an average EV/EBITDA multiple of 23x.

 

  EV/EBITDA
AMZN US  20.7x
APRN US  24.6x
ASC LN  19.1x
BOO LN  24.2x
BOOZT SS  21.2x
ZAL GY  27.9x
Average  23.0x

     

    To remain conservative, however, we apply a multiple of 15x which gives us a per share value of ~£27 and therefore an upside of ~103%.

    SOTP Valuation  
    Ocado Retail EBITDA 555
    Ocado Solutions EBITDA 670
    Group EBITDA 1,225
    EV/EBITDA multiple  15x
    EV  18,382.5
       
    Total Debt 244.30
    Cash & Cash Equivalents 410.80
       
    Equity Value 18,548.97
    Shares Outstanding 691.97
       
    Equity Value per share (£) 26.81 

    This valuation, however only takes into account deals and CFC build-outs that have already been announced. Assuming a mere 2 additional deals with supermarkets with a turnover of £15Bn each, with 15% penetration of the online channel for which Ocado charges a 4% capacity fee with a corresponding 1% of capacity being the cost to manage this capacity, adds another £135M of steady state EBITDA which drives the share price to ~£30 – an upside of ~127%. Even an assumption of 2 additional international deals, however, is extremely conservative. Given the recent pace at which Ocado has been signing on partners, combined with the flexibility that the large cash inflow which the M&S JV has provided it with and its vastly superior customer proposition, we expect Ocado to sign a much higher number of partners in the coming years.

    • Further optionality from assumptions

    It must be noted that Ocado’s constant optimization of its operations in the form of technological advancements and the consequent efficiency gains are likely to drive EBITDA margins further in its Ocado Retail business segment from the current 10% in its first-generation facilities to at least ~12%.

    Furthermore, in our valuation of the Ocado Solutions segment we have taken partners’ revenues as of their last reported financial statements. However, research shows that online grocery services are equivalent to a high-service customer-loyalty program helping supermarkets not only retain their most loyal customers but also capture a greater share of their wallet. In addition, delivery services in the case of first movers (most of Ocado’s partnerships are firsts in their respective geographies) are likely to win over new customers. Between 50-70% of sales are incremental for retailers that offer delivery, meaning that the provision of an online delivery offering is likely to be a big top line growth driver for Ocado’s international partners.  This means that there is further optionality in terms of the fees that Ocado will be able to reap from its international partnerships.
     
    Ocado currently trades on a ’19 EV/EBITDA of ~95x and an operating cash flow yield of 1.66%, which while optically pointing to the company already being very expensive, are the result of it being in the early investment stages of both its JV with M&S and its large international partnerships. These outlandish metrics are therefore a reflection of the company being at the early stages of a steep growth trajectory.


    Ocado’s revenue growth in its Ocado Retail segment has averaged 17% over the past 10 years and is unlikely to slow going forward given the supply-led nature of the market (as already explained above) and the large build-out as part of the M&S JV. These growth rates will be exceeded in the Ocado Solutions segment as the business completes the investment phase of its partnerships and starts earning capacity fees. 

     

    Shareholders

    Looking at the shareholder register of the company, the top shareholders stand out as being very long-term minded investors. Jorn Rausing – a billionaire and co-owner of Tetra Laval (packaging company), for example, invested as early as 2003, and is still the 3rd largest holder.

    Top shareholders also include the founder and CEO – Tim Steiner, pointing to the alignment of interests between management and shareholders. Another co-founder – Jason Gissing, also owns shares amounting to 0.58% of shares outstanding.

    An analysis of insider transactions shows extensive buying activity over the past years with no selling of Ocado shares having taken place by insiders since August 2018.

       

      Risks

      • Andover Fire

      A key risk that many investors will be focusing on is the recent fire in CFC3, Andover. However, our extensive analysis of the situation points to investors’ overreaction to the incident and the consequent dampening to the upside that its shares could have otherwise experienced to date.

      There is no doubt that the incident will majorly affect Ocado’s operations as the Andover CFC formed 10% of Ocado’s Retail capacity and the extent of the fire means that the site is not operational at all and will have to be knocked down and rebuilt. With the building of the previous CFCs having taken somewhere between 2 and 2.5 years, we aren’t expecting CFC3 to be up and running again any time soon. But when it is rebuilt, we’d expect the facility to be much more efficient, being equipped with the 3rd generation bots (if these aren’t further optimized before the build-out of the facility). All other Ocado CFCs are currently running at capacity with the 5th CFC only beginning to be built in H1 2019, thus limiting the company’s options for any immediate capacity shifts across its existing facilities.

      On its Q1 19 trading update, however, the company detailed the numerous options open to it that it has implemented and will further deploy to shift capacity:

      • Have increased capacity at Erith by smoothing demand across the week, thus squeezing a higher than ever number of orders per week from CFC4
      • Setting up a spoke in Andover
      • Looking at solutions that cannot comment on, but that will bring on capacity much faster than the company would have otherwise done (mgmt. will only comment on this when plans are finalized)

      During the trading update, the company also stressed that it would prioritize minimizing the impact to its sales from this incident as it realizes the importance of minimizing the degree to which its customers are impacted.

      Further relief should come from the company’s insurance contracts. Ocado has:

      • £3.25Bn of property insurance which should compensate it fully for the lost property and infrastructure housed in the facility
      • £1.25Bn of business interruption insurance which will cover the loss of profits resulting from the incident; however, given the more contentious nature of determining the exact amount of profits lost due to the disaster and how much of this can be mitigated by reductions in staff etc., the extent to which this insurance contract will enable Ocado to further cushion the blow from the fire is more uncertain
      • We expect another payout to be secured from Ocado’s £10M stock insurance

      At its Q1 19 trading update, mgmt. said that the company has already received ~£30M of insurance payments.

      Apart from the short-term relief provided in the form of insurance payments, however, we think certain facts around the incident itself point to the one-off nature of the event and therefore the unlikely nature of this having any material effect on the long-term growth story of the company. From the company’s video footage, it appears that the fire started from the robots’ charging point, but the exact reason the fire started isn’t a fundamental design flaw but rather a minor design suboptimality which will be tweaked going forward. This means that all other facilities are able to run at full speed and capacity as there is no fundamental design flaw in the robots inhibiting their safe functioning.

      The company has also developed a quick and cheap medium-term solution for the incident based on how the extent of this fire could have been mitigated. One reason for the fire causing the extent of damage that it did was the failure of the company and fire brigade to immediately realize the extent of the fire and their mistaken belief that the fire was under control. This mistaken belief was partially the result of an inability to monitor the temperature in the section of the facility where the fire started – the ambient section. As opposed to the ambient sections of the facility, the temperature in the chilled sections of the CFC is always monitored. Thus, the company expects its installation of temperature monitoring equipment in all sections of the facility to enable the company to ensure more prompt detection of such issues in the future.

      Moreover, it is important to note that the safety of all other facilities is not something that investors have to take the company’s word for but is something that both insurance companies with which Ocado has contracts and the fire brigade have previously certified. In addition, the continued running of these facilities at full speed and capacity points to the lack of any fundamental operational/design issue affecting all operations, rather pointing to the one-off nature of the event and the ease with which it can be mitigated in the future.

      • Removal of Waitrose and some branded products from offering after M&S JV

      M&S has more private label goods and a smaller selection of branded goods, and unless Ocado is able to replace the branded goods it used to buy with Waitrose through direct relationships with branded grocery suppliers, it may have downward pressure on its JV topline due to customer attrition, also stemming from the loss of customers loyal to Waitrose. However, mitigating this potential downward pressure is the gain in customers loyal to M&S who only account for £400M of Ocado’s sales at the moment, and the relationships that Ocado has cultivated with suppliers as already mentioned above

      • Slower than expected uptake of online in grocery shopping

      If services being built out in new markets end up taking the form of click and collect due to lack of favourable delivery economics, the take up of online grocery shopping could be meaningfully slower than expected with the key factor of convenience needed for greater online penetration lacking.

      • Execution risk of build-out

      Longer than expected building works or issues with planning permission in any of Ocado’s geographies whether under its Ocado Retail M&S JV or its international deals could weigh on its share price given the consequent delay in operations.

      • Companies developing solutions in-house rather than partnering with Ocado

      Companies deciding to develop in-store picking solutions or dark room warehouse-based solutions, like Tesco or Sainsbury’s, could also prove to be a risk to Ocado. However, as already explained above the “cost-plus” nature of these models makes them inherently less profitable and in most cases unprofitable, mitigating the risk of such a development in the longer-term.




             

            Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purposes only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author has a position in this stock and may trade this stock.

          • I do not hold a position with the issuer such as employment, directorship, or consultancy.
            I and/or others I advise hold a material investment in the issuer's securities.

            Catalyst

            • UK
              • Increased penetration of the UK grocery retail market
              • Increased density of delivery network allowing for better economics of last-mile delivery
              • Margin expansion from ramping up of build-out (capital efficiency and better facility economics) and due to optimization of CFC operations from technological advancements
              • Rebuilding of CFC3 post the fire
              • Building of CFC5
              • M&S partnership
              • Use of solutions to upgrade traditional retailers’ infrastructure both within scope of M&S JV and in Morrisons partnership, reducing need for use of regional distribution centers
              • Non-food licensee


            • International
              • Execution
              • Signing on of non-food partners
              • New geographies with existing partners
              • Further deals with international partners

             

            • Investor awareness of Ocado as a company, their differentiated solution, technological capability and superior economics to all other online grocery services providers in the market
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              Description

               

              Thesis Summary: Ocado is a UK-based logistics tech company specialising in online grocery retailing. Over the last 19 years the company has developed a solutions platform that allows grocery orders placed online to be processed, picked and delivered in a fast, accurate and profitable way. Prior to signing its first international deals, market perception of the company had been negative for years as investors attached a negative value to Ocado’s IP. Over the last 18 months Ocado has signed several lucrative licensing deals with large retailers in X countries (Krogers, ICA, Casino, Coles, etc), which has rerated the stock from a low base. Despite the move in share price, we believe Ocado is only at the beginning of its growth trajectory driven by a combination of the scaling of its solutions platform through international partnerships (present and future), increasing online penetration of the grocery market globally and various other market opportunities.

               

              Company Overview:

               

              History and background

               

              Ocado is the world’s largest dedicated online grocery retailer and solutions provider. The company was founded in 2000 effectively as Waitrose’s online business, as in November of the same year it entered into its first branding and sourcing arrangement with Waitrose. The UK market at the time was and still is an oligopoly with under 10 major players capturing nearly all of the market. Among these major players, Waitrose differentiates itself with its premium product offering while its online offering through its partnership with Ocado allowed it to become a first-player in what has since become a much bigger market – online grocery retail.

              Ocado’s partnership with Waitrose together with the deal it struck with Morrisons in 2013, allowed it to develop a fully automated grocery picking and packing warehouse model over the span of a decade. As part of its buildout of the first Customer Fulfilment Centre (CFC) in Hatfield, Ocado developed bespoke systems and processes, avoiding the need to use off-the-shelf software packages and solutions that would have constrained its ability to reach the needed levels of complexity and efficiency for a profitable large-scale online grocery operation.

              Grocery retail market and online segment dynamics

              A look at how most other grocers have chosen to solve the online grocery challenge points to Ocado’s high differentiation and unique offering.

              Grocers typically operate on very low margins, usually in the range of 1-4%. This means that unless under pressure, investing in an online offering is not on top of most grocers’ agenda. This explains why most grocers, in their attempt to develop an online offering, have invested in the least capital-intensive models e.g. in-store picking.

              While providing a short-term solution to the loss of customers to grocers with an online offering, the potential for in-store picking to satisfy long-term demand while maintaining grocers’ already low margins is very limited. First of all, each store typically has a capacity of just ~1,000 orders per week, inherently limiting the ability of any in-store picking model to meet higher levels of demand. In addition, the reliance of this model on manual labour to pick customers’ orders inherently limits its efficiency in terms of the fully loaded picking rate (total number of items picked divided by total labour hours) to a range of 75-100 items an hour, which compares to 182 at Ocado’s newest CFCs. Furthermore, in-store picking is only suitable for certain types of stores, as the inventory and range of assortment available in small stores isn’t large enough to operate an online offering. Small stores’ isles are too narrow for efficient picking and there is no space for buffering orders in the backroom. Large crowded stores aren’t suitable to serve as a basis for an online operation either given the inevitable competition for produce between pickers and regular customers and the resulting deterioration of the in-store customer experience.

              Ocado’s online grocery model, on the other hand, manages to completely overhaul the grocery picking and packing system. While from a customer’s point of view the action of going to a physical store for a bi-weekly or weekly stock-up adds little value given the largely homogenous/fixed nature of the basket bought each week, from the grocer’s point of view fulfilling these orders is a very complicated operation. This is due to the varying size, shape, fragility, shelf-life and temperature needs of each product, particularly in the fresh category. It is the Herculean nature of this task that makes Ocado’s achievement to date a true feat.

              Ocado’s technology over the years

              Ocado’s first-generation of CFCs – CFC1 and CFC2, are based on linear conveyor systems with zone picking. Automated conveyors route customer totes down different aisles to pick stations, where pickers select from adjacent “shelves” which are automatically replenished from inbound goods which are decanted and stored in high racking. CFC1 was able to achieve a “units per total warehouse labour hour” (UPH) rate of 150. However, CFC2’s improvements to layout, hardware and the use of automated storage and retrieval systems for slow moving ambient SKUs have increased the UPH to 175. This first generation of CFCs has reached a combined EBITDA margin of 10.1% (after including delivery costs).

              In its second-generation CFCs (CFC3 and CFC4), Ocado has developed an altogether different model of operation – the Hive concept. Unlike the previously linear nature of the operation, the Hive relies on robots (automated guided vehicles) moving across a grid which sits on top of a storage array – lifting and lowering totes containing customer orders or inventory to locations within a three-dimensional grid. 

               

              https://www.youtube.com/watch?v=iogFXDWqDak

               

              https://www.bbc.co.uk/news/av/business-38897417/the-ocado-warehouse-run-by-robots

               

              The robots store products in the Hive (either the ambient or the chilled section), which they will then dig for and pick up upon the execution of an order – carrying the needed goods to the picking station where pickers pick the items from the product tote and place them in a customer order tote. Once a customer order is ready for delivery the bots will store them within the Hive before the order needs to be dispatched, when the bots will retrieve the orders from the Hive to be loaded onto the delivery trucks.

               

              The benefits of the Hive system can be summarized as follows:

               

               

              Thus, in addition to having an operational model which completely overhauls and automates the store-based picking operation, Ocado has managed to also greatly improve on its own initial offering by relentlessly innovating and improving upon its own technology.

              Market perception of the company over the years

               

              In Ocado’s early years as a public company its reinvestment of at least £50M per year of its free cash flow into further automation and development of the picking and packing process as part of its Ocado Solutions business,  weighed down on its share price as the market failed to perceive the highly valuable nature of the solution it had developed, its highly transferrable nature and scalability across the globe. This market perception was reinforced by Ocado’s failure to get an international deal through its Ocado Solutions platform by its initially targeted deadline of the end of 2015, instead signing its first major international deal in November 2017 (with Casino in France).

               

              The large increase in the company’s share price since the signing of the Casino deal reflects the partial realization by investors of the coveted nature of the technology and intellectual property developed by Ocado. However, in our view, the company’s share price today only partially reflects its value given the platform-like nature of its Solutions business which is not only highly transferrable across different retailers, type of product and geographies but is also the best in class and unrivalled by any other grocer or online grocery delivery service provider in the world.

               

              Therefore, the good performance of the stock over the past year doesn’t in the least indicate full or even substantial reflection of the total value of the company in its stock price. This is because the recent share price increase is coming from a low base that persisted throughout the company’s pre-2018 history, which was caused by the ascription of negative value to the company’s IP – an attitude which still persists given the early stage of development of Ocado’s partnerships, which are still in their capex phase, and Ocado’s inability to book revenues in connection with these partnerships that it derives in the form of license fees upon signing and fees running up to the launch of CFCs due to IFRS 15 rules.

               

              We therefore believe that the recent share price appreciation is a small move in the bigger picture that is the scalability of Ocado’s solutions and its direct relevance to many issues faced by online retailer grocers.

               

               Business Segments

               

              Ocado operates in 2 business segments:

               

               

               

              Investment Thesis:

              Ocado’s proprietary state-of-the art solution to online grocery services

              Ocado has tackled the concerns that have held back penetration rates in the online grocery segment to date. Some of the reasons that the shift to online in the grocery segment has been slow are customers’ concerns about freshness, the possibility of substitutions when ordering online, the difficulty of arranging a delivery and the costs associated with delivery services.

              “Many grocers don’t have technology that can readily track inventory in real-time. That means items listed as available online often aren’t in the nearest stores filling a delivery order, leading employees to make their best guess or rely on computer recommendations that can suggest unsuitable substitutions. …

              There are a number of reasons why many online grocery services struggle to offer substitutions customers want. Shoppers typically depend on suggestions from online tools, and algorithms can make mistakes or suggest inappropriate alternatives. Services that rely on gig-economy workers who pick items off store shelves can exacerbate the selection problem, since many aren’t food experts and juggle many orders a day. Grocery consultants say.

              Mishandling substitutions is expensive for retailers, as it often leads to refunds or a replacement item that is pricier than the original. Refunding incorrect items decreases an online order’s profitability by 1% to 2% on average, according to research by McKinsey & Co. The problem can be particularly bad with promotions, angering suppliers when their products are swapped out for a rival’s”.

              Below is a summary of how exactly Ocado has tackled all of these issues:

              1. Ocado’s disintermediation of the traditional supermarket supply chain has meant that it is able to guarantee the provision of products which are fresher than those found at a supermarket, reaching Ocado ~24 hours earlier than they would a physical supermarket.

              Traditional supermarkets operate through a large network of retail distribution centers (RDC) where suppliers deliver groceries. It is then from these RDCs that the products are delivered to supermarkets. Ocado, on the other hand, has the groceries delivered by suppliers directly to its CFCs. It is then from the CFCs themselves that the products are delivered to the customers, after a stopover at a spoke for 2/3 of deliveries where the goods are re-distributed to smaller vans. This system implies that Ocado has less buffer stock, minimizes the time its product spends in warehouses and maximizes the speed of delivery from the source. The result is that Ocado can guarantee that 2/3 of the code life of a product will be spent in the customer’s refrigerator, something that traditional supermarkets are simply unable to do.

              2.                   The highly automated process within the CFCs themselves, ensuring less human interference in the handling of products and therefore reduced human error, together with higher rotation of stock due to a shorter supply chain, reduces wastage/shrinkage costs to ~0.8% of net sales vs. traditional retailers’ shrinkage cost of 2-3% of sales. This not only impacts Ocado’s bottom line, but also contributes to products’ greater freshness when delivered to customers, given reduced handling of fresh produce by workers.

               

              3.                   The high level of automation in Ocado’s operating model together with its 100% online model also means that Ocado has high visibility of its available and inbound stock, and any pending customer orders. This translates to a superior ability to notify customers of the availability of its products for specific delivery slots, thus reducing the number of orders in any year that have substitutions to <1%.

              4.                   It is this very same operating model which allows Ocado to operate at such a cost advantage to physical supermarkets as to make the delivery of groceries at low costs to customers economically viable. Ocado’s cost advantages can be broadly broken down as follows:

              Disintermediation of the RDC network: the RDC model costs retailers ~2-5% of sales and Ocado is able to eliminate ~90% of these through its shorter supply chain

              High automation: Ocado’s first generation CFCs – CFC1 in Hatfield and CFC2 in Dordon, use conveyor systems to route customer totes down aisles to pick stations, with pickers (human labour) selecting from adjacent shelves which are themselves automatically replenished with inbound goods, decanted and stored in high racking; Ocado’s second generation CFCs – CFC3 in Andover and CFC4 in Erith, are even more technologically advanced – operated through a Hive system where robots decant products from suppliers into totes, dig for a required SKU, carry a product tote to the pick station, carry completed customer orders to storage and then retrieve the customer totes ahead of loading a van for its route; this state of the art proprietary technology and end-to-end highly automated process allows Ocado to save on a lot of labour costs which amount to as much as ~9% of sales for traditional retailers vs 0.7% at Ocado

              Reduced waste costs: as already mentioned above, this highly automated process reduces costs related to shrinkage/waste from the ~3% of sales at traditional retailers to ~0.8%

              Lower property occupancy costs: Ocado’s pure-play online business model means that it doesn’t require a whole network of retail space for physical shops; instead Ocado uses warehouse space on light industrial land, which is considerably cheaper; this also impacts expenditure on utilities due to extensive chilling and electricity needs in retail locations of grocers; traditional retailers’ spending on the property and utilities amounts to 6-8% of sales vs. <2% for Ocado

              Media and other income benefits: Ocado also benefits from the income it derives from the sale of advertising space and targeted promotions on its online platform to Fast Moving Consumer Goods (FMCG) suppliers; this segment amounted to ~4% of sales in 2018 and has been a structural tailwind to gross margins over the years, especially with the increased use of Ocado’s mobile channel where pricing for advertising is higher

               

              These cost advantages amount to ~19-23% of sales and allow Ocado to accommodate last-mile delivery costs which amount to ~11% of sales, without having to charge customers too much for the service. This is in addition to costs relating to its CFCs which stand at ~8% of sales. As a result, Ocado is able to offer efficient delivery within 1-hour time slots – ensuring convenience for the consumer for a reasonable delivery charge - averaging £1.50 in the UK with certain deliveries above £75 and deliveries to SmartPass subscribers being free.

              It is the very fact that Ocado has completely reconfigured the operations of a traditional retailer in developing its online grocery solution that makes its offering highly attractive and greatly superior to solutions of competitors.

               

              Kroger deal and further optionality from international deals

              The success of the Ocado Solutions segment of the Group points to the fact that rather than a simple online retail grocer, Ocado is a technology, logistics and software company, with know-how and IP in the optimization of grocery supply-chains unparalleled by anyone in the world. This is likely to drive further deals with international supermarket chains as the moves that some have already made in partnering with Ocado are likely to kickstart defensive moves by competitors to also create an online offering, thus further driving the online penetration of the grocery retail market of that particular geographic area. This trend has already been witnessed in relation to Amazon’s entry into the online grocery segment with Amazon Fresh, Amazon Pantry as well as Whole Foods’ online offering, as US grocery retailers have rapidly accelerated their investment in online capabilities in response.

              The Kroger deal is the most expansive international deal that Ocado has signed to date, with plans to build 20 CFCs over the next 3 years. Given the size of the US grocery retail market where Kroger is the 2nd largest player with a 7.17% market share as of 2016 and sales of $122Bn in 2017, this deal is likely to be the primary revenue generator for Ocado in the medium-term. Besides driving strong top-line growth for Ocado, this deal is also likely to result in improved economics for Ocado’s Solutions Platform.

              Ocado’s partnership with Kroger is particularly notable among its international deals given the companies’ agreement to build 20 CFCs over the next couple of years – an operation of a scale that Ocado hasn’t undertaken to date. The scale of the Kroger deal is likely to drive profitability to a new level.

              The build-out is likely to further improve the capex/sales ratio of the new facilities given its unprecedented scale vs the very gradual build-out of only 4 CFCs in the UK that has taken place to date. More specifically the scale of the build-out will allow for better procurement of the mechanic handling equipment (MHE) which includes the robots which operate the Hive, the aluminum railing/grid along which they travel and the pick stations, likely to result in dramatically improved economics for Ocado’s partnership with Kroger in the form of greater capital efficiency. These improved capex dynamics could already be seen in CFC4 (Erith) where the MHE capex/sales ratio dropped to 10% from the 13% ratio in CFC3 (Andover), and the total capex/sales ratio dropped to 19% from the 21% in CFC3. This opportunity for further capital efficiency will further be helped by the modular nature of Ocado’s second-generation Hive CFCs, allowing smaller scale build-outs to still be economically viable, thus allowing for a quicker return on  investment.

              The superior economics created by large scale procurement combined with Ocado’s negative working capital model, provide for attractive returns on invested capital (ROIC), with the fourth CFC at Erith already achieving a ROIC of over 50%.

              However, the international partnerships story is about more than mere capital efficiency, as most of the markets where Ocado has signed partners and particularly the US, have yet to experience even the first leg of growth in online grocery sales - experienced in the UK over the past several years. Kroger’s strong position in the US market combined with its plans for a prompt launch of the online offering on a massive scale in a market with online penetration of the grocery market as low as ~1.5% is promising for Ocado. More specifically, we expect Ocado to enable Kroger to develop a delivery to home solution, which given Kroger’s large market share bodes well for the fees that Ocado will be able to derive from its ongoing capacity fees.

              There is further optionality from Kroger implementing Ocado’s solution for replenishing its own stores, as this could allow Kroger to reduce the number of regional distribution centers it uses as a midpoint between its suppliers and its retail stores, shifting capacity to Ocado’s CFCs instead. This would allow Kroger to improve the margins of its core business while allowing Ocado to maximize the flow of goods through the CFCs which would also require higher capacities, thus allowing Ocado to reap higher annual capacity fees from Kroger. It has been reported that Kroger is already considering implementing Ocado’s solutions for supplying its Walgreens concessions.

              Furthermore, Ocado’s ability to build-out capacity in a modular way and thus to start operations with small capacity before fully scaling a CFC, will allow Kroger to penetrate regions of the country where it may not have operated to date, which it will be particularly incentivized to do given that an online grocery offering like Ocado’s is likely to attract customers away from other grocers. This is likely to be the case even in those regions where grocers already have their own online offerings due to Ocado’s superior operations and cost structure which translates into better customer service with cheaper delivery fees, while maintaining a profitable business.

               

              Superiority of proposition and operations to that of competitors

              It is important to note that Ocado’s above described solutions to key issues surrounding the online buying and delivery of groceries stand out from those adopted by competitors such as Instacart, Peapod and some supermarkets, not only allowing it to create a superior customer experience but also allowing it to do this profitably, for reasons already described above. Here we will focus on alternative models adopted by competitors and the reasons why they don’t match up to Ocado’s offering.

              Third-party delivery companies currently handle ~50% of the online grocery market. Instacart is the largest independent third-party grocery delivery provider, with estimated sales of ~$2Bn in 2017.

              Partnering with Instacart allows supermarkets to offer their customers delivery services. However, while Ocado manages to completely overhaul the supplier to customer chain of travel of grocery products, thus saving costs amounting to ~19-23% of sales to then be able to invest in automating the order and delivering it to the customer at low or no cost to the customer while still remaining profitable, Instacart leaves grocery retailers’ operating model intact instead acting as an intermediary - buying from a physical supermarket on behalf of the customer. The company allows shoppers to order groceries from supermarkets that have signed up in the particular area, and sends gig economy workers to pick up and deliver the orders. In the case of partner supermarkets, Instacart offers their products at no markup on its platform, while marking up the products of non-partner supermarkets by on average 15%. In addition, it charges customers delivery fees in the range of $3.99-9.99 or fees of $99-149 per annum for membership which allows free delivery on orders above $35.

              From the customer’s point of view, this model of grocery delivery results in substantially higher prices from the combination of higher product prices (in the case of non-partner supermarkets) and high delivery fees. In addition, the freshness of products is not comparable to Ocado's offering.

              Grocers pay these third-party delivery companies an average fee of 10-25% on each order, making their online grocery offering a money-losing operation. In addition, from supermarkets’ point of view, this strategy is risky in the long-run given that they lose control over the quality of the service provided to the customer while at the same time getting blamed for any shortfalls in quality of service. In addition, retailers lose valuable customer data.

              Instacart itself is unprofitable (when administrative expenses are accounted for), putting in doubt the sustainability of its business model. While to date the company has benefitted from large uptake of its services by US consumers, this success is largely the result of a lack of viable alternatives. Ocado’s superior customer proposition as well as its superior proposition for partners, is likely to significantly stall if not completely eradicate Instacart’s progress to date. It is important to note that Kroger itself has been using Instacart as a temporary solution to its lack of an online offering before the build-out of Ocado’s CFCs.

              The contrast in the operational model of an Instacart-type vs. Ocado, results in the former being easily disruptable by the latter, as Ocado enables retailers to develop in-house online delivery solutions allowing them to retain control over the quality of service to the customers and the data derived from their purchases, while providing an online offering profitably and with potential cost benefits to its existing internal supply chain and physical infrastructure.

              Grocers tend to opt for one of two options in developing their online grocery operations in-house – manual picking and packing from physical stores or semi-automated operations in dark stores.

              As already briefly discussed above, the manual picking and packing from physical stores is highly problematic given the already low profit margins of supermarkets – in the range of 1-4%, which means that such a “cost-plus” model which effectively develops an add-on delivery service while leaving the basis of the operating business intact, inevitably reduces the profitability of the retailer, while also potentially negatively affecting the shopping experience of the regular customer who now has to compete for products with the pickers, a problem exacerbated with grocers’ struggle to accurately track their inventory real-time.

              The “cost-plus” nature of this model is revealed by the extensive investments that grocers have had to undertake in order to implement it, including “reconfiguring their stores, installing coolers for delivery orders, creating dedicated checkout lanes for online-order shoppers and redesigning backrooms and parking lots”(https://www.wsj.com/articles/consumers-love-food-delivery-restaurants-and-grocers-hate-it-11552107610?mod=searchresults&page=1&pos=18).

              Semi-automated dark stores while potentially achieving margins comparable to physical stores by separating the operations of the physical stores from the online segment of a grocer, nevertheless also underperform in terms of profitability. This is because the largely fixed cost base of store-based grocery retailing (72% of costs fixed vs. 28% variable) makes traditional grocers highly vulnerable to channel shifts from offline to online grocery shopping. This is because while dark stores manage to somewhat overhaul the online segment of grocers, they still leave the legacy store-based part of the business intact. This is in stark contrast to Ocado’s development of an end-to-end solution which takes out a large part of these fixed costs from grocers’ operating models, allowing not only the operation of a profitable online operation but also having the potential for replacing fulfilment of products to physical stores, something that is likely to be implemented in the M&S JV and Kroger deal.

              In addition to the fulfillment of online grocery orders being logistically and financially cumbersome for grocers, they also face the challenge of solving the delivery problem, the extensive costs of which have already been set out above.

              Peapod and parent company Ahold Delhaize’s combined online grocery offering is a hybrid between the manual picking and packing and semi-automated dark stores described above. Peapod’s operations while conducted from warehouses which are separate from Ahold’s physical stores, are highly labour intensive and equivalent to the labour undertaken by pickers in physical stores. This means that Ahold’s online offering also operates on a “cost-plus” basis, as the system of physical stores is once again left intact, heavily hampering the grocer’s profitability. This explains why Peapod is only profitable in a handful of the markets it operates in.

              The lack of traction that Amazon’s roll-out of Amazon Pantry and Amazon Fresh has had and its announcement of entry into the physical grocery business itself is just another sign of just how much it takes to establish a sustainable and profitable online operation, with its lack of success once again being largely attributable to the lack of automation in its warehouses and the non-transferability of its management and delivery of non-fresh items to fresh items.

              All this points to the extraordinary nature of Ocado’s technology both in its ability from a practical standpoint to manage fresh produce as well as its ability to do so profitably. This is a testament to Ocado’s position as a technology, logistics and software company rather than merely a grocer, as evidenced by its employment of 1,300 technology employees and over 500 engineers.

               

              Further penetration of UK market and consequent margin expansion

              We expect considerable growth in the UK business going forward. As of 2017, the penetration by online of the wider grocery sector was only ~7% in the UK, which although the 3rd highest rate in the world after South Korea which has online grocery penetration of ~10% and Japan with ~7% penetration, is still considerably below online penetration rates in other product markets. Online retail penetration in the electricals, music and video segments in the UK, for example, are closer to 45-50% while online penetration of the clothing & footwear market is ~25%. This makes the grocery sector the anomaly and points to its likely growth as a percentage of the wider grocery retail market in coming years, as evidenced by the vast differential in the growth rates of the total grocery market – growing at low single digits, and the online grocery segment – growing in the mid to high teens in the UK.

              Further evidence for the fact that the online grocery market is only going to grow in the future is that so far it has been supply that has been the constraint on demand rather than the other way around, as Ocado has been managing demand through its limited provision of delivery time-slots. It is this supply-led nature of the market that has allowed all incremental capacity to be fully utilized. This points to the existence of strong latent demand for online grocery shopping and the likelihood of its future growth.

              Ocado is still at the early stages of an inflection point in the growth of the online grocery market, as Ocado has 721,000 customers in a UK market comprised of 27M households, and its revenue of ~£1.5Bn in its Retail segment is a small fraction of the £200Bn UK food and grocery market vs. Tesco’s £38.5Bn and Sainsbury’s £28Bn.

               

              It is important to note that further penetration of the UK grocery market is only part of the growth story of the UK part of the business, as greater penetration with the consequent higher sales volumes that will pass through Ocado will considerably improve the economics of its operations. While Ocado has managed to break the correlation between scale and efficiency in Andover - its 3rd CFC, allowing  for further expansions through modular facilities, operating at a larger scale would nevertheless still improve its margins through greater capital efficiency. But above all the benefit of larger sales volumes in the UK would be derived from better delivery economics. Higher demand in Ocado’s existing catchment areas increases the density of customer orders, allowing them to continuously improve the efficiency of routing through the use of complex algorithms, ultimately resulting in a higher number of deliveries per van per week. In 2018, deliveries per van per week rose 6.6% to 194, a figure that has consistently grown alongside sales/volume growth over the past years.

               

              Ocado’s JV with M&S makes the future of the UK story even more promising while also strengthening the financial position of the overall business. The upfront payment of £562.5M by M&S to Ocado for 50% of its Retail operations and the deferred consideration of £187.5M, strengthens Ocado’s balance sheet position ensuring that the company is well funded to deliver the 23 CFCs signed by Casino, Sobeys, ICA and Kroger, any other potential international partners in the future and the 8 CFCs planned with M&S in the UK over the next 12 years.

               

              In addition, the JV structure with M&S is superior to Ocado’s current tie-up with Waitrose due to its better alignment of incentives between the two grocers, as both will benefit from the optimization of Ocado.com’s product/SKU offering, removing the inevitable push-and-pull that arose from the Waitrose agreement, where Ocado was limited in its ability to expand its private label offering (restricted to 20% in the earlier years, later rising to 30%). In addition, Ocado up until recently had to pay Waitrose sourcing fees which amounted to as much as a £15M drag on Ocado’s EBITDA (and would’ve amounted to £20M in 2019) arising from fees that Ocado had to pay whenever it sourced branded products from CPG companies directly rather than together with Waitrose.

               

              Moreover, the M&S JV contributes to the further monetization of Ocado’s Solutions Platform, providing a >£50M annual income stream for the business segment’s provision of its solutions and technology to the JV. OSP’s provision of services to the JV also creates potential for the deployment of the platform’s state-of-the-art automated solutions in M&S’s own supply chain (something Kroger is considering for supplying its Walgreen’s concessions) creating further optionality in the agreement.

               

               

              However, Ocado’s ability to continue to provide a wide range of SKU’s through the M&S agreement is worth a closer look given the market’s division on this issue.

               

              Ocado’s current offering spans 54,000 SKUs, and 65% of Ocado’s annual sales come from branded products, with 40% being branded products sourced through Waitrose and the remaining 25% sourced by Ocado directly (for which it pays the sourcing fee to Waitrose). Thus, the market concern is that the termination of the Waitrose agreement may substantially reduce Ocado’s branded product offering given M&S’s limited branded product offering. The JV structure of the agreement together with the removal of sourcing fees penalizing Ocado for expanding its branded product offering, however, mean that Ocado will have more leeway in developing relationships with CPG companies allowing the maintenance of the majority of this branded SKU range and its further expansion. Ocado’s existing direct relationships with some of these CPG suppliers through its direct sourcing efforts over the years as well as its provision of advertising space on its online and mobile platforms puts it in a strong position to replace the branded SKUs that it previously obtained through Waitrose and continue expanding this range. Moreover, Ocado’s development into a UK household name and a “supermarket” in its own right, means that CPG suppliers themselves are likely to be incentivized to maintain direct relationships with the online retailer.

               

              The loss of the private label offering of Waitrose, on the other hand, will be fully compensated by M&S’s own private label offering. Of the 54,000 SKUs currently offered, 4,000 are Waitrose private label. M&S plans to replace at least that many and potentially add more private label SKUs, and has stated that on 3,400 of those private label goods, M&S’s products are 4% cheaper than those offered by Waitrose, with M&S planning to invest in the pricing of other SKUs over coming months.

               

              Thus, the M&S JV will ensure just as rich and expansive a range of inventory in the form of >50,000 SKUs.

               

               

              Further areas of optionality are likely to be the symbiosis between Ocado’s Zoom offering (described below) and M&S’s wide range of ready-to-eat products (its ‘eat now’ proposition), making a Deliveroo/Uber Eats type offering likely, as Zoom is scaled with the opening of more micro fulfilment centers.

               

               

              Immediacy – Ocado Zoom

               

              The above described growth in the online grocery market in the UK, however, is only one dimension of the UK/Ocado Retail growth story. Ocado’s entry into the “Immediacy” online grocery market is likely to be a game changer for the Group. In 2018, Ocado reported average orders per week of 296,000 and an active customer base of 721,000, which equates to ~20-22 orders per customer per year. Together with an average order size of £106.85 this points to the fact that Ocado’s main market to date has been in the larger basket segment i.e. the 42% of the UK grocery retail market which is the weekly/bi-weekly stock-up. The remaining 58% of the UK grocery retail market is comprised of “top up” shopping, defined as shopping for baskets <£60.

               

              Ocado has started trialing an immediacy service – Ocado Zoom, from March of this year in West London. The service will provide delivery within 60 minutes, of shopping baskets of <£60 in value and offer 10,000+ SKUs (vs ~1,000 SKUs in the average convenience store). The company explains the economics behind the offering as underpinned by the adaptation of Ocado’s unique supply chain model used for its Ocado.com webshop for the Zoom service, with products going from CFCs directly to a micro automated fulfillment facility, instead of going to a spoke or directly to a consumer. In addition, clever software will allow Ocado to replenish the micro fulfillment centers very cheaply and efficiently in small batches of daily deliveries, allowing them to carry a large range of SKUs in a small site ensuring freshness and immediacy.

               

              Apart from the efficiency of the supply chain leading up to the micro fulfillment center, the economics of this offering will be supported by the density of demand around any particular micro fulfillment center. Since Ocado envisages delivery from these facilities by third party couriers, with one or two deliveries being made on a journey within a 4-5km radius of the center, for the economics of this undertaking to make sense Ocado needs to be able to generate sufficient demand from a particular micro fulfilment center within a limited radius. Thus, the company will be identifying areas with rich density to ensure that the demand for the service is indeed there before building a micro fulfillment center.

               

              This new offering will enable Ocado to penetrate an altogether different part of the UK grocery market both increasing the number of its customers and further penetrating the grocery shopping of those who already shop with Ocado for their larger weekly/biweekly baskets. Furthermore, convenience (i.e. the immediacy segment) is one of the few segments of the UK grocery market that is still growing and is not facing pressures from the discount segment, making entry of the segment particularly attractive.

               

               

              Expansion into general merchandise

               

              Expanding its operations to the delivery of general merchandise - whether additional household items or clothes, would be a natural development for Ocado. This is because the logistics that goes behind the management and delivery of non-fresh items is nowhere near as complicated and doesn’t required the same level of technological advancement as does the delivery of groceries, and any such endeavor could be carried out within its existing technological infrastructure (barring capacity constraints) given the fact that Ocado already has a small general merchandise offering as part of Ocado.com and Fetch.com – its pet store.

               

              The potential for any such undertaking is more likely following the M&S JV, given M&S’s expansive general merchandise offering which will provide Ocado with a way to materially expand its offering in an altogether different addressable market which it has barely monetized to date. M&S’s general merchandise offering is likely to be highly complementary to Ocado’s overall customer proposition as many of M&S’s clothes and home products are sold at a low price-point meaning that they are viewed by consumers as disposable and are therefore easily purchased online.

               

              Ocado could also penetrate this market through partnerships with such companies as Primark (Associated British Foods) creating CFCs that would solely cater to the delivery of general merchandise. Such partnerships could also potentially have better economics as the expenditure requirements would be less demanding given the lack of need for separate chilled and ambient sections as well as automated pickers with such technology as to ensure a lack of damage to fragile produce, as pickers using suction cups could often suffice in a general merchandise operation.

               

               

              Continued development of IP and state of the art technology

               

              The company’s continued commitment to developing IP and proprietary technology creates optionality from further improvements to the efficiency of its end-to-end grocery supply chain solution and consequent further attractiveness and monetization of the Ocado Smart Platform.

               

              One such ongoing development is robotic picking and packing of groceries which would constitute a very notable technological advancement given the non-uniform size, shape, rigidity and fragility of fresh groceries and therefore the need for any robotic arm carrying out the task to mimic the capabilities of the human hand while using advanced vision systems.

               

              Ocado has also developed what is called OSPick – a system designed to pick a range of groceries within the CFCs using a simple suction cup mounted on an articulated robot arm, with an intelligent vision system that can pick a wide range of products without prior knowledge of the items presented to it.

               

              Ocado’s R&D activities in the space of physical infrastructure and robotics will drive further efficiency in its existing and future CFCs by further reducing the need for labour and all the risks associated with having humans employed at CFCs. Yet in addition to the greater efficiency that such developments will drive, such technological advancements are likely to be revenue drivers in themselves, making them more than a way to minimize costs. This is particularly likely given the recent announcement of Ocado’s JV with M&S which marks Ocado’s shift to the OSP segment of its business and likely greater future concentration on monetizing its IP and state of the art supply solutions, making advances in R&D all the more important in driving Ocado’s future value.

               

              Ocado’s advanced software capabilities must also be stressed. The recent announcement of a deal with Coles includes not only the build-out of CFCs but also a front-end solution for their in-store picking solution which operates in more rural areas of Australia. While not a significant fee and value driver for the company, a partner’s decision to use Ocado’s solution rather than their in-house software from prior operation of the online grocery offering, points to Ocado’s superiority in consumer-facing aspects of its operations as well i.e. its highly functional front-end websites providing efficient basket building capabilities as well as accuracy of information about inventory/availability. Ocado’s expertise in building front-end solutions has played a role in its earning of a reputation for industry-leading customer levels.

               

              In the context of its international partnerships, Ocado’s software solution can act as bait – a starting point for a relationship that may develop to become much more comprehensive, as the low level of fees (<1% of sales) that this solution is sold for as well as its high quality attracts many traditional retailers struggling with their in-house software capabilities. Such a front-end only solution creates the perfect starting-point for Ocado to then take over the whole operation of the online grocery services of the partner in question.

               

              A mere look at the kind of personnel/cadres Ocado employs speaks to the importance and centrality of R&D to the company’s business model and customer proposition, with Ocado employing 1,300 technology employees and over 500 engineers.

               

               

              Monetizing data

               

              What is also overlooked by the investor community is the treasure trove of data that Ocado collects upon each customer order. Not only does this data and its analysis allow Ocado to understand consumption patterns and thereby make its offering highly relevant to the needs of the modern consumer, Ocado uses this data to personalize the journey of each customer on the site as Ocado segments its customers to be able to offer them different items in different areas of the site, customize searches, promotions and the checkout walk. Ocado’s ability to use this data to “suggest” products to customers is of great value at a time when more than half of its orders are coming from the mobile channel and therefore a smaller screen, giving Ocado immense power in shaping the customer’s final basket.

               

              The importance of enabling the customer to build a basket quickly and efficiently mustn’t be underestimated. Websites which have poor navigability, aren’t intuitive and don’t consider customers’ previously exhibited preferences tend to dissuade the customer from subsequent use. If the experience of shopping online ends up being as time-consuming as going to the store, the customer proposition of online grocery retail is significantly reduced. Thus, online grocers’ ability to suggest products to customers not only based on their exact prior product purchases but also according to a categorization of customers as bargain-shoppers, health conscious or premium shoppers will majorly affect the grocer’s value in the customer’s eyes.

               

              The improved functionality of Ocado’s customer-facing interface has been one of the drivers of topline growth in recent years, with Ocado’s ability to provide relevant suggestions and maximize its margin whenever it is suggesting one product out of a range offered by a number of competitors e.g. in the case of ingredient suggestions for a recipe as part of a meal planning exercise, forming an important part of this.

               

              Valuation

               

              We take a sum of the parts approach to the valuation given the different earning models of the two business segments – Ocado Retail and Ocado Solutions.

               

              At a steady state – once the Ocado/M&S build-out of 8 additional CFCs is completed, CFC3 is rebuilt and all the CFCs are operating at full capacity (the 8 additional CFCs will be the size of CFC3 in Andover), we’d expect the EBITDA of Ocado Retail to be ~£550M, based on an EBITDA margin of 10% - a level already achieved at Ocado’s first generation CFCs.

               

               

              Ocado Retail Revenue capacity (£M) EBITDA margin EBITDA (£M)
              Ocado CFC1 1,000 10% 100
              Ocado CFC2 x 50% 600 10% 60
              Ocado CFC3 350 10% 35
              Ocado CFC4 x 67% 800 10% 80
              Ocado CFC 5 - 12 2,800 10% 280
              Total 5,200   555

               


              We also project a steady state EBTIDA from OSP - Ocado Solutions, after the build out of all CFCs for signed on international partners, with an assumption for the percentage of turnover for each retailer that will move online and the consequent total capacity managed by Ocado for its international partners. We assume 10% online penetration for Bon Preu given that it’s lack of concentration in urban centers and 5% penetration for Coles given that it already has an in-house store-pick solution which it will continue to operate, with an assumption of a steady state online penetration of 15% for the remaining partners given the 7% penetration already achieved in the UK and the likely further growth of this figure as online grocery sales growth outpaces the general grocery market’s growth. We estimate a 4% capacity fee charged by Ocado on all these partnerships and 1% recurring costs of managing this capacity provision, which results in ~£670M of steady state EBITDA.

               

              International deals Revenue (£M) % Online Revenue capacity Fee as % of capacity Costs as % of capacity EBITDA (£M)
              CFC2 x 50% (Ocado + Morrisons JV) 600 100% 600 5%   30
              CFC4 x 23% (Morrisons) 400 100% 400 4% 1% 12
              Bon Preu  1,000 10% 100 4% 1% 3
              Casino  17,000 15% 2,550 4% 1% 77
              Sobey's 14,000 15% 2,100 4% 1% 63
              ICA 8,500 15% 1,275 4% 1% 38
              Kroger 92,500 15% 13,875 4% 1% 416
              Coles 21,000 5% 1,050 4% 1% 32
              Total 133,000   19,900     670

               

              To determine an appropriate EV/EBITDA multiple we take as peers online delivery companies of both food and general merchandise. It is key to recognize that Ocado’s peers aren’t physical supermarket chains, as the core of Ocado’s business is fundamentally very different – being much more concentrated on the development of technological solutions to logistics issues in the supplier to customer transportation/delivery of fresh produce and general merchandise. This is particularly the case following the Ocado/M&S JV which will shift Ocado even more towards the Solutions part of its business, as it sheds management of the site and servicing of CFCs, instead only concentrating on the technology that they house.

              Thus, taking a peer group of online delivery companies we see an average EV/EBITDA multiple of 23x.

               

                EV/EBITDA
              AMZN US  20.7x
              APRN US  24.6x
              ASC LN  19.1x
              BOO LN  24.2x
              BOOZT SS  21.2x
              ZAL GY  27.9x
              Average  23.0x

               

              To remain conservative, however, we apply a multiple of 15x which gives us a per share value of ~£27 and therefore an upside of ~103%.

              SOTP Valuation  
              Ocado Retail EBITDA 555
              Ocado Solutions EBITDA 670
              Group EBITDA 1,225
              EV/EBITDA multiple  15x
              EV  18,382.5
                 
              Total Debt 244.30
              Cash & Cash Equivalents 410.80
                 
              Equity Value 18,548.97
              Shares Outstanding 691.97
                 
              Equity Value per share (£) 26.81 

              This valuation, however only takes into account deals and CFC build-outs that have already been announced. Assuming a mere 2 additional deals with supermarkets with a turnover of £15Bn each, with 15% penetration of the online channel for which Ocado charges a 4% capacity fee with a corresponding 1% of capacity being the cost to manage this capacity, adds another £135M of steady state EBITDA which drives the share price to ~£30 – an upside of ~127%. Even an assumption of 2 additional international deals, however, is extremely conservative. Given the recent pace at which Ocado has been signing on partners, combined with the flexibility that the large cash inflow which the M&S JV has provided it with and its vastly superior customer proposition, we expect Ocado to sign a much higher number of partners in the coming years.

              It must be noted that Ocado’s constant optimization of its operations in the form of technological advancements and the consequent efficiency gains are likely to drive EBITDA margins further in its Ocado Retail business segment from the current 10% in its first-generation facilities to at least ~12%.

              Furthermore, in our valuation of the Ocado Solutions segment we have taken partners’ revenues as of their last reported financial statements. However, research shows that online grocery services are equivalent to a high-service customer-loyalty program helping supermarkets not only retain their most loyal customers but also capture a greater share of their wallet. In addition, delivery services in the case of first movers (most of Ocado’s partnerships are firsts in their respective geographies) are likely to win over new customers. Between 50-70% of sales are incremental for retailers that offer delivery, meaning that the provision of an online delivery offering is likely to be a big top line growth driver for Ocado’s international partners.  This means that there is further optionality in terms of the fees that Ocado will be able to reap from its international partnerships.
               
              Ocado currently trades on a ’19 EV/EBITDA of ~95x and an operating cash flow yield of 1.66%, which while optically pointing to the company already being very expensive, are the result of it being in the early investment stages of both its JV with M&S and its large international partnerships. These outlandish metrics are therefore a reflection of the company being at the early stages of a steep growth trajectory.


              Ocado’s revenue growth in its Ocado Retail segment has averaged 17% over the past 10 years and is unlikely to slow going forward given the supply-led nature of the market (as already explained above) and the large build-out as part of the M&S JV. These growth rates will be exceeded in the Ocado Solutions segment as the business completes the investment phase of its partnerships and starts earning capacity fees. 

               

              Shareholders

              Looking at the shareholder register of the company, the top shareholders stand out as being very long-term minded investors. Jorn Rausing – a billionaire and co-owner of Tetra Laval (packaging company), for example, invested as early as 2003, and is still the 3rd largest holder.

              Top shareholders also include the founder and CEO – Tim Steiner, pointing to the alignment of interests between management and shareholders. Another co-founder – Jason Gissing, also owns shares amounting to 0.58% of shares outstanding.

              An analysis of insider transactions shows extensive buying activity over the past years with no selling of Ocado shares having taken place by insiders since August 2018.

               

              Risks

              A key risk that many investors will be focusing on is the recent fire in CFC3, Andover. However, our extensive analysis of the situation points to investors’ overreaction to the incident and the consequent dampening to the upside that its shares could have otherwise experienced to date.

              There is no doubt that the incident will majorly affect Ocado’s operations as the Andover CFC formed 10% of Ocado’s Retail capacity and the extent of the fire means that the site is not operational at all and will have to be knocked down and rebuilt. With the building of the previous CFCs having taken somewhere between 2 and 2.5 years, we aren’t expecting CFC3 to be up and running again any time soon. But when it is rebuilt, we’d expect the facility to be much more efficient, being equipped with the 3rd generation bots (if these aren’t further optimized before the build-out of the facility). All other Ocado CFCs are currently running at capacity with the 5th CFC only beginning to be built in H1 2019, thus limiting the company’s options for any immediate capacity shifts across its existing facilities.

              On its Q1 19 trading update, however, the company detailed the numerous options open to it that it has implemented and will further deploy to shift capacity:

              During the trading update, the company also stressed that it would prioritize minimizing the impact to its sales from this incident as it realizes the importance of minimizing the degree to which its customers are impacted.

              Further relief should come from the company’s insurance contracts. Ocado has:

              At its Q1 19 trading update, mgmt. said that the company has already received ~£30M of insurance payments.

              Apart from the short-term relief provided in the form of insurance payments, however, we think certain facts around the incident itself point to the one-off nature of the event and therefore the unlikely nature of this having any material effect on the long-term growth story of the company. From the company’s video footage, it appears that the fire started from the robots’ charging point, but the exact reason the fire started isn’t a fundamental design flaw but rather a minor design suboptimality which will be tweaked going forward. This means that all other facilities are able to run at full speed and capacity as there is no fundamental design flaw in the robots inhibiting their safe functioning.

              The company has also developed a quick and cheap medium-term solution for the incident based on how the extent of this fire could have been mitigated. One reason for the fire causing the extent of damage that it did was the failure of the company and fire brigade to immediately realize the extent of the fire and their mistaken belief that the fire was under control. This mistaken belief was partially the result of an inability to monitor the temperature in the section of the facility where the fire started – the ambient section. As opposed to the ambient sections of the facility, the temperature in the chilled sections of the CFC is always monitored. Thus, the company expects its installation of temperature monitoring equipment in all sections of the facility to enable the company to ensure more prompt detection of such issues in the future.

              Moreover, it is important to note that the safety of all other facilities is not something that investors have to take the company’s word for but is something that both insurance companies with which Ocado has contracts and the fire brigade have previously certified. In addition, the continued running of these facilities at full speed and capacity points to the lack of any fundamental operational/design issue affecting all operations, rather pointing to the one-off nature of the event and the ease with which it can be mitigated in the future.

              M&S has more private label goods and a smaller selection of branded goods, and unless Ocado is able to replace the branded goods it used to buy with Waitrose through direct relationships with branded grocery suppliers, it may have downward pressure on its JV topline due to customer attrition, also stemming from the loss of customers loyal to Waitrose. However, mitigating this potential downward pressure is the gain in customers loyal to M&S who only account for £400M of Ocado’s sales at the moment, and the relationships that Ocado has cultivated with suppliers as already mentioned above

              If services being built out in new markets end up taking the form of click and collect due to lack of favourable delivery economics, the take up of online grocery shopping could be meaningfully slower than expected with the key factor of convenience needed for greater online penetration lacking.

              Longer than expected building works or issues with planning permission in any of Ocado’s geographies whether under its Ocado Retail M&S JV or its international deals could weigh on its share price given the consequent delay in operations.

              Companies deciding to develop in-store picking solutions or dark room warehouse-based solutions, like Tesco or Sainsbury’s, could also prove to be a risk to Ocado. However, as already explained above the “cost-plus” nature of these models makes them inherently less profitable and in most cases unprofitable, mitigating the risk of such a development in the longer-term.




               

              Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purposes only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author has a position in this stock and may trade this stock.

            • I do not hold a position with the issuer such as employment, directorship, or consultancy.
              I and/or others I advise hold a material investment in the issuer's securities.

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