Description

Thesis

Ocado is the global technology leader in groceries, providing a complete end-to-end solution that allows their food retail partners to grow a profitable online business. Ocado’s technology for large, out-of-town centralised customer fulfilment centers (“CFCs”) combined in a network with in-city micro CFCs creates the lowest cost solution to fulfil online orders whatever the customer needs. For this reason, we believe Ocado and their partners will be the online winners in their respective markets over the long-term.   

Historically, online grocery penetration has lagged other retail categories, but the Covid-19 pandemic has been a catalyst for accelerated global online adoption. For example, in the US online penetration has increased from ~5% pre-pandemic to ~10% today. Ocado will benefit from this step change as their existing partners accelerate the roll-out of online capacity and as Ocado signs new international food retailers who are now forced to have a credible online strategy. 

Over the next decade, Ocado’s installed base of CFCs for both their international and UK partners will approach 200 as industry online penetration grows >20%. At this point, Ocado will be generating roughly £2bn of high quality recurring income for which the market will pay a high multiple. At a market cap of £14bn, we find the current valuation compelling and see 80% upside with multiple catalysts over the next year. This view is also supported by numerous recent insider buys.

Background 

Ocado started out as a pure-play online grocery business in the UK in 2000. Over the years, management realised that their accumulated knowledge of the online market and the technology they had created would be valuable to other grocery partners both domestically and internationally. In the last 4 years, the business has started licensing its proprietary and rapidly evolving end-to-end solution. Today Ocado Group can be split into 3 main areas:

1. Ocado UK Retail. This is the original Ocado.com UK retail business. They used to partner with Waitrose, a high-end UK grocer, and sell a combination of Waitrose branded products, Ocado branded products as well as third party brands. However, in 2019, they sold 50% of the UK Retail business to M&S (MKS:LN), forming a UK Retail JV. M&S food replaced Waitrose food on the platform last year. This JV is a customer of Ocado Solutions and pays fees to Ocado Group in a similar way to other international clients. The JV currently operates 5 CFCs generating ~£2.5bn sales and is building and identifying sites for a further 3-4 CFCs. In addition, they are in the process of rolling out their immediacy solution (next hour delivery) Zoom. Ocado’s 50% stake in this business accounts for <20% of the value of the company, but, as the largest of the current Ocado Solutions partners, it provides an insight into the profitability of the Ocado online solution. As Ocado controls the JV, they fully consolidate it into their accounts. 

2. Ocado Solutions. This is the technology business that is 100% owned by Ocado Group, and which owns and develops the IP (Ocado Smart Platform, “OSP”) that Ocado sells and runs for its grocery partners. They earn fees based on sales capacity provided to their partners. In return, they build and maintain the equipment and software for their partners and the partners have access to all of the ongoing innovation. The business is split into two areas:

1. International Solutions. To date, Ocado has signed 8 international grocery partners onto the platform; they are in active discussions with others and intend to sign further deals in the future. Their largest partner is Kroger (KR), in the US. Most of their international partners have exclusive rights to the Ocado technology in their geography, provided they continue to grow and try to lead online grocery development in their market. 

2. UK Solutions. Ocado has 2 partners in the UK: the Ocado UK Retail JV, of which they still own 50%, as well as Morrisons. The Morrisons relationship is subtly different as Morrisons own 50% of the equipment alongside a few other minor details. 

3. Ocado Ventures. Ocado has also made some early stage speculative investments in ideas complementary to their existing technology (e.g. vertical farming) where they believe they can add value and which may ultimately be of interest to their OSP partners. However, today, this is immaterial and so we do not focus on it in the write-up, but long-term it may provide some optionality and further upside. 

Business

What is Ocado’s technology solution (Ocado Smart Platform)?

Lots of investors who know the case will have seen the videos of robots moving across the top of a grid in an Ocado fulfilment warehouse; if not, we recommend you watch this: https://www.youtube.com/watch?v=g2uMfpAHdGY. However, we believe there is a misconception in the market that this is the only bit of technology that Ocado provides its partners. In reality, they provide a full end-to-end solution for running a profitable online grocery business that will evolve and improve over time with the latest Ocado technology innovations. This includes the website, the software to run the fulfilment facility, the routing software for the vans, etc. 

As we outline below, all together, this provides partners with the lowest cost online solution, even after the fees payable to Ocado. As Kroger said at their recent Capital Market’s Day, by year 5, they expect their online business from the Ocado-powered fulfilment centres to be higher margin than their store-based business. This presents an interesting tipping point in the future when groceries can potentially be delivered to your front door at a lower price than it costs to buy them in store. Alongside a higher SKU range to choose from and fresher items, this presents a very compelling customer proposition and a reason why long-term online adoption will likely continue to grow well beyond 20%, with Ocado’s partners having a cost advantage in their market. This should lead to these partners having higher market shares in their online businesses.  

Economics of the Ocado Solution

Ocado’s solution originated as a centralized fulfilment solution. This has several cost advantages over both a basic pick-in-store online model and over a more advanced in-store automated micro-fulfilment solution. We estimate the centralized solution has a ~15%-of-sales cost advantage over a basic pick-in-store model and a ~7-8% advantage over micro-fulfilment. In a low margin industry, these savings are enormous. The disadvantage of only running a centralised model is that the distance from the customer makes it harder to do same day delivery. However, we discuss later how the Ocado solution is evolving towards a network of large out-of-town fulfilment centres alongside in-city micro and mini fulfilment centres and why the Ocado solution is becoming the lowest cost solution for all customer needs. 

Pick-in-store models have numerous inefficiencies, these include the increased costs of manual shelf replenishment (~6%), check-outs/customer service (~3%), higher shrinkage/food waste (~3%), higher store occupancy costs (~5%), with only the small advantage (~2%) of being close to the customer lowering the delivery cost. Given this ~15% cost disadvantage, we do not see this as a viable long-term online solution for grocery businesses. The only reason to do pick-in-store is to ramp online sales and grow your customer base while building an economically viable long term solution. Some grocers are currently claiming pick-in-store is profitable, but we believe this is only possible on a contribution basis if not allocating the costs of running the stores or charging the customer higher pricing alongside a delivery fee.

Micro-fulfilment solutions, including retrofitting micro-fulfilment in a section of an existing large store, is the route that many grocery businesses have taken. Given it involves a lower upfront capital cost and they can leverage some of the existing store base (sunk cost), it is a lower risk option but not the best long-term solution in our opinion, especially if the industry is going to >20% online. Building a micro-fulfilment solution has a ~10% margin disadvantage versus a larger out-of-city centralized fulfillment center, given factors such as the increased rent costs,  with only a ~2-3% margin advantage of being closer to the customer (i.e. 7-8% net). The main advantage of micro-fulfillment is the ability to do same day delivery. However, in the future, this is likely to make up only part of the online market. 

You can make the comparison in the offline world of convenience stores versus large superstores. In the UK, the grocery market is ~50:50 in £ terms between the two, with customers doing large weekly shopping at lower cost superstores, and topping up as needed at convenience stores. Convenience stores are more expensive to run (higher rent in city centers, etc) and as a result prices are ~10% higher. We believe the ultimate online winner will be the retailer who can offer the lowest prices for all of the customer needs.

Ocado is currently the only company that has the technology and track record of building and running large automated central fulfilment centers (“CFCs”) successfully. To put the size of their facilities into scale, their CFC in Erith, UK, which runs their latest technology, has capacity to do annual sales of >£1bn. The more usual “Andover”-sized CFCs, which are closer in size to what most partners are ordering, have capacity to do ~£350m annual sales. Even at this smaller scale, they have 25x more sales capacity than your average micro fulfilment centre. Bears often underestimate this scale difference when they quote the low build cost of a micro fulfilment centre vs the cost of an Ocado CFC. 

Ocado also builds mini and micro CFCs which are more suitable for city centers. These also contain the hive technology solution, containing the same grid and totes. Most importantly, the food to stock these facilities can arrive from the larger out-of-city CFCs already packaged in totes. This benefits the economics of the facility as the totes can be fed directly into the grid on arrival. This means an Ocado-built micro CFC as part of a larger network of CFCs has a lower cost per order than competitors just running micro fulfilment. Therefore, Ocado can provide micro-fulfilment at a lower cost than competitors for the shopper who is willing to pay a higher price for same day/next hour delivery, while also catering for the customer who is happy to wait until the next day for the lowest price shop. 

The other advantage of the dense Ocado hive solution alongside centralized fulfilment is that they can hold a much larger SKU range for customers, as well as managing inventory more efficiently. All combined, we believe the Ocado solution provides the customer with the best proposition at the lowest price. This is backed up by the early feedback from international partners who are now live on the platform and fulfilling orders from an Ocado-powered CFC. This includes Kroger who said in June ‘21 that their NPS scores from their first live CFC were “among the highest in digital retail”.

Economics For the Partner

A frequent question is how can a low margin food retailer afford to pay Ocado an ongoing ~5% fee (as well as some upfront fees) for their technology and still be profitable. The answer is found in what Ocado provides to the retailer in return for that ~5% fee. Ocado funds the building and maintenance of their best-in-class fulfilment centres (hardware & infrastructure inside the warehouse) at a materially lower cost than the retailer could. In addition, Ocado is funding all of the R&D and software development required to successfully run the online business. 

In the UK, the Ocado Retail JV is the only partner which is operating at scale while also paying Ocado Group fees in a similar structure to the international partners. This, therefore, gives a glimpse into the potential margins for the partner. In H2 20, the JV did 8.8% EBITDA margins (after the fee to Ocado), which is higher than most store-based grocers. This was helped by larger baskets during Covid, offset by the fact that only a third of sales were from the Erith CFC which is higher margin and runs the latest technology. Longer-term, we believe the margin profile for the online sales of a partner running the Ocado technology is higher than their store-based margins. This is backed by the comments made by Kroger at their recent investor day in March: Kroger said their CFCs will be at store level profitability in year 3 and ahead in year 5. 

Economics for Ocado

Ocado’s partners are responsible for providing Ocado with an empty warehouse and buying the vans. Ocado builds and maintains the fulfillment solution within the warehouse (the “hive”) as well as providing the software to run the online business. Ocado are paid upfront fees by the partner to offset some of the cost of the upfront capex, and then pay an ongoing fee based on the available sales capacity out of the Ocado facilities. 

Ocado normally talks and gives guidance in “Andover”-equivalent-sized CFCs (the facility that can provide 65k orders per week or ~£350m annual sales). For an Andover-sized CFC, the cumulative cash burn for Ocado after the upfront fees is ~£30m. Once built, Ocado receives a ~5% ongoing fee from the retailer which is calculated as a percent of available sales capacity. Ocado then has the ongoing cost of maintaining the facility. Once fully ramped, we assume each facility makes ~50% FCF margins for Ocado, i.e. ~2.5% of the sales of the partner. Just over half of the costs are the engineering, hosting and support costs to run the facilities, with the remainder being the replacement and parts. This means for each “Andover”-sized facility running £350m of sales, Ocado is making ~£9m of annual FCF. The reality is that the facilities being built by partners will be a variety of sizes but the economics (i.e. the 50%) will be similar for all facilities. 

At a group level, Ocado also invests huge amounts into R&D to continually improve the solution. Being able to leverage this across a number of global clients, combined with the shared learnings from each client (network effect), means that Ocado is well placed to stay ahead of the competition from a technology perspective.

How the Technology is Advancing

The economics described above should improve in the future in two ways. First if Ocado can lower the cost to build and maintain a facility they get to keep the benefit. Second, as Ocado develops new features to the solution that will further lower the cost for the partner (e.g. robotic pick arms), Ocado will be able to sell these into their partners. Consequently, we expect the ~5% take rate to increase over time, as well as the margin Ocado makes on it. 

There are a number of areas of R&D that Ocado is working on. The ones we are aware of that are likely to have the biggest impact are:

• Robotic pick arms, which have the potential to remove ~£7m of annual cost per CFC. Following the Kindred and Haddington acquisitions, the development of this has been accelerated. We would expect these savings to be shared between Ocado and their partner.

• Next generation robots (“bots”). The bots are the biggest cost of building a CFC; as Ocado develops future generations there is an opportunity to materially lower the built cost. This is particularly interesting because it is likely to make the Ocado solution viable in countries with lower labor costs (e.g. China/India) over time, as well as improving the ~50% FCF margins over time. 

We believe the ultimate end game is a CFC that requires no humans to fulfill a customer order: just a few engineers on site to ensure the facility is correctly running. Combine this with a world of autonomous delivery trucks (Ocado has a stake in Oxbotica, an autonomous vehicle software company) and it gives an insight into what the solution could look like in the very long-term. 

TAM and Future Growth 

The global grocery industry is £7.6tn, of which the company believes £2.8tn is in countries which are suitable for the Ocado solution. The smaller market is mainly a function of labour costs in each country, and, as the cost of the Ocado solution falls, this £2.8tn is likely to rise. If Ocado partners with one of the leading grocery retailers in a country and they take an outsized market share of their online market, we believe 25% market share is realistic, or £0.7tn. The next assumption is how much of the industry is going online; if we assume 20%, then the TAM for Ocado is £140bn of online sales. At a 5% take rate, this is £7bn of fee (revenue) opportunity today. If the world is going 50% online this fee opportunity rises to £17.5bn (or ~£9bn of FCF). 

If you just focus on Ocado’s current partners, they do ~£225bn of annual sales. If 20% of their partners' sales go online that is £45bn of sales. At a 5% take rate this is £2.2bn of annual recurring fees to Ocado. At 50% online penetration, this rises to £5.6bn (or ~£2.8bn of FCF).

We forecast growth on a bottom-up basis by current partner and with a conservative assumption of future countries that are suitable where they are likely to find new partners. We also model a small improvement in the take rate over time as Ocado sell-in new features to their partners, as well as their margins slowly improving over time as they are able to lower the build cost of CFCs. Putting it all together, by 2030, we believe Ocado’s installed base of “Andover” - equivalent CFCs will be approaching 200 as the industry is >20% online. These will be generating ~£2bn of high quality recurring FCF for Ocado.

We do not know what the level of global online grocery penetration will be in the future, but several data points allow us to make reasonable assumptions. Today, online grocery penetration varies massively by geography. South Korea has well over 20% online penetration, and the UK is another leader with low-to-mid teens online penetration, but most other geographies are still in single-digits. One of the main reasons grocery has lagged other retail categories, in terms of online penetration, is that, given the poor economics, the incumbents have not been incentivized to move online and grow the market. However, following the Amazon acquisition of Whole Foods and the impact of Covid-19, this is changing. Other retail categories are already significantly further online, e.g. apparel in the US currently approaching 50%. While remaining a laggard to other retail categories, we believe it is a reasonable assumption that the grocery industry will be >20% online in Ocado’s addressable markets by 2030. 

Valuation 

We believe the market will pay a high multiple for this ~£2bn of very sticky and growing FCF. Once a partner has built out a network of Ocado CFCs that is powering their entire online business, it will be almost impossible for them to replace Ocado. The exact timing of when Ocado reaches this ~£2bn of FCF for their solutions business will be dependent on the speed of online adoption. We assume the industry will be ~20% online in 2030. If we assume the market will pay 25x given the quality of the FCF and continued growth potential, this gives a value for just Ocado Solutions of £50bn or £65 per share. Discounting back to today at 10% this values this part of the company at £32 per share.

Additionally, there is Ocado’s 50% share of the UK Retail JV. As they build out and deliver on their current expansion plans, we believe they will be doing ~£5bn of revenue in 2024. If we value the business on 1.0x sales (given we believe it will be capable of ~5% FCF margins and still growing >20%), and just taking Ocado’s 50% stake, this is worth £3 per share.  

Combined we therefore believe Ocado is worth £35 per share, or 80% upside from today. In our upside case, at 30% online penetration we believe the stock is worth £50 discounted to today. As a supporting data point, the CEO’s £100m share incentive scheme (over 5 years), only pays out in full with a ~£34 share price in 2024. Recent insider purchases tell a similar story: during the Spring, board member Jorn Rausing bought ~£50m at ~£19 and, over the summer, the Chairman bought £100k at £17 and the CEO of Ocado Solutions bought £200k at £18.

At sub £20, with the stock down from close to £30 last year, we think the valuation provides a particularly compelling entry point. We think the shares have been wrongly pressured on a combination of ongoing litigation, unfounded competitive fears, and possible harder short term dynamics given the tough Covid comps. 

Catalysts

• Over the coming year, we expect the existing partners to expand the size of their orders with Ocado. The most material will be Kroger, whom we expect to place their next order and expand beyond the initial 20 CFC commitment. 

• We expect Ocado to sign deals with new international partners. 

• Acceleration of the UK Retail JV in 2022 as new capacity comes online after years of being capacity constrained 

• Unveiling new technology developments which improve the economics of the Ocado solution and expand the size of the TAM. For example, revealing the cost of the next gen bots which could materially lower the build cost of the solution.   

Risks 

• There is a risk that Ocado’s technology is surpassed by a new entrant. However, we think this risk is remote, as Ocado is the first mover, innovates constantly in R&D, has 20 years of hard-earned experience in this very difficult online grocery retailing business, receives feedback and insights from a global partnership base, and has scale. 

• Execution of the deals. To date, Ocado has built 5 CFCs in the UK and 4 internationally. Over the next 3 years this will grow to >30 CFCs, including 15 that are currently under construction. With this comes execution risk. We believe Ocado is managing this risk (eg. bringing in Jabil and Flex with their global manufacturing capabilities) and appears well prepared, though unforeseen temporary delays are always possible (eg. fire at Andover, they have since made improvements to the solution)

• There is currently an ongoing litigation with Autostore. We are not patent experts but for now, Ocado appears to be winning the battles (2 of 6 UK patents successfully opposed, 2 of 5 US patents noted in Ocado’s favour from the independent board, Ocado patents confirmed in Europe). We believe it is unlikely there is an outcome that materially impacts the future economics or growth of Ocado. 

• Key man risk. Tim Steiner, the CEO/founder, is impressive and very important for the continued success of the business.

Catalyst

• Expansion of existing deals, in particular the next Kroger order

• Signing new international partners

• Acceleration of the UK Retail JV in 2022 as new capacity comes online 

• New technology developments