Backing Ocado requires investors to maintain blind faith. The online grocery company is ploughing cash into rapidly building online fulfilment capacity on behalf of third-party retailers and its own joint venture with Marks & Spencer. The payback comes when those facilities reach sufficient scale and generate enough cash to counter the cost of signing new commercial partners. Yet the path to achieving the lofty earnings growth ambitions implied in the group’s market valuation is fraught with risks.
A deal to build fulfilment centres for Lotte, the South Korean retail conglomerate, sparked an increase in the share price of almost 40 per cent in one day at the start of November, the biggest daily rise recorded since Ocado signed its first significant international partnership with Kroger, the American grocer, in 2018. The scope of the Lotte deal might be smaller, with Ocado due to build six fulfilment centres by 2028, compared with the twenty agreed for Kroger, but it is still the largest agreed since before the pandemic.
It also comes after a substantial sell-off in the shares, in which Ocado has given up all the gains made during the pandemic. Yet despite Ocado’s market value shrinking by more than two thirds since a peak at the end of 2020, an enterprise value of 82 times forecast earnings before tax and other charges puts the shares nowhere near bargain territory.
Justifying the heavy losses associated with fitting-out the customer fulfilment centres in Britain and overseas is Ocado’s greatest burden. The construction of warehouse buildings is funded by clients, but the cost of the software and automation technology is borne primarily by Ocado. The solutions business charges clients an upfront fee and a continuing fee based upon delivered sales capacity.
A natural lag between funding the fitting of facilities and the associated sales capacity reaching full potential continually leaves a hole in Ocado’s bottom line. These facilities start generating a return for the group only after three years of being operational. In fact, 2020 aside, distribution and administration expenses have swelled at a rate that has exceeded the rate of revenue growth over each of the past five years.
This year, the British solutions business’s adjusted earnings before taxes and other charges is expected to be £79 million, far outweighed by losses of £117 million from the international unit. The overseas losses are expected to be smaller next year and the group is expected to return a £91 million profit. But inflationary pressures also complicate the contribution made by the retail business, which analysts expect to generate £68 million of total earnings.
Does Ocado have the cash to fund its expansion? A £578 million equity-raising and securing a £300 million credit facility gave the group access to almost £2 billion in cash and undrawn debt facilities in July. The company reckons those resources give it enough capital to fund the building of the fulfilment facilities it has already committed to, as well as deals that might be in the works.
Net debt had risen to just under £760 million by the end of May, a figure that analysts expect to be broadly steady at the end of November before jumping to £1.35 billion at the same point next year and to £1.7 billion in 2024. That is alongside forecasts for adjusted earnings before taxes and other charges of £100 million and £247 million, respectively, which would equate to eye-watering leverage multiples. With no solid guidance on generating a statutory profit in sight, scepticism towards Ocado is warranted.
ADVICE Avoid
WHY Cost of living pressures, inflation and high capital expenditure could cause trading figures to miss market expectations
Kainos
Convincing investors that splurging on hiring more people and expanding product development will provide a worthy return is harder in the face of double-digit inflation and recession. Kainos, however, lifted revenue and pre-tax profits ahead of analyst expectations during the first half of its financial year, which should persuade the market that higher capital expenditure is merited.
The FTSE 250 software group, which designs IT systems for commercial, public sector and healthcare clients, reported a 26 per cent rise in revenue over the six months to the end of September, while adjusted pre-tax profit was 16 per cent higher, ahead of the annual growth rates anticipated by analysts for the full financial year.
Shore Capital, the broker, expects to upgrade revenue and adjusted pre-tax profit forecasts for this year to about £370 million and £68 million, respectively. The latter figure would represent annual profit growth of 17 per cent, an improvement on the 3 per cent recorded last year.
The caveat? Much of the boost to profit so far this year has been derived from a strengthening dollar. At a constant currency level, profits were 3 per cent lower over the six months to the end of September.
Investing in sales, marketing and research and development across the Workday Products business suppressed earnings but could lay the groundwork for faster growth in the United States, where the division already makes the bulk of its profits. This year will mark the “step change” in investment, according to Brendan Mooney, Kainos’s chief executive, to be followed by smaller, incremental increases in expenditure.
Over the past five years, revenue has expanded at a compound annual rate of 29 per cent, profit at a rate of 33 per cent. A record of pacey growth and a high degree of recurring revenue have earned the group a forward earnings multiple of just over 32. That’s in line with the average recorded since the group’s 2015 floatation, but is a way below a peak of 59 in 2020.
If Kainos can contain the jump in costs to this year, there is every chance that the rally in the shares since June could be sustained.
ADVICE Hold
WHY Revenue and profits have been more resilient than anticipated
