Shares in Ocado Group (LSE: OCDO) and TalkTalk Telecom Group (LSE: TALK) bounced nearly 10% higher when markets opened this morning, after both firms issued trading updates.
However, these early gains soon started to fade. In this article, I’ll explain why I think both companies have problems and deserve sell ratings.
Ocado
Ocado’s pre-tax profits rose by 65% in 2015, from £7.2m to £11.9m. This sounds impressive, but Ocado’s £1,566m market cap means that the group’s shares are still trading on a trailing P/E of 133!
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Even assuming that Ocado meets forecasts for earnings per share growth of 50% in 2016, the shares will still trade on 88 times earnings. That seems too high for a business with an operating margin of just 1.9% and no dividend.
The second problem for Ocado is that it doesn’t seem able to generate economies of scale as it grows. For example, total revenue rose by 16.7% to £1,107.6m last year, but the group’s total distribution and administrative costs rose by 19.8%.
The big problem is that this is a very capital-intensive business — every extra sale or delivery costs Ocado money. This is different to a bricks-and-mortar shop, where if extra customers visit, overheads remain the same and profits rise.
Indeed, the impression I get from today’s results is that Ocado wouldn’t be making a profit at all, if it wasn’t for the £18m of fees charged to Morrisons last year.
Ocado is still trying to attract additional customers for its home delivery business, but so far this hasn’t happened. Even if it does, I’m not sure the profit potential from another customer like Morrisons would be big enough to justify Ocado’s valuation.
I rate Ocado as a sell.
TalkTalk Telecom
TalkTalk said today that last year’s cyber attack will cost the firm around £60m, thanks to £15m of lost sales and exceptional costs of £40m to £45m.
Despite this, TalkTalk expects full-year earnings before interest, tax, depreciation and amortisation (EBITDA) to be in line with expectations, at between £255m and £266m.
TalkTalk also reiterated its commitment to increasing its dividend by 15% this year. This gives a potential payout of 15.9p per share and equates to a yield of about 6.8%. However, I believe this is too generous.
TalkTalk’s earnings per share are only expected to be about 10.5p this year, leaving the dividend uncovered by earnings for the third consecutive year. During this time, TalkTalk’s net debt has risen from £393m to £644m. I believe some of this borrowed money has been used to fund unaffordable dividends.
Although it’s acceptable for companies to pay uncovered dividends occasionally, the explosion in TalkTalk’s debt levels suggests to me that a dividend cut will be necessary to bring the situation under control.
TalkTalk said today that next year’s dividend will be “no lower” than this year’s payout. To me, this suggests investors are being softened up for a possible cut.
Analysts’ forecasts suggest that TalkTalk’s earnings per share will rise by 50% next year. This should help improve cash flow and perhaps reduce debt. However, with TalkTalk shares already trading on 15 times 2016/17 forecast earnings, I don’t see any value here, and believe the risk of disappointment is quite high.
