This morning’s half-yearly results from Ocado Group (LSE: OCDO) revealed that the online grocer is finally making a profit — but having looked more closely, I wasn’t surprised to see the firm’s shares slide by nearly 5% when markets opened:
| Ocado Group | H1 2014 | H1 2013 |
|---|---|---|
| Sales | £429.7m | £355.9m |
| Operating profit | £10.9m | -£1.1m |
| Operating margin | 2.5% | n/a |
| Earnings per share | 1.28p | -0.66p |
Source: Ocado Group results.
Ocado may have proved its most bearish doubters wrong — it can deliver groceries profitably, without the benefits of a nationwide store network — but despite this apparently good news, I still rate the firm’s shares as a strong sell.
Can Morrisons deliver?
Ocado supporters point to the firm’s ability to grow by offering home delivery outsourcing services of the type it is now providing for Wm. Morrison Supermarkets (LSE: MRW) (NASDAQOTH: MRWSY.US).
However, there don’t seem to be any other such deals in the pipeline, and the deal with Morrisons generated less than 5% of Ocado’s revenue during the last six months. In my view, it’s too early to judge the potential of this line of business.
Right company, wrong price?
Ocado reported earnings per share of 1.28p for the first half of this year, finally breaking into post-tax profitability.
Assuming the trends seen in the first half of this year continue, my calculations suggest that Ocado could report full-year earnings per share of around 2.9p, significantly ahead of recent analysts’ forecasts of 2.5p.
Despite this, Ocado’s 350p share price still equates to a prospective price to earnings (P/E) rating of 120, falling to 66 in 2015, if analysts’ forecasts that earnings will rise to 5.3p per share next year are correct.
That’s just plain bonkers in my view, as Ocado has not yet provided any proof that it can benefit from economies of scale: Ocado’s distribution costs rose by 25% during the first half of this year, even though sales rose by just 20%.
In my view, Ocado shares might be fairly priced on a forecast P/E of 25 — say around 75p. I reckon that anything more than that is just speculation.
How big is enough?
Ocado’s 2.5% operating margin is below the supermarket sector average of around 4%, and the firm’s sales would have to rise by a further 190% to match Tesco’s home delivery sales, which totalled £2.5bn last year, and generated a profit margin of 5%.
Ocado continues to invest in new capacity to fuel continued growth, but in my view the firm’s current valuation makes the online retailer uninvestable.