The Guide to Investing in Stocks and Shares

Ocado - Public Offering (IPO)

Dan Tebbutt - A Shareworld Contributor

Published - 15th July 2010

Ocado, the online supermarket, will shortly be doing an Initial Public Offering (IPO), giving members of the public a chance to buy shares in them for the first time. I like the idea of buying shares in a business I know something about - and I've been buying my groceries from Ocado for more than 7 years, so they fit the bill nicely. Of course, as with any investment, price is all important - I‘ll only be buying their shares if they look cheap.

As part of an IPO, a company issues a prospectus, which should provide the basis of any decision to invest. It provides a lot of the information that a publicly listed company would put in their annual reports, and which aren't so easily available for a private firm. Ocado's prospectus can be found here: Ocado prospectus

Shares will be offered at between 200 and 275 pence each. At a price of 240p the market cap of the company would be about £1.2bn.

So what does that valuation rest on? I can think of 3 ways to value the company:

• Based on earnings
• Based on book value
• Based on their future prospects

Let's take each one in turn.

Earnings

This shouldn't take long. Last year Ocado lost £23m after tax. The year before it was £33m. And before that, £40m. So they're going in the right direction - but I'm not going to value a company at over a billion pounds based on those sorts of numbers.

Book value

At the moment Ocado's balance sheet includes (rounding to the nearest £10m):

• £90m of property plant and equipment
• £10m of intangibles and tax assets
• £10m of inventory.
• A net negative balance of £30m of trade and other receivables/payables.
• Net debt (including lease obligations and subtracting cash) of £110m

That makes minus £30m. Even after raising £200m in their IPO, their net asset value still only makes it up to £170m. That's not going to support a valuation of £1.2bn.

Future prospects

So the only thing that can support a valuation anywhere near £1.2bn is Ocado's future. Let's be as charitable as we can and work out where they might go over the next 10 years:

• They have grown revenue at 20% per year for the last 2 years. Let's assume that continues for 10 years.
• Gross margin has been about 30%, so lets assume that continues.
• Distribution and Administration costs have historically risen less than revenue, so let's assume they rise by 10% per year.
• Let's assume finance costs remain constant.
• Let's assume that they can sustain this growth from cash flow, without the need to raise new capital - but equally that this leaves them no room for dividends or accumulating a cash pile.

After 10 years that would leave them earning £353m per year after tax. At a P/E ratio of 15, that would put them on a value of £5.3bn. Fantastic - but we need to consider the opportunity cost of holding Ocado shares rather than something else. I reckon I could earn an annual return of about 10% per year elsewhere - so that £5.3bn in 2020 is only worth about £2bn today.

But that's still substantially more than £1.2bn - and if I was convinced that those prospects were realistic, I think I'd be tempted. But let's look again at that position in 2020 and see how realistic it looks:

• Net margin of 12% - double that of Tesco today (and Tesco is way ahead of its rivals).
• Assuming all earnings have been reinvested and they take on no further debt, Return on Capital Employed of over 20% (vs. current 12% for Tesco).

I'm sure Ocado's supporters would point out that it is an online retailer, more akin to Amazon than Tesco. But I don't see it - all the successful online retailers I can think of are dealing with high-value, low-volume, non-perishable goods. Amazon can cut their costs to the bone by running a small number of super-large warehouses, squeeze their suppliers further than anyone else because they are the biggest game in town, and drive out their rivals by being the cheapest.

Ocado will always have to compete against the supermarkets, and they can leverage their existing warehouse / distribution network and supplier relationships to offer goods at least as cheaply as Ocado can. And if Ocado are facing cut-throat competition from the supermarkets, I don't see how they could achieve net margins of 12% and a return on capital employed above 20%.

Conclusion

I'm not even remotely tempted at the price range that Ocado are pitching their shares at. In my view they would still be expensive at half the price.