Financial Analysis Coursework April 2016 - Ocado

01 April 2016

Ocado Group PLC

Fundamental Research NUBSFinancial

Company fundamentals

Share price history

UK grocery sector

BUY

Source: IGD UK

Source: Google Finance

www.NUBSFinancial.com

Ocado is the UK’s major online-only grocery retailer with a

business model that integrates online grocery sales with

the development and commercialisation of intellectual

property (IP) and technology used in a retail environment.

Beta: 1.74

Net Income: £11.8m

Current Share Price: 345p

1 Year Change:6.69% ↓

Source: Google Finance

LSE: OCDO:LN

Web: ww.ocadogroup.com

CEO: Tim Steiner

CFO: Duncan T-Brown

Shares: 590.04m

Market Cap: £2.04bn

Growth: 1.7%

Worth: £117.bn

Contents:

1. Industry Analysis

a. 1.1 Porter’s 5 Forces

b. 1.2 PESTEL

c. 1.3 SWOT/Strategy Analysis

2. Accounting Analysis

a. 2.1 Accounting Policies

3. Financial Analysis

a. 3.1 Profitability

b. 3.2 ROE and DuPont

c. 3.3 Liquidity

d. 3.4 Debt

e. 3.5 Z-Score

4. Forecasting

a. 4.1 Assumptions

b. 4.2 Forecasts

5. Valuation

a. 5.1 Residual Income

b. 5.2 Multiples

6. Conclusion

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www.NUBSFinancial.com April 1, 2016

OCADO GROUP PLC FTSE: (OCDO)

1

01

Industry Analysis



2

Existing rivalry

Industry stagnating

The industry’s annual growth rate has fallen from 4.3% (2010) to 1.7% (2015) (IGD, 2015) with year-

on-year decline since 2012. Although the 12-week growth up to March 2016 was 0.5% (McKevitt,

2016a), a Christmas mini-price war has put pressure on retailers (Felsted, 2016a) that could threaten

industry progress. While grocery

retailing is stagnating, online retailing

purports significant customer growth

of 29.0% for the 52-weeks up to April

2016 (Mintel.com, 2016), in addition

to the rise of discounters Lidl and

Aldi whose cumulative market share

is up to 10.7% (Felsted, 2016b) from

5.0% in 2011. This indicates a shift in consumer preferences towards low cost products, due to

austerity measures post-financial crisis, and accommodation for hectic modern lifestyles.

Industry increasingly fragmented

Discount retailers Aldi and Lidl have fragmented the industry by utilising their low-cost model to

undercut rivals, making it more difficult for supermarket giants to coordinate pricing strategies.

Industry-wide price deflation has persisted, shown in Figure 1, with the average shopping basket

down 2.1% on last year (McKevitt, 2016b) and

further cuts expected with Tesco slashing 25%

on 380 items, Morrison’s targeting £1bln of

cuts over the next three years, Sainsbury’s

slashing prices by £50m, and Asda aiming to

narrow its own-brand price gap to within 5% of

Aldi’s (Canocchi, 2016; Butler, 2015). Online

retailing is seeing more competition, with Sainsbury’s seeing year-on-year online sales increases

(Vandevelde, 2016a), Waitrose a 31% rise in online grocery sales (John Lewis, 2015) and the

introduction of Amazon Pantry (Weinger, 2015). Ocado’s competitive advantage - through advanced

robotics and proprietary IP - looks set to be challenged by the supply and logistics expertise of

Amazon. Discounters Aldi and Lidl have yet to move online, but Aldi have seen success with their

wine and non-food website (Butler and Farrell, 2015a), adding more competition to online retailing.

Figure 2 – Food Deflation (Locket, 2015)

Figure 1 – Market Share (Kantarworldpanel.com, 2015)



3

Products undifferentiated and switching costs negligible

Supermarkets offer broadly undifferentiated products through widely-offered branded items and

near-substitutes in own-brand ranges. The proliferation of discounters indicates the price sensitivity

of the average consumer and limited customer loyalty to established chains. Those with customer

loyalty schemes – most prevalent of which are Tesco and Sainsbury’s – hope to lock-in consumers,

but falling rewards (Cook, 2016) coupled with the shift in consumer preferences are dampening their

influence. Switching grocers entails no additional costs, with supermarket’s charging similar delivery

fees that are independent of the distance travelled and stores being easily accessible – with London

having on average 1.1 stores per square kilometre (Barrett, 2015) - making it straightforward for

customers to switch. In 2015, 24% of all British shoppers switched (Perrett, 2015). The ease of

switching incentivises price competition, adding to price deflation and ensuing price wars.

Entrants

Scale economies and substantial capital requirements

Big 4 supermarkets have significant advantages in terms of economies of scope and scale, brand

awareness, provision of services and large capital reserves. All-time high short positions on grocery

stocks (Colvin, 2015) indicates low investor confidence in the industry, which will make it difficult for

new entrants to obtain funding on the scale necessary to compete with the supermarket giants. This,

compounded by capital requirements and scale economies, act as a significant barrier for new firms.

Land hoarding

The 2000s saw large land hoarding from supermarkets (Goodley and Haddou, 2014) so as to prevent

rivals operating close to existing stores in profitable regions, acting as a barrier to entry. Despite the

Land Agreements Exclusion Revocation Order from the Competition Commission, hoarding is still an

issue, with Tesco currently being sued for anti-competitive behaviour (Armstrong, 2016).

Substitutes

Independent food shops

Despite the retreat of butchers, fishmongers and greengrocers across Britain, London has seen an

emergence of high-end independent grocers (Jack, 2014) that stock organic and ethically sourced

products. Whilst these establishments will attract ethical consumers who may otherwise frequent

more up-market supermarkets, their decline indicates little threat of substitutes.



4

Suppliers

Minimal bargaining power

The relative size of supermarkets to their suppliers enables them to exercise significant power in

securing favourable contractual terms, but bullying tactics employed by supermarkets (Competition

Commission, 2008) have resulted in a new industry code, the Groceries Supply Code of Practice (BIS,

2009) to curtail this influence. The Groceries Code Adjudicator has investigated Tesco for non-

compliance (Butler and Farrell, 2015b) but financial distress is persisting among suppliers, with a

92% increase as a consequence of the price war with discount retailers (Palmer, 2015). This

indicates both minimal bargaining power but also little protection afforded by the GCA, and as such

fresh regulation may be introduced to give the GCA greater powers to protect suppliers.

Buyers

Significant collective power

Consumers exhibit significant power due to the lack of differentiation and low switching costs. Their

power has been augmented as a consequence of the increasing fragmentation of the market, with

discounters offering low-cost alternatives. Grocery retail accounts for 51.3p in every £1 of UK retail

sales (IGD, 2016) indicating its significance in consumers’ cost structures. Price comparison websites

further add to consumers buying power, as well as price matching utilised by many supermarkets.

Political and Legal - Taxation, ‘Brexit’ and accounting framework

Ocado operates in a stable UK marketplace, where we expect to see corporation tax reduced to 19%

(2017) and 18% (2020) (Gov.uk, 2015), which will help strengthen cash flow over the coming years.

Ocado’s strategy of internationalising may be hindered, however, as uncertainty over Britain’s exit

from the EU presents fresh challenges in securing international partners for the Smart Platform.

Adjustments to IFRS 15, Revenue Recognition, (Ias.com, 2015) could impact positively or negatively

on Ocado’s income statement as customer contracts and performance obligations are altered.

Environmental - Bag disposal and carbon footprint

Consumers are increasingly informed about and concerned with companies’ corporate social

responsibility. Ocado is a natural beneficiary of this, with their business model centred on minimising

stores. Despite this, major fuel use through delivery could deter customers, although news reports

suggest that Ocado is investing in electric vans (Van Fleetworld, 2016). Ocado also offers customers

5p for every bag recycled (Ocadogroup.com, 2016), which customers should view favourably.



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Strengths – online retail solutions and advanced systems

The commercialisation of Ocado’s IP has led to the creation of the Smart Platform, the “most

advanced end-to-end online solution” (Ocado, 2016), as a move away from the previously single-

minded focus of online grocery operation. The Smart Platform benefits from cost leadership in the

key grocery cost drivers of people, property, waste and energy, with their systems, processes and

hardware having been developed in a live retail environment (Ocado, 2016). Ocado have seen

accelerating delivery rates of units per man-hour that are currently at 153 and are expected to hit

180, in comparison with most other supermarkets struggling to reach 80 (Ford, 2015), indicating

more advanced and efficient systems compared to competitors. These key competencies – simplicity

of supply-chain, advanced operating systems and technological expertise – give Ocado a competitive

advantage in the online environment as they centrally coordinate and automate picking of groceries.

Weaknesses – narrow consumer focus

Tesco, Sainsbury’s and Asda operate strategies with provision of services and a complete shopping

experience at their heart (Tesco, 2015; Sainsbury’s 2015; Walmart, 2015), contrasted to Ocado’s

online-only focus. Their lack of presence physically may be cost-efficient, but ensures they lose out

to more casual shoppers and do not capitalise on footfall patterns and localised shopping trends.

Opportunities – commercialisation of IP and internationalisation

Ocado’s IP is fundamental to their strategy, and their advancements in robotics are lauded by the

industry (Twentyman, 2015). To maintain its current competitive advantage and prepare for

Amazon’s entry, Ocado is seeking funding on a pan-European robotics project, funded by the EU

(Vandevelde, 2016). The expansion of operations to include the more-efficient Customer Fulfilment

Centres (CFCs) 3 & 4 gives Ocado the ability to accommodate any global partner or sales expansions.

Threats – increasing competition and dual business model

The entrance of Amazon Pantry, with their deal to sell Morrison’s own-brand products (Vandevelde,

2016), puts pressure on Ocado due to the strong financial power, economies of scale and scope of

Amazon, as well as their own sophisticated technology. This puts them in an ideal place to make

short-to-medium-term losses in order to capture market share. The question still remains as to

whether Ocado can continue with its dual business model of grocer and technology firm, with

Director of Technology, Paul Clarke, stating “[w]e are morphing Ocado to become the fusion of a

technology business, a retailer and a platform business” (Clarke, 2015 cited in Twentyman, 2015)

whilst Director of retail consultancy firm Retail Vision, John Ibbotson, stated “the status quo will

eventually become untenable” (Ibbotson, 2016 cited in Thomas and Brown, 2016).



6

02

Accounting Analysis



7

Capitalisation of software costs – executive remuneration risk

The Group pursues a policy of capitalising costs relating to the development of proprietary software,

including CFC equipment, the asset fulfilment solution and Smart Platform (Ocado, 2016). More

specifically, rather than expensing costs as operational in the current period, an intangible asset is

recognised and amortised over subsequent periods. In consequence, the Group’s EBITDA is inflamed

for the period which, in turn, lowers the quality of this key financial metric. For FY15, the Group

recognised £24.1m of internal development costs, an increase of 39.3% (£17.3m) from FY14 and

59.6% (£15.1m) from FY13 (Ocado, 2016). Despite the discretion offered by IAS38, the Audit

Committee – headed by independent non-executive director Ruth Anderson, who also chairs three

other audit committees of listed UK companies – has reported judgements to be reasonable and

amounts not materially sensitive (Ocado, 2016), and such an increase is justifiable considering the

Group’s strategy of developing intellectual property.

What is concerning, however, is the Group’s executive director ‘Annual Incentive Plan’ (AIP) being

based primarily upon EBITDA, with total AIP increasing by 22.2% this year (Ocado, 2016). We thus

believe, in contrast to EBITDA, EBIT should be used as the future performance measurement metric.

Depreciation and Amortisation – less aggressive

Ocado, like its competitors, adopts a straight-line depreciation and amortisation approach (Ocado,

2016; Sainsbury’s 2015; Tesco, 2015). The useful life of freehold buildings and leasehold properties

set by Ocado is 25 years (Ocado, 2016), which is significantly lower than the useful life used by

Tesco, 40 years, (Tesco, 2015) and Sainsbury, 50 years, (Sainsbury, 2015), indicating a less aggressive

depreciation and amortisation policy relative to competitors. Total depreciation and amortisation

costs have increased year-on-year and were £60.1m at FY15, an increase of 9.3% from the year

before, reflecting the Group’s strategy of domestic and international expansion as they look to

increase the number of CFC’s and vans in order to attract and accommodate further partnerships.

Supplier volume rebates – estimates and judgements

Volume-related rebates are listed as one of the three facets of commercial income, calculated based

on estimations of meeting volume-related targets included in annual agreements with suppliers

throughout the year (Ocado, 2016). The Audit Committee report that these rebates are of a material

amount and are satisfied with managerial judgement for the policy (Ocado, 2016), but such rebates

were an integral part of Tesco’s profit overstatement in 2014 (Barrett et al., 2014) and require



8

significant estimations and judgements in order to recognise the income on an accruals basis, and

therefore in the period incurred. The Auditors Report outlines commercial income and volume

rebates as areas of focus due to the subjectivity of estimations, with volume rebates the area that

“involves the most judgement” (Ocado, 2016: p121). PwC, the auditing firm, addressed this by

assessing the historical accuracy of estimates, gaining direct confirmation for accrued amounts from

suppliers and re-performing calculations based on invoiced amounts (Ocado, 2016). PwC highlighted

volume rebates as a risk with significant estimation and assumption, but assurance given through

testing does not mitigate the risk involved when recognising such forms of commercial income.

Fixed asset level – cost-and energy-efficient

The table below highlights Ocado’s fundamentally variable cost based business model, with PPE

turnover at 3.38 - 0.91 and 0.4 better than Sainsbury’s and Tesco’s, respectively, (FAME, 2016). Not

only does this highlight the Group’s cost efficiency in sales, but it also recognises their strategic

commitment to becoming “the UK’s most sustainable and environmentally friendly supermarket”

(Ocado, 2016). Unlike other competitors, the Group’s business model does not rely on physical

stores generating excessive emissions and waste (Ocado, 2016), and as such this acts as a key

competitive advantage in a targeted strategy to attract ethically and sustainably driven consumers.

FY15 Ocado Tesco's Sainsbury’s

Sales (£m) 1,107.60 54,433.00 23,775.00

PPE (£m) 327.30 17,900.00 9,648.00

PPE Turnover 3.38 3.04 2.46

Table 1 – PPE Turnover



9

03

Financial Analysis



10

Profitability

While a shopping basket costs 2.1% less a year ago (Uk.kantar.com, 2016) - causing gross profit

margins among industry peers to decline from 10.61% to 8.18% - Ocado’s gross profit margin has

increased steadily, driven by the Morrison’s joint venture and the subsequent growth of Morrison’s

online sales from £45.1m FY14 to £73.7m FY15 (Ocado, 2016). This can also be attributed to a 30%

rise in Ocado’s customer base (Brinded, 2016), which is underpinned by broadening customer

demographics (This Is Money, 2015) and a significant expansion in their product range by 26% in

2015 (Thegrocer.co.uk, 2015). Ocado also predominately sells branded produce, as opposed to own-

label, where margins are higher (Palepu et al., 2013). Despite this healthy gross profit margin,

distribution and administration expenses - which include picking and delivery costs for both Ocado’s

and Morrison’s operations as well as costs to enable the Group to develop the Smart Platform - have

risen, with them up 19.8% this year (Ocado, 2016). Although EBIT and net profit margins have risen,

they remain sluggish relative to gross profit margin. While Ocado could be enhancing their net profit,

they continue to invest heavily in the Smart Platform, which makes us again question whether to

classify them as a technology or supermarket company. It also concerns us that, despite growth,

costs are seeing higher increases, suggesting Ocado is not realising any scale economies (Fool, 2016).

Industry peers FY12 FY13 FY14 FY15

Gross Profit Margin 10.61% 10.39% 10.56% 8.18%

EBIT Margin 4.76% 4.11% 3.53% -1.52%

Net Profit Margin 3.03% 2.27% 1.73% -2.11%

Table 3 – Industry peers’ average profitability ratios

Return on Equity

Table 4 displays ROE for Ocado, its industry peers and the industry average from FY12 to FY15. While

hostile conditions have affected the larger retailers - leading to negative ROE at Tesco’s, Sainsbury’s

and Morrison’s - Ocado’s ROE has risen from -1.17% to 4.88% - significantly above the average.

Ocado FY12 FY13 FY14 FY15

Gross Profit Margin 30.55% 31.25% 32.98% 33.87%

EBIT Margin 0.50% -0.29% 1.76% 1.95%

Net Profit Margin -0.35% -1.58% 0.77% 1.07%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

FY12 FY13 FY14 FY15

Ocado

Industrypeers

Graph 1 -EBIT Margin FY12 to FY15

Table 2 – Ocado profitability ratios



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ROE Ocado

Group PLC

Tesco

Group PLC

J

Sainsbury

Morrison

PLC

Waitrose

Limited

Aldi

Limited

Other

peers av.

FY15 4.88% -81.19% -3.00% -21.17% 6.80% 9.86% -17.74%

FY14 3.35% 6.62% 11.93% -5.07% 10.88% 10.85% 7.04%

FY13 -6.18% 0.75% 10.71% 12.37% 8.62% 6.97% 7.88%

FY12 -1.17% 15.79% 10.62% 12.78% 9.16% 3.81% 10.43%

Table4 – Return on Equity (net profit/equity)

DuPont Analysis and Operational

We extend our ROE evaluation by utilising DuPont analysis. Ocado’s increase in ROE can be credited

to an improvement in asset turnover and, to a lesser extent, net profit margin. Asset turnover has

increased from 151.37% at FY12 to 187.22% at FY15 – a rise of 23% that outstrips the 9% increase

seen across the industry indicating superior operational performance. This can be attributed to the

Morrison’s joint venture and the simultaneous development of its second distribution centre in

Bury, Lancashire, which has over seven times the asset turnover compared to a traditional grocer

(Fletcher, 2013). This has further extended Ocado’s capital advantage over store-based incumbents,

and this efficiency will enable Ocado to operate at thinner margins relative to other UK grocers

(Lse.co.uk, 2016) which will be vital as commodity and price deflation remain prevalent.

Liquidity

The current ratio provides a key-index measure of Ocado’s short-term liquidity, whilst the acid test

provides a more robust measure by excluding inventory. Each year both Ocado’s current and quick

ratios have beaten the industry average, thanks this year to £45.8m of cash at FY15 (Ocado, 2016),

which makes us confident that the Group can meet all of its short-term obligations. While cash can

act as a drag on a company’s balance sheet, this additional liquidity, coupled by an undrawn credit

DuPont Net Profit

Margin

Asset

Turnover

Equity

Multiplier

Ocado

ROE

FY15 1.07% 187.22% 244.56% 4.88%

FY14 0.77% 176.31% 246.65% 3.35%

FY13 -1.58% 159.02% 246.10% -6.18%

FY12 -0.35% 151.37% 217.94% -1.17%

Table 5 – Du Pont Analysis

0

50

100

150

200

FY12 FY13 FY14 FY15

Graph 2 – Ocado Asset Turnover



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facility of £210m in place until FY19 (Ocado, 2016), is fundamental to Ocado’s overall strategy, as it

enables them to channel significant funding into Smart Platform growth (Seekingalpha.com, 2016).

Table 6 – Current ratios Table 7 – Quick (acid test) ratios

Debt

Table 8 shows Ocado’s coverage ratio from FY12 to FY15. Since delivering its first profit at FY14,

Ocado’s coverage ratio has improved significantly and is now sufficiently within its bank covenants,

which have also been loosened (Ocado, 2016) as a result of improved profitability. Table 9 displays

leverage ratios for Ocado and its industry peers’ average, respectively, defined as total liabilities over

shareholders equity. Since the increase in leverage at FY12 due to the Morrison’s arrangement and

the simultaneous development of its second distribution centre (Ocado, 2016), the Group’s leverage

ratio has remained relatively unchanged and is significantly below the industry average. While this

capital structure stability has been necessary as Ocado has searched for profitability, the Group now

has the potential to pursue a more aggressive debt policy over the forthcoming years, so that it can

utilise the benefits of debt finance particularly when internationalising its operations.

Quick

ratio

Ocado Industry peers

FY15 54.64% 38.45%

FY14 71.37% 50.67%

FY13 98.18% 50.05%

FY12 104.42% 45.47%

Current

ratio

Ocado Industry Peers

FY15 69.64% 54.21%

FY14 87.50% 56.37%

FY13 112.96% 63.47%

FY12 117.43% 64.20%

Leverage

Ratio

Ocado

Group

Industry

peers

FY15 1.45 2.32

FY14 1.47 1.66

FY13 1.46 1.19

FY12 1.18 1.12

Interest

Coverage

Ocado

Group

FY15 2.23

FY14 1.76

FY13 -0.23

FY12 0.85

Graph 3 – Leverage Ratios

Table 9 – Leverage Ratios

0

0.5

1

1.5

2

2.5

FY12 FY13 FY14 FY15

OcadoGroup

Industrypeers

Table 8 – Coverage Ratios



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Altman’s Z-score (Altman, 2000)

Altman’s Z-Score is a statistical tool that incorporates debt, liquidity and profitability measures into a

composite score to indicate the likelihood of the company facing financial distress. This is defined as:

𝑍 = 1.2𝑋1 + 1.4𝑋2 + 3.3𝑋3 + 0.6𝑋4 + 1.0𝑋5

Table 10 shows that Ocado is comfortably within the safe zone of > 2.99, with Z-scores of around 6

at FY13, FY14, and FY15, thus indicating that the Group is easily safe from bankruptcy.

Coeff. 1.2000 1.4000 3.3000 0.6000 1.0000

Variable X1 X2 X3 X4 X5 Z

FY15 -0.1006 0.2341 0.0365 6.2903 1.8722 5.9740

FY14 -0.0390 0.2209 0.0310 6.9261 1.9050 6.4256

FY13 0.0414 0.2152 -0.0046 8.2748 1.5902 6.8908

FY12 0.0457 0.2596 0.0076 1.6851 1.5137 2.9682

Table 10 – Altman’s Z-Score

0

2

4

6

8

FY12 FY13 FY14 FY15

Graph 4 – Z-Score history



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04

Forecasting



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Background – macroeconomic

The UK’s economic outlook remains mixed, with growth forecasts of 2.0%, 2.2% and 2.3% for 2016,

2017 and 2018, respectively (BBC, 2016). The government is pursuing austerity to meet a surplus at

FY20, which will see annual disposable income falling by, on average, £1,500 by 2020 (Women’s

Budget Group, 2016). A period of deflationary pressure is likely to persist, with interest rates on hold

and inflation expectations revised down (This Is Money, 2016) which will boost consumers’ real

incomes (EY, 2015). UK corporation tax cuts to 19% (2017) and 18% (2020) are expected (Gov.uk,

2015). While there is uncertainty over the UK’s EU position, we ultimately believe the UK will remain

inside, and thus do not consider any import duty increases or implications for globalising operations.

Assumptions

Sales: Ocado’s turnover has risen, on average, 16.54% per year since FY10, fluctuating from

13.42% to 19.80%, indicating an upward trend that outstrips market growth. IGD (2015) forecast

the UK’s online grocery sales to increase by 92.9% to FY20. Ocado’s management, as of 2016 Q1,

expects sales to continue to grow ahead of the market (Ocado, 2016) with the implementation

of new distribution centres and the expectation of internationalising operations. Despite this, a

lack of progress has been made in securing international partners (Thomas and Brown, 2016), so

we do not expect any deal made prior to the UK’s EU referendum. Assuming the UK retains its

association, we expect to see multiple deals overseas from 2017 onwards. Austerity measures

will lead to a further shift towards Aldi and Lidl, with Kantar Worldpanel (Don, 2016) predicting

them to own 14% of the market at FY20. Despite this, Ocado’s increasing margins and market

share from FY13 to FY15 indicate that Ocado has been relatively unaffected by their presence.

Real consumer incomes will also increase, which suggests that Ocado will continue to be

protected from discounters’ lower prices. The introduction of Amazon Fresh in 2016, however,

will bring competition and reduced sales, although this is likely to be realised from FY17 once

fully operational. With online sales expected to increase by 18.58% per year from FY15 to FY20

(IGD, 2015), we see Ocado’s sales continuing to beat this. International expansion post-FY16 will

increase sales overseas, but the impact of Amazon post-FY16 in the UK, and maybe overseas, will

counteract any further sales increase. We thus assume a 19.12% YoY increase.

Cost of Sales: Cost of sales has increased with turnover but at a slower rate, averaging 15.66%,

with no more than a 1.5% variation change between them (Ocado, 2016). As sales rise, we thus

expect cost of sales to rise at a similar level, but an extensive 2,000-supplier network increases



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procurement prospects and expansion provides scale economy opportunities. The 1-year trend

for all agricultural commodities is negative, with cattle and sugar in double-figures (FT, 2016),

which would lead to lower wholesale prices, although the sugar tax post-2018 will mean rises for

some products. We thus forecast a 17.2% YoY rise, around the 1.5% variation seen previously.

Distribution Costs: The operational efficiency of Hatfield and Durdon CFCs has improved by

more than 10 units per hour (UPH), and we expect this to increase as the new asset fulfilment

solution is implemented - making further efficiencies in picking deliveries - and CFC 3 and 4

becoming operational. We also expect fuel-efficiency improvements, in line with Ocado’s carbon

reduction strategy, particularly with trials of electric vans in London (Van Fleet World, 2015).

We forecast a distribution cost rise of 23.5% at FY16, then a diminishing rise by 0.1% until FY20.

Administrative Expenses: Admin expenses have continued to rise, predominately due to Smart

Platform investment, and were up 12.4% last year. Further domestic and international expansion

will incur even further fees, as would making new CFCs operational, and so we expect short-term

increases to FY18 of 14%. However, from FY18 we expect admin fee increases at a lower level of

13%, once the Smart Platform is finalised, CFCs operationalised and scale economies realised.

Corporation Tax: We assume a corporate tax decrease to 19% from FY17 and then 18% at FY20.



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Table 11 – Forecast Ocado Consolidated Income Statement FY14 – FY20

Analysis

We forecast a 2.27% NPM at FY20 – a trend towards the industry mean norm. With Ocado’s business

model being fundamentally variable cost based as well as a natural beneficiary of the proliferation of

the online sector, efficiencies will be realised and sales will accelerate, so such a net profit increase is

justifiable. The 5-year EPS forecast - assuming no equity issuance - is shown.

Income Statement FY14 FY15 FY16E FY17E FY18E FY19E FY20E

£m Actual Actual Project Project Project Project Project

Revenue 948.90 1,107.60 1,319.37 1,571.64 1,872.13 2,230.09 2,656.48

Cost of Sales (636.00) (732.50) (858.49) (1,006.15) (1,179.21) (1,382.03) (1,619.74)

Gross Profit 312.90 375.10 460.88 565.49 692.93 848.05 1,036.74

Gross Profit Margin 32.98% 33.87% 34.93% 35.98% 37.01% 38.03% 39.03%

Other Income 39.40 49.00 58.80 70.56 84.67 101.61 121.93

Distribution Costs (253.10) (309.40) (382.11) (471.52) (581.39) (716.27) (881.73)

Admin Expenses (85.00) (95.60) (108.98) (124.24) (141.64) (160.05) (180.85)

Oper Profit bf. JV 14.20 19.10 28.59 40.28 54.58 73.34 96.08

Share results fr. JV 2.40 2.30 2.20 2.20 2.10 2.10 2.00

Exception Items (0.30) - (0.30) (0.40) (0.50) (0.60) (0.70)

Operating Profit 16.30 21.40 30.49 42.08 56.18 74.84 97.38

Finance Income 0.40 0.20 0.20 0.20 0.20 0.20 0.20

Finance Costs (9.50) (9.70) (11.60) (14.00) (16.80) (20.10) (24.10)

Profit before tax 7.20 11.90 19.09 28.28 39.58 54.94 73.48

Taxation 0.10 (0.10) (3.82) (5.66) (7.52) (10.44) (13.23)

Net Profit 7.30 11.80 15.27 22.63 32.06 44.50 60.26

Net Profit Margin 0.77% 1.07% 1.16% 1.44% 1.71% 2.00% 2.27%

EPS Monitor FY15 FY16E FY17E FY18E FY19E FY20E

Earnings (£m) 11.80 15.27 22.63 32.06 44.50 60.26

Shares (m) 590 590 590 590 590 590

EPS (£) 0.02 0.03 0.04 0.05 0.08 0.10 0.00

0.05

0.10

0.15

Table 12 – EPS forecast

Graph 5 – EPS forecast



18

05

Valuation



19

Cost of Capital – CAPM

We employ the CAPM (Sharpe, 1964) to compute the cost of equity. We utilise the UK Gilt rate as a

proxy for the risk-free rate, and adopt a 5-year horizon to minimalize exposure to reinvestment and

interest rate risk (Damodaran, n.d.). Dimson et al. (n.d.) document a real equity geometric return.

CAPM Source

5-year Gilt Rate 0.0081 Bloomberg.com (2016)

Market Return 0.0530 Dimson et al. (n.d.)

Ocado Beta 1.7500 Marketsft.com (2016)

Cost of Equity 0.0867

Fundamental Valuation – Residual Income

A residual income valuation method is most suitable, with the Group having no intention of paying

dividends (Russell, 2015) and only just producing positive cash flow (Pinto, 2010). The economic

outlook is also uncertain, so using book value at FY15 provides a benchmark for making future

estimates more reliable. The clean surplus assumption also requires no equity issuance, which we

envisage being the case with Ocado, as they look to utilise the benefits of debt whilst

internationalising. Whilst the model is reliant on accounting data which can be manipulated, our

accounting analysis reveals the Group’s accounting profile is aligned with fundamental performance.

Valuation FY15 FY16E FY17E FY18E FY19E FY20E FY21E

£m Actual Actual Project Project Project Project Project

Book Value 241.90 257.17 279.80 311.85 356.36 416.61 498.62

Net Earnings 11.80 15.27 22.63 32.06 44.50 60.26 82.00

Equity Charge

20.97 22.29 24.25 27.03 30.89 36.11

Residual Income (5.69) 0.34 7.80 17.47 29.37 45.89

Discount Factor

1.09 1.18 1.28 1.39 1.52

PV of Residual Income (5.24) 0.28 6.08 12.53 19.38

SUM PV of Residual Income 33.04

Book Value 241.90

PV Terminal Value

1,816.22

Price 2,091.16

Shares Outstanding (m) 590.04

Table 13 – Cost of Capital

Table 14 – Residual Income



20

Our 7% perpetual growth assumption in estimating terminal value RI is justifiable, reflecting Ocado’s

100% plough-back ratio, significant sales expansion forecasts, and current low market penetration

which permits considerable growth and partner opportunities. Calculations for the model are in the

appendix. We calculate the share price at 354p, 9p more than the FT’s price (Marketsft.com, 2016).

Relative Valuation – Multiples

Table 16 displays multiples, including P/E, EV/Revenues and EV /EBITDA ratios. Unlike other grocers,

Ocado is a new company with a unique business model that is aligned with the structural

transformation of the market and a competitive advantage focused on technology (Ocado, 2016).

Investors are thus willing to pay a premium, particularly with global growth prospects for the Smart

Platform (IG, 2016) and the possibility of a takeover bid from Amazon materialising (Martin, 2016).

While the results imply Ocado’s equity is overvalued, we do not believe this is representative.

Multiples Equity Multiples Firm Value Multiples

Company Name Price/Earnings Per

Share (EPS) Enterprise

Value/Revenues Enterprise

Value/EBITDA

Sainsbury's 13.04x 0.56x 7.35x

Morrison’s 20.55x 0.36x 7.20x

Marks & Spencer 17.08x 0.84x 6.56x

Tesco's (excluded as minus) 0.46x 9.65x

Peer Group Mean 16.89x 0.56x 7.69x

Earnings FY15 (£m) 11.80

Revenue FY15 (£m)

1,107.60

EBITDA FY15 (£m)

81.50

Valuation (£m) 199.30 620.26 626.74

Net Debt (£m) - 127.00 127.00

Equity Value (£m) 199.30 493.26 499.74

Shares Outstanding (m) 590.04 590.04 590.04

Share Value (£) 0.34 0.84 0.85

Valuation

£

Forecasted Share Price 3.54

Share Price (Marketsft.com, 2016) 3.45

Difference 0.09

Table 15 – Share Price

Table 16 – Multiples



21

Conclusion – strong business model, growth expected

Over the next five years, we would expect to see continued domestic growth and the beginning of

international expansion for Ocado, who are able to capitalise on the efficiency of their supply-chain

and logistics systems, as well as the commercialisation of their proprietary technology and IP. Our

fundamental valuation is 9p above their current share price, and as such we would state that Ocado

is currently undervalued on the market. With the expectation of continued expansion and sales

growth, coupled with their undervalued share price, we would recommend you BUY Ocado.

(3958)

BUY



22

Appendix - Fundamental Valuation Model Calculations

PV of Terminal Value is calculated as FY21 Residual Income, £45.89m, divided by the cost of equity

minus the perpetual growth rate 7%. This is then discounted by (1 + r)^5. Formula is shown:

𝑷𝑽 𝒐𝒇 𝑻𝒆𝒓𝒎𝒊𝒏𝒂𝒍 𝑽𝒂𝒍𝒖𝒆 = 𝑹𝑰 𝑭𝒀𝟐𝟏

(𝒓−𝒈)⁄

(𝟏+𝒓)𝟓



23

Appendix - Multiples Calculations



24

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Documents

Financial Analysis Coursework April 2016 - Ocado