Is the Ocado share price about to fall off a cliff?

Ocado Group plc (LON:OCDO) looks priced for perfection, says Roland Head. Is it time to sell?

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When Ocado Group (LSE: OCDO) founder and chief executive Tim Steiner unveiled a £750m joint venture deal with Marks and Spencer recently, the market cheered him and pushed the Ocado share price to a new record high.

The deal has realised Mr Steiner’s ambition for Ocado to be seen as a tech firm, not a grocer. The group’s automated warehouse technology is very impressive. But I think there’s still a real risk that the shares are seriously overvalued.

Just in time

When I last wrote about Ocado, I noted that the firm planned to spend £350m building warehouses for new customers over the next year or so. This expenditure — and more — is needed before the company can generate any revenue from its solutions deals.

The M&S deal answers one question, by explaining how Ocado will pay for these buildings. The company has confirmed that the £562.5m upfront payment it will receive from M&S will be used to fund the development of all the warehouses it’s currently contracted to build.

In my view, the firm’s requirement to build expensive new warehouses for every new customer deal is a key risk for investors. I think it limits the company’s ability to generate the fast growth and high profit margins the market expects from technology firms.

In a similar way, the constant need for more drivers and vans to do deliveries is a limiting factor. Distribution networks are expensive — distribution and administrative costs for Ocado’s UK retail business rose by 15% to £401.8m last year, even though sales only rose by 12%.

A good deal for M&S?

Marks & Spencer will be paying £750m for a 50% stake in a business whose sales and profits are hard to predict. But if we use Ocado’s current retail business (in partnership with Waitrose) as a base, then this price tag equates to a multiple of 18 times EBITDA (earnings before interest, tax, depreciation and amortisation).

That’s pretty expensive. But in some ways I think M&S shareholders might have the better half of the deal. The retailer is gaining a sophisticated business that is profitable and should fit well alongside its existing operations. If M&S can attract online food shoppers, the business could grow significantly.

For Ocado shareholders, the retail business was never likely to be big enough to justify the group’s valuation. All hopes rest on the solutions business, which builds and operates automated warehouses for other retailers. The problem is that losses from the Solutions business increased from £6.6m to £17.9m last year, even though revenue from the Morrisons partnership rose by 15.8% to £123m.

My view: I expect that the Ocado solutions business will eventually make a profit. But huge amounts of investment are needed and it’s not yet clear to me when the business might move into the black.

In the meantime, Ocado’s £9.5bn valuation means that investors are paying almost six times sales for a stake in a business that’s expected to lose money for at least the next two years. In my view this is a risky and speculative situation. I wouldn’t be comfortable owning the shares and would certainly take some profits if I was invested.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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