While the delivery of a first annual pre-tax profit in its 15 year history is welcome, Shares remains wary of online supermarket Ocado (OCDO). Punchy valuation metrics leave no room for disappointment and fail to factor in the risks of heightened competition, slowing growth and margin pressure.

Floated in 2010 Ocado, which supplies Waitrose products and its growing own-branded range, long-struggled to convince investors. Yet a late 2012 funding agreement, then a first third-party deal with supermarket Morrisons (MRW) in 2013, saw Ocado transform itself into a web-based grocer plus a fulfilment and logistics provider with a potential role as a third party consultant to international retailers tacked on.

Positive progress

Full-year results (3 Feb) to November 2014 revealed a swing from a £12.5 million loss to a £7.2 million pre-tax profit on retail sales up 15.3% to £972.4 million. Positive operational leverage helped EBITDA margins rise to 7.5% (2013: 5.4%), slim yet ahead of superstore rivals.

CEO Tim Steiner highlighted growth ahead of the wider online grocery market, with on-time deliveries and order accuracy improving further. In addition, the Ocado.com product range continues to expand with a second non-food site launched. Encouragingly the retailer is improving price competitiveness and growing active customer numbers.

Ocado’s distribution centres in Hatfield and Dordon, the latter shared between its own service and Morrisons, are operating to high levels of accuracy and efficiency. To build capacity, Ocado is investing in its third and fourth sites, set to open in Wiltshire and Kent at the end of 2015 and during 2017 respectively.

Supporters argue all this means Ocado is uniquely positioned to commercialise its intellectual property and technology to drive retail sales growth and to develop partnerships with global grocery retailers seeking the best online solution. The first commercialisation of this IP was the Morrisons tie-up, while management has flagged potential for signing a first international licence under its ‘Ocado Smart Platform’ offering during 2015.

Growth: MEDIUM

Shift towards online shopping continues. Healthy top-line growth is forecast, though there is a threat as rivals raise their online game.

Risk: HIGH

Competition will intensify, the relationship with Waitrose needs watching and Ocado is forecast to have £45 million net debt this year.

Quality: LOW

Margins are fairly thin and the retailer operates in a price competitive market.

Buyer beware

Yet this comes at the price of ongoing hefty investment and any delay in signing deals would leave the market disappointed. At the same time, Ocado’s domestic store-based competitors are making progress with store picking, fufilment via so-called ‘dark stores’ as well as click & collect, which means the competitive threat is growing and gross margins will come under pressure.

As Shore Capital’s Clive Black outlines, Ocado remains dependent on ‘two old school supermarkets’, namely Waitrose and Morrisons. Though the latter landmark deal provides some visibility and security, it also gives Morrisons a say in what Ocado can and can’t do in the grocery market. Furthermore, fees paid to Waitrose, upon which it depends for a material portion of its products, are helping to fund a competitor to Ocado.

Crazy valuation

Ocado’s valuation appears detached from reality at a time when grocery volumes are weak and the major supermarkets are investing in cutting prices and in their own online operations. For the year to November, Numis Securities forecasts 26% pre-tax profit growth to £12.7 million which translates as a 23.5% earnings per share (EPS) advance to 2.1p. In the November 2016 financial year it expects pre-tax profits of £29.4 million and EPS of 3.7p. What’s more there’s no dividend in sight. Based on these estimates, Ocado trades on a stratospherically-high prospective price-to-earnings ratio of 181.9, falling to 103.2 next year, metrics which fail to price in significant risks facing the business.

Ocado (OCDO) 382p

Stop loss: 458.4p

Market value: £2.22 billion

Prospective PE Nov 2015: 181.9

Prospective PE Nov 2016: 103.2

Prospective dividend yield: n/a

Bid/offer spread: 0.18%

Analyst price target: 500p*

*Numis Securities, 3 February 2015