Ocado hits new high as bags contract with Australia's Coles

Ocado has won a contract to develop an online grocery business for Australian supermarket and liquor store operator Coles Group.

Coles, which will pay Ocado up-front fees upon signing and during the development phase, and Ocado have agreed to build and operate a robot-run depot in Sydney and one in Melbourne, both expected to go live by March 2023.

From that stage, Coles will pay ongoing fees linked to both sales achieved and installed capacity.

The deal is Ocado's sixth overseas contract for its Solutions business and the first since February's massive fire at its Andover warehouse.

As with its five other overseas contracts, this deal is likely to be negative for earnings in the current financial year as no cash fees are to be recognised as revenue until operations begin. Ocado expects "minimal additional capex" in the current year, with the majority of additional spending in the 18 months prior to the opening of the so-called customer fulfilment centres, thought to be no more than £30m apiece.

Coles, which already makes more than A$1bn a year from its online business, will also transition its current store-pick operations to the Ocado Smart Platform and this is expected to take place in parallel with the two CFCs going live.

Coles said it had signed up with Ocado to enable its online business to serve customers in the country's larger urban areas through the robot-operated CFCs, while its service in less populated areas will continue with store-pick operations benefiting from Ocado's store-pick software.

The agreement is exclusive in Australia as long as certain conditions continue to be maintained, the companies said.

Coles chief executive Steven Cain said, "Ocado is singularly focused on online grocery shopping and, as a result, has become the best in the world. We are delighted to be partnering with them to make life easier for Coles' customers here in Australia. Ocado's ongoing investment and retail partnerships around the world will help us continue to improve our offer into the future".

MARKET REACTION & ANALYSIS

Ocado shares, already up by two thirds since Christmas, gained more than 5% on Tuesday to hit a new all-time high of 1,333.5p.

Given the lower fee levels for a store-pick model, analysts at RBC Capital Markets said they expect a lower operating contribution margin from this contract compared to other international deals.

"For FY19, the impact of this transaction should be earnings negative as no cash fees will be recognised in revenue until operations commence. Management has guided for a maximum negative impact of £5m," RBC noted.

The deal provides further reassurance after the Andover fire, said broker Peel Hunt, noting that this deal is "slightly different, only in the sense that Coles is already an online market leader in the country".

Analysts at Numis said while the shape of the deals is consistent with those previously announced, "we see this as a strong endorsement from a partner operating a material (>£500m) store-pick operation".

The key rhetorical question for Societe General is "what is priced in already by the market" and having answered that, analysts see the stock as "significantly overvalued".

From a valuation standpoint, SocGen values each international CFC at circa 15p per share on the basis of favourable assumptions, ie a 5% fee on capacity and 100% capacity in the third year.

"At current share price levels, we calculate that the ‘market’ is factoring in c.30 additional CFCs over and above the 25 already contracted for. So fundamentally we think the stock is significantly overvalued following a circa 60% jump since the start of the year. Bear in mind that the group’s recent deal with M&S did not have a surprisingly positive impact on the value of Ocado’s UK Retail business.

"All eyes on execution Ocado looks set to be very busy for the next three/four years with 25 CFCs to build all around the world. Execution will be key, in particular as it could have an impact on the group’s ability to seal more long-term deals. All in all, we reiterate our Sell rating mainly on valuation grounds."