Ocados deal with Morrisons could irk Waitrose

Ocado's deal with Morrisons could irk Waitrose

Given a hesitant Morrisons has lagged behind its major UK rivals in setting up an online grocery business, today's (17 May) announcement of a deal with Ocado enables the country's fourth-largest food retailer the best available entry into what is a fast-growing channel.

Some will question the wisdom of signing a 25-year deal in what is a rapidly-evolving online marketplace but Morrisons' management have been cautious in their long deliberations over whether and then how to launch a home delivery service and the agreement is probably another example of that pragmatism.

Morrisons gains access to what is seen to be some of the leading technology and distribution capabilities in UK online food retail. The deal, as chief executive Dalton Philips colourfully - but rightly - says, will "turbo-charge" Morrisons in London and the South East, further diversifying the business away from its heartlands in the north, which have been more affected by the prolonged economic downturn.

Sure, Morrisons' sales remain under pressure (as exampled by another fall in like-for-likes in its first quarter). While Philips insists Morrisons is "sharpening" its promotions and marketing, the UK grocery sector remains fiercely competitive; you only have to listen to Asda's comments this week about the level of vouchering so far this year to appreciate how intense competition remains.

However, while online remains around 4-5% of total UK grocery sales, it is growing rapidly. Philips said today over 30% of the growth in the sector is coming from online and convenience. Morrisons, which has accelerated its push into c-stores, needed to be online. Home delivery may, at present, represent a small portion of industry sales but its share is growing and any retailer worth its salt needs to offer consumers that alternative. It is where the market is going.

Some in the City have argued why Morrisons has not set up independently, using its own stores. Philips insists the tie-up with Ocado is less risky than going it alone, a notion that, given Morrisons' late entry into the channel, would not have appealed to management.

And the stock market seems today to have welcomed Morrisons' deal with Ocado. Shares in the retailer climbed as the market analysed the move.

Ocado's stock at one point leapt over 40%. At 15:28, it had eased off a touch but was still up over 31% on the day. On paper, the deal looks positive for Ocado, which has still yet to make a profit. It gets cash from Morrisons' decision to buy its second warehouse in Dordon. Morrisons will also pay a licence for technology and IP, as well as contribute to future R&D costs. Ocado will get a share in the profits from Morrisons' online food arm, which is expected to generate a positive EBIT by 2017/18.

"The terms of the 25-year agreement will offer Morrisons much more visibility in the marketplace and provides Ocado with the security it needs by generating a welcome chunk of funds for the firm to pay down debt. Morrisons, which is strong in the north of England, also offers Ocado a counterbalance to its deal with Waitrose, which is much stronger in the south," Sam Fuller, UK head of consumer and leisure at international investment bank Altium, said today.

However, it is Ocado's deal with Waitrose that is a potential fly in the ointment. Ocado sells Waitrose own-label goods throughout the UK, a long-standing deal that was renewed for ten years in 2010.

Over the weekend, Waitrose managing director Mark Price expressed concern at the possibility of a deal between Ocado and Morrisons. Ocado insisted - and repeated today - the Morrisons agreement would not affect its deal with Waitrose.

For its part, Waitrose said little about the Morrisons/Ocado venture today, revealing only it had asked lawyers to look into the agreement to see if it breached its deal with the online specialist. The Waitrose/Ocado deal runs until 2020 but there is a break clause that allows Waitrose to walk away in 2017. The upmarket retailer refused to comment on whether it would activate the clause but there is a feeling in the City it could quit the deal in four years time, leaving Ocado with a potentially big hole in its sales.

"It appears that Ocado is not in breach of its contract with Waitrose, so we don't expect anything to happen in the short run," Panmure Gordon analyst Philip Dorgan wrote today. "However, the chances of Waitrose exiting from its supply arrangement in 2017 must now be high. If this were to happen, there would be a big hole in Ocado's business and while there is time to build up the necessary infrastructure, it will lose Waitrose's buying power as well as all of those lovely own label products."

He added: "Ocado has struck what looks to be an excellent deal with Morrisons. However, we think that it increases the risk that Waitrose will walk away from its supply arrangement in 2017. Therefore, we would be cautious as to the long-term implications of this deal, despite the immediate positive impact upon the P&L."