Ocado’s shares have dropped 30% this week after investors were spooked by a trading update and fears of a step-up in competition in the UK. There appears to be a rocky road ahead for the online retailer. Dean Best reports.

“We now expect Ocado to lose money for at least the next two years.” The words of one UK retail analyst today (21 September) amid speculation that Tesco is planning a major new offensive on price.

Ocado, the online retailer, has a long-running campaign that matches the price at which Tesco sells branded goods in the UK. Any significant push in the coming days by the country’s largest retailer could hit Ocado.

“It looks like the sector’s big dirty secret is about to reveal itself. Market gossip suggests that Tesco is set to launch a significant price offensive next week,” Panmure Gordon analyst Philip Dorgan said today. “Ocado is playing with the big boys now. Unfortunately, scale is a big advantage in food retailing, so we expect Tesco’s planned price initiative to hurt Ocado disproportionately. We therefore now expect Ocado to lose money for at least the next two years.”

Given Ocado has yet to make a full-year profit, those words would have sounded alarm bells with some investors. Ocado’s shares, which dropped by nearly 12% on Monday after it reported a slowdown in sales and said its margins would be lower than initially forecast, fell again today. At 15:40 UK, Ocado’s stock was down 10.46% at 103.6p. Given that Ocado’s shares closed on Friday at 133.7p, the stock has slid over 30% this week.

There has been a lot of commentary around Ocado since it announced plans for an IPO two years ago. The debate about the value of the business intensified in the run-up to the listing, which happened last July with anything but a fanfare as its shares fell on the opening day.

The retailer has remained under scrutiny ever since, with Waitrose, its long-time partner, launching its own online service in and around London. Ocado has sold Waitrose own-label products since 2000. The two companies renewed their agreement last year and will continue to work together until 2010. However, there is no longer a non-compete clause covering the M25 region and Waitrose now has its own online service in the area.

There are also signs that the UK’s largest retailers are keen to step up their investment in a growing channel – Morrisons‘ ambition to launch its own online service in two years a notable example. However, the rest of the Big Four believe they can generate growth through investment in their online operations, even if, according to some observers, returns remain low.

“Online retailer platforms should offer significant opportunities for retailers to interface with consumers to improve brand identity, drive customer loyalty and further align store and online models,” RBS analyst Justin Scarborough said this week. 

Some have also pointed to the capacity problems that Ocado has also faced at its distribution centre in Hatfield. “It is disturbing that the much-vaunted Hatfield warehouse is still suffering from capacity problems and the case for a second warehouse has therefore not been proven,” analysts at Arden Partners said on Monday.

Ocado, however, is confident despite those concerns. CEO Tim Steiner said on Monday that it is worked to expand capacity at Hatfield and insisted “significant progess” had been made over the summer. Steiner also said investment in “improving our key customer metrics” was “paying off”.

There are indications that Ocado is looking to set itself apart from its rivals. In June, the retailer launched a range of French products supplied by Carrefour. On Monday, alongside its third-quarter numbers, it unveiled the Ocado Savings Pass, which, for an annual subscription fee, gives customers 10% off 500 selected brands.

The company is also sanguine about Waitrose’s move to set up an independent online service. “I don’t think Waitrose’s expansion within the M25 is a threat. There is a strong belief that there is room in the market to keep growing,” a spokesperson said.

Certainly, industry forecasts echo Ocado’s belief that there is room in the market. The IGD says the channel is worth GBP4.8bn and its analysts expect that to more than double to GBP9.8bn by 2015.

However, there is uncertainty among some industry watchers about Ocado’s prospects. Scarborough acknowledges that Ocado’s sales are increasing “strongly” and that its EBITDA margins are heading upwards but says there needs to be “higher visibility and confidence” in how the retailer’s accounts will look in the future.

“Against such as growing but competitive backdrop, the outcomes for Ocado’s sales and profits by say year five [since its IPO] could be wide-ranging.”

Of course, Ocado remains confident and believes, for example, that its investment in Hatfield will improve efficiency. Factors like this could boost the retailer’s shares but, as Scarborough notes: “There are a few too many ‘ifs’ to attract new investors.”