Online grocery retailer Ocado reported a strong rise in sales this week and managed to narrow its losses. But as it contemplates a possible IPO later in the year, Ben Cooper writes, the UK firm will have to answer some tough questions about its profitability and most critically about its relationship with Waitrose.

A year ago, the recession put paid to one of the most established names in UK retailing. Hit by the recession and unable to refinance, Woolworths plc went to the wall. Contrast this with Ocado. Although the online grocery retailer is still not in profit after eight years in existence, it continues to retain the confidence and patience of its creditors and investors.

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So why is it, at a time of such economic turmoil, that Ocado appears to be regarded so positively? The primary reason lies in the nature of the business, and why in those terms it simply cannot be compared with Woolworths.

To begin with, it is a relatively new business. Nobody expects a start-up to turn in a profit straightaway and while eight years seems a long time to wait, and must be stretching the patience of investors to a degree, Ocado has continued to show strong sales growth in that time. 

Earlier this week, the company posted a 25% rise in revenues for the year to 29 November to GBP402m. EBITDA more than trebled to GBP9.2m, while operating losses were down from GBP21.6m to GBP14.4m.

“Ocado had an excellent year with strong sales performance both in absolute terms and on a like for-like basis,” said CFO Andrew Bracey this week. “This has delivered a substantial increase in EBITDA profitability. In a difficult retail environment we have reported good results that show further growth in all areas of the UK that we currently serve.”

The growth is critical. Not only does it support the contention that management knows what it is doing – Ocado wins awards and is viewed as an innovative and creative force in the market – but it also speaks to the prime distinction between Ocado and Woolworths. 

Woolworths had been around for years and represented a sector that was being replaced by other types of retailing, had stopped growing and had ceased to be relevant to consumers. As an online retailer, Ocado belongs to a part of the retail market that is expanding all the time, is in tune with the times and providing what customers want. 

So Ocado is the future. Or at least that is what its investors still appear to believe.

All that said, Ocado finds itself with questions to answer, particularly if it intends to go ahead with the IPO that it has long said is part of its plan. 

Neil Saunders, consulting director at retail analysts Verdict Research, suggests that ahead of an IPO, Ocado will have to answer serious questions about the programme for moving into profit and its plans for future expansion. But most crucially the company will have to address its seemingly contradictory relationship with Waitrose.

Ocado was originally set up to sell Waitrose goods online. Since then, Waitrose has itself launched Waitrose Deliver, its own online operation, which it is committed to expanding. 

On the face of it, there appears to be duplication and, as Waitrose Deliver expands geographically, that duplication will only become more pronounced. Furthermore, the current agreement between Waitrose and Ocado is due to expire in 2013.

A continued question mark over Waitrose’s commitment beyond 2013 “would raise very serious questions among investors and would undermine the IPO”, Saunders says.

However, Saunders believes the overlap between Ocado and Waitrose Deliver does not represent a terminal risk to the former. He believes that Waitrose is taking a pragmatic view towards its partnership with Ocado and sees it offering benefits to the Waitrose business overall. 

Waitrose managing director Mark Price has recently posited the idea of the Waitrose brand being sold through other smaller retailers, and Saunders believes this underlines the pragmatic view taken by the company. He sees the relationship with Ocado fitting in with that thinking. Also, Saunders believes that the size and style of Waitrose stores means “there is going to be a natural limit as to how much Waitrose Deliver can grow”. Ocado will therefore have a role both in meeting demand in areas where Waitrose Deliver might operate as well as broadening the geographical scope for home delivery of the Waitrose brand overall.

Waitrose’s parent company, the John Lewis Partnership, through its pension fund, owns 28.5% of Ocado, and clearly wants to look after its investment.

However, potential new investors will want more than a nod and a wink that Waitrose remains on board, particularly in an investment climate which has proved extremely unpredictable for IPOs.

Analysts are also unhappy about Ocado’s valuation which some have even suggested is reminiscent of the rabid over-valuations of the ‘dot com’ boom. While Nick Bubb, retail analyst at Arden Partners, is encouraged by Ocado’s current performance he has his doubts about the valuation. 

“It’s quite encouraging that sales growth accelerated last year and that they moved into a positive EBITDA position,” Bubb tells just-food. “But justifying a GBP1bn IPO valuation is still a tall order and the ‘central warehouse/central picking’ business model remains suspect. I am still sceptical, even though JLP/Waitrose seem supportive.”

It seems a certainty that an IPO, which could be scheduled for later in the year after the General Election, would have to be accompanied by some form of explicit statement of commitment from Waitrose, most probably an extension to the current deal. Saunders for one believes this is “highly probable”.

“The question is so critical to the future of the Ocado business that they will have to say something on it, and that has to almost be an extension or some legal agreement that the partnership will continue,” Saunders says.

Indeed, he believes the fact that the management is contemplating an IPO this year implies that it has already received that commitment from its partner. It would, however, make much more sense to reveal it as it launches the IPO.

At a time when market reaction to IPOs is unpredictable, the confirmation of Waitrose’s continued operational commitment, along with the continued equity participation of one of the country’s most respected companies, might yet make Ocado a compelling prospect for investors.