Is Ocado's £1bn valuation laughable?

The seemingly never-ending run up to flotation for online grocery retailer Ocado was knocked off course slightly this week with the publication of a critical report from broker Bernstein Research.

At Retailinsider.com we have long reckoned the £1 billion valuation that has been mooted in the press has sounded a tad too rich. This has, admittedly, been based on nothing more scientific than Ocado simply doesn't make any money.

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But now we have Bernstein Research raising the same question through some much more valid criteria. Its research note certainly casts some doubt on the justification of pinning a £1 billion price tag on Ocado.

The core difference between Ocado and the home delivery propositions of the major grocers is its centralised distribution as opposed to their store-picking models. This suggests high fixed costs but the upside is that incremental sales should add a decent margin contribution. The only problem is that this doesn't seem to be the case at Ocado.

Bernstein's report states that the firm appears to currently have £40 million of fixed costs but while it has continued to attract new customers this extra revenue has not added much to the profitability of the business. Incremental revenue attracted just a 10% contribution margin in 2009. Its cost structure seems to have largely scaled with revenue increases.

Ocado looking to deliver £1 billion to its investors

This doesn't sound too good to me. Adding to the worries for potential particpants in its IPO is the fact that Ocado has only managed to generate modest growth in average basket size, which would add greatly to its profitability since the company is already bearing the cost of delivering the product. Why is this the case I wonder?

The conclusion of the Bernstein research is that Ocado only becomes a real threat to the major grocers once it enjoys superior economics to its rivals as it can then reinvest any surplus profits in gaining market share. But the way it stands, the broker calculates that Ocado is a long way from achieving this.

It states that in order to hit a 14% contribution margin on incremental sales (just like Tesco) Ocado needs to achieve £1 billion in revenues. And to deliver the same return on capital (ROCE) enjoyed by Tesco it would need to reach sales of £700 million.

With annual sales running at just £402 million in 2009 these chunky revenue figures are probably some years away, which suggests we've been right all along in our belief that the £1 billion IPO valuation is simply too much and investors will balk at this number when Ocado finally reaches the end of the flotation runway.