OCDGF - Ocado Group: CFC Closure Not As Bad But Impact To Valuation Unknown

2023-04-26 06:01:27 ET

Summary

• I believe the trend toward online grocery shopping will continue to grow, but Ocado may face challenges in expanding its CFCs in the current environment.
• The closure of the Hatfield facility makes sense from an operational standpoint, as underutilized facilities can have a negative impact on profitability and cash generation.
• The closure will also result in better utilization and cost savings for the company.

Investment thesis

I think the trend toward online grocery shopping will continue to gain traction, especially among the younger generations, and eventually become the norm. While dwindling consumer spending is still a short-term challenge, I anticipate steady growth in the medium term, propelled by expanding online access and expanding market share in the UK. Although Ocado Group ( OTCPK:OCDGF ) appears to be benefiting from the long-term growth trend, it is also evident that the transition to more CFCs is not going to be as fast as I expect, especially given this macro environment that large deployments are not welcome (in order to shore up cash). Also, supermarkets seem to prefer in-store picking solutions to maximize profits from their existing store network. Ocado also announced yesterday that it would be shutting down its Hatfield facility in the UK, which handled 80,000 orders and 20% of its total capacity. As soon as its new facility in nearby Luton opens later this year, production there will be moved there. Even though this is a bit of good news for the Retail JV, my worries about the longevity of the other CFCs have been heightened by the closure of the oldest one (which had been open for 21 years). This has crucial repercussions for the current method of valuing each CFC (the discounted cash flow model). If each CFC only lasts for 21 years, the impact on future valuation could be huge. Net-net, as a result of this shutdown, I am concerned on how the market will react to this, as such I staying neutral.

Rational move?

From a purely objective standpoint, this is not shocking information. In the most recent earnings call, management hinted at the possibility of a shutdown. On the previous earnings call, the CEO was questioned about the possibility of closing UK facilities. He subsequently alluded to the fact that the oldest facility may be in an overcapacity situation. From an optimization of operations standpoint, the change will result in less under-utilization at Ocado Retail. From the current 600,000, Ocado Retail could handle up to 700,000 orders per week once the Luton CFC opens later this year, with about 60% utilisation. Hatfield CFC, on the other hand, has the ability to process 175,000 orders per week but is only fulfilling around 80,000 of them, or about 45% of its total capacity.

Furthermore, it can be costly to operate facilities that are underutilized, which can have a significant impact on both profitability and cash generation. On the most recent earnings call, management estimated that 35% of the margin pressure was due to the fixed cost of establishing and operating a customer fulfillment center, which is the minimum fixed cost. In light of the numbers, I think it's safe to say that shutting down Hatfield will boost retail utilization. Better technology and automation also play a role. The modernized building will be more productive and require fewer workers than before. As such, this building's closure makes perfect sense. The media's emphasis on the headline warning of "shutting down" the CFC, in my opinion, may be exaggerated. The facility may be mothballed rather than closed or sold, giving the company more options for future capacity needs.

Valuation impact

While I previously stated that the valuation methodology may be impacted because investors now have a datapoint to benchmark against (the lifespan of a CFC is now benchmarked to 21 years), I would point out that the value difference is not as significant from a DCF perspective because anything beyond the tenth year is not impactful. The impact of this datapoint will be felt much later, when a group of CFCs reach their 20th year, and if Ocado does not have enough CFC in the pipelines or operational by then, it may be valued similarly to a mining company (life of remaining assets). OCDO is currently trading at 55x forward EBITDA, while the MSCI world/metals&mining index is trading at 5x forward EBITDA. This illustrates the difference in valuation paradigms.

Conclusion

The recent closure of Ocado's Hatfield facility is not surprising and will result in better utilization and cost savings for the company. Although there may be some impact on the valuation methodology in the future, it is not significant in the short-term. Overall, I remain neutral on Ocado stock as I do not know how the market will digest this news, and the impact on valuation.

For further details see: