Ocado Group plc (OCDO) Ordinary 2p

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Ocado confirmed that its US supermarket partner Kroger has decided to close three Customer Fulfilment Centres (CFCs), which use Ocado’s technology to fill customers’ orders. This is set to reduce Ocado’s fee revenue in the current year by around $50mn.

Ocado expects to receive compensation of more than $250mn for the early closure of these sites.

In areas where demand density is higher, Kroger will continue to operate CFCs using Ocado’s technology.

The shares fell 21.9% following the mid-afternoon announcement.

Our view

Ocado’s shares fell sharply following confirmation that its major US partner, Kroger, is pulling back on its warehouse partnership. These rely on robots to sort orders using Ocado’s technology, bringing fee revenue in the door. But with demand not strong enough in some locations, Kroger is cutting its losses by closing three of its warehouses, cutting off around $50mn of revenue for Ocado this year.

Ocado’s set to receive around $250mn in compensation from Kroger for the early closure of these sites, but that’s still well below what they would have generated otherwise. Some of its other retail partners have also been having second thoughts about opening more Customer Fulfilment Centres (CFCs). With a deteriorating outlook for future growth, Ocado’s path to profitability remains unclear.

CFCs are the cornerstone of Ocado’s Technology Solutions division. Running operations through Customer Fulfilment Centres (CFCs) brings a host of cost savings and efficiency benefits that could offer a competitive advantage for those who can afford it. But the current economic outlook poses challenges, putting pressure on existing and potential partners to cut unnecessary spending in areas where demand simply isn’t strong enough.

There’s pressure to establish a long runway of CFC openings because Ocado is stumping up hundreds of millions to fund these centres. This has led to significant fundraising from shareholders. Medium-term plans for free cash flow generation from existing CFCs seem ambitious to us, and we can't rule out Ocado burning through its available liquidity faster than planned.

Ocado Retail, the grocery delivery business half-owned by M&S, is doing well. Customer numbers have shot past the million mark, and volumes are improving as a result. In part, that’s thanks to M&S’ improved quality and value perception, which helps to lure more customers onto the website.

Ocado’s striving to expand its product range, increase delivery slot availability and is investing in keeping prices low to prevent customers switching to competitors. While we’re positive about progress, we must point out that this division is still loss-making and there’s no timeline for reaching the land of profitability.

There’s also potential legal action with M&S over a withheld £190mn performance payment, after pre-defined targets weren’t met. The saga remains ongoing and it’s something we’re following closely. Regardless of the outcome, it’s hard to imagine it will benefit relations.

We should be clear - Ocado has an amazing product. However, the group is still loss-making. We can’t rule out further fundraising from investors down the line, which could dilute current shareholders’ ownership. And if partners continue to cut back on CFC expansion plans, it could further damage the valuation.

Environmental, social and governance (ESG) risk

The retail industry is low/medium in terms of ESG risk but varies by subsector. Online retailers are the most exposed, as are companies based in the Asia-Pacific region. The growing demand for transparency and accountability means human rights and environmental risks within supply chains have become a key risk driver. The quality and safety of products as well as their impact on society and the environment are also important considerations.

According to Sustainalytics, Ocado’s management of ESG risk is strong.

The group has an adequate environmental policy and its whistleblower programme is strong. However, ESG reporting falls short of best practice and the group lacks regular risk assessments on data privacy.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by LSEG. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment.

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