Should you sell Tesco plc & Ocado Group plc and buy Amazon.com, Inc.?

Is Amazon.com, Inc. set to beat Tesco plc & Ocado Group plc at their own game?

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News of the launch of AmazonFresh in the UK last week was probably not the best tidings that Tesco (LSE: TSCO) and Ocado (LSE: OCDO) shareholders could have wished for.

From their high points on the day of the announcement on Thursday, Tesco shares had fallen 6% by the end of Friday, with Ocado shares down 7.6% — as I write, Tesco has now shed 33% since late June 2015 to 149p, while Ocado has lost 51% since its July 2015 high point to 231p.

Tesco’s big struggle is against the cut-price bricks-and-mortar supermarket chains of Lidl and Aldi, and one of its few competitive advantages is its online retailing operation. It was the first of the UK’s big supermarkets to offer the service, though it’s not always the pioneers of a new service who end up prospering from it — so online retailing is no guarantee of Tesco’s future success.

Stiff competition

As well as Ocado and the other supermarkets, Tesco is now also up against the muscle of Amazon.com (Nadaq: AMZN), which has launched a groceries delivery service in 69 London postal districts — Amazon Prime subscribers can now get their food shopping delivered, for a fee of £6.99 per month. If that’s successful, we should see further roll-outs to other major UK cities.

Amazon’s existing delivery service is already known for its effectiveness, and for its extensive use of automation to keep wages and costs down, and that’s going to make it a serious competitor for Tesco, and very possibly a contender for the number one spot in the future.

And if it’s bad news for Tesco, it’s even worse news for Ocado, which launched amid great fanfare, but whose shares, to me, have looked seriously overvalued from day one. From its launch in 2010, it took until 2014 for Ocado to turn its first profit, and even in 2015 it only recorded a pre-tax profit of £11.9m. Funding has been tight too, with net debt of £127m reported at the end of November 2015.

Massive valuation

Looking at valuation, based on this year’s forecasts Ocado shares are on a vertigo-inducing P/E  of 110. And even with a 44% rise in EPS pencilled in for 2017, that would still drop to only 76. Ocado needs 2017 forecasts to come good, and then on top of that it needs more than a five-fold rise in earnings per share to get its P/E down to around the long-term FTSE 100 average.

And now Amazon can waltz in with its masses of cash and its full delivery infrastructure already in place, and challenge Ocado’s only real competitive advantage over the tradition supermarkets — its high-technology automation and lower costs.

While Ocado shares already looked overvalued to me, they now look even more unsustainably priced. Current forecasts don’t account for the Amazon factor, and I expect them to be revised downwards in the coming weeks and months — and that would lengthen Ocado’s P/E even further, just when it desperately needs to see it shortening.

Can Ocado survive?

A competitor that probably won’t suffer from Amazon’s entry into the market is Wm Morrison Supermarkets which looks set to benefit from its partnership with Amazon and so offset the extra competition for its own offering online. But I really do see this as bad news for Tesco shareholders — and potentially devastating for Ocado.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Alan Oscroft has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Amazon.com. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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