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3 Reasons Why I’d Sell Ocado Group PLC And Buy Tesco PLC

Shares in online supermarket Ocado Group (LSE: OCDO) slipped around 6% lower this morning, despite the firm reporting a 15% rise in fourth-quarter sales compared to the same period last year. For an established retail business, 15% quarterly sales growth is pretty good, so what was the problem?

1. Uncertain outlook

I suspect investors are disappointed because today’s update made no mention of progress on finding another home delivery outsourcing customer like Wm Morrison Supermarkets.

Back in June, chief executive Tim Steiner reiterated the group’s target of “signing a first [European] agreement during 2015”.

That now seems unlikely. Indeed, I’m not sure how much demand there will ever be for Ocado’s technology from other supermarkets. Most retailers seem to have chosen to operate their own delivery services.

2. Crazy valuation

For me, the problem is that Ocado’s valuation already prices in growth from several new customers on similar deals to Wm Morrison. Without these deals, Ocado’s valuation doesn’t make sense. After all, the group’s shares currently trade on a 2015 forecast P/E of 164, falling to 112 in 2016!

Even if Ocado’s earnings per share grew at 50% per year for the next five years, the firm’s stock would still have a P/E rating of 14.6 at today’s share price. To me, this means that today’s valuation is simply too high. I can’t see any realistic potential for shareholder returns.

3. Ocado is too small

In my view, Ocado is too small to be a competitive supermarket on its own. Sales of £1,027m last year only generated a post-tax profit of £7m.

One problem is that the firm’s online model means that rising sales don’t seem to translate into faster profits growth for Ocado. This seems to be due to the crushing costs of home delivery.

During the first half of the current year, Ocado’s own retail sales (excluding Morrisons) rose by 15.1%. However, the firm’s distribution costs rose by 11.9%. That doesn’t leave much room for profits growth, especially as the average number of items per order isn’t growing.

By comparison, the cost of operating a conventional supermarket is fairly stable, regardless of how many customers come in. This means that a rise in sales translates into a much bigger increase in profits than it would for Ocado.

My choice of Tesco (LSE: TSCO) as a buy may seem surprising. The UK’s largest supermarket is still struggling with a difficult turnaround that could take several years. But Tesco does have some advantages.

The group remains the UK’s biggest supermarket with a market share of around 28%. Total Tesco group sales this year are expected to be £55bn.

With such high revenues, a tiny percentage increase in profit margins or a small reduction in costs can deliver a big increase in cash profits. Analysts expect Tesco’s earnings per share to rise from a forecast of 4.8p for the current year to 8.9p in 2016/17, even though sales are expected to be flat.

The reason these forecasts are plausible is that as Tesco cuts costs, reduces debt and closes lossmaking stores, the group’s profit margin should rise and cash flow should improve.

I’m backing Tesco for a long term turnaround and rate the shares a buy at current prices. In my view Ocado remains seriously overvalued and too risky to buy.

You may not agree with my view on Ocado, but I'm certain you'll want to know more about the income stock the Motley Fool's analysts are backing for 2016.

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James believes that the group's profit margins could rise substantially over the next few years.

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Roland Head owns shares of Tesco and Wm Morrison Supermarkets. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.