Shareholders in online retailer Ocado Group (LSE: OCDO) have had a great year. The Ocado share price has risen by about 60% so far in 2020, making it the best performer in the FTSE 100.
Should investors keep buying, or is it time to take profits? Today, I want to explain why I’d sell Ocado shares at current levels.
Retailer or tech firm?
First of all, let’s forget about Ocado’s UK grocery retail business. The latest market research figures show that Ocado only has a 1.7% share of the UK grocery market, even after sales rose by 40% during the second quarter.
Last year, Ocado’s retail business generated cash profits of just £35m. For a FTSE 100 company with a £15bn market-cap, this just isn’t enough to move the needle.
No, the investment case for Ocado shares is all about technology. The company wants to be seen as a tech firm that can roll out its automated online retail systems all over the world. This could be very profitable. According to management, Ocado Group has “a fee opportunity” of £3.5bn-£26.3bn globally. Surely shareholders should stick around for that.
Too much guesswork
Although the company boasts of this big “fee opportunity”, I think such a broad prediction is pretty meaningless. Is it £3.6bn, or £26.3bn? No one knows.
We also have no way of knowing how long it might take to earn these fees. That’s important. If it takes you five years to earn £25bn, that’s £5bn per year. But if it takes you 25 years to earn the same amount, that’s only £1bn per year.
Obviously, a company earning £1bn each year will be worth much less than one earning £5bn per year. This highlights one of the problems I have with Ocado. Management provides very little financial information about the expected value of their deals with retailers.
For example, when the group’s latest deal with Japanese retailer Aeon was announced, all the firm said is that it would be paid “certain upfront fees” during development, followed by “ongoing fees” when its warehouses are in operation.
Given that the firm plans to roll out warehouses in Japan from 2023 through to 2035, I think that’s pretty vague. This makes it hard to value the stock. It also makes me cautious.
Ocado shares are already priced for success
So let’s try a different way of valuing this business. Because Ocado doesn’t make any profit (a loss of £161m is forecast in 2020), we can’t use the price/earnings ratio.
One alternative that’s often used with fast-growing stocks is the price/sales ratio. This compares a company’s market-cap with its revenue. A high multiple usually means the stock is expensive.
At about 2,000p, Ocado shares trade on around 8.7 times 2019 sales. To provide some comparison, Amazon — which is profitable — trades on about five times last year’s sales. Netflix, which is also profitable, trades on about 10 times sales.
Given that Ocado is expected to stay loss-making until at least 2022, I think Ocado shares look pretty expensive.
Don’t get me wrong — the Ocado share price might continue to rise. But I think anyone buying the shares today is probably speculating, not investing. We simply don’t know how much profit this business might be able to generate — if it ever does.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Roland Head has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Amazon and Netflix and recommends the following options: long January 2022 $1920 calls on Amazon and short January 2022 $1940 calls on Amazon. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.