Marks & Spencer Group PLC (LON:MKS) expects its online grocery joint venture with Ocado PLC (LON:OCDO) to deliver cost savings and RBC Capital Markets thinks this is key to making the deal more attractive.
In February, M&S announced a venture with Ocado that would see it provide an online grocery delivery service to customers for the first time.
As part of the deal, M&S will buy a 50% stake in Ocado’s UK retail business for up to £750mln and will fund the purchase through a £600mln rights issue.
M&S also plans to cut back its dividends to free up cash for the deal, which spelt the end of Ocado’s long-running partnership with Waitrose.
High price for M&S to pay but deal makes sense in the long term, says RBC
“At first sight this looks like a high price,” RBC said as it maintained a ‘sector perform’ rating on M&S but cut its target price on the shares to 270p from 300p.
“In effect M&S is selling close to 15% of its business at 6x EV/EBITDA to finance a business valued on a trailing EBITDA basis at over 30x.
“However M&S believes it can achieve synergies of at least £70mln per annum by the third year following completion and we think retention of these will be key to making the deal more attractive.”
RBC expects M&S will retain half the estimated cost synergies after investing in making its grocery items more price competitive. That would lead to M&S not exceeding its weighted average cost of capital (WACC) until after 10 years, RBC estimates.
Based on a recent RBC survey of 50 branded and own label M&S products, the company is 8% more expensive than the average basket for six grocers and 10% more pricey than fellow upmarket supermarket Waitrose.
“Strategically the transaction makes more sense for the long term,” RBC said.
“M&S will be gaining access to a scalable, albeit low margin online food business, which caters for affluent, time constrained shoppers.
“It combines M&S’ reputation for quality with Ocado’s tech platform, centralised distribution and operational efficiency.”
M&S moves to moderate dividend yield but with potential for earnings growth
The decision to reset its dividend down by 40% to preserve cashflow is the second time M&S has cut its payout.
RBC said M&S is essentially moving from being a yield high, no-growth stock, to one with a more moderate yield of 4% but with some potential for earnings per share growth in the longer term. However, the broker thinks the Ocado joint venture is unlikely to be material to the bottom line for several years.
“Sentiment is fairly depressed but M&S now trades at a small P/E premium to peers,” RBC said.
RBC 'remains on the sidelines' on Ocado
For Ocado, RBC believes the company is uniquely positioned to leverage the” significant potential” for global online grocer.
It said the joint venture with M&S is further validation of Ocado’s “best-in-class” online grocery solution but thinks this is fairly reflected in the share price.
RBC repeated a ‘sector perform’ rating on Ocado but lifted its target price to 1,000p from 750p, saying: “In light of execution risk and lack of visibility on future cash flow, we remain on the sidelines.”
The broker values the joint venture at 230p per share, or £1.6bn, on a discounted cash flow basis. The valuation reflects an estimated compound annual growth rate in revenue of 11% over 10 years, a terminal EBITDA margin of 4.3%, a capital expenditure to sales of 1% and a WACC of 10%.
“Our forecasts assume a 10% churn of Ocado customers that are loyal to the Waitrose brand and that c.50% of M&S online shoppers convert to Ocado.com over 10 years, spending an incremental £300 online annually.”
Ocado to reach 15% global market share through partners, RBC estimates
RBC values Ocado’s solutions business, which supplies its digital platform and warehouses to other retailers looking to set up an online delivery service, at 220p per share, or £1.6bn. This is based on deals Ocado has with Morrison Supermarkets PLC (LON:MRW), Bon Preu, Casino, Sobeys, ICA and Kroger and M&S.
“The difficulty in valuing Ocado shares is in predicting the scale of future grocery partners,” RBC said.
“Rather than assuming an arbitrary number of potential future deals being signed, we estimate the global market share of online grocery we view as achievable through Ocado's partners in 10 years': 15%, similar to Ocado's market share of the UK online grocery market. This implies the equivalent of six Morrisons-sized deals.”
RBC cut its forecasts for Ocado’s 2019 adjusted earnings (EBITDA) by 55%. It also reduced estimates for 2020 and 2021 adjusted EBITDA by 35% and 14%, respectively.
The downward revisions to forecasts are due to changes under accounting rules IFRS 15 that mean the recognition of up-front and development fees from solutions partners can only be recognised once operations start. The estimates also take into account higher costs related to the solutions unit.
In midday trading, M&S shares edged up 0.7% to 267p and Ocado edged down 0.7% to 1,046p.