Interactive Investor

Stockwatch: assessing the odds of recovery at AO World

5th October 2021 09:43

Edmond Jackson from interactive investor

After a spectacular share price crash last week, should you bag a bargain or steer clear. Our companies analyst gives his view.

Having noted a couple of small-cap growth plays on high ratings, I should examine potential over-valuation in mid caps – especially where supply chain issues are liable to compromise profit. 

AO World (LSE:AO.) is a £760 million online retailer of electrical white goods and audio-visual products which has just cut profit guidance for its March 2022 year. Earnings will also hinge on its key selling period - Black Friday to Christmas. 

For its first half-year to 30 September, revenues rose 5% despite strong comparatives during the first Covid lockdown. But the UK has suffered a lack of deliver drivers and supply chain disruption, also online completion hampered sales in Germany (albeit barely 7% of group total anyway). 

Mitigating actions have been taken in logistics, and the revenue growth rate is expected to be maintained in the second half, hence full-year adjusted EBITDA (close to operating profit) anticipated in a range of £35 million to £50 million. This compares with £64 million achieved in the March 2021 year and £22 million in 2020.  

AO shares initially fell 25% in market price to 165p last Friday, but started this week firmly. However, they closed Monday down 4% at 158p. That could potentially still put the shares on some 60x March 2022 earnings. There is no dividend either, and net assets per share are around 20p.  Holders must hope current setbacks are overcome such that 2023 onwards enables operational gearing to hum. 

Volatile sideways chart reflects AO’s business model 

The market has been in two minds about AO’s prospects and valuation since it floated in early 2014.  

Such was enthusiasm for online retail, AO opened at a huge premium to its 285p flotation price, soaring to over 400p, representing more than five times annual revenue. A £1.6 billion market value was greater than Home Retail Group, which at the time owned Argos and Homebase.  

Yet the last six years to March 2021 (see table below) shows AO only broke into profits for that year, benefiting from exceptional demand for home goods through online retail. 

The market does have a semblance of efficient pricing given October 2014 saw the stock fall to 170p. It then rallied to 300p, but this did not hold and a downturn resumed to 125p in August 2015. The price fell as low as 60p when Covid initially struck, then took off as online retailers benefited from people sat at home spending money that would have gone on holidays or eating out. 

While investors have salivated over online stocks (after Amazon showed that it paid off to own its shares will it generated operating losses), AO’s business model appears to need a positive environment. Even the last successful year had cost of sales over 82% of sales, before admin costs. Operational gearing means AO needs to further leverage sales to show earnings that justify a high growth rating. 

Plenty of UK competition and from the US too

Rivals include Currys and Argos, although when I had a fitted fridge replaced a year ago, I ended up using the UK subsidiary of Whirlpool Corp (NYSE:WHR), which co-owns the Hotpoint and Indesit brands. I did look at AO, which matched Whirlpool on price, although I was impressed with Whirlpool’s customer service and felt this likely to extend to the fitting job. Owning a brand implies incentive to maintain its value.    

Competition in white goods helps explain AO’s breakthrough measly operating margin of 1.8%, although even that immediately boosted returns on equity and total capital to around 20%.  

Yet distribution costs must rise - if only due to fuel costs - also wage rises look likely amid UK skills shortages. I am sceptical that a worthwhile margin can be sustained despite AO saying it has taken action to mitigate logistics’ challenges.  

Investors’ infatuation with sales growth only lasts so long before an inevitable moment of truth: “revenue is vanity, profit sanity”. 

Macro risks are probably the dominant factor     

Reports of inflation rising to 4% or 6% seem complacent. I think the real rate of UK inflation will in the next six months or so, soar to over 10% given big rises in energy costs conflating with a jump ahead in council tax and national insurance.  

It remains to be seen whether the Bank of England lets inflation rip, to “inflate away” public and private debt, or interest rates possibly several times – raising debt and eventually mortgage service costs. 

Even if this is too dire a scenario, caution seems prudent towards stocks that have benefited from buoyant consumer goods sales in the last 18 months. Those able to cut costs may preserve a measure of profits, but I question any on a big rating and modest operating margins. 

Consensus forecasts need downgrading 

Relative to the 1 October update guiding EBITDA into a £35 million to £50 million range, net profit of £31 million was anticipated for the March 2022 year, rising to near £38 million in 2023.  

At 158p, the stock would trade on 43x current year’s implied earnings, but last year for example £64 million EBITDA became £17 million at the net profit level. Latest guidance most likely bumps the price/earnings (PE) figure up materially higher and investors must decide how temporary or longer-lasting the change could prove. 

My concern is that it involves revenue and costs, beyond supply chain issues currently - where a latest survey of 500 UK firms shows over a quarter are experiencing disruption. 

AO World - financial summary
Year end 31 Mar

Turnover (£ million)5997017979031,0461,661
Operating margin (%)-1.8-1.7-2.0-1.7-0.41.8
Operating profit (£m)-10.6-12.0-16.2-15.2-4.329.7
Net profit (£m)-6.0-6.6-13.4-17.50.817.1
EPS - reported (p)-1.4-1.6-2.9-
EPS - normalised (p)-1.4-1.5-2.7-
Price/earnings ratio (x)     38.5
Return on equity (%) -14.6-22.4-23.31.421.2
Return on total capital (%)-19.0-20.3-10.5-8.7-2.616.2
Operating cashflow/share (p)-0.80.8-3.4-
Capital expenditure/share (p)
Free cashflow/share (p)-2.4-0.6-4.5-5.51.321.9
Cash (£m)33.429.456.028.96.967.1
Net debt (£m)-25.4-12.034.683.699.228.2
Net assets (£m)48.342.277.572.469.697.7
Net assets per share (p)11.510.016.915.314.620.4

Source: historic company REFS and company accounts

How does the financial structure stack up? 

AO’s end-March 2021 balance sheet showed bank debt eliminated, albeit £21.4 million of near-term lease liabilities and £73.9 million longer-term, versus £67.1 million cash.  

The annual net finance cost was £9.5 million which note 5 clarifies as chiefly £4 million lease liabilities relative to exceptional factors such as £6.8 million, non-cash foreign exchange losses on intra-group loans. 

That would look pretty resilient, to endure a tougher climate, were it not for a 65% jump in near-term trade payables to £411 million versus trade receivables up 23% to £166 million. Note 9 cites improved credit terms with various suppliers, increasing the average credit period for trade purchases to 62 days from 52, also an increase in customer cash-back redemptions, although it is still a big overall jump. 

It meant the ratio of current assets to current liabilities was 0.86 against 0.79 in March 2020 when AO had just £6.9 million cash. 

In terms of financial risk, this hardly constitutes distress but looks to rate at the upper end of cautious.      

Two short sellers have recently edged up their positions 

Only a modest 1.4% of AO’s issued share capital is out on loan. However, in September the asset management arms of BlackRock and JP Morgan both slightly raised their short positions to around 0.7% each. 

Holders should keep an eye on whether hedge funds start to borrow-and-sell stock, which seems possible if the UK consumer environment deteriorates. 

The chief medium-term hope for the stock seems to be that enough shareholders prepared to hang on through a possible UK winter of discontent. I am fundamentals-driven and see too much downside risk given AO’s business model does not appear robust to cope with a harsher consumer climate. Sell. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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