Stockwatch: is it time to buy AO World shares?

26th November 2021 11:04

Edmond Jackson from interactive investor

Our companies analyst correctly rated the shares a sell just before the crash. Here’s what he thinks of the online white goods retailer following a recent bounce in the price.

Early last October, I detailed a “sell” case for online electronics retailer AO World (LSE:AO.) at 158p - along mean reversion principles. As a stand-out among stocks benefiting from lockdowns, I thought it had been ramped far above any sense of fair value – reaching 430p in January 2021 and still looked overvalued on all criteria.

Supply chain issues were liable to affect products, and deliveries and their cost, too, given higher fuel prices and better wages needed to attract more drivers. AO’s reputation for lowest prices among domestic white goods, mobile phones and laptops is all very well, but there is tough competition and the table shows it only breaking into modest profit in the March 2021 year – despite exceptional demand.

Adverse fundamental and market technical indicators

The stock fell briefly below 90p last Tuesday after interim results showed AO back into an £11 million operating loss, the same as interim results for the March 2020 year. It recovered to 109p this morning as enough buyers swallow management’s emphasis on “continued strong revenue growth of 67% over a two-year period”.

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This essentially takes it back to pre-Covid levels in January 2020 when it was trading at around 90p, and to similar prices as in February 2019 at 109p.

The near-term crux for perception seems to be what extent traders are willing to assume an historic view: that e-commerce stocks should be valued on revenues, hoping for the next Amazon (NASDAQ:AMZN) (or a specialist industry equivalent) to materialise.

Or, has a moment of truth arrived and focus shifted to profit – hence e-commerce stocks are mean-reverting downwards, as the market probes a realistic valuation? As they say, “revenues are vanity, profits sanity.”

The latter seems why four hedge funds are now short of AO equity. Having followed Marshall Wace over years in disclosed shorting data, I find them astute (but not infallible). Last Tuesday they increased their short position by 0.17% of AO’s issued share capital, to 0.89% on the interim results day. On Wednesday, they increased again to 0.95% and Citadel Advisors LLC appeared on the list with a 0.53% short.

Since early September, the total short position in AO has risen from 0.6% over 4%.

Selling pressure may not be over, given that £515 million market value makes AO a candidate for demotion from the FTSE 250 – hence potentially index funds ditching it.

A one-third hike in admin costs did the damage

The income statement shows AO’s interim gross margin stable just below 20%, but administrative costs – cited as including digital marketing, warehousing and R&D – have soared.

It would help if AO specified where distribution costs are accounted for, as deliveries must be a key factor. Given the operational highlights cite some 500 new drivers to meet peak period demand.

Ironically, there is a section in the narrative – “Doing the right thing” in terms of caring for people and the planet, but management does not address the key issue going forward: how it intends to mitigate various cost increases.

Net debt is highlighted at £102 million, though does include leases, the only bank debt is stable at £20 million – versus £11 million cash. £2.9 million finance costs were more than offset by £3.1 million income from foreign exchange gains on intra-group loans and a discount unwinding on contract assets. Financial liabilities are not therefore going to accentuate any downturn here.

The UK economic context is not helping

Black Friday is bringing forward an aspect of Christmas period sales – on zilch margin – with for example my Google ads flashing Currys’ cut-price TV’s today.

But a key macro influence is how inflation pans out in 2022, both for industry costs and its impact on consumer discretionary spending. Rises in council tax and national insurance also beckon.

I think the Bank of England has lost the plot, with wage increases now embedded in distribution especially. If it wants to combat the likelihood of inflation around 7% by next spring, it will have to take tougher action, but doing so could cause a recession.

AO’s outlook statement already cites “meaningful supply chain challenges with poor availability in certain categories…and consumer price inflation”.

Despite preparations for annual peak period demand, this is already said to be “significantly softer than we anticipated only eight weeks ago”, hence full-year revenue to be flat to 5% down, year-on-year.

Electrical goods sales boomed during lockdowns due to home improvements and diverting cash that might otherwise have been spent on going out. Another driver has been housing market activity, but the end of the stamp duty holiday recently halved home sales rate and interest rate rises will not help the market.

AO World - financial summary
Year end 31 Mar

	2016	2017	2018	2019	2020	2021
Turnover (£ million)	599	701	797	903	1,046	1,661
Operating margin (%)	-1.8	-1.7	-2.0	-1.7	-0.4	1.8
Operating profit (£m)	-10.6	-12.0	-16.2	-15.2	-4.3	29.7
Net profit (£m)	-6.0	-6.6	-13.4	-17.5	0.8	17.1
EPS - reported (p)	-1.4	-1.6	-2.9	-3.8	0.2	3.7
EPS - normalised (p)	-1.4	-1.5	-2.7	-3.1	0.6	4.1
Price/earnings ratio (x)						25.9
Return on equity (%)		-14.6	-22.4	-23.3	1.4	21.2
Return on total capital (%)	-19.0	-20.3	-10.5	-8.7	-2.6	16.2
Operating cashflow/share (p)	-0.8	0.8	-3.4	-4.5	3.0	23.8
Capital expenditure/share (p)	1.6	1.4	1.2	1.0	1.7	1.9
Free cashflow/share (p)	-2.4	-0.6	-4.5	-5.5	1.3	21.9
Cash (£m)	33.4	29.4	56.0	28.9	6.9	67.1
Net debt (£m)	-25.4	-12.0	34.6	83.6	99.2	28.2
Net assets (£m)	48.3	42.2	77.5	72.4	69.6	97.7
Net assets per share (p)	11.5	10.0	16.9	15.3	14.6	20.4

Source: historic company REFS and company accounts

Profit expectations may be unrealistic

It’s unclear quite whether the consensus forecast for £9 million net profit in the current year to March 2022, reflects considered views on these interims. I am also sceptical of £20 million targeted for 2023. Even if both happen, earnings per share of 3.1p rising to 4.7p imply a price/earnings (PE) multiple of 35x, easing to 23x.

There is no dividend and a market value of £516 million is 6x to 11x book value, according to whether you recognise goodwill/intangibles.

Management continues to insist that revenue is what counts, and now it also has delusions of grandeur. It contends the market continues to migrate online and AO can become the global destination for electronics. As yet, however, the UK represents 87% of revenue, otherwise in Germany where it fell slightly due to competition.

Hard to see who might buy it currently

As I pointed out nearly two months ago, established manufacturers have their act together. In 2020 I bought a replacement Indesit fridge from Whirlpool Corp (NYSE:WHR) which also owns Hotpoint, at the same price including delivery and installation as AO offered. Irrespective of complimentary cleaning items Whirlpool included, I felt more comfortable having my sales contract directly with the manufacturer.

I find the same applies to mobile phones and laptops, where if the device goes wrong, I want to speak directly to its customer service. Although I concede that plenty of people still buy from Amazon!

In this respect also, it is curious how AO has £173 million trade receivables. Note 8 in the accounts clarifies as “contract assets…representing the expected future commission receivable in respect of product protection plans and mobile phone connections.”

Quite why people buy such plans is unclear. If a product has some defect, it is likely to go wrong in its first year under warranty. You also have the Consumer Rights Act, albeit as time passes would have to argue the defect existed at purchase.

Anyway, extended warranties are another item exposed to any spending downturn, and you wonder at the extent this income means AO would otherwise be losing more money.

Potential buyers of the business could be Currys (formerly Dixons Carphone plc), although Sainsbury’s/Argos has stronger cash capability, and Amazon always seems up for extending market share. But with the UK trading situation liable to get worse before better, this could be some way off – given there is also downside risk in the stock price. Any point where investors capitulate looks a way off yet.

Rather than hope, my stance on the financial evidence remains: Sell.

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

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