Interactive Investor

Stockwatch: The mother of all short squeezes?

23rd January 2018 09:51

Edmond Jackson from interactive investor

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Is the £3 billion online grocery/technology stock Ocado to be squeezed even higher as short sellers feel pain? This week has brought news of a second international technology/warehousing deal - with Canada's second-largest retailer after a major French retailer only seven weeks ago. These deals have inflated Ocado shares well over two-thirds in market value, to 525p.

Before the Canadian deal, Ocado was the third-largest short on the London market, with 13.5% of issued shares loaned out, thus now putting hedge funds in a dilemma whether to nurse losses, increase their shorts or close out.

It has wider relevance beyond Ocado, ie how much notice should you take of accumulated short positions and when? The collapse of Carillion is now proclaimed obvious in hindsight, with 14.0% of its equity having been loaned out, making it the second most-shorted stock. Debenhams at number one is having a sore time, too, its market value halving in the last six months.

International partnerships drive upside

Prior to this, Ocado shares had traded in a circa 200p to 300p range for nearly two years, down from over 600p in 2014. Since listing in July 2010 there has been a longstanding battle between traders who see it as an over-hyped logistics firm on very thin margins, and those who see it as a beacon for digital retail - more recently offering a unique technology platform to enhance retail partners anywhere in the world.

While such potential is frankly old news - the chief executive having shown 50 people from international retailers around Ocado's HQ back in 2014 - the proof now by way of deals has lit up expectations. Independent analysts at RBC declare Ocado's "the most robust and profitable fulfilment solution...our valuation assumes Ocado can sign 6 international deals, which suggests to us that the shares are fairly valued."

This element of the story had quite lost credibility and short positions accumulated versus a seemingly ridiculous price/earnings (PE) of several hundred times, no dividend or material asset backing. Hedge fund traders can be quite animal-spirited, such that if RBC's stance becomes the new consensus, with more such deals emerge, shorters are more likely to cut positions and move on. It only needs about half of them to quit for over 6% of the shares to need buying back - potentially a material influence to kick in during months ahead.

Amazon Inc as a value-comparative

Not to say this is wholly justified, but note what's become established. Shares in the US-listed online retail giant Amazon are up five-fold in market value over four years, currently on a trailing PE of 330 and forward PE over 161 times - with a five-year expected PEG (PE/growth) ratio near 15 times. Ideally you are looking for sub 1.0 and not over 1.5.

Also, Amazon's price/sales ratio approaching 4 times is twice 1.9 for Ocado. It's an invidious comparison in some respects and the UK launch of AmazonFresh presents competition for Ocado, besides encouraging speculation that the US giant will buy this smaller UK company out as it seeks to gain share in the global food market.

Amazon's hot house valuation has persisted over 20 years of stockmarket listing, transforming $5,000 (£3,600) into nearly $3 million today. It shows how so long as the story doesn't deteriorate, pockets of over-valuation can persist.

According to broker forecasts for Ocado late last year, it's questionable whether the company will be profitable this financial year to 3 December, with two of three analysts anticipating losses despite a consensus £1.8 million profit.

The latest announcement cites the Canadian deal as "earnings neutral in the 2018 financial year, with costs of establishing the partnership offsetting the initial fees payable...additional capex of £15 million and further capex in future years (however) in 2019 and beyond the profitability of Ocado Solutions is likely to grow as fees from the transaction increase and as other deals are signed."

Short-sellers are, therefore, on the ropes as the Ocado story re-invigorates; I would regard as very different from Carillion and Dignity lately where the story deteriorated, and in terms of directors' shareholdings - at Carillion they barely owned much and at Dignity they sold substantially down last year. At Ocado, the chief executive has owned a consistent 4.7% of this £3,250 million company, and three other directors including the chief financial officer have lately increased their holdings.

Part-similarity with Home Retail Group

Six years ago, I overlooked 22% of shares in Home Retail Group out on loan, to make a "buy" case at 85p versus a "sell" consensus - because the Argos subsidiary was pioneering "click and collect", group trading statements were resilient and the directors buying shares. The city elite seemed fixated on "the next HMV" retail disaster to happen, but the real story was overall robust. Moreover, the stock was cheap on fundamentals.

Admittedly, it took four years, but a total 171.5p per share offer from Sainsbury affirmed value and doing the opposite of a fat consensus of shorters. This example again shows the importance of being attuned to the tenor of underlying story: mainly commercial developments, but also the directors' equity positioning. Hedge funds can hunt like a pack of hyenas but may still club together irrationally at times.

Confirmed bears may dismiss Ocado's current situation as a technical squeeze, citing the adage how "in the short term the market is a voting machine but in the long term a weighing machine" ie a day of reckoning ultimately awaits Ocado shares.

Capital expenditure needs have also consistently out-weighed cash flow (see table) despite cash flow per share trending at substantial multiples to earnings per share. But a very positive turn in its commercial story is being affirmed, and there's possibly a growing sense of "a British answer to Amazon" in the air, not just bid speculation linking them.

Ocado Group - financial summary           Consensus estimates
year ended 3 Dec 2012 2013 2014 2015 2016 2017 2018
               
Turnover (£ million) 679 792 949 1,108 1,271    
IFRS3 pre-tax profit (£m) -0.6 -12.5 7.2 11.9 12.1    
Normalised pre-tax profit (£m) 1.9 -3.9 10.1 13.7 15.2 6.0 1.8
Operating margin (%) 0.8 0.3 1.8 1.9 2.1    
IFRS3 earnings/share (p) -0.5 -2.2 1.2 1.9 2.0    
Normalised earnings/share (p) 0.02 -0.7 1.7 2.2 2.5 0.9 -0.7
Earnings per share growth (%)       33.3 12.3 -62.2  
Price/earnings multiple (x)         208 578 -743
Historic annual average P/E (x)     187 222 126 416  
Cash flow/share (p) 7.0 10.5 13.0 15.5 17.7    
Capex/share (p) 19.3 13.2 13.5 16.8 20.8    
Net tangible assets per share (p) 30.0 28.4 29.0 30.2 29.0    
               
Source: Company REFS              

Speculative long-term buy

I should point out, the stock rose 50p alone in the hours while writing this piece, after Monday's initial mark-up to 430p, ie volatility could work both ways in the short term - the stock may settle back after the impact of the Canadian news.

Yet the market has probably scented bears' blood, making it hard to judge when and what extent the price will fall again. Admittedly, I'm departing from my usual focus on fundamentals to engage a speculative guessing game, but feel on a 2-3 year view that, unless Ocado makes mistakes with the technology roll-out, then its stock is likely to go higher still. There's big potential to roll out what Ocado has achieved here, with online supermarkets a relatively new concept abroad. Speculative buy.

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Disclosure

We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

Please note that our article on this investment should not be considered to be a regular publication.

Details of all recommendations issued by ii during the previous 12-month period can be found here.

ii adheres to a strict code of conduct.  Contributors may hold shares or have other interests in companies included in these portfolios, which could create a conflict of interests. Contributors intending to write about any financial instruments in which they have an interest are required to disclose such interest to ii and in the article itself. ii will at all times consider whether such interest impairs the objectivity of the recommendation.

In addition, individuals involved in the production of investment articles are subject to a personal account dealing restriction, which prevents them from placing a transaction in the specified instrument(s) for a period before and for five working days after such publication. This is to avoid personal interests conflicting with the interests of the recipients of those investment articles.

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