Ocado Retail Lowers Guidance Amid Cost Headwinds, Cost of Living Weighs on Demand; Shares Cheap

Ocado Retail reported a third-quarter trading update with sales up 2.7% (up 42% compared with the prepandemic period) driven by a strong increase in new customers (up 23% to 946,000), which in turn boosted the number of average orders per week by 10.7%. This nonetheless was partially offset by smaller baskets (at GBP 116 down 6%, approaching prepandemic levels) and noticeable downtrading (average selling price increased by 5% composed of 7% inflation and negative 2% decrease due to customers buying lower-priced products), as customers are seeking value-for-money items in response to the rising cost of living in the U.K. In addition to downtrading, the average number of items per basket during the quarter was 45, down 10% versus a year ago. The company called out cost pressures (energy and dry ice), which now expect to weigh on profitability in the fourth quarter. The grocer expects the added burden from higher energy costs to be GBP 20 million to GBP 25 million (at fiscal-year 2021 consumption levels) and GBP 15 million-GBP 20 million for dry ice (used to keep food fresh in transit). Hence, Ocado downgraded its full-year guidance for the business to a "small sales decline and close to breakeven EBITDA" versus previous guidance of positive low single digits for both. Lower profitability is also a function of deleveraging with new capacity coming online (four new CFCs opened since the beginning of 2021) during a period of slowing/declining demand. Growth guidance implies mid-single-digit growth in the fourth quarter. As a result, in intraday trading, shares were down as low as 12% on Sept. 13, pricing in management's cautious growth/inflation outlook and a second profit warning for the year. We expect to reduce our GBX 1,870 fair value estimate for Ocado by a low-double-digit percentage after incorporating the aforementioned growth and cost headwinds.