Ocado (OCDO.L) - Is it really worth so much?

Ocado (LSE:OCDO) is an online supermarket and the largest online food retailer in the world. Originally founded by a group of former Goldman Sachs bankers who joined together to create an online delivery grocery fulfilment platform, they managed to get Waitrose (one of UK's largest groceries) as their partner. Last year, the company finished it's second fulfillment center for £230 million, which was instrumental in securing a new agreement with Wm Morrison Supermarkets. 

Ocado does business in the most competitive field, groceries. It competes with traditional mom and pop stores, huge chains (Tesco, Sainsbury's) and discount supermarkets (Aldi, Lidl). In addition, almost all supermarket stores in UK maintain an online presence, either through store pickup or direct house delivery. Tesco, ASDA and Sainsbury's websites all rank ahead of Ocado in terms of traffic (according to Alexa).

Let's take a look at Ocado's financials:

Source: Company Annual reports

As you can see, the company is growing on most fronts. But it's slowing down: In 2010, revenue growth was 28%, while from 2011 it hovers around 16%. Also, administrative costs have grown by a faster pace than revenue (135% vs. 97%) for the 5-year period. Gross margins have fluctuated at around 30-31%.

Ocado has not yet shown a profit since it's start, and although EBITDA margins are improving, one of the reasons is a huge increase in other income (from 2.6 mil. in 2009 to 23 mil. now):
Other income comprises the fair value of consideration received or receivable for advertising services provided by Ocado to suppliers and other third parties on the Webshop, commission income, rental income, sublease 
payments receivable and amounts receivable not in the ordinary course of business. (Source: Annual report)

If I take other income out and consider only it's grocery business, the EBITDA for 2013 is only 22.7 million with a margin of 2.86%, lower than 3% recorded in 2010.

Valuation

Let's take a look at Ocado's market value compared to it's competitors:

Source: http://www.4-traders.com/

According to Mr. Market, Ocado is worth more than one third of Sainsbury's which has 25 times higher sales and 60 times higher EBITDA and is actually producing a profit. It is clear that the whole valuation of OCDO is based on growth expectations, which are estimated at 21%, 18% and 17% for 2014, 2015 and 2016 respectively. This growth still seems slow given it's valuation and that "ground" competitors like Lidl and Aldi are growing faster. Also, some of the big retailers are reporting bad results because of the toughest grocery market since 2005.

I have done a three-stage DCF valuation based on these assumptions: 
- OCDO will grow by 15% in the next 5 years
- growth will slow down to 7.5% for years 6-10 (2nd phase)
- terminal growth rate of 2% indefinitely
- they are expected to grow revenues to 1.14 billion in 2015
- a miracle will happen and they will show of profit of 34.3 million next year (3% margin, still quite high)

Even under extremely optimistic conditions (growing 15% p.a. for the next 10 years), Ocado's value is close to ₤1.4 billion, which represents a share price of 2.4 GBP (242 pences). The current market cap is ₤2.2 billion, which implies a downside of at least 36%. A pessimistic scenario shows a share price between 1 GBP and 1.9 GBP, a downside of 50-75%. Short sellers already hold positions in this stock, including Jim Chanos of Kynikos Associates and John Griffin of Blue Ridge Capital.

I think Ocado is not going to show a reasonable profit anytime soon and it's future growth (if any) is not high enough to justify the valuation. Therefore, I'm initiating a short position in OCDO.