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Why the new £1.5bn Ocado-Marks & Spencer tie-up makes sense

Oscar Williams-Grut
·Senior City Correspondent, Yahoo Finance UK
An Ocado delivery van parks outside a residential address near Liverpool in north-west England during a delivery of food and drink for supermarket Waitrose. Photo: Paul Ellis/AFP/Getty Images
An Ocado delivery van parks outside a residential address near Liverpool in north-west England during a delivery of food and drink for supermarket Waitrose. Photo: Paul Ellis/AFP/Getty Images

Marcado? Ocado & Spencer? Whatever they call it, the tie-up between Ocado (OCDO.L) and Marks & Spencer (MKS.L) has everyone excited.

Both retailers confirmed plans to set up a joint venture on Wednesday, following press reports on Tuesday that an announcement was imminent.

M&S will pay up to £750m ($995m) for 50% of Ocado’s UK retail operation under the deal. M&S is planning to raise £600m through a rights issue to finance the deal. M&S’ range will replace Waitrose on Ocado.com when the Waitrose contract ends in 2020.

Shares in both Ocado and Marks & Spencer rose on Tuesday after it emerged that the pair were in discussions about a joint venture. It suggested investors in both businesses see upside from the partnership.

“The deal makes lots of strategic sense for both M&S and Ocado,” Bruno Monteyne, an analyst with Bernstein who covers the supermarket sector, said in a note on Tuesday.

Ocado can focus on tech

For Ocado, hiving off their retail assets into a new joint venture allows the company to focus on its long-held ambition of becoming a pure tech company.

Ocado’s CEO Tim Steiner said in Wednesday’s announcement that the joint venture would create “a stronger platform from which to innovate and develop our unique and proprietary technology.”

Ocado has invested millions into fully automated warehouses, robotics, and self-driving vans over the years and is now selling itself as a “smart platform” for retailers. Buy Ocado’s off-the-shelf tech and you can become an online retailer overnight, it promises.

Investors were initially sceptical. In mid-2016, Ocado was one of the most shorted stocks in the UK with over 20% of its shares out on loan to hedge funds betting the price would fall.

But Ocado struck its first deal to provide services to a retailer in June 2017 and has inked a string of deals around the world since then, including a huge deal with US retailer Kroger last year that sent shares jumping over 40%. The short interest in the stock is now less than 2%.

Under the terms of the deal announced on Wednesday, M&S is signing up as a customer to the platform side of Ocado’s business as well as signing up to the joint venture. The JV plans also include investment in eight new customer fulfilment centres — Ocado’s fully automated warehouses — over the next 12 years.

Finally, analysts think the deal will help showcase its new Zoom one-hour delivery service thanks to M&S’s more upmarket, ready meal-focused range.

“Ocado wins thrice,” said Bernstein’s Monteyne in a separate note on Wednesday. “(1) by monetizing its retail business, (2) by signing up a massive new technology partner in M&S, and (3) preparing to become a real technology business.”

‘Accelerated change’ at M&S

For Marks & Spencer, this joint venture should help the company catch up in online grocery, an area that it’s fallen well behind in.

Food was once one of the few bright spots for Marks & Spencer, a classic British retailer that has been battling falling sales and declining relevance for the last decade. But in recent years it has taken its eye off the ball as it focused on trying to fix its clothing business and went too upmarket with its grub.

M&S’s comparable food sales in the UK fell by 2.1% in the most recent third quarter, which followed a 2.9% decline in the first half of the year.

A big part of that slump is down to M&S’s failure to spot the shift to online groceries. Chairman Archie Norman, who was appointed in mid-2017, wrote in last year’s annual report that “the growth of home delivery in food” was one of several “threats that are eroding our business and market position.”

“Accelerated change is the only option,” Norman wrote.

M&S has tried to do online food delivery itself but said in Wednesday’s deal announcement that the trial was “uneconomic due to the high cost of manually picking from store.”

The Ocado tie-up gives Marks & Spencer access to market-leading warehouse and delivery technology, as well as the expertise on how to best run the operations. Overnight, it would acquire online food delivery capabilities.

M&S CEO Steve Rowe said in Wednesday’s announcement: “Our investment in a fully aligned joint-venture with Ocado accelerates our Food strategy as it enables us to take our food online in an immediately profitable, scalable and sustainable way.”

‘Does M&S have the appeal for larger shops?’

While the transaction does make a lot of sense for both sides, there are risks — particularly for M&S.

Marks & Spencer used Wednesday’s announcement to reduce its dividend by 40%, which could anger investors. Shares in M&S fell by 8% on Wednesday morning after the divi cut and rights issue were announced.

Independent retail analyst Nick Bubb said M&S “still haven’t proved that they can generate a high enough shopping basket to make online grocery pay, so this seems a huge leap in the dark for them.”

Neil Wilson, chief market analyst at Markets.com, raised similar points.

Investors were happy with the deal outline yesterday but they won’t be too chuffed that the board is slashing the dividend by 40%,” he said in an email on Wednesday morning.

“The question is does M&S have the appeal for larger shops? Basket sizes at M&S are extremely small relative to other larger supermarkets and significantly below the current Ocado minimum for delivery.

He added: “I would also query whether M&S can retain the current Ocado customer base who are used to getting Waitrose products. There is a high risk of customer leakage as consumers rotate to Waitrose’s in-house delivery service.”

The transaction is set to close in the third party of this year.

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Oscar Williams-Grut covers banking, fintech, and finance for Yahoo Finance UK. Follow him on Twitter at @OscarWGrut.

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