Ocado Group plc (OCDO) Earnings Call Transcript & Summary

Good day, and welcome to the Ocado Q3 analyst call. At this time, I would like to turn the conference over to David Shriver, Director of Communications. Please go ahead, sir.

Thank you. Good morning, everybody. Welcome to the third quarter sales call for Ocado Retail, which, as you all know, is a 50-50 joint venture between Ocado Group and Marks & Spencer. Tim Steiner, the Chairman of Ocado Retail; and Stephen Daintith, the CFO of Ocado Group, will give you a brief summary of Ocado Retail's performance in Q3 and then we'll go to questions. Tim, over to you.

Thank you, David. Before we begin, I would like to express on behalf of all my colleagues at Ocado Retail and Ocado Group our profound sadness at the passing of Her Majesty, Queen Elizabeth. We join millions in the United Kingdom and around the world in mourning the loss of an extraordinary human being whose dedication to serving her people with love, empathy and compassion provides a constant source of inspiration to us all. In the midst of grief, we also recognize the value and importance of continuity in those things that bind us together, and we welcome the ascension of our new monarch, Charles III, wishing him a long and happy reign. God save the King. Let's now turn to Ocado Retail. When looking at our performance in the third quarter, 2 things are clear: the first is that the current cost of living crisis is forcing consumers to manage their spending carefully, looking for value, trading down and putting fewer items in their shopping basket. The second is that more and more customers are coming to Ocado to find value. The record number of customers now actively shopping with Ocado is testament to the continued channel shift away from brick-and-mortar to online grocery and the fact that Ocado is increasingly seen as the best place to shop for food online. To put some numbers on this, I'm going to hand over to Stephen.

Thanks, Tim. So in the third quarter, Ocado Retail sales grew by 2.7% and are up on 2019 levels significantly. The number is driven by an increase in the number of customer transactions of 10.6%, offset by a fall in the value of the average basket by 6%. Record numbers of customers are now shopping with Ocado. Since the start of the year, we have grown our active customer base by 23% to 946,000. Customer acquisition continues to trend at rates almost double those previously. Strong growth in customer numbers translates into a significant and encouraging increase in customer transactions. It's clear that increasing numbers of customers are looking to Ocado for value in the middle of the cost of living crisis. Furthermore, pressure on consumer spending means that these consumers are, on average, spending less per transaction. The 6% decline in the value of the average basket to GBP 116 is driven by a combination of a higher average selling price offset by, on average, fewer items in the basket. Now let's look at those numbers here in a bit more detail. Food price inflation at Ocado is running at around 7%. This is materially less than the double-digit food price inflation for the market as a whole reported by Kantar and the ONS. We've been able to do this by working closely with suppliers to provide value for customers and keep inflation as low as possible. Value-seeking customers have traded down to own label and other new entry-level products. And as a result, Ocado's average selling price has increased by only 5%, which is the net of a 7% increase in food price inflation offset by a 2% decrease related to customers choosing lower-priced alternative products. In addition to trading down, customers are adding fewer items to their baskets. The number of items per basket during the quarter was 45, down 10% compared with the same quarter last year and now in line with pre-pandemic shopping patterns. So the 6% decline in the value of the average basket reflects an increase in the average selling price of around 5%, offset by a decline in volumes of around 10%. The headline numbers I'm giving you include some rounding up and rounding down, as you can see. The net result from a strong 10.6% growth in customer transactions, but lower average baskets is an overall increase, as I mentioned a little earlier, in sales of 2.7% of the business in Q3. In the fourth quarter, we expect a combination of continued strong growth in customer numbers and orders to result in a sales number that, if anything, is likely to be slightly lower than 2021 levels. This revenue, however, is not sufficient to offset full year growth, as I've just mentioned. This will still leave us well ahead of where we were at the end of 2019. At the end of Q3, we were 38% ahead of where we were in the corresponding period pre-COVID. Regarding profitability, the business continues to target a low single EBITDA margin for the full year. But I think now we are likely to be closer to a break-even outcome given the headwinds, in particular, around electricity, rising costs there and also for dry ice, which we use to transport frozen food. Tim, back to you.

These are challenging times for everyone, and at Ocado Retail, we're committed to fighting for our customers to make sure we can provide them with the best possible value to help them navigate the cost of living crisis. We're encouraged by the positive underlying trends in the business, which underline the value of Ocado's differentiated proposition: the customers. Our online grocery model, which creates efficiency through advanced technology, offers customers a combination of competitive prices, the widest ranges and industry-leading service. As we've seen in Q3, customer numbers are sharply up as consumers either switch from other providers or try online grocery for the first time. Underlying productivity and fulfillment and the last mile continued to improve. And our outstanding new CEO of Ocado Retail, Hannah Gibson, brings fresh vision and energy to the business. As consumer spending stabilizes, we expect Ocado Retail will again deliver attractive and accelerating growth in sales and a strong recovery in profitability. For all these reasons, we're optimistic for the future even while recognizing the challenges that higher energy bill and other inflationary pressures are creating for our customers today. With that, I'm now happy to take questions.

[Operator Instructions] Our first question today comes from William Woods of Bernstein.

I've got 2 questions, if I may. The first one is, obviously, you're seeing strong customer growth, plus 23%, but orders are growing a little behind that at plus 11%. Could you just talk about 2 things. Are you seeing increased churn within the core customer base? And secondly, are the new customer cohorts slightly less sticky or developing slower than the previous cohorts? And then secondly, obviously, guidance for the breakeven at full year implies a loss-making H2. Could you just walk through some of those component parts? Obviously, you've highlighted energy. But could you just talk about the impacts on marketing spend, CFC efficiency and drops per van and things like that?

Sure. It's Tim here. William, when -- it's a good question to ask, why do your average customer numbers increase and yet your average order is not increasing at the same rate. And the answer to that is that if you're comparing it to a period where we weren't acquiring customers, then all the customers in the active pool at that time were kind of, what I would call, active-active. They were not only active in the last 12 weeks, but they had a very high expectation of being active for the next 12 weeks. Whereas in a period where you are acquiring new customers, you have some of those new customers we've always spoken about that will churn out in those first few orders. And so you will end up having a higher active number compared to the number of orders that you have, and you'll see this effect that you're seeing where there's a higher percentage growth in the active base compared to the actual growth in orders. That doesn't continue over time. So when you start to annualize that, if your growth in new customers is at a similar rate as a percentage of sales as it is now, you'll see that normalize, but that's the impact now. In terms of are we seeing increased churn from the active the kind of historical base? No, we're not. And then in terms of stickiness, I think it's a little bit too early to tell actually. It's only at the start of this quarter that we really saw the uptick in customer acquisition. And therefore, it's early to see whether the stickiness remains kind of at historical levels or not. We'll probably be able to comment more on that the next time we report. And then your question was on profitability. I think Stephen's indicating to me that he's going to speak.

Yes, I've got a few points to raise on that one. Look, there are 2 or 3 significant items to bear in mind here. First of all, let's talk about energy costs, electricity and just put some numbers around it. Last year, fiscal '21, our total electricity bill was around GBP 10 million. This year, based on current pricing, we're estimating it's going to be about GBP 30 million. That's a GBP 20 million increase year-on-year. And the vast majority of that is in the second half of the year, okay, where electricity inflation has been particularly pronounced. Fuel costs. Fuel costs last year were about GBP 18 million. This year, they're going to be a tick higher at about GBP 22 million or so, but again, impacting EBITDA. And then dry ice is the one that's moved most significantly in the last few weeks. I may be just give you some numbers around this. From the period from the 1st of September to the end of the year, we're estimating an incremental cost of around GBP 300,000 per week for dry ice costs. So those 3 items are then you can look at the material impact that they are having of well ahead of GBP 30 million or so of impact, almost GBP 40 million of impact in the second half of the year and particularly pronounced in Q4. And then the final and the important piece to bear in mind here is that our numbers today carry the cost of the capacity, the investment capacity that we're growing into as we add new customer numbers. So we're averaging around 360,000 or so orders per week. We've got capability for capacity of around 600,000 orders per week from the CFCs we've added over the last couple of years. And I think we feel very confident given the strong customer numbers we're reporting today, the growth in those customer numbers, well over 900,000 now and heading towards that 1 million number, we can grow into that capacity and then offset those fixed costs that we're carrying today that are impacting EBITDA in fiscal '22. So those are the key dynamics to bear in mind as we think about the EBITDA number.

Yes, I'll just add the marketing as well where, as I said, going through COVID because the existing loyal customer base was shopping with such frequency in such large basket sizes, we were unable to add new customers then. And therefore, to grow now up about 40% in volume over the 2-year -- or now a 3-year period, we need to acquire a lot of new customers. And so marketing spend has been significantly at record levels to achieve the level of new customer growth that we're seeing. And it's an important time for us to spend on marketing and acquire new customers because we built this increased capacity that we would like to fill over the next few years.

We now move on to our next question, which is Andrew Gwynn of BNP Paribas.

Thank you very much, Stephen, for those sort of extra points of explanation. I'm just wondering if you could translate it into the group numbers. Obviously, for the Solutions business, lower volume would weigh a touch, but also going into next year, that unsold capacity. So loosely, where do you think group EBITDA expectation should be for this year and perhaps just touching on some of the moving parts for next year. Second question, just help us understand very quickly on the products people have stopped buying. Is there anything there, maybe just around premium positioning of M&S and maybe sort of household products that people are perhaps buying elsewhere? Or is it actually just broader based?

Let me just take the last one in terms of what people are buying. It's just in the mix. It's like it's a smaller pack size or it's a brand substitution or it's I was buying a steak and now I'm buying mint. It's really hard to see any kind of very particular trend. There is, as I mentioned this on the previous results call, there was also a higher purchase of alcohol during the lockdowns in the baskets last year due to the venues that people might go and entertain and drink-outs have been closed. And alcohol, on an average, has a higher item price as well. So there's just a blend of a lot of movements going on that just takes that couple of percent of the average selling price down in terms of if you -- so basically what happened is if you take last year's basket at last year's velocity, the average price is up 7%. And then you look at what we're actually selling and it's up 5%.

Okay. Thank you, Tim. And then as we think about EBITDA and group EBITDA, consensus today is GBP 48 million for EBITDA -- for Retail, sorry. And we believe that now we've guided today that, that's going to be -- you should be thinking around breakeven. That's the only number in respect to the group where consensus is -- where you need to change consensus. We're comfortable with where it is for UK Solutions & Logistics and also for International Solutions.

Okay. That's clear. Going into next year, what's your thinking about some of that unsold capacity? Is there something we should be doing for our numbers there, sorry?

I'm not going to give any comments at this stage on next year's numbers given that, number one, that's quite a way away. We tend to use our full year results to do that. And secondly, there remains huge uncertainty right now. So I think it's wise to restrain the territory around fiscal '23 guidance.

Marcus Diebel of JPMorgan has the next question.

Just a follow-up on kind of that guidance and longer-term guidance, which you reiterated. I mean now we are basically EBITDA breakeven given the down trading and then the rising costs that you highlighted. I mean just conceptually, you highlighted midterm guidance again. Is that the increase in profitability, is that really coming through scale, by you ramping up production and more volume? Or do you need also kind of like the down-trading trends to reverse to achieve kind of like mid-single-digit EBITDA margins in the midterm? I guess from the onset, it sounds like it's scale, but just wanted to clarify.

So Marcus, the scale alone, so filling up the capacity that we've actually put live at the moment, we're bringing EBITDA back to the mid-single digits. But obviously, don't assume that we're not going to see a further 10-odd -- or percent drop in the basket, which would have a negative impact. But as we're now back at pre-COVID levels in basket size and we are seeing these reductions in average selling price versus inflation, all that's required to get back to that level is mid-single digit -- sorry, is -- to the mid-single digits is capacity growth. Actually, we see a lot of other opportunities to improve the business as well, but nothing else would be required to get there than to fill the capacity that we've turned online.

We now move on to Xavier Le Mené of Bank of America.

The first one, you mentioned the sharp increase of energy cost in H2. So is it fair to, of course, expect that to roll out into H1 and then to be a bit more cautious for fiscal year '23? So back to Andrew's question. And the second one is are you concerned with all the cost increase of the energy, electricity, dry ice, does that potentially put your model in question and are your partners concerned outside the U.K.?

Xavier, let me just try and answer as best as I can. I think in terms of forward guidance for energy prices, we both have to watch the markets, but also to have a better understanding of the measures of the new government here in the U.K. have announced because they have possibly said that businesses who are going to get to buy electricity the price is significantly lower than we've been buying it for the last several months. So I think we have to wait to see better clarity on that. I think you then also asked about the high energy prices, a cause -- I think generically kind of caused a problem to our model or something like that. We are strongly of the belief that we use -- or we and our clients use less electricity to distribute through this way than is used in the traditional supermarket/hypermarket/convenience store models. And therefore, whilst it's currently a drag on our numbers, actually high energy prices in theory is a competitive advantage to our model versus that of the store-based models.

Okay. And the second part of the question -- second question, sorry.

Sorry, Marcus (sic) [ Xavier ], what was the second question again? .

Yes, it was just the increase in costs you got in H2. So is it fair enough, of course, to expect that to fall into H1 next year?

Again, I'll just repeat what Tim had to say really that we would have to see what the government initiatives will actually deliver that were announced last week. So it's too early to call that one, Marcus (sic) [ Xavier ], I'm afraid.

We now move on to our next question, which is Nick Coulter of Citi.

I have a couple. I'll ask some them one by one, if I may. Firstly, on the under inflation versus the grocery market. What's the driver there? Is that strategic? Is that fear of elasticity? What's the rationale for what you're doing? Because if you have a better SG&A profile, you're obviously choosing not to recover that SG&A profile. So I'm just curious on the pricing strategy here? That's the first one.

Nick, I think what's happening here is that some of the inflationary numbers that are quoted are based on kind of a theoretical index, a loaf bread -- I'm making it up, I don't know the inputs are, but a loaf bread and 6 eggs and a pint of milk. And whatever has been chosen in that index is actually not representative of what's actually bought in U.K. supermarkets. So the first thing is the index signals a higher price rise than the average items bought in any of the supermarkets, I believe. And so as I say, the average item price of those bought in our supermarket without any change in baskets would be the 7% lower than the quoted numbers that we keep reading about in the press. And then our customers are making some changes to drive that 7% down to 5%. I don't -- it's not -- we've always been a price follower in terms of our pricing strategy, ensuring that our customers get best value for money from the combination of wider ranges, fresher food and better service and not having to pay a premium for it. It's not a particularly deliberate -- we're not going to follow the market or we're going to do something to it, SG&A or anything else. It's really where the items that we're selling are heading. Obviously, we work hard with our suppliers to maintain low prices. And so that's really -- that's where it is.

Okay. So we're unchanged on pricing policy basically. And then just on your energy, am I right in believing that you're not hedging here, that you're paying spots? And then just to check in on the base cost in your income statement of dry ice in a normal year.

Sure. So we have -- we have had short-term hedges on, but we had nothing on that secured the energy that we've needed in the last 6 months that were on prior to the market rallying in the corona wake -- in the post COVID-19 wake-up and then in the war. We have some hedges on for the next 12 months, but it's the minority of usage, which at the moment looks like -- no, we don't know, actually. It's too early to tell. As I say, let's wait and see if we can understand what the government policy is really saying. In terms of dry ice, just to give you a kind of an indication, I think, 1.5 weeks or 2 weeks ago now, we got an e-mail from the supplier. I read about the next day in one of the English newspapers. So it was widely talked about by a number of other users of dry ice. But it just basically said, from 3 days' time, the price is going, from memory, it was from GBP 600 a kilogram to GBP 4,000. Please sign this piece of paper and accept that, otherwise you won't be receiving any deliveries on Monday, and that was on a Friday afternoon. And it's related to different plant closures around Europe and people turning off other businesses because the CO2 in dry ice is a byproduct of fertilizer production. That's the predominant source. It's obviously used for medical reasons. It's used for carbonation of drinks and beer. It's used for processing meat, poultry and stuff like that. But when the supply gets disrupted because the primary business slows down stock so it's uneconomic, suddenly to produce it in its own right is 7x the cost. Historically, this would have been a few million pounds a year, I think GBP 2.5 million a year. And at the rates that are currently being charged, it would be more like 20 to 30. As we mentioned in the statement, we are working on some long-term alternatives to dry ice.

We now move on to Luke Holbrook of Morgan Stanley.

Just a couple, if I may. The labor market remains tight in the U.K. Are you seeing any impact here from driver shortages or from kind of higher salaries among your retail staff? And just secondly, can you just remind me on the parameters of the GBP 190 million payment due for M&S next year? I'm not sure if you've released much in terms of the way of details around that.