The hotly awaited tie-up between supermarket giant WM Morrison (MRW) and online grocer Ocado (OCDO) has finally happened and, judging by the details of the 25-year agreement, the big winner here is Ocado, for whom the deal will virtually wipe out its debt and provide a much-need revenue boost.
Ocado says the arrangement will contribute a “mid-single digit percentage” of revenue in the first full year as well as being “significantly accretive” to its profitability, contributing a “mid-teen million pound improvement” to net profit, largely from service fees and cost sharing arrangements.
For Morrisons, the arrangement is less beneficial. Not only has it tied itself to a 25-year agreement with a grocer whose business model has never turned a profit, but it has done so under what can only be described as rather onerous terms. Morrisons will pay roughly £135m to buy Ocado’s Dordon Customer Fulfilment Centre (CFC) and half of its equipment, £30m for licensing the intellectual property and, when Morrisons.com becomes profitable, Ocado will take at a 25 per cent slice of the operating profit (at least) for the first 15 years, falling to 10 per cent for the remainder of the period.
As well as paying Ocado, Morrisons will have to shell out a further £46m to expand Dordon and integrate its systems and £25m in development costs. Half of the Dordon CFC will be used by Ocado, for which it will pay roughly £2.45m a year in rent.
The cost structure of the operations also includes an annual IT payment to Ocado of 1 per cent of Morrisons.com revenue - with a minimum £3.5m to cover the maintenance, operations and infrastructure costs of IT services. There will be a 4 per cent annual management fee on operating costs and Morrisons will also pay one third of Ocado’s yearly research and development spend, fixed at £8m for the first two years and capped at £8m thereafter.
The new business isn't expected to generate positive cash profits before tax until 2016-17 or an operating profit until 2017-18. Capital expenditure will increase by £100m to £1.2bn, indicating a negative free cash flow of more than £150m, according to some analysts. And that means net debt will rise from the current consensus of £2.6bn to £2.7bn. Ultimately what all of this means is that Morrison’s big move online will negatively impact operating profit for at least five years, squeeze margins and drive the net debt/cash profit before tax ratio above 2 times for the first time since the acquisition of Safeway in 2006.
For Ocado, the terms of the deal seem positive at first glance. It will allow it to pay down its chunky debt pile, boost revenue and profit, share operational costs and use any additional cash on the balance sheet to expand in the UK and internationally. But the deal raises a number of question marks. Ocado built the new Dordon facility to expand capacity to give it the scale it needed to become profitable. Now it's leasing half of that capacity to Morrisons, so maybe the demand just wasn't there in the first place. There are also restrictive covenants to consider, under which Ocado cannot provide online grocery services in the UK to more than one competitor of Morrisons at any one time for the next 25 years. The contradicts Ocado's previous suggestion that exporting its model to other players will be a significant source of future growth. Furthermore, the deal could still fall through should Ocado's existing partner, Waitrose, decide to mount a legal challenge. With so much uncertainty, it would be wise for anyone who's hung onto Ocado's shares to sell them now, particularly as they've soared 28 per cent to 259p on the news.
