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Morningstar | Ocado-M&S Joint Venture Is Latest Sign of an Ailing U.K. Grocery Industry in Need of Consolidation

On Feb. 27, Ocado and Marks & Spencer announced the creation of an equal-participation joint venture, putting an end to rumors of a potential tie-up between the two companies. The joint venture will include Ocado's U.K. grocery retail business (GBP 1.5 billion sales, 700,000 customers) and a new partnership for fulfillment and delivery services provided by the Ocado Smart Platform (management of warehouses and logistics via an annual capacity fee under a long-term contract) along with products and sourcing from M&S. M&S will pay Ocado GBP 750 million (GBP 187.5 million of which is payable after five years plus interest conditional on achieving specific targets), with the majority of the consideration being financed by a rights issue (raised up to GBP 600 million). M&S also announced a 40% dividend cut, which will make future dividends more "sustainable." Ocado has already a similar sourcing agreement in place with Waitrose, which expires in 2020 and will be replaced by the new joint venture, rendering it one of Ocado Solutions' largest partners.

Gauging by the current operational and financial situations of the two companies, it's relatively easy to assess which party had the upper hand at the negotiating table. Since the launch of the service, typical Ocado Smart Platform clients have been grocers with a lack of time and capital to develop their own online retail business from scratch; in that respect, M&S is no different. For M&S, this partnership is an opportunity to resurrect its ailing food sales by increasing penetration to the 700,000 clients of the joint venture (Ocado's clients spend on average more than GBP 100 per basket). Further, M&S will seek to boost scale and improve sourcing and access to one of the highest-growth channels in the U.K. grocery market using the most efficient operator/format (automated warehouses).

On the other hand, Ocado, by retaining an economic interest in the online grocery business (50% of the joint venture), monetizes a portion of its assets to invest in future projects already in the pipeline (Kroger, Sobeys, Casino); maintains retail exposure as a showcase to future clients of the effectiveness and efficacy of its core technology solutions; and most important, separates the core Ocado Smart Platform operations from the more commoditised retail business, which helps in terms of valuation (towards a pure-play tech company) and attractiveness in future takeover attempts by larger companies.

We firmly believe that in a highly competitive U.K. grocery market that is currently undergoing structural changes (online, hard discounters, nontraditional retailers selling groceries), winners and losers will be determined by three main criteria: current channel positioning, self-help potential (cost savings), and strategic growth options ahead (acquisitions and partnerships).

In that context, we see J Sainsbury’s competitive positioning after the negative preliminary assessment by the Competition and Markets Authority on its proposed acquisition with Asda challenged by its suboptimal strategic decision to expand its offering beyond food by acquiring Argos in a period when most competitors are focused on and investing in expanding volume and driving traffic in the core food segment. While Morrisons' strategy of diversifying its channel exposure through capital-light partnerships (including Ocado) is logical given the circumstances, strong initial results are off a low base and shouldn’t be enough to offset competitive pressures from discounters and its big four peers. Tesco is the only grocer that satisfies all three criteria: It has the most complete channel exposure in the U.K.; it is well positioned to achieve its 3.5%-4% EBIT margin target by fiscal 2020, aided by a GBP 1.5 billion cost-saving program; and its Booker acquisition aligns with the firm’s strategic plan to boost scale by consolidating its supplier base and indirectly enhance its food sales through Booker’s overlapping food category efforts.

Although large companies with skillful management teams should be able to extract costs from the business (self-help), we think grocers that score low in the channel exposure criterion sooner or later find out that the odds are against them (M&S and Morrisons). With Ocado's client book already including Morrisons and Marks & Spencer (through the joint venture) and the U.K. being one of the most advanced online grocery markets globally, we think that the two primary beneficiaries of the online grocery disruption are Ocado and the final consumer.