AO World - Still a Crazy Valuation

http://ao.com/

AO World Logo

Initial Public Offerings (IPOs) in 2014 have had mixed fortunes with many companies listing on particularly high valuations as a result of a bullish market earlier in the year. AO World is one company who was caught up in the IPO hype, and despite the company's operations being high quality, the valuation upon IPO at 285p was incredible, and was even more incredible when it rose to around 400p in the weeks after the IPO. The share price has since slipped back by almost a third from its IPO price and now stands at 205.50p. The big question is whether this decline has removed the froth from the valuation or whether AO World still trades at an unjustifiably high valuation both in comparative terms versus peers, but also in absolute terms.

Technicals


AO listed at 285p in March this year in an IPO that initially attracted controversy given how the prospectus was released particularly late, some claim in an attempt to limit scrutiny of the financials. At that level the company was capitalised at £1.2bn. However, a large number of institutions were locked out of the IPO given how few new shares were being issued and that assisted in pushing the share price to as high as 400p over the following week.

Warning signs were visible from the IPO in terms of share movements too. CEO and Founder John Robert sold £85m worth of shares, albeit the CEO and CFOs stakes still account for around 39% of the total shares in issue. The second warning sign was that pre-IPO shareholders sold out during the process, banking nearly £350m between them; whenever a company decides to undertake a new listing you have to question the rationale for doing so as all too often it is just a process of cashing in on an inflated valuation, which represents poor value for new investors.

Suffice to say, that has definitely turned out to be the case and many of the institutional investors who bought in during the IPO will be carrying significant losses at current prices. A couple of institution have since increased their stake although "The Nomad Investment Partnership" reduced their stake to below 4% within just one month of the IPO and 3% after two months when the share price was below the list price.

Underlying the technical picture is a hive of shorting activity from both institutions and retail investors. Since April the quantity of shares on loan has increased from around 0.5% to 2.36% currently, having reached as high as 3%. That has been driven by shorts taken out by JP Morgan, Artemis Investment Management and Contour Asset Management. JP Morgan Asset Management have since reduced their holding to below the notifiable threshold whilst Artemis and Contour have been increasing their stakes to 1.64% short and 0.72% short respectively. A decent proxy for retail shorting activity can also be seen on IG Index, who show two thirds of all open positions betting on the share price falling. This shorting activity is important as it can lead to covering rallies, but also depress the share price if it increases.

The three core bookrunners who set up the AO IPO were Jefferies, JP Morgan and Numis, so it's highly disconcerting to see that JP Morgan have effectively been betting against their own IPO (to an extent). It suggests that there is a conflict of opinions about AO within the company, and no doubt the researchers are being overly bullish. Despite one of the analysts at Jefferies (another bookrunner) admitting that the "IPO valuation looks punchy", they still have a 410p price target on the stock whilst JP Morgan has a 400p price target and Numis has a 350p price target. All of these companies were involved with the IPO so to an extent they almost obliged to be positive.

The only broker outside the fray was Shore Capital who had a sell note on AO, which was more in line with reality at the time. They had a share price target of around 150p-175p when the share price was 100p higher, but recently reversed that position as the share price hit the bottom end of that range. They moved their rating to Hold and upgraded their UK business "fair value" to 194p from 145p. That is partly what has caused the recovery off 150p as shorts have been prompted to re-but their positions. There has also been some (likely desperate) rumours circulated regarding a potential £3/share takeover from Amazon, but that seems a left-field idea to try and halt the share price decline rather than a credible rumour.

As it stands, the technical picture is still bearish unless the share price can surpass its recent minor high at between 230p and 240p.

Operations

In terms of the actually quality of the business, AO rates highly and the fact that they were ranked #4 in the Sunday Times' "Best Companies to Work For" is testament to that.

AO is a leading online retailer of domestic appliances (i.e. washing machines, ovens, vacuums etc.) with sales through both its own branded AO.com website and third party websites. AO actually stands for Appliances Online. The company is growing its sales particularly quickly with its core differentiating factor being the excellent customer service it offers, and has made moves recently to expand into Europe starting with Germany where they have launched AO.de; a German language site. They also cater for delivery, installation and recycling of the products they sell, and offer logistics solutions to other companies, but to a much smaller extent. Equally importantly the company sells product protection plans primarily at (or soon after) the point of product sale; these plans provide protection against faults or wear and tear beyond the manufacturer's typical 12 month warranty.

The market backdrop is relatively positive with home delivery easier than buying in-store, and a buoyant housing market and a decent economic recovery driving up sales. However, this is also a sector where there is very little brand loyalty and goods are very price elastic given how price competitive it is. That provides little differentiation for AO and the company therefore faces competition from a number of avenues:

       - Electrical Retailers (e.g. Curry's) which account for around 40% of the market
       - Generalist Retailers (e.g. Argos) which account for around 17% of the market
       - Online Specialists (e.g. Shop Direct) which account for around 10% of the market
       - Supermarkets (e.g. Tesco) which account for a few percent of the market
       - Small Independent Retailers which account for the balance of the market

Against that competition, AO searches and aggregates price data from competitors and bases price data off the lowest competitor price "subject to minimum margin requirements". The competitive environment means that AO is a low margin company. Over 80% of the company's sales are derived from Indesit, Beko, Bosch, Samsung or Electrolux. The wider backdrop is that online appliance sales are forecast to grow at low double-digit CAGR over the next few years.

John Roberts, Chief Executive Officer said: "I am delighted by the achievements the AO team has delivered over the course of the last year and the progress we have made in positioning our business structurally and financially to realise the very exciting opportunity we have ahead of us. Our UK business continues to build strongly aided by a successful rebranding, introduction of same day delivery and entering the small domestic appliance and television markets.  We are making great strides in preparing for our launch into Germany as the first step to becoming a leading European online electrical retailer."

Aside from the company having launched a TV proposition earlier in the year, there is little else important to comment upon regarding the operations. The business model is simple and easy to understand, and this is a largely low margin general retailer.

Financials

Years shown are calendar years rather than financial years
From a purely top-line perspective, AO demonstrates admirably high sales growth, especially when considering the sector of operation. That goes part way towards explaining the extremely high £1.2bn valuation put on the company on listing. However, the underlying profitability has been erratic and low over the past few years with £6.8m in post-tax profits in 2012 and the 2013 figure at a loss due to £15.4m of exceptional listing costs incurred earlier this year.

Ordinarily though, you would attribute a relatively high rating for a company demonstrating such strong organic growth, especially since it is only in the early stages of its broader European expansion plans. That said, the company was listed earlier this year in what has clearly been a strong year for IPOs and as per the numbers later on, the listing valuation was simply crazy.

Indeed, the last set of financial figures were released in the FY results to the 31st March and showed excellent revenue growth of 30% to £384.9m as above. That was led by increased AO website revenues up 45.4% and 3rd party website sales tracking higher to just shy of 30%. These were other key metrics:
    - Adjusted EBITDA up 10.9% to £11.2m
    - Adjusted EPS of 1.50p putting the shares on a trailing PER of 137
    - Cash generated from operations of £13.6m with Free Cash Flow of around £11m
    - Year-end net funds of £48.7m
    - Advertising/Marketing up to 4.7% of sales vs. 2.6% in the prior year
    - Strong Balance Sheet: Net assets of £58m. Tangible assets = 1.63x total liabilities and current assets = 1.31x total liabilities. Current assets = 1.40x current liabilities

Therefore, whilst growth is excellent, the main question is the valuation as the company is trading on a trailing PER of well over 100. What matters though is not the trailing valuation, but the future valuation based on forecast figures. In July AO noted that they had seen like-for-like (L4L) sales growth of 30% and that the financial performance was in-line across the board. That places them on track to hit forecast 2015 revenues of around £500m.


As a point to note, prior to an updated note yesterday, Shore Capital had 2015 EPS forecasts of 2p and a 2016 forecast of 3.8p, so whilst they have slashed their near-term profit forecasts, they have appreciably raised their medium-term forecasts. Unfortunately, that fails to change my point of view that AO shares remain significantly overvalued. Taking the previous figure for 2015 at face value and using 2.5p EPS, the shares are on a forward PE of 82.2 with no dividend forecast and taking the lowered figure, that PE ratio rises to 257. Ultimately though it's the 2016 numbers that matter more and taking a mean forecast EPS of 4.45p puts the shares on a PE of 46.2. That is once again a very lofty figure especially for a company dealing in appliances, regardless of the rate of growth. With the setup costs of the German venture (which requires £120m in sales to breakeven) expected, those 2016 forecasts are relatively punchy, not least because an exchange risk between the GBP and EUR comes into play.

"We are pleased to confirm our continued progress to the plan set out at IPO, even with the backdrop of such a major project in Germany. Whilst the early launch in Germany has clearly brought forward all associated costs into the current financial year, the UK business continues to perform well with overall UK revenue growth and EBITDA on track to meet our full year expectations.  We continue to drive increased market share through our differentiated service proposition and look forward to announcing our interim results for the first 6 months to 30th September 2014 on 25th November 2014."

Since the absolute rating is so high, it is not much use comparing the company with peers. If you did want to, Dixons pre-merger would have been a sensible peer given how they account for around 28% of all major domestic appliance sales and have strong growth rates as well. Yet Dixons traded on a price-sales ratio of a fraction of 1.

There is a further important debate, and that surrounds AO's profit breakdown. The company refused to disclose the level of profits made through the sale of product protection plans upon IPO, and it is widely believed that the product protection plans (this is essentially insurance) accounts for at least 1/3rd of profits (potentially as high as 50% of 2014 EBITDA). Given that point of sale insurance if usually poor value for money and is an unregulated area of business, any introduction of regulation into the area would likely dent AO's profitability.

The bigger question for now is whether you should value AO as a fast growing general retailer of a fast growing insurance firm. Insurance firms typically trade on forward PE ratios of between 8 and 12, whilst general retailers generally trade on forward PE ratios of between 12 and 18. In any instance, a two-year ahead PE ratio of 46.2 is extremely high and is on par with the sort of PE ratios seen at BooHoo and Just Eat. Yet despite both seeing earnings downgrades for FY2016, BooHoo only trades on a PE ratio of 27.5 with Just Eat on a higher 67.6 (albeit there is a more attractive play in that case). There is nothing particularly 'special' about AO's business model to justify the lofty valuation, especially if the wider market adjusts downwards again.

28% Lower than the IPO Price

Although the share price is now less than 75% of the IPO price and roughly only half of the intra-day peak, the share price continues to look unjustifiably high. The amount of shorting activity already within the market could keep the shares volatile in the event of good news, so it makes sense to open up a Sell tag with a 150p initial target price, but using a strict stop loss at between 228p and 232p to protect against any potential bear squeeze. The shares remain extremely highly valued and there is little obvious attraction to buy the shares at these prices; even if they exceed 2016 expectations by 50% and hit EPS of 6.75p then AO is trading on a forward PE of 30.4. Results due on November 25th could once again underscore this. The valuation still appears absolutely crazy and may also prove to be a decent hedge against any further downward market swing.

Article Updates (Click to view)
UPDATE (26/11/14) - Stop loss on AO World removed. The shares remain significantly overvalued in my view and the results yesterday did not dent the bear case. With Numis already having slashed 2016 forecasts to 2.38p. The 200 day moving average at 238p should prove to be resistance. I have now increased the sell tag to two slots at 234.50p, giving a blended average of 220p.

UPDATE (06/12/14) - Stopped out of second slot and half the first slot at 252p. Will seek to re-enter soon when momentum fades again. As a result, and the fact that it is a Sell tag, the average price falls to 181.60p
(16/12/14) - As per the previous update, I have been monitoring for signs of momentum failure, and the shares have fallen through support on the daily chart.
UPDATE (25/02/15) - I have moved AO from Sell to No Rating at 199.65p for a 15.17% profit, in-line with the cessation of company reviews
 

5 comments:

  1. AO is utter froth in my opinion. At least Just eat has some defensible technology in a niche area that is highly cash generative. its a simple model that is capable of huge cash generation and huge operational gearing. This is not and there is nothing remotely exciting. How long until there is a crack down on bringing regulation to ensure no misselling of these extended warranties. These are always crap value for money.

    I expect these to be under 120p by March next year

    Frederic

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  2. Bonkers in foresight and bonkers in hindsight :-). The brokers had their eyeson the wallets and should be laws about minimum prospectus viewing time :-0

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  3. great article many thanks, Tim

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  4. Keep patient with this one el1te! Your call that carpetright was over valued was spot on but you ran out of space (?) and missed a 42% decline lol!
    Antoher basket case here. 27% upside against 9% downside seems a fair risk reward.

    CraigJ

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  5. why r they now over £3.00 pound ?

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