Ocado Group's (OCDGF) CEO Tim Steiner on Q2 2017 Results - Earnings Call Transcript

Ocado Group plc (OTCPK:OCDGF) Q2 2017 Earnings Conference Call July 5, 2017 4:30 AM ET

Executives

Stuart Rose - Non-Executive Chairman

Duncan Tatton-Brown - Chief Financial Officer

Tim Steiner - Chief Executive Officer

Analysts

Andrew Gwynn - Exane

Stewart McGuire - Credit Suisse

Bruno Monteyne - Sanford C. Bernstein

James Tracey - Redburn

Niamh McSherry - Deutsche Bank

Rob Joyce - Goldman Sachs

Daniel Ekstein - UBS

Francois Halconruy - Morgan Stanley

Stuart Rose

Good morning, everyone. Nice, bright, sunny day in London. Welcome to the half-year results for Ocado for the 26 weeks ending 28 May.

I’m Stuart Rose. I’m the Chairman. You'll have to put with me for a very short period of time as I’m going to hand you over to the usual presentation from Duncan and from Tim.

But just a couple of comments as headlines. Growth continues to go pretty well both for Morrisons and for Ocado. You'll hear from Duncan and from Tim about what we're doing to improve operational efficiency in a positive way. So, that's just work in progress as we keep doing, but it's moving in a positive direction.

You'll hear about Andover. Andover is scaling up. Some of you have been there, I think. But it is an impressive site. And for those of you who haven’t been there for some time, if you were to go tomorrow, you'll find there's a big step change from where we were before.

And the good news is, in the recent weeks that we've announced our first international deal, which I’m sure Tim and Duncan will comment on.

And perhaps more important from me, as you all know, so I’m not going to even teach you – or begin to teach you how to suck eggs. The world is changing. I came back from Dubai last night where not many people – and I chair an FMCG business in the Middle East. And the talk of the town there is what's happening with digital and channel shift and disintermediation.

I was in Australia a couple of weeks ago, same conversations going on with the same people there because we've all seen what's happening here with Booker and Tesco, with Sainsbury's and Nisa. We've seen what's happened with Amazon and Whole Foods. We've seen what's happened with Little. I think they opened their first store in the States or are about to. Aldi really pushing on there.

So, the world is really, really moving. And I think this is very exciting. I’d much rather work in a world where there is plenty of change going on, and our opportunity is to make sure that we are well-placed to take advantage of that change.

So, without any further ado, I’m going to hand you over to Duncan.

Duncan Tatton-Brown

Thanks. Thank you, Stuart. Good morning, everyone, and welcome to our interim results presentation for the first half of 2017.

The format for today is consistent with previous presentations, and I'll cover the financials before Tim takes you through a strategic update and then we'll be open to questions.

We've continued to grow strongly ahead of the online grocery market and much faster than the overall market. The market is now seeing increases in selling prices, driven by cost of goods inflation resulting from a falling Sterling and also perhaps from a shift in emphasis by the major players as they try and improve their profitability.

We made good progress on our operational efficiencies, not all of which is apparent in our reported numbers due to the impact of opening capacity at Andover.

We've invested in new capacity, scaling Andover and progressing well at Erith. We also grew our capacity in our existing mature facilities, at the same time as heavily investing in the new platform, particularly in technology.

And finally, we've recently refinanced the business with a longer-term, cost-effective capital structure, giving us the flexibility to continue to invest over the coming years.

So, on to a summary of our financial results. As you will have seen, our results for this year are for 26 weeks rather than 24 weeks in the prior year. As a result, we've shown here a comparative 26-week basis for last year, and that's how we'll do the rest of the presentation.

Note that it also happens to be the case this year that we report 53 weeks, so we'll have the suitable 52-week comparison again at the full-year results.

Revenue, which includes the benefits of the Morrison's agreement, grew 12.5% to over £710 million. EBITDA grew slower, up 2.7% to £45.2 million, and I'll go on to details in this in a moment.

Interest costs were down slightly due to lower interest charges for MHE JV Co.

Depreciation was £3 million up on the year, largely as we started to appreciate Andover and its related software and fulfillment developments. This depreciation started from the point when the asset was considered in use a few months after we first started delivering to customers. I would expect to see our total depreciation to be £15 million pounds higher for the year from both Andover opening and the continued development of our technology platform.

As a result, profit before tax and exceptionals was £7.7 million, down on the prior year of £9.4 million on a 26-week basis.

Retail revenue grew in line with total revenue, up 12.5%. Operating contribution, which is EBITDA before the impact of our arrangements with Morrisons and before central costs, grew faster, up 13.5%. And I’ll cover operating contribution and central costs later, but it's worth commenting on Morrisons.

Our fees from Morrisons at the moment only relate to our original arrangement as we have not yet received fees for providing store pick capacity or for capacity in Erith as neither were live.

The fees grew slower than our overall revenue growth as some of the fees are fixed in nature. The small elements of the fees are charged on the costs we incur on their behalf and these grew faster than our overall revenue growth, but have themselves slowed as we're operating Morrisons share of capacity at a level close to its capacity limit.

Finally, the impact to the MHE JV Co on EBITDA was lower than in prior years as this comes from the payment by Morrisons for their share of the lease payments that we paid to this joint venture company. These will continue to decline as we're not spending much to maintain Dordon, which you'll see later.

So, as a result of central cost growth and the Morrisons impact, EBITDA grew slower, up 2.7%.

So, on to retail performance. Retail revenue was up 12.5% on the year, continuing our trend of double-digit sales growth and we believe running well ahead of the rest of the online grocery market.

Total orders grew faster, up 15% with Ocado.com up nearly 13% and with strong growth from our destination sites, particularly Fetch and Fabled. Ocado.com order growth was matched by our growth in active customers.

Since the second half of last year, we've modified our customer acquisition strategy, generally reducing the amount of discount that we offer, with the aim of increasing the retention rate of new customers.

This is working and we're seeing better dynamics with stronger growth in loyal shoppers, alongside a fall in the number of the more expensive first-time triers.

It's also worth noting at this point, we only include in active customers, those customers who shop at Ocado.com. We're gaining customers, particularly for Fetch and Fabled websites who are not yet customers of Ocado, and so we're creating a further mechanism to acquire new customers for our overall business.

Overall basket size declined 2.3%, partly due to the very strong growth of destination site orders, which – although growing – are smaller. The decline of the Ocado.com basket was due to a decrease in the number of items, partly as a consequence of increased share of loyal Smart customers and from growing mobile penetration, both of which lower basket sizes, but lead to more total spend.

But the new factor in basket size was a reduction in the amount of multi-buy promotions that we ran, partly as the market moved away from them, but also out of choice as these were often unfunded and impacted margin.

Offsetting these declines in number of items we saw in the second half of the period an increase in the item prices as we followed the market with selling price increases. And the change in selling prices can be seen here, with a sustained period of price deflation of the last few years now over, although there's some way to go before we get back to where prices were.

Our gross margins grew for the first time in a few years, up 60 basis points, partly due to this price inflation, but in addition we benefited from the reduction in our promotional activity, particularly for multi-buy promotions.

We've also worked hard on a further tightening of our operational processes, which has led to a variety of savings from lower customer refunds for damage to less credit card fraud.

And we continue to work closely with our suppliers to provide them opportunities to improve their sales in our business and have again increased our supplier income up 20 basis points.

On to the efficiency of our existing operations. Our mature CFCs continued to improve in efficiency with UPH again increasing up over 3% to 164. Dordon is now regularly operating over 180 UPH.

Delivery efficiency also improved with drops per van up 2.7%. As our delivery catchments remained almost identical, our growth results in increasing customer density, and this alone improved DPV, but we continue to look for further gains from marginal improvements in our routing software.

We also benefited from an increase in Sunday deliveries, which improves our utilization of the van, and so reduces CapEx over time. This part of the improvement does not on its own improve labor efficiency and comes with some higher wage premiums.

Wastage cost remained low at 0.7% of revenue, which we believe to be an industry-leading level. We would normally expect an increase in waste when we open a new CFC. As many of you know, we're currently shipping product picked from our Dordon CFC to supply inbound product for Andover, which means that we significantly reduce the additional waste cost incurred at low volumes. This is very good for waste, but it does have a modest impact on delivery costs, as you'll see in a moment.

So, as promised, I wanted to come back to retail operating contribution. This increased slightly, up to 10.1% of revenue in the half. The primary driver of this was the increase in gross margin and the supplier income, up by 80 basis points.

Operating costs for trunking and delivery were 30 basis points higher, despite the improvement in DPV. This is due to both high wage rates from national living wage pressures and the higher mix of Sunday premiums, and it's also due to the increased trunking costs for bringing inbound stock from Dordon to Andover. Overall, we're saving more in waste than we're incurring in additional trunking.

CFC costs increased, also by 30 basis points. This was primarily due to the impact of Andover, which is operating at lower productivities as it scales and currently has higher fixed cost of operation as a percent of revenue.

The CFC cost for Hatfield and Dordon were lower as a percent of revenue as the efficiency gains offset the impacts of cost inflation. There was also an increase here due to the cost of the Fabled store.

Central costs grew faster than revenue, increasing from 4.9% of revenue to 5.1%. This was all due to increased costs of technology and fulfillment development as we continue to innovate and improve our platform.

We grew the size of our technology team to nearly 1,000 people, who are based in the UK and in four development centers in Europe, and we also grew our engineering team.

We spent £74 million of CapEx in the first half with £60 million of it on growth in capacity and innovation. Half of this was on our new CFCs at Andover and Erith and with the other half on technology and fulfillment development. Our guidance for the full-year is unchanged and we still expect to incur around £175 million of CapEx.

Now, after the end of the period, we refinanced the business to take advantage of the historic low costs in the public debt market. We issued £250 million, seven-year bond and now have a low-cost, longer-term capital structure with increased flexibility.

As a result, we're in the process of reducing our existing debt obligations. Given cash deposit rates, we'll incur a higher interest charge over the next 12 to 18 months. But in the longer term, the structure should mean lower cost than would've been the case with our previous facilities.

The bond was six times oversubscribed and priced below expectations, which I think further indicates the strength of our business model. We believe it makes sense to invest on our business because it can generate very attractive longer-term returns.

And to help demonstrate this again, I want to show you the returns from our CFCs. At the prelims in February, I showed you the expected return on investment from our new capacity, showing greater than a 50% return for our fourth CFC in Erith. This is shown here again, in summary form, on the left of the slide.

Today, I wanted to highlight the cash generation from our mature CFCs, something that was readily evident to debt investors during our recent financing.

The approximate revenue that we generate from our mature CFCs, Hatfield and our share of Dordon, is £1.25 billion. You saw earlier that we generated retail operating contribution. That is EBITDA pre-overheads of 10.1% of revenue.

I won't adjust this for the negative impact of Andover in the first half. And so, conservatively, we generate £126 million of contribution from these CFCs each year. The CFCs are in good condition. We maintain them with engineers on site 24/7 and we don't incur a significant capital cost to replace assets.

This year, we'll only incur £5 million and we don't expect this to change over the coming years. So, you'll see that generating the impressive cash flow return each year of close to 10% of revenue.

Note that this year Andover is a drag on performance as we're operating a fraction of its capacity and not at end game efficiencies, so it will impact EBITDA this year by between £5 million and £10 million. This is temporary and it will be a positive contribution next year.

So, in summary, we continue to grow strongly, gaining share in a competitive market. We've continued to improve the quality of our model as we improved efficiencies and operated at lower leakage.

We've invested heavily to build new capacity and to further improve the quality of our platform.

And finally, we have adequate resources to enable us to continue to invest with confidence.

Thank you. I’ll now hand over to Tim.

Tim Steiner

Thanks, Duncan. Morning, everybody. So, the highlights. Our strategy remains as it was before, driving growth, maximizing efficiency and utilizing our proprietary knowledge. And we're applying that constantly both to our own retail business and to our solutions business.

So, we're trading well with all of the brands – Fetch, Fabled, Ocado and Sizzle – in a competitive market. We're driving continued efficiency gains, as Duncan has walked you through. And we're now scaling up the Andover CFC and continuing to develop Erith for an on-plan opening next year.

In our solutions business, we have, obviously, grown the Morrisons business. We're continuing to invest to build further competitive advantage. We've announced our first international partnership and our general merchandise business announced another brand, Dobbies, to be utilizing their platform.

Our platform and online grocery is taking market share. So, if you looked across the UK online sector, Tesco, Asda, Waitrose and Sainsbury's have all been losing market share. We are second in the market share gains, second to Morrisons running on our platform. So, Ocado and Morrisons, the only two brands growing their market share in online grocery.

Our own trading now at a 14% CAGR over the last five years, so continued strong retail growth. But some new information here just to explain. Even in our most developed and mature markets, we're continuing to see double-digit growth.

So, if you look at the chart on the right-hand side, this is postcode sectors where we have penetration under 1% of sales. And where we're delivering to less than 1% of the households in a week in the left-hand bar. In the middle bar where we're delivering to between 1% and 5% of the households in a week.

And then our strongest areas, in the right way, where we're delivering to more than 5% of the households in a week, which peaks somewhere in the mid-20%. So, there are some postcards in the UK where we're now delivering to nearly one in four, one in five households every week.

And what you can see there is, even in the greater than 5% penetration households, we still have double-digit year-on-year sales growth. So, to any question of the addressability of the market, the total size of the market, you can see that even in the most mature areas, where we are at more than five times our average penetration, we're still growing at more than 10%.

And that's because we're continuously working on improving our customer proposition in the same areas. We always discuss in service in terms of accuracy and on-time orders, and I think here we've got some new data from trust pilot, showing where the average of ours and Morrisons ratings, a significant multiple of the grocery – rest of the grocery retail sector.

You can see also, we're continuing to increase our range, while the sector is decreasing range. And the highlights of this period were launching the Harvey Nichols shop in-shop in our site and listing their products.

We continue working with a number of the small suppliers and we have a portal for them to find it easier to come and try and get listed on Ocado as well as having a competition to find the year's new supplier.

And the winner this year was The Garlic Farm from the Isle of Wight and there's a couple of vodka products at the bottom there.

Price is, obviously, always an important factor with our customers in the general sector, and so we continue running the low-price promise and our Smart Pass.

We also introduced personalized coupons, working with our suppliers this year, enabling our suppliers to offer personalized coupons to specific customers and making it easy for those customers to redeem that incremental value by just adding the item to their trolley without having to input any extra detail. So, individualized and personalized coupons.

We launched with Vitality – enabling Vitality customers to offer special discounts to their healthy eating customers, obviously to improve their risk profile, and just we continue to decrease our average delivery income – average delivery charges over the course of the period.

Making good progress in both capacity and efficiency in our mature CFCs. So, I think Duncan showed you the efficiency there, but you can see here, over a five-year time period, moving up from just over 100 to – in the mid-160s now in terms of mature CFC efficiency and continually over 180 UPH most weeks in Dordon.

But also, we increased our throughput in our mature CFCs by over 10% in the first half. We're now regularly in the mid-160s in Hatfield. I think this time last year, we told you we could take Hatfield to 150 orders – 150,000 orders per week and we're now regularly actually at 165.

We've taken Dordon to over 190,000 orders a week. And we believe that we will take it up towards 200,000. So, continuing to get more capacity out of our existing warehouses as well as more efficiency.

With our new CFCs, Andover is scaling as planned. We have now increased the bot numbers from when launched the site to today by circa six-fold. So, we now regularly have north of 300 bots operating on the Andover grids.

We continue also increasing, obviously, the order volumes that that’s shipping. And you can see that the order volumes are actually increasing at a faster rate than the bot numbers on the grid as we continue to get better efficiency from the fleet that we are operating, as well as operating a continually growing fleet. We continue working on the value engineering of the solution, so that we can build it for less money in the future.

And the build-out of Erith is progressing well and Erith is due to open in 2018.

In the solutions business, things are progressing. We announced our first international partner after the half year-end. We continue to develop the software at a great rate. We continue to be in discussions with multiple retailers and have an increasing number of live discussions and continue to believe that we will sign multiple deals in the medium-term.

We saw very strong growth at morrisons.com. And as you saw before, they were the fastest growing market share in the UK online sector. We've continued to give them more capacity as we've managed to scale more volume out of the Dordon facility.

Morrisons have taken the incremental volume 30% of Erith, once that goes live in 2018, and have just started their live testing with real customers of our new store pick solution.

We are investing very, very heavily at the moment in innovation. We're investing across all of these sectors, automation and robotics, data science and AI, big data and the cloud, and the Internet of Things.

We are not just investing in the robotic – the swarm robotics solution inside our warehouses. We're investing on the future automation of the picking and the tow handling in those warehouses. We're investing in automation in terms of the deliveries.

We were involved in a driverless trial last week in Greenwich, of making deliveries using a driverless vehicle. We're doing a lot of work behind the scenes on the data predicting customer orders, predicting volumes that will enhance our own ordering capabilities to lower waste in the future, improve our availability.

So, there's just a hoard of innovation going through our business and a significant amount of investment on it that we believe will, in the future, improve our solutions for our retail customers, improve our solutions for our retailer customers, as well as improve our operating efficiencies and reduce our capital requirements.

So, in summary, it's been a busy period for us of growth and investment. We continue trading well in a competitive market. Our model is driving continued efficiency gains. Andover is scaling and Erith is on plan for opening next year. Our first international partnership was announced. We continue to enable strong growth at Morrisons.com and we're continuing heavy investment to build for further competitive advantage.

With that, Duncan will take the difficult questions and I'll take the easy ones.

Yeah?

Question-and-Answer Session

Q - Andrew Gwynn

[Indiscernible].

Tim Steiner

It depends which one of us you want to ask it to.

Andrew Gwynn

[Indiscernible].

Tim Steiner

Okay.

Andrew Gwynn

It's Andrew Gwynn from Exane. The easy one for Tim then. So, Whole Foods, discussed.

And then, for Duncan, the more difficult I suppose – it's not that difficult really – but gross profit performance, clearly, very, very good. How much do you think we can extrapolate going forward, how much do you think is down to the market?

And could you – it's optimistic – but maybe split out the moving parts in terms of I think 60 basis points broadly what came from changes in your sort of refunds and all the other things that you listed. Thank you.

Tim Steiner

I think the question was, what do we think of the Amazon/Whole Foods move. Was that the first part of it?

Andrew Gwynn

Yes. I’m just opening a door to you…

Tim Steiner

I think that we've already seen that it has just livened up the debate about channel shift in the US. So, interestingly, over the last few years, it's apparent that the US grocery sector has been less focused on channel shift and less of believers in channel shift and the ultimate size of the online grocery market than we've seen in Europe and the rest of the world.

And I think that Amazon's move has possibly changed some of that perception and accelerated some people's thinking out there. And so, I think I see that as an opportunity for our solutions business.

Duncan Tatton-Brown

So, in terms of visibility of margins going forward, and I think I’ll take that as overall margins, both gross and profit margins going forward, first of all the headline gross margins, the leakage improvement that we got in the first half, are we still working on that, might there be some improvements in the second half? Yes, we would hope so.

And it's not from one particular thing. It's from a host of – hundred-plus different initiatives just working on the real, real detail. How can we grind the next little bit of opportunity? So, I gave you a couple of examples there. But that should continue in the second half.

The pricing dynamic, I think, the answer will be the same as it always should be for Ocado, as we are a price follower. So, if you want us to give you a real forecast on gross margins, we need you to give us a forecast of what is going to happen to the industry because we're going to decide to follow.

Our expectation is that the industry is relatively low profit margins and can't afford a price war. I think that was proven to be correct in the first half and is probably likely to be the case in the second half. But we will continue to follow.

And I think what Tim has shown and what we've shown over the years, you should expect us to continue to drive efficiency gains in our operations going forward. We've done it over the last five years, more than five years, and will continue to do that.

And last point, I did give you the flag on the Andover impact for the year, so you’ve got a sense of that across the year.

Andrew Gwynn

Sorry, [indiscernible], just the labor costs. I mean, clearly, there's a Brexit type impact. A lot of your employees are effectively from outside the UK. Do you think that’s particularly material? Have you felt it yet?

Tim Steiner

I think we've seen now two or three years of wage inflation, which was running ahead of goods inflation. It looks like it's more in line now with goods inflation, which is back to the kind of more of the normality. We haven't seen any particular kind of shortage or lack of availability of labor post-Brexit. Haven't seen any material change.

Andrew Gwynn

Thank you.

Tim Steiner

Go ahead, Stewart.

Stewart McGuire

Good morning. Stewart McGuire, Credit Suisse. Three very easy questions for Tim.

Question number one, when do you expect to direct-ship to Andover, i.e. move away from shipping from Dordon?

Question number two, what are the statuses of your patents, and you’ve got a lot that have been filed, but none have been granted so far? Is that according to plan? Just not clear [pb] on that.

And then, third question, can give us any idea on Smart Pass growth and overall percentage of Smart Pass for your active customers?

Tim Steiner

So, you thought they were all easy questions, but let me explain.

We are direct shipping to Andover as well as shipping from Dordon. So, in our mature CFCs today, we have 90% direct ship approximately and 10% actually comes from the Waitrose RDC.

So, that enables us to take – where a supplier insists on full trailers or full pallets or layered pallets, we're going to manage to get 90% according to the suppliers' rules, we would take 10% case pick through the Waitrose RDC.

What we've done in Andover is that we increased it to free options where we can take full pallets from the supplier, we can take cases from Waitrose now on-route – what we call Route C within our business – and we can pick singles from Dordon and ship those down.

And so, there is not a single date where we just turn one off and turn the other on. It's actually a constant move where we just – every single week, we take more direct, we take more from Waitrose, and we ship less from Dordon.

But it may be that, in the long term, it's always worth taking some small amount of the tail and that that would lower our overall stock holdings in the business to pick a small amount around our CFCs and move them between them.

Moving on to the patents one, I think the best thing to do, if you want to look at the state of the patents, is go to the UK patent office website. And I think from the last time I checked, I think the number is four that have actually been granted – six that have actually been granted, I’m reliably told from the back corner, and we've filed over 50 families of patents, some of which are published, some of which are not yet published.

But patents take a long time to move from filing to publishing and then to granting and there's a lot of toing and froing in that process. So, we're very much, I think, on plan and where we would expect to be. And I think we filed a lot of protection around what we think is a very unique set of innovations on our solution.

And then the Smart Pass one, I think we have said that Smart Pass penetration is continuing to grow. It's a number of years now since we told you that Smart Pass have reached less than half the customers, but more than half the orders. And it's continued to grow each year year-on-year from there.

So, I think what we could say is it's a fairly significant majority of the orders are placed by a large minority of the customers, but we don't go into specific numbers.

Sorry, there's two. Bruno.

Bruno Monteyne

Good morning. Bruno from Bernstein. My first one is on the retail growth. And I know that your weekly order growth has declined from about 17%, 18% down to 14.5%. At the same time, your marketing spend has accelerated, growing at twice the rate, at about 26%.

So, the order growth is slowing down. It's getting hard to get by with higher marketing spend. Should we expect a further decline in the weekly order growth from the current 14.5% in the second quarter to closer to 10% in the next few quarters?

Tim Steiner

I don't think so. So, I think we're seeing very consistent growth in the second half as we saw in the first half. And I think our marketing spend – because we break that – so, as we play with different methods of marketing, and we always actually disclose both the above-the-line and voucher and marketing costs. And I think it's been between 2% and 2.3% between the two of them for the last five years. I don’t expect it to break out of that area. So, I don't think that marketing is going to change and I don't think the customer growth is going to change either.

Bruno Monteyne

And then, my second question is on the deals, I did notice that you called it platform partnerships in this release rather than deals before in the press release. Does it say something about the nature of the deals, what we should think about them, because also you said there was zero impact on profits and cash generation from the first…

Tim Steiner

Can you just ask me the first part of the question again?

Bruno Monteyne

So, reading the press release, when you're talking your – expecting – in the past, you called it expecting multiple deals.

Tim Steiner

Okay.

Bruno Monteyne

This time you called it multiple platform partnerships. Is there any meaning in the change in the wording, given also the low revenues and cash generated from…?

Tim Steiner

I don’t know there's any difference in the wording. No. And I think that, as we stated about the Morrisons transactions, the way we're structuring these is that most of the payments will occur post go-live or at go-live. And therefore, as in the first half, we didn't go live either with Erith or with store pick, and our new customer is going to go live – hasn’t gone live immediately, then there's no change or there's no impact on either revenue or profitability.

Bruno Monteyne

And when will they start impacting this first international deal?

Duncan Tatton-Brown

I think we stated the last time that it would be earnings neutral for this year and next year. So, we haven’t said when they would launch because that’s actually up to them. And the fees that we might earn in the first two years, we might also utilize to upweight our capabilities in this space. Our confidence, if anything, is getting higher, and therefore we'll continue to invest in that.

So, actually, it's not saying we get no fees from them, but the earnings impact for the business of signing that deal is neutral.

Bruno Monteyne

Thank you.

Duncan Tatton-Brown

The next deals.

Tim Steiner

And we'll keep passing it around.

James Tracey

Hi, Tim. Hi, Duncan. James Tracey from Redburn. Two questions from me. The first one is on consensus EBITDA. Bloomberg saying £94 million for the full year, which would imply £49 million in the second half, which is 23% growth versus 3% in the first half.

So, I know there's an extra week, which would be about 4% on EBITDA. Is there a reason to expect a big acceleration in the growth rate in the second half EBITDA versus first half?

Second question is on this agreement with Morrison to do store pick. Could you please quantify the fee income you receive and the CapEx and OpEx that you're incurring to develop that? Thank you.

Tim Steiner

I’ll let you speak about consensus.

Duncan Tatton-Brown

I think we're comfortable with consensus. I don’t think there was anything particular in the release that people can pick up and say, well, there's a sign that I need to change consensus. So, we're relatively comfortable. I’m going to get into the details of that, how we're going to get to EBITDA consensus because it's not right for me to give you a sales number or a margin number or anything like that.

Are there any explanations in the second half? You've already picked up one. That’s the fact – that’s the 53rd week. I think the other thing I would flag to you is look at the two-year like-for-likes. For example, order growth. So, the two-year like-for-likes have been very strong in the first half of the year. So, if you look at what happened last year in the second half versus – so that might give you a clue. Anyway, we're comfortable where the market is from a consensus perspective.

James Tracey

And do you see £94 million as a consensus?

Duncan Tatton-Brown

There's always the question on consensus of who has actually updated their model and therefore should be included in consensus. And I would encourage many of you – some of you in the room to make sure you’ve updated model. But those who have updated their model, I think that's a reasonable consensus, yes.

Tim Steiner

I’m not going to answer your second question because, clearly, we did announce all the details of the first Morrisons transaction because it was a class one transaction. We had to put a prospectus out and get shareholder approval for it. But it's clearly not commercially sensible for us to outline the full details of every commercial transaction we enter into with partners. It would destroy any negotiating ability we had in the future. It's just not a sensible thing to do.

I think we've been fairly clear to say that, in a platform software solutions business, we would expect to earn higher margins in the medium to long term than we do in a retail business.

And I think we've also been fairly clear to say that the percentage of capacity or the percentage of total transaction value would, obviously, be much lower in a store pick model than it would be in an automated model because we're only providing software and solutions rather than a significant amount of physical infrastructure as well, of which we own the IP to and, obviously, generate the manufacturing scale, etc.

So, it's a positive transaction for us to enter into. We think it's both revenue and earnings accretive over time, but we're not going to get into the detail of it.

James Tracey

Could you say – in five or ten years, could it be tens of millions or less than 1 million? Can you give…?

Tim Steiner

I mean, it depends on the amount of – volume of what Morrisons put through. If you're talking about just Morrisons running it, if Morrisons put through billions of pounds of sales on it in ten years' time, then it could be tens of millions of pounds. If Morrisons put through hundred million pounds of sales through it, then it could be less than £1 million.

James Tracey

Thanks, Tim.

Niamh McSherry

Good morning. Niamh McSherry, Deutsche Bank. I had two questions. Also, the first one is on the Sunday – increased Sunday slots. Would you be able to quantify what that impact was on the order growth? That’s the first one.

Duncan Tatton-Brown

I don't think that has a significant impact on order growth. So, creating greater availability there doesn’t on its own drive more order growth. So, it's just – it's capacity that people can use. If they can't get a slot on Sunday, they’ll order a slot on Monday.

So, by providing slots on Sunday – the design for that was not about driving order growth. The design for that was about utilizing our assets more fully across the week.

Tim Steiner

What we found over time is that, when we started the business, our peak day was 22%, 23%. Today, it's sub 17%. And so, we found, as customers have used our services more, they’ve been less focused on, I want a Friday afternoon delivery, right? Just naturally, we see a natural flattening. And so, when we first started the business and opened Sundays, we used to actually operate half the Sunday and deliver half the Sunday. Then we operated half the Sunday in terms of the warehouse. It's then delivered across the whole of Sunday, but that maximized Sunday to half the volume of Friday. And as demand increased, we saw that we were turning customers away on Sunday, but they were – most of them would then book on a Monday, but it's enabled us to flatten the week out by running the whole of Sunday.

It's also partly that we used to feel that we needed this second shift on Sunday for the amount of the pace of change that we were incurring in the existing facilities because with the infrastructure we use in Hatfield and Dordon, unlike the new infrastructure we have in Andover and Erith, you can't work on it when you're actually shipping orders. So, we usually need the Sunday, half the Sundays to work on the facilities.

But as Duncan has outlined, the facilities are in great shape. They are doing record volume. They are doing record efficiency. And we're spending very little money on them. And that's enabling us to operate them almost every Sunday of the year.

James Tracey

Okay. The second question is on the additional – the increased trunking costs at Andover, which I think is due to the lower direct shipping. As you say, that's changing all the time. So, basically, should we see that change in the second half of this year or next year in terms of a better development on trunking costs?

Duncan Tatton-Brown

What, again, I think Tim was saying is in terms of the products that we're supply into Andover, there was a mix between routes. And we can make decisions this week to move a certain number of products from one source of supply to another. So, it's going to be quite a gradual transition.

If you go back into Ocado's history and look at when Dordon and look at the waste percentage, the waste percentage went up quite dramatically, I think, to 1% or 1.1%.

So, that gives you just a sense of the savings we've made, which is greater than the overall trunking and delivery cost increase. So, absolutely, this is the right thing.

Now, when does that unwind? What Tim is basically is saying is it unwinds gradually. So, I wouldn't expect you to think it could quickly unwind in the second half of the year because we don't expect Andover to be operating at 100% capacity by the end of the year.

James Tracey

Okay. An then the third one was just about general merchandise orders. Of your general merchandise orders, how many of them get shipped with a grocery order if you know the answer to that?

Duncan Tatton-Brown

Roughly a quarter.

James Tracey

Okay, thank you.

Tim Steiner

One behind. Sorry, and then we'll try and get over.

Unidentified Analyst

It's James Locke [ph] from Peel Hunt. I’ve got a relatively open question. You’ve been running for around 15 years now. And I can't imagine the amount of data you’ve collected over that time, but it's surely to be in the ballpark of hundreds of millions, if not billions of pieces of customer preference data through orders actually placed, but also items intentionally removed from baskets and hence not bought.

Can you talk about the data analytics and insight capabilities you are investing in, whether your platform is in the private or public cloud? And if the public, who your provider is?

And how this technology could or is both improving the customer experience as well as yours and your retail partners' businesses on things like pricing and range optimization, the likes of Auto Trader are already doing for cars and are actually charging for? Thank you.

Tim Steiner

So, quite a lot of questions around data there. We store a lot of the data on-prem in our own systems. As we're migrating on to the Small Platform, then we're storing more data in the cloud. Most of the customer data – we in the cloud – our two main providers are AWS and Google, but most of the customer-specific data is in Google.

We do use that data. We use that data and have used that data in increasing amounts across the whole site to drive personalization of our site. We use it to segment our customers, so we can offer them different items in different areas of the site. We use it to customize things like searches, like promotions, like the checkout walk, and stuff like that.

So, we're using it all over the place. We're continuing to use more of it. We have a team of approaching 20 data scientists, all mathematics PhDs, who are just looking for opportunities to utilize data to drive improvements in our customer service, our customer proposition, in our website, in our routing efficiencies, in our warehouse efficiencies to basically just drive algorithms and optimizations across the business.

There are more opportunities to use more of it. We were an early user of some of the new machine learning tools in the Google platform. I think we were mentioned in one of the recent Google's earnings calls as a result of that, where we were using 15 years of accumulated data from our call center in terms of inbound emails and outbound responses to help us to categorize the inbound emails coming in, so we can deal with them more efficiently, particularly more efficiently in terms of the customer response as well as more efficiently in terms of the cost of operating them. And that's just a gradual process of introducing machine learning into the area and into our business generally.

We're a big user of some of the tools in the AWS cloud. And our CTO was one of the speakers at their AWS conference here last week.

And so, analytics and data, you're right. We have a lot. We've kept a lot. Spent more money than maybe we needed to keep a lot even when we weren't yet able to use it, so that we would have that wealth of data when we were able to use it to read rather than then turning something on that learns over time. We can learn from our history even as soon as we write a new learning software. And that’s the general direction.

And then, all the learnings that we have and all the learning tools that we develop can be instantly used by our customers – our retail customers in their own businesses to make themselves more efficient for their customers.

Rob? Sorry. And then I know you’ve got question from the very beginning. We'll get the mic back over and start again.

Rob Joyce

Rob Joyce, Goldman Sachs.

Couple of questions. Firstly, how close to capacity are you guys now? And would you be growing orders faster if you had more of that capacity available to you?

And the second one, one for Duncan on some of the numbers, just on the slide where you highlight the negative impact of Andover this year on EBITDA, when we look to the year ahead, 2018, then we could simply think of that as headwind gone, i.e. the sort of £10 million headwind not there next year. Thank you.

Tim Steiner

The capacity question is a great one, Rob. We are – I think, first 15 years, we've been operating very close to capacity. And it's a constant battle of creating capacity in order to be able to grow into it. And so, sometimes I think people think that you build a new facility, like a Dordon, and you say phase 1 is 120,000 orders. And that means the day you turn it on, you can do 120,000, but it doesn't. It means that you've put enough kit in it that you will be able to scale over a period of time, both as you work out the bugs and intricacies of that kit, as well as hire the people that you will need to operate it to gain to 120,000 orders.

So, where we stand now, I think Hatfield, as I mentioned before, is doing 10% more than we told it was the maximum it could do. And it's probably – there's not much more we can eke out of it.

In Dordon, we are continuing to eke out more capacity beyond the 190-odd-thousand order that we've reached, which again is already beyond the 180,000 we said it could achieve and we're also scaling up Andover.

And so, no, we're not sitting with 5% or 10% excess capacity tomorrow that we could sell if any of the customers would come in. We're literally very, very finely balanced between our acquisition and our capacity.

Having said that, if you gave me 10% tomorrow, I couldn’t guarantee – I haven’t got a clue. I’m not like the Hard Rock Cafe in 1990 with a line outside waiting to come in. But we do match our marketing activities to the amount of capacity we think we can generate. So, we tell our marketing department the most we can do next week is this and then we go and do something plus or minus 1%, 1.5% of that number.

And, obviously, within each week, we try and get it exactly right. So, I think if we had more capacity, we would be more active and probably be able to grow at a faster pace.

I mean, another way of looking at it is, in 15 years, we've never managed to create capacity and not sold it.

Rob Joyce

And are you seeing the margin, the same sort of lifetime value of customer versus the acquisition cost, is that still where it's going?

Tim Steiner

Generally, we've seen improvements in that over time. Some of the marketing can slightly cost more, but the – you can direct it more specifically. I think Duncan mentioned before that we've seen slightly less new customers because we've particularly found ways of targeting – within the new customers we were acquiring, we've been able to work out which ones have got higher lifetime values and focus more on those, which means that overall we've got less in, but we know some of the ones that we haven't got in that aren’t in this week's sales actually won't affect next year's sales at all, if that makes sense, because they are the ones that we wouldn't have retained.

And we've been introducing small changes also to try and improve it. So, for example, customers that are kind of very shrewd, shall we call them, looking around to kind of work out and optimize two promotions at once or do something like use an [indiscernible] voucher to buy a product you can only buy anywhere in the UK at our RP [ph].

And so, some days, you would acquire customers who would buy a Phillips Hue lightbulb or something like that. And so, we've changed some of the software to say that our vouchers and discounts and things are for the grocery shopping. They are not to buy general merchandise items and stuff like that.

So, we've done a lot of work there to try and maximize or optimize the marketing spend.

Rob Joyce

Thank you.

Duncan Tatton-Brown

Just on the EBITDA, so assume that the impact from this year is in the base. And now say – assume we took an extra £100 million in the sales out of Andover next year, is the £100 million in sales north of 10% operating contribution because that includes the fixed cost. It's a marginal operating contribution of, call it, 14%. So, £100 million of extra sales is £14 million of extra profit from Andover next year.

So, what you have is, when you add – open a facility, you incur all the fixed costs. And then the sales were on top of it. Of course, Andover itself should also be slightly more efficient next year because it should improve its efficiency, as our first facilities did. So…

Rob Joyce

Makes sense. Thank you.

Tim Steiner

Sorry. One at the very far end. Patiently waiting. Thank you.

Daniel Ekstein

Thank you. It's Dan Ekstein from UBS. I’d like to better understand the movement in gross margin in relation to some of the dynamics we're seeing in the market. So, in broad terms, my understanding would be that you purchase on terms fairly similar to Waitrose, given your purchasing agreement for a lot of the range. Your low-price promise sees you price match Tesco on a significant portion of the range as well.

Now, the inflation data that I've seen suggests Waitrose is pushing through more inflation, quite considerably more inflation than Tesco. And just following one from the other, that would suggest to me that there was risk of gross margin pressure for you by continuing to pursue the low-price promise. And so, has there been any change in the percentage of items that you are sort of matching on? Or is there something else that I'm completely missing here?

Tim Steiner

No. So, our matching policy isn’t to choose what we want to match on. And then, therefore, say, oh, it's a bit expensive this week, we'll match on less. We match on everything that we can match on according to a rule set.

And so, look, I think what Duncan was outlining before is some people think gross margin is your buying margin. Your buying margin is the first thing. Your gross margin is after a number of other costs, right? And we have been working, as he mentioned, to improve some of those costs. And so, that has helped us. I'm not sure exactly what data you’ve looked at that tells you that Waitrose is getting less price competitive versus Tesco. I'm sure if we ask them, they would dispute that. And I'm not sure that they're seeing worse buying terms than Tesco or that Tescos are doing a better job of holding back the line. I don’t know that.

We are seeing relatively stable buying margins and we've done some efforts to improve the other metrics there. And as Duncan mentioned, we've seen slightly – we've got slightly less multi-buy, funded by Ocado promotions because, as the mainstream players, Tescos and Sainsbury's have moved towards more everyday low pricing versus more high/low multi-buy type discounts.

We maybe have been a little bit late to the party in reducing the number of them. So, we've been following Tescos on the base prices, but we're still running a higher level. And I think we're now running at still a higher level than Tescos are on the promotions, but not as much higher as it was for a period at the backend of last year.

And overall, we continue – we shared with some ways – some of the operating metrics and wastage is one that’s above that outline where did see a 10-basis point improvement. But there are other metrics there as well. Duncan mentioned fraud. And there were a number of other ones that we're working very hard to improve.

Daniel Ekstein

Thank you. That was helpful. Just on the unfunded promotional activity, that's kind of a one-time benefit. Is it – I suppose is the question – or is the further to go?

Tim Steiner

I would take it as a one-time. But, obviously, we're constantly reviewing our pricing policy to make sure that we're competitive in the market. And as I say, the market has been trying to move in the last couple of years. We're probably one of the most promotionally-driven grocery markets in the world. And the main players, in light of kind of response to the discount that’s emerging as a bigger force in this country, have been trying to move more towards every day kind of low pricing and have less multi-buy promotions out there. So, it may continue.

Within that, we were under pressure to maintain a similar amount of promotions and in the right categories at the right time, which sometimes we didn't have as much supply of funding as we might have liked to have had and we were funding more of them.

As we gain in scale and importance in the industry, we would expect more supplier support for them. So, we'd hope to be able to move in a positive direction, but I wouldn't bank on anything material.

Daniel Ekstein

You quantified the benefit from wastage. Would you quantify the benefit from dialing back on the unfunded promotions?

Tim Steiner

I don’t think we're going to go into that level of detail.

Daniel Ekstein

Okay. And then, just a follow-up question on Andrew's question on Amazon/Whole Foods, do you think the deal suggests that Amazon and perhaps others have concluded that store pick solutions and having sort of a click and collect type model is the future for online grocery rather than standalone warehouses?

Tim Steiner

Look, I think you'll have to wait and see. I think we can all speculate on why Amazon has bought Whole Foods. My personal belief is they’ve not bought it for its existing store network, but they’ve bought it for its brand. It's sourcing and that type of stuff. So, we'll see how they try and conquer the grocery market, now they've acquired that as well as the existing businesses that Amazon has in grocery. But I don't think that Amazon has figured out that click and collect is the – or store pick is the way forward. I think they just wanted to buy some scale and the brand name in the grocery market, but we'll wait and see. That’s just my perception. I wasn't involved in the strategic decision.

Daniel Ekstein

Thank you.

Tim Steiner

James?

Duncan Tatton-Brown

We've got questions online as well.

Tim Steiner

Sorry, can we take one first before we get back to James?

Duncan Tatton-Brown

So, it's from Francois from Morgan Stanley. It was a question on depreciation. Is it correct to assume that Hatfield is already close to being fully depreciated, while Dordon will probably drop off your books in around full years? Judging by the slide you’ve shown on returns on immature CFCs, clearly, there's a life beyond that. So, I was wondering, if, hindsight, we think that it might be over-depreciating our assets and if this could change in the future.

So, the answer to his question is, yes, Hatfield is quite heavily depreciated, although there are some assets in Hatfield that were bought in the last three or four years. Clearly, they are not depreciated yet. But, no, it's a relatively modest appreciation left on Hatfield.

And when open Dordon, I think I’ve said that the average depreciation life at Dordon would be about eight years, and that’s about four years ago. That doesn't mean that we're half written off because some of those assets depreciated over 20 years and some of them depreciated over three or five. But still, you'd assume that Dordon is fairly well written down.

And is there a question about whether you're being too aggressive in your depreciation – I think that’s a fair question and we will look at it in the second half of the year.

So, that’s that question.

Tim Steiner

[indiscernible] from James.

Unidentified Analyst

Thanks, Tim. Just a follow-up on the depreciation. When did you start depreciating CFC 3. Is it fair that it was halfway through the first half, not at the beginning of the first half?

Duncan Tatton-Brown

Absolutely. If you heard me in my speech, what I said is we started depreciation when it's considered in use. And it's not considered in use when you ship the first order to customers. So, it's considered in use when it's been trading for three months because, in three months after launching any piece of software which is in beta, from an accounting perspective, the first three months, you're changing the software. You haven't launched the live software.

So, it's a similar scenario. We'd operate that in any of our facilities. The day it opens isn’t the day it starts depreciating. We have a three-month window because you continue to refine it. And then it's live. So, depreciation was not six periods of depreciation in the first half. Again, flagging why a £3 million year-on-year growth in depreciation in the first half doesn't translate into £6 million for the full year or flagged it's a £15 million growth across the year in total. So, expect more depreciation in the second half.

Unidentified Analyst

Okay. Just on CFC 3, you’ve got 65,000 orders per week capacity from that and it's now running. So, does that mean we will see a step up in sales growth, given the point that you made earlier about sales growth being driven in large part by the amount of capacity and getting the marketing team to sell it. Can they now sell a lot more capacity?

Tim Steiner

Look, I think what I also explained at the time is, when you turn a facility on – you build a facility capable of 65,000 orders, the day you turn it on or six months later, you're not normally ready to do 65,000 orders. We grew Hatfield last year, which we opened in 2002. We grew it 10% last year to 165,000 orders of capacity, 15 years after we opened it. That's unusual, okay?

But in Dordon, we reached 180,000, which was its original stated capacity earlier this year, in 2017. We opened the facility in 2013. We completed the phase 2 buildout around Christmas time 2014 or beginning of 2015. So, it's somewhere between two-and-and-a-half and four-and-a-half years old and we're probably somewhere between two and four years that we hit the 180,000.

So, if you took the midpoint of that three, then you can see that it's unrealistic to expect us by the end of one year to ramp Andover to its full capacity. It's going to take longer than that.

Unidentified Analyst

Can you say what you expect the growth rate in available capacity to be?

Tim Steiner

We're confident to carry on growing at approximately the rate we've been growing. We've started the second half well. And so, we expect growth to continue at the type of levels we've seen in the first half. And beyond that, we're not going to be spending more.

Unidentified Analyst

Thanks, Tim.

Tim Steiner

If there is no more, I just want to say thank you all for coming this morning.

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