Sunday share tips: Ocado, Drax

In the ‘Inside the City’ column for the Sunday Times, Simon Duke was warning against predicting the future too confidently - specifically pointing to Phil Dorgan’s declaration eight years ago that Ocado was worth zero.

Today, investors have valued the grocery delivery firm at £5.3bn, after it announced a mammoth alliance last week with the second-largest US grocer Kroger.

Ocado’s robot warehousing tech will be used to construct up to 20 automated distribution centres for Kroger in the US over the next three years, with the Americans also taking a 5% stake in the British company.

It’s the biggest out of recent deals involving Canadian and Swedish retailers, and French supermarket giant Casino.

Duke said the deal settled the years-old City question of whether Ocado’s tech was worth the share certificates it was staked on, or whether it was just another grocer with thin margins.

“The deal is a mighty endorsement of Ocado technology and should put to bed arguments over Ocado,” said Mirabaud’s Neil Campling.

Founder and boss Tim Steiner has made no secret of his massive investments in Ocado’s technology - now protected by two dozen patents - since he launched the company in 2000.

Apparently, robots at its Andover facility travel up to 60 km each day, can pack a grocery order in five minutes, and leave Amazon’s automation aspirations for dust.

But the bears were still asking when Ocado will give shareholders the long-promised meaningful cash flows, Duke asks.

While it does take a slice of all revenue generated at the warehouses powered by its tech, it still needed to stump up at least part of the £30m required for each facility.

Thus, each time a new licensing deal is signed, the promise of profits is shunted farther into the future.

Duke said it seemed reminiscent of concerns which used to plague Amazon, when its retail side was still hemorrhaging money and before its cloud computing megabet reaped rewards.

“But the comparison is imperfect,” Duke added.

“Amazon’s tentacles have spread into almost every corner of retail - and beyond.”

Ocado, by contrast, operated almost exclusively in groceries, which Duke called an “unappetising arena” characterised by its skinny margins.

“Time to take profits.”

Over in the Mail on Sunday, Joanne Hart was looking at government targets to reach 30% renewable energy as a share of total production by 2020 in her ‘Midas’ piece, claiming that Drax was in the right place to drive such change.

She said its shares - currently around 350.25p - should head north as the firm’s renewables business and related divisions developed.

Drax also maintained its commitment to rewarding investors through dividends, buybacks and one-off payments, giving the stock an appetising yield.

The company was founded in 1967 and spent most of its first five decades as a coal burning juggernaut, before undergoing what Hart called a ‘transformation’ in the last six years.

Of its six generating units at its headquarters in Selby - all of which used to run on coal - three were now burning wood-based biomass pellets, with a fourth undergoing conversion to biomass and the remaining two expected to shift to gas burning from coal.

Turning biomass into energy required huge amounts of the fuel, with Drax getting through seven million tonnes last year, with just over a fifth of them coming from its own American production facilities and the rest coming from external suppliers, also primarily American.

Hart said Drax mainly used US suppliers as the scale of forestry there was far greater than this side of the pond.

Additionally, the felled trees are replaced immediately, with the amount of carbon absorbed by new saplings much greater than that absorbed by older trees - enough so for Drax to qualify for renewable energy subsidies.

CEO Will Gardiner was reportedly keen to increase the share of pellets produced in house to 30%, both by making the existing facilities more efficient and by purchasing more capacity.

Production was ahead 35% last year, with Hart noting that as the company made more and more pellets in house, its profit margins should improve - a particular help given the expected withdrawal of renewable energy subsidies by 2027.

Beyond its generation activities, Drax has an energy supply business which focuses on large industrial users, which has been growing fast and was looking to fire up four possible new gas-fired power stations around the UK.

It was planning to use these plants as flexible generation options for the National Grid, ready to be fired up at any time should the more variable power sources such as solar and wind fail to meet demand on any given day.

Earlier in the year, however, Drax withdrew from the auction for flexible energy supply in 2021 and 2022 as the prices were deemed too low.

The next auction will be held in the next 12 months, but Hart said Gardiner would only go ahead with the flexible generation plants if the economics were there.

Otherwise, cash would be returned to shareholders.

Analysts were picking a 9% improvement in underlying earnings this year to £250m, then rising to £300m in 2019.

Its dividend was expected to grow to 14.2p this year from 12.3p last year, and again to 15.6p in 2019.

“Drax is contributing to the UK’s renewable energy future and delivering for shareholders at the same time,” Hart said.

“A good, long-term buy, with generous dividends too.”