AO World Share Price Tumbles on Supply Chain Worries

AO World Profit Warning: Shares in electrical retailer AO World (LON:AO) fell by around 25% in early trade today as the half-year report flagged up some problems which will affect this years profits. The market is in unforgiving mood recently with many prices being battered, so this reaction could have been worse. The shares fell on open but since have recovered some of their losses:

AO World should be a familiar name to UK residents. A relative newcomer to the retailing scene, in the last years it has gradually ramped up its attack on the home electrical market. The catchy advertising jingle ‘AO, let’s go’ was often commonly heard on TV and radio. They sell items across virtually all of the domestic segments, from computers to mobile phones, to washing machines and kitchenware.

Of course this has become a massively competitive segment and customers have become very price sensitive – made much easier by the existence of product comparison sites. This being said, AO’s very large scale has given them some benefits over smaller competitors. They have made very large investments into their logistics side and this is on a par with Amazon. They boast a very high customer satisfaction rate.

What did the AO World profit warning say? 

This comes out in the half-year figures. These are slightly less meaningful in that there is a second half weighting to results (this contains the all-important Christmas period). The outlook contains some remarks, some of which may have been known already:

At the start of our financial year in April, we planned for continued revenue growth and built up our cost base accordingly. However, since then, growth in the UK has been impacted by the nationwide shortage of delivery drivers and the ongoing disruption in the global supply chain, and the German online market has seen significantly increased competition.

The driver shortage has been well publicised. Effectively companies in different sectors are in competition with each other for this resource, and the most obvious result is higher pay.

As we now look to the second half, we continue to see meaningful supply chain challenges with poor availability in certain categories, particularly in our newer products where we have less scale, experience and leverage. In addition, shipping costs, material input prices and consumer price inflation remain challenging uncertainties.

This also is of little surprise, with semiconductor ship shortages most likely to affect the company. Shipping prices have also gone up by some way. Many products can sell at standardised price points. Passing the cost on to the consumer is not difficult (ie iPhones) but will inflation mean less disposable income?

As a result of these factors, the all-important current peak trading period is significantly softer than we anticipated only eight weeks ago. As a result, we now expect full year Group revenue to be flat to minus 5% year on year, with Group Adjusted EBITDA in the range of £10m to £20m.

That is the most damaging line. With the depreciation and amortisation charge at over £20m this mot likely means a return to statutory loss. We only need to go back to the last trading update to get a sense of the drift. That estimated the same figure to be in the £35m-50m range, which was also downgraded on the previous figures! That can be seen in the share price which has featured poor sentiment amidst sharp steps down. It looks like today will be another of those steps.

AO World: Lockdown winners

AO was always priced fairly extravagantly, and priced for tremendous growth. Growth happened, but the company still incurred losses. This started to really change in 2020. The company wound up its loss-making Netherlands operation and concentrated on the UK. But it was the lockdown period which really turbo-charged company revenues. Their year end is 31 March, so pretty much started when restrictions first happened. This shows the increase:

Revenues jumped to £1,661m – a c.60% increase year on year. This was much ahead of even the most optimistic forecasts at the time. Notably after years of losses, this brought the company to its first meaningful profit, although no dividends were declared. This was also transformational for the balance sheet: debts were cleared and the cash balance jumped to a high of £67.1m at year-end, and no new shares were issued.

However, this was also not unnoticed by the market. From pandemic lows of around 50p the shares stood at over eight times the value at the start of the year, putting the market capitalisation at over £2bn. The narrative had changed in the space of a few months from a company that was going to go bust to one that had a great growth runway ahead. What happened in these few months seems quite obvious in retrospect. Many people in the UK were forced to stay at home, and had a level of income higher than before due to reduced expenses. For some others home working meant that upgrades to computers were needed.

As the company points out, it provides a great service as evidenced by their net promoter/Trustpilot scores. I have used this myself and can confirm that the service is really good – purchasing a computer off AO is actually a little better than Amazon (if you can ignore their spammy calls to upsell warranties). However, a good business is not necessarily a good investment.

In terms of solvency, the situation is much improved although the company is heavily operationally geared. This means that it has relatively high costs which do not flex in downturns. The main items of this will be the leasing costs for warehouses and the staff to fill them. In part I think this has been a factor in the rapid improvement of share price rise and fall: the cash balance highs of March have now declined and borrowings have come back. This cycle of cash is common for companies which have seasonal variations in trading. The trading note remarks on headroom from its credit facility of some £65m. Given the share price movement it would have been more prudent to raise capital when it was above 400p.

Two businesses, one company

Some of the results hide the fact that its European businesses has cancelled out the UK performance:

To put in a nutshell, the UK makes money while Europe loses it again. For a few reasons it may be simple to see why this is the case; AO has invested heavily into the UK and has established a good reputation and brand awareness. Breaching into new markets involves a lot of setup costs and marketing activity, which is also costly to write off. The bull case seems to be – what if Germany could become like the UK, as it is a country of similar size? That seems to be a big unknown though. With this half-year in Germany still loss-making it appears that more time is needed.

Is the AO World profit warning a buying opportunity?

CEO John Roberts owns a large stake in the business (over 20%). He was another beneficiary of the terrific year, unsurprisingly hitting all the targets required with the variable pay element at 300% of pay. This quantum in both percentage and value appears slightly on the generous side to me considering that very little value has been delivered for shareholders.

AO World seems to me to have some similarities with some other companies that recently warned on profits. Much like Best of the Best, it does seem that lockdown has put a rocket under their sales due to people having more time and money. This growth has ended, and it may be an uphill battle to prevent revenues from shrinking. Thus when looking at profit figures it should be the case that 2021 is an anomalous year.

Also much like Purplebricks this is a tale of two businesses: one trading profitably in the UK let down by loss-making overseas businesses. I am not familiar with the German market at all, but a quick search shows they are 24th in revenues whereas they would be one of the top in the UK. Having already withdrawn from the Netherlands, one must wonder if Germany may go the same way. The bull case is obvious, that if the headwinds continue to be favourable and Germany becomes another UK this may end up being good value. However I am sceptical of that; favourable conditions produces more competition. There is little to stop places like supermarkets selling laptops.

One of the biggest problems I have is that the business is just not very attractive. Margins are very slim and the profitable bits are the ancilliary revenues such as insurance and servicing. AO have very little pricing power – if they raise prices people will just go to the place that is cheaper. And whilst everything was in its favour last year – a time where people could not visit physical shops – there seems to be quite a few things that will be problematic next year. There is no furlough or government support anymore and people’s incomes are likely to be less in real terms due to increases in costs, notably energy. A return to normality (with people going on holiday again) is likely to reduce disposable incomes.

Another thing is that wage costs are rising quite steeply. AO had almost 4,000 employees in the last year with an average wage of under £37,000 per annum. Many of these workers will be close to minimum wage. This rose by over 6% in the last year. Next year’s rise may just be as big if inflation sticks around. Truck driver wage increases are likely to be larger than this. But these rises are permanent and are unlikely to unwind. Staff shortages may also be an issue. At the minimum wage end, warehouse workers are also potential supermarket workers or shop workers. So companies may find themselves paying more than the mininum to attract workers, and more importantly keep them.

AO had a wage bill of £145m last year, so with little pricing power it could be the case that all the increases drop to the bottom line. With very thin margins on products there doesn’t seem to be much room for error here.

So whilst the immediate future is secure I am not really convinced that long-run it will turn out well. Cuts to save money end up worsening customer satisifaction rates. That is not to say the shares could ever become good value, but at this price I am not tempted. 1/5.

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