Shares in Ocado Group (LSE: OCDO) and TalkTalk Telecom Group (LSE: TALK) bounced nearly 10% higher when markets opened this morning, after both firms issued trading updates.
However, these early gains soon started to fade. In this article, Ill explain why I think both companies have problems and deserve sell ratings.
Ocado
Ocados pre-tax profits rose by 65% in 2015, from 7.2m to 11.9m. This sounds impressive, but Ocados 1,566m market cap means that the groups shares are still trading on a trailing P/E of 133!
Even assuming that Ocado meets forecasts for earnings per share growth of 50% in 2016, the shares will still trade on 88 times earnings. That seems too high for a business with an operating margin of just 1.9% and no dividend.
The second problem for Ocado is that it doesnt seem able to generate economies of scale as it grows. For example, total revenue rose by 16.7% to 1,107.6m last year, but the groups total distribution and administrative costs rose by 19.8%.
The big problem is that this is a very capital-intensive business every extra sale or delivery costs Ocado money. This is different to a bricks-and-mortar shop, where if extra customers visit, overheads remain the same and profits rise.
Indeed, the impression I get from todays results is that Ocado wouldnt be making a profit at all, if it wasnt for the 18m of fees charged to Morrisons last year.
Ocado is still trying toattract additional customers for its home delivery business, but so far this hasnt happened. Even if it does, Im not sure the profit potential from another customer like Morrisons would be big enough to justify Ocados valuation.
I rate Ocado as a sell.
TalkTalk Telecom
TalkTalk said today that last years cyber attack will cost the firm around 60m, thanks to 15m of lost sales and exceptional costs of 40m to 45m.
Despite this, TalkTalk expects full-year earnings before interest, tax, depreciation and amortisation (EBITDA) to be in line with expectations, at between 255m and 266m.
TalkTalk also reiterated its commitment to increasing its dividend by 15% this year. This gives a potential payout of 15.9p per share and equates to a yield of about 6.8%. However, I believe this is too generous.
TalkTalks earnings per share are only expected to be about 10.5p this year, leaving the dividend uncovered by earnings for the third consecutive year. During this time, TalkTalks net debt has risen from 393m to 644m. I believe some of this borrowed money has been used to fund unaffordable dividends.
Although its acceptable for companies to pay uncovered dividends occasionally, the explosion in TalkTalks debt levels suggests to me that a dividend cut will be necessary to bring the situation under control.
TalkTalk said today that next years dividend will be no lower than this years payout. To me, this suggests investors are being softened up for a possible cut.
Analysts forecasts suggest that TalkTalks earnings per share will rise by 50% next year. This should help improve cash flow and perhaps reduce debt. However, with TalkTalk shares already trading on 15 times 2016/17 forecast earnings, I dont see any value here, and believe the risk of disappointment is quite high.
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Roland Head owns shares of Wm Morrison Supermarkets. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
