Richard Gill on AO World – Awfully Overvalued?

Today’s profits warning from ASOS (its second in three months) goes to show how stellar rated stocks can quickly plummet if they fail to meet market expectations. Valued at up to 100 times earnings (and rarely below 50 times) for the past few years, the shares are down by c.30% today after the firm warned that margins will be lower than previously expected.

Another highly rated stock reporting today (but actually meeting expectations) is the online white goods retailer AO World. The firm, which sells washing machines, fridges, televisions and so on via its ao.com website, joined the London markets in March this year in a blaze of glory. Helped by a compound annual revenue growth rate of almost 30% between 2011 and 2013, the clever bankers at J.P. Morgan, Numis and Rothschild et al managed to slap a £1.2 billion valuation on the firm. The problem was this represented a multiple of 176 times historic profits. Never mind internet bubble territory, these shares were being valued at prices seen at the height of tulip mania!

Shorters have already made a pretty penny on the shares. They have slipped back from the IPO price of 285p – and from highs of 378p – to the current 251p. However, I believe that they still look grossly overvalued, especially on the back of today’s annual figures.

Run of the mill results…

While AO World claims to have met market expectations for the financial year to March 2014, the results are incredibly uninspiring for a company which has been promising so much.

it’s true that revenues for the year continued their good run, increasing by an impressive 40% to just shy of £385 million. With a business like this you would expect operational gearing to kick in and really drive profits as it duly has. But, AO World didn’t demonstrate this in the 2014 financial year with admin costs rising by a more pronounced 55%.

On the back of this, operating profits for the year were actually down from £8.4 million to £8.2 million. Even the malleable “adjusted EBITDA” figure revealed moribund growth of 10% to £11.2 million. In fact, it looks like a £11 million increase in advertising costs for the year (to over £18 million) didn’t actually help drive profits at all. Add in £15.4 million of IPO related costs, and the business actually made a loss before tax of £7.55 million.

To give it its credit, the business ended the year with net cash of £48.7 million after receiving £40 million of IPO proceeds. And the net cash from operations was £13.6 million – but again ignoring the IPO costs.

Crucial concerns…

Adding to the lacklustre figures there are several concerns regarding the AO World business model. In particular, for an internet stock valued at such a high level, AO World has incredibly uninspiring margins. Gross margins have run at an average of around 18% over the past four years (albeit rising to 19.3% in 2014). While not being a perfect comparable, internet business ASOS enjoys gross margins of just over 50%. ASOS’s operating margins are also significantly higher at a historic average of around 7 – 8% compared to AO World’s 2 – 3%.

Perhaps one of the most crucial points surrounding the business model however (pointed out by several commentators such as our good friend Evil Knievil and Artemis fund manager Tim Steer) is that AO is arguably an insurance broker with a washing machine website added on.

After it sells one of its white goods, via an agreement with D&G Services Limited, AO sells a range of “product protection” insurance – extended warranties and the like upon which commissions are earned. The key point here is that AO recognises the full amount of expected future commission payments on day one of the sale. In other words, the firm puts the commissions in the profit and loss account despite having to wait perhaps several years for the full “expected” payment to be received. This is all fully allowable under accounting rules but a bit iffy nonetheless. There were £14.3 million of such accruals in the accounts in 2013, if you strip these out and it can be questioned whether the website operations made any profit at all.

Valuation…

AO World’s current valuation is £1.06 billion – a multiple of around 200 times last year’s profits if we ignore the IPO costs. To put this into perspective, the established Debenhams, which made pre-tax profits of £154 million last year and pays a decent divided yield of around 4.4%, is valued at £900 million – a shade under SIX times. AO World pays no dividend and is arguably loss making. In fact, while the business has made a small profit in the past, on a statutory basis the current retained loss position stands at £2.17 million.

Bulls of the stock would argue that the current valuation reflects the company’s growth prospects, especially in mainland Europe in countries such as Germany, which has an appliance market valued at £6.6 billion according to the firm. They would also point to the company having built up the infrastructure, brand and logistics to take advantage of the potential growth. But as yet, there is very little evidence of this growth being achieved at the bottom line, let alone enough evidence to justify the current valuation.

I note that AO World entered the FTSE250 at the most recent reshuffle. Don’t be surprised to see it shuffled out by the end of the year, especially if the firm fails to meet targets. My target price could be as low as 13.8p (net asset value as at 31st March) if the firm fails to deliver. Even a generous valuation of 30 times 2013 net profits would equate to a target of 45p.