The word “transformative” can sometimes be used loosely in today’s fast-moving retail landscape, but Ocado’s board could be forgiven for such language this week.

The online grocer and technology specialist’s coup of securing US grocery giant Kroger as its latest international partner is undoubtedly the most tantalising deal it has struck to date.

After signing up French player Casino, Canadian grocer Sobeys and Swedish outfit ICA to its Ocado Smart Platform (OSP), the agreement with Kroger marks a deal on a completely different level – one that vindicates Ocado boss Tim Steiner’s strategy to sell its proprietary technology to third-party retailers.

Under that long-term plan, the US was always going to be a key target for Ocado and, given that market leader Walmart’s online grocery business is already well established, Kroger represents the prize catch.

The largest pure grocer in the US and the third-largest retailer in the world, Kroger generated sales of $122bn (£90.2bn) in its 2017 fiscal year.

Headquartered in Cincinnati, Ohio – from where Steiner and Ocado Solutions chief executive Luke Jensen were jetting back when news of the deal was revealed on Thursday morning – Kroger employs 443,000 staff and serves 8.5 million customers every day through 2,796 food stores in 35 American states.

Bricks and mortar continues to account for the vast majority of sales in the gargantuan US food retail market, and grocery stores raked in a mammoth $641bn (£474.1bn) in revenue last year, according to Statista. 

“The number of CFCs that Kroger is potentially signing up for is materially ahead of anything we had expected”

Bruno Monteyne, Bernstein

But Ocado plans to help Kroger tap into an ecommerce market that is forecast to boom over the next 10 years.

“Online grocery penetration in the US at the moment is quite low, between 1% and 2%,” Ocado finance boss Duncan Tatton-Brown explains. “But some very well-respected consultants recently said they expect it to be 20% to 25% in the next decade. There is an awfully large market in the US and an awful lot of that can go online.”

As a result, Kroger and Ocado have wasted no time getting to work. They aim to identify three sites this year on which to build automated customer fulfilment centres (CFCs), and up to 20 are forecast over the first three years of the agreement alone.

While the deal and its scale sent shockwaves coursing through both the grocery and financial markets – Ocado’s share price rocketed almost 45% to 797.2p on the day of the deal’s announcement, giving it a higher valuation than M&S – it should not have come as too much of a surprise.

In a note in January, broker Bernstein named Kroger as the fourth most likely grocer to strike a full OSP deal with Ocado – just behind ICA, incidentally – following an analysis of 257 food retailers in 50 countries.

Despite that, Bernstein analyst Bruno Monteyne admits: “The number of CFCs that Kroger is potentially signing up for is materially ahead of anything we had expected.”

Running before it can walk?

Is there a risk, then, that Ocado is biting off more than it can chew? After all, it warned last September – before it had even struck the Casino, Sobeys or ICA deals – that additional investment in developing distribution centres would send costs soaring in the short term.

The Kroger tie-up is larger than those three contracts combined. Delivering that won’t come cheap.

And as Goldman Sachs analyst Rob Joyce points out: “Given Kroger’s size, they could commit to materially more CFCs than the 20 announced.”

Yet Tatton-Brown is adamant Ocado has both the working capacity and financial firepower to fulfil the partnerships it has struck.

Kroger has lent a helping hand with the latter, snapping up a 5% stake in Ocado for a cool £183m – cash that will be used to help fund the new warehouses Ocado is constructing across the globe.

Tatton-Brown says Ocado is now “moving at pace” after years struggling to pen a maiden deal, but insists: “We raised money in February, we are raising money today. That, in aggregate, will give us more than £300m in capacity to deliver these CFCs.

“We are looking, with Kroger, at ways to bring forward some of the payments that reduce our capital need, so we are optimistic we can fund this without going to shareholders.

“But if we can’t, that’s a really good problem to have because we are generating value for our shareholders. Our shareholders have shown in the past that they are willing to support us with the problem of having so much demand for our platform.”

Will effort equal reward?

Demand for Ocado’s warehouse technology, logistics expertise and online nous may well be high at present, but that is no guarantee of success in the future. Forecasts that ecommerce will account for a quarter of US grocery sales in 10 years’ time are exactly that – forecasts.

Ocado will know full well the situation in the UK, where online grocery sales have plateaued at around 10% despite some of the bolder predictions of the past.

Exane sector head of food retail Andrew Gwynn sums up such concerns. “Short-term, we’d be minded not to get too far ahead of ourselves,” he cautions. “This is food online, which could be summarised as lot of effort for not a lot of reward – low gross profit, high cost to serve.”

Despite that, Gwynn estimates that each Ocado warehouse could generate £6m of EBIT for the business. It doesn’t take a master mathematician to figure out that Kroger’s 20 CFCs alone would therefore add £120m to Ocado’s bottom line.

“We are confident in our ability to deliver this. There may always be bumps in the road, we can’t guarantee that it will be issue-free, but we remain confident”

Duncan Tatton-Brown, Ocado

Numis analyst Andrew Wade agrees. “We have little doubt that an attractive ROIC [return on investment capital] will be achieved on the huge amount of capital set to be invested across Ocado’s global OSP partnerships and, with a significant long-term earnings runway now in place, retain our positive stance.”

Tatton-Brown is bullish. “Do we have the capacity to sign more deals? Yes. Do we have unlimited capacity? No,” he says.

“If you want a deal with Ocado, there are now seven of the world’s leading grocers on our platform. If you want to join that group of people, you need to make a decision sooner. It creates a sense of urgency for the people we are talking to.”

He concludes: “We are confident in our ability to deliver this. There may always be bumps in the road, we can’t guarantee that it will be issue-free, but we remain confident.”

If Ocado can turn that poise into profit, it will put the increasingly global business firmly on the map.