Avoid AO World as profits slump

AO World
217.3p+0.3p
Questor says SELL

Internet retailers are a funny business. The usual measures such as profit before tax are considered passé and investors are instead guided towards growth rates and adjusted earnings in order to support extraordinary valuations. Questor thinks investors should get back to basics and ignore the bubble in share prices.

Yesterday’s results at fridge and electronics website AO World were a prime example. The company reported revenue £217.1m, an increase of 25.1pc. Its adjusted earnings more than doubled to £7.3m during the first six months ending September 30. John Roberts, chief executive, described the performance as “another period of strong trading”. Given the results, investors would probably have been perplexed to see the shares down 1pc to 214.5p.

However, shareholders could be forgiven for being confused. They had to leaf through pages of effusive language on the growth prospects before turning to page 10, which showed the company had made just £779,000 in reported pre-tax profits, less than half the £2.14m it posted at the same stage last year.

That is a staggeringly low profit on sales of £217.1m and a margin of just 0.36pc. It is that lack of profit which goes some way to explaining why the shares are down 25pc from their February float price of 285p, and have nearly halved in value from the 412p peak they reached on the first day’s trading.

Market consensus is for adjusted pre-tax profits of £7.93m, giving 1.84p in earnings per share for the year ended March. Even after adjusting the profits the shares are trading on an eye-watering 118 times earnings. Analysts expect profit to more than triple in the year after that to £22.1m, giving earnings per share of 4.27p. Even if it achieves that heroic level of growth the shares would still be trading on 50 times earnings.

Given the first-half profit performance, those forecasts look fanciful at best. The company has its reasons for the profits being so low during the first six months. It has expanded into the German market and setup costs for doing this were £3.3m. AO also recognised costs of £1.3m related to share options. This is standard practice for early stage technology companies that entice people to work there by offering shares that will enrich them if the company is a success.

Questor thinks that any company can strip out the costs it doesn’t like and argue they are “one-offs”. What is much more difficult to achieve is reported profits after tax that can be returned to shareholders. This should be the only measure that investors care about; all else is vanity, or even worse. Investors who are drawn on to the rocks by the siren call of growth will end up losing their money very quickly.

There were plenty of city analysts prepared to sing the praises of AO World’s growth story after yesterday’s results. Price targets of 400p were slapped on the shares and clients advised to buy into the growth story. Then again, it was the very same banks that shared £19.7m between them for IPO costs so at that price you’d expect them to be all singing from the same hymn sheet.

So what price AO World? Well there is no doubting that the company is growing very fast, and the profits should eventually start following the sales.

Questor thinks that high growth comes with risk and a more conservative rating of about 16 times earnings should reflect that risk.

So taking the forecast earnings of 1.84p for the year ended March and applying a conservative rating of 16 times earnings reaches a forecast share price of about 30p.

Investors don’t have to agree with the methodology, but sticking to the basics is the best way to protect investment capital from a precipitous fall in value. Sell.