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Just opened a short on AO world – AO.L

This is a relatively simple company involved in selling appliances online.

I have shorted equivalent to 4% of my portfolio – so a pretty small position. I used to short reasonably often but havent done much or had much success since 2003. I think the market is still a bit toppy and due a fall, in addition this stock seems really overvalued. A short balances out the rest of my portfolio quite nicely – hopefully it will prove profitable as well.

To summarise – this stock is trading on a PE of 195. It has free cash flow of under 3p per share, tangible NAV is £45m. Broker estimates of EPS in 2017 are 7.7p per share. Even then at 285 (about where I shorted it) the stock is trading at a 2 year forward PE of 37.

These figures are silly. I would instead put a 24 PE on 2017 earnings of (lets be generous) 7.7p – giving a fair value of 184. I actually dont think they will get to 7.7p earnings in 2017. If we are more optimistic giving them (say) 5p earnings gives a value of 100p at a 20X PE.

There are also questions which can be raised over the quality of these earnings. Essentially a good proportion of these come from selling insurance policies on appliances. They receive the revenue from these policies over a period of time but book it when the appliances is sold as that is when they incur the cost of selling the policy.

They say they have experience valuing the likely return from these policies so can accurately book the revenue in advance.

I am not alleging any dodgy dealings here – but given this accounting treatment there is the an increased likelihood of unforeseen negative surprises. I believe these policies account for about a third of profits.

Regardless of the quality of the earnings between 2013/4 Revenue increased 40% but the company’s own measure of EBIT before exceptional actually fell…

The company are looking to expand in Europe – they said they could expand into Germany with incremental Capex of about £5m. They use a hub and spoke model – so a central warehouse serves depots near population centres – which hold no stock. I can see how they think they can expand cheaply – it is actually very clever. They hope to rapidly expand to cover all Europe – hence the multiple.

I am sceptical – I believe Europeans will be slow to shop for major items from a website they have never heard of. There is much less internet shopping in Europe vis a vis the UK. Even if they are successful competition will rapidly eliminate any excess profits they can hope to earn from this business model – given the low barrier to entry. In Buffet terms – the ‘moat’ of this business is very shallow….

Another weakness of the AO model is they are aiming to provide top-notch service and be the cheapest supplier in the market place. I do not believe both can be done at the same time profitably.

They are also offering an installation service – the guy who drives the van with your wide screen TV will also install it. I doubt this will work. If you are a van driver will you have the skill to do this? Even if you have the skill you will want to be paid more for this so costs will go up. If the company refuses to pay you will go and work elsewhere which is less demanding. Glassdoor has (admittedly only 2) negative reviews on them…
(http://www.glassdoor.co.uk/Reviews/Employee-Review-Expert-Logistics-RVW4191551.htm)

What I expect to happen here is a slow drift down in the share price. It is possible insiders will sell more shares – pushing the price down further.

I then expect some problems to the growth plans and results will consistently disappoint. The share’s multiples will be consistently reduced and the share price will crater. Insiders will then buy it back – probably with the money they paid in the first place.

My concern is that they will have a brief spurt of good growth somewhere in the business and given the high multiple this will have a major effect on the share price. Even if they do have limited success I would expect competition to eventually wear them down, if this model works everyone will soon be copying it. I will probably stop myself out about the £4 mark…

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