Shares in Ocado (OCDO) surged more than 30% to £5.67 in London on Thursday on media reports of takeover interest from Amazon (AMZN).

The US retail giant has declined to comment on the report in The Times, which suggested that Amazon is looking at a picking up the UK online grocer at a cheap valuation. But the rumour was enough to lift Ocado shares significantly on Thursday.

Ocado shares have been on the slide since peaking in February 2021 at £28 and were recently trading below £4. Investors have lost patience with the company’s “path to profitability", especially after reporting a crashing £500 million loss in February this year. With food prices soaring, the cost-of-living crisis has also turned Britons towards cheaper grocery alternatives like Aldi and Lidl. An already competitive supermarket sector has been put under significant pressure to avoid accusations it is using “greedflation” tactics; and the government has been in talks with retailers about ways to keep prices rises restrained. Middle England's purchasing power has also been eroded by steep rises in mortgage costs.

All this creates difficulties for Ocado’s premium-priced offering, which delivers Marks & Spencer groceries and Ocado branded goods to households via Ocado liveried brands. Marks & Spencer took a 50% share in Ocado’s retail business in February 2019, effectively ending the tie-up with Waitrose, which had been in place since the company was founded.

Ocado stopped selling Waitrose products in September 2020, with Waitrose operating rival “click and deliver” services. Some customers have complained that prices have risen in the transition to M&S, a period in which prices for basic foodstuffs have hit multi-decade highs. 

What's in it for Amazon? It already has a foothold in the UK grocery market via a venture with Morrisons, which was taken private in 2021. In certain postcodes and metropolitan areas like London and Birmingham, customers ordering via Amazon receive Morrisons groceries.

Morningstar's Ioannis Pontikis, who covers the retail sector, says any deal doesn't make obvious sense: "A potential acquisition of Ocado by Amazon would be rather surprising, given the established and strong partnership Ocado has built with Kroger in the US since 2018.

"While it is understandable to contemplate Amazon's desire to utilise Ocado's proprietary technology for its own retail operations, including any non-US licensing agreements with other grocers, it would certainly be intriguing to observe Kroger's reaction, considering its position as a direct competitor to Amazon in the US grocery market. The implications of such a deal remain uncertain due to the presence of exclusivity clauses within the US agreements between Ocado and Kroger."

The takeover interest has still not lifted Ocado shares close to the fair value according to Morningstar metrics. We assign Ocado a FVE of £15.50, and it's one of the most significantly undervalued European shares under our coverage. 

Ocado was primed for ejection from the FTSE 100 in the latest quarterly reshuffle but just survived the drop.