Qualiport

How many of the 10 criteria do they pass?

Before we dive in and have a look at the valuation of PizzaExpress, we first need to establish whether they are a quality company. Doyen of value investors Benjamin Graham used to hunt out companies that were absurdly cheap in comparison to their assets, and buy them almost regardless of the underlying business. Graham's disciple Warren Buffett started his investment life following a similar strategy, but over the years refined it so that he was looking for great companies which could be bought at attractive prices.

The Quality Portfolio (Qualiport) very much follows the Buffett approach to investing, although we arguably haven't done too well (so far) with our value criteria. First and foremost we look for a growing company, in a growing industry, and above all with excellent management. Only when we've established that we're looking at a great company will we look at valuation.

The Qualiport Test

As we saw in last Friday's introduction to PizzaExpress, there is no doubt they are a growing company. As to whether they are in a growing industry, I'd say the answer is yes. More and more people are eating out. As leisure time becomes increasingly important and the whole culture of the country changes, it is far more acceptable and affordable for people to eat out. Have a think about this yourself. Do you eat out more often today than you did five years ago? Kids may throw a spanner into the works, but remember that PizzaExpress do not target a family audience, instead concentrating on the affluent DINKY (Double Income No Kids Yet) market.

Pizza has been around for years. It is not going to go away. Competition in the eat out market has always been intense, yet PizzaExpress have kept coming up with the goods. Everyone loves pizza.

We have already established the criteria we like to see in a great company. As we all know, there is no perfect company, so whilst these are qualities we'd like to see in a company, we must realise it is very rare for a company to possess them all. As far as PizzaExpress is concerned, they happen to pass most criteria with flying colours.

1. A well managed company.

As judged by their past record, this is not in doubt. Great companies have a simple formula and consistent past growth records. Although the past is no guarantee of future performance, it does give investors confidence in the management.

There have been some management changes over the years. Luke Johnson, the man credited with much of the recent success of PizzaExpress, has moved to a non-executive role within the company. David Page, the former Chief Executive, has replaced him as Chairman. Peter Boizot, the founder of PizzaExpress way back in 1965 is no longer officially involved in the company, although did own more than 3% of the share capital as at September 1997. Most of the people responsible for the company's success are still involved in some capacity or other.

2. Strong, and ideally increasing, margins.

No doubt about this one either. Operating margins have increased every year since the company was established back in 1993. They now stand at an impressive 22.7%, quite astounding for a company in such a competitive industry.

As to whether they can keep on stretching operating margins, you would have to think there is not much room left for manoeuvre. Companies like PizzaExpress must be careful to provide their customers with a good value for money experience. If they keep cutting down on the size of pizzas and the number of mushrooms that go on each one, customers will eventually rebel. There is nothing worse than still being hungry after you've eaten your main course. The trick for the restaurateur is to leave you with just that little bit of space in your stomach for really high margin sweets and coffee.

3. Strong brand name and competitive advantage.

The PizzaExpress brand name is well known. It is a by-word for good pizza in an attractive and usually vibrant environment. Yet, its restaurants are still not represented in many towns across the UK. In fact, some people will have never heard of the company or its restaurants. Rather than seeing that as a negative, it perhaps shows the as yet untapped potential of an already successful formula.

The pizza business is very competitive. You will never have to walk too far to find an establishment that has pizzas on the menu. PizzaExpress has a competitive advantage insofar as the "experience" is quite different to your average restaurant. For the high disposable income clientele, it is more than a restaurant. It is a place to be seen, and to be seen with a group of friends. Because of the "experience", PizzaExpress doesn't compete on price. This is a distinct advantage.

4. A company which you understand, and which has predictable earnings.

I know the company, like its pizzas and enjoy dining at its restaurants. I know other Fools are not such big fans of the restaurants, but we're all different, and have distinctive tastes and expectations.

As for the predictable earnings, that's easy. Whilst they will undoubtedly suffer during a recession and an economic downturn, PizzaExpress is not a cyclical company. The earnings of the company are predictable and very transparent.

5. A company which has a proven past growth record.

As we saw last Friday, a 5 year 51% compounding annual share price rise is very impressive. That share price growth has been fueled by earnings growth averaging about 40% per annum over the past 5 years. Operating margins have constantly improved. All in all, PizzaExpress is a company with an outstanding past growth record.

6. A company with minimal working capital requirements.

and

7. A company which has a high return on equity.

PizzaExpress lease the vast majority of their restaurants. They do not have to concern themselves with the ups and downs of the property market. Their expertise is making and selling pizza, and not being property tycoons. By not owing the properties, they are not tying up valuable cash, which can be used for restaurant expansion.

I have calculated PizzaExpress' return on average equity over the past 3 years as;

1996 32.2%
1997 26.4%
1998 24.2%

Admittedly this is not going in the right direction. Ideally, I like to see companies increasing their return on equity (ROE). The 24.2% achieved in 1998 is, however, still very high. It is way above the cost of capital, and far better than any building society rate. Most companies struggle to get their ROE above 15%.

In their annual report, PizzaExpress say that they have an average of over 60% return on capital after the third year of a restaurant's life. Unlike other companies and concepts, the PizzaExpress restaurant matures and grows stronger with age. With more than half of the outlets less than 3 years old, if this trend continues it augurs well for the future.

8. A company which is a strong cash generator.

PizzaExpress' cash flow per share has always comfortably exceeded its accounting earnings per share. That fact alone ought to give investors a degree of confidence in the numbers the company presents every 6 months. In 1998, operating profits of £22.6m translated into net cash inflows from operating activities of £28.0m.

That cash generated is then ploughed back into the business and helps fuel the company's expansion programme. Whilst they are achieving such good returns on investment, it is no use the company leaving that money in the bank account, earning 7% per annum interest.

PizzaExpress do not generate any free cash-flow, and in the past have resorted to raising more money from equity investors. This cash has been used to fund their aggressive acquisition and new restaurant opening programme. As the company grows, the cash it throws off each year will likewise increase. At the same time, the new restaurant opening programme will naturally slow. In a few years time, the company could have an embarrassment of free cash, especially if they find future opportunities somewhat limited. That is a problem investors would hope that the company could tackle then, but at the moment a combination of strong cash generation and moderate borrowings should provide the company with enough money for their near term expansion schemes.

Ideally, you'd like to invest in a company that can grow completely organically, with no borrowings and no additional equity raised. In the case of PizzaExpress, to expand at the pace they have, they needed to raise cash. In hindsight, especially given their high return on equity, they could easily have gone into serious debt to fuel the expansion programme. In the long run, that would have possibly created more shareholder value, although I'm sure those investors who've ridden the success story all the way up from 100p will hardy be complaining.

9. A company which has identifiable future growth prospects.

PizzaExpress are very confident about the future. They say there is room for about 350 pizza restaurants in the UK alone, up from the current 182. The world is their oyster. Overseas franchising of PizzaExpress restaurants has already begun.

They have cautiously started to buy and roll out a pasta restaurant concept. Although this will almost certainly never be the hugely successful winner the pizza business is, at least they are sticking to what they know.

Although the next phase of life for PizzaExpress holds more risks than it did in the past, it is also arguably a stage of great excitement. We could be seeing the start of a worldwide food chain. Just as McDonalds restaurants are everywhere, who's to say that each town in the world couldn't have a PizzaExpress restaurant?

Admittedly, this is unlikely to be the case. The most important thing is that the company knows where it wants to go, and has the experience to get there. Competition will be that much tougher from now on, and there is no guarantee that the foray abroad will be a success. Potential shareholders will have to weigh up these risks.

10. A company which is attractively valued.

As ever, this will be the tricky one. We'll leave it to Friday.

In the meantime, do you think we are looking at a quality company? I think it passes most tests with flying colours. All answers, as usual, to the Qualiport message board.

Bruce Jackson (TMFGoogly)

Qualiport Numbers

Today's Numbers       Date    30/09/98


                    Day      Month     Year      History
Qualiport          0.71%    (6.82%)   21.64%     24.38% 
FTSE 100          (0.87%)   (3.52%)   (1.38%)     0.88% 
FTSE All Shares   (0.77%)   (3.93%)   (2.74%)    (0.70%)


Qualiport Stocks

Last Rec'd  Total #  Security   In At    Current    Change
 17/04/98    337       EMAP    £11.998    £9.150  (23.74%)
 11/05/98    736       MKS      £5.604    £4.490  (19.88%)
 19/12/97   1565       RTO      £2.582    £3.600   39.43% 
 17/07/98    595       ULVR     £6.804    £5.010  (26.37%)


Last Rec'd  Total #  Security   In At     Value    Change
 17/04/98    337       EMAP   £4043.37  £3083.55 (£959.82)
 11/05/98    736       MKS    £4124.37  £3304.64 (£819.73)
 19/12/97   1565       RTO    £4040.63  £5634.00 £1593.37 
 17/07/98    595       ULVR   £4048.38  £2980.95(£1067.43)


Cash:               £67.82
Current Total:  £15,070.96
Profit/(Loss): (£ 1,113.66)