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It's our 6th Qualiport company
Before I dive into the buy report, I'll update you on the current state of the real money Quality Portfolio (Qualiport).
Having sold half of our positions in our first four Qualiport companies, we raised just short of £8,000 cash. Last Wednesday we announced our fifth buy, Independent Insurance. That transaction was completed yesterday. Here are the details:
755 shares bought at 258p = £1,947.90. Add to that commission of £15 and stamp duty (yuk -- get rid of it. The government should be encouraging people to buy shares. Putting a tax on it is hardly the smartest revenue raising method for the government) of £9.74 and we've invested a total £1,972.64 of our cash balance into Independent Insurance. We're happy to welcome them to the Foolish fold.
The latest numbers are at the bottom of this page. Today was not nice!
We ran a 4 part series on PizzaExpress earlier this month. We concluded that they would be a worthy member of the Qualiport, but we first needed to raise some cash in order to buy them. With £5,925.16 sitting in our bank account, we can now afford to make our purchase.
Here's the buy report.
PizzaExpress
This is a company I've long admired. More importantly, I also like their restaurants and their pizzas. Dave and I had our early Fool meetings in the Bayswater branch, one of their oldest. I've always regretted never being a shareholder and have enviously watched as their share has gone from 82p in mid 1993 to the current price of around 768p. That's a compounding annual growth rate (CAGR) of an amazing 56.4%. This sort of growth will not be repeated in the future, but it gives you an idea of the success the company has had over the last 5 years.
The first PizzaExpress was established in 1965 in Wardour Street, Soho, London. It is no fly-by-night operation, and that original location with its relatively unchanged formula is still going strong today. As at September 1997, the founder, Peter Boizot, sill held over 3% of the share capital, although these days he is no longer a company director.
PizzaExpress listed on the London Stock Exchange in 1993, having reversed into the Star Computer Company. That computing business was soon sold, and since then they have gone on an unprecedented expansion programme, opening up restaurants in many parts of the country. The average number of restaurants in 1994 was 31. Today there are 191 across the world, although the vast majority are in the UK.
Recently, PizzaExpress has started branching out into other restaurant concepts. The first effort is called Pasta di Milano, which follows the successful pizza formula of operating with a simple menu and serves freshly prepared pasta dishes. In June this year, PizzaExpress acquired Café Pasta, a London-based chain of just 6 restaurants. The company sees significant scope for rolling the formula out across the country and sees the pasta concept as being complimentary rather than competitive to the PizzaExpress restaurants.
For those Fools who haven't been into a PizzaExpress restaurant, the concept is remarkably simple, yet effective and extremely profitable. The company is very conscious of the location and the cost of its outlets. You will see many restaurants slightly off the High Street, in converted banks or old pubs. Because the company does virtually zero marketing, and relies solely on word of mouth and repeat business to drive customers to their restaurants, they don't need to be in prominent locations.
Compare the advertising and the locations of a national chain such as Pizza Hut to the low profile backstreet PizzaExpress. No expensive washed up footballers are needed to promote the PizzaExpress name. The cheapest form of advertising and marketing is no advertising and marketing. As we see from our own business here at the Motley Fool, word of mouth is a powerful marketing tool.
PizzaExpress play on the "experience" each customer has when they dine in one of their restaurants. The typical visitor will have relatively high disposable income. Spending per head per visit is over £10. It is not a family restaurant, and can't be compared to chains such as Pizza Hut or Deep Pan Pizza. Families are altogether more cost conscious and wouldn't necessarily be attracted to a PizzaExpress. Whilst the company would be happy to have any customers walk through their doors, they are determined not to compete on price. This is a key to their success. If customers enjoy the PizzaExpress "experience," there is a very good chance they will be repeat customers. They will also tell their mates about their "experience," and so the word of mouth marketing swings into action.
The menu is deliberately very basic and largely unchanged over the years. This serves two important purposes. Firstly, customers know that whichever PizzaExpress restaurant they enter, they will get exactly the same menu choices. We are creatures of habit, and if we enjoy something once, the chances are that we will go back and have that meal over and over again. The other big advantage about having a limited menu is company profitability, as we shall see below.
Show Me Da Numbers
Company share prices rarely rise in a vacuum. Over a long period of time, consistent earnings growth will always drive the share price higher, just as the opposite is also true for struggling companies. The 5-year 51% compounding rise in the PizzaExpress share price is as a result of explosive earnings growth fuelled by the aggressive restaurant opening programme. Have a look at these earnings per share (EPS) growth numbers:
1994 +26%
1995 +34%
1996 +50%
1997 +57%
1998 +38%
These are tremendous growth numbers, the envy of any listed company. To me, the most impressive part about PizzaExpress is their absurdly high operating margin. As they've rolled out this successful formula all over the country, it has allowed them to spread the relatively low head office costs over an increasingly higher sales base. But the big thing, and we alluded to this above, is their hugely increased buying power. No longer are they some tin pot company with a few restaurants -- they are a national chain, and because of their size, they can negotiate favourable deals with food and drink suppliers and distributors.
From an operating margin of 8.7% in 1993, PizzaExpress now sports a operating margin of 22.7%. For every £100 in sales, the company makes £22.70 in profit, before taking interest charges and tax into account. That margin is in the very top echelon of quoted companies. It is not hard to work out why they can achieve such a high level of profitability. As well as purchasing power, they spend nothing on advertising, deliberately locate themselves slightly off the beaten track in lower rent premises, and have a simple standard menu. They don't compete on price, so don't get caught in a price war, and their standard customer has a high amount of disposable income. It all adds up to a very profitable organisation.
The Future Strategy
As of now, there are 179 UK company owned PizzaExpress restaurants. Only three more franchised operations exist, most of them having been bought out by the company in 1997. By June 1999, the UK will have in excess of 200 PizzaExpress restaurants. The company says that they see room, in the UK alone, for over 350 such restaurants. In the future, they will be targeting specialist locations such as airports, cinema complexes and retail/leisure outlets.
The pasta division currently has 12 restaurants, and the company plans to open at least another 10 in the 1999 financial year.
PizzaExpress is now cautiously moving abroad, and 8 franchised restaurants are already operating in places as diverse as Delhi, Cairo, Paris and Istanbul. Outlets under construction are in Moscow, Paphos and Karachi.
The Qualiport Test
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.
There is no doubt that PizzaExpress 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.
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.
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.
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, consider that 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.
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.
A 5 year 56% 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.
and
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.
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.
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 McDonald's 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.
Before looking closely at a company's valuation, we first must determine whether we are looking at a quality company. I don't know about you, but I think PizzaExpress fly through just about all of our criteria. There are some doubts, of course, because no company is perfect. My concerns at the moment would be:
a. rowth will slow from the rates achieved in the past. Oh how we all wish we'd bought into this great success story back in 1994, when the shares were 109p. But those investors who missed out on buying Vodafone at 158p in 1994 could still have jumped on the wagon in 1997 at 330p and seen their investment double. The same holds true for great companies like Coca Cola and Microsoft -- in the last 15 years you could have bought shares in them at just about any point and seen your investment grow significantly. Who knows, PizzaExpress could be the next McDonald's
b. Future restaurant expansion will be more challenging than the past. Café Pasta and Pasta di Milano are a break from the pizza business, and that sector is more competitive. Overseas expansion has been the bane of many a UK business. Just look at the mess Laura Ashley have got themselves into as an example of what can go wrong.
c. The return on equity (ROE) has been on a downward trend. Ideally you want to invest in a company that is increasing its returns as it grows.
However, taking those reservations into account, I believe PizzaExpress are a quality company and a worthy Qualiport entrant. They pass our first 9 tests, and they do so in a way that some of our existing Qualiport companies don't.
Now that we are willing to add PizzaExpress to the Qualiport, we next must look at their valuation. Fools who witnessed the battle between Dave and myself surrounding Unilever and its valuation will be interested to know that won't happen again (I'm declaring victory). In hindsight (and isn't this always the way) we overpaid for Unilever. With a little patience, we could still have picked up our shares in the company, but at a 20% or more discount to the price we paid. Having learnt from that experience, I'm determined to not let it happen again. Dave would argue that we could miss out on ever buying the shares, as a company could be permanently overvalued. Whilst that is undoubtedly the case with some great companies, over time most companies see their valuation drift back to a normal level.
We are long-term investors, and patient ones. We can afford to bide our time, waiting for an opportune moment to buy shares in a company. There are many different investment styles and strategies, and some involve simply buying the best companies whatever their valuation and holding for the long term. The Cash-King Portfolio at the US Fool is an excellent example of this strategy in action. However, most UK companies are not in the same league as Microsoft, Intel, American Express or Cisco. I argue, therefore, that valuation is important.
The Valuation -- PizzaExpress
For those Fools familiar with our earlier How To Value Shares series, we will now look at the various methods to determine whether PizzaExpress offers value. The current share price is around 768p.
Earnings Growth Rate Projections
Year EPS P/E Price Growth CAGR Divs
1998 26.2 29 768 4.25
1999 33.6 22 739 5.20
2000 41.2 22 906 6.32
2001 48.6 20 972 7.20
2002 57.4 20 1147 8.21
2003 67.7 20 1354 76% 12.0% 9.36
2004 79.9 18 1438 10.67
2005 94.3 18 1697 12.17
2006 111.2 18 2002 13.87
2007 131.2 18 2362 15.81
2008 154.9 18 2788 263% 13.8% 18.03
111.11
Share Price 2787.57
Total Dividends 111.11
Total 10 Year Return 2898.68 277% 14.2%
The following assumptions were used:
Any forecasting model is only as good as its assumptions. The 18% long-term growth rate I have used above is quite optimistic. Based on their past record, it is conservative. It is very difficult for companies to exhibit sustainable growth of 18%. Only the very best will achieve that goal.
With 12% long-term growth and 12% dividend growth, the 10 year compound annual growth rate (CAGR) is 9.7%.
With 15% long-term growth and 12% dividend growth, the 10 year compound annual growth rate (CAGR) is 11.9%.
With 20% long-term growth and 16% dividend growth, the 10 year compound annual growth rate (CAGR) is 15.7%.
The Qualiport's aim is to grow by 15% per annum. The first model falls just short of that target, but not by much.
Return On Equity
Year Equity Profits Dividend Retained 1998 66,839 18,036 2,833 15,203 1999 82,042 22,200 3,445 18,755 2000 100,797 27,300 4,190 23,110 2001 123,907 29,738 4,758 24,980 and so on, until... 2008 448,142 107,554 17,209 90,345
The PizzaExpress current market capitalisation is £528m. A 2008 P/E of 18 multiplied by the 2008 profits of £107.55m gives an implied market capitalisation of £1,936m. Add to that the total dividends received of £89m, and you have a total 2008 value of £2,025m. From the current capitalisation of £528m to the 2008 projected capitalisation of £2,025m, that gives a CAGR of 14.4%.
The following assumptions were used:
Again, these are only assumptions. A sustainable 24% return on equity is no easy task. The ROE figure has been on the slide in recent years, as the company has expanded rapidly.
With a long term ROE of 18% and a dividend payout ratio of 18%, the CAGR is 7.8%.
With a long term ROE of 20% and a dividend payout ratio of 18%, the CAGR is 10.0%.
With a long term ROE of 28% and a dividend payout ratio of 16%, the CAGR is 18.4%.
Price To Sales Ratio (PSR)
The PSR is simply calculated as:
Market Capitalisation
---------------------
Sales
PizzaExpress' current PSR is 4.8. The PSR is not a valuation tool in itself, and there is no number that jumps at you and says "overvalued" or "undervalued." The number is much dependent on the sector a company operates in and its margins. For example, the highly competitive supermarket chains have a PSR of about 0.6. The high flying and highly valued telecommunications sector has a PSR of about 6. PizzaExpress is in the breweries, pubs and restaurants sector, which has a PSR of about 1.4.
Over time, as companies grow, PSRs head back towards a normal level. If you say a normal level for a company like PizzaExpress is 2.5, you can get some sort of future valuation for the company
If sales grow 18% every year for the next 10, they will be £521m in 2008. Multiply those sales by a PSR of 2.5 and you get an implied market capitalisation of £1,302m. The current market capitalisation is £528m, giving a 10 year CAGR of 9.5%.
On sales growth of 15% per annum and a PSR of 2, the CAGR is 4.3%.
On sales growth of 20% per annum and a PSR of 3, the CAGR is 13.4%.
Discounted Cash Flow
We have not used a cash flow based valuation method on PizzaExpress. Discounted cash flow analysis works best on mature companies, especially ones that throw off a lot of free cash flow. PizzaExpress is still very much in the growing phase, and all the cash it generates is being invested back into the business. As we saw in the earlier reports, their cash earnings exceed their accounting earnings, which is usually a good sign that profits are real, not conjured up by devious accountants. As PizzaExpress are earning 24% on average equity, it makes perfect sense for them to reinvest their cash back into the business. Why leave it sitting in the bank account earning 7% interest when they can use it to expand the business at an average rate of 24%?
Bringing It All Together
High Mid Low
Earnings Growth 15.7% 14.2% 9.7%
Return On Equity 18.4% 14.4% 7.8%
PSR 13.4% 9.5% 4.3%
Fool Buys
PizzaExpress pass virtually all our Qualiport criteria with flying colours. In our view, they are indeed a quality company.
It has been disappointing to see the share price on a bit of a tear over the last few weeks. Since our original articles, they fell as low as 640p, only to hit their straps and rise to 768p in the last 10 days. That's a 20% appreciation and could conceivably mean we don't see them rise much higher in the short term.
However, as we have seen, the valuation 10 years out looks relatively attractive. There are quite a few risks, and we have clearly set them out above. Buying any company on a trailing P/E of 29 is risky -- a shock profit warning could easily see them trade on a P/E of 8, which would wipe 73% from our investment in one fell swoop. Now that would hurt.
Some of the valuation assumptions we have used could turn out to be either pessimistic or optimistic. On the downside, because of their lofty current valuation, our returns may turn out to be far less than expected. However, we are hoping to achieve our goal of 15% compounding annual returns over a 10 year period.
Over the next 5 days, in accordance with the Fool's buying policy, we will purchase £1,975 worth of PizzaExpress shares, including costs. As ever, this is our own decision, and we don't encourage you to do the same unless you've done your homework in this or any other company. We know the potential rewards, but more importantly, we know the risks.
What you can do, however, is make sure you eat out at PizzaExpress restaurants every night of the week and tell all your friends to do the same. If they tell their friends...
Your thoughts and opinions are encouraged on either the Qualiport message board, or the PizzaExpress individual share board on the web.
Bruce Jackson (TMF Googly)
Qualiport Numbers
28/10/98 Close
Company Change Bid
EMA -0.78 9.87
IIG 0.00 2.50
MKS -0.25 4.36
RTO -0.02 3.53
ULVR -0.03 5.91
Qualiport Stocks
Last Rec'd Total # Company In At Current Change
19/12/97 783 RTO 2.55 3.53 34.5%
27/10/98 755 IIG 2.58 2.50 (3.1%)
17/04/98 169 EMA 11.85 9.87 (16.7%)
17/07/98 298 ULVR 6.72 5.91 (12.1%)
11/05/98 368 MKS 5.54 4.36 (21.2%)
Last Rec'd Total # Company In At Value Change
19/12/97 783 RTO 2046.53 2763.99 717.46
27/10/98 755 IIG 1972.64 1887.50 (85.14)
17/04/98 169 EMA 2052.57 1668.03 (384.54)
17/07/98 298 ULVR 2052.54 1761.18 (291.36)
11/05/98 368 MKS 2054.11 1604.48 (449.63)
Cash: £5,925.16
Current Total : £15,610.34
Total Invested: £16,184.62
Profit/(Loss) : (£574.28)
Value Per Share
Day Month Year History
Qualiport -2.46% 4.14% 26.95% 29.81%
FTSE 100 -0.70% 4.53% 3.08% 5.45%
FTSE All Share -0.55% 4.14% 1.28% 3.41%
For an explanation of Value Per Share accounting, please click here.