QUALIPORT
Fool Sells PizzaExpress

By Maynard Paton (TMFMayn)
September 10, 2001

Carburton Street, London – Earlier this month, PizzaExpress (LSE: PIZ) issued its annual results. While the company remains in good health, the shares are presently fully valued. As will be explained, it's now time for this portfolio to "top slice" its PizzaExpress holding.

Extrapolation

The nature of PizzaExpress' business lends a certain amount of simplicity to valuation matters. Estimate the number of restaurants operating in the future and their profitability, and you've got the foundation for the prospective worth of the company.

Now, I'm pretty wary of extrapolating any company's performance far into the distance. I'm very much a fan of immediate value techniques, principally the free cash flow yield. But even with my aversion for projecting profits into the years ahead, it's worthwhile to calculate what, on a conservative basis, could happen at PizzaExpress. Indeed, such projections have worked very well in the past for the Qualiport. Therefore, it's now time to update this PizzaExpress valuation effort from twelve months ago.

(As a refresher, you may wish to read the original valuation article and the subsequent update before I jump straight in with today's nitty-gritty.)

UK & Ireland Pizza

PizzaExpress kindly inform shareholders of the "maturity profile" of a typical new pizza restaurant. In the past, I have used the following table, issued by PizzaExpress in February 2000:

Year    Profit before Tax    Sales               
              (£k)           (£k)

 1             70             500
 2             90             540
 3            125             595
 4            150             655
 5            180             720 

However, over the past eighteen months or so, PizzaExpress have made some slight downward revisions:

Year    Profit before Tax    Sales               
              (£k)            (£k) 

1              30             500 
2              90             540 
3             120             580 
4             150             620 
5             170             660 

In terms of additional UK pizza restaurants, I'll keep to the 30 openings per year I used in last year's calculations. So, using that rollout schedule and the revised maturity table, the following summary shows how profits before tax (PBT) could develop over the next five years from the pizza outlets.

Year to       Number of          Total Pizza PBT     
30th June  Pizza restaurants         (£m)           

 2002            303                  47.3 
 2003            333                  50.0 
 2004            363                  53.6 
 2005            393                  58.1 
 2006            423                  63.2 

Bear in mind that for the year ending June 2001, PizzaExpress reported profits before tax of £40m with 273 pizza restaurants. So the above table may be a tad optimistic.

Café Pasta

Café Pasta is a fledgling restaurant chain owned by PizzaExpress. It's now a profitable operation, with 18 outlets open at the moment and potential for over 100. Five pasta restaurants are expected to open in the current financial year.

Last time, I assumed that Café Pasta restaurants would have 75% profitability of a typical pizza restaurant. Given the division's subsequent progress, I'm now assuming profitability will be on a par with the pizza chain. I'm also assuming seven new pasta restaurants will open every year for the next five years.

So, here's how the pasta chain's profitability could look in the years to come:

Year to       Number of         Total Pasta PBT 
30th June  Pasta restaurants         (£m) 

 2002             25                  0.75 
 2003             32                  2.46 
 2004             39                  3.84 
 2005             46                  5.43 
 2006             53                  6.98 

Retail

The sale of pizzas, garlic bread and salad dressing in supermarkets generated profits of £0.7m in the latest financial year. As mentioned last week, essentially this profit was largely generated over a six-month period. So, assuming an annualised profit of £1.4m and growth of 25% per year, we get the following profitability:

Year to          Total Retail PBT     
30th June             (£m)                                              

2002                  1.75
2003                  2.19 
2004                  2.73 
2005                  3.42 
2006                  4.27 

What price PizzaExpress in 2006?

Adding all the expected divisional profit before taxes together, applying a 30% tax charge throughout (in line with revised company guidance) and gradually increasing the dividend payout ratio from this year's 20% to 30% gives the following:

Year to     Group PBT  Earnings  Dividend payout  Dividends 
30th June     (£m)       (£m)         (%)            (£m)                                              

2002          49.8       34.9          22            7.7  
2003          54.6       38.3          24            9.2 
2004          60.2       42.1          26           11.0 
2005          67.0       46.9          28           13.1 
2006          74.5       52.2          30           15.6 

For the core pizza chain, I'm inclined (as I was last year) to value its 2006 earnings (of £44.25m) using a price to earnings (P/E) ratio of 17. This rating also encapsulates the general profit expectation of the embryonic international operation plus the 80-odd UK pizza restaurants that could open beyond 2006 (the UK can cater for "at least 500" pizza restaurants). All in all, the pizza chain could be worth £752m in 2006.

For the pasta operation, again I'm inclined to use the same rating as last year. So, 2006 pasta earnings of £4.89m on a P/E of 20 (given the "next PizzaExpress" potential) produce a divisional value of £98m.

For the retail division, a 2006 P/E of 15 is very reasonable for what is essentially an "intellectual property" operation (albeit in chilled foods!). With earnings of £2.99m anticipated five years out, a divisional value of £45m is derived.

Including the £57m of dividends collected on the way, my 2006 valuation of PizzaExpress is £951m (£752m + £98m + £45m + £56m), or 1,331p per share. At 883p per share, an annual return of 8.5% is on the cards for the next five years. While my assumptions may prove optimistic and pessimistic in parts, overall, I'm pretty happy with the general valuation calculation.

But whichever way you look the company's valuation, especially when a fair amount of the company's potential relates to uncertain international ventures, it's obvious that PizzaExpress shares are no bargain at the moment.

Top Slice

In the next five trading days, the Qualiport will sell £5,000-worth of PizzaExpress shares, 60% of our holding.

The gist of the sale is this:

* PizzaExpress is by far the Qualiport's largest holding. But why should it be, when, of the four portfolio constituents, its current share price is the furthest from an attractive valuation? Surely the portfolio should be weighted towards its "cheapest" constituents?

* The Qualiport should have cash ready and waiting for attractive investment opportunities. At the moment, the present cash balance permits just one additional company to join the portfolio.

Looking back at Qualiport's watch list, there are a few shares (e.g. Lloyds TSB (LSE: LLOY), Emap (LSE: EMA), Johnston Press (LSE: JPR), Allied Domecq (LSE: ALLD), Carpetright (LSE: CPR) and even Ultraframe (LSE: UTF)) that could all soon fall into attractive territory.

That being the case, I'd prefer to have cash waiting for multiple opportunities, rather than be forced to sell PizzaExpress shares in the future at what could be a depressed price.

Disclosure: The author owns shares in Carpetright.