QUALIPORT
Fool Averages Down On PizzaExpress

By Maynard Paton (TMFMayn)
May 2, 2002

Following Monday's announcement, Tuesday morning saw the Qualiport:

* Sell 244 Emap (LSE: EMA) shares at 817.5p each. After dealing commission of £15.00, the disposal raised £1,979.70.

* Buy 289 PizzaExpress (LSE: PIZ) shares at 676p each. After dealing commission of £15.00 and stamp duty of £9.77, the transaction cost £1,978.41.

The purchase lowered the average cost (including all charges) of the Qualiport's PizzaExpress holding to around 691p per share.

Switch

So, why the switch? There are two reasons for the move:

1. PizzaExpress shares are cheap while Emap's are probably the portfolio's most expensive, and;
2. As the table shows, the portfolio previously had double the exposure to Emap than it did to PizzaExpress.

Holding                 Pre-switch Percentage

PizzaExpress                      11%
Lloyds TSB                        18%
Johnston Press                    24%
Carpetright                       18%
Emap                              22%
DFS Furniture                      5%

Cash                               2%

At 676p, PizzaExpress shares stand on a trailing price to earnings (P/E) ratio of 16.2. If you believe the present forecasts, the shares also stand on a forward P/E of 15.4. However, there's more to valuing PizzaExpress than P/E ratios. Here are four points to consider:

1. Cash balance

PizzaExpress had net cash of £26.9m at the end of December 2001. For some time now, PizzaExpress' expansion has been fully funded by internal cash flow. Subtracting a recent dividend payment of £1.8m, this 'excess' cash balance is equivalent to 35p per share.

2. UK pizza restaurants

As new restaurants open part way through the financial year and incur start-up costs, reported earnings do tend to understate the underlying profitability of the PizzaExpress estate. In addition, the company's 'word of mouth' approach to generating custom does take time to build up restaurant sales. The table below shows the 'maturity profile' of a typical new pizza restaurant:

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

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

Overall, if PizzaExpress stopped opening new outlets, profits would still grow for a time. For example, 30 restaurants going from their first full year to their second should create an additional £1.8m (30 * (£90,000 - £30,000)) of pre-tax profit.

In fact, over the past four years, the company has opened at least 30 new restaurants per annum. Assuming there was just 30 per year, the above table suggests pre-tax profits would grow by £4.2m in the current year purely through improving restaurant 'maturity'.

(Of course, these calculations are only valid if the figures provided by PizzaExpress are representative of real life. Taken from the latest interim results, annualised profit per average pizza restaurant comes to around £146,000. With around two thirds of the PizzaExpress estate under five years old, the presented 'maturity' table appears a fair reflection of reality.)

3. Depreciation

PizzaExpress is one of the few companies that commendably breaks down its capital expenditure into expansionary (i.e. money spent on new restaurants) and maintenance (i.e. money spent on the existing estate). Although this reporting has only covered the past three years, it's clear that profits are a little understated by a generous depreciation charge.

Year to June 30th    Depreciation     Maintenance Capital
                        (£m)              Expenditure
                                             (£m)

      2001              8.2                  5.7
      2000              6.2                  2.0
      1999              5.4                  4.7

4. Supermarket profits

During the six months ending December 2001, PizzaExpress generated £1m pre-tax profit from the sale of supermarket pizzas through J Sainsbury (LSE: SBRY).

While projections of rosy growth are generally a dangerous affair, ignoring upbeat management comments and related developments at this new sales avenue would be far too conservative. In short, an annual profit of £2m-plus from Sainsbury's is certainly on the cards, while another £1m-£2m is distinctly possible from genuine opportunities with other UK food retailers.

Pizza Value

In the past, the Qualiport has used the earlier restaurant maturity table combined with an estimated schedule of new restaurant openings to propose a value for PizzaExpress. Using this methodology, a sub-700p share price was deemed to be 'very attractive'. However, it's also worth looking at PizzaExpress via a free cash flow yield perspective.

In the twelve months ending December 2001, up to 287 UK pizza restaurants combined to generate an operating profit of £40.5m.

Assuming...

* No further restaurants are opened;
* The maturing estate brings in additional profits of £4.2m over the next twelve months;
* Supermarket profits of £3m are generated;
* Reported earnings are fully reflected in cash, and;
* Tax is 30%.

... then post-tax profits of £33.4m, or earnings per share of 46.5p, are produced. Subtract the 35p per share cash balance from the 676p share price, and the free cash flow yield comes to 7.3% ((676p - 35p) / 46.5p). Note that this valuation gives the group's Café Pasta, PizzaExpress To Go and international ventures a value of zero (a figure that may prove to be quite conservative in the years to come!).

Although not an absolute bargain, on balance, a 676p share price looks attractive -- especially when the projection ignores the real possibility of another 200 UK pizza restaurants as well.

Of course, undervalued shares don't usually appear without reason. At the moment, a drop-off in the central London restaurant trade has fuelled fears of a slowdown in profit growth. Although sales are static in the capital, fresh comments from the company tell of 5% like-for-like sales growth outside the M25. This diverse performance suggests PizzaExpress has not lost its operational edge. If you believe the recent reduction in London tourists and City workers is a temporary affair, a robust investment opportunity is at hand.

More: PizzaExpress discussion board