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QUALIPORT
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Qualiport company PizzaExpress (LSE: PIZ) published its annual results on Tuesday. The statement contained three concerns: * The development and possible acquisition of further restaurant formats; Contradicting this Qualiport article from June, the statement showed there was more to the company's deteriorating performance than just a lack of London tourists. On the day of the results, PizzaExpress shares fell 23%. But at 300p, they look cheap. Financials Here's the five-year record of PizzaExpress: Although opening 29 new restaurants helped sales improve 15% to £214m, an "increasingly competitive market" saw pre-exceptional operating profits fall from £39.2m to £38.7m. PizzaExpress also recorded its first exceptional items in quoted form -- a £1.5m charge relating to a company reorganisation and the closure of its US operation. The dividend improved 25% to 10.5p per share. During the year ending June 2002, like-for-like (LFL) sales increased by 1% -- a credible performance given the +10% comparable figure for 2001. However, LFL sales growth was just +2% in 1999 and +3% in 2000. Over the past four years then, compound LFL growth has been 3.9% per annum. Not great, and below the implied LFL model the company has stated in the past. On a quarter-by-quarter basis for 2002, LFL sales growth at the core pizza chain was +2%, +4%, +1.5% and -4%. The deterioration in the second half of the year, especially the fourth quarter, impacted heavily on operating margins. In the first half, sales of £104m and continuing operating profits of £21.4m gave an operating margin of 20.6%. For the second half, sales of £110m and continuing operating profits of £17.3m produced an operating margin of 15.7%. Margin pressure Unfortunately, PizzaExpress remarked that there had been no uplift in LFL trading since the last quarter (i.e. LFL sales are presently declining by 4%). Furthermore, the company highlighted the prospect of extra "cost pressures" -- additional National Insurance payments, the minimum wage increase, higher rent and rising insurance premiums. Although part of the extra burden will be offset by the cessation of a one-off advertising campaign, the figures bandied about at the company's results briefing implied operating margins could be reduced by about 1.5%. Just to add to the gloom, disruption from the refurbishment programme is expected to reduce profits both this year and next by £1m. There were no significant developments at the company's other restaurant operations. Café Pasta remains a minimal profit generator, international efforts are still loss making and Pizza To Go (fast food pizza) will open its second outlet this Autumn. The only operational bright spot concerned the sale of pizzas via supermarkets. The deal with J Sainsbury (LSE: SBRY) produced sales of £4.3m and profits of £2.2m. A recent agreement with Waitrose should bolster this division's profits in the current year. PizzaExpress also revealed talks with another leading supermarket were continuing. Importantly, independent market research has revealed the company's supermarket sales do not cannabilise revenues from the restaurants. Concerns As stated earlier, the results contained three shareholder concerns: 1. New formats: Over the past few years, PizzaExpress has branched out into pasta and fast food pizza, and has now begun experimenting with a Gourmet Pizza chain. In February, PizzaExpress bought a handful of Gourmet Pizza restaurants with the intention of converting them into the company's traditional pizza/pasta formats. Since then, the company has decided to abandon the conversion to instead try and roll out the chain. Indeed, PizzaExpress are to experiment converting three traditional pizza outlets to the Gourmet format. The other February purchase, the Kettners restaurant in London, is also touted as a possible rollout format. In addition, "an examination of [more] acquisitions that could give us different formats that do not conflict with our existing brands" is also on the cards. Why are the different formats a worry? Firstly, the historic recipe for success at PizzaExpress has been largely founded on its simplicity. In short, running one chain with a limited menu means less chance of logistical and operational hiccups. More formats, more menus, more ingredients, more trouble. Too many cooks, and all that. Secondly, it suggests the scope for expansion at the traditional pizza chain has diminished. It's worth noting that the 500 pizza outlet target stated in the past was not specified in the latest results; instead, a general "more than 600 locations where our formats could operate" description was provided. Thirdly, rather than continually dabbling with unproven, embryonic chains, PizzaExpress could reliably generate shareholder value by effectively investing -- via a share buy back -- in an already proven restaurant format. Although management said in February they were "going to do something" in terms of returning excess cash to shareholders, a share buy back "isn't a priority" at the moment. That's because... 2. Refurbishment: PizzaExpress revealed a substantial refurbishment programme on Tuesday, with 60 or so 'mature' pizza restaurants set for a facelift. During the year, the older pizza restaurants (those open for over ten years) generated a LFL sales performance of -3% (newer restaurants registered +3% LFL growth). Chief executive David Page admitted the company had "rested on its laurels a little". Maybe too much attention to the secondary formats diverted management's attention. The following table shows depreciation squaring up with 'maintenance' capital expenditure: On this six-year basis then, the depreciation charge still remains a good proxy for maintenance capital expenditure. Of the three older sites refurbished so far, LFL growth of 10% has been subsequently recorded. However, at what point the next round of heavy refurbishment takes place is anybody's guess. The fear here is that there has been a fundamental step change in the requirement for capital expenditure, as the company's rivals get their act together... 3. Competition: David Page commented on Tuesday that five years ago, PizzaExpress was the "only decent restaurant operator" around. Now his firm has "three or four very good competitors". As such, competition on the high street is "likely to remain tough in the short term". Will regional management restructures, menu reviews and site refurbishments suitably distance PizzaExpress from the competition? And if so, for how long? One worry is that, now having caught up, rivals of PizzaExpress will continually enhance their food/service/restaurants as well. Operating margins of 20%-plus at PizzaExpress could now well be a thing of the past. Valuation and summary All these concerns, however, are reflected in the PizzaExpress share price. Conservatively assuming... * Annual sales of £220m (i.e. double the turnover generated in the six months to June 2002, effectively implying new restaurants offset declining LFL trade); ... earnings per share of 29.0p could be generated in the year to June 2003. At 300p per share, that equates to a forward price to earnings (P/E) ratio of 10.3. If the dividend were increased 20% this year, the shares would offer a prospective 4.2% yield. As highlighted before, PizzaExpress is like a re-run of the Carpetright (LSE: CPR), Games Workshop (LSE: GAW) and JJB Sports (LSE: JJB) stories. All four retail operations expanded quickly during the 1990s, only to see competition eventually stifle profits and send the share prices plummeting. Carpetright, Games Workshop and JJB all recovered (although the latter has since hit more problems) as their leading industry positions pulled them through the trouble. Can PizzaExpress do the same? Certainly there's a glimmer of hope. The early refurbishments sound promising, and various initiatives underpin management talk of a modest sales improvement later in the year. Undoubtedly, the difficult industry conditions will mean a sector shake-out, and it's a fair bet that PizzaExpress' significant refurbishment could turn the screw a little more on the weaker players. Valued conservatively on a P/E of 10, the stock market obviously thinks the gig's up for PizzaExpress. However, it's not too difficult to visualise the experienced management team leading a revival over the next two to three years, with refreshed restaurants, fewer rivals and returning tourists all combining to boost sales and profits. Such an outcome would see the shares rise significantly. That said, the restaurant sector remains inherently fickle, operationally tricky and very competitive. And it would appear PizzaExpress can no longer rely on the failings of others to provide superior returns. The company's sustainable competitive advantage rests entirely with its directors and staff -- not ideal for long-term 'franchise' investors. Looking even further down the line, the continual development of different formats could spell more trouble. But for the time being at least, it's difficult to ignore the investment potential of a medium-term recovery. The author owns shares in Carpetright, Games Workshop, JJB Sports and PizzaExpress.
* Enhanced competition on the high street, and;
* The need for a substantial refurbishment programme.Year to June 30 1998 1999 2000 2001 2002
Turnover (£m) 99.6 126.6 150.1 185.6 213.7
Operating profit (£m) 22.6 29.1 32.0 39.2 38.7
Pre-tax profit (£m) 23.0 28.7 32.2 40.0 38.0
Earnings per share (p) 27.2 33.7 36.4 43.1 37.6
Dividend per share (p) 4.5 5.4 6.7 8.4 10.5
Year to June 30th Depreciation Maintenance Capital
(£m) Expenditure
(£m)
2004 14.0* 11.0**
2003 11.6* 13.0**
2002 9.7 6.6
2001 8.2 5.7
2000 6.2 2.0
1999 5.4 4.7
(* Qualiport estimate)
(** PizzaExpress guidance)
* Operating margins of 13.5%;
* The net cash balance of £18m, and interest payable thereon, is ignored (the money will be funding the refurbishments);
* 30% corporation tax, and;
* 71.6m shares in issue.