Pizza Express

Pizza Express                                                                                          Ticker: PIZEXP

 

 

Isin	Issue Size	Rating M / S&P	Coupon	Min Piece	Maturity	Next Call	Offer	YTW	Govt Spread
XS1028948120	£465mn	B2 / B-	6.625% s/a	£100k	Aug 2021	Now to Aug 2018 @ 103.313	98.25	7.16%	+ 649bps
XS1028948047	£200mn	Caa1 / CCC	8.625% s/z	£100k	Aug 2022	Aug 2018 @ 104.313	91	11.1%	+1,026bps

 

 

Bond prices dropped off with the market in mid-2016, but after Q1 results came out this year they’ve seen a fairly steady downtrend as the main business in the UK digests various inflationary pressures.  Mitigating measures should start to claw back the margin loss during the second half.  Yields for the highly levered group are now starting to make some sense and in the medium term, expansion in the Far East with the backing of Chinese owner Hony Capital provides a good route to growth for a business with a solid UK core and experience in overseas markets.

 

 

Bonds

 

Bonds are issued out of two financing vehicles: PizzaExpress Financing 1 for the 6.625% first lien and PizzaExpress Financing 2 for the 8.625% second lien.  Coupons and ratings reflect their respective seniority and ranked claims on collateral.

 

• First lien bonds rank pari passu with the group’s £20mn RCF, but the RCF is super senior on enforcement together with hedges.
• Collateral is the bulk all of the assets of the issuers and guarantors. Guarantors must represent at least 80% of consolidated EBITDA and consolidated total assets as per the RCF covenants, but at issue they tied in 95% – a minimum of 80%.  They represented 95% of EBITDA at issue.  Companies outside the guarantor group have negligible assets/income.
• Covenants are in place to restrict liens, indebtedness, mergers and sale of asset, etc, but as is common these days, they’re long, convoluted and no fun to unpick. There is a full menu of carve outs.  Financial covenants: a fixed charge cover ratio maximum of 2.0x and a consolidated secured leverage ratio maximum of 4.5x.  New or refinanced credit facility of £70mn or 75% of consolidated EBITDA, whichever is greater.  We calculate the latter at something over £113mn on a straight EBITDA calculation, but the group’s definition of EBITDA is very flexible, (see financial section below).  Leasing and other debt also have “whichever is greater” carve outs using total assets that we estimate at £61mn and £98mn respectively.
• Events of default at least capture breach of covenants, and cross default and cross acceleration have a £20mn trigger.
• Note also that similar covenants on the Revolving Credit Facility are only tested quarterly if 25% or more of the facility is drawn on the testing day.

 

 

Business

 

Founded in 1965 in the UK, Pizza Express has owned and franchised full service, casual dining restaurants ever since. It now operates 603 restaurants across the UK and ROI (491), UAE, India, Indonesia, Singapore, Hong Kong and mainland China.  46 of the international restaurants are franchises, although none in China – they were bought back in 2015.  The UK and ROI represent 83% of revenue and restaurants bring in almost 97% of thereof, with small contributions from wholesaling, overseas franchise income and merchandising. It was floated on the LSE in 1993, taken private by TDR Capital & Capricorn Associates in 2003, then refloated in 2005 via Gondola Holdings plc, which was taken private by Cinven in 2007. It was last sold in 2014 to Hony Capital, the Chinese fund with $10bn assets under management that likes to take Chinese businesses overseas and bring overseas businesses to China. Hony’s origins began in 2003 and it has particular expertise with state owned enterprises. It has been helpful in expanding the Pizza Express brand in that important market, although the Far East operations first began in 2001 in Hong Kong.

 

The business performs successfully, despite the usual competition and macroeconomic factors – you don’t stay in the restaurant business for decades without doing a lot right. Its “single cooking platform (an oven)” does make things simple and low cost, and the Pizza Express Way, its global operational and marketing procedures and training programs, ensures consistency across the estate.

The last major downturn was in the early 2010s and they know how to keep customers coming, even if not as many come and others spend a bit less. The demographic appeal (or acceptability perhaps) is quite broad: it can appeal to pretty much anyone, and people can trade up or down to it depending on circumstances. There’s a fair bit of investment going on, with a new point-of-sale system in the UK/ROI during Q2 for example, and modest restaurant portfolio growth that’s been scaled back.  Expansion is really kicking off in the Far East (LFL growth 17.7%% in 1H 2017, total growth over 49.1%).  The big focus is on China, where the brand is Pizza Marzano.  It has now established itself as a reliable and strengthening lessee, helping lower lease costs and steadily increase the scale of the operations.  New site openings continue to absorb cash and keep Chinese operations in the start-up loss phase, but more established sites are approaching UK margin levels.

 

 

Financials                                                        1H to 2^nd July 2017

 

In the first half of this year, consumer confidence and revenue trends in the UK and ROI are looking roughly flat, so like-for-like sales and overall growth of 1.3% and 3.2% respectively is a decent result.  Falling margins are apparent over the years we’ve covered in our summary below, and while weaker GBP has helped overseas earnings, it has also lowered margins in the UK business as cost inflation hits on the 15-20% of food sourcing affected by exchange rates.  There has also been domestic pressure, predominantly increases in business rates increases and national living wage rates.  The reduction in EBITDA in the first half is quite pronounced in historical context, although it moved up during the second quarter to 14.74% from a first quarter low of 13.69%.  PIZEXP works endlessly, and fairly successfully, on making efficiency gains to mitigate the impact.  Inflationary pressure has had reduced margins by 300-350bps, but they think by the end of the year they will have clawed back just under half of that on a run rate basis.

 

Repeated buyouts have left their mark: changed accounting period ends, massive debt & eyewatering leverage, progress into statutory losses and diminished – although still adequate – cash interest cover.  Net worth has been fully eroded by the buyouts, and it will keep going the same way until the Far East expansion reaches critical mass, which is a medium-term goal.

 

As mentioned, PIZEXP uses an adjusted EBITDA figure and shareholder debt is excluded from calculations.  It therefore reports better margins and leverage than our standard analysis indicates, as per this commentary from the first half results:

 

At 2 July 2017, Adjusted Net Debt* stood at £649.0m and Adjusted EBITDA* was £102.4m, giving an Adjusted Net Debt : Adjusted EBITDA ratio of 6.3x. This compares with 5.8x at the end of the previous financial year (1 January 2017) and 6.5x at the time of the original acquisition of the Group by Hony Capital in August 2014.

 

*Adjusted EBITDA is the EBITDA for the preceding 52 week period inclusive of an adjustment for expected run rate trading for all restaurants open less than 18 months as management believe the first 6 months of a restaurant’s trading are not representative of run rate trading.

 

At least we can say Hony has some decent skin in the game – its shareholder loan notes roughly equate to the goodwill that represents £381mn of the £903mn intangibles and it’s at the back of the creditor queue.  The rest is £552mn of trademarks.  Working capital is low with such fast turnover of customers and inventory, so those intangibles, plus the property, plant & equipment of £236mn are pretty much what’s balancing the £1bn of debt.  There are some obvious vulnerabilities to those assets, not least that almost 70% of PPE is leaseholds, not owned property.

 

PIZEXP will keep expanding the business, although at a scaled back rate in the UK (five over the second half of this year; 20-25 for the full year internationally, mostly in China).  The balance sheet will therefore continue to deteriorate.  All surplus cash is earmarked for growth, so delevering will come via increased EBITDA rather than debt reduction.  This calls for some patience on investors’ part, something Hony probably has.  Hony makes a point of saying all its holdings as at the 2011 recession came through alright, and we can expect that a general downturn will occur sometime during the coming four-to-five years.  We can hope those maturities don’t coincide with a difficult capital market.  Maturities would appear longer than the expected payback from investment in China, so that’s a positive.  It really could use extra fat in the cash interest cover margin judging by the first half’s 1.3x, and the best of businesses can be overwhelmed by debt servicing obligations, so we will be watching the second half’s progression on that front with great interest.  That said, there are weaker leveraged buyouts than PIZEXP, particularly among GBP issuers.

 

Funding

 

• Revolving Credit Facility – usually undrawn.  It’s a multicurrency facility and PIZEXP can therefore use EURIBOR or HIBOR as the reference rate if drawing euro or Hong Kong dollars. This facility could potentially be increased via a new facility or additional tranche/s and may be at a different interest rate.  The margin ratchets down if certain leverage ratios are met.  Default interest attracts an extra 1% on the overdue amount. Some covenants disappear if there’s an IPO, leverage is 3.5x or lower, or IG rating achieved.  Leverage covenant is only tested on a rolling quarterly basis if at least 25% of the RCF is drawn on the test date and if breached only acts as a drawstop to further drawings under the RCF.  Plus they get 4 cures to use up over the 5 year term.  Handy!
• The subordinated shareholder loan notes were issued by PizzaExpress Financing 2 (issuer of the 1^st lien bond) as £307.6mn 10.00 % 2024 to Hony’s investment vehicle, Crystal Bright Developments. Interest is non-cash pay and capitalises so the balance had risen to £405mn at the half year.

 

View

 

PIZEXP is clearly a well run business judging by its longevity and ongoing appeal to investors.  Together with Hony it has taken full advantage of the high yield-friendly conditions, allowing it to gear up cheaply.  The focus on China is an obvious way to build on its existing Asian presence and Hony’s support is a strong positive. High gearing will remain a feature until China drives EBITDA higher.  In that context, bond prices below par finally make it worth a glance.  £465mn of 1^st lien bonds stacking up against £716mn of long term assets looks the best bet, and 7-8% is relatively good in this market, but we would also suggest being ready for better prices in the senior bonds next time the market has the jitters to ensure investors are being paid properly for the risk that high leverage squeezes cash flow cover in leaner years.  Please contact the desk if you wish to discuss.

Penelope Fitzherbert

PIZEXP Bonds