Pizza Express' Capital Restructuring

Pizza Express, a casual dining chain, are facing growing problems with their capital structure causing real concern for the company’s future (The Financial Times, 2019a). Capital Structure is simply, ‘the mix of securities and financing sources used by corporations to finance real investment’ (Myers, 2001).The main research conducted into capital structure focuses on the debate of debt vs equity and tries to establish the optimal ratio between the two types of finance (if one even exists) (Myers, 2001). This week’s blog will look at the case of Pizza Express as their current capital structure is causing concerns for bondholders (The Financial Times, 2019a). Also, this week’s blog will look at possible reasons why Pizza Express have chosen the capital structure they currently have and compare this to relevant theories of capital structure whilst also looking at possible solutions to improve their current financial situation.

Pizza Express have undergone some difficult times in recent years as high street stores and restaurants close at an alarming rate due to the growing competition of online retailers and food delivery services (The Financial Times, 2019a). The recent collapse of Thomas Cook leaves 563 empty stores on the high street, demonstrating the decline of high street retailers and restaurants (The Financial Times, 2019a). Pizza Express are owned by a private equity firm, Hony Capital, and all their finance is raised through the issue of bonds (a form of debt) (The Financial Times, 2019a). Pizza Express’ current net debt stands at an astonishing £1.1 billion (The Financial Times, 2019a).

Pizza Express’ annual report 2018. Source: Pizza Express Annual Report and Financial Statements 2018

To make matters worse, Pizza Express currently has a debt to EBITDA (earnings before interest, tax, depreciation and amortisation) ratio of 14:1. This means Pizza express has 14 times more debt than EBITDA (The Financial Times, 2019a). It is for this reason that Bondholders in Pizza Express are urging the company to rethink their Capital Structure in order to preserve the future of the business (The Financial Times, 2019a). If there are safer and more sustainable capital structures for companies to adopt, then we can ask, why have Pizza Express opted to rely solely on debt finance in their capital structure?

One such answer to the question above is the argument that debt is cheaper than equity and so using debt as a form of finance will reduce a company’s WACC (Weighted Average Cost of Capital). In Modigliani and Miller’s (1963) revised model of the cost of capital they argue that, due to the tax shield companies receive when paying back debt, a company’s WACC can be reduced by taking on more debt and less equity, making debt finance more attractive for a company. This contradicts Modigliani and Miller’s (1958) original model which stated there was no optimal ratio between debt/equity because the share price would change to reflect the increase/decrease in a company’s gearing level and so the cost of equity would increase if more debt was taken on and vice versa, meaning there would be no change to the company’s WACC. If we apply Modigliani and Miller’s (1963) revised model of the cost of capital to Pizza Express, then Pizza Express should have gained an advantage by taking on more debt as this is a cheaper form of finance. If this is the case, why are bondholders calling for a debt restructuring? (The Financial Times, 2019a).

There is another theory of the cost of capital commonly known as the trade-off theory (Stretcher & Johnson, 2011). Although this is like the revised model from Modigliani and Miller (1963) with respect that having more debt as opposed to equity will decrease a company’s WACC, it considers the dangers of taking on too much debt (Stretcher & Johnson, 2011). The trade-off model shows that as a company takes on a higher percentage of debt, they become financially distressed due to the large interest payments the company is obliged to pay back (Stretcher & Johnson, 2011).

Trade-Off Model - Firms Value on the Y-axis and debt ratio on the X-axis. Source: Stretcher & Johnson, 2011. 

This is where the negatives to debt finance come into play. Companies are obligated to pay back loans, bonds and other forms of debt finance in full and with interest whereas there is no obligation to pay shareholders dividends, making equity less risky (Stretcher & Johnson, 2011). If we apply the trade-off model to Pizza Express, it becomes apparent why the bondholders are calling for Pizza Express to change their Capital Structure.

Pizza Express desperately need to find a way to reduce their £1.1 billion net debt in order to become more financially stable (The Financial Times, 2019a). One option for Pizza Express to try and reduce their debt is to sell off some of their assets. This would be in the form of some of their 480 sites across the UK (The Financial Times, 2019a). However, this would be good for the short term as it would generate revenue but negative for their long-term value as they will lose out on further income through the sites they sell. Although, with only 95% of their restaurants in the UK and Ireland currently profitable there would be 24 non-profitable sites which could be sold (The Financial Times, 2019b). However, this will most likely fall short in reducing their debt to a reasonable level as there current £1.1 billion net debt amounts to roughly £1.6 million per restaurant which, according to the Financial Times (2019a), is much larger than the value of each restaurant itself.  Another option for Pizza Express could be a debt-for-equity swap in which bondholders could exchange their loans for shares in Pizza Express (The Financial Times, 2019c). Some bondholders have even offered to put more money into Pizza Express if this were to be the outcome of the capital restructuring (The Financial Times, 2019c). There isn’t much of an option for Pizza Express to go public and try and raise money through the sale of shares as calculations from The Financial Times (2019c) estimates Pizza Express’ ‘£1.1bn in net debt easily exceeds estimates of its equity value.’

As issuing shares isn’t really an option for Pizza Express, the main options to consider are the sale of assets or a debt-for-equity swap. Both would succeed in reducing the company’s eye-watering amount of debt however both have opportunity costs to consider. The sale of assets would provide short term monetary gain which could be used to reduce their debt. However, this is at the expense of long-term value and income which could hinder Pizza Express’ future success. The debt-for-equity swap would eliminate large portions of the debt whilst also providing fresh investment for the company to use to grow. However, this would be at the cost of control as the current bondholders would become shareholders in the company and so a lot of control would be lost. Personally, I think the best option is the debt-for-equity swap as the sale of assets wouldn’t reduce the debt enough as the debt is just too large. Also, the debt-for-equity swap would solve a large portion of the debt problem whilst also providing Pizza Express with fresh investment. Unfortunately for Pizza Express, this appears to be the only viable option at this moment in time.

Reference List

Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American economic review, 261-297.

Modigliani, F., & Miller, M. H. (1963). Corporate income taxes and the cost of capital: a correction. The American economic review, 433-443.

Myers, S. (2001). Capital Structure. Journal Of Economic Perspectives, 15(2), 81-102. doi: 10.1257/jep.15.2.81

Pizza Express. (2018). Annual Report and Financial Statements 2018. Retrieved from https://corporate.pizzaexpress.com/~/media/Files/P/Pizza-Express/documents/2018-annual-report.pdf

Stretcher, R., & Johnson, S. (2011). Capital structure: professional management guidance. Managerial Finance, 37(8), 788-804.

The Financial Times. (2019a). PizzaExpress bondholders press for debt restructuring | Financial Times. Retrieved from https://www.ft.com/content/18ec966e-e91c-11e9-a240-3b065ef5fc55

The Financial Times. (2019b). PizzaExpress’s Chinese owner to buy back chain’s debt | Financial Times. Retrieved from https://www.ft.com/content/dda91e4e-007a-11ea-be59-e49b2a136b8d

The Financial Times. (2019c). PizzaExpress bondholders escalate push for debt restructuring | Financial Times. Retrieved from https://www.ft.com/content/28459880-0493-11ea-9afa-d9e2401fa7ca