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UVA-F-1553 CALIFORNIA PIZZA KITCHEN Everyone knows that 95% of restaurants fail in the first two years, and a lot of people think it's \"location, location, location.\" It could be, but my experience is you have to have the financial staying power. You could have the greatest idea, but many restaurants do not start out making moneythey build over time. So it's really about having the capital and the staying power. Rick Rosenfield, Co-CEO, California Pizza Kitchen1 In early July 2007, the financial team at California Pizza Kitchen (CPK), led by Chief Financial Officer Susan Collyns, was compiling the preliminary results for the second quarter of 2007. Despite industry challenges of rising commodity, labor, and energy costs, CPK was about to announce near-record quarterly profits of over $6 million. CPK's profit expansion was explained by strong revenue growth with comparable restaurant sales up over 5%. The announced numbers were fully in line with the company's forecasted guidance to investors. The company's results were particularly impressive when contrasted with many other casual dining firms, which had experienced sharp declines in customer traffic. Despite the strong performance, industry difficulties were such that CPK's share price had declined 10% during the month of June to a current value of $22.10. Given the price drop, the management team had discussed repurchasing company shares. With little money in excess cash, however, a large share repurchase program would require debt financing. Since going public in 2000, CPK's management had avoided putting any debt on the balance sheet. Financial policy was conservative to preserve what co-CEO Rick Rosenfeld referred to as staying power. The view was that a strong balance sheet would maintain the borrowing ability needed to support CPK's expected growth trajectory. Yet with interest rates on the rise from historical lows, Collyns was aware of the benefits of moderately levering up CPK's equity. 1 Richard M. Smith, \"Rolling in Dough; For the Creators of California Pizza Kitchen, Having Enough Capital Was the Key Ingredient to Success,\" Newsweek, June 25, 2007. This case was written by Elizabeth W. Shumadine (MBA '01), under the supervision of Professor Michael J. Schill, and is based on public information. Funding provided by the L. White Matthews Fund for Finance case writing. Copyright 2008 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation. This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. -2- UVA-F-1553 California Pizza Kitchen Inspired by the gourmet pizza offerings at Wolfgang Puck's celebrity-filled restaurant, Spago, and eager to flee their careers as white-collar criminal defense attorneys, Larry Flax and Rick Rosenfield created the first California Pizza Kitchen in 1985 in Beverly Hills, California. Known for its hearth-baked barbecue-chicken pizza, the \"designer pizza at off-the-rack prices\" concept flourished. Expansion across the state, country, and globe followed in the subsequent two decades. At the end of the second quarter of 2007, the company had 213 locations in 28 states and 6 foreign countries. While still very California-centric (approximately 41% of the U.S. stores were in California), the casual dining model had done well throughout all U.S. regions with its family-friendly surroundings, excellent ingredients, and inventive offerings. California Pizza Kitchen derived its revenues from three sources: sales at companyowned restaurants, royalties from franchised restaurants, and royalties from a partnership with Kraft Foods to sell CPK-branded frozen pizzas in grocery stores. While the company had expanded beyond its original concept with two other restaurant brands, its main focus remained on operating company-owned full-service CPK restaurants, of which there were 170 units. Analysts conservatively estimated the potential for full-service company-owned CPK units at 500. Both the investment community and management were less certain about the potential for the company's chief attempt at brand extension, its ASAP restaurant concept. In 1996, the company first developed the ASAP concept in a franchise agreement with HMSHost. The franchised ASAPs were located in airports and featured a limited selection of pizzas and \"grab-n-go\" salads and sandwiches. While not a huge revenue source, management was pleased with the success of the airport ASAP locations, which currently numbered 16. In early 2007, HMSHost and CPK agreed to extend their partnership through 2012. But the sentiment was more mixed regarding its company-owned ASAP locations. First opened in 2000 to capitalize on the growth of fast casual dining, the company-owned ASAP units offered CPK's most-popular pizzas, salads, soups, and sandwiches with in-restaurant seating. Sales and operations at the company-owned ASAP units never met management's expectations. Even after retooling the concept and restaurant prototype in 2003, management decided to halt indefinitely all ASAP development in 2007 and planned to record roughly $770,000 in expenses in the second quarter to terminate the planned opening of one ASAP location. Although they had doubts associated with the company-owned ASAP restaurant chain, the company and investment community were upbeat about CPK's success and prospects with franchising full-service restaurants internationally. At the beginning of July 2007, the company had 15 franchised international locations, with more openings planned for the second half of 2007. Management sought out knowledgeable franchise partners who would protect the company's brand and were capable of growing the number of international units. Franchising agreements typically gave CPK an initial payment of $50,000 to $65,000 for each location opened and then an estimated 5% of gross sales. With locations already in China (including Hong Kong), Indonesia, Japan, Malaysia, the Philippines, and Singapore, the company planned to expand its global reach to Mexico and South Korea in the second half of 2007. This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. -3- UVA-F-1553 Management saw its Kraft partnership as another initiative in its pursuit of building a global brand. In 1997, the company entered into a licensing agreement with Kraft Foods to distribute CPK-branded frozen pizzas. Although representing less than 1% of current revenues, the Kraft royalties had a 95% pretax margin, one equity analyst estimated.2 In addition to the high-margin impact on the company's bottom line, management also highlighted the marketing requirement in its Kraft partnership. Kraft was obligated to spend 5% of gross sales on marketing the CPK frozen pizza brand, more than the company often spent on its own marketing. Management believed its success in growing both domestically and internationally, and through ventures like the Kraft partnership, was due in large part to its \"dedication to guest satisfaction and menu innovation and sustainable culture of service.\"3 A creative menu with highquality ingredients was a top priority at CPK, with the two co-founders still heading the menudevelopment team. Exhibit 1 contains a selection of CPK menu offerings. \"Its menu items offer customers distinctive, compelling flavors to commonly recognized foods,\" A Morgan Keegan analyst wrote.4 While the company had a narrower, more-focused menu than some of its peers, the chain prided itself on creating craved items, such as Singapore Shrimp Rolls, that distinguished its menu and could not be found at its casual dining peers. This strategy was successful, and internal research indicated a specific menu craving that could not be satisfied elsewhere prompted many patron visits. To maintain the menu's originality, management reviewed detailed sales reports twice a year and replaced slow-selling offerings with new items. Some of the company's most recent menu additions in 2007 had been developed and tested at the company's newest restaurant concept, the LA Food Show. Created by Flax and Rosenfield in 2003, the LA Food Show offered a more upscale experience and expansive menu than CPK. CPK increased its minority interest to full ownership of the LA Food Show in 2005 and planned to open a second location in early 2008. In addition to crediting its inventive menu, analysts also pointed out that its average check of $13.30 was below that of many of its upscale dining casual peers, such as P.F. Chang's and the Cheesecake Factory. Analysts from RBC Capital Markets labeled the chain a \"Price- Value-Experience\" leader in its sector.5 CPK spent 1% of its sales on advertising, far less than the 3% to 4% of sales that casual dining competitors, such as Chili's, Red Lobster, Olive Garden, and Outback Steakhouse, spent annually. Management felt careful execution of its company model resulted in devoted patrons who created free, but far more-valuable word-of-mouth marketing for the company. Of the actual dollars spent on marketing, roughly 50% was spent on menu-development costs, with the other half consumed by more typical marketing strategies, such as public relations efforts, direct mail offerings, outdoor media, and on-line marketing. 2 Jeffrey D. Farmer, CIBC World Markets Equity Research Earnings Update, \"California Pizza Kitchen, Inc.; Notes from West Coast Investor Meetings: Shares Remain Compelling,\" April 12, 2007. 3 Company press release, February 15, 2007. 4 Destin M. Tompkins, Robert M. Derrington, and S. Brandon Couillard, Morgan Keegan Equity Research, \"California Pizza Kitchen, Inc.,\" April 19, 2007. 5 Larry Miller, Daniel Lewis, and Robert Sanders, RBC Capital Markets Research Comment, \"California Pizza Kitchen: Back on Trend with Old Management,\" September 14, 2006. This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. -4- UVA-F-1553 CPK's clientele was not only attractive for its endorsements of the chain, but also because of its demographics. Management frequently highlighted that its core customer had an average household income of more than $75,000, according to a 2005 guest satisfaction survey. CPK contended that its customer base's relative affluence sheltered the company from macroeconomic pressures, such as high gas prices, that might lower sales at competitors with fewer well-off patrons. Restaurant Industry The restaurant industry could be divided into two main sectors: full service and limited service. Some of the most popular subsectors within full service included casual dining and fine dining, with fast casual and fast food being the two prevalent limited-service subsectors. Restaurant consulting firm Technomic Information Services projected the limited-service restaurant segment to maintain a five-year compound annual growth rate (CAGR) of 5.5%, compared with 5.1% for the full-service restaurant segment.6 The five-year CAGR for CPK's subsector of the full-service segment was projected to grow even more at 6.5%. In recent years, a number of forces had challenged restaurant industry executives, including: Increasing commodity prices; Higher labor costs; Softening demand due to high gas prices; Deteriorating housing wealth; Intense interest in the industry by activist shareholders. High gas prices not only affected demand for dining out, but also indirectly pushed a dramatic rise in food commodity prices. Moreover, a national call for the creation of more biofuels, primarily corn-produced ethanol, played an additional role in driving up food costs for the restaurant industry. Restaurant companies responded by raising menu prices in varying degrees. The restaurants believed that the price increases would have little impact on restaurant traffic given that consumers experienced higher price increases in their main alternative to dining outpurchasing food at grocery stores to consume at home. Restaurants not only had to deal with rising commodity costs, but also rising labor costs. In May 2007, President Bush signed legislation increasing the U.S. minimum wage rate over a three-year period beginning in July 2007 from $5.15 to $7.25 an hour. While restaurant management teams had time to prepare for the ramifications of this gradual increase, they were ill-equipped to deal with the nearly 20 states in late 2006 that passed anticipatory wage increases at rates higher than those proposed by Congress. 6 Destin M. Tompkins, Robert M. Derrington, and S. Brandon Couillard, Morgan Keegan Equity Research, \"California Pizza Kitchen, Inc.,\" April 19, 2007. This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. -5- UVA-F-1553 In addition to contending with the rising cost of goods sold (COGS), restaurants faced gross margins that were under pressure from the softening demand for dining out. A recent AAA Mid-Atlantic survey asked travelers how they might reduce spending to make up for the elevated gas prices, and 52% answered that food expenses would be the first area to be cut.7 Despite that news, a Deutsche Bank analyst remarked, \"Two important indicators of consumer health disposable income and employmentare both holding up well. As long as people have jobs and incomes are rising, they are likely to continue to eat out.\"8 The current environment of elevated food and labor costs and consumer concerns highlighted the differences between the limited-service and full-service segments of the restaurant industry. Franchising was more popular in the limited-service segment and provided some buffer against rising food and labor costs because franchisors received a percentage of gross sales. Royalties on gross sales also benefited from any pricing increases that were made to address higher costs. Restaurant companies with large franchising operations also did not have the huge amount of capital invested in locations or potentially heavy lease obligations associated with company-owned units. Some analysts included operating lease requirements when considering a restaurant company's leverage.9 Analysts also believed limited-service restaurants would benefit from any consumers trading down from the casual dining sub-sector of the fullservice sector.10 The growth of the fast-casual subsector and the food-quality improvements in fast food made trading down an increasing likelihood in an economic slowdown. The longer-term outlook for overall restaurant demand looked much stronger. A study by the National Restaurant Association projected that consumers would increase the percentage of their food dollars spent on dining out from the 45% in recent years to 53% by 2010.11 That longterm positive trend may have helped explain the extensive interest in the restaurant industry by activist shareholders, often the executives of private equity firms and hedge funds. Activist investor William Ackman with Pershing Square Capital Management initiated the current round of activist investors forcing change at major restaurant chains. Roughly one week after Ackman vociferously criticized the McDonald's corporate organization at a New York investment conference in late 2005, the company declared it would divest 1,500 restaurants, repurchase $1 billion of its stock, and disclose more restaurant-level performance details. Ackman advocated all those changes and was able to leverage the power of his 4.5% stake in McDonald's by using the media. His success did not go unnoticed, and other vocal minority investors aggressively pressed for changes at numerous chains including Applebee's, Wendy's, and Friendly's. These 7 Amy G. Vinson and Ted Hillard, Avondale Partners, LLC, \"Restaurant Industry Weekly Update,\" June 11, 2007. 8 Jason West, Marc Greenberg, and Andrew Kieley, Deutsche Bank Global Markets Research, \"Transferring Coverage-Reservations Available,\" June 7, 2007. 9 As of July 1, 2007, CPK had $154.3 million in minimum lease payments required over the next five years with $129.6 million due in more than five years. 10 Jeff Omohundro, Katie H. Willett, and Jason Belcher, Wachovia Capital Markets, LLC Equity Research, \"The Restaurant Watch,\" July 3, 2007. 11 Destin M. Tompkins, Robert M. Derrington, and S. Brandon Couillard, Morgan Keegan Equity Research, \"California Pizza Kitchen, Inc.,\" April 19, 2007. This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. -6- UVA-F-1553 changes included the outright sale of the company, sales of noncore divisions, and closure of poor-performing locations. In response, other chains embarked on shareholder-friendly plans including initiating share repurchase programs; increasing dividends; decreasing corporate expenditures; and divesting secondary assets. Doug Brooks, chief executive of Brinker International Inc., which owned Chili's, noted at a recent conference: There is no shortage of interest in our industry these days, and much of the recent news has centered on the participation of activist shareholders ... but it is my job as CEO to act as our internal activist.12 In April 2007, Brinker announced it had secured a new $400 million unsecured, committed credit-facility to fund an accelerated share repurchase transaction in which approximately $300 million of its common stock would be repurchased. That followed a tender offer recapitalization in 2006 in which the company repurchased $50 million worth of common shares. Recent Developments CPK's positive second-quarter results would affirm many analysts' conclusions that the company was a safe haven in the casual dining sector. Exhibits 2 and 3 contain CPK's financial statements through July 1, 2007. Exhibit 4 presents comparable store sales trends for CPK and peers. Exhibit 5 contains selected analysts' forecasts for CPK, all of which anticipated revenue and earnings growth. A Morgan Keegan analyst commented in May: Despite increased market pressures on consumer spending, California Pizza Kitchen's concept continues to post impressive customer traffic gains. Traditionally appealing to a more discriminating, higher-income clientele, CPK's creative fare, low check average, and high service standards have uniquely positioned the concept for success in a tough consumer macroeconomic environment.13 While other restaurant companies experienced weakening sales and earnings growth, CPK's revenues increased more than 16% to $159 million for the second quarter of 2007. Notably, royalties from the Kraft partnership and international franchises were up 37% and 21%, respectively, for the second quarter. Development plans for opening a total of 16 to 18 new locations remained on schedule for 2007. Funding CPK's 2007 growth plan was anticipated to require $85 million in capital expenditures. 12 Sarah E. Lockyer, \"Who's the Boss? Activist Investors Drive Changes at Major Chains: Companies Pursue 'Shareholder-Friendly' Strategies in Response to Public Pressure,\" Nation's Restaurant News, April 23, 2007. 13 Destin M. Tompkins and Robert M. Derrington, Morgan Keegan Equity Research, \"California Pizza Kitchen, Inc.,\" May 11, 2007. This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. -7- UVA-F-1553 The company was successfully managing its two largest expense items in an environment of rising labor and food costs. Labor costs had actually declined from 36.6% to 36.3% of total revenues from the second quarter of 2006 to the second quarter of 2007. Food, beverage, and paper-supply costs remained constant at roughly 24.5% of total revenue in both the second quarter of 2006 and 2007. The company was implementing a number of taskforce initiatives to deal with the commodity price pressures, especially as cheese prices increased from $1.37 per pound in April to almost $2.00 a pound by the first week of July. Management felt that much of the cost improvements had been achieved through enhancements in restaurant operations. Capital Structure Decision CPK's book equity was expected to be around $226 million at the end of the second quarter. With a share price in the low 20s, CPK's market capitalization stood at $644 million. The company had recently issued a 50% stock dividend, which had effectively split CPK shares on a 3-for-2 shares basis. CPK investors received one additional share for every two shares of common stock held. Adjusted for the stock dividend, Exhibit 6 shows the performance of CPK stock relative to that of industry peers. Despite the challenges of growing the number of restaurants by 38% over the last five years, CPK consistently generated strong operating returns. CPK's return on equity (ROE), which was 10.1% for 2006, did not benefit from financial leverage.14 Financial policy varied across the industry, with some firms remaining all equity capitalized and others levering up to half debt financing. Exhibit 7 depicts selected financial data for peer firms. Because CPK used the proceeds from its 2000 initial public offering (IPO) to pay off its outstanding debt, the company completely avoided debt financing. CPK maintained borrowing capacity available under an existing $75 million line of credit. Interest on the line of credit was calculated at LIBOR plus 0.80%. With LIBOR currently at 5.36%, the line of credit's interest rate was 6.16% (see Exhibit 8). The recent 10% share price decline seemed to raise the question of whether this was an ideal time to repurchase shares and potentially leverage the company's balance sheet with ample borrowings available on its existing line of credit. One gain from the leverage would be to reduce the corporate income-tax liability, which had been almost $10 million in 2006. Exhibit 9 provides pro forma financial summaries of CPK's tax shield under alternative capital structures. Still, CPK needed to preserve its ability to fund the strong expansion outlined for the company. Any use of financing to return capital to shareholders needed to be balanced with management's goal of growing the business. 14 By a familiar decomposition equation, a firm's ROE could be decomposed into three components: operating margin, capital turnover, and leverage. More specifically, the algebra of the decomposition was as follows: ROE = Profit Equity = (Profit Revenue) (Revenue Capital) (Capital Equity). This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. -8- UVA-F-1553 Exhibit 1 CALIFORNIA PIZZA KITCHEN Selected Menu Offerings Appetizers Avocado Club Egg Rolls: A fusion of East and West with fresh avocado, chicken, tomato, Monterey Jack cheese, and applewood smoked bacon, wrapped in a crispy wonton roll. Served with ranchito sauce and herb ranch dressing. Singapore Shrimp Rolls: Shrimp, baby broccoli, soy-glazed shiitake mushrooms, romaine, carrots, noodles, bean sprouts, green onion, and cilantro wrapped in rice paper. Served chilled with a sesame ginger dipping sauce and Szechuan slaw. Pizzas The Original BBQ Chicken: CPK's most-popular pizza, introduced in their first restaurant in Beverly Hills in 1985. Barbecue sauce, smoked gouda and mozzarella cheeses, BBQ chicken, sliced red onions, and cilantro. Carne Asada: Grilled steak, fire-roasted mild chilies, onions, cilantro pesto, Monterey Jack, and mozzarella cheeses. Topped with fresh tomato salsa and cilantro. Served with a side of tomatillo salsa. Thai Chicken: This is the original! Pieces of chicken breast marinated in a spicy peanut ginger and sesame sauce, mozzarella cheese, green onions, bean sprouts, julienne carrots, cilantro, and roasted peanuts. Milan: A combination of grilled spicy Italian sausage and sweet Italian sausage with sauted wild mushrooms, caramelized onions, fontina, mozzarella, and parmesan cheeses. Topped with fresh herbs. Pasta Shanghai Garlic Noodles: Chinese noodles wok-stirred in a garlic ginger sauce with snow peas, shiitake mushrooms, mild onions, red and yellow peppers, baby broccoli, and green onions. Also available with chicken and/or shrimp. Chicken Tequila Fettuccine: The original! Spinach fettuccine with chicken, red, green, and yellow peppers, red onions, and fresh cilantro in a tequila, lime, and jalapeo cream sauce. Source: California Pizza Kitchen Web site, http://www.cpk.com/menu (accessed on August 12, 2008). This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. UVA-F-1553 -9Exhibit 2 CALIFORNIA PIZZA KITCHEN Consolidated Balance Sheets (in thousands of dollars) As of 12/31/06 1/1/06 Assets Current assets Cash and cash equivalents Investments in marketable securities Other receivables Inventories Current deferred tax asset, net Prepaid income tax Other prepaid expenses & other current assets Total current assets Property and equipment, net Noncurrent deferred tax asset, net Goodwill and other intangibles Other assets Total assets Liabilities and Shareholders' Equity Current liabilities Accounts payable Accrued compensation and benefits Accrued rent Deferred rent credits Other accrued liabilities Accrued income tax Total current liabilities $ $ $ 213,408 4,513 5,967 4,444 274,254 7,876 4,745 11,721 7,178 5,388 37,917 10,709 4,596 11,834 8,769 6,444 49,530 255,382 5,867 5,825 5,522 310,513 271,867 6,328 5,754 6,300 339,779 $ 15,044 15,042 14,532 4,494 13,275 3,614 66,001 8,683 27,486 8,662 32,436 197 231,159 (34,013) (7) 197,336 $ 193 221,163 (13,013) 291 228,647 (3,050) 208,343 225,888 274,254 $ $ 5,383 24,810 Shareholders' equity: Common stock Additional paid-in-capital Accumulated deficit Accumulated comprehensive loss Total shareholders' equity 7,054 13,068 13,253 4,056 9,294 $ 8,187 46,725 Other liabilities Deferred rent credits, net of current portion Total liabilities & Shareholders' Equity 11,272 $ 11,408 4,109 3,776 8,437 1,428 5,492 45,922 7/1/07 $ 310,513 $ $ 14,115 15,572 14,979 5,135 13,980 9,012 72,793 339,779 Sources of data: Company annual and quarterly reports. This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. UVA-F-1553 -10Exhibit 3 CALIFORNIA PIZZA KITCHEN Consolidated Income Statements (in thousands of dollars, except per-share data) Fiscal Year(1) 2004 2005 2003 Restaurant sales Franchise and other revenues Total revenues Food, beverage and paper supplies Labor Direct operating and occupancy Cost of Sales $ 356,260 3,627 359,887 87,806 129,702 70,273 287,781 $ 418,799 3,653 422,452 103,813 152,949 83,054 339,816 21,488 20,714 4,147 1,221 18,984 28,794 23,975 737 36,298 25,440 4,051 5,552 2,700 1,333 25,097 1,160 152 600 26,840 317 571 (349) (32) (143) 428 General and administrative Depreciation and amortization Pre-opening costs Severance charges(2) Loss on impairment of PP&E Store closure costs Legal settlement reserve Operating income Interest income Other income Equity in loss of unconsolidated JV Total other income (expense) Income before income tax provision Income tax provision (benefit) Net income Net income per common share: Basic Diluted Selected Operating Data: Restaurants open at end of period Company-owned open at end of period(3) Avg weekly full service rest. sales(3) 18-mo. comparable rest. sales growth(3) $ $ $ $ 5,520 (82) 5,602 $ 25,525 7,709 17,816 $ $ 0.93 0.92 0.30 0.29 168 137 54,896 $ 3.4% $ 474,738 $ 547,968 4,861 6,633 479,599 554,601 118,480 135,848 173,751 199,744 92,827 108,558 385,058 444,150 $ $ $ 1.01 0.99 171 141 57,509 $ 8.0% $ 134,604 1,564 136,168 33,090 49,272 26,214 108,576 $ 156,592 1,989 158,581 38,426 56,912 30,773 126,111 11,035 7,070 800 12,206 9,022 852 43,320 29,489 6,964 707 768 29,971 8,687 9,622 718 739 1,105 (22) 1,822 28,662 9,172 19,490 Three Months Ended 7/2/06 7/1/07 2006 287 91 718 287 91 $ 30,689 9,689 21,000 $ 8,974 2,961 6,013 $ 9,713 3,393 6,320 $ $ 1.08 1.06 $ $ 0.20 0.20 $ $ 0.22 0.21 188 157 62,383 $ 7.5% 205 176 65,406 5.9% $ 193 162 65,427 $ 4.8% 213 182 68,535 5.4% Notes: (1) For the years ended December 31, 2006, January 1, 2006, and January 2, 2005, December 28, 2003. Severance charges represent payments to former president/CEO and former senior vice president/senior development officer under the terms of their separation agreements. (3) Data for company-owned restaurants. (2) Sources of data: Company annual and quarterly reports and quarterly company earnings conference calls. This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. UVA-F-1559 -11Exhibit 4 CALIFORNIA PIZZA KITCHEN This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. Selected Historical Comparable Store Sales (calendarized) California Pizza Kitchen Applebee's International, Inc. BJ's Restaurants, Inc. Brinker International(1) The Cheesecake Factory, Inc. Chipotle Mexican Grill, Inc. Darden Restaurants, Inc.Red Lobster Darden Restaurants, Inc.Olive Garden McCormick & Schmick's Seafood Restaurants, Inc. Panera Bread Company P. F. Chang's China Bistro RARE-Longhorn Steakhouse Red Robin Gourmet Burgers Ruth's Chris Steak House, Inc. Sonic Corporation Texas Roadhouse, Inc. CY03 CY04 3.4% 9.3% 4.1% 4.8% 3.3% 4.0% 2.1% 1.9% 0.7% 3.9% 24.4% 13.3% 0.0% 3.9% 2.2% 4.7% 1.1% 3.8% 0.2% 2.7% 5.1% 3.0% 4.6% 5.0% 4.1% 7.5% 1.4% 11.6% 1.6% 7.0% 3.5% 7.6% Note: (1) Brinker's comparable store sales were a blended rate for its various brands. Source of data: KeyBanc Capital Markets equity research. CY05 6.4% 1.8% 4.6% 3.2% 1.7% 10.2% 4.2% 8.6% 3.0% 7.8% 1.2% 2.8% 3.8% 10.4% 5.4% 5.6% Q1 4.8% 2.6% 6.8% 2.7% 1.3% 19.7% 1.6% 5.7% 4.1% 9.0% 1.3% 3.7% 4.8% 6.8% 5.5% 6.4% CY06 Q2 Q3 Q4 5.9% 5.6% 6.9% 1.8% 2.3% 1.1% 5.9% 5.3% 5.5% 2.0% 2.1% 2.1% 0.8% 1.6% 0.8% 14.5% 11.6% 10.1% 9.4% 2.1% 0.7% 2.5% 2.9% 2.9% 2.8% 2.9% 2.0% 3.2% 2.8% 2.0% 1.0% 0.5% 0.9% 0.4% 0.3% 1.5% 3.3% 0.8% 0.2% 6.0% 4.3% 7.4% 4.3% 4.0% 3.4% 1.2% 2.3% 3.3% CY07 Q1 4.7% 4.0% 6.9% 4.4% 0.4% 8.3% 4.6% 1.0% 2.8% 0.0% 2.5% 1.0% 0.5% 1.9% 2.0% 0.9% UVA-F-1553 -12Exhibit 5 CALIFORNIA PIZZA KITCHEN Selected Forecasts for California Pizza Kitchen This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. Firm Oppenheimer and Co. Inc. CIBC World Markets KeyBanc Capital Markets RBC Capital Markets Morgan Keegan & Co., Inc. MKM Partners Date of Price 2007E Report Target Revenues EPS 4/9/07 $ 40 $ 652.9 $ 1.33 4/12/07 37 647.5 1.29 5/11/07 NA NA 1.28 5/11/07 37 650.7 1.31 5/11/07 NA 644.2 1.33 5/11/07 39 647.5 1.34 Source of data: Selected firms' equity research. 2008E Revenues EPS NA 755.1 NA 753.1 742.1 754.3 NA 1.57 1.55 1.59 1.58 1.69 2009E Revenues EPS NA NA NA NA NA NA 878.2 1.90 NA NA NA NA -13Exhibit 6 CALIFORNIA PIZZA KITCHEN Stock Price Comparison This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. Note: Adjusted for the June 2007 50% stock dividend. With such a dividend, an owner of two shares of CPK stock was given an additional share. The effect was to increase CPK shares by one-third, yet maintain the overall capitalization of the equity. Sources of data: Yahoo! Finance and Datastream. UVA-F-1553 UVA-F-1553 -14Exhibit 7 CALIFORNIA PIZZA KITCHEN This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. Comparative Restaurant Financial Data, 2006 Fiscal Year (in millions of dollars, except per-share data) Fiscal Year End California Pizza Kitchen Applebee's International, Inc. BJ's Restaurants, Inc. Brinker International(1) Buffalo Wild Wings, Inc. The Cheesecake Factory, Inc. Chipotle Mexican Grill, Inc. Darden Restaurants, Inc.(2) Frisch's Restaurants, Inc. McCormick & Schmick's Panera Bread Company P.F. Chang's China Bistro RARE Hospitality Int'l Inc.(3) Red Robin Gourmet Burgers Ruth's Chris Steak House, Inc. Sonic Corporation Texas Roadhouse, Inc. Month Dec. Dec. Dec. June Dec. Dec. Dec. May May Dec. Dec. Dec. Dec. Dec. Dec. Aug. Dec. 7/2/2007 Share Price Revenue $22.10 $55 24.28 1,338 20.05 239 29.37 4,151 41.78 278 24.57 1,315 86.00 823 44.14 5,721 30.54 291 25.66 308 46.02 829 35.37 938 26.76 987 40.19 619 16.80 272 22.00 693 12.81 597 EBITDA Net Profit Margin 10.7% 15.9% 9.6% 12.0% 13.3% 12.2% 13.0% 13.2% 31.6% 9.7% 16.3% 10.5% 11.6% 13.7% 15.6% 24.9% 12.5% Margin 3.8% 6.5% 4.1% 4.7% 5.8% 6.2% 5.0% 5.9% 3.1% 4.3% 7.2% 3.6% 5.1% 4.9% 8.7% 11.4% 5.7% Earnings Dividends per Share per Share $0.71 $ 0.00 1.17 0.20 0.41 0.00 1.49 0.20 0.93 0.00 1.02 0.00 1.28 0.00 2.16 0.40 1.78 0.44 0.92 0.00 1.87 0.00 1.24 0.00 1.45 0.00 1.82 0.00 1.01 0.00 0.88 0.00 0.44 0.00 Book Value per Share Beta $7.20 0.85 6.49 0.80 7.78 1.05 8.59 0.90 6.61 1.10 9.09 1.00 14.56 NA 8.37 1.00 19.84 0.60 11.20 1.10 12.53 1.25 11.41 1.10 11.17 0.57 14.68 1.05 2.93 NA 4.66 0.90 4.30 0.90 UVA-F-1553 -15Exhibit 7 (continued) This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. California Pizza Kitchen Applebee's International, Inc. BJ's Restaurants, Inc. Brinker International(1) Buffalo Wild Wings, Inc. The Cheesecake Factory, Inc. Chipotle Mexican Grill, Inc. Darden Restaurants, Inc.(2) Frisch's Restaurants, Inc. McCormick & Schmick's Panera Bread Company P.F. Chang's China Bistro RARE Hospitality Int'l Inc.(3) Red Robin Gourmet Burgers Ruth's Chris Steak House, Inc. Sonic Corporation Texas Roadhouse, Inc. Current Assets $38 105 96 242 75 203 179 378 12 30 128 65 125 29 26 43 53 Current Liabilities $66 187 36 497 26 163 61 1,026 31 40 110 104 134 70 59 78 78 Total Debt $0 175 0 502 0 0 0 645 43 0 0 19 166 114 68 159 36 Share Debt/ Interest Equity Capital Coverage $ 208 0.0% NMF 487 26.5% 11.7 203 0.0% NMF 1,076 31.8% 14.4 116 0.0% NMF 712 0.0% NMF 474 0.0% NMF 1,230 34.4% 10.9 101 30.1% 5.9 160 0.2% NMF 398 0.0% NMF 290 6.2% NMF 360 31.6% 29.2 244 31.9% 7.7 68 50.0% 12.8 392 28.9% 15.0 319 10.2% 19.9 Total Capital Return on Turnover Capital Equity 2.7 10.1% 10.1% 2.0 14.0% 18.0% 1.2 4.9% 4.9% 2.6 13.2% 18.0% 2.4 14.0% 14.0% 1.8 11.4% 11.4% 1.7 8.8% 8.7% 3.1 20.6% 27.5% 2.0 7.9% 9.1% 1.9 8.3% 8.3% 2.1 15.1% 15.1% 3.0 11.1% 11.5% 1.9 9.8% 13.9% 1.7 9.3% 12.5% 2.0 18.6% 34.9% 1.3 15.3% 20.1% 1.7 9.7% 10.7% Notes: (1) For the years ended December 31, 2006, January 1, 2006 and January 2, 2005, December 28, 2003. Severance charges represent payments to former president/CEO and former senior vice president/senior development officer under the terms of their separation agreements. (3) Data for company-owned restaurants. (2) Sources of data: Company annual and quarterly reports and conference calls. UVA-F-1553 -16Exhibit 8 CALIFORNIA PIZZA KITCHEN Interest Rates and Yields This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. 2000 2001 2002 2003 2004 2005 2006: Jan. Feb. Mar. Apr. May. June July Aug. Sept. Oct. Nov. Dec. 2007: Jan. Feb. Mar. Apr. May. June U.S. Treasury Securities Bills Notes & Bonds 3-month 6-month 3-year 10-year 5.85% 5.92% 6.22% 6.03% 3.45% 3.39% 4.09% 5.02% 1.62% 1.69% 3.10% 4.61% 1.02% 1.06% 2.10% 4.01% 1.38% 1.58% 2.78% 4.27% 3.16% 3.40% 3.93% 4.29% 4.20% 4.41% 4.51% 4.59% 4.72% 4.79% 4.96% 4.98% 4.82% 4.89% 4.95% 4.85% 4.96% 5.02% 4.97% 4.88% 4.77% 4.63% 4.30% 4.51% 4.61% 4.72% 4.81% 4.95% 5.09% 4.99% 4.90% 4.91% 4.96% 4.88% 4.94% 4.97% 4.90% 4.87% 4.80% 4.77% 4.35% 4.64% 4.74% 4.89% 4.97% 5.09% 5.07% 4.85% 4.69% 4.72% 4.64% 4.58% 4.79% 4.75% 4.51% 4.60% 4.69% 5.00% 4.42% 4.57% 4.72% 4.99% 5.11% 5.11% 5.09% 4.88% 4.72% 4.73% 4.60% 4.56% 4.76% 4.72% 4.56% 4.69% 4.75% 5.10% Sources of data: Economic Report of the President and Fannie Mae Web site. 30-year 5.94% 5.49% ...... ...... ...... ...... ...... 4.54% 4.73% 5.06% 5.20% 5.15% 5.13% 5.00% 4.85% 4.85% 4.69% 4.68% 4.85% 4.82% 4.72% 4.87% 4.90% 5.20% Corporate bonds (Moody's) Aaa 3 Baa 7.62% 8.36% 7.08% 7.95% 6.49% 7.80% 5.67% 6.77% 5.63% 6.39% 5.24% 6.06% 5.29% 5.35% 5.53% 5.84% 5.95% 5.89% 5.85% 5.68% 5.51% 5.51% 5.33% 5.32% 5.40% 5.39% 5.30% 5.47% 5.47% 5.79% 6.24% 6.27% 6.41% 6.68% 6.75% 6.78% 6.76% 6.59% 6.43% 6.42% 6.20% 6.22% 6.34% 6.28% 6.27% 6.39% 6.39% 6.70% Average Prime Lending 9.23% 6.91% 4.67% 4.12% 4.34% 6.19% Average LIBOR 3-month 6.55% 3.63% 1.79% 1.22% 1.67% 3.63% 7.38% 7.50% 7.63% 7.75% 7.88% 7.13% 8.25% 8.25% 8.25% 8.25% 8.25% 8.25% 8.25% 8.25% 8.25% 8.25% 8.25% 8.25% 4.68% 4.82% 4.99% 5.15% 5.23% 5.51% 5.49% 5.40% 5.37% 5.37% 5.37% 5.36% 5.36% 5.36% 5.35% 5.36% 5.36% 5.36% UVA-F-1553 -17Exhibit 9 CALIFORNIA PIZZA KITCHEN Pro Forma Tax Shield Effect of Recapitalization Scenarios (dollars in thousands, except share data; figures based on end of June 2007) Debt/Total Capital 20% Actual 10% Interest rate (1) Tax rate 6.16% 32.5% 6.16% 32.5% 6.16% 32.5% 6.16% 32.5% Earnings before income taxes and interest(2) Interest expense 30,054 0 30,054 1,391 30,054 2,783 30,054 4,174 Earnings before taxes Income taxes Net income 30,054 9,755 20,299 28,663 9,303 19,359 27,271 8,852 18,419 25,880 8,400 17,480 0 225,888 225,888 22,589 203,299 225,888 45,178 180,710 225,888 67,766 158,122 225,888 0 22,589 45,178 67,766 643,773 643,773 628,516 651,105 613,259 658,437 598,002 665,769 Book value: Debt Equity Total capital 30% Market value: (3) Debt (4) Equity Market value of capital Notes: (1) Interest rate of CPK's credit facility with Bank of America: LIBOR + 0.80%. Earnings before interest and taxes (EBIT) include interest income. (3) Market values of debt equal book values. (4) Actual market value of equity equals the share price ($22.10) multiplied by the current number of shares outstanding (29.13 million). (2) Source: Case writer analysis based on CPK financial data. This document is authorized for use by mamadou traore, from 1/11/2016 to 3/3/2016, in the course: MBA 7294: Advanced Financial Analysis - John Bish (Spring 2016), Wilmington University. Any unauthorized use or reproduction of this document is strictly prohibited. WILMINGTON UNIVERSITY COURSE TITLE: Advanced Financial Analysis COURSE NUMBER: MBA 7294 FACULTY MEMBER: John Bish Week #3 Case Study - California Pizza Kitchen Case Study Questions: 1. Summarize the Modigiani-Miller (1958) capital structure irrelevance propositions and the concept of debt tax shields. a. Discuss optimal capital structure as described within Capital Structure Theory: A Current Perspective b. Summarize the critiques of the Modigiani-Miller capital structure approach as described within Capital Structure Theory: A Current Perspective 2. Utilizing case data from Figure 9 answer the following questions a. If CPK's Debt/Total Equity Capital Ratio was 10%; i. What would be CPK's Return on Equity? ii. What would be CPK's WACC? b. If CPK's Debt/Total Equity Capital Ratio was 20%; i. What would be CPK's Return on Equity? ii. What would be CPK's WACC? c. If CPK's Debt/Total Equity Capital Ratio was 30%; i. What would be CPK's Return on Equity? ii. What would be CPK's WACC? 3. Utilizing case data from Figure 9 answer the following questions a. If CPK's Debt/Total Equity Capital Ratio was 10%; iii. What would be CPK's anticipated share price? b. If CPK's Debt/Total Equity Capital Ratio was 20%; iv. What would be CPK's anticipated share price? c. If CPK's Debt/Total Equity Capital Ratio was 30%; v. What would be CPK's anticipated share price? d. What role does the tax deductibility of interest play in encouraging debt financing at CPK? 4. What capital structure policy would you recommend for CPK? Case Study Assumptions: 1. This case introduces the Modigiani-Miller capital structure irrelevance propositions and the concept of debt tax shields. 2. To calculate CPK's WACC utilize the CAPM model 3. CPK's Beta can be modeled using the following formula: a. L = U[1 + (1 T)D/E] i. L = CPK's Beta with leverage ii. U = CPK's Beta without leverage iii. T = Corporate Tax Rate iv. D = Market value of Debt v. E] = Market value of Equity 4. Beta will need to be adjusted to account for the difference between actual and target debt ratio by unlevering beta to determine an unlevered asset beta and levering beta at the target debt rate. Case Study Analysis Papers grading rubric Grading Criteria Summarize the Modigiani-Miller (1958) capital structure theory as described within Capital Structure Theory: A Current Perspective Summarize your interpretation of optimal capital structure as described within Capital Structure Theory: A Current Perspective Summarize the critiques of the Modigiani-Miller capital structure approach as described within Capital Structure Theory: A Current Perspective Discuss Return on Equity for CPK if; Debt/Total Equity Capital Ratio was 10%; Debt/Total Equity Capital Ratio was 20%; and Debt/Total Equity Capital Ratio was 30%. Discuss WACC for CPK if; Debt/Total Equity Capital Ratio was 10%; Debt/Total Equity Capital Ratio was 20%; and Debt/Total Equity Capital Ratio was 30%. Discuss the anticipated share price for CPK if; Debt/Total Equity Capital Ratio was 10%; Debt/Total Equity Capital Ratio was 20%; and Debt/Total Equity Capital Ratio was 30%. Develop and discuss your proposed capital structure for CPK. Proper spelling, punctuation, report components, and APA Formatting Total Maximum Points 15 15 10 15 15 15 10 5 100