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CASE .California Pizza Kitchen Everyone knows that 95% ofrestaurants fail in the rst twoyears, and a lot ofpeople 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 Rosenfiefd, (lo-CEO, California Pizza Kitchen: In early July 2007, the financial team at California Pizza Kitchen (CPR), led by Chief Financial Ofcer 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 rms, which had experienced sharp declines in customer trafc. Despite the strong performance, industry difculties 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 benets of moderately levering up CPK's equity. Fee 392 California Pizza Kitchen Inspired by the gourmet pizza offerings at Wolfgang Puck's celebrity-filled restaurant, Spago. and eager to ee their careers as white-collar criminal defense attorneys, Larry Flax and Rick Rosenfield created the rst 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 ourished. 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 [1.5. regions with its family-friendly surroundings, excellent ingredients, and inventive offerings. California Pizza Kitchen derived its revenues from three sources: sales at company-owned 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 1 70 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 rst 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 200 7, 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 grth 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 Iuly 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, Iapan, Malaysia, the Philippines, and Singapore, the company planned to expand its global reach to Mexico and South Korea in the second half of 2007. 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; 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": A creative menu with high-quality ingredients was a top priority at CPK, with the two co-founders still heading the menu-development team. Exhibit 32.1 contains a selection of CPK menu offerings. "Its menu items offer customers distinctive, compelling avors to commonly recognized foods," A Morgan Keegan analyst wrote; 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 ofthe 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 Roseneld 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. EXHIBIT 32.1 | 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 1935. 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 lack, 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 ltalian sausage and sweet ltalian 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 jalapeno cream sauce. Source: California Pizza Kitchen Web site, WW {accessed on August 12, 2005'). 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 RF. 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-ofmouth marketing for the company. Of the actual dollars spent on marketing, roughly 50% was s - ent 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. 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 we ll-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 rm 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 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; and o 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 out~purchasing 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 wae increases at rates higher than those proposed by Congress. 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 cutl Despite that news, a Deutsche Bank analyst remarked, "Two important indicators of consumer healthdisposable 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.g Analysts also believed limited-service restaurants would benet from any consumers trading down from the casual dining sub-sector ofthe full-service sector The growth ofthe 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 oftheir food dollars spent on dining out from the 45% in recent years to 53% by 2010. That long-term 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 a ; _ressively pressed for changes at numerous chains including Applebee's, Wendy's, iand Friendly' 5. These 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 dive sting 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 activistlz 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 32.2 and E contain CPK's nancial statements through Iuly 1, 2007. Exhibit 32.4 presents comparable store sales trends for CPK and peers. Exhibit 32.5 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 trafc 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 environmentu EXHIBIT 32.2 | Consolidated Balance Sheets (in thousands of dollars) As of 1/1/06 12/31/06 7/1/07 Assets Current assets Cash and cash equivalents $ 11.272 $ 8,187 $ Investments In marketable securities 11.408 Other receivables 4.109 7.876 10.709 Inventories 3,776 4,745 4.596 Current deferred tax asset, net 8,437 11,721 11.834 Prepaid income tax 1.428 8.769 Other prepaid expenses and other current assets 5.492 5.388 6.444 Total current assets 45,922 37.917 49.530 Property and equipment, net 213.408 255,382 271.867 Noncurrent deferred tax asset, net 4.513 5,867 6.328 Goodwill and other Intangibles 5.967 5.825 5,754 Other assets 4.444 5,522 6.300 Total assets $274.254 $310,513 $339.779 Liabilities and Shareholders' Equity Current liabilities Accounts payable $ 7.054 $ 15.044 $ 14.115 Accrued compensation and benefits 13,068 15,042 15.572 Accrued rent 13,253 14,532 14,979 Deferred rent credits 4.056 4,494 5,135 Other accrued liabilities 9.294 13.275 13.980 Accrued Income tax 3,614 9.012 Total current liabilities 46,725 66.001 72,793 Other liabilities 5.383 8.683 8.662 Deferred rent credits, net of current portion 24.810 27.486 32,436 Shareholders' equity: Common stock 197 193 291 Additional paid-in-capital 231.159 221.163 228.647 Accumulated deficit (34,013) (13,013) (3,050) Accumulated comprehensive loss (7) Total shareholders' equity 197.336 208,343 225.888 Total Ilabilities and Shareholders' Equity $274,254 $310.513 $339,779 Sources of data: Company annual and quarterly reports. EXHIBIT 32.3 | Consolidated Income Statements (in thousands of dollars, except per-share data)Fiscal Year(1) Three Months Ended 2003 2004 2005 2006 7/2/06 7/1/07 Restaurant sales $356,260 $418,799 $474.738 $547,968 $134.604 $156,592 Franchise and other revenues 3,627 3.653 4.861 6.633 1,564 1,989 Total revenues 359,887 422,452 479.599 554,601 136,168 158,581 Food, beverage and paper supplies 87.806 103,813 118,480 135.848 33.090 38.426 Labor 129,702 152,949 173.751 199.744 49,272 56,912 Direct operating and occupancy 70,273 83.054 92.827 108,558 26,214 30,773 Cost of Sales 287,781 339,816 385,058 444,150 108,576 126,111 General and administrative 21,488 28,794 36.298 43,320 11,035 12,206 Depreciation and amortization 20,714 23,975 25.440 29,489 7.070 9.022 Pre-opening costs 4.147 737 4.051 6,964 800 852 Severance charges 1.221 Loss on Impairment of PP&E 18,984 1,160 Store closure costs 2,700 152 707 768 Legal settlement reserve 1,333 600 Operating Income 5,552 25,097 26,840 29,971 8,687 9.622 Interest Income 317 571 739 718 287 91 Other Income 1.105 Equity In loss of unconsolidated JV (349) (143) (22) Total other Income (expense) (32) 428 1.822 718 287 91 Income before Income tax provision 5,520 25,525 28,662 30,689 8,974 9.713 Income tax provision (benefit) (82) 7,709 9.172 9,689 2,961 3,393 Net Income $ 5,602 $ 17,816 $ 19.490 $ 21,000 $ 6.013 $ 6,320 Net Income per common share: Basic 0.30 $ 0.93 $ 1.01 $ 1.08 $ 0.20 $ 0.22 Diluted 0.29 $ 0.92 $ 0.99 $ 1.06 $ 0.20 $ 0.21 Selected Operating Data: Restaurants open at end of period 168 171 188 205 193 213 Company-owned open at end of perlod 137 141 157 176 162 182 Avg weekly full service rest. sales $ 54,896 $ 57,509 $ 62,383 $ 65,406 $ 65,427 $ 68,535 18-mo. comparable rest. sales growth" 3.4% 8.0% 7.5% 5.9% 4.8% 5.4% Notes: ()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. Sources of data: Company annual and quarterly reports and quarterly company earnings conference calls. EXHIBIT 32.4 | Selected Historical Comparable Store Sales (calendarized)CY06 CY07 CY03 CY04 CY05 Q1 Q2 Q3 Q4 Q 1 California Pizza Kitchen 3.4% 9.3% 6.4% 4.8% 5.9% 5.6% 6.9% 4.7% Applebee's International, Inc. 4.1% 4.8% 1.8% 2.6% -1.8% -2.3% -1.1% -4.0% BJ's Restaurants, Inc. 3.3% 4.0% 4.6% 6.8% 5.9% 5.3% 5.5% 6.9% Brinker International 2.1% 1.9% 3.2% 2.7% -2.0% -2.1% -2.1% -4.4% The Cheesecake Factory, Inc. 0.7% 3.9% 1.7% -1.3% -0.8% -1.6% 0.8% 0.4% Chipotle Mexican Grill, Inc. 24.4% 13.3% 0.2% 19.7% 14.5%% 11.6% 10.1% 8.3% Darden Restaurants, Inc.-Red Lobster 0.0%% -3.9% 4.2% 1.6% 9.4%% -2.1% 0.7% 4.6% Darden Restaurants, Inc.-Olive Garden 2.2% 4.7% 8 6% 5.7% 25% 2.9%% 2.9%% 1.0% Mccormick & Schmick's Seafood Restaurants, Inc. 1.1% 3.8% 3.0% 4.1% 2.8% 2.9% 2.0%% 2.8% Panera Bread Company 0.2% 2.7% 7.8% 9.0%% 3.2% 2.8% 2.0% 0.09% P. F. Chang's China Bistro 5.1% 3.0% 1.2% 1.3% -1.0% -0.5% -0.9% -2.5% RARE-Longhorn Steakhouse 46%% 5.0% 2.8% 3.7% -0.4%% -0.3% 1.5% -1.0% Red Robin Gourmet Burgers 4.1% 7.5% 3.8% 4.8% 3.3% 0.8% 0.2% -0.5% Ruth's Chris Steak House, Inc. 1.4% 11.6% 10.4% 6.8% 6.0% 4.3% 7.4% 1.9% Sonic Corporation 1.6% 7.0% 5.4% 5.5% 4.3% 4.0% 3.4% 2.0% Texas Roadhouse, Inc 3.5% 76% 5.6% 6.4% 1.2% 2.3% 3.3% 09%% Note: ()Brinker's comparable store sales were a blended rate for its various brands. Source of data: KeyBanc Capital Markets equity research. EXHIBIT 32.5 | Selected Forecasts for California Pizza Kitchen Date of Price 2007E 2008E 2009 Firm Report Target Revenues EPS Revenues EPS Revenues EPS Oppenheimer and Co. Inc. 4/9/07 $40 $652.9 $1.33 NA NA NA NA CIBC World Markets 4/12/07 37 647.5 1.29 755.1 1.57 NA NA KeyBanc Capital Markets 5/1 1/07 NA NA 1.28 NA 1.55 NA NA RBC Capital Markets 5/11/07 37 650.7 1.31 753.1 1.59 78.2 1.90 Morgan Keegan & Co., Inc. 5/1 1/07 NA 644.2 1.33 742.1 1.58 NA NA MKM Partners 5/1 1/07 39 647.5 1.34 754.3 1.69 NA NA Source of data: Selected firms' equity research. 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. 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 Page 397revenue 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 32.6 shows the performance of CPK stock relative to that of industry peers.EXHIBIT 32.6 | Stock Price Comparison Value of $100 Invested In CPK and S&P SmallCap 600 Restaurants Index $140 $130 CPK $120 $110 $100 S&P SmallCap 600 Restaurants $90 $80 006 006 7/3/2006 3/20 06 9/3/2 1/3/2006 007 12/3/20 06 2007 1/3/20 2/3/200 4/3/2007 5/3/2007 10/3 3/3 6/3 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. 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. Financial policy varied across the industry, with some firms remaining all equity capitalized and others levering up to half debt financing. Exhibit 32.7 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 32.8). EXHIBIT 32.7 | Comparative Restaurant Financial Data, 2006 Fiscal Year (in millions of dollars, except per-share data)Fiscal 7/2/2007 Year End Share EBITDA Net Profit Earnings Dividends Book Value Price Revenue Margin Margin per Share per Share Beta California Pizza Kitchen Dec. $22.10 $55 10.7% 3.8% $0.71 $ 0.00 $7.20 0.85 Applebee's International, Inc. 4.28 .338 15.9% 6.5% 1.17 0.20 6.49 0.80 BJ's Restaurants, Inc. 20.05 239 9.6% 1.05 Brinker International() 29.37 4.151 12.0% 4.7% 1.49 0.20 8.59 0.90 Buffalo Wild Wings, Inc. 41.78 278 13.3% 5.8% 0.93 0.00 6.61 1.10 The Cheesecake Factory, Inc. 24.57 .315 12.2% 6.2% 1.02 0.00 9.09 1.00 Dec. 86.00 823 5.0% 1.28 0.00 NA Chipotle Mexican Grill, Inc. 13.0% 14.56 Darden Restaurants, Inc. 5.721 2.16 Frisch's Restaurants, Inc 30.54 291 31.6% 3.1% 1.78 0.44 19.84 0.60 Mccormick & Schmick's 25.66 308 9.7% 0.92 0.00 11.20 1.10 46.02 16.3% 7.2% 0.00 12.53 1.25 P.F. Chang's China Bistro 35.37 938 10.5% 3.6% 1.24 0.00 11.41 1.10 RARE Hospitality Int'l Inc. 26.76 987 5.1% 0.57 Red Robin Gourmet Burgers Dec. 40.19 619 13.7% 4.9% 1.82 0.00 0.00 14.68 1.05 Ruth's Chris Steak House, Inc. 16.80 272 8.7% 0.00 Aug. 22.00 693 24.9% 11.4% 0.88 0.00 4.66 Sonic Corporation 0.90 Texas Roadhouse, Inc. 12.81 12.5% 5.7% 0.00 0.90 Tota Share Debt/ Return on Assets Liabilities Debt Equity Capital Coverage Turnover California Pizza Kitchen 66 $ 208 0.0% NMF 10.1% 10.1% Applebee's International, Inc. 105 187 175 487 26.5% 14.0% 18.0% BJ's Restaurants, Inc. 96 0 203 0.0% NME 4.9% 4.9% Brinker International" 242 497 502 1.076 31.8% 14 4 2.6 13.2% 18.0% Buffalo Wild Wings, Inc. 0 00%% 14.0% 14.0% The Cheesecake Factory, Inc. 203 163 712 0.0% NME 18 11.4% 11.4% Chipotle Mexican Grill, Inc 179 61 0.0% NME 8.8% 8.7% Darden Restaurants, Inc. 378 1.23 34.4% 10.9 20.6% 27.5% Frisch's Restaurants, Inc. 31 43 101 30.1% 59 2.0 7.9% 91% Mccormick & Schmick's 40 0.2% NME 8.3% 8.3% Panera Bread Company 128 110 0 398 0.0% NMF 15.1% 15.1% P.F. Chang's China Bistro 65 104 19 6.2% 11.1% 11.5% RARE Hospitality Int'l Inc. 125 134 166 360 31.6% 29.2 9.8% 13.9%% Red Robin Gourmet Burgers 29 70 114 244 31.9% 77 1.7 9.3% 12.5% Ruth's Chris Steak House, Inc. 26 50.0% 12.8 34.9% Sonic Corporation 43 78 159 392 28.9% 150 1.3 15.3% 20.1% 10.7% Texas Roadhouse, Inc 53 36 319 199 ()For the years ended December 31, 2006, January 1, 2006 and January 2, 2005, December 28, 2003. (2)Severance charges represent payments to former president/CEO and former senior vice president/senior development officer under the terms of their separation agreements. 13Data for company-owned restaurants. Sources of data: Company annual and quarterly reports and conference calls. EXHIBIT 32.8 | Interest Rates and YieldsJ.S. Treasury Securities Corporate bonds Average Average Bills Notes & Bonds (Moody's) Prime LIBOR 3-month 6-month 3-yea 10-yea 30-yea Aaa Baa Lending -month 5.94% 8.36% 2000 5.85% 5.92% 6.22% 6.03% 7.62% 9.23% 6.55% 2001 3.45% 3.39% 4.09% 5.02% 5.49% 7.08% 7.95% 6.91% 3.63% 7.80% 2002 1.62% 1.69% 3.10% 4.61% 6.49% 4.67% 1.79% 2003 1.02% 1.06% 2.10% 4.01% 5.67% 6.77% 4.12% 1.225 4.27% 5.63% 6.39% 4.34 1.67% 2004 1.38% 1.58% 2.78% 3.93% 4 29% 5.24% 6.06% 6.19% 3.639 2005 3.169 3.40% 6.249 7.389 2006: Jan. 4.30% 4.35% 4.42% 5.299 4.68% 4.20% Feb. 4.419 4.51% 4.64% 4.57% 4.549 5.35% 6.27% 7.50%% 4.82% 4.51% 4.61% 4.72% 73% 5.53% 6.41% 7.63% 4.99% Mar. 4.74% Apr. 4.59% 4.72% 4.899 4.99% 5.06% 5.84% 6.68% 7.75% 5.15% May. 4.72% 4.81% 4.97% 5.11% 5.20% 5.95% 6.75% 7.88% 5.23% June 4.79% 4.95% 5.09% 5.11% 5.15% 5.899 6.78 7.13% 5.51% 4.96% 5.09% 5.07% 5.09% 5.13% 5.85% 6.76% 8.25% 5.49% July 8.25% 5.40% Aug. 4.98% 4.99% 4.85% 4.88% 5.00% 5.68% 6.59% 8.25% 5.37% Sept. 4.82% 4.90% 4.69% 4.72% 4.85% 5.51% 6.43% 8.25% 5.37% Oct. 4.89% 4.91% 4.729% 4.73% 4.85% 5.51%% 6.42% 5.37% Nov . 4.96% 4.60% 8.25% 4.95% 4.64% 4.69% 5.33% 6.20 1 88% 4.58% 4.56% 4.68% 5.32% 6.22% 8.25% 5.36% Dec. 4.859 4.94% 4.79% .76%% 4.85% 5.40% 6.34% 8.25% 5.36% 2007: Jan. 4.96% 4.72% 4.82% 5.39% 6.28% 8.25% 5.36% Feb. 5.02% 4.97% 4.75% 8.25% 5.35% Mar . 4.97% 4.90% 4.51% 4.56% 4.729 5.30% 6.27% Apr. 4.88%% 4.87% 4.60% 4.69% 4.87% 5.47% 6.39% 8.25% 5.36% May 4.77% 4.80% 4.69% 4.75% 4.90% 5.47% 6.39% 8.25% 5.36% 5.36% June 4.63% 4.77% 5.00% 5.10% 5.20% 5.79% 6.70% 8.25% Sources of data: Economic Report of the President and Fannie Mae Web site. 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 32.9 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. EXHIBIT 32.9 | Pro Forma Tax Shield Effect of Recapitalization Scenarios (dollars in thousands, except share data; figures based on end of June 2007)Debt/Total Capital Actual 10% 20% 30% Interest rate () 6.16% 6.16% 6.16% 6.16% Tax rate 32.5% 32.5% 32.5% 32.5% Earnings before Income taxes and Interest 30.054 30,054 30,054 30,054 Interest expense 1,391 2,783 4,174 Earnings before taxes 30.054 28,663 27,271 25,880 Income taxes 9.755 9,303 8,852 8,400 Net Income 20,299 19,359 18,419 17.480 Book value: Debt 0 22,589 45.178 67.766 Equity 225,888 203,299 180.710 158,122 Total capital 225,888 225,888 225,888 225,888 Market value: Debt(3) 22,589 45,178 67,766 Equity 643,773 628.516 613.259 598,002 Market value of capital 643.773 651.105 658.437 665.769 Notes: ()Interest rate of CPK's credit facility with Bank of America: LIBOR + 0.80%. ()Earnings before interest and taxes (EBIT) include interest income. ()Market values of debt equal book values. ")Actual market value of equity equals the share price ($22.10) multiplied by the current number of shares outstanding (29.13 million). Source: Case writer analysis based on CPK financial data.1. What is going on at CPK? What decisions does Susan Collyns face? What do you recommend? a. Discuss the operating performance of CPK b. Discuss management's agenda c. Discuss stock price performance of CPK 2. How does debt add value to CPK? a. Add the following values to the table provide in Exhibit 9 and complete it #fem for the actual scenario and the three proposed scenarios: Market value of Debt/MV of Capital Price per share Shares repurchased (thousands) Shares outstanding (thousands) Earnings per share Price to earning ratio Beta Cost of equity WACC Blevered = Bunlevered [ 1+ (1-t) D/E] Present value of tax shield using perpetuity formula = (ka X D x t)/ka = D X t. Post-announcement share price = PN = Pre-Announcement Price + D x t/shares outstanding. Number of shares repurchased = D/PN. Cost of Equity = Risk Free Rate(Given in Ex. 8) + Beta*(MRP=5%) WACC: Use MV weights and Debt Rate provided and Cost of Equity calculated b. Discuss what scenario investors would prefer and what the tradeoff is for investors as the firm adds leverage. Conclude with which scenario you recommend and why. 3. What is the case for not doing recapitalization