CASE 33: CALIFORNIA PIZZA KITCHEN

INTRODUCTION California Pizza Kitchen (CPK) is a restaurants services company that operates a casual dining chain, with a particular focus on the premium pizza segment. The company is headquartered in Los Angeles, California and employs 14,800 people as on December 30th, 2007. The company recorded revenues of $633 million during the fiscal year ended December 2007, an increase of 14.1% over 2006. The increase in revenue was driven from its full service restaurants, ASAP restaurants and from LA Food Show. The operating profit of the company was $22 million during fiscal year 2007, a decrease of 28.3% compared with 2006. The net profit was $15 million, a decrease of 29.5% compared with 2006.

In 1985 the California Pizza

Kitchen was created by Rick Rosenfield and Larry Flax in Beverly Hills, California. Rosenfield and Flax both hold the title of Co-President, Co-CEO, and Co-Chairman of the Board of Directors for California Pizza Kitchen. It was known for its hearth-baked barbeque-chicken pizza, the designer pizza at off-at-the-rack prices concept flourished. 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 pizza in grocery stores. California Pizza Kitchen is in the food industry business. California Pizza Kitchen is a casual dining restaurant chain that specializes in innovative and non-traditional pizzas. California Pizza Kitchen also provides various soups, salads, pasta, sandwiches, and desserts at higher quality for lower prices. California Pizza Kitchen is in 213 locations in 28 states (41% located in California). California Pizza Kitchens core patrons tend to have an average household income of $75,000 (survey results

CASE 33: CALIFORNIA PIZZA KITCHEN

from 2005); creating less of an impact on patrons dining habits during times of inflated gas and food prices. California Pizza Kitchens inventive menu was not the only draw-in for patrons, their below average check (usually around $13.30) was much lower than their

competitors such as, The Cheesecake Factory, Olive Garden, P.F. Changs, Chilis, Red Lobster, and Panera Bread to name a few. The California Pizza Kitchen chain was labelled by RBC Capital Markets as the Price-Value-Experience leader in its sector. California Pizza Kitchen began their growth process by developing the ASAP restaurant concept (located mostly in airports and malls: limited selection of pizzas and grab-n-go sandwiches and salads) but later halted all new ASAP locations. California Pizza Kitchen then moved into franchising full-serve restaurants internationally (6 foreign countries as of 2007).

SWOT Analysis Strengths CPK chooses and specifically points out differentiation as its main strategy. CPK

differentiates itself through product quality through the use of quality ingredients, menu design and innovation, and expanded services and offerings beyond their main dining experience. In addition, the management also reviewed detailed sales reports twice a year and replaced slow-selling offerings with new items.

CASE 33: CALIFORNIA PIZZA KITCHEN

Cost Advantages Unique Products Technology Give the Pizza Kitchen an Edge Strong Management is Helpful for CPKI Brand Name - California Pizza Kitchen Creative Pizza Ideas

Weaknesses Bad Acquisitions Hurt California Pizza Kitchen Lack of Scale as Compared to Competitors of CPK Weak Brand - Not as Strong As Rivals Opportunities New Services Help to Retain Customers at CPK New Products Are Important to California Pizza Kitchen Threats Substitute Products is a Problem for All Pizzerias Intense Competition - Restaurants Industry STATEMENT OF THE PROBLEM

CASE 33: CALIFORNIA PIZZA KITCHEN

With the recent 10% share price decline, CPK management ponder if it would be an ideal time to repurchase shares and potentially leverage the companys Balance sheet with ample borrowings available on its existing line of Credit.. In order to preserve the firms ability to fund the strong expansion, it is open to adapt any use of financing to return capital to shareholders which is relevant to balance with managements goal of growing the business. In line with this, what capital structure policy should CPK adapt in order to achieve its aim for growth and expansion.

1) In what ways can Susan Collyns facilitate the success of CPK? a. The avoidance of CPK management to putting any debt in its Balance sheet which relates to the idea of maintaining the borrowing ability needed to support CPKs expected growth trail but Collyn is convinced with the benefits of leveraging the CPKs equity; b. Maintain the ASAP restaurants where brand extensions of the company are being disposed. The ASAP restaurants in airport locations numbered 16 and contributed to the revenue and to the success of CPK; c. Maintain the company-owned full-service CPK restaurants which are 170 units and still cite for expansion in other locations locally and internationally; d. Allot more or spend more on marketing the CPK frozen pizza brand; e. Continue to create new menus with high quality ingredients which can leave a mark to customers tastes. In this way, customers will likely to come back; f. CPK can spend 3% to 4% of sales on advertising just like what its competitors like Chilis, Red Lobster, Olive Garden and Outback Steakhouse spent yearly;

CASE 33: CALIFORNIA PIZZA KITCHEN

g. On the financial side, the management should increase its ROE by letting its assets exceed its equity base in the Balance Sheet. h. Leveraging by borrowing to acquire more assets is one way to increase ROE. One benefit with leveraging is that, it reduces the corporate income tax liability of CPK, which had been almost $10 million in 2006.

1) Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK? What about the cost of capital? In assessing the effect of leverage on the cost of capital, you may assume that a firms CAPM beta can be modelled in the following manner: L= U[1+(1-T)D/E], where U is the firms beta without leverage, T is the corporate income tax rate, D is the market value of debt, and E is the market value of equity. We have computed the financial leverage of CPK to measure its use of debt to acquire certain assets. The results on financial leverage shown in Exhibit 3 of CPK for the years 2004, 2005 and 2006 were 60.2%, 76.5% and 109.1% , respectively. The results show the increase in its financial leverage for the three years. This means that they are having increasing returns for the three years consecutively and utilizing its excess funds in high risk investments in order to maximize returns.

The group used the beta of .85 per stated in Exhibit 7 to determine L.
ACTUAL 10% .85 32.5% 22589 20% .85 32.5% 45178 30% .85 32.5% 67766

u
Tax rate D=Market value of debt

.85 32.5% 0

CASE 33: CALIFORNIA PIZZA KITCHEN

E=Market value of equity
643773 628516 613259 598002

.85

0.87

0.89

0.915

Leverage Effect on ROE (see Exhibit 3-highlighted) The operating leverage effect on ROE is percentage change of EBIT is more than percentage change in Sale. If percentage change of EBIT is more than the percentage change in sales, this operating leverage will effect ROE positively because at this level, per unit fixed cost will decrease and small increase in sale will boost EBIT. If EBIT will increase, ROE will also increase. After dividing percentage

change of EBIT with percentage changes in sales, we can take ratio of it and it indicates, how will change EBIT if changes will be done in sales. As interest is fixed cost, so with this ROE will increase.

A high operating leverage is not good and maybe high risky. While a low operating leverage may be useful when sale market is fluctuating. The effect of operating leverage is the percentage change of EBIT less than percentage Change in Sales.

In another scenario, when percentage change of EBIT is less than percentage changes in sales, it means 200% sale will increase, 100% EBIT will increase if operating leverage is 1:2. This situation is less effective for enhancing ROE.

The effect of financial leverage on ROE is that financial leverage may decrease or increase return on equity in different conditions. A high financial leverage will incur a huge debt by borrowing funds at a lower rate of interest and utilizing the excess

CASE 33: CALIFORNIA PIZZA KITCHEN

funds in high risk investments in order to maximize returns. While a low financial leverage will mean incurring a low debt by borrowing funds. The asset being purchased decreases its value which is a positive effect.

However, the effect of high operating leverage and high financial leverage in the case of CPK will increase Return on Equity but entails high risk as well. While the effect of low operating leverage and with high financial leverage is an optimum combination for bringing optimum ROE (return on Equity). The 10.1% ROE of CPK as per stated in the case, did not benefit from financial leverage.

2) Based on the analysis in case Exhibit 9, what is the anticipated CPK share price under each scenario? How many shares will CPK be likely to repurchase under each scenario? What role does the tax deductibility of interest play in encouraging debt financing at CPK? The anticipated share price under each scenario in Exhibit 9, would be $20-$22.10. Because CPK used its proceeds from its 2000 IPO to pay off its outstanding debts, the company completely avoided debt financing. Repurchasing shares is one possible leftover retained profit of the firm. In this way, CPK can reduce the numbers of shares held by the public. The reduction of publicly traded shares would mean that even if their profits remain the same, the EPS increase. So, repurchasing shares, particularly when a company's share price is perceived as undervalued or depressed, may result in a strong return on investment. The group opted for scenario with 20% D/E. This scenario is safer in a sense, since CPK would be earning and at the same time filling in debt into the financial statement.

CASE 33: CALIFORNIA PIZZA KITCHEN

One reason that CPK would rather keep a substantial portion of its earnings than distributing such to its shareholders, that even if it has not reinvested profitable, it would be an embarrassment for the firm to cut dividends. The normal reactions of investors is adverse and the cutting of dividend is one major issue in such situations rather than postponing or disregarding the buyback program. Aside from paying out larger dividends during the period of excess profitability, the firm would rather reduce such during leaner times. A repurchase may also indicate a firms undervaluation. If CPKs CEO, Rick Rosenfield believes their firm's stock is currently trading below its basic value they may consider repurchases. CPK had share in the low 20s while the market has a share price of 22.10. Its share price is lower than the market share price so a repurchase can be the option. An open market repurchase, whereby no premium is paid on top of current market price, offers a potentially profitable investment for the manager. That is, the firm may repurchase the currently undervalued shares, wait for the market to correct the undervaluation whereby prices increases to the essential value of the equity, and re issue them at a profit. Alternatively, the management of CPK may undertake a fixed price tender offer, whereby a premium is often offered over current market price, sending a strong signal to the market that the management believes the firms equity is undervalued, proven by the fact that he is willing to pay above market price to repurchase the shares. Another reason why CPK considered and preferred share buybacks is that executive compensation is often tied to executives' ability to meet earnings per share targets. In companies where there are few opportunities for organic growth, share repurchases may represent one of the few ways of improving earnings per share in order to meet targets. Therefore, safeguards should be in place to ensure that

CASE 33: CALIFORNIA PIZZA KITCHEN

increasing earnings per share in this way will not affect executive or managerial rewards, even though this does not always occur. Furthermore, increasing earnings per share does not equate to increase in shareholders value. This investment ratio is influenced by accounting policy choices and fails to take into account the cost of capital and future cash flows, which are the determinants of shareholder value. Share repurchases avoid the accumulation of excessive amounts of cash in the corporation. Companies with strong cash generation and limited needs for capital spending like CPK will accumulate cash on the balance sheet, which makes the company a more attractive target for takeover, since the cash can be used to pay down the debt incurred to carry out the acquisition. Anti-takeover strategies therefore often include maintaining a lean cash position, and at the same time the share repurchases bolster the stock price, making a takeover more expensive. Share repurchases also allow companies to covertly distribute their earnings to investors without inflicting them with double taxation. This only holds true in jurisdictions which do not operate imputation tax credit systems. According to the trade-off theory, mature companies with stable cash flows and limited opportunities for investment should have higher leverage ratios, both to take advantage of the tax deductibility of debt and because of their lower financial distress costs. ALTERNATIVE COURSES OF ACTION: 3) What capital structure policy would you recommend for CPK? In the scenarios given, the group decided to opt for scenario with 10% D/E Capital structure does differ by industry. We have listed at list three propositions so we can recommend the best capital structure for CPK:

CASE 33: CALIFORNIA PIZZA KITCHEN

I. Proposition I (Using CAPM) - In this option, there are no taxes or bankruptcy costs-thus, no optimal capital structure; The value of the firm is not affected by changes in the capital structure. The cash flows of the firm do not change; therefore, value doesnt change. II. Proposition II (Tax Deductibility of Interest) In this option, the firm has corporate taxes but no bankruptcy costs involved. Therefore, it can achieve optimal capital structure with almost100% debt. And with each additional dollar of debt, increases the cash flow of the firm. Therefore, when a CPK adds debt, it reduces taxes, all else equal. The reduction in taxes increases the cash flow of the firm. The value of the firm increases by the present value of the annual interest tax shield. The WACC of the firm is not affected by capital structure and interest is tax deductible. The WACC decreases as D/E increases because of the government subsidy on interest payments. III. Proposition III In this option, there are corporate taxes and bankruptcy costs involved so, optimal capital structure is part debt and part equity. This occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs. In this option, bankruptcy costs are added. As the D/E ratio increases the probability of bankruptcy increases. This increased probability will increase the expected bankruptcy costs. At some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost. At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added.

CASE 33: CALIFORNIA PIZZA KITCHEN

RECOMMENDATIONS: In terms of managerial decisions, the group discussed and considered that 1) the tax benefit is only important if the firm has a large tax liability; 2) the greater the risk of financial distress, the less debt will be for the firm; 3) the overall value of the firm is unaffected by changes in capital structure. In the case of CPK, it can increase leverage by issuing debt and repurchasing outstanding shares or it can decrease leverage by issuing new shares and retiring outstanding debt. It is the best time to repurchase shares since their share price is lower than the prevailing market share price. Per our further researches, conversely, a company that repurchases some of its own stock signals an undervalued stock. Buying stock back, the theory goes, will reduce the supply and increase the price. There are two main theories of capital structure choice namely: The trade-off theory says that companies have optimal debt-equity ratios, which they determine by trading off the benefits of debt against its costs. In the original form of the model, the chief benefit of debt is the tax advantage of interest deductibility. More recent versions of the model also attempt to incorporate Jensens free cash flow argument, in which debt plays a potentially valuable role in mature companies by curbing a managerial tendency to overinvest. The primary costs of debt financing are those associated with financial distress, particularly in the form of corporate underinvestment and defections by customers and suppliers. The idea of deleverage which is by paying off securities at lower, discounted prices through tax-free exchanges of equity for debt, debt for debt, assets for debt and cash for debt CPK can either avoid default and save jobs.

CASE 33: CALIFORNIA PIZZA KITCHEN

The group recommends Proposition II where there is the advantage of the tax deductibility of interest where the firm can enjoy the benefit of tax shield each year. CPK management must consider filling in debt portion of its Balance Sheet or may have 100% debt but it can somehow achieve optimal capital structure where bankruptcy is never an issue by adapting Proposition II.

REFERENCES:

http://www.investopedia.com/terms/r/returnonequity.asp#ixzz1XH3C5anK http://www.investopedia.com/university/ratios/profitabilityindicator/ratio4.asp#ixzz1XH3i1tb http://online.wsj.com/article/SB124027187331937083.html http://www.investopedia.com/terms/d/dfl.asp#ixzz1XLANU4Oc http://www.thefreelibrary.com/California+Pizza+Kitchen+Enters+into+Accelerated +Stock+Repurchase...-a0174099190