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    California Pizza Kitchen – case Essay

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    California Pizza Kitchen – case essay BY Krysta143 Executive Summary California Pizza Kitchen (CPK) was founded in 1985 by Larry Flax and Rick Rosenfleld with a vision of offering customers designer pizza at reasonable prices. CPK’s target market is geared towards affluent customers making $75,000 annually, and over the span of 2 decades the business was able to grow from a single location into 213 locations across 28 states and 6 foreign countries. CPK generates revenue from 3 main sources: company restaurants, franchises, and royalties.

    CPK stands out from its peers because it offers a compelling menu at low prices, does virtually no arketing, and currently generates profits using zero debt. Despite CPK’s positive growth projections, the food industry at the end of 2007 is experiencing increased pressure from higher commodity prices, increasing wages and lower consumer discretionary income. Over the last 2 years we were able to grow sales by 16% while decreasing labor by . 03% in the same period.

    Despite our strong performance we are currently being pressured by institutional investors to take on additional leverage and re-buy outstanding shares in response to a 10% decrease in our stock price. To etermine if levering the firm would be beneficial I decided to evaluate the benefits of leverage by doing different scenario analysis based on different debt structures 10% – 100% leverage. What I found in my analysis was that as we leverage the firm there are many benefits that we are missing out on such as a larger tax shield, increased ROE and disciplined growth effect.

    On the negative side; there is also the chance that we run into trouble and it may put a squeeze on project spending and in the most unlikely case land us in bankruptcy if we are not careful. It is my ecommendation that we should lever the firm by 30% of debt which should yield us a tax savings to us of roughly $1. 35mm per year and boost our ROE to 11. 05%. Case Analysis California Pizza Kitchen (CPK) is a homemade style pizza company located predominantly in the western region of the United States.

    It was founded in 1985 by Larry Flax and Rick Rosenfleld with a concept aimed at delivering designer pizza at reasonable prices in family friendly environment. This included an innovative menu that featured items like; Singapore shrimp roll, Shanghai Garlic Noodles, and Chicken Tequila Fettuccine that distinguished it from competitors. Their target market was geared towards affluent consumers making at least $75k annually. Its attractive menu and word-of-mouth marketing concept enabled CPK to expand from a single location to 213 locations across 28 states and 6 foreign countries.

    CPK’s main sources of revenue include: company owned restaurants, franchise, and royalties generated from starting up new franchises. The company also generates royalties through a licensing agreement with Kraft Foods for the manufacture of frozen pizzas that accounts for roughly 5% of annual revenue. Other new sources of revenue include the new brand extension of ASAP stores at various airports. This concept has not been entirely successful and we plan on divesting the remaining 16 new and taking a $770k write down.

    From a marketing perspective; the company spends minimal amounts on advertising compared to industry standards, as CPK relies heavily on word 0T moutn to attract new customers. I nls allows us to spend only around 1 their overall revenue on advertising. The food industry was divided into two sections; full service and the limited segment. Full service is further divided into asual dining and fine dining while the limited segment is subdivided into fast food and fast casual.

    CPK is predominantly focused on the limited segment with a sub segment in full service. The CAGR for the limited service segment is projected to grow 5. 5%, while CPK’s full service is projected to grow 6. 5%. To hit our 6. 5% growth rate in 2008, we have scheduled between 16 – 18 new store openings in the coming year. This will require an additional investment of 85 million dollars. A study by the National Association of Restaurants estimates that consumer discretionary spend for ining will increase from 45% to 53% over the next 3 years.

    Even though spending is on the uptick, the industry is experiencing pressure from rising commodity and labor prices with the new increases in minimum wage instituted by the Bush Administration. Despite the financial pressure, CPK still continues to growth under challenging market conditions. Sales grew by 16% from 2005 to 2006 and royalties increased by 36%. Labor as a percentage of sales decreased from 36. 6% to 36. 3% in the same period. Even with all of these positive metrics CPK’s share price saw a decline in the last month by 10% to $22. 0.

    The decline in share prices was a result of pressure from activist shareholders calling for a buyback of shares via a restructuring of CPK’s capital structure. To respond to this drop in share price I have proposed that we explore the possibility of levering up the company. This could be achieved by issuing debt and repurchasing CPK’s shares, however this is a big step for our business as we have never used debt financing in the past. I decided to analyze the costs and benefits of debt and compute the value of the firm by analyzing the effect of debt financing (and tax shield) at CPK’s WACC.

    Recent FCF and Pros and Cons of Debt for CPK Prior to determining if changing the CPK capital structure is appropriate, we first need to assess the current free cash flows as well as the pros and cons to taking on debt. During fiscal year 2006, free cash flows to the firm totaled $35. 8 million (Exhibit 1). Even with the capital required for store openings and increased operations, the very positive free cash flows indicates that CPK should return income to shareholders. Since activist shareholders will want us to lever the company and repurchase shares, we need to be aware of the impact that debt will have on CPK.

    The positive impacts of levering CPK with debt are; the tax shield from interest paid, and the magnification of ROE. Investors also view the obligation that debt creates as a benefit. Debt is a disciplining force because it would motivate us to take fewer risks and focus on generating earnings to meet existing obligations. Another item to consider is the interest rates for debt. Interest rates are currently low but projected to increase, so if we are going to issue debt now is the appropriate time. The main negative impact of additional leverage for CPK is the loss of financial flexibility.

    If we ssue debt, CPK will create an obligation that needs to be met each year. There may be situations where large or risky investments have to be delayed or cancelled, because the firm cannot withstand taking losses. This would impact the rate at which we invest in new stores and new concepts. New store growth is expected to require $85MM in capital and there is a chance the extra debt burden puts a squeeze on aa t 01 Ional Investment. Based on I-YU6, tnat would De tnree years 0T Tree cash flows. There is not an endless supply of debt, nor does it make sense to over- borrow.

    If CPK borrows to repurchase shares, then investments will have to be empered toa rate which can be funded by cash flow from operations. Given the strong free cash flows and general stability of our business, this concern should not hold us back from levering for a share repurchase. In the past we completely avoided debt financing, and instead used the proceeds from our 2000 initial public offering (IPO) to pay off all outstanding debt. Since then we have maintained our borrowing capacity with a secured $75 million credit line with a rate of interest of LIBOR interest rate of 5. 6% (plus 0. 80%). Compared to 30- Year U. S. Treasuries we are paying Just 96 bps above prime rate of 5. % (Exhibit 2). Using the scenarios analysis in Exhibit 3, I analyzed the effects of leverage on ROE. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested. The basic formula for ROE is: Net income / Shareholder Equity. I found that as I evaluated different debt structures as net income and equity decrease, ROE always increased.

    The main reason that ROE increases is due to net income being spread across less equity than in a case with zero leverage. Our current ROE is 8. 99% and as we can see from xhibit 3, as the percentage of leverage increases it improves with each scenario of increased debt. By increasing our debt structure by 10% intervals, each scenario will effectively increase our ROE by 50bps above the base case with zero debt. The most important benefit of using additional leverage is that as we increase leverage it will lower our EBIT and allow us to pay less in the form of income tax.

    Exhibit 3 illustrates this point. As we move to the right from 20% leverage to 30% leverage and finally to 40% leverage each time I reduce my taxes paid to the government in higher increments by $400k and $1. mm respectively (Exhibit 3). I also took into account the tax deductibility of interest, because it eliminates double taxation on shareholders. Shielding our income from tax will give shareholders more money to purchase additional stocks, and will yield higher returns since we plan on using the additional debt to repurchase shares. For example: Spending $22. million buying back shares of CPK will remove 1 million shares from the market, leaving 28. 13 million shares at $22. 10. This means CPK’s investors with 1,000 shares still has $22,100, and the government receives no tax revenue. There is no net change in investor wealth. Comparing the different scenarios of debt leverage, we can see that CPK’s overall valuation continues to rise until we reach 30% debt (6. 16% interest rate). When leveraging more than 30% taking on additional debt will be viewed as riskier to our creditors and we will be forced to borrow at higher interest rates.

    At 35% leverage we assume each additional dollar of debt would force us to pay about 9. 5% per year in interest (Exhibit 3). At this higher interest rate we run the risk of not being able to invest in all of our positive NPV projects, and could even force ourselves into bankruptcy in an extreme situation. We have always remained a stable growth company and I see no need to go above the 30% threshold and subject ourselves to higher rates of interest. If I were to go back the past 3 years we have proven that we can grow comp store sales diligently with zero debt (Exhibit 4).

    By taking on 30% wortn 0T aeot we snoul a nave enougn extra casn to Duy DacK enougn snares to Doost ROE and still have money left over for our store expansion plans next year. I should also mention that if we benchmark ourselves compared to other restaurant chains, at 30% leverage we would be structured like many of our key competitors such as Darden Restaurants, Brinker International and Red Robin (Exhibit 4). In the past we have outperformed these 3 competitors, but for this to continue it would help to protect our earnings from tax as the market becomes more challenging.

    Final Recommendation: As the CFO of California Pizza Kitchen I can say with assurance that the decision to lever up the business has less to do with appeasing influential shareholders, and more to do with the tax savings and the disciplining effects of taking on debt. We have already proven to the market that this business has a disciplined approach to rowth, and I see no reason that levering up the company won’t have this same sobering effect when we go to pay on our obligations.

    Based on (exhibit 3) I am safe with taking on an additional 30% of debt which should yield us a tax savings to us of roughly $1. 35mm per year and boost our ROE to 11. 05%. We would turn around and use 100% of the initial proceeds to buy back shares and re-evaluate how to fund the remaining $85mm in capital we need for the remainder of 2007 using secondary financing. If some of our new stores plans are riskier investments perhaps we scale this back in the near term to focus on our existing store footprint.

    By levering up we are essentially going to pay less income tax to the government in the foreseeable future, allowing us to shield the income that we earn in the difficult period ahead. Already this year our core business has been challenged by higher commodity prices, rising minimum wage, higher energy prices, and eroding consumer discretionary income, but the long term prospects of our business look much better. To make sure that we still maintain flexibility in the interim I will be reviewing our debt structure on a quarterly basis once we make the decision to lever up.

    This will allow us to control he business and make sure that we avoid a situation where we can’t invest in positive NPV projects, or get ourselves into a situation where we are at risk of bankruptcy. From an external standpoint by taking on debt and buying back shares we will be able to boost our ROE to be more competitive with other restaurant chains, and send a positive message to analysts that we have faith in our underlying business. If we are to act on this idea I believe we must act now; access to low interest rates are not going to last much longer and we must lock rates in now before the market deteriorates further.

    This essay was written by a fellow student. You may use it as a guide or sample for writing your own paper, but remember to cite it correctly. Don’t submit it as your own as it will be considered plagiarism.

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    California Pizza Kitchen – case Essay. (2018, Oct 20). Retrieved from https://artscolumbia.org/california-pizza-kitchen-case-essay-16016-59394/

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