Context and Key Issues The financial team at California Pizza

Context and Key Issues

The financial team at California Pizza Kitchen (CPK) led by CFO, Susan Collyns, were compiling the preliminary results for the second quarter. The company was about to announce a near-record quarterly profits with profits over $6 million despite the industry challenges. Their sales have increased more than 16 percent and royalties from their Kraft partnership and international franchises were up 37 percent and 21 percent respectively. Compared to other casual dining companies, the company's results were that much more impressive. Other companies had experienced more of a decline in customer traffic this quarter than normal.

Even with CPK's strong second quarter performance, their stock price had declined 10 percent. Because of this stock price drop and activist shareholders becoming interested in the industry, management is considering repurchasing company shares. The company does not have extra excess in cash, which means that if they did a large repurchase program it would need to be financed with debt. It has been CPK's policy to avoid putting any debt on the balance sheet since going public in 2000, however with interest rates on the rise from historical lows, Collyns is aware of the benefits of moderately levering up CPK's equity.

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Background

California Pizza Kitchen was created in 1985 in Beverly Hills, California by two criminal defense attorneys, Larry Flax and Rick Rosenfield. The company is known for their barbeque chicken pizza and "designer pizza at off-the-rack prices" and is considered casual dining. The concept of CPK was well received by consumers and today they have 213 locations in 28 states and 6 in foreign counties but are still predominantly located in California with 41 percent of their restaurants located there.

Today, CPK has three main sources of revenue: sales at company-owned restaurants, royalties from franchised restaurants and royalties from a partnership with Kraft Foods. Their partnership with Kraft Foods allows Kraft to sell CPK-branded frozen pizza in grocery stores. The company has expanded their revenue sources from the original concept of CPK, but their focus remains on operating company-owned full-service CPK restaurants which they have 170 restaurants. According to analysists, the company has potential to have 500 company-owned full-service California Pizza Kitchens.

In 1996, the company in a franchise contract with HMSHost created a concept called ASAP which were in airports and featured a limited selection of pizzas and "grab and go" options. Both investors and management were less certain about the attempt of CPK's brand expansion, which was the idea of the company's chief. ASAP was not a huge revenue generator for the company, but management was impressed with the success of the 16 ASAP locations. The company then decided to own company-owned ASAP restaurant's inside the airport, which offered seating in-restaurant seating and their most popular pizzas, sandwiches and salads. This concept was not as successful and are planning to terminate the project to open another location.

Even with their doubts about ASAP both investors and management are excited about the idea of franchising full-service CPKs internationally. As of July of 2007, the company had 15 stores internationally and are planning to open more in the second half of 2007.

Management saw its partnership with Kraft as another avenue to continue building a global brand. The partnership accounts for less than 1 percent of the company's revenue, but the royalties have a 95 percent pretax margin. In addition, the partnership states that Kraft had to spend 5 percent of gross sales on marketing, which was more than the company often spent on its own marking.

All in all, management believed its success was due to its "dedication to guest satisfaction and menu innovation and sustainable culture of service". CPK top priority is a creative menu, which is why of the 1 percent CPK spends of its sales on advertising, 50 percent of those dollars are spent on menu-development costs. Additionally, CPK's core customer base has an average income of more than $75,000, which allows them to be sheltered from macroeconomic pressures that might lower sales at competitors with fewer well-off customers.

Within the restaurant industry CPK is considered a "price-value-experience" and is a leader in its section. The five-year CAGR for CPKs subsectors of full-service segment was projected to grow at 6.5 percent. However, the restaurant industry has been experiencing several challenges including an increase in commodity prices, high labor costs, softening demand due to high gas prices, deterring housing wealth and intense interest in the industry by activist shareholders. CPK is able hedge themselves against some of these challenges because the company's business portfolio. Both the Franchises and royalties from Kraft are good to help address the higher costs that are arising from some of these challenges.

Proposed Method of Action

Management at CPK is concerned about the 10 percent stock price decrease after such a great second quarter. They are considering changing their current capital structure but want to make sure that their goal of growing the business is not forgotten. To fund their current growth plan, they are anticipating needing $85 million in capital expenditures.

The company's book equity was expected to be about $225 million and market capitalization was around $644 million. The company recently issued at 50 percent stock dividend which split CPK shares on a 3-for-2 shares basis. CPK investors received one additional share for every two shares of common stock held.

If the company is considering a capital structure decision then they will need to figure out what the value of the firm is levered with debt, using the Modigliani - Miller theory proposition one. Using this information, they will be able to figure out what their new cost of equity is which can be determined using the Modigliani - Miller theory proposition two. This company operates within the United States, which mean that they need to consider the affect of too much debt and how it will affect their bankruptcy risk so they will need to balance the two. An analysis of their liquid ratios at the new value of liabilities can help them determine the affects of taking out the debt.

While the company is working through this decision, they need to take into consideration some of the pros and cons of changing their capital structure. Besides the obvious advantage of providing a different way of raising capital without using equity and going away from management's focus, if they were to do this it does allow them to potentially send a positive signal to investors, because it signals that management believes that the stock is undervalued. It also has the potential to increase ROE because the company's shareholder's equity will decrease. Buying back stocks and financing using debt will allow the company to remain in control of their business more, because they are decreasing the amount of the company their shareholders can own. All in all, the company will need to calculate what the new value of the leverage firm and what their weighted average cost of capital will be at their optimal amount of debt without increasing their bankruptcy risk too much and make a decision from there.