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California Pizza Kitchen – Case Study

Introduction

In July of 2007, California Pizza Kitchen (CPK) was moments away from releasing initial data from the second quarter of 2007. In this quarter, CPK yet again had experienced profits much higher than competitors in the full-service, casual-dining sector. These near-record profits were over $6 million. However, even with the recent and constant growth of revenues and profits within the company, the stock price had recently declined by 10% to $22.10. Faced with this, CEO, Rick Rosenfeld was faced with a decision of how to combat this decrease, and what the company believed as a low valuation of their stock price. With no current debt, Rosenfeld began to contemplate whether it was ideal to repurchase shares, which could potentially leverage the company’s balance sheet. With this, Rosenfeld hoped to purchase the stock, and hold it until the stock price is a better reflection of the intrinsic value of equity, when at this point CPK would be able to re-issue the stock for a profit. However, at the same time a repurchasing program may potentially decrease the opportunity to continue the rapid growth CPK had experienced by using equity within the company.

History

When CPK was first established in 1985, the company immediately took actions that were not usually present in the restaurant industry. Offering a higher quality, yet still, casual dining experience with a much lower ticket price attracted many consumers – and still does. At the end of the second quarter in 2007, CPK had; 213 locations in 28 states and 6 countries, and a successful partnership with Kraft Foods – selling CPK branded frozen pizza’s in grocery stores. CPK was very successful at attracting the ideal restaurant consumer. In 2005, after a guest satisfaction survey, it was found that the average household income of a customer was above $75,000, yet the average check is still a low $13.30. In recent years, and with current macroeconomic issues, the restaurant industry was seeing a decline in profits and revenues, however CPK was on the upswing. The 5-year compound annual growth rate (CAGR) for full service restaurants was projected to be 5.1%, while CPK’s CAGR was projected to be 6.5%. And with such high equity, CPK was able to continue to expand the number of restaurants, while also attracting consumers who were not highly affected by the macroeconomic changes that were present (ex. Higher gas prices).

Alternatives

Repurchasing stock is not the only action that CPK is able to take. CPK also has the option to issue more dividends. This would decrease the companies equity, potentially decreasing the rate of growth, however the payment of dividends would be attractive to shareholders, especially potential future shareholders. With the payment of dividends, some shareholders may see a decrease in holdings because of tax implications however, many investors would see dividends paid as attractive and be more likely to invest in the company. If paying dividends worries the company because of the decrease in equity, CPK could also increase their number of franchises. The company receives an initial payment of $50,000 to $65,000 for each new location and receives an estimated 5% of gross sales. There are pro’s and con’s to increasing the number of franchises. They would be able to increase the number of CPK’s across the country at a lower fixed cost than opening company held restaurants, however they would also potentially lose the operational control and quality they possess with company held restaurants.

Recommendation

After further evaluation of the restaurant industry, direct competitors, financial data and the state of the economy, I recommend that CPK does indeed issue a repurchase program. I think that the stock is valued lower than it should be and a repurchase program will help the company potentially increase the stock price and attract more investors. CPK currently holds no debt, and I believe the growth of the company will not greatly suffer with a decrease in equity. The Modigliani – Miller theory states that in an efficient market, with the absence of taxes, among other things, the value of a firm is unaffected by how the firm is financed. However, this requires an efficient market and I do not believe that CPK is currently present in an efficient market, and that their capital structure will indeed affect their valuation. With the current growth of CPK, financial successes and a beta of .8 - the movement of the company is generally in the same direction as the market, but less than the benchmark of the market – the company seems to be more successful than their competitors, yet their stock price does not accurately reflect this. CPK’s stock price seems to be a more accurate representation of a restaurant that is affected by macroeconomic issues – CPK has done a successful job at avoiding these risks by presenting a business model that many others did not choose to take. CPK offers an inexpensive, yet high quality dining experience, and attracts the ideal restaurant customer. I think that a stock repurchase program will be very successful for CPK and help increase stock price and attract more investors and help increase overall financial success of the company.

Business


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