UVA-F-1553
Rev. Apr. 26, 2018

This case was prepared by Elizabeth W. Shumadine (MBA ’01), under the supervision of Professor Michael J. Schill, and is based on public
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California Pizza Kitchen

Everyone knows that 95% of restaurants fail in the first two years, and a lot of people 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 money—they build over time. So it’s
really about having the capital and the staying power.

—Rick Rosenfield, Co-CEO, California Pizza Kitchen1

In early July 2007, the financial team at California Pizza Kitchen (CPK), led by Chief Financial Officer
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 those of many other casual
dining firms, which had experienced sharp declines in customer traffic. Despite the strong performance,
industry difficulties 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 Rosenfield 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 benefits of
moderately levering up CPK’s equity.

1 Richard M. Smith, “Rolling in Dough; For the Creators of California Pizza Kitchen, Having Enough Capital Was the Key Ingredient to Success,”

Newsweek, June 25, 2007.

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California Pizza Kitchen

Inspired by the gourmet pizza offerings at Wolfgang Puck’s celebrity-filled restaurant, Spago, and eager
to flee their careers as white-collar criminal defense attorneys, Larry Flax and Rick Rosenfield created the first
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 flourished. 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 US stores were in California), the casual dining model had done well throughout all US 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 170 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 first 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 2007, 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
growth 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 July 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, Japan, 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.2 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

2 Jeffrey D. Farmer, CIBC World Markets Equity Research Earnings Update, “California Pizza Kitchen, Inc.; Notes from West Coast Investor

Meetings: Shares Remain Compelling,” April 12, 2007.

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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.”3 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 1 contains a selection of CPK
menu offerings. “Its menu items offer customers distinctive, compelling flavors to commonly recognized
foods,” a Morgan Keegan analyst wrote.4 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 of the 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 Rosenfield 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.

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 P.F. 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-of-mouth marketing for the company. Of the actual dollars spent on marketing,
roughly 50% was spent 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 online marketing.

CPK’s clientele was attractive not only 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 well-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 firm 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.6 The five-

3 Company press release, February 15, 2007.
4 Destin M. Tompkins, Robert M. Derrington, and S. Brandon Couillard, Morgan Keegan Equity Research, “California Pizza Kitchen, Inc.,” April

19, 2007.
5 Larry Miller, Daniel Lewis, and Robert Sanders, RBC Capital Markets Research Comment, “California Pizza Kitchen: Back on Trend with Old

Management,” September 14, 2006.
6 Tompkins et al., “California Pizza Kitchen, Inc.”

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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

 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 had to deal not only with rising commodity costs, but also with rising labor costs. In May
2007, President Bush signed legislation increasing the US minimum wage 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 wage 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 cut.7 Despite that news, a Deutsche Bank analyst remarked, “Two
important indicators of consumer health—disposable income and employment—are 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.9 Analysts also believed limited-service restaurants would benefit
from any consumers trading down from the casual dining sub-sector of the full-service sector.10 The growth
of the fast-casual subsector and the food-quality improvements in fast food made trading down an increasing
likelihood in an economic slowdown.

7 Amy G. Vinson and Ted Hillard, Avondale Partners, LLC, “Restaurant Industry Weekly Update,” June 11, 2007.
8 Jason West, Marc Greenberg, and Andrew Kieley, Deutsche Bank Global Markets Research, “Transferring Coverage–Reservations Available,”

June 7, 2007.
9 As of July 1, 2007, CPK had $154.3 million in minimum lease payments required over the next five years with $129.6 million due in more than five

years.
10 Jeff Omohundro, Katie H. Willett, and Jason Belcher, Wachovia Capital Markets, LLC Equity Research, “The Restaurant Watch,” July 3, 2007.

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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 of their food dollars spent on
dining out from the 45% in recent years to 53% by 2010.11 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 aggressively pressed for changes at numerous chains
including Applebee’s, Wendy’s, and Friendly’s. These changes included the outright sale of the company, sales
of noncore divisions, and closure of poorly performing locations.

In response, other chains embarked on shareholder-friendly plans including initiating share repurchase
programs; increasing dividends; decreasing corporate expenditures; and divesting 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
activist.12

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 2 and 3 contain CPK’s financial statements through July 1,
2007. Exhibit 4 presents comparable store sales trends for CPK and peers. Exhibit 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 traffic 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 environment.13

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.

11 Tompkins et al., “California Pizza Kitchen, Inc.”
12 Sarah E. Lockyer, “Who’s the Boss? Activist Investors Drive Changes at Major Chains: Companies Pursue ‘Shareholder-Friendly’ Strategies in

Response to Public Pressure,” Nation’s Restaurant News, April 23, 2007.
13 Destin M. Tompkins and Robert M. Derrington, Morgan Keegan Equity Research, “California Pizza Kitchen, Inc.,” May 11, 2007.

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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 revenue 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 per pound by the first week of July.
Management felt that many 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 6 shows the performance of CPK stock relative to that of industry peers.

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.14 Financial policy varied across the industry, with some firms
remaining all equity capitalized and others levering up to half debt financing. Exhibit 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 8).

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 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.

14 By a familiar decomposition equation, a firm’s ROE could be decomposed into three components: operating margin, capital turnover, and

leverage. More specifically, the algebra of the decomposition was as follows:
ROE = Profit ÷ Equity = (Profit ÷ Revenue) × (Revenue ÷ Capital) × (Capital ÷ Equity).

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Exhibit 1

California Pizza Kitchen

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 1985. 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 Jack, 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 Italian sausage and sweet Italian sausage with sautéed 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 jalapeño cream sauce.

Source: California Pizza Kitchen website, http://www.cpk.com/menu (accessed on August 12, 2008).

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Exhibit 2

California Pizza Kitchen

Consolidated Balance Sheets
(in thousands of dollars)

Data sources: Company annual and quarterly reports.

As of

1/1/2006 12/31/2006 7/1/2007

Assets

Current assets

Cash and cash equivalents 11,272$ 8,187$ 7,178$

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 & 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 liabilities & shareholders’ equity 274,254$ 310,513$ 339,779$

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Exhibit 3

California Pizza Kitchen

Consolidated Income Statements
(in thousands of dollars, except per-share data)

Notes:

(1) For the years ended December 28, 2003; January 2, 2005; January 1, 2006; and December 31, 2006.

(2) 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.

Data sources: Company annual and quarterly reports and quarterly company earnings conference calls.

Fiscal Year
(1)

Three Months Ended

2003 2004 2005 2006 7/2/2006 7/1/2007

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 …