Description
California Pizza Kitchen is a down and out restaurant operator that is being treated as if the concept is broken, the outlook bleak, and balance sheet loaded with debt. However, despite the street unanimously giving up on the company, CPKI trades a compelling valuation, their problems have been identified, solutions are in place and it offers significant turnaround potential in terms of a EPS and trading multiple.
1) History of Company
From the latest 10K Filing:
We opened our first casual dining restaurant in 1985 in Beverly Hills, California and grew steadily to 25 restaurants by early 1992. Our concept, with its signature line of innovative, premium pizzas, open-flame ovens in exhibition-style kitchens and excellent guest service, attracted PepsiCo, Inc. (hereafter referred to as "PepsiCo") which bought a controlling interest in our company in May, 1992.
During the approximately five-year period when PepsiCo was our controlling shareholder, we opened 60 restaurants, 16 of which have subsequently been closed. We experimented with different locations and different restaurant sizes, ranging from 3,600 square feet to more than 11,000 square feet. Our rapid expansion strained our infrastructure, resulted in a variety of management and operational changes, diverted our attention from the execution of our concept and led to disappointing operating results and financial performance, including a decline in comparable restaurant sales in 1996.
At the end of 1996, PepsiCo concluded that it would sell or otherwise divest all of its restaurant businesses, including California Pizza Kitchen. In September 1997, we consummated a series of transactions to effect a merger and leveraged recapitalization through which an investor group led by Bruckmann, Rosser, Sherrill & Co., L.P. acquired PepsiCo's interest in our company.
Since the beginning of 1998, we have instituted an accelerated, but disciplined, growth plan, focusing largely on further penetrating our existing markets. Between January 1998 and December 2002, we opened 49 new company-owned, full service restaurants and three ASAP restaurants. We intend to open a minimum of 22 company-owned, full service restaurants in 2003. We have signed lease agreements or letters of intent for all of these restaurants. We anticipate that our new restaurants will require a cash investment, net of landlord contributions, of approximately $1.3 million per restaurant. Pre-opening expenses for each of these new restaurants is expected to average approximately $180,000 to $185,000 per restaurant. Additionally, our new restaurants experience higher cost of sales, labor and direct operating and occupancy costs for approximately their first 90 to 120 days of operations in both percentage and dollar terms when compared with our mature restaurants. Accordingly, the volume and timing of new restaurant openings has had, and is expected to continue to have, an impact on pre-opening expenses, cost of sales, labor and direct operating and occupancy costs until our restaurant operating base is large enough to mitigate these opening costs and inefficiencies.
Today the company currently operates 134 full service California Pizza Kitchen restaurants. They also franchise 31 restaurants with 24 of these operated by Host Marriot in airports under the name ASAP California Pizza Kitchen. These units are in a much quicker grab and go format and do not have waiter service. They are currently working on one company owned ASAP to determine if it has greater rollout potential as the minimal investment allows it to achieve pretty attractive returns.
2) History of EPS problems
On March 25th 2003, CPKI lowered 1Q EPS to 21 cents from 23 cents and cites a combination of weak Feb. SSS due to weather and the in suing affect on labor expense as the cause. The stock only slips 3.4% as most believe the problem will be contained to this Q as the company tells investors that SSS returns to normalized trends in March.
The first real bombshell drops on April 22, ’03 when the company lowers 2Q guidance by a more substantial 4-6 cents or to 21-23 from 27 cents. They maintained their full year guidance of .98-1.02 which implied that margins get much stronger in the 2H. They also admit that weak new store productivity is causing much of the weakness. Due to the shortfall, skepticism regarding their 2H guidance, realization that the problems are much more deep rooted in nature, and the expected downgrades that came with this release, the stock falls 17%.
They then report 2Q SSS on July 2nd that are on the low side, but reaffirm the midrange of the lowered 2Q guidance. Just as it appeared that things may have stabilized, CPKI comes on July 25th and lowers ’04 guidance by 10% to $1.05-1.10, announced the resignation of CEO Fred Hipp, the return of former Co-CEO’s Rick Rosenfield and Larry Flax, and admit that the new store productivity is the main culprit of EPS problems. The new CEO’s explain that new stores are weak because of bad real estate selection (and blame this on the ousted CEO). The stock falls 15.7%.
’04 Guidance comes down again to .95-1.00 on October 24th and this is explained by an incremental G&A spend of 2.5 million because the company has been running too lean. The stock drops 6.3% on this news as well as the comment that LT growth rate is 10-15%.
The latest disappointment came on Jan. 30th, ’04 as the company lowered the 1Q to 17-19 cents vs. consensus of 23 cents and said that they are “comfortable with the low end” of their .95-1.00 guidance. The stock falls another 6.4% and that is about where we are today.
While the company obviously has a bad track record with being open and honest with the street, the main problem seems to have been identified and there is reason to believe that the return of the founders will have success in fixing the issue. The problem is a real estate one. While I will go into more detail below, CPKI began to compromise on locations as they accepted sites from a national agency in an effort to hit aggressive expansion plans. The agency ran would run basic demographic studies that would decide on their new locations often in new markets. These studies would focus on characteristics such as growth rates and median income levels. Often what they would miss, however, is that the sites were still years away from having the necessary population to maintain the margins and ROIC they CPK had come to expect from earlier sites. CPK is still a small enough concept that they do not need to settle on lower quality sites. They can afford to wait for these new markets to develop further before they enter them. In the meantime, CPK can focus on markets were they enjoy solid returns, brand recognition, and still have plenty of room to grow before they reach saturation.
3) Comparison of pre-02 restaurants and ‘02/’03 restaurants
In their Q4 press release, CPKI decided to provide much more data on margins and cash flow for their core restaurants and underperforming new ones. This breakdown allows you to quickly realize where the margin erosion is coming from. The full year of ’03 saw restaurant level margins fall 120 bps, however, this was caused by the ’02 stores falling 110 bps and new stores coming new in at 4.7% or about a quarter of the system’s average. The performance of these two classes of restaurants was enough to offset the 30 bp gain in pre’02 stores. For the 4th Q, while we saw a 130 bps decline in margins because the weighting of the ’03 stores increased, the ’02 stores showed an improvement of 70 bps. This is encouraging because it provides some evidence that the change in management is having a positive impact as they try to improve the performance of these stores.
Fourth quarter Full Service Full Service Rest
2003 # of Sales Net Restaurant Cash flow
Stores Average Sales Cash flow %
Pre-2002 94 $58,341 $71,818 $14,278 19.9%
Prior year 96 $55,641 $69,440 $13,613 19.6%
Year over
year change 4.9% 3.4% 4.9% 30bps
Class of 2002 18 $47,148 $11,033 $1,334 12.1%
Prior year 18 $51,783 $10,416 $1,185 11.4%
Year over
year change -9.0% 5.9% 12.6% 70bps
Class of 2003 22 $42,805 $11,038 $560 5.1%
Prior year
Year over
year change
Total full
service 134 $54,496 $93,888 $16,172 17.2%
Prior year 114 $55,106 $79,856 $14,798 18.5%
Year over
year change -1.1% 17.6% 9.3% -130 bps
Fiscal Year Full Service Full Service Rest
2003 # of Sales Net Restaurant Cash flow
Stores Average Sales Cash flow %
Pre-2002 94 $57,644 $286,780 $58,520 20.4%
Prior year 96 $55,798 $278,541 $55,930 20.1%
Year over
year change 3.3% 3.0% 4.6% 30bps
Class of 2002 18 $46,696 $43,707 $5,053 11.6%
Prior year 18 $54,627 $21,602 $2,744 12.7%
Year over
year change -14.5% 102.3% 84.2% -110 bps
Class of 2003 22 $43,274 $22,330 $1,053 4.7%
Prior year
Year over
year change
Total full
service 134 $54,896 $352,817 $64,626 18.3%
Prior year 114 $55,712 $300,143 $58,674 19.5%
Year over
year change -1.5% 17.5% 10.1% -120 bps
The bottom line on this is that the 70% of the system that was opened before ’02 is accounting for over 90% of the company’s profits. Not only are the trends at these stores not in bad shape, they have been actually outperforming the industry in terms of AWS and margin expansion. Thus this is not an issue of a broken concept, but one where the prior management made mistakes that are correctable.
Below, I provided a very realistic turnaround scenario where the ’02 and ’03 class stores show reasonable improvement of 500 and 700 bps respectively in restaurant level margin expansion, but still significantly below the pre ’02 levels. I also modeled a 5% increase in AWS which also seems conservative considering the very low base and the sales building initiatives throughout the year. Doing this simple analysis, we could see almost 20% EPS upside from ’03 actual EPS without assuming any unit growth. Current estimates only call for 8% EPS growth for ’04 on a 10% increase in units. To gauge what the “potential” earnings power of the company would be if all units were performing at the high pre ’02 level, we would see 63% higher EPS.
Fiscal Year Full Service Full Service Rest
2003 # of Sales Net Restaurant Cash flow
Stores Average Sales Cash flow %
Pre-2002 94 $57,644 $286,780 $58,520 20.40%
Prior year 96 $55,798 $278,541 $55,930 20.10%
Year over
year change 3.30% 3.00% 4.60% 30bps
Class of 2002 18 $46,696 $43,707 $5,053 11.60%
Prior year 18 $54,627 $21,602 $2,744 12.70%
Year over
year change -14.50% 102.30% 84.20% -110 bps
Class of 2003 22 $43,274 $22,330 $1,053 4.70%
Prior year
Year over
year change
Total full
service 134 $54,896 $352,817 $64,626 18.30%
Prior year 114 $55,712 $300,143 $58,674 19.50%
Year over
year change -1.50% 17.50% 10.1% -120 bps
2004
Pre-2002 94 $58,797 $287,399 $59,204 20.60%
Prior year 96 $57,644 $286,780 $58,520 20.40%
Year over
year change 2.00% 1.17% 20 bps
Class of 2002 18 $49,031 $45,893 $7,618 16.60%
Prior year 18 $46,696 $43,707 $5,053 11.60%
Year over
year change 5.00% 50.77% 500 bps
Class of 2003 22 $45,438 $51,981 $6,082 11.70%
Prior year $43,274 $22,330 $1,053 4.70%
Year over
year change 5.00% 477.56% 700 bps
Total full
service 134 $55,292 $385,273 $72,904 18.92%
Prior year 134 $54,896 $352,817 $64,626 18.30%
Year over
year change 0.72% 12.81% 62 bps
EPS with No Unit Growth $ 1.066
Actual '03 $ 0.890
% Improvement 19.8%
4) Long Term Outlook
Few question the viability of the brand which could provide further downside if it is indeed broken. In my opinion, the performance of the core restaurants is all you need to know that the concept is strong and the problems are fixable. CPKI is not the first company to run into trouble by trying to grow too quickly and being forced to compromise real estate and returns in order to pacify the street. Eventually this catches up to companies and managements as it has here. Most importantly, CPKI has learned their lesson and will go forward without making the same mistake. The density of their California stores (37% of the system) supports the argument that the concept is far from mature, but points to the fact that greenfield locations do not provide them with attractive returns. CPK will refocus on markets that they tend to perform better in. This means that they will fill out markets where they have solid name recognition and above average AWS rather than move into suburbs of new markets where they simply can’t generate the necessary sales levels to hit an attractive ROIC. Once CPK gets the new stores back to an acceptable level and fixes their real estate problem over the course of 2004, their growth rate should be able to return to 10-15% on a unit basis and 15%+ on EPS for many years.
Below is the return calculation of California Pizza Kitchens at the unit level which illustrates the strength of the concept in a normalized environment.
Mature AUV $ 2,900,000
Unit Level EBITDA Margin 19.7%
Unit Cash Flow $ 571,300
Total Unit Cash Investment $ 1,300,000
Pre-Opening Cost $ 185,000
Total Cash Investment $ 1,485,000
Cash on Cash Return 38.5%
Rent $ 150,000
Capitalized at 8x $ 1,200,000
Fully Capitalized Investment $ 2,685,000
Fully Capitalized Return 21.3%
5) Valuation
After several missteps that has crippled EPS and called into question management credibility and focus, the stock has clearly been a laggard. It was down 20% in ’03, is 31% off of its 52 week high, 49% off its all time high, and is down 22% from its closing day IPO price back in August of ’00. The decline in the stock price has occurred as a result of a lower multiple on lowered forward expectations. CPK did actually have its most profitable year in ’03, so they have not seen any declines year over year.
This has left the company trading at 18x C’04 EPS of $.96 and an EV/EBITDA multiple of 6.5x. A substantial part of the difference is that CPKI has no funded debt and cash/marketable securities of $23.5 million leaving them with an Enterprise Value of $305 million compared to its market cap of $328 million. CPKI has been a free cash generator despite its rapid growth rate and this will obviously look more attractive this
year as they slow the unit openings. Capex with still be artificially high this year at $30-33 million as they spend $20 million on new units, $7 million on remodels and the balance for maintinance capex and other projects. This would leave a little over $5 million in free cash or a yield just under 2%.
To get a truer sense of the cash generation of this company, we can assume that they do no new units and capex ex is just for maintenance of current restaurants. This would free up an additional $2 million from no pre-opening costs and require an annual capex of only $2.7 million ($20,000/restaurant). Free cash flow would then be just over $35 million for a yield of 11.6%. This is all based on current forecasts that give no credit for an increase in the performance of their class of ’02 and ’03 stores. Given that the company has had solid comps throughout its life, this yield can be maintained or increased by simply taking a few percent in pricing on the menu each year.
6) Near term outlook (’04)
CPKI has several items that should make ’04 a much easier year than prior years in terms of EPS growth.
Pre-opening Expense: Since CPKI typically expenses about $180,000 in pre-opening expense per restaurant, EPS is pulled down fairly significantly for a company of its size (especially when those new units are underperforming). They should see a benefit of $1.4 million net of tax or 7 cents from the reduction in this expense due to the opening of 10-12 units rather than last years 22.
D&A: CPK wrote off PPE for 11 units in the 3rd Q and another one in the 4th. None of these units have been closed and only 2 are expected to be. The benefit will also be about $1.4 million or 7 cents in the reduction of Depreciation expense in ’04. While this is not exactly the highest quality source of EPS upside, it should help highlight the value of the company that is not recognized by just superficially looking at the P/E.
53rd weak: While already in their guidance, CPK has a 53rd week this year that should provide an additional 6 cents for the year (according to the company). Again, while not an improvement in operations, it will help results that have been less than stellar the past 4 Q’s.
Rent expense: Due to the poor performance of their stores, CPK has gone back to their landlords and asked for rent reductions. They have commented that these discussions are progressing well which seems reasonable since a less profitable tenant is better than no tenant at all for these disappointing mall locations. Based on rental expense that equals about 30% of D&O, I get an incremental 1.5 cents by assuming that they get a 10% reduction in 75% of their ’03 stores as well as in 50% of their ’02 stores.
Cheese costs: While I don’t have an estimate, cheese costs pressured CPK’s COGS line for the year with the largest affect in the back half of the year. This pressure should ease as the company laps the 2Q. The total effect for the year was 30 bps or 4 cents. While we should not expect to trend back to ’02 levels, comparisons should look better if this line does not continue to pressure margins.
G&A: After returning to the company in July, the former founders determined that the company was operating with too little G&A and that the number needs to be taken up fairly significantly. This line should go from roughly 6% of sales to about 6.5% or from $21.5 million to $27 million. The incremental cost to the company above a more normal 15% rise will cost the company about 8 cents to the bottom line.
At the end of the day the increased G&A expense should offset the decrease in pre-opening and leave the leverage off the flat D&A line and rent expense savings as a source of upside for the year (I am looking at this on a 52 week basis and ignoring the non-recurring benefit of the extra week). Analysts’ models are ignoring the impairments that result in a decline in depreciation, the rent savings, and are assuming that margins actually decline even though we began to see improvement in the 4th Q. This is the case because subtracting the extra week from current consensus of 96 cents; you get essentially the same number that they earned in ’03 despite all of the benefits that I have mentioned.
And maybe most importantly, the street completely ignored the fact that the company said SSS were running ahead of their 2-3% guidance which could also be a source of upside (many others competitors are seeing the same thing as they benefit from challenging weather in ’03.)
7) Negative sentiment on the stock
The sellside is extremely negative on the stock with current recommendations looking like this:
CIBC: Underperform
BAC: Sell
SG Cowen: Market Perform
RBC: Underperform
RJ: Peer Perform
McDonald: Peer Perform
JMP: Market Underperform
Sterne, Agee: Buy
Oppenheimer: Buy (recently upgraded)
Most of these analysts became negative on the stock after CPK disappointed along the way. None of them actually pointed out the issue of poor performing new stores that would eventually lead to negative revisions. Thus, while I not only think that their opinions aren’t particularly relevant here, I think that potential upgrades as things get better will provide useful catalysts for the stock in the future. The main argument made by the sellside currently is that the stock is still expensive given their problems. Every one of them points to the P/E and ignores EV/EBITDA. Given the market cap of the company today, it is understandable that they don’t devote much time to the name. However, this could work in the stock’s favor as it appears that their models are ignoring several areas of upside. For example, they are still modeling for D&A to be up with the unit growth number (10%) even though they have written off 13 restaurants over the past 2 Q’s. They are also ignoring the rent relief that they will see from the renegotiations of many of these same stores that have been written off, but not closed (despite have poor returns, they are still cash flow positive and thus closure would be worse for shareholder value).
The buyside is also very negative on the stock as evidenced by its short interest. With shorted shares at 2.37 million and a float of only 17 million, the short interest as a % of sales is 14% and 8 days to cover. This is 500,000 shares shy of its record despite the 52 week low share price. I believe that they are to late, have pressured the shares recently and will become anxious buyers as the business improves. Their also has been a substantial turnover in the shareholder base as we often see in busted growth companies. Many of the larger shareholders have bought their stakes with the past few quarters which suggest to me that the real float is actually lower since these investors got involved with full acknowledgment of the issues. This should provide a nice support level for the shares as well as amplify any potential short squeeze.
8) Other
ASAP
The founders of the concept that have now returned to the company are much more optimistic on the potential of ASAP units. They believe that prior management ignored this concept and they want to continue testing it outside of airports as a “fast casual” concept more similar to a Baja Fresh or Pei Wei. In two locations that average about 2,000 square feet, they are seeing about $1,000 of Sales/Sq Ft. which is extremely remarkable. This concept may allow them to achieve higher returns and do it in areas that the main concept would not be appropriate.
Potential Takeover
Given were the stock is trading now, there is fairly nice downside protection of a deal being consummated. There are several private equity shops that would be attracted to a self funding, well known concept, with a solid FCF field and $30 million of net cash. Many companies in significantly worse shape rarely trade below 5x EBITDA and this includes some companies with bankruptcy risk. CPKI has ties to a PE shop that bought them from Pepsi Co and took them public, Bruckmann Rosser Sherrill & CO. Considering where they took the company public and subsequently got out of almost all over there position, they might be willing to get back involved if the company could be had for these levels.
9) Risks
1) The key risk is more of a timing issue than anything in my opinion. The turnaround of the ’02 and ’03 stores may simply take much longer than I am anticipating. We also won’t have the benefit of clarity on the new opening under the current management since these won’t begin to open until after the summer is over and they will need a few months to get an initial read on them.
2) Several analysts cite the many initiatives that the company is working on as a barrier to fixing the core issue. While I agree that fixing the underperforming stores should be the focal point, the ASAP concept could be a high return growth vehicle for them that I don’t think will take too much attention away from management.
3) Competition and low carb diets. Many competitors have added specialty pizzas to their menus diminishing the niche that CPK serves. While it has not has a clear effect to date, the low carb dieters avoidance of bread could have an adverse affect on their pizza sales. Preemptively, CPK has been adding many more non carb focused foods to their menu such as salads.
Catalyst
*Should comp above guidance as they lap severe national weather last year and more specifically rain in key markets like CA where they rely on patio seating
*Any change in sentiment should be a boost as almost the entire street is negative on the name with several Underperforms
*Will lap the return of the founders this summer who have kept guidance low to "lower the bar".
*Will lap the spike in cheese prices this summer that have caused margin pressure
*Easy margin comparisons throughout '04 as '03 was down over 100 bps at the restaurant level.