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WIKI ANALYSIS
Founded by two lawyers in 1985 in Beverly Hills, California, California Pizza Kitchen (CPKI) owns and operates a chain of 223 restaurants of which 190 are company-owned and 33 operate under franchise or license agreements in 29 states. Featuring an open-flame brick oven, the restaurants offer individual pizzas with non-traditional toppings (eg. BBQ chicken, Thai chicken) an homage to Wolfgang Puck's signature item at the famous Spago celebrity-dwelling restaurant - as well as pastas, salads, sandwiches, appetizers and deserts. CPKI is open for lunch and dinner with entrees ranging from $5.29 to $16.99 in 2006, and with the average guest check totaling $12.85 during 2006. Average guest check was $13.30 in 3Q07.
In 1992, PepsiCo acquired a majority interest in CPKI, which it divested in 1997 after suffering dismal comps and operating losses. Soon thereafter, an experienced senior management team lead by CEO Frederick Hipp was installed. In 1999, CPKI went public.
Expanding distribution channels
This new team attempted to implement a more disciplined growth plan, while broadening the number of CPKI's distribution channels. To explore development opportunities in high-traffic venues, such as airports and malls, in 1996 CPKI introduced a high-quality fast-casual concept called California Pizza Kitchen ASAP. CPKI's ASAP restaurants are smaller and offer a limited selection of popular menu items. With just 10 ASAP restaurants open, the company stopped development while it attempts to reduce the cost structure and improve profitability. It plans to open four new units and close additional unprofitable units in 2008.
To gain supermarket distribution, in 1997 CPKI signed an agreement with Kraft Pizza Company, a subsidiary of Kraft Foods to manufacture and distribute a line of CPKI's frozen pizzas in the U.S. and Canada. Currently, CPKI's pizzas are sold in 50 states in more than 17,000 points of distribution throughout the U.S. Kraft intends to expand into markets where its own restaurants are located. The licensing deal with Kraft is very lucrative with margins approximating 97%, and while increasing CPK's brand awareness, it also provides free advertising for CPK. Kraft is obligated to spend 5% of its CPK pizza revenues in advertising for the product. This far outweighs CPK's own advertising, which amounts to about one-tenth of 1% of restaurant revenues.
Aggressive expansion leads to opening of underperforming restaurants
Funded with proceeds from the IPO in August 2000, the company began expanding aggressively, opening and franchising new restaurants at a rapid pace in 2000 (16 new units), 2001 (19), 2002 (18), and 2003 (22). However, sales and profitability of the new restaurants began to lag greatly behind existing restaurants, apparently owing in part to bad locations. Restaurants added in 2002 generated operating margins (sales less restaurant operating costs) that year of 12.7% compared to 20.1% for all the restaurants opened prior to 2002. Restaurants added in 2003 generated 4.6% compared with 11.6% for the restaurants opened in 2002, and 20.4% average for all the restaurants opened prior to 2002.
The founders' return
In 2003, a second consecutive year of dismal results from the new restaurants, CEO Frederick Hipp resigned, and co-founders Richard Rosenfeld and Larry Flax re-assumed their former co-CEO and co-Chairmen positions, effective July 2003. They slowed growth to focus on improving profitability, including reviewing the site selection process and testing a new prototype that is not only larger than the previously opened restaurants (5,800 square feet with 200 seats versus 4,800-5,200 square feet and 150 seats) but also contains a bar area. In 2004, just four new restaurants were opened, three of them with the new design. In 2005, 15 of the 22 restaurants opened, and in 2006, 16 of the 20 restaurants opened were built on the new prototype.
GROWTH STRATEGY
In our view, CPKI can grow earnings at a mid-teens rate over the next couple of years through its plan to generate positive comps, add full service restaurants in existing and new markets, increase revenue through its new prototype restaurant design, and further penetrate the fast casual market with the new ASAP concept. The company grew its full service restaurant chain by 13 units or 9% in 2005, 16 units or 11% in 2006, and it expects to add another 17 units (10%) in 2007. With a chain of just 223 restaurants, we think the company can grow the units at about 10%, while keeping an eye on profitability.
New Prototype Poised to Drive Comps
Most of these additions will be designed in the new, larger and more upscale prototype. After dining in a new prototype restaurant, we think the interior, which includes more upscale furnishings and an attractive semi-circular bar, increases the customers' perception of the price-value relationship offered by CPKI, and will in turn enable the company to add higher-priced items to the menu and earn additional high-margin revenue from the bar. We think, the incremental revenue can generate positive comps (about 3%) coupled with operating and marketing efficiencies from opening most of these new restaurants (the company estimates 75%) in existing markets, which can offset the increased cost of the new format and boost margins slightly. Indeed, management indicated the new prototype is generating ROI above 20%.
ASAP Platform Offers Potential Growth
Ten ASAP restaurants (the smaller format designed for malls and airports) have been opened as of November 2007. Management stopped opening these restaurants to reduce the cost structure and improve profitability. They are currently revamping ASAP's operating strategy and plan to continue closing unprofitable units and open four new units in 2008. After reaching a peak of 16.5% in the second quarter of 2006, ASAP restaurant margins declined to 13.1% in the third quarter and fell further to 8.3% in the fourth. We think if management gets it right and improve the concept's profitability, ASAP could be a strong growth vehicle for the company with potential for expansion nationwide.
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