TEXT-S&P revises California Pizza Kitchen rating outlook
Overview -- U.S. casual dining restaurant operator California Pizza Kitchen has performed below our expectations because of revenue declines due to weak traffic and store closures. -- While EBITDA has improved slightly in the past year, we believe there is significant downside risk to operating performance in the second half of fiscal 2012. -- We are revising the outlook to negative from stable and affirming our 'B' corporate credit rating on the company. -- The negative outlook reflects our expectation for modest cash flow generation and slightly worsening credit protection metrics despite efforts to enhance operations through cost cutting this year. Rating Action On Aug. 28, 2012, Standard & Poor's Ratings Services revised its outlook on Los Angeles-based California Pizza Kitchen Inc. (CPK) to negative from stable. At the same time, we affirmed all of our ratings on the company, including our 'B' corporate credit rating. The outlook revision reflects the latest two quarters of performance, when de-leveraging was below our expectations, and our view that sales are likely to decline over the near term due to continued negative comparable-store sales and expected commodity cost inflation. It also incorporates our view that credit metrics and covenant cushions will remain weak relative to the rating category over the coming year. Rationale The speculative-grade rating on CPK reflects its "highly leveraged" financial risk profile as a result of the Golden Gate Capital LBO. It also incorporates our "vulnerable" assessment of the company's business risk profile, reflecting its participation in the highly competitive casual dining segment of the restaurant industry, limited format diversity, exposure to volatile commodity costs, and geographic concentration in California, where more than 30% of the company's units are located. We calculate CPK's cushion to its leverage covenant under a credit agreement at 11.1% in the second quarter ended July 1, 2012, and expect it to remain between 10% and 15% by the end of fiscal 2012. While credit protection metrics have improved in the first half of 2012 compared to the end of fiscal 2011, we expect modest erosion by the end of fiscal 2012 as the company continues to post negative sales. As such, we forecast lease-adjusted total debt to EBITDA will worsen to 6.5x by the end of fiscal 2012 from 6.3x in the year through July 1, 2012. We also project EBITDA coverage of interest will decline to 1.5x by the end of fiscal 2012 from 1.8x in the year through July 1, 2012, due to added interest expense following the LBO. Principal economic factors we considered in our forecast include real GDP growth of 2.1% in 2012 and 1.8% in 2013, consumer spending growth of 2.0% in 2012 and 2.3% in 2013, and the unemployment rate remaining at or above 8% through 2013. Further specific details underlying our forecast for CPK include: -- Low-single-digit percent sales decline as weak traffic causes continued negative comparable-store sales; -- Gross margin likely to decline in the mid-double-digit basis points (bps) as low-single-digit commodity cost inflation offsets menu simplification and savings associated with food waste; -- Selling, general, and administrative expense anticipated to decrease in the low-single-digit percent rate due to continued reduction in headcount and wages; -- Modest increase in capital expenditure for maintenance, but not restaurant growth, with no unit expansion forecast in the medium term; and -- Adjusted EBITDA projected to increase in the mid-single-digit percent this year as continued aggressive cost-cutting through renegotiated food and distribution contracts and lower labor expenses offset declining sales. We believe CPK's operating results were weaker than expected in 2011, in part due to the delay in installing a new CEO and CFO, which delayed realizing procurement and staffing savings. Our 2012 outlook remains negative for the casual dining industry in which CPK competes and more favorable for quick-service pizza players like Pizza Hut franchisee NPC International Inc. and Domino's Pizza Inc. Both are posting positive comparable sales figures this year due to promotions and increased delivery and we believe such trends are detracting from full-service dine-in players like CPK. Liquidity We view CPK's liquidity as "adequate," covering cash needs over the next several years, even in the event of moderate, unforeseen EBITDA declines. As of July 1, 2012, the company had $33 million in cash on hand and no outstanding borrowing under its revolver. We do not expect CPK to borrow under its revolver for the remainder of fiscal 2012. Cash on hand, cash flow from operations, and availability under the revolver are likely to provide adequate liquidity sources to fund the company's capital spending needs. Additionally, a credit agreement mandates the company use 50% of excess cash flows for debt repayment in coming years, resulting in modest de-leveraging. Other relevant aspects of the company's liquidity are as follows: -- We expect that liquidity sources over the next 12-24 months will exceed uses by 1.2x or more. -- We also expect that net sources would be positive, even with a 15% decline in EBITDA. -- The company's debt maturities over the medium term are manageable, in our view. -- We believe CPK's cushion to its leverage covenant will remain at or below 15% by the end of fiscal 2012. Recovery analysis For the complete recovery analysis, see the recovery report on CPK, to be published soon after this report on RatingsDirect. Outlook Our negative rating outlook on CPK reflects our base-case forecast that the company's operating performance and credit measures will worsen slightly over the near term. We could lower the rating if poor execution of CPK's strategic initiatives, greater-than-expected commodity cost pressure, and intensified competition result in 50 bps of gross margin deterioration or an annual sales decline in the mid-single-digit percent range for fiscal 2012. This would result in flat EBITDA, with leverage remaining close to 7x and coverage remaining below 2x. A lower rating could also result from a tightening of the leverage covenant cushion to below 10%. We could revise the outlook to stable if CPK demonstrates a consistent commitment to de-leveraging, successfully driving sustainable positive sales in the low-single-digit percent range or improving gross margin about 50 bps. This would result in EBITDA growing in the mid-double-digit percent, pushing leverage down to the mid-5x range and coverage to the mid-2x range. It would also result in the covenant cushion remaining above 15% for the remainder of fiscal 2012. Related Criteria And Research -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- 2008 Corporate Criteria: Ratios And Adjustments, April 14, 2008 -- Key Credit Factors: Business And Financial Risks In The Restaurant Industry, Dec. 4, 2008 Ratings List Ratings Affirmed; Outlook Action To From California Pizza Kitchen, Inc. Corporate Credit Rating B/Negative/-- B/Stable/-- Ratings Affirmed; Recovery Ratings Unchanged California Pizza Kitchen, Inc. Senior Secured B Recovery Rating 3
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