Equity Analysis and Valuation of P.F. Chang s China Bistro

Transcription

1 Equity Analysis and Valuation of P.F. Chang s China Bistro Brett Schroeder Gates Enoch Jd Benton Drew Williams Rosemary Musoke Brett.Schroeder@ttu.edu Gates.Enoch@ttu.edu Jd.Benton@ttu.edu Drew.Williams@ttu.edu Rosemary.Musoke@ttu.edu 1 P age

2 Contents EXECUTIVE SUMMARY...9 INDUSTRY ANALYSIS ACCOUNTING ANALYSIS FINANCIAL ANALYSIS VALUATION ANALYSIS COMPANY OVERVIEW...22 INDUSTRY OVERVIEW...24 FIVE FORCES MODEL...26 RIVALRY AMONG EXISTING FIRMS Industry Growth Rate Concentration of Competitors Differentiation Switching Costs Scale Economies Fixed To Variable Costs Excess Capacity Exit Barriers THREAT OF NEW ENTRANTS Economies of Scale First Mover Advantage Access to Channels of Distribution and Relationships Legal Barriers Conclusion THREAT OF SUBSTITUTE PRODUCTS Relative Price and Performance Customer s Willingness to Substitute Conclusion BARGAINING POWER OF CUSTOMERS Differentiation Page

3 Price Sensitivity Number of Customers Importance of product for costs and quality Volume per buyer Switching Costs Conclusion BARGAINING POWER OF SUPPLIERS Switching Costs Differentiation Importance of Product for Costs and Quality Number of Suppliers Volume Per Suppliers Conclusion INDUSTRY CLASSIFICATION GIVEN FIVE FORCES ANALYSIS OF KEY SUCCESS FACTORS...67 DIFFERENTIATION Superior Product Quality Superior Customer Service Investment in Brand Image Conclusion COST LEADERSHIP Economies of Scale Efficient Production Research and Development and Brand Advertising Tight Cost Control System Conclusion COMPETITIVE ADVANTAGE ANALYSIS...79 SUPERIOR PRODUCT QUALITY SUPERIOR CUSTOMER SERVICE PRODUCT COST Page

4 CONCLUSION ACCOUNTING ANALYSIS...83 KEY ACCOUNTING POLICIES...84 TYPE ONE ACCOUNTING POLICIES Economies of Scale Superior Customer Service Superior Product Quality TYPE TWO ACCOUNTING POLICIES Defined Contribution Plan Goodwill Operating Leases ASSESS DEGREE OF ACCOUNTING FLEXIBILITY...94 OPERATING/CAPITAL LEASES BENEFITS AND PENSION PLANS GOODWILL RESEARCH AND DEVELOPMENT EVALUATE ACTUAL ACCOUNTING STRATEGY...99 OPERATING/CAPITAL LEASE DEFINED CONTRIBUTION PLANS GOODWILL RESEARCH AND DEVELOPMENT CONCLUSION QUALITY OF DISCLOSURE QUALITATIVE ANALYSIS SUPERIOR PRODUCT SERVICE/QUALITY DEFINED BENEFITS PLAN BUSINESS SEGMENTS GLOBAL BRAND DEVELOPMENT ECONOMIES OF SCALE OPERATING LEASES Page

5 QUANTITATIVE ANALYSIS SALES MANIPULATION DIAGNOSTICS Net Sales/Cash from Sales Net Sales/Inventory (raw) Net Sales/Inventory (Change) Net Sales/Net Account Receivables Net Sales/Unearned Revenues Net Sales/Unearned Revenues (change) Net Sales/Warranty Liabilities Sales Diagnostics Conclusion EXPENSE MANIPULATION DIAGNOSTICS Asset Turnover (raw) Asset Turnover (change) CFFO/OI (raw) CFFO/OI (change) CFFO/NOA (raw) CFFO/NOA (change) Total Accruals/Sales (raw) Total Accruals/Sales (change) Pension Expense/SG&A Other Employment Expenses/SG&A Expense Diagnostics Conclusion IDENTIFY POTENTIAL RED FLAGS OPERATING LEASES UNDOING ACCOUNTING DISTORTIONS OPERATING LEASES FINANCIAL STATEMENTS Balance Sheet Balance Sheet Restatement Evaluation Income Statement Page

6 Conclusion FINANCIAL ANALYSIS, FORECASTING, AND ESTIMATING COST OF CAPITAL ESTIMATION FINANCIAL ANALYSIS CURRENT RATIO QUICK ASSET RATIO ACCOUNTS RECEIVABLE TURNOVER DAYS SALES OUTSTANDING INVENTORY TURNOVER RATIO DAYS SUPPLY OF INVENTORY WORKING CAPITAL TURNOVER CASH TO CASH CYCLE CONCLUSION PROFITABILITY RATIO ANALYSIS GROSS PROFIT MARGIN OPERATING EXPENSE RATIO OPERATING PROFIT MARGIN NET PROFIT MARGIN RETURN ON ASSETS ASSET TURNOVER RETURN ON EQUITY CONCLUSION CAPITAL STRUCTURE RATIO ANALYSIS DEBT TO EQUITY RATIO TIMES INTEREST EARNED DEBT SERVICE MARGIN Z-SCORE INTERNAL GROWTH RATE SUSTAINABLE GROWTH RATE CONCLUSION Page

7 FINANCIAL FORECASTING INCOME STATEMENT As Stated Income Statement Restated Income Statement BALANCE SHEET As-Stated Balance Sheet Restated Balance Sheet STATEMENT OF CASH FLOWS ESTIMATING COST OF CAPITAL COST OF EQUITY SIZE-ADJUSTED COST OF EQUITY ALTERNATIVE COST OF EQUITY COST OF DEBT WEIGHTED-AVERAGE COST OF CAPITAL (WACC) METHOD OF COMPARABLES Trailing Price to Earnings (P/E) Forward Price to Earnings (P/E) Price to Book (P/B) P.E.G Ratio Price to EBITDA Enterprise Value to EBITDA Price to Free Cash Flow Conclusion INTRINSIC VALUATION MODELS DISCOUNTED DIVIDENDS MODEL DISCOUNTED FREE CASH FLOWS MODEL RESIDUAL INCOME MODEL As Stated Residual Income Sensitivity Analysis Restated Residual Income Sensitivity Analysis LONG RUN RESIDUAL INCOME MODEL Page

8 As Stated Long Run Residual Income Model Restated Long Run Residual Income Model ABNORMAL EARNINGS GROWTH MODEL As stated Abnormal Earnings Growth Sensitivity Analysis Restated Abnormal Earnings Growth Sensitivity Analysis APPENDIX TRIAL BALANCES (ON NEXT PAGE) PROFITABILITY RATIOS CAPITAL STRUCTURE RATIOS GROWTH RATE REGRESSIONS METHOD OF COMPARABLES INTRINSIC VALUATION MODELS (SEE NEXT PAGE) P age

9 Executive Summary Analyst Recommendation: SELL (Overvalued) PFCB NasdaqGS (6/01/2010) $ Week Range $33.19 $43.48 Revenue 1, Million Market Capitalization 1, Million Shares Outstanding Million As Stated As Stated Book Value per Share Return on Equity 13.90% 12.04% Return on Assets 6.68% 4.48% Cost of Capital Estimated Adj. R² Beta Size Adj. Ke 3 month % 1 year % 2 years % 5 years % 10 years % As Stated Restated Backdoor Ke 4.76% N/A WACCbt 11.30% 12.53% WACCat 10.70% 11.04% Cost of Debt 6.62% 11.83% 9 P age

10 Lower Bound Center Value Upper Bound Ke 7.17% 11.23% 17.06% Size Adj. Ke 8.87% 12.93% 18.76% WACCbt 7.03% 11.30% 14.35% Financial Based Valuations As Stated Restated Trailing P/E $ N/A Forward P/E $ $ Dividends to Price N/A N/A Price to Book $ $ P.E.G Ratio $ $ Price to EBITDA $ $ EV/EBITDA $ $ Price to FCF $ N/A Altman Z-Score Initial Scores Adjusted Scores As Stated Restated Discounted Dividends $ N/A Free Cash Flows $ N/A Residual Income $ $ Long Run Residual Income $ $ Abnormal Earnings Growth $18.73 $ P age

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12 Industry Analysis P.F. Chang s Bistro competes in the Restaurant industry, but more specifically the up-scale restaurant industry. The firm establishes high quality food from which the ingredients are shipped from all parts of the world so they can provide their customers with a great authentic Chinese cuisine. P.F. Chang s competitors are comprised of The Cheesecake Factory, O Charley s Steak Houses, and Chipotle Mexican Grill. The one aspect of business in which all companies compete on in this industry is superior customer service and high quality food. The first step we took in determining the positions of each firm and their relative forces that drive competition and profits was to complete Porter s Five Forces Model. This allowed us to view each company and how well they position themselves within the industry to gain market share and increase profits. The table below provides the data that was accumulated throughout the industry and company analysis. PF Chang's Competitive Force Rivalry Among Existing Firms: Threat of New Entrants: Threat of Substitute Products: Bargaining Power of Customers: Bargaining Power of Suppliers: Level of Competition Moderate-High Low High High Low The above table provides evidence that the rivalry among existing firms is moderately high to high. This is caused by price competition and the need to expand businesses throughout the country and partially overseas. The overall industry competitiveness helps the individual firm s lower prices and to compete against one 12 Page

13 another on market share. This creates a high degree of rivalry among existing firms in the restaurant industry. The threat of new entrants tends to be very low in this particular industry mostly due to the opening costs and creativity it takes to open a new style of restaurant and compete with the already existing firms. The government regulates the number of industries and provides standards for the quality of goods produced to customers. In the restaurant industry, restaurants must obtain certain licenses and permits in order survive in this industry. Firms in this industry maintain a competitive advantage over its competitors by following these rules and regulations. The threat of substitute products is very high in the restaurant industry which is mostly caused by customers not willing to spend their income on up-scale restaurants and fine dining experiences. In the restaurant industry the main focus is cost cutting strategies, overall quality of service, and differentiation from competitors. In the restaurant industry the threat of substitute products is high and switching costs are low which makes the market very volatile. The bargaining power of customers in the restaurant industry tends to be very high as well. Although individual customers can do little to influence the price and quality of particular restaurants, the customer base is able to exert pressure on firms within the industry; if a firm s prices are too high or the quality is lacking, discerning consumers will avoid the firm altogether, causing a failure of the firm. The last five force is bargaining power of suppliers, which is very low in the restaurant industry. The reason is that there is a large plethora of suppliers with very little differentiation between products. If a company is upset with the quality or pricing of its purchases with a supplier, it can easily look around for another supplier to step in and fill its needs. The restaurants will drive prices down to increase revenue and profitability with its bargaining leverage it has on its suppliers. Overall, the restaurant industry or the up-scale restaurant industry is very competitive within the existing firms, but does not show any threat to new entrants entering the industry. In order to make it in this industry it is shown that these companies must adopt and maintain a mixture of cost leadership strategies and product 13 P age

14 differentiation. This allows each firm to fully utilize their resources and compete at the highest level possible so they can make sure profits increase in the future. Accounting Analysis P.F. Chang s key accounting policies can begin to give us some insight into the true financial positioning that they have within the restaurant industry. With the GAAP policies in place, there is a push toward uniformity in the financial workplace, but there is still room for managers to be flexible with the reporting of numbers and level of disclosure of information presented. This flexibility though can be taken advantage of and sometimes abused by managers if not closely watched. Managers have the capability of easily distorting accounting numbers to the point that they can make the company show whatever they want to. This can make the true valuing of a company difficult and does not show true transparency. A way to not have such a vague view of a company, one can look at the type one and two accounting policies to determine useful ways to restate distortions in financial statements. Type one key accounting policies are directly tied with the disclosure key success factors of the firm. P.F. Chang s competes on differentiation and cost leadership within the restaurant industry. The type one key accounting policies for P.F Chang s are economies of scale, superior customer service, and superior product quality. The success level and the way that these policies are implemented is a direct link to how a firm s success. For the most part, P.F. Chang s does a good job in disclosing information regarding type one policies, the level of disclosure is fairly high in this area. As always, more literature could have been added but we do not feel as though P.F. Chang s was trying to hide any information. Type two key accounting policies are the items on the financial statements that are commonly distorted by managers of a firm. The type two policies that we looked at in P.F. Chang s are defined contribution plan, goodwill, and operating leases. As stated 14 Page

15 earlier GAAP allows flexibility in these areas, and it is allowed as long as it does not alter the financials to a high level. For P.F. Chang s operating leases were the only item that was needing to be restated. The next step in accounting analysis is to look at a firm s accounting strategy. This is the way that a firm uses the flexibility to show the kind of numbers that they want to report. There is two ways of reporting: aggressive strategy or conservative strategy. Aggressive firms will understate liabilities and overstate assets to increase their equity and net income. In contrast, conservative firms will overstate liabilities and understate assets, which decrease equity and net income. The ability to identify which strategy a firm is using will allow investors and analysts to have a more transparent and clear view of the firm s true value. After looking at P.F. Chang s statements, we concluded that they are taking an aggressive accounting strategy. The only real distortion was through the use of operating leases to keep liabilities off the books. The level of disclosure on this matter is high but that still does not take away from the fact that these items needed to be restated to get a better picture of the firm financially. Evaluating the financials of a firm can give us the big picture of a firm but may not be a fair representation of how the firm is truly operating. To get this the quality of disclosure on the firm as a whole must be evaluated. A firm can either have a low level of disclosure of information or can have too much irrelevant information, both of which could be used to hide the useful information. After assessing P.F. Chang s level of disclosure, it is apparent that the information is moderate to low in the area of disclosure. Identifying potential red flags is the key step in overall accounting analysis. This is the method of deciding what items will be restated in a company s financials to make the value more transparent. In P.F. Chang s the only red flag that we found was the use of operating leases to decrease the value of liabilities. We then rested the financials to show the capitalization of operating leases. After this restatement, we compared the two sets of financials, as stated and restated, and it was obvious that the numbers were 15 P age

16 being distorted. The restated financials then gave us a more clear view of the true financial strength of the company. Financial Analysis There are three major steps to complete when evaluating the financial status of a firm. They are financial analysis, forecasting, and estimating the cost of capital. The financial analysis is completed by using various ratios. The ratio analysis can be utilized to determine the firm s value in comparison to its competitors and the industry averages. We will use liquidity, profitability, and capital structure ratios to forecast P.F. Chang s income statement, balance sheet and statement of cash flows. By using these comparisons, we are able obtain a basis for making forecasts of future performance. Forecasting for a firm is when ratios are completed in the financial analysis and add industry intuition, knowledge, and estimations to show the possible future financial status of the firm. Once this is completed, the forecasting is used to estimate the cost of capital. The cost of capital will be estimated by utilizing the Capital Asset Pricing Model, and the cost of dent will be calculated by using the stated interest rates. The before and after tax Weighted Average Cost of Capital will be valued using the cost of debt and cost of equity estimations. The chart below will include results from all liquidity ratios for P.F. Chang s Bistro. Liquidity Ratio Analysis Ratio Trend Performance Current Ratio Slightly Decreasing Underperforming Quick Asset Ratio Steady Average Inventory Turnover Steady Outperforming Days Supply of Inventory Steady Outperforming Accounts Receivables Turnover Slightly Decreasing Slightly Underperforming Days Sales Outstanding Slightly Increasing Slightly Underperforming Cash to Cash Cycle Steady Slightly Outperforming Working Capital Turnover Slightly Decreasing Underperforming Overall Slightly Decreasing Underperforming 16 P age

17 Based on the liquidity ratio analysis, P.F. Chang s has maintained a slightly decreasing trend for the past five years for all ratios and has underperformed the industry as a whole. These ratios describe how quick and accessible P.F. Chang s can generate or receive cash. The next set of ratios is the profitability ratios. Profitability Ratio Analysis Ratio Trend Performance Gross Profit Margin Operating Profit Slightly Increasing Outperforming N/A Restated Performance Margin Steady Average Average Net Profit Margin Slightly Steady Underperforming Underperforming Asset Turnover Slightly Decreasing Outperforming Underperforming Return on Assets Slightly Decreasing Average Underperforming Return on Equity Slightly Increasing Slightly Outperforming Increasing Overall Based on the profitability ratios, P.F. Chang s has still been slightly decreasing in their ratios for the past five years, but look to be outperforming the market as a whole for the profitability ratios. The restated ratios look to be underperforming the market as a whole. 17 P age

18 Capital Structure Ratio Analysis Ratio Trend Performance Restated Performance Debt to Equity Slightly Decreasing Slightly Outperforming Underperforming Times Interest Earned Slightly Increasing Underperforming Underperforming Debt Service Margin Steady Underperforming N/A Altman's Z-Score Slightly Increasing Slightly Underperforming Slightly Increasing Internal Growth Rate Slightly Increasing Slightly Outperforming Slightly Underperforming Sustainable Growth Rate Increasing Outperforming Slightly Outperforming Overall The capital structure ratios for P.F. Chang s have showed a positive trend for the past five years and seem to be underperforming the market as a whole. The restated performance shows to be underperforming the market as well. To get a clear picture of the future financials, we forecasted ten years out on the income statement, balance sheet, and the statement of cash flows. We started with the income statement, because it is the most important of the financials when determining the future profitability of the company. P.F. Chang s fiscal year ends on December 31 st, which allows us to receive the first quarterly report of This gives a more precise starting point for the sales forecast in year To start, we looked at the fourth quarter sales for 2009 as a percentage of total revenue in This amount came out to be roughly 25% of total revenues in The next step was to take the first quarter of 2010 and multiply it by four to come up with 2010 total sales. Since P.F. Chang s sales have been decreasing over the past few years, we determined that a growth rate of 1.06% would justify the sales in Due to the effects of capitalizing operating leases, P.F. Chang s Balance Sheet must be evaluated on an as-stated and restated level. Some of the balance sheet accounts, such as current assets and current liabilities, are not affected by the capitalizing of operating leases. However, since some other balance sheet accounts are 18 Page

19 affected, it follows that the future forecasts of these accounts must be done on an asstated and restated level. The statement of cash flows is the final forecasted financial statement, which revolves around the cash in and out flows of a firm. The statement of cash flows is comprised of cash flows from operating activities (CFFO), cash flows from investing activities (CFFI), and cash flows from financing activities (CFFF). In order to obtain projected sales, we had to determine the growth rate of sales by using net income as a percentage of sales. We concluded that net income would remain that same as in the as-stated income statement. We utilized the same rate in forecasting net income on the income statement, which is the same rate as the as stated. For the years of , the percent of sales of net income was volatile; we then proceeded to review the average. We took an average of the as stated net income, which was 3.57 % and utilized 3.7% of projected total sales as our first line item, which is how we calculated net income. Valuation Analysis After the industry, accounting, and financial analyses are done, we are then able to perform a valuation analysis. When doing a valuation analysis, an analyst position must be taken, this is the percentage more or less than the observed price that would consider a firm s stock overvalued or undervalued when running valuation models. We chose to use a 10% analyst position as we felt this would be the most reliable and consistent results. If a 5% position is used this could be too small of a variance to be considered under or overvalued, and 20% we felt would give too much leeway to fair pricing valuation. With P.F. Chang s an observed price of $38.34 on June 1, 2010 means that any price less than $39.13 P.F Chang s stock would be considered overvalued and any price greater than $47.83 P.F. Chang s stock would be considered undervalued. The two different techniques to performing a valuation analysis are method of comparables and intrinsic valuation models. 19 Page

20 The first valuation analysis we performed was through the method of comparables. This is by using various industry ratios to compare to P.F. Chang s and create an adjusted price per share for each. This method is unreliable in one way due to the fact that outliers of the industry must be thrown out of some ratios because it would distort the overall industry average. Although these ratios are unreliable and untrustworthy, many people in the valuation industry use them so it is useful to run the models regardless. The method of comparables told us that P.F. Chang s for the most part is undervalued as six of the twelve models ran showed this. For each model, that we were able to, we ran as stated and restated numbers. The trailing price to earnings ratio was only on an as stated basis and calculated a price per share of $51.48, a number that is undervalued but not significantly. The forward price to earnings ratio had P.F. Chang s severely undervalued with as stated and restated price s per share of $ and $88.44 respectively. We were unable to run dividends per share ratio, as none of our competitors paid out a dividend. The price to book ratio had the closest prices per share to our observed price with the as stated and restated numbers being $44.53 and $ The most overvalued numbers we came up with was the P.E.G. ratio which takes the price to earnings ratio and divides it by the future growth opportunities, the respective price s per share were $17.90 and $ The price to earnings before interest, taxes, depreciation, and amortization (EBITDA) gave us price s per share of $42.56 and $46.06 for as stated and restated. The enterprise value to EBITDA showed price s per share for as stated and restated of $51.12 and $ The last model ran was price to future cash flow which only had an as stated price per share of $ Many of these ratios had P.F. Chang s stock price as undervalued but as said earlier this method is very unreliable. The intrinsic valuation models have great explanatory power and can influence an analyst s recommendation greatly. These models take into account forecasted financial numbers and discount these numbers back to present value to give time consistent implied prices. The intrinsic valuation models we used were discounted dividends, free cash flows, residual income, long run residual income, and abnormal 20 Page

21 earnings growth. The discounted dividends and free cash flow models are considered flawed because they only take in individual aspects of a firm that may not be of the most influence, such as dividend streams and free cash flows. The discounted dividends model for the most part had P.F Chang s as overvalued and negative values in the sensitivity analysis where the growth rate was larger than the cost of equity. The free cash flows model did not have a consistent census of the value of P.F. Chang s with valued ranging from $30.08 to $ This model does have P.F. Chang s fairly valued in some situations but the variance with the numbers can lead us to believe that the free cash flow model is inconsistent. The residual income model has the highest explanatory power of all of the valuation models with an R 2 percentage that can reach 90%. This is largely influenced by the fact that the residual income is the only model to take into account the firm s current book value of equity. Also, the residual income model uses a benchmark income calculated by using this book value of equity times the cost of equity. The residual income model was run for both the as stated and restated financials for P.F. Chang s, and in every case in the sensitivity analysis, using various cost of equity s and negative growth rates, the firm s price was considered overvalued. The only way that the firm would be fairly stated is with a cost of equity below 7.17%, which is unreasonable and very improbable. The last valuation we ran was the abnormal earnings growth model, which similarly to the residual income has a very high explanatory and is a substantial influence on the analyst recommendation. Like the residual income the abnormal earnings growth uses a forecasted benchmark net income, but in a different way by multiplying the previous year s net income by one plus the cost of equity. This is not taking the book value of equity into account. In almost every combination of cost of equity an negative growth rates the abnormal growth earnings considers P.F. Chang s to be overvalued, similar to the residual income. With both of these models showing an overvalued share price, consistently, we have determined that overall P.F. Chang s is overvalued. 21 Page

22 Company Overview P.F. Chang s China Bistro, Inc. was incorporated in January 1996 as a Delaware corporation. The company offers a harmony of taste, texture, color and aroma by balancing the Chinese principles of fan and t sai, which mean balance and moderation.(p.f. Chang s Bistro 10-k). The meals are prepared with the highest quality and freshness of foods delivered from special regions in china. The company owns and operates a total of 197 P.F. Chang s Bistros and 106 casual Pei Wei restaurants. The company objectives are to develop and deliver high quality meals with great customer service, resulting in repeat business. The dining experience is one of high sophistication and satisfaction. In order to achieve these objectives, P.F. Chang s China Bistro strives to offer this high quality cuisine while providing a memorable experience through superior customer service. P.F. Chang s China Bistro represents a more upscale, high class environment that every family can enjoy. The meals are served a traditional Chinese way where the meal is brought out in large portions for the whole family or party to enjoy. The food is prepared by a Mandarin Wok cooking style which sears in all the spices and herbs, allowing the customer to have a flavorful and distinct type of cuisine. P.F. Chang s also operates another restaurant called Pei Wei. Pei Wei offers a more casual style environment in which the food items are placed on a standard menu with items ranging anywhere from $6 to $10. This style of restaurant also operates in the United States and represents just under a quarter of P.F. Chang s total sales at 23%. The company has historically placed both Bistro and Pei Wei s in high traffic high volume areas where customer volume is at its greatest. Metropolitan areas have been a great location for both types of restaurants. The location of the Bistros is often placed near malls, entertainment properties, strip centers, and accessible high class regions of the United States. P.F. Chang s currently leases all of their properties and does not plan on owning any real estate in the future. 22 Page

23 P.F. Chang s competes in the restaurant industry with Cheesecake Factory, O Charley s, and Chipotle Mexican Grill. These companies all compete in the restaurant industry and provide upscale high quality cuisines like P.F. Chang s. The companies within this industry strive to compete on food quality, superior customer service, and the price per product. To obtain high volumes of sales, P.F. Chang s utilizes its research and development to come up with new distinct food items and menus regularly.(pfcb 10-k). Below are a couple charts that represent the sales volume for P.F. Chang s and Pei Wei restaurants. Net Sales by P.F. Chang's China Bistro (in thousands $) P.F. Chang's China Bistro 675, , , , ,321 Pei Wei 131, , , , ,858 Total 806, ,116 1,084,193 1,198,124 1,228,179 Based on the above values, P.F. Chang s Bistro provides most of the revenue brought in by the company. Although Pei Wei operates through smaller more quick style of restaurants, they do provide around 20% of the overall company revenue. The 2009 fiscal year results conclude that there was a 2.5% increase in revenue rising up to $1.2 billion. This could have been caused by the increase in restaurants opened up during the fiscal year Bistros that were opened during 2009 produced revenues 23 Page

24 of a little more than $13 million, while the Pei Wei s that opened in 2009 produced revenues of more than $6.5 million. Industry Overview PF Chang s is in the ever fast growing restaurant industry, which is projected to spike from 2.5 percent to 4 percent of the U.S. gross domestic product during (National Restaurant Association) The restaurant market has steadily grown since 1970, due to an increasing volume in share of the food dollar. The industry is projected to captivate 49 percent of the food dollar in the coming year. The restaurant industry is a very fragmented industry in that the top 50 biggest restaurants only hold 20 percent of the market share. There are over 945,000 current locations, with two major divisions. The two primary divisions are full service restaurants and limited service eating places which include quick service establishments. There are a few underlining differences between full service and quick service. Quick service usually has the customer pay for the product before they receive it, and full service allows the customer to pay after the fact. In full service restaurants, waiters take orders, serve the meal, wait on drink orders, and pick up and process the check. Quick service has no waiters/waitresses and typically has the customer self serve on drinks and extras throughout the meal. Typically most quick service restaurants are fast food however, they also include casual restaurants which offer a higher quality food without the table service. Industry revenue is roughly evenly split between full service restaurants and quick service restaurants. Annual sales average for full service restaurants is 833,000 dollars. The annual sales average for quick service restaurants is 694,000 dollars. (National Restaurant Association) Demand is driven by demographics, personal taste, and consumer income. Profitability of individual companies varies, so companies compete on different levels. Quick service restaurants rely on high volume sales and efficient operations, while full service restaurants focus on high-margin items and effective marketing. Personal taste 24 Page

25 has a large part to do with whether a restaurant is successful or not. Not only does the establishment have to concentrate on the taste of the food produced, but with the going green and healthier living era hitting the United States hard, they have to worry about the type of ingredients used to make the product. Over 55 percent of adults said that they are more likely to visit a restaurant that offers food grown or raised in an organic or environmentally friendly way. Also, 73 percent of adults surveyed said that they have been trying to eat healthier at restaurants now, then they did two years ago. (National Restaurant Association) Restaurant Sales (Billions of Current Dollars) $ $ $ $ $ $ $ Page

26 Five Forces Model The main force behind any firm is to function in a way that will increase shareholder s wealth. This is directly tied to increasing profit margins which leads to managers to focus on this as a main goal for the firm to prosper and see longevity. Different industries, though can, sustain various profit levels to remain successful which leads to interesting questions left up to the business managers. The Five-Forces model is widely accepted as the basis for answering many of these questions by giving insight into the industry analysis and business strategy development. This model can be beneficial to an existing or potential investor to gain a better understanding of the industry in which the firm operates. The five elements will enable us to examine the restaurant industry as well as their profitability as a whole. The Five-Forces model shows that there are two separate factors that affect a firm s profitability: the actual and potential competition to a firm and the bargaining power of suppliers and buyers. The competition aspect can be split up into three different subcategories which are rivalry among existing firms, the threat of new entrants, and the threat of substitute products. While only one of these is actual competition, the risk and possibility of the other two factors makes all three challenging for managers. All of these factors create an industries make-up and shape s how a firm will price its products. The level of competition an industry has is a huge component to a firm s success in the market. If there is a great amount of rivalry then a firm will be more reactive to the market rather than proactive due to the volatility of the customer. The threat of new entrants affects this as well; if an industry is easily entered then prices need to be carefully selected to maintain a level of profitability. Also, substitute products play a role in competition that allows customers to move away from a firm s product which can decrease profitability and create unexpected negative effects on a firm. The second part of the model deals with the bargaining power of suppliers and buyers. To maximize this 26 Page

27 relationship a firm needs to be in balance with both sides. In a perfect world a firm would have complete control over the input or buyer market as well as the output or seller market, but economically this proves to be untrue. On the supplier side there is competition between firms to gain business which goes back to the first aspect of the Five-Forces model: the more firms in an industry the more options the supplier has to get the best available prices. On the buyer side, a firm must choose the best prices, products, and availability to reach the consumer in the most profitable manner. Consumer selection is such a narrow window that all aspects must be in line to have the best possible success. Overall, the Five-Forces model shows us that when entering an industry there are three levels of competition: High competition which involves many firms and does not allow much room for variance from the standard pricing of products, mixed competition which has some form of both high and low competition elements, and low competition which allows companies to specialize in one or few products permitting them to control their prices and markets. All of these aspects of the Five-Forces model come together to measure the profitability of an industry or firm. PF Chang's Competitive Force Rivalry Among Existing Firms: Threat of New Entrants: Threat of Substitute Products: Bargaining Power of Customers: Bargaining Power of Suppliers: Level of Competition Moderate-High Low High High Low 27 Page

28 Rivalry Among Existing Firms Rivalry among existing firms measures the amount of competition in an industry. When firms face a low demand in the industry, price competition will occur and the level of competition will increase at a high rate. At the opposite end, when firms in an industry tend to remain at a constant level of demand they must compete on market share in order to maximize profits. By analyzing the competition of the industry, one may conclude that a particular firm gains an advantage over others by adjusting or adapting to the economy and the industry it operates in. A few key aspects to analyze when dealing with industrial competition of existing firms are: Growth rate within each firm and industry Switching and fixed- variable costs Differentiation Concentration of competitors and Exit barriers. By combing all of these characteristics, one firm can improve its efficiency and become more profitable over time. Industry Growth Rate The industry growth rate affects the rivalry among existing firms, because if the industry is growing rapidly then firms within the industry don t need to obtain market share from each other to grow. The industry growth rate helps business analysts perform conclusions on where the industry is headed in the future, and how each firm must react in order to compete and have majority market share over the others. In a high growth industry, firms can have an advantage by attracting new consumers and 28 Page

29 developing new products to attract these consumers. In a low growth industry, firms must achieve maximum profitability by taking away consumers from other firms in the industry. Pricing competition occurs when the growth rate of an industry is low. When measuring the growth of the restaurant industry it is important to note that the higher quality of food, atmosphere, and customer service - the greater the profits will be in the future. The food service business is the third largest industry in the country. It accounts for over $240 billion annually in sales. The independent restaurant accounts for 15% of that total. The average American spends 15% of his/her income on meals away from home. This number has been increasing for the past seven years. In the past five years the restaurant industry has out-performed the national GNP by 40%. (virtualrestaurant.com) In the restaurant industry a great way to grow as a company and produce high returns is to franchise the business one owns. When it comes to growth, the big barrier for any restaurateur is always capital. Since the franchisee provides the initial investment in the restaurant, growth can occur at a much lower cost. Opening up new and more innovative restaurants allows the company to expand across greater boundaries and gain a new group of customers. This also creates an opportunity for a new manager to step in and add more creative ideas for the restaurant. (entrepreneur.com) Within the restaurant industry there are many types of cuisines that compete against one another. The type of companies in the industry we are valuing consist of a more upscale, semi formal dining experience with high quality means and superior customer service. 29 Page

30 Total Sales (in thousands $) P.F. Chang's Bistro O'Charley's The Cheesecake Factory Chipotle Mexican Grill Total Industry Sales , , , ,027 2,381, , , , ,579 3,009, , ,329 1,182, ,077 3,537, , ,751 1,315, ,787 4,045, ,084, ,497 1,511,577 1,085,047 4,650, ,198, ,317 1,606,406 1,331,968 5,066, ,228, ,909 1,602,020 1,518,417 5,228, Page

31 Annual Sales Growth P.F. Chang's Bistro 12.63% 13.19% 14.03% 9.51% 2.45% O'Charley's 6.19% 5.87% 0.95% 4.21% 5.73% Cheesecake Factory 18.00% 10.13% 12.98% 5.90% 0.27% Chipotle Mexican Grill 25.04% 23.75% 24.45% 18.54% 12.28% Industry 14.94% 12.56% 13.00% 8.22% 3.09% 31 Page

32 In terms of net sales for the industry and competitors P.F. Chang s, Cheesecake Factory, and Chipotle Mexican Grill control most of the market share, but have seemingly been decreasing over the past few years. O Charley s Restaurant franchises many of their businesses creating revenue from those venues. This could explain why their net sales are considerably lower than the others. Over the past two years O Charley s has received revenues from the franchisees in amounts of $900,000 and $800,000 respectively. With the recent recession, it seems that the industry has held its own and has not been affected too badly by it. Many customers have changed their ways of eating thus creating less demand for the upscale restaurants. Although net sales have risen in terms of the past five years, the restaurant industry is looking for new ways to redeem themselves and create better cuisines for each individual customer. If the company can be franchised like O Charley s, growth becomes more powerful and allows the company to gain revenues off something other than restaurant sales. Concentration of Competitors The degree of concentration in an industry is dependent on the number and size of the firms. This influences the extent to which firms in an industry can regulate pricing and other competitive moves. If there is one dominant firm within the industry, it will be the price leader which other firms will base their price off of. Two or three equally sized firms can cooperate with each other and avoid destructive price competition. While a fragmented industry will face severe price competition. 32 Page

33 Concentration within the restaurant industry is very low with regards to new restaurants opening up all over the United States. Consumers are looking to spend more money out at restaurants then cooking at home themselves. The level of price competition varies among the industry due to the quality and class of the restaurants. Many different types of restaurants such as steak, Chinese, American, Mexican, and Italian pay different prices for these different foods, which causes price competition to somewhat decrease. Although reasonable prices are what restaurants strive to give their customers, many consumers are fully aware of what they are going to pay before walking in to these businesses. Since the industry focuses mainly on prices and food quality, many companies have ventured in to the market in hopes to create a well established profitable restaurant. Furthermore, the opportunity of new entrants can cause a threat to existing restaurants in terms of market share and customer satisfaction. Below represents the market share for P.F. Chang s and its existing competitors. 33 Page

34 In terms of market share relative to sales it seems that The Cheesecake Factory has majority of shares, but Chipotle and P.F. Chang s Bistro have consistently held their own for the past few years. Since restaurants charge different prices for their different products this could be factored in to Cheesecakes net sales. Also considering that Cheesecake Factory operates a bakery inside each restaurant this can lead to higher revenues. In 2009 the bakery represented 15% of Cheesecake Factory s revenue while 14% in (CAKE 10-K) For instance, P.F. Chang s Bistro has an average ticket price of $21.00 per person including alcoholic beverages. Cheesecake Factory has average sales around $19.00 in Since Chipotle is a more get in get out kind of restaurant, their meals tend to be a little less expensive. Here is a pie chart better representing the market share for P.F. Chang s and its competitors in Chipotle Mexican Grill and The Cheesecake Factory have controlled most of the market share in the past few years resulting in great return for their companies. It seems as if O Charley s is struggling to gain market share, but the restaurant s the company owns tends to be more of a casual diner with less elegant foods for a lower price. This has allowed O Charley s to take consumers away from the other three competitors, in result, making price competition amongst firms a bit more intense throughout the industry. 34 Page

35 Differentiation The extent to which firms in an industry can sustain a competitive advantage on price is dependent on how much each firm can differentiate their products and services from another. Similar products make it easy for a customer to switch from firm to firm on a pure price basis. Switching costs will also affect a customer s willingness to switch firms. High switching costs will yield less price competition, while low switching costs will yield high price competitions. If two restaurants in the same industry have similar products available to its consumers than price competition between these two firms increases. On the other hand if restaurants in the same industry have different products and services, the competition becomes less price sensitive, and the firms compete on product quality and superior customer service. P.F. Chang s for instance uses high quality ingredients shipped over from china, and the restaurant uses a variety of very distinct herbs and spices to give the business its own flavor different from its competitors. O Charley s owns and operates three different types of restaurants ranging from American food to steak houses. These products are offered in a wide range of restaurants around the United States, so this would mean O Charley s would need to compete on price considering their product is not very differentiated from its competitors. Chipotle Mexican Grill strives on food with integrity more importantly serves food for a low price, but of very high quality (Chipotle 10-k). We believe our restaurants are recognized by consumers for offering value with menu items across a broad array of price points and generous food portions at moderate prices. This year, we introduced new menu items and categories at our restaurants, further enhancing the variety and price point offerings to our guests (Cheesecake factory 10-k). P.F. Chang s Bistro creates new products through its 35 Page

36 research and development to add amore unique meal to the menu. As a result of our extensive research and development efforts, we periodically change our menu. For example, during 2009 the Bistro introduced Chang s for two, a prix-fixe menu offering a four-course meal for two people for $39.95 (P.F. Chang s Bistro 10-k). This company had differentiated its products by offering a full course meal, something the competition has not offered to its customers. Another means of differentiation comes through the type of service or atmosphere the company offers. Chipotle Mexican Grill for instance offers four main items that are prepared right in from of the customer in a timely manner. For customers looking to get a high quality quick meal, Chipotle offers this service that its other competitors do not. The Cheesecake Factory and P.F. Chang s Bistro strives on creating superior customer service within a well designed and sophisticated atmosphere. Our restaurants distinctive contemporary design and decor create a high energy, non-chain image and upscale ambiance in a casual setting. Whenever possible, outdoor patio seating is incorporated in the design of our restaurants, allowing for additional restaurant capacity, as weather permits, at a comparatively low occupancy cost per seat (CAKE 10-k). This can be part of Cheesecakes differentiation strategy by offering a high quality atmosphere for customers who seek a nice evening out to eat. Conclusion Within the restaurant industry differentiation in products and services play a huge role. The degree of differentiation tends to be high for many reasons. One reason is the type of foods each company serves to its clients and the level of quality each restaurant prepares its food. Also the atmosphere allows the various companies to differentiate themselves from others through their designs and concepts throughout the restaurants. Many consumers will decide where to eat based solely on the 36 Page

37 atmosphere the business offers. Last, the service that each restaurant provides to its customers can differentiate themselves from the other competitors. For instance, P.F. Chang s Bistro strives to provide superior customer service for its clients, making the experience a memorable one with hopes of having repeat customers. Switching Costs Switching costs for firms is the cost incurred when a firm decides to discontinue its operations in the current industry and enter into another. In the restaurant industry, firms require a great deal of construction and maintenance costs when designing a new restaurant. If a company were to stop operations and need to exit the industry and enter a new one, it would be very costly and therefore requiring the firm to cut prices to compete with the other firms. When the switching cost is high, a firm will spend a large sum of money on raw materials which will make troublesome to switch from one industry to another, because they will incur a lot of expenses. Vice versa, lower switching costs will, however, lead to firms switching to another industry without spending a lot of money on raw materials. When switching costs are low, firms will engage in price competition because the risk can be low, allowing firms to easily enter and exit the market. Low switching cost indicates that a firm will use fewer expenses to produce products in another industry. Businesses in the restaurant industry or more specifically the upscale finer restaurants design their restaurants with superior decorations and experienced staff. All the natures of the business require a great amount of preopening costs within the first two months, and need great sales in order to gain back those costs. If a company were to close down operations, they would need to get rid of all the kitchen supplies, restaurant seating tables and all renovations they made would need to be taken down and sold off. This makes the switching costs very high for a restaurant and to enter into a totally new industry would make it difficult. There are not many supplies or 37 Page

38 equipment in the restaurant industry that would be available to the business to use in another industry. Overall the switching costs for the restaurant industry are very high can create a price competition between existing firms. This causes each firm to cut costs in order to get rid of the entire old inventory the restaurant once used. Conclusion With regards to the restaurant industry, switching costs are relatively low resulting in a price war between firms and their competitors. This allows the customer to choose the restaurant he or she feels solely on a pure price basis. Also if the quality is better at one restaurant compared to another, clients can easily choose a different route due to the wide range of restaurants available. If a restaurant fails the costs associated with getting out of business tends to be low as well considering the input costs to starting the business is relatively low as well. Scale Economies In any industry, a firm must research and evaluate the learning curved involved with each product, so they can determine the possibility of whether they have the resources available to increase sales and gain market share. If there is a steep learning curve or there are other types of scale economies in an industry, size becomes an important factor for firms in the industry (Business Analysis & Evaluation text). Firms that achieve high learning economies thus are more likely to gain market share and increase revenues. In the restaurant industry the size of a firm can play a major role in terms of customer volume, but in many circumstances small businesses have controlled a large portion of market share due to brand loyalty, ingredients, and overall customer service. Below is a graph representing the total number of assets for each firm and their competitors. 38 Page

39 As shown above The Cheesecake Factory and Chipotle Mexican Grill have significantly more assets than the other firms, yet the industry still competes with one another. Chipotle Mexican Grill in terms of the size of restaurants is substantially smaller in size compared to the other firms, but they have opened more restaurants than the others, and created a product of their own. According to Chipotles 10k, Chipotle Mexican Grill operates 956 restaurants in over 35 states throughout the U.S., it also plans on opening 120 to 130 additional restaurants in (CMG 10k) In comparison to P.F. Chang s 197 full service Bistro restaurants and 166 casual Pei Wei restaurants. Conclusion Most firms in the restaurant industry are looking to increase their research and development of new and improved menu items creating a higher learning curve, which then will help each firm increase market share and revenue. This will lead to increased price competition within the industry. For example, as a result of P.F. Chang s extensive 39 Page

40 research and development efforts, the restaurant has been able to periodically change their menu. (PFCB 10k) The restaurant now offers a daily Happy Hour from 3-6pm, with special on drinks and appetizers. The new addition to the menu will allow P.F. Chang s to compete with other restaurants that have a Happy Hour special or with restaurants that do not have this special, which further increase sales and market share to the firm. Fixed To Variable Costs The ratio of fixed to variable costs can be a determining factor in the level of price competition and profitability. If the ratio of fixed to variable costs is high, firms have an incentive to reduce prices to utilize installed capacity. This causes the industry to become more competitive, thus creating price competition. On the other hand if a firm or industry can maintain a low fixed to variable costs ratio and control the costs of the firm, the industry has less incentive to engage in price competition. For example, The Cheesecake factory leases many of their operations, resulting in a fixed cost every month for payments. If the company had reduced sales for a year, which Cheesecake Factory did, they would need to cut costs to maintain costs control. As a percentage of revenues, other operating costs and expenses increased to 24.7% for fiscal 2008 versus 23.4% for fiscal This increase was primarily due to deleveraging of fixed costs due to lower average weekly sales at our restaurants as well as higher utility rates (CAKE 10-K). This caused the firm to cut prices and ultimately engage in price competition with the other firms. In order to calculate the fixed to variable costs ratio, we need to collect information from each firm in the industry. First, we need to calculate total cost of goods sold by subtracting cost of goods sold from the current period by the cost of goods sold in the previous year. Next is to divide that total by sales in the current year minus sales from the previous years. This number will then be multiplied by sales in the current year to form total variable costs for that period. After that we calculate the total fixed costs by subtracting variable costs from total costs. With these two amounts 40 Page

41 we can then figure the ratio for each firm and the industry. Below is the data collected and calculated: P.F. Chang's Bistro Cheesecake Factory O'Charley's Chipotle Mexican Grill Page

42 Fixed to Variable Costs Ratio P.F. Chang's Bistro Cheesecake Factory O'Charley's Chipotle Mexican Grill Page

43 Fixed to Variable Costs Ratio (operating costs) Based on the above results, the industry has a relatively high fixed to variable costs ratio due to the large amount of fixed costs relative to variable costs. This once again creates price competition within the industry and firms therefore reduce their menu prices. As seen in the graph above, P.F. Chang s Bistro had a tremendous amount of fixed costs in 2009 possibly due to the amount of leasing agreements made in that period. In 2009 Cheesecake Factory had a very low ratio because of the deleveraging of the company in order to sell more products. Overall, the industry is very consistent in terms of fixed to variable costs and all compete on prices for their products. Excess Capacity In terms of meeting demand for products in an industry, excess capacity is the overall level of production produced beyond the consumers demand. It is important to keep excess capacity low, as inventory expenses and unsold products can cause a decrease in net income. Since the restaurant industry receives meals on a moderate basis, the demand for the company s product is carefully measured and the amount of food supplies is ordered on a timely basis. For instance, P.F. Chang s Bistro receives food and ingredients in a timely manner. We negotiate short-term and long-term contracts depending on demand for the commodities used in the preparation of our products (P.F. Chang s Bistro 10-k). For most upscale causal restaurants, the inventory for food is measured and brought in to the restaurant as needed for each week of operations. 43 Page

44 One problem in the restaurant industry results from a business opening up a new restaurant in a new location, but does not have the high volume of customers surrounding the location to enjoy the product. This does not mean the quality or service is under rated, but more specifically due to the location the restaurant was placed was not well populated. In order for firms to maintain and control excess capacity, they must create a healthy infrastructure and monitor and forecasts sales for the future. This can create a more precise inventory count and not allow the companies to overstock on their food products resulting in a loss of money. One way of measuring an industry s excess capacity would be to take the firms total sales and divide those figures by their Property, Plant, and Equipment. This will indicate if a firms fixed costs are producing positive returns and creating profits. The lower the ratio, the more excess capacity exists, therefore resulting in a price war amongst competitors. 44 Page

45 Cheesecake P.F. Chang's Bistro O'Charley's Factory Chipotle Grill N/A With regards to the chart above, the restaurant industry has experienced a positive trend in the sales/pp&e ratios which have resulted in a good amount of excess capacity. This means that the company s in this industry are able to produce a sufficient amount of materials to meet the demands of their consumers. The companies listed above have consistently held the same ratio for the past five years. Conclusion Excess capacity has shown to exist in the restaurant industry especially for the upscale more casual restaurants like the firm listed above. This shows that these firms are competing on price to gain customer volume. P.F. Chang s Bistro has shown the most consistent ratio of all competitors, while Cheesecake Factory has produced the lowest ratio. This could explain why most of the businesses in the restaurant industry have charged on average the same price for their meals. 45 Page

46 Exit Barriers Sometimes in an industry, firms will decide to leave. Whenever this happens there are relative costs associated with this choice. These costs and regulations are known as exit barriers (Book P. 2-3). Often times the most costly exits are those from industries where specialization is the key success factor involved in a firm. To exit there must be a liquidation of the company and all of the company s assets. Again, with a specialized firm some of the assets may be difficult to liquidate. On the other hand, in a highly competitive market a firm s material liquidity may be one of relative simplicity and the regulations may be minimal. The restaurant industry is one of moderate exiting. For the most part many of the firms are not going to have much specialized equipment which allows the sale of these tools and appliances to be quick. The main problem that restaurants can run into when exiting is the lease agreements or ownership of buildings in which the business is run. Encountering all of those possible complications with property can prove to be very costly. Conclusion For the overall competitiveness of the restaurant industry, the rivalry among existing firms tends to be moderately high. Firms within this industry focus on competing prices, product quality, and customer service. The firms listed above all share the same goals and compete against one another for those specific goals. The overall industry competitiveness helps the individual firm s lower prices and to compete against one another on market share. This creates a high degree of rivalry among existing firms in the restaurant industry. 46 Page

47 Threat of New Entrants Firms of any industry should not limit their concentration on existing competitors of that industry, but must also concentrate on new/potential firms entering the industry. A firm that can easily enter a market could have a profound effect on the existing firm s profitability due to an increase in competition that will further increase rivalry amongst the firms in that industry. In the result of an increase in competition, new entrants can impose a threat on prices and market share. In the restaurant industry is highly competitive, it is very easy for firms to enter and be successful in an industry as well as to exit and be unsuccessful. An upscale restaurant such as P.F. Chang s strives on its quality in food, customer service, and restaurant atmosphere (dine-in experience) which makes it difficult for entrants to easily enter the industry. Factors such as economies of scale, first mover advantage, relationships, and legal barriers determine an industry s threat of new entrants. Economies of Scale Economies of scale deal with the choice of new entrants: either investing in a large capacity that may not be used right away or investing in small capacity. Economies of scales states that unit cost is reduced as the size of production increases. A successful firm in an industry is the one, which can produce high quantities of products using a lower cost per unit. This is how a firm can earn the highest profit and competitive advantage to its competitors. The new entrants to the industry would be faced with the difficult task of maintaining economies of scale unlike the existing firms. This is due to the fact that firms have to invest in producing innovative products and higher quality ingredients, which will make them more competitive than existing firms by increasing the market share. If a firm decides to enter, it will be faced with cost disadvantage in competing with the incumbents in the industry. Fixed and variable costs 47 Page

48 are the two main costs that are affected, with variable cost depending on the number of units produced. The two largest firms in this industry, in terms of casual dining currently Cheesecake Factory with 161 restaurants and $1,046,751,000 in total assets and Chipotle with 956 restaurants and $961,505,000 in total assets. Although P.F. Chang s is not that the largest firm in the industry, it plans to open three to five Bistro, Pei Wei restaurants this year, but is considering opening 10 to 15 of its smaller Pei Wei locations next year. (WSJ) Since Cheesecake factory and Chipotle are top competitors they are able to set prices/costs in the industry. Total Assets (thousands) P.F. Chang's 652, , , , ,859 Cheesecake Factory 1,046,751 1,142,630 1,145,753 1,039, ,250 O'Charley's 462, , , , ,610 Chipotle 961, , , , , Page

49 First Mover Advantage The first mover advantage states that firms can gain an advantage by entering into a market prior to its competitors. Early entrants or market leaders might set industry standards that will prevent the future entrants from entering into the market. These standards might include first mover firms from acquiring scarce government licenses to operate in regulated industries. In the restaurant industry, obtaining first mover advantage is moderately low. Established restaurants have already built relationships with its customers. Considering that the restaurant business is highly diverse with a wide array of different types of foods and prices it s rather difficult to gain an advantage over an existing restaurant. According to the Cheesecake Factory s 10k, The sizes of our restaurant trade areas vary by location, depending on a number of factors such as population density; demographics; retail, business, entertainment and other traffic generators; and geography. As a result, the opening of new restaurant could impact the sales of one or more of our existing restaurants nearby (CAKE 10k) An opening of new restaurant could have an impact on sales if the restaurant has established name or if it s a franchise. As mentioned early, it would be difficult to compete against a restaurant that has developed clientele and provides a different type of food/way of service. Access to Channels of Distribution and Relationships Limited capacity in the existing distribution channels and high costs of developing new channels can act as powerful barriers to entry. (Palepu) Firms trying to enter a competitive industry could be faced with barriers that they must overcome. Established firms in an industry have existing relationships distributors and suppliers that are contract based. According to P.F. Chang s 10k, their supply chain management function provides their restaurants with high quality ingredients at competitive prices 49 Page

50 from reliable sources. Consistent menu specifications, as well as purchasing and receiving guidelines, ensure freshness and quality. (PFCB 10k) In the restaurant industry, upscale restaurants must maintain a positive relationship with their suppliers in order to fulfill the high need for quality ingredients and supplies to conduct their business at the level to sustain a competitive advantage over its competitors. Many restaurants in this industry have negotiated short-term and long-term contracts in order to secure the demand for the many ingredients and supplies needed to prepare their products. For commodities such as produce, they mainly utilize distribution market advantage which is comprised of numerous food distributors throughout the nation. Restaurants benefit from using distribution market advantage because the vegetables needed to produce their dishes are perishable and are required on a daily basis, having close contact with suppliers is vital for survival in this industry. Items that are highly important to the firm are contracted annually in order insure stable prices and availability. For example, P. F. Chang s outsources it Asian s specific spices sauces directly from Hong Kong, China, Taiwan and Thailand. (PFCB 10k) In this industry, firms must have a developed network of suppliers and must sustain positive relationship in order to ensure that they the firm can obtain all ingredients supplies needed to conduct their business. Legal Barriers Legal barriers are patents, copyrights, or regulations that limit or prohibit a firm from entering industries. Standards enforced by the government might be costly for a new firm to enter into the market. These standards may be hard to follow; or are costly to the ones who are trying to use economies of scale to achieve a competitive advantage over its competitors. These government standards are sometimes aimed by the government to reduce the number of firms in an industry in order to reduce the competition among firms in an industry, which might harm the consumers. Also, 50 Page

51 standards set by industries are aimed at reducing the number of firms entering an industry or it might be aimed at offering the right product quality to the consumers. Restaurants in this industry have a competitive advantage over its competitors due to the standards set by the government, which makes it complicated for new firms to enter. These include payment of money to the government, and also making sure that the firm is able to produce the right quality of goods and services to the consumers. The restaurant industry is subject to numerous laws and regulations such as licensing and regulation by various governmental authorities, which includes but is not limited to safety, health, sanitation and alcohol and beverage control, building and fire agencies in the state or municipality in which the restaurant is located. (CHUX 10k) For example, most restaurants require a business license in order to conduct business, if there is any difficulty in obtaining the license it could possibly affect the opening of a new restaurant. Also, restaurants must obtain permits to in order sell and provide alcoholic averages in the restaurant as well to extend the hours in which they can sell the beverages. If a restaurant does not obtain a license to sell alcohol they could be forced to close the business and furthermore lose profit. Conclusion The Threat of new entrants does not play a major role in this industry. Since the above factors affect other firms from entering the industry, the level of threat is low. The main reason is due to the fact that P.F. Chang s and its competitors are upscale restaurants with a diverse menu and developed clientele. As mentioned earlier, establishing good relationships with distributors enables a timely deliverance of ingredients or supplies need to conduct business. The government regulates the number of industries and provides standards for the quality of goods produced to customers. In the restaurant industry, restaurants must obtain certain licenses and permits in order survive in this industry. Firms in this industry maintain a competitive advantage over its competitors by following these rules and regulations. 51 Page

52 Threat of Substitute Products The threat of substitute products exists in any market whether it is easily recognizable or not. A substitute product may not be something that is in the same form as other products but simply is a product that serves the same function. Substitutes are a challenge facing any new firm looking to enter an industry with a high degree of competition. In such a highly competitive industry like the restaurant business with so many identifiable brands, it is hard to keep customers loyal due to the sheer volume of restaurants there are. This leads firms to focus on efficient pricing strategy and, brand recognition. It has led many firms to try and separate themselves with new and innovative products. It still remains though the restaurant business is one centered on cost leadership. This is a result of high competition and very small switching costs. Also, in the restaurant business one huge threat of substitution is the resurgence of the grocery store. With the economic situation the way it is, people are looking to save money in every facet of their lives which includes eating more at home and not going out to restaurants. This leads restaurants to focus on building feelings of brand loyalty and treating the meal out as more of an experience than just a meal. Relative Price and Performance In any profit-based industry, firms are looking to gain an edge over competitors by offering the best product at the most reasonable price. This pertains to the restaurant and grocery store businesses completely. If a customer feels that he/she is getting a satisfying product but at a price that is not reasonable or vice versa they will pursue other substitutes, which means that relative price and performance must both be in balance to maximize profitability. In the restaurant industry it is mainly split up into two segments: full service and quick service. 52 Page

53 In the full service segment, quality is the key to retaining customers. One of the success factors is quality of service. How well the customer is being treated is the main key to having repeat guests. If someone does not feel as though they are being treated respectfully then they will not come back. Another factor is the quality of food. This is important because if a customer is not getting enjoyable food at a restaurant then the chances of substitution to a grocery store or cooking at home is greatly increased. The last aspect is the price of the meal. This may be the easiest way to turn on/off a customer from a full service restaurant. Expectations are made before a person steps through the door of a restaurant and if those expectations are not met then satisfaction can be quickly erased. When quality of service, quality of food, and price all come together it creates an environment of pleasure and therefore increases the number of customers and increases overall profitability. The quick service segment is mainly geared on price and ease of process. When going to a quick service restaurant generally the prices are lower than a full service restaurant due to the fact that the customer are not being waited on. Simplicity is a key factor in this environment. Customers want to get their food in a timely manner and generally speaking do not want to be at the location for an extended amount of time. Drive-through windows show this as customers choose to not leave their vehicle when ordering and receiving their meals. The quality of service and food is important but in this segment it may take a back seat to the smoothness of operations. Customer s Willingness to Substitute The threat of switching costs for customers is low in the restaurant industry. The amount of competition and number of marketing channels make it relatively simple for a customer to switch segments and suppliers. Differentiation, cost cutting strategies, and quality of services are the major factors in pleasing new customers and retaining existing customers. In both segments finding a new outlet would take a minimal amount of time. In 2009 almost half of quick-service operators reported increases in sales while fine dining had a whopping 62 percent of operators experiencing 53 Page

54 plummeting sales (Odesser-Torpey). This causes brand loyalty to be rare because if costs are not reasonable to the customer the ease of transfer is quick. Although brand loyalty is hard to find, the major restaurants that are successful have some form of recognition that plays into this success and longevity. Another aspect of switching costs is in the grocery store industry. Switching costs are low in this area as well. Generally speaking it is less expensive to go to a store and purchase food than to go somewhere and have someone else prepare it. The amount of funds spent on gas driving to a different restaurant every night can cause a consumer to switch to grocery stores. On the other hand people value time. When buying foods at a grocery store and cooking it, there is shopping, preparation, and clean up time that all goes into this process. This goes back to what was talked about earlier in the ease of the process to go to a restaurant. Conclusion In any industry, there will be the threat of substitute products. What matters is to know what a firm s key factors to success are and how to best retain customers. In the restaurant industry the main focus is cost cutting strategies, overall quality of service, and differentiation from competitors. In the restaurant industry the threat of substitute products is high and switching costs are low which makes the market very volatile. Bargaining Power of Customers Every business, regardless of industry, relies on customers to purchase their products or services so that they will, potentially, turn a profit. Customers may be businesses, the general public, or a combination of the two. Within the restaurant industry, the customer base is comprised of the general public: individuals or groups of individuals. 54 Page

55 When discussing the bargaining power of customers, we are talking about the ability of the customer to put the firm under pressure. This has a lot to do with the price sensitivity of the customer. When price is an issue to the customer, a firm must take that into consideration. Likewise, when price has little effect on customers, this must also be taken into consideration. Differentiation Differentiation among products refers to how close a particular product is to its next competitor. For instance, within the computer industry, there is little product differentiation between Dell s and HP s consumer laptops. They are essentially the same, and perform the same tasks. Within the restaurant industry, no significant differentiation among products exists. Sure, there are different types of cuisine being served, but each restaurant is serving a meal at a certain price. A customer can just as easily walk across the street to a competitor and essentially get the same thing: a meal. The small amount of differentiation occurs with the service within the industry. Each restaurant has their own image and reputation for service and quality. This reputation is what differentiates each firm from the next one. Price Sensitivity Consumers are also sensitive to price, and want to get the best deal for the lowest amount. Therefore, casual dining establishments have engaged in different promotions in order to entice customers. This enticement indicates that consumers are willing to consider alternatives within the industry itself. However, there are little to no 55 Page

56 switching costs to the consumer when choosing a restaurant, since it is mostly personal preference, and no two restaurants are exactly alike within the casual sit-down dining segment. Further, when considering the industry as a whole, there are different segments which appeal to different consumers: high-end sit-down dining, casual sitdown dining and fast food. Each segment represents a different cost to the consumer, trending downward from high end to fast food. Therefore, it follows that consumers will choose a certain segment based on personal preference, time constraints and price. Within each segment, consumers many times base their decision on price. It follows that firms in the industry will set prices comparable to each other, and attempt to undercut each other (within their particular segment) in order to drive consumers to their particular brand. According to a recent Gallup poll, consumer spending is on the rise, with 47% of Americans stating they have been spending less money in recent months, compared to 57% in February of this year. 56 Page

57 Number of Customers Important to any industry is the customer base for which the industry draws. The number of customers can influence the customer s bargaining power with the firms in the industry. Within the restaurant industry, the number of customers is practically limitless. However, each sub-category caters to a different clientele. The number of customers frequenting the high-end restaurants is much smaller than casual dining and fast food. The number of customers is dictated mostly by the economic outlook and consumer spending patterns within the target market. As consumer spending increases, as shown above, more individuals are willing to spend more at a casual dining experience versus eating at home or eating fast food. Gas prices also play a major role in the number and volume of customers coming in to full-service restaurants. According to a recent survey, 57.7% of Americans said they would have to cut back on discretionary spending as soon as gas prices reach $3.00 a gallon (BeemerReport.com). An increase in gas prices tends to decrease the amount of consumer discretionary spending, as consumers spend what would have been discretionary spending on gas. (GasBuddy.com) 57 Page

58 In addition, many individuals seek lower cost alternatives to full service restaurants during periods of high gas prices. If gas prices remain steady, and spending patterns continue (as shown above), consumer discretionary spending may rise. (Bloomberg BusinessWeek) As shown by the graph above, the Consumer Services industry performance is closely tied with the S&P Consumer Discretionary Index. This means that the number of customers within the industry is closely related to the economic outlook and the amount of extra funds customers have to spend on luxuries. Due to the large number of customers, it would seem logical to say that customers have high bargaining power based on the number of customers. However, the number of customers with significant influence over the industry is practically nonexistent. Yes, there are many customers, but the buyers are fragmented: no one single buyer or group has a significant influence over the industry. The contradiction comes when evaluating customer buying power as either individual customers or the entire customer base. An individual customer holds very little bargaining power, yet the whole customer base holds a large amount of bargaining power. 58 Page

59 Importance of product for costs and quality Consumers are constantly looking to achieve the maximum benefit for the least amount of money. If the price and quality are not comparable, then customers will not purchase the product. Therefore, it follows that customers have some bargaining power in terms of product cost and quality. Consumer expectations are tied to brands and preference. Many brands are tied to certain tastes and quality levels. When consumers make the choice to dine out, there are a myriad of different choices. The majority of consumers, when committed to a certain price range, base their final choice on personal taste and brand recognition. When a decision is made based on brand recognition, consumers expect the same quality across the board for the same brand. Major restaurant chains must maintain the same standards of quality and preparation across all restaurants and franchises in order to meet consumer expectations and to ensure some form of brand loyalty. (10-K, PFCB, CAKE, CMG, CHUX). In addition, when consumers make the decision to step up in price from a quick service restaurant to a full service restaurant, there is an expectation of higher quality food. As prices go up, consumer expectations rise as well, making restaurants commit to quality foods and service. A customer also has some bargaining power in regard to quality of food in that the customer may elect to send a poor quality dish back, or ask for a refund. Usually, this interaction leads to the customer receiving a new dish or a refund of the purchase. However, the restaurant reserves the right to refuse these types of gratuities. This type of understood interaction increases the bargaining power of the customer by ensuring that the restaurant maintains the quality of their food. 59 Page

60 Volume per buyer Many industries have discounts for customers who order products in large quantities. Within the restaurant industry, the volume at which products are bought has virtually no effect on the bargaining power of the consumer. In some instances, discounts may be given to a customer ordering large quantities, but this usually happens with quick-service restaurants, such as pizza companies. In the full-service environment, there is no bargaining power in terms of volume, as prices are set and are non-negotiable; a consumer ordering one entrée will pay the same price per entrée as the consumer ordering three. Volume discounts do not typically apply to the general consumer within the full-service restaurant industry. In some instances, volume discounts can occur with catering or private bookings, but these are usually set prices, dictated by the company themselves. Switching Costs Switching costs refers to the cost of switching to a comparable product, either within the same industry or switching to an alternative industry. The number of close alternatives and substitutes dictates the relative bargaining power customers have on firms. Within the restaurant industry, consumer switching costs low. Many different alternatives exist, sometimes clustered right next to each other. In addition, substitutes outside of the restaurant industry, such as take-home meals from grocery stores, can dictate the amount of customer traffic. When considering different alternatives, factors such as price, wait times, and convenience are considered. If an individual consumer goes into a restaurant and discovers a long wait time, they might weigh the alternatives of going to another restaurant. However, if the particular restaurant has a good reputation for quality and service, the individual may wait in line for a table. In 60 Page

61 addition, the permeation of substitutes outside of the industry, namely frozen meals available at grocery stores, adds to the substitution choice for consumers. The bottom line: bargaining power is high for the customer, and restaurants must keep customers happy by providing good customer service and prices. Conclusion Customers of the restaurant industry, when taken as a collective, have a high level of relative bargaining power. Although individual customers can do little to influence the price and quality of particular restaurants, the customer base is able to exert pressure on firms within the industry; if a firm s prices are too high or the quality is lacking, discerning consumers will avoid the firm altogether, causing a failure of the firm. In order to continue functioning, firms in the restaurant industry must focus on customer service, quality and value to ensure a continued supply of customers. Therefore, it follows that the pressure created by customers manifests itself as price wars between firms in the industry, in a continued battle for market share and revenues. 61 Page

62 Bargaining Power of Suppliers The bargaining power of suppliers is based upon the supply and demand model of economics. Suppliers are basically a firms distributor who sells goods or raw materials to a firm at certain prices. Suppliers gain power and the upper hand when there are a limited amount of companies and substitutes available to their customers. The degree of importance to the customers business is also a key factor. The higher the importance, the more leverage and power the supplier obtains. Switching Costs Switching cost is the fixed cost incurred by a buyer when doing business with a supplier. The cost is directly related to the amount of alternatives and variable prices between alternatives. The switching cost for the industry is going to be low due to the large amounts of suppliers and substitutes available. There is a broad area of food markets and sources to choose to purchase from if a supplier decides to raise prices or quality of product deteriorates. PF Chang's has a non-exclusive contract with Distribution Market Advantage. The non-exclusive aspect of the contract is significant to the switching cost, because if the switching cost were high, the contract would most likely be exclusive. We believe that competitively priced alternative distribution sources are available should they become necessary. (PFCB 10k) The most important items are contracted annually to ensure availability. PF Chang s Asian-specific ingredients are outsourced directly from Hong Kong, China, Taiwan, and Thailand. They have an extensive network of suppliers in that region to keep switching costs low. The supplier in this industry has a generally low bargaining power, which means PF Chang s has a relatively low switching cost and most of the bargaining power. 62 Page

63 Differentiation The higher the level of product differentiation, the higher the level of bargaining power the supplier has. In this industry there are very few ways to differentiate a product. The bargaining power of the supplier stays relatively low, compared to the consumer, because of the ability to obtain materials elsewhere. There is really no differentiation of product between one chicken to another besides organic or non-organic. Under both factors, there are many different options to purchase either one. The same goes for all other food in the industry. Because of this, suppliers must compete on quality of service, timeliness, and cost. Therefore, the suppliers do not have the upper hand in bargaining prices and stipulations with the purchasers. Importance of Product for Costs and Quality Product costs and quality in the food industry is of the upmost importance. The determining factors between one restaurant and another, is the quality and pricing of the food. In order to compete on these factors, restaurants must be able to find the best quality foods for the cheapest prices possible. There is usually some volatility in the food market. For example, if the corn crop in the United States had a bad year, then the corn prices would rise due to scarcity. This would in turn cause the prices of feed for farmers of chicken and beef to rise. In turn, the farmers would have to pass the cost they incurred to the restaurants when purchasing the beef and chicken. This is why most firms in the restaurant industry negotiate short-term and long-term contracts depending on the demand for the commodities. Contracts can range in time from anywhere between two and twelve months. 63 Page

64 The quality of the product is just as important as the price. The suppliers must obtain a high quality product, especially in the restaurant industry, because there are many standards and regulation that must be met by the FDA in order to obtain operating licenses. Number of Suppliers There are a large number of raw food suppliers in the United States. The large number of farmers and ranchers give the raw food suppliers very little bargaining power. There is very little difference between one rancher and the next ones final product most of the time. The only way they can compete is with price. Since the switching costs are low, this allows the restaurants to search for the best possible price or shop around until they find the best deal available. This is a huge disadvantage for the suppliers. According to Chipotle s 10k, maintaining the high levels of quality we expect in our restaurants depends in part on our ability to acquire fresh ingredients and other necessary supplies that meet our specifications from reliable suppliers. We purchase from various suppliers, carefully selected based on quality and their understanding of our mission, and we seek to develop mutually beneficial long-term relationships with them. We work closely with our suppliers and use a mix of forward, fixed and formula pricing protocols. We've tried to increase, where necessary, the number of suppliers for our ingredients, which we believe can help mitigate pricing volatility and supply shortages, and we follow industry news, trade issues, weather, exchange rates, foreign demand, crises and other world events that may affect our ingredient prices. (CMG 10k) Also when restaurants seek specialty goods from suppliers oversees or for commodities, the supplier will also have a low bargaining power due to the limited amount of suppliers who provide the specialty good. Even though the suppliers have very little bargaining power, the restaurants don t have much either, due to government regulation of commodities. 64 Page

65 Volume Per Suppliers When determining relative bargaining power, the volume of suppliers plays a large factor. The restaurant industry is a very large industry housing over 945,000 current locations. An industry this large needs a very large base of suppliers. The large companies in the industry will usually try to lower costs by buying in bulk or signing contracts with suppliers in order to lock in prices. At Chipotle, raw materials are not purchased directly from farmers or other suppliers but they do have selected and approved all of the suppliers from whom ingredients are purchased for our restaurants. Distribution centers purchase ingredients and other supplies from suppliers we select based on our quality specifications, and purchase within the pricing guidelines and protocols we have established with the suppliers. (CMG 10k) Chipotle will increase the number of additional distribution centers as the restaurant expands in size. Overall, there are many different options on suppliers so the bargaining power of the suppliers is generally on the lower side. Conclusion Taking all five of these factors into consideration, there is no doubt that the suppliers of the restaurant industry have very little bargaining power. The reason is that there is a large plethora of suppliers with very little differentiation between products. If a company is upset with the quality or pricing of its purchases with a supplier, it can easily look around for another supplier to step in and fill its needs. The restaurants will drive prices down to increase revenue and profitability with its bargaining leverage it has on its suppliers. 65 Page

66 Industry Classification Given Five Forces Porter s five forces model has been implemented in order to understand the overall level of competition within the restaurant industry. Since the restaurant industry is very large in terms of number of units and size of each company, we narrowed the industry down to the more upscale finer restaurants. These restaurants; P.F. Chang s, Cheesecake Factory, O Charley s, and Chipotle Mexican Grill all compete on price, product quality, and superior customer service. Competition among existing competitors or firms in the industry is very high in regards to the prices each company charges and the market share each company is trying to gain. The switching costs, economies of scale, and exit barriers make this industry a very competitive one and especially within the four firms listed above. The threat of new entrants in terms of small mom and dad restaurant is high, because anyone can invest their money into opening a new restaurant, but trying to gain market share away from the existing firms is very low. The restaurants listed above have spent many years in the industry and have gained market share over that time period. This makes it difficult for a newly opened business to control the industry or take away market share from the existing firms. Threat of substitute products is very high in the restaurant industry considering the tough economic times in the recent years, but also the availability of new grocery store locations. Many people can choose to stay home and eat rather than spend the money to have a night out to eat. If a customer feels as if the restaurant industry is raising prices there is more incentive to go down the street to the local grocery story and gather food for the house at a much cheaper price. Bargaining power of customer which includes any persons that dines out to eat is very high in the restaurant industry. Customers have the power to dictate prices relative to the competition, because if the prices are too high, the customer will go elsewhere for a cheaper price. Customers are very price sensitive and will demand lower prices or take their business elsewhere. 66 Page

67 Bargaining power of suppliers is low in the restaurant industry due to the wide variety of suppliers that do business with these firms. Certain firms get there foods and ingredients from different parts of the country, but if one supplier cannot provide or decides to raise their prices, the firms can go elsewhere for their menu items. The overall competitiveness of the restaurant industry in regards to the five forces model is moderate to moderately high. All factors above result in the competitiveness of the industry and are only increasing with the quality of restaurants and food each existing firm and new entrants provide. Analysis of Key Success Factors The main goal of all firms across the board is to create shareholder wealth. The way a firm creates shareholder wealth lies within the firm s ability to accumulate competitive advantages over the other firms. There are two basic ways that firms accomplish gaining a competitive advantage. The first is cost leadership. Cost leadership enables a firm to supply the same product or service offered by its competitors at a lower cost. (Text Book 2-9) There are multiple ways to obtain cost leadership including economies of scale, economies of learning, economies of scope, efficient production, simple product design, efficient organizational process, and lower input costs. This strategy is typically implemented when the product is similar for all firms and has a basic product. The second strategy is differentiation. A firm following the differentiation strategy seeks to be unique in its industry along some dimension that is highly valued by customers (Palepu 2-9). A firm can add to its differentiation by providing superior service, product quality, product bundling, product variety, and flexible delivery timing. Most firms try to concentrate on either cost leadership or differentiation, but it is noted that a firm still needs to pay attention to both strategies. Many firms even combine to have a mix between competing on both strategies. In the restaurant 67 Page

68 industry specifically, firms use a mix between differentiation and cost leadership. The reason is restaurants all serve food, which is a basic product. In order to retain customers, restaurants must compete on price. As described above, a firm may use cost leadership to lower product price and increase revenue. On the other hand, restaurants try and create a certain type of atmosphere that is enjoyable to a large consumer base to attract customers as well as having a high product quality. The way a firm obtains these tasks is by using differentiation. Differentiation Generally speaking, differentiation is the strategy of a firm that sets it apart from their competitors. Within this strategy there are different implementation approaches that can help achieve differentiation. As discussed earlier, the five-force analysis gives us a description on the competitiveness of an industry as a whole, while cost leadership and differentiation strategies are intended to show firms how to best gain competitive advantages amongst their individual industry. While successful firms choose between cost leadership and differentiation, they cannot completely ignore the dimension on which they are not primarily competing. (Palepu 2-9) In the restaurant industry cost leadership is the main focus amongst firms but to maximize profitability any business must focus somewhat on both aspects. We have found some key factors in differentiation that in the restaurant industry can prove to be useful to firms. These have been shown to be superior product quality, customer service, and investing in brand image. 68 Page

69 Superior Product Quality In any industry, for the most part, if a firm s product is superior to their competitors then a firm will be able to differentiate itself from all the rest. This is no different in the restaurant industry and is actually shown to be a very critical point in judging a firms competitive advantage. For example, at the Cheesecake Factory, the menu is comprised of all natural chicken with no added hormones, premium beef that is Certified Angus, fresh fish that is either longline or hook & line caught whenever possible, cooking oils that contain no trans fat according to United States Food and Drug Administration Food Labeling Guidelines, and produced that is mainly sourced directly from premium growers. (CAKE 10k) The restaurant also offers organic coffee and tea. The cheesecake factory is a good example of how restaurants in the casual dining industry focus on superior product quality as compared other firms in this industry. When a consumer goes to a restaurant they are expecting the product to be worth the price they are going to pay. Sandy Beall, CEO of Ruby Tuesday, stated that consumers will focus less on price, price, price and more on food quality (USA Today). The restaurant industry is very fickle in the fact that just one bad meal or visit to a particular restaurant could cause a customer to not return. This is why quality is such a huge factor in the restaurant industry. Another side of product quality is that the customer expects the food that a restaurant produces to be uniform no matter which location they go to. If a customer attends two different locations of a firm and receives un-similar products, this can easily sway their opinion of the business. Consistency is key in the restaurant industry. A firm is more likely to have repeat customers if they know that they are going to be getting the same food experience time and time again. In the restaurant industry superior product quality is a major factor because customers are choosing a firm on many different reasons, but the main one being the actual product that they are providing. 69 Page

70 Superior Customer Service Superior customer service in any industry can be a great competitive advantage and can allow firm s to differentiate themselves in an industry. Customer service is highly valued due to the fact that the restaurant industry is geared to pleasing the consumer. Nick Shepherd, CEO of Carlson, when questioned on the TGI Friday s $5 sandwich and salad promotion, stated Like most promotions, the short-term economics were tough, but the long-term payoff comes from highly satisfied guests who become valuable loyal guests, which is critical for the health of our brand and franchises. (NY Times). With such a high price competition, customer service is one of the traits that can set a firm apart from all the rest. At Chipotle, customer service is key factory in regarding to retaining customers and gaining recognition. According to Chipotle s 10k, Consistent with our emphasis on customer service, we encourage our restaurant managers and crew members to welcome and interact with customers throughout the day. (CMG 10k) Having employees interact with their customers allows them to develop relationships and also to ensure loyalty. It also shows the importance of customer satisfaction, which is a highly important factor to customers when deciding if they will return to the restaurant. The top firms in the industry will not hold back in pleasing the customer in whatever means necessary. Re-preparing a meal, refunding money, and offering discounts are just a few of the different ways to achieve outstanding customer service. These methods can vastly improve a firm s competitive advantage in the restaurant industry. 70 Page

71 Investment in Brand Image Brand imaging is an invaluable resource that firms in any industry can realize. A brand image is accomplished by developing a consistent theme in the customers mind through advertising and marketing. This image can create a feeling of loyalty over time and can increase the amount of repeat customers for individual firms in an industry. In the restaurant industry brand imaging is very crucial through various outlets. According to William Neuman of the New York Times, Forced by the recession into deep discounting, the chains are going beyond traditional advertising to get the word out. (NY Times). Through this advertising and brand imaging, customers can get a notion of the quality of a restaurant. Brand imaging plays a huge role in any industry by causing customer loyalty. As stated by Nick Shepherd in the previous paragraph, investment in customer service results in an investment in brand image. If the customer comes away satisfied, it is likely that they will return to the same chain, and advertise their experience through word-of-mouth. All of the major firms in the restaurant industry have some form of an image that differentiates them from the competition. This image is then projected upon the consumer which leads to increased sales and overall profitability. O Charley s revenues are heavily based on brand marketing and advertising, compared to the other restaurants in this industry. 71 Page

72 Note: Cheesecake Factory s Advertising expense for 2005 and 2006 was Immaterial (CAKE 10-K). Conclusion Product quality, customer service and brand image clearly differentiate a firm from others within a particular industry. The competitive advantage arising from these elements allows customers to draw clear distinctions between different firms. In fact, within the restaurant industry, firms are rewarded for excelling in these categories, earning prestige among competitors. In 2009, Restaurants & Institutions awarded the 29 th Consumers Choice in Chains award to P.F. Chang s China Bistro and The Cheesecake Factory (BusinessWire.com, 2009). The Consumer s Choice in Chains is a survey of 3,000 consumers, who rate chain restaurants on eight customer-satisfaction attributes: food quality, menu variety, value, service, atmosphere, cleanliness, reputation and convenience (BusinessWire.com, 2009). According to Dan Hogan, publisher of Restaurants & Institutions, [The award] sends a powerful message to the industry and beyond, for which these restaurants have earned continued business and guest loyalty. Although the restaurant industry primarily competes using cost 72 Page

73 leadership strategies, these differentiation strategies play a major role in the success of firms within the industry. Cost Leadership Firms within the restaurant industry, when looking at the most basic level, all sell the customer food. The industry as a whole is very fragmented, which means no one restaurant owns a huge percentage of the market share, consumers have no switching costs, and on the most basic level there is very little product differentiation. These factors all feed into the high level of price competition for the industry. In order to compete with other firms, restaurants must implement cost leadership to their advantage. Economies of Scale The restaurant industry is no different from any other industry in that economies of scale are important. Economy of scale is when one can reduce cost per unit from increased production. This comes in to play when trying to gain market share in a highly price competitive market. If the firm can cut costs and offer a good at a lower value, market share is soon to follow. One of the restaurant industries biggest cost is their raw materials. This is a cost that all competitors have to take. If it were possible to increase market share to where the firm would receive a lower price on the same good as its competitors, the firm would gain a huge competitive advantage. For example, the bigger the restaurant gets, the more chicken it needs to order. Because of this, the more chicken it orders, the better prices the firm receives. The trend in the restaurant market has been expand, expand, expand. Cheesecake Factory, Chipotle, and P.F. Changs have all opened new stores every year for the past five years. The following charts, shown below, represent the geographical location of each firm s restaurants across the United States. 73 Page

74 74 Page

75 ( Data for Charts taken from PF Changs 10-K, Cheesecake Factory 10-K, and Chipotle 10-K) Efficient Production The restaurant industry produces the same meals, millions of times a year. The industry can cut costs using efficient production strategies. This basically says that the firm will allocate resources in the most efficient way possible. If don t properly, profit and market share will follow. The restaurant industry is also subject to guest traffic increases and decreases. When a recession hits and guest traffic decreases, the firm will need to cut costs somewhere to maintain its quality of service that its customers are use to. To offset the lack of sales, restaurants can discover more efficient ways of operation. Whether or not 75 Page

76 the firm can become more efficient could determine whether the firm survives the recession or not. This is why efficient production in the restaurant industry is so important. Another way the restaurant industry manages production is through the management of labor. Many firms within the restaurant industry experience high labor costs due to the number of employees at each establishment. For example, Chipotle s labor costs from 2007 to 2008 rose by $ million. Now, restaurants are attempting to cut the costs of labor in order to save money and increase profitability. One way the industry has cut back on labor charges has been the reduction of actual employees, as shown by the graph below. (WSJ) Firms are scaling back on the number of employees, and are ramping up the hours and duties of those who remain. 76 Page

77 One specific example of a way the restaurants compete on efficiency is the Open table seating reservations that allow customers to book reservations on line. This system is very efficient and has been catching like wild fire amongst restaurants since opening in Research and Development and Brand Advertising Within the cost leadership structure, firms tend to focus on not spending money on research and development, and in some cases of the restaurant industry, businesses spend little money on brand advertising as well. This is just another factor to why cost leadership companies maintain such a tight cost control system. In the restaurant industry, firms do not invest in research and development and if so, very little money goes towards that fund. New menu items are cheap to create and allow available to the customers. Although, since some restaurants do engage in research and development to better their menu or change the atmosphere of the restaurant, it tends to be for a one year period. Overall the industry does little research and development, therefore leading to decrease expenses at the end of the accounting period. Brand advertising is a bit more complex. Since the restaurant industry must showcase their products and get their name out to customers through TV, radio, newspapers, and magazines, money is spent in to doing so. This is very true for the industry as a whole, but in terms of the more upscale restaurants, they try to advertise their products through word of mouth. We believe that word-of-mouth advertising is a key component in driving guests initial trial and subsequent visits, and that creating a great experience for guests will always be the ultimate marketing vehicle (P.F. Chang s Bistro). Word-of-mouth is a major advertising technique for the more upscale restaurants, because of their superior product quality and fantastic customer service they all strive for. The Cheesecake Factory also relies on repeating customer to get their name out in the public. Our operational excellence continues to be a highly effective approach to attracting and retaining customers. Accordingly, we have 77 Page

78 historically relied on our reputation as well as our high profile locations, media interest and positive word of mouth to retain and grow market share rather than using traditional paid advertising (CAKE 10-k). Through little research and development costs along with a low costs of brand advertising, firms in the restaurant industry save their money to invest in more operations or expand globally. Also since the industry is very price competitive, the firms save their money in case they need to cut costs for any particular reasons. Overall, this industry combines many of the cost leadership strategies with differentiation strategies, making it a mixture of strategies for creating competitive advantage. Tight Cost Control System Companies in an industry who focus on cost leadership strategies look for a way to achieve superior performance. There are many ways to achieve cost leadership, including economies of scale and scope, efficient production, and efficient organizational processes. (Palepu & Healy 2-9) If these firms can maintain a cost leadership strategy they will experience high returns and profitability. These companies have a tight cost control system where they spend money only when they need to and invest only when necessary. Recently, some restaurants, facing a hike in minimum wage requirements, have found creative ways to cut costs. At some of Darden Restaurant s LongHorn Steakhouses, servers are required to share tips with bartenders, hosts and table busers in an attempt to cut labor costs (WSJ). Firms with tight cost control systems know what they need, know what they have, and know what they can do without. All levels of cost leadership ultimately lead to tighter cost control systems. In the restaurant industry, firms have a mixture of cost leadership strategies and product differentiation, but for the most part maintain a tight cost control system. This is due to the little research and development companies spend each year and the efficient production methods the industry offers. This is why P.F. Chang s Bistro, 78 Page

79 Cheesecake Factory, O Charley s, and Chipotle Mexican Grill can sustain high profitability and keep costs down for future expectations. Conclusion Overall the industry has created a mixture of both cost leadership strategies and differentiation strategies that allow the firm to engage in different types of competitive strategies. The more upscale restaurants in the industry spend little money on designs and concepts they do not need, resulting in a tight cost control system for the firms. This allows the companies to save money and in the long run create higher returns and more profits for future periods. Competitive Advantage Analysis In the restaurant industry, both differentiation and cost leadership play important roles in sustaining a competitive advantage over its competitors. P.F. Chang s is a mixture of both cost leadership and differentiation, but with a stronger emphasis on differentiation. In order for a firm to succeed, the firm must identify the features of the product; meet the customers needs, and lower the cost of a differentiated product so that it is lower than what the customer is willing to pay. Competitive advantage analysis is utilized to determine if the firm is taking the proper actions to attain a competitive advantage. By obtaining a competitive advantage, the firm is able to outperform its competitors and become in leader in the industry. The restaurant business is intensely competitive with respect to food quality, price-value relationships, ambiance, service and location, and many existing restaurants compete with us at each of our locations (PFCB 10k) P.F. Chang s competes on superior product quality, superior customer service, and price. 79 Page

80 Superior Product Quality Products must be of high quality to meet the increasingly high standards of the market in this industry. The consumers lives and well-beings are dependent on the product. Through superior quality products, customers are able to get a high level of satisfaction. For example, chefs at P.F. Chang s are trained to produce distinctive Chinese cuisine using tradition recipes from the major culinary regions of China updated with a contemporary twist. (PFCB 10k) P.F. Chang s also ensures quality products by maintaining a good relationship with their suppliers in Hong Kong, China, Taiwan, and Thailand. These suppliers provide a variety of ingredients needed to create quality Chinese cuisine. Today, consumers are concerned with personal wellness and eating healthy. P.F. Chang s restaurants are appealing to customers who have healthy eating habits by offering a wide variety of vegetarian/specialty dishes. For example, all of the dishes offered at P.F. Chang s are MSG and gluten free. Restaurants are responding with revamped kids' menus, healthier food and kids-eat-free nights. Such moves are tricky to do well because restaurants must appeal to young palates while addressing parents' health concerns. (WSJ) Recently, P.F. Chang s and Cheesecake factory have created the first kid s menu. According to the Wall Street Journal, parents felt that P.F. Chang s was not a child-friendly restaurant due to the fact that they did not have a menu for children. The new menu includes such entrees as the Baby Buddha's Feast, which contains steamed or stir-fried snap peas, carrots and broccoli, and kids' lo mien, or egg noodles stir-fried with chicken. (WSJ) Most dine in restaurants that offer a kid s menu provide foods, such as chicken fingers and hot dogs, but P.F. Chang s has continued to provide quality Chinese cuisine with a little twist that is appealing to children. The production of quality products gives the company a competitive advantage over other firms. Moreover, firms in the restaurant industry offer several varieties of products to customers. The continued introduction of different varieties of products by the firms in the industry also gives them a competitive advantage over other firms from different industries. 80 Page

81 Superior Customer Service Like other firms in the industry, P. F. Chang s takes measures to improve customer service relations. One of P.F. Chang s main goals is to create a loyal customer base that generates a high level of repeat business and provides superior returns to their investors. (PFCB 10k) In order to fulfill that goal P.F. Chang s will continue to strive on providing quality Chinese cuisine in an atmosphere that is memorable to the customer. Another tactic that P.F. Chang s uses to maintain good relationships with their customers is by encouraging the Chinese traditional way of dining and that is family-style. By continuing to follow these tactics, P.F. Chang s will be able to achieve customer loyalty. Product Cost Product cost is another key determinant in sustaining competitive advantage over its competitors. P.F. Chang s competes on price, by offering a menu that is appealing to the customer s wallet. P.F. Chang s is an upscale restaurant that has entrées that go up $ In today s economy, many consumers want to save money and budget their dining expenses by either cooking their own food or going to restaurants that offer discounts. As mentioned earlier, P.F. Chang s introduced Chang s for two, a prix-fixe menu offering a four course meal for two people for the price of $39.95, this deal includes two soups, one starter, two entrées and two mini desserts, all of which can be chosen from an extensive selection of signature dishes and guest favorites. (PFCB 10k) P.F. Chang s allows consumers to experience premium dining at an affordable price. P.F. Chang s ability to accommodate its customers by lowering or applying discounts to their menu allows them to obtain a competitive advantage over its competitive, hence gaining market share. 81 Page

82 Conclusion P.F. Chang s Bistro has competed in the restaurant industry for many years, and by doing so they have gained human capital as well as a competitive advantage over other firms in the industry. The company has strived to perfect their goods they proved and excel in customer service over any other firm. P.F. Chang s has positioned itself as a mixture of cost leadership and differentiation. The company does insist on keeping costs low as well as understanding what it takes to be a successful restaurant in this industry. They have positioned themselves for great future earnings and profitability. 82 Page

83 Accounting Analysis After completing a thorough industry analysis using the five forces model, the next step is a formal accounting analysis to better assess the firm. Managers of a firm often try to influence prospective investors by manipulating the firms accounting numbers, or just by the amount of disclosure reported on the financial statements. For this particular reason, the SEC (Securities Exchange Commission) has provided guidelines and strict rules on the amount of information disclosure a firm must fairly identify to future investors. Any company in the United States must obey the rules of the SEC, but more importantly, the SEC governs smaller private sectors known as GAAP, and FASB. These private sectors create and establish other accounting policies firms must abide by. In order to properly asses a firm, it is important to work through a formal accounting analysis. A completed formal accounting analysis shows the firm in actuality, because it takes out some of the distortions created by upper management of the firm. There are six steps in performing this analysis, each one creating a better opportunity to gain knowledge of the firm. The first step is to identify key accounting policies within the firm. After configuring the key success factors from part 1, the key accounting policies are implemented on how a firm measures the success factors from an accounting basis. The second step in the analysis is to assess the accounting flexibility of these step one policies. The amount of flexibility a firm can have is determined by the GAAP rules there for regulated. Having a high amount of flexibility can assist a manager in ways to better the information provided or be a more informative firm. On the other hand, having little or no flexibility can prevent a firm from presenting great factual information that could be more understanding. The third step is to evaluate the firms accounting strategy. Given the amount of flexibility of a firm, managers can either use this flexibility to present more knowledgeable information or to distort certain items from the financial statements. Just by looking for changes in accounting policies can give a better understanding of what strategy a firm may be aiming for. The next step in the process is to evaluate the quality of disclosure. To gain 83 Page

84 a better perception on the quality of information disclosed would be to assess other firms in the industry competing on the same product line. Since these firms have considerable amount of flexibility, evaluate the firm to see if they are being fair to all investors or hiding useful information one might find beneficial to the investment. The fifth step in the process would be to identify any potential red flags in the accounting statements. This step involves looking for changes in accounting numbers from year to year. The fourth and fifth steps are used to assess the quality of the firm through the information disclosed on the annual reports. For the last step in the analysis, investors would undo any accounting distortions found throughout the reports. Once the accounting distortions are identified and restated, the company s financial statements will show a more realistic picture of how they stack up to their competitors. It is important to keep in mind that it is almost impossible to perfectly undo these distortions with the limited knowledge the public has access to. However, it still paints a better picture of the corporation than just viewing the skewed financials. Key Accounting Policies Key accounting policies of a firm help to get a better view of a firms actual financial standing. Managers of the firms are entrusted with producing accurate information because they have inside information that outsiders do not have access to. They are basically given a basic accrual accounting framework to follow, and the rest is judgment of the manager. There are benefits and disadvantages to this type of system. The managers sometimes have incentives to distort profits by using biased assumptions (Text Book, 3-2). A few agencies have risen due to the misuse of the manager s power with inside information. The Securities and Exchange Commission (SEC) is in charge of setting accounting standards. The SEC relies on the Financial Accounting Standards Board (FASB) and Generally Accepted Accounting Principles (GAAP) to set the 84 Page

85 standards. The uniform accounting standards reduces a manager s ability to distort the books; it doesn t eliminate it. With the benefit also comes some negative repercussions from the uniformed standard. Accounting rules introduce noise and bias because it is often difficult to restrict management discretion without reducing the information content of accounting data (Text Book, 3-5). Managers are only human, so some noise comes from just sheer human mistake. All of these factors input into the actuality of how factual a firms financial statements are. In order to understand how a firm is producing their financial statements, it is important to understand the key accounting policies. They are broken down into two segments, which are Type One and Type Two. Type One key accounting policies are related to the industry as a whole. Key success factors are intricately connected with Type One key accounting policies. Type Two key accounting policies are more individual firm specific based off a managers ideals and actions. This is the type that is linked with the distortion or misrepresentation of financial statements. There is great economic benefit to be held in distorting the financials at times. Completely understanding the Type Two of the accounting policies would better prepare a potential investor to check out the fishy parts of the financials. Putting the two accounting policies together will give potential investors the best look into a firm s financial state of being. Type One Accounting Policies Type Once key accounting policies directly link the firm s financial disclosure to the key success factors of the firm. P.F. Chang s competes on differentiation and cost leadership amongst their competitors. The Type Once accounting policies that P.F. Chang s has incorporated into their strategy is as follows; economies of scale, superior customer service, and superior product quality. 85 Page

86 Economies of Scale Keeping a tight costs control system is vital to success and competition in the restaurant industry. Economies of scale is when a firm expands their markets share in attempt to lower the cost per unit produced. Lowering the costs per unit of the company s product can result in higher earnings and ultimately increased profits. Firms can do this by combining operations or simply by getting rid of unprofitable ones. In the restaurant industry, not every restaurant opened is going to generate profits, possibly due to bad locations, or just not a well-populated area for the restaurant. These firms can combine businesses, or in our circumstances, get rid of a restaurant that is not producing. P.F. Chang s decreased their costs for food, beverages, and packaging in 2009 partly due to the increase in price sales and the number of restaurants opened in In 2008, food costs increased as a percentage of revenue due to increased product cost, primarily cheese, chicken and avocados, partially offset by menu price increases in selected markets (P.F. Chang s Bistro 10-k). P.F. Chang's saw significantly higher costs for many raw ingredients in For the years ended December 31, % % increase increase Food, beverage and packaging $ $ $ over over 2008 As a percentage of revenue 31.90% 32.40% 30.70% 24.70% 7.90% 86 Page

87 The table above shows the increases in price over the past three years to compensate for the price of food, beverages, and packaging costs. These costs have decreased over the past three years as a result from the price increase for menu items. The cheesecake factory offers sales per square foot for each restaurant on average, which has decreased over the past three years. Average sales per productive square foot (defined as interior plus seasonally-adjusted patio square feet) for restaurants open for the full year were approximately $830 for fiscal 2009, $860 for fiscal 2008 and $920 for fiscal 2007 (CAKE10-k). This decrease in sales per square foot could have gone down due to the bad economic times over the recent years, and the company is not utilizing all the space they have available in each restaurant. Below represent an analysis of average weekly sales for new restaurants opened in 2005,2006,2007,2008, and Then we divided the number of units by the average weekly sales to come up with the average weekly sales per newly opened units. P.F. Chang's Bistro number of units average weekly sales average weekly sales/unit Pei Wei Asian Diner number of units average weekly sales 35,889 36,028 31,945 30,824 36,198 average weekly sales/unit Page

88 From above we can conclude that upon opening new restaurants, weekly sales per unit has increased over the years. This indicates that P.F. Chang s Bistro is creating greater sales with their new locations, partly because the locations chosen are for highly populated areas. Overall, the restaurant industry tries to maintain cost control through economies of scale. This allows the company s to produce more products or generate more sales through decreasing the price per unit at each restaurant. P.F. Chang s has done so by increasing prices on their menus, therefore driving food, beverages, and packaging costs down. In addition, the new stores opened in the past five years have generated increased sales per unit on a weekly basis. This shows the company has researched and placed new restaurants in high profitable areas, and has exceeded expectations of average weekly sales. Superior Customer Service In the restaurant industry customer service is very valuable, especially with the amount of interaction that takes place between the employee and the consumer. The focus of the restaurant business is to please the customer with a great time, and an even better experience. This is very important in the restaurant industry because if the customer isn t happy with the service they receive, they are not very likely to return. The restaurant industry is taking great strides to increase the level of service that is provided. As well as the four week culinary training for all management positions, P.F. Chang s also requires a four week training program that focuses on service strategies, guest relations, and administration. (Chang s 10-k) As well, all Pei Wei management must take a three week training program focusing on service strategies focused on dine-in and take away service, guest and employee relations, and administration. (Chang s 10-k) With the situation of the economy, the inability to attract and maintain 88 Page

89 employee levels can create an adverse affect on customer service that is industry wide. Inability to recruit and retain qualified individuals may delay the planned openings of new restaurants while high employee turnover in existing restaurants may negatively impact customer service and customer relations, resulting in an adverse effect on our revenues or results of operations. (Chang s 10-k) As shown in the graph below, the industry trend for the last five years has shown that labor costs are decreasing in percentage every year. This shows that companies are not able to hire or pay employees as much as they used to. This can cause frustration in the workplace and effect overall customer service. 89 Page

90 Superior Product Quality Superior Product quality is a very important factor in the restaurant industry. The customer is coming to a restaurant mainly for the quality of food that they are receiving. If the quality is not kept up to a high standard then a firm could lose potential and existing customers. In the restaurant industry as a whole, quality is a key area that firms focus on and we believe that P.F. Chang s is at the forefront of this group. As mentioned earlier superior product quality is a key success factory in our company. In P.F. Chang s 10-k it describes some of the ways it is attained. Our supply chain management function allows us to utilize only fresh ingredients in our meals and inventory is maintained at a minimal level. (Chang s 10-k) Keeping with the type of meal received at P.F. Chang s, the Asian-specific ingredients such as spices and sauces are primarily brought in from Hong Kong, China, Taiwan, Thailand. This type of attention adds to the value of the experience a customer encounters at P.F. Chang s. Along, with this is the eight-week management development program. All management must go through this program with four of the weeks with the focus being on culinary job functions and culinary management. (Chang s 10-k) Pei Wei has a similar program with six weeks of hand-on culinary functions and culinary management. (Chang s 10- k) Overall, the level of disclosure for quality in the restaurant industry is moderate to high. With food borne illness being a very big deal, it is necessary to pay close attention to the quality of products. 90 Page

91 Type Two Accounting Policies Type Two accounting policies are some of the most common overstated. They are commonly overstated because they are the items on the financial statements with the most accounting flexibility. A manager may use the flexibility to distort the financials into a more favorable outcome. The managers may possibly distort the following under the Type Two accounting policies; noncontributory defined benefit plan, goodwill, post retirement benefits, operating leases, and research and development. P.F. Chang s upper management uses a great deal of operating leases, which in turn distorts the financials. The following items, including operating leases, will be discussed below for P.F. Chang s Type Two accounting policies; defined contribution plan, and goodwill. Defined Contribution Plan A defined contribution plan is a company retirement plan where the employee chooses to defer a portion of their salary into the plan, and bears interest risk (Invst.) They are promoted by the company to attract employees and reward the ones that stay invested in the firm. A couple of defined contribution plans are 401K s and 403b plans. P.F. Chang s uses 401k s to compensate its employees. Most 401k s are used with a mutual fund being managed with stocks, bonds, money market investments or a combination of the above. These plans are generally on a pre-tax basis, which provides an advantage because all of the gains are tax-deferred. This allows for maximum return over long periods of time. This kind of plan allows companies to eliminate some of the liabilities in comparison to a defined benefit plan. With the defined benefit plans employees can increase a monthly benefit plan that 91 Page

92 begins when the employee is no longer working and that is payable until death. This kind of plan has many unknowns, which leads to greater liabilities as stated above. The restaurant industry uses primarily defined contribution plans to compensate its employees. Goodwill Goodwill, a highly intangible asset, is used to reflect the book value of entities not directly associated with assets and liabilities. It reflects the chance to make higher profits than would be derived from selling the tangible assets of the company. In other words, goodwill reflects the company s value beyond their asset value. The basic goodwill formula is: goodwill= purchase price fair market value of net assets. When a company acquires another company, the merger eliminates the goodwill written in the acquired company s books, and is recalculated into the acquiring company s books. Goodwill can only be impaired, not amortized. Instead of reducing a percentage of the company s goodwill over a certain period of time, goodwill is now valued as fair value. Using present values of future cash flow, companies compare goodwill to their carrying value (book value of assets added to goodwill minus liabilities). If the fair value is less than the carrying value, then goodwill needs to be impaired. When goodwill is impaired, it is just reduced to equal the value of the current carrying value. In the end, goodwill is reported separately on the income statement and a new adjusted value of the goodwill is recorded on the balance sheet. 92 Page

93 P.F. Chang's Bistro 1.97% 1.62% 1.31% 1.30% 1.37% Cheesecake Factory N/A N/A N/A N/A N/A Chipotle Mexican Grill 5.21% 4.38% 4.43% 3.74% 3.45% O'Charley's N/A 20.12% 21.45% N/A N/A The chart above depicts the numbers for the formula to determine whether goodwill needs to be impaired. P.F. Chang s goodwill has been very consistent throughout the five-year period researched above. The cut off is 20 percent, and P.F. Chang s was well under this every year since These numbers prove that goodwill is immaterial and does not need to be restated on the financial statements. Operating Leases Current U.S. G.A.A.P policies allow for the accounting of leases under two separate categories: capitalized leases and operating leases. There is no real pre-set form dictating the use of one or the other in accounting for leases in the financial statements. This loophole in accounting policies allows firms to choose which type of lease accounting they use. Each type of lease accounting is accounted for in a different way. Capitalized leases are treated like fixed assets: the value of the lease is depreciated over the lifetime of the lease, and depreciation and interest expense are recognized on the income statement. In contrast, operating leases are treated as temporary assets, that is, the firm does not claim ownership of the assets, just the use of the asset. In contrast to capitalized leases, operating leases are not reported on the balance sheet, since there is no recognition of a future/current asset or future/current liability. Payments are recognized as expenses only, which leads to an overstatement of net income, since expenses are understated. 93 Page

94 Assets = Liabilities + Owner's Equity U U O Since G.A.A.P. provides firms flexibility when accounting for leases, many firms within the restaurant industry, such as P.F. Chang s, choose to use operating leases, as this leads to off-balance sheet financing and a relative overstatement of earnings. Assess Degree of Accounting Flexibility The degree of accounting flexibility for a firm fluctuates from industry to industry. The government strictly regulates some firms accounting policies while other firms policies are only slightly regulated. This all dependent on what type of industry the firm is in. The amount of flexibility a firm is able to utilize depends on GAAP as well as other standards and regulations. FASB (Financial Accounting Standards Board, is the firm that developed GAAP and determines what firms can do on financial statements as far as flexibility goes. If there is high flexibility, a firm can determine how to represent their current financial situation. This normally results in the firm presenting its self as positively as possible. This is not always a good thing as it can often lead to a firm misconstruing financial statements and misleading investors and others outside of the firm. As a result of this, analysts must interpret firms with flexible accounting policies differently than highly regulated firms. If managers have little flexibility in choosing accounting policies and estimates related to their key success factors, accounting data are likely to be less informative for understanding the firms economics. Accounting numbers have the potential to be informative, depending upon how managers exercise this flexibility. (Palepu) Firms in the restaurant industry utilize flexibility in terms of operating/capital leases, defined pension plans, goodwill and research and 94 Page

95 development. In the following paragraphs, we will explore P.F. Chang s ability to exercise flexibility in terms of it key accounting policies. Operating/Capital Leases The Generally Accepted Accounting Principles and the Financial Accounting Standards Board permit great flexibility for firms that hold both operating and capital leases. The table below displays that P.F. Chang s does not hold complete possession of all of their assets; they actually have the preference of leasing them through either capital or operating leases. Once a lease is signed, assets and liabilities are not recorded on the balance sheet. They are recorded when payments are made. An operating lease records no assets or liabilities on financial statements. On the other hand, capital leases record lease assets and lease liabilities at the contract signing. Under operating leasing, leases are treated as a rent expense. Through capital leasing, the leased asset is recorded on the balance sheet and reflects its corresponding lease obligations. P.F. Chang s utilizes both operating and capital leases. The following table shows our purchase commitments by category as of January 3, 2010 (in thousands): 95 Page

96 Payments Due by Period Less Greater Than Than Total 1 Year Years Years 5 Years Long term debt $ 42,957 $ 41,236 $ 126 $ 128 $ 1,467 Operating leases 341,414 49,635 96,184 82, ,754 Capital leases 3, ,263 Purchase obligations 205, ,142 78,851 10,037 Total $ 592,744 $ 207,429 $ 175,993 $ 93,838 $ 115,484 (Table was taken from PFCB s 10k) In order to impose whether a property will be classified as operating or capital leased, P.F. Chang s will evaluate each property prior to the beginning of each lease. According to P.F. Chang s, the restaurant accounts for tenant incentives received from its landlords in connection with certain of its operating leases as a deferred rent liability within lease obligations and amortizes such amounts over the relevant lease term. (PFCB 10k) As for increases in rent, P.F. Chang s utilizes the straight-line depreciation method and records the total amount of rent payable during the contract period. The difference between the straight-line rent and the minimum rents paid is recorded as a lease obligation. Some leases contain certain limitations that are dependent on restaurant sales volume, which requires an additional amount of rental payments. At P.F. Chang s the management can make judgments regarding the appropriate term for each restaurant property which can affect the classification and accounting for 96 Page

97 a lease as capital or operating lease. These actions may create indifferent amounts of depreciation, rent expense and amortization, which could be avoided if the assumed lease terms were used. If P.F. Chang s continues to make these judgments, assets and net income will be overstated while expenses and equity will remain understated. Assets Liabilities Stock Revenue Expenses Net income Holders equity O N U N U O Benefits and Pension Plans P.F. Chang s provides a great amount of information regarding pension plans. Employees who have completed at least six months of employment and have attained the age of 21 can qualify for the restaurant s 401(k) defined contribution plan. The 401(k) allows employees to contribute to the plan and also allows for the firm to make matching contributions. P.F. Chang s, matches contributions in amounts equal to 25% of the first 6% of employee compensation contributed, resulting in a maximum contribution of 1.5% of participating employee compensation per year (subject to annual dollar maximum limits). (PFCB 10k).The restaurant can only begin to match contributions only when the employee has worked from P.F. Chang s for at least one year and has a minimum of 1000 hours. P.F. Chang s discloses the exact percentage that will be contributed to the employee s 401(k) plan and provides a substantial amount of information on the plan as a whole allowing the restaurant to have room for flexibility. 97 Page

98 Goodwill Goodwill arises when then the purchase price of an asset that is being exchanged goes far beyond the fair market value. Goodwill is also referred to as buying hidden value ; it is an intangible asset that has an uncertain life is amortized. The sum of goodwill can be determined by subtracting the fair market value of net assets from the purchase price. According to the Generally Accepted Accounting Principles, goodwill can only be impaired and not amortized. Firms are now required to uphold the fair value of the reporting units, while using the present value of future cash flows, and comparing it to their carrying value. If the fair value were found to be less than the carrying value, the value of goodwill would need to be minimized in order for the fair value to be equivalent to the carrying value. P.F. Chang s does not provide sufficient amount information on goodwill. P.F. Chang s ratio of goodwill over Property Plant and Equipment is less than 20%, which is rather low and will not be relevant to the firm in terms of restatements. Provided that P.F. Chang s only discloses the amount of goodwill on its balance sheet and nowhere else, it is safe to say that this firm will always have a small amount of flexibility in this section. Research and Development Research and Development is classified as an asset on the balance sheet, which allows firms to plan potential growth by doing extensive research in order to develop new products and improve operations. According to GAAP, the policy states that Research and Development must be treated as an expense, which further results in an overstated expenses and understated assets. In the restaurant industry, specifically casual dining, research and development is not an important factor. P.F. Chang s has no 98 Page

99 amount of research and development and therefore is less than 20% of operating income. The importance of research and development is irrelevant to the firm. Evaluate Actual Accounting Strategy Accounting flexibility refers to allowing firms to strategize their use of accounting flexibility in order to conceal or communicate the firm s current economic situation or performance. A firms accounting strategy can either be aggressive or conservative. Firms that partake in conservative accounting will have an understatement in assets and an overstatement in its liabilities, which will further decrease net income and equity. In the contrary, firms who utilize aggressive accounting will understate its liabilities and overstate its assets, which will decrease equity and net income. Having the ability to identify a firm s accounting strategies as either aggressive or conservative, will allow investors or outsiders to be able to view the firms current financial position. The firm s financial statements will be transparent and fair. Firms have the option of choosing the amount of information they want to disclose. Firms who display a nominal amount of information on their financial statements are concealing information from investors and outsiders, which can make it difficult to determine the firm s value. In order to obtain a clear picture of a firm s performance, it is crucial to evaluate a firm s accounting strategies in order to determine its value. Operating/Capital Lease Operating and capital lease are major component of the restaurant industry. As mention earlier, P.F. Chang s does not hold complete ownership over its properties. P.F. Chang s has the preference of leasing through capital or operating leases. Although P.F. Chang s utilizes both operating and capital leases, operating leases accounts for the majority of the leases on its balance sheet. P.F. Chang s is aggressive in terms of their operating leases. According to PFCB s 10k, For leases that contain rent escalations, we 99 Page

100 record the total rent payable during the lease term, as determined above, on a straightline basis over the term of the lease (including the rent holiday period beginning upon our possession of the premises), and record the difference between the minimum rent paid and the straight-line rent as a lease obligation. (PFCB 10k) Although P.F. Chang s utilizes aggressive accounting, the firm discloses a large amount of information in regards to it capital and operating leases. Most firms in this industry use aggressive accounting as their strategy Lease % by Type P.F. Chang's Cheesecake Factory Chipotle O'Charley's Operating Lease 99.17% % % 94.93% Capital Lease 0.83% % In the table above, it can be seen that P.F. Chang s competitors are aggressive in terms of their use of operating leases. As mentioned earlier, most firms in this industry have a great amount of operating leases than capital leases or have no amounts of capital leases. The Cheesecake Factory and Chipotle both have a zero amount of capital leases. Defined Contribution Plans Unlike most firms, P.F. Chang s discloses a minimal amount of information on its defined contribution plan. P.F. Chang s utilizes a 401(k) plan which allows employees to contribute to the plan and also allows for the firm to make matching contributions. The 100 Page

101 firm specifically states the exact percentage limit and percent in matching contributions that can be obtained through the plan. Although P.F. Chang s is a low disclosure firm with regards to its defined contribution plan, it allows outsiders to obtain a small picture of its overall plan. As mentioned earlier, defined contribution plans eliminate some of the firms liabilities compared to a defined benefit plan. Employees who utilize defined benefit plans have the ability to increase their monthly plan until the employees are longer working for firm or until their death. Defined contribution plans have many unknowns which lead to increase in liabilities; therefore the firm utilizes aggressive accounting in this section. P.F. Chang s benefit plan is contributory and will not be included in the restatements. Goodwill P.F. Chang s ratio of goodwill over Property Plant and Equipment is less than 20%, which is low and will not be relevant to the firm in terms of restatements. Research and Development P.F. Chang s research and development is less than 20% of operating income; therefore irrelevant in terms of restatements. Conclusion After evaluating the firm s accounting strategy, we have determined that P.F. Chang s has an aggressive accounting strategy. For the most part, P.F. Chang s discloses a great amount of information in regards to its operating and capital leases. As for its defined contribution plans, P.F. Chang s provides a minimal amount of information, which can be difficult for investors and outsiders. In addition, P.F. Chang s 101 Page

102 plan is contributory and will be irrelevant in terms of restating. The firm has a small amount of goodwill, which is actually less than 20% of its P.P.E. Like many firms in this industry, restaurants have either a small amount or no amount of research and development. P.F. Chang s does not have any research and development. Both goodwill and R&D will not be of importance to the firm. Quality of Disclosure Evaluating a company s financials can give us a picture of the value of the firm, but this may not always be a fair representation of how the company is truly operating. The level of disclosure a firm gives to the public allows analysts and investors to perform a valuation but could be misconstrued due to the flexibility that companies have with accounting standards. Under GAAP, companies have a great deal of leeway to show the outside only what the managers want to show. Also, useful information can be hidden amongst large amounts of irrelevant information. This means that firms may not be as transparent as they are leading the public to believe. Firms can take two approaches when it comes to the manipulation of financial statements. One way a company can report numbers is very conservatively and show a clear picture of how it is performing. These firms usually run their numbers as close to the truth as possible, which gives analysts and investors a better idea of how to value the firm. The second method is to report numbers very aggressively and have the best reports for their company while following all of the necessary accounting standards. This aggressive nature can lead to misrepresentation of asset values, liabilities, and earnings. This distortion gives a false view of a company and possibly leads analysts and investors to undervalue or overvalue the true assessment of a company. 102 Page

103 Qualitative Analysis It is necessary to assess the quality of disclosure performance by companies. The more information given in the financial documents provided by the firms, the easier it is as an investor to see what s really going on in the company. The firm may make the factual evidence simple or very difficult to assess. There are certain requirements of GAAP that firms must follow when disclosing information. As long as all the minimum standards are met by GAAP, a firm is free to leave out anything they feel like, hide less attractive data, and complicate matters with extra information not needed. Page after page of data doesn t always translate into great company disclosure. Companies may add tons of irrelative information in order to make it difficult to extract the important data. They might be doing this to falsify the feeling that they actually are disclosing everything, when really they are leaving out the most important parts. The key in assessing the quality of disclosure performance by companies is to know how to separate the valid useful information from the extra noise. Superior Product Service/Quality P.F. Chang s takes great pride in having excellent service and quality, which leads to the disclosure of different methods of achieving this. The level of disclosure for these techniques is very high and P.F. Chang s does a great job of allowing themselves to be transparent in this area. There are a few different ways that P.F. Chang s achieves this service and quality. With quality, the amount of disclosure on the distributor in which they get their food is relatively high. There is also information on the culinary training in which all management level employees must go through. With service, all management level employees again must take a training course. This kind of information is valuable to analysts and investors to see value in things that may not 103 Page

104 have been easily visible before. P.F. Chang s does not try to hide, or not disclose this information. The level of disclosure on this information is reasonably high. Defined Benefits Plan The level of disclosure on defined contribution plan for P.F. Chang s and our competitors was relatively good. With such a common plan as a 401k it is not hard to believe that the disclosure of information is high. Although cheesecake factory does tell all of the details describing their plan, they do not give the actual numbers per year expensed, stating that they were insignificant. For the rest of the companies the information on the numbers is very detailed. Also, the level of disclosure on the format of the plans such as matching policies is very in-depth too. All relevant parameters are in plain sight and are not hidden in large amounts of ramble. P.F. Chang s recently started offering a 401k plan to their employees in With this in mind and after looking over all of the 10-k s for our company and our competitors, P.F. Chang s does a great job of having equal amounts of information as the rest. Business Segments In any industry, having multiple business segments is always a good way for a firm to expand its profitability and to reach more potential customers. With P.F. Chang s, there are two main business segments, P.F. Chang s (Bistro) and Pei Wei. These are the two main areas that are focused on. Recently though, there has been some investments in the brand development section, mainly focusing on the cooperation with Unilever to get a line of frozen foods out to the public. With the two main segments, the level of disclosure is extremely high. Within almost every individual section, it talks about the Bistro and Pei Wei individually, talking about how each is different than each other. For example, when it talks about development in the 10-k, it shows how many, what the total investment of capital should be, and the preopening 104 Page

105 costs for each store in each segment. This kind of information is shown throughout the entire 10-k which allows someone dissecting the 10-k to have adequate knowledge on both segments. Although the financial numbers for the two are generally integrated it does give a few of the most important data for each throughout the 10-k such as number of stores, costs and expenses, revenues, profits, capital expenditures, total assets, and goodwill. This allows analysts and investors to get an overhead view of each individual segment proportion relative to the corporation as a whole. With the investment in the frozen food segments there is essentially no information in the 10-k and this can be attributed to the partnership with Unilever. In P.F. Chang s conference call, a question is asked about this frozen food segment and the response is as follows, I m going to be relatively silent on that. Our friends at Unilever have asked us not to talk too much. We re excited about it but they would like to get everything in place It s going to cost us about $0.07 this year. We think next year that investment will decline to about $0.03 maybe $0.04 next year and hopefully go positive in 2011 so I know that s not specific enough to your question but that s probably as much as I m going to give you. (2009 Quarter 3 analyst review and conference call) This information shows that the partnership is in the process of being completed, and they have a good idea of the returns will occur, but both P.F. Chang s and Unilever would like to stay relatively quiet until the progression is final. Global Brand Development Recently, P.F. Chang s has entered into three development and licensing agreements with partners to begin expanding restaurants into international locations. The information and disclosure of this is minimal in the fact that they are not completed with the development of these stores. It also states that P.F. Chang s is continuously in talks with various partners about opening up new restaurants in foreign sites. As time 105 Page

106 goes along, we believe that the disclosure of these international markets will increase, but for now, it is very limited. Economies of Scale To reach the highest potential as a firm, in any industry, a firm would like to achieve economies of scale. This idea is again that a firm wants to reduce costs by increasing expansion. P.F. Chang s operates in different segments but both segments are relatively tied together in the financial aspect, as they are both restaurants. To see how a company is progressing on this, we can look at items such as assets and PPE to assess how this company is growing over a period of time. As far as P.F. Chang s goes within the 10-k, as I stated earlier we can look at the firm as a whole to see how this is making progress. P.F. Chang s discloses most of these numbers when they show their balance sheets. As this is where a large quantity of this information comes from. Overall, we can see how P.F. Chang s is accomplishing economies of scale, and the level of disclosure on this information is fairly moderate in comparison to our competitors. Operating Leases Overall, the level of disclosure on operating leases is relatively low. P.F. Chang s does discuss operating leases throughout their 10-k but it is fairly small. The extent that is talked about is only the stipulations surrounding these lease obligations and the amount of payments due by period. The information could be a lot more open when talking about this section. In general, it could be helpful as we are analyzing P.F. Chang s to know why the choice was to do primarily operating leases versus capital leases. If there were more literature, this would also allow us to better analyze the riskiness of the firm as a whole. 106 Page

107 Quantitative Analysis By running a quantitative analysis, one can better understand and capture potential red flags for a firm in any industry. By performing an analysis for P.F. Chang s Bistro, certain ratios will bring out the possible accounting distortions managers have chosen to provide. Two sets of diagnostic ratios will be performed to measure these distortions. The first is sales manipulation diagnostics. These diagnostics include ratios that compare net sales with cash from sales, account receivables, warranty liabilities, unearned revenues, and inventory. After performing these ratios, we will better understand what items are distorted in the financial statements and identify potential red flags. This signifies whether managers are cooking the books and making earning more than they really are, or if managers are taking a big bath meaning to intentionally understate net earnings. The second sets of ratios are derived from the expense diagnostics. These ratios include; asset turnover, CFFO divided by OI, CFFO divided by NOA, total accruals divided by change in sales, pension expense divided by SG&A, and other employment expenses divided by SG&A. These ratios will provide evidence to whether or not P.F. Chang s in understating their expenses for any given year. By performing these ratios for the past five years, we will recognize trends among the industry and realize how distortive each firm s accounting items really are. 107 Page

108 Sales Manipulation Diagnostics When presenting the financial statements for any company, managers have the option to present sales in many ways in order to manipulate the data. This can be a major concern for investors, business partners, or customers in general. If more generated sales mean that mangers can receive bonuses, stock options, or just make the overall firm look better than it really is, managers will have more incentives to cook the books and increase sales. Another way managers may distort information on the books is by taking a big bath. If financial times are hard or the economy is on a downward slope, and the public is already expecting terrible earning for a specific company, managers will decrease sales and increase expenses. Although this looks bad for the period completed, the public had already been expecting the worst so in the long run the company has more earning than what they originally displayed, making the overall business look better in the long run. By providing these ratios for each competitor in the restaurant industry for the past five years, one can spot trends or outliers in the industry. This can show misrepresentations in accounting data or revenue sales for that specific firm. If a large discrepancy from year to year is spotted, this is noted as a red flag. Red flags should be checked into further to make sure that the proper steps have been taken to report the right information. The ratios displayed in this section include; sales divided by inventory, sales divided by cash from sales, sales divided by account receivables, and sales divided by unearned revenues. The raw ratios represent material based on changes from year to year. P.F. Chang s will be compared to the rest of its competitors in the industry to see where they company lies in terms distorting financial items. This will also show us how big or small the changes are from year to year within each company. The sales manipulation diagnostics are presented below in raw and in change form. 108 Page

109 Net Sales/Cash from Sales From this ratio, analysts can evaluate the performance in the collections of accounts receivable. This can be seen by dividing the amount of sales made by the actual cash received for performing these obligations. In the restaurant industry, with the small amount of accounts receivable, this ratio is always going to be close to one and will not ever have a very large variance. This is because in serving food to customers there are no long-term obligations involved. With a constant ratio of one, we did not feel that the change form ratio was necessary. 109 Page

110 P.F. Chang s Chipotle Cheesecake Factory O'Charley s Industry Average Net Sales/Inventory (raw) The first ratio computed measures the generated sales of each firm compared to the total amount of inventory on hand for that specific period. A firm would benefit the most if its inventory is low and the sales generated are high. This means the company is utilizing its inventory and getting rid of it more quickly. This ratio better analyzes inventory turnover and how quick a firm can get their inventory in and out of the door. The chart below represents the following ratio: 110 Page

111 P.F. Chang's Bistro Cheesecake Factory O'Charley's Chipotle Mexican Grill Industry Average This analysis indicates that there is a constant turnover rate for the firms. They all stay around the same area, not jumping much from year to year. P.F. Chang s and Chipotles by far have the best ratios. This means that they do a better job turning over their inventory after ordering it. Although the industries are pretty constant in the ratio levels, there is an upward sloping trend from 2006 to 2007 and 2008 to The industry as a whole, little by little, is becoming more efficient at turning over their inventory on hand. In addition, since P.F. Chang s ratio is so high, this could be a potential red flag in terms of the managers overstating their revenues in 2007 and 2008, and possibly understating their return in 2009 due to the economic downturn. Net Sales/Inventory (Change) Along with the raw ratio, we have conducted a ratio that relates the change in sales revenue from year to year to the inventory for that period. The size of the ratio does not become a factor, only the sign changes for each company relates to the manipulation of the financial statements. 111 Page

112 P.F. Chang's Bistro Cheesecake Factory O'Charley's Chipotle Mexican Grill Industry Average P.F. Chang s Bistro showed no sign changes, which could mean they have no potential red flags causing distortions in there accounting standards. For the rest of the industry, no real potential red flags come up except for O Charley s in 2007, 2008, and 2009, which could have been due to an increase in revenues with a drop in inventory. Overall, the industry has sustained a positive change in terms of sales and inventory for the past five years. 112 Page

113 Net Sales/Net Account Receivables This ratio is a very important ratio in terms measuring if the company is collecting their money from revenues generated through that period. If the company cannot collect their accounts receivables in a timely manner then their cash received from their revenues generated decreases causing the ratio to be very low. A firm would typically like to be paid in cash at the point of sale rather than collect the money at a future date. If a company can collect their receivables in a timely manner, than that account decreases causing an increase in the overall ratio. P.F. Chang s Bistro does not have an account for receivables so the sales that they generate are all comprised of cash at the time of sale. Gift cards are the only source of accounts receivables for P.F. Chang s, but the way they account for this item is through operating costs of the firm. The amount is not material enough for the firm to contribute a line item on the financial statements, so therefore the ratio will not be included below. Net Sales/Unearned Revenues The ratio of net sales to unearned revenues measures how much of the service or product has been earned in terms of total sales accumulated through the year. If the service provided has not yet earned its money through the year, then the amount unearned is listed as a liability on the balance sheet. The more money that has been earned relative to the total amount of sales leads to a reduced ratio, which shows the company has collected money for the service or product they provided. The more unearned revenue the company has means more liability, which drives the ratio up leading to a possible overstatement of net sales. P.F. Chang s was the only company listed that had an item for unearned revenues for the past five years. The chart is shown below. 113 Page

114 The ratio is decreasing from 2005 to 2009, which shows the company could possibly be understating their revenues to make the firm look better in the long run. Since the economy has been in a downfall for the past several years, the understating of revenues decreases retained earnings, lowering the overall net income for that period. This could be a potential red flag for P.F. Chang s. The rest of the industry does not have an account for unearned revenues; therefore, no comparisons will be made. 114 Page

115 Net Sales/Unearned Revenues (change) The change form of the ratio will indicate if there are any possible red flags for the company over the past five years. There were no sign changes for P.F. Chang s Bistro, which shows that there are no possible concerns resulting from the data. The size of the ratio does not come into effect all we are looking for is a negative sign change where there is not a direct correlation between sales and unearned revenues. If more sales occur, there should be more unearned revenue to match the difference. Vice versa, if sales decrease for a period, than so should the unearned revenues section describing that the firm has collected more money over the year for the services performed. Based on the above results, P.F. Chang s does not have any concerns for potential red flags regarding sales and unearned revenues. The other companies in the industry did not accumulate unearned revenues on their financial statements, therefore they were not calculated. 115 Page

116 Net Sales/Warranty Liabilities In the ratio of net sales to warranty expense, the computation is comprised of dividing net sales by warranty expense. This ratio tells analysts and investors the amount of warranties expensed with relation to the total sales of the company. If this ratio is high then the liability of a firm s product down the road is very low. This is because if the ratio is high then larger amounts of sales can be made with no warranty expense. If the ratio is low, then the probability that a firm will be using more warranty expense is greater because it does not take a significant amount of sales before warranties would need to be expensed. In the restaurant industry, with no long-term products, most firms will have little to no warranty expense. This is due to the fact that customers come in to a restaurant, eat their food, and leave. The product has no longterm liabilities to the company. This allows restaurants expenses to be cut down as well. Sales Diagnostics Conclusion There were very few ratios in this section that pertained to P.F. Chang s Bistro. The net sales divided by cash-to-cash ratio is calculated by dividing sales by total cash less accounts receivables. Well since P.F. Chang s does not have accounts receivables, there ratio is a perfect one. The net sales divided by inventory ratio showed that P.F. Chang s had the highest ratio for the past five years. This means that they are getting their inventory in and out the door in a timely manner. The company s ratio was so high that they get their inventory in and out in around a day and a half. That is extremely well. The rest of the industry follows a trend with increasing inventory turnover ratios, so there are no possible concerns or potential red flags. Like stated above, P.F. Chang s does not have account receivables so the next ratio, net sales/accounts receivables, is not calculated for the industry. The net sales/unearned revenue was only calculated for P.F. Chang s, because they are the only company that has that line item. The ratio shows that the company is decreasing for the past few 116 Page

117 years, possibly showing that they are understating their revenues or overstating expenses. The company along with its competitors does not have any warranty liabilities on their financial statements, so that ratio was not performed as well. Expense Manipulation Diagnostics Relative to the sales manipulation diagnostics, which measure the potential effects of distorting net income by changing the amount of sales, expense manipulation diagnostics show how the managers can manipulate net income through changing expenses. Just like overstating sales, understating expenses increases net income and shows the managers have chosen to distort the items on the income statement. On the other hand, managers could have incentives to overstate expenses in order to decrease net income making the financials seem worse than they really are. This is called taking the big bath, so in the long run the company will seem better off than before. The ratios that are involved in the expense manipulation diagnostics include; asset turnover, CFFO divided by OI, CFFO divided by NOA, total accruals divided by change in sales, pension expense divided by SG&A, and other employment expenses divided by SG&A. By comparing P.F. Chang s to other competitors in the industry, we can get a better look at outliers or possible trends in the industry. All ratios will be provided in raw form, to show the changes from year to year, and in a change form, which will show positive or negative sign changes from year to year, which would show potential red flags. The following ratios are performed below: 117 Page

118 Asset Turnover (raw) The ratio is calculated by diving net sales in the current year by total assets in the previous year. If the ratio is low, this indicates that the company is not utilizing their assets to generate greater profits. A high ratio lets us know the company is using the assets provided to better generate sales and increase future profits P.F. Chang's Bistro O'Charley's Cheesecake Factory Chipotle Mexican Grill Industry Average Page

119 Based on the above results there is a correlation between each of the firms in the industry in the sense that they all react to the economy about the same. P.F. Chang s represents the highest asset turnover, which can conclude that they are utilizing their assets well enough to generate profits. This can be from new store openings placed in great locations to increase sales. There are no outliers or drastic changes in the ratio, which can tell us that there are no potential red flags in distorting net income on the financial statements. The slight increase in 2009 for O Charley s could have been due to an overstatement in expenses, therefore driving net income down for the 2009 period. This could potentially lead to a red flag in the financial statements. Asset Turnover (change) The change in asset turnover measures the net sales divided by the change in assets from the previous year. Once again, the size of the ratio is irrelevant, but the sign changes are relevant. When looking at this ratio, the underlining substance is that when increases in sales occur, there should also be increases in assets. 119 Page

120 P.F. Chang's Bistro O'Charley's Cheesecake Factory Chipotle Mexican Grill Industry Average Sign changes in this ratio create possible red flags and distortions on the financial statements. P.F. Chang s showed no negative sign changes, which means it s a good measurement, since they are utilizing their assets well. O Charley s creates a possible red flag when they experienced a year of negative sign changes, beginning with 2006, where they drastically fell off. This can create concerns for the accounting 120 Page

121 practices that are taken into effect at that company. This states that O Charley s could have understated their expenses for the period, causing the ratio to have a drastic decrease in value. P.F. Chang s still maintained an industry trend with no outliers or possible red flags. CFFO/OI (raw) Cash flow from operations divided by operating income measures the amount of income the firm is generating compared to the total amount of cash collected during that period. Since operating income has many line items including most expenses, it is a valid measurement to figure the amount of income brought in by the operating activities. 121 Page

122 P.F. Chang's Bistro Cheesecake Factory O'Charley's Chipotle Mexican Grill Industry Average Except for O Charley s, all the other firms in the industry do not show very many changes that would raise a potential red flag. Every company for the most part maintains a relatively high ratio providing more cash from the operating income section on the income statement. O Charley s experienced a negative operating income in 2008 that drastically brought the ratio way down. This was caused by a $93 million goodwill impairment charge. P.F. Chang s had no years of outliers or potential red flags for the raw form. CFFO/OI (change) When taking the change form of the CFFO divided by OI ratio, we can better establish results for firms with potential red flags. The key differences we are looking for are when the ratio dips negative for a period or periods. The ideal scenario is when cash flows increase, so should the operating income for the same period. 122 Page

123 P.F. Chang's Bistro Cheesecake Factory O'Charley's Chipotle Mexican Grill Industry Average P.F. Chang s Bistro raises some concern for their first three years because they all have negative ratios, which mean that for the cash flow from operations decreased while operating income increased. This states that P.F. Chang s could have understated their expenses leading to an increases operating income. Cheesecake Factory and Chipotle Grill experienced an increase in ratio for the years 2007 and This could be due to an overstatement of expenses ultimately driving operating income down and cash flow from operations up. 123 Page

124 CFFO/NOA (raw) Cash flow from operations divided by net operating assets presents how well the company is using its plant, property, and equipment to generate cash flows for the company. If the assets are not depreciated as needed, then the ratio will be much smaller then what the company would like to have. This also indicates that a company may be understating its expenses and therefore driving the ratio downwards P.F. Chang's Bistro Cheesecake Factory O'Charley's Chipotle Mexican Grill Industry Average Page

125 Based on the above values, there is an industry trend between the companies and no possible outliers exist or cause concern for potential red flags. Although they do show a slight upward trend possible overstating their expenses, the industry is increasing as a whole, so no possible threats occur. CFFO/NOA (change) In the change form of the ratio, the companies have still maintained a trend within the industry and no real possible outliers exist. Each company did experience at least one year of negative sign changes, which result from an unexpected decrease in the ratio due to an understatement in expenses for that period. This also says that for a negative sign change, assets are increasing relative to the cash flows from operations decreasing. 125 Page

126 P.F. Chang's Bistro Cheesecake Factory O'Charley's Chipotle Mexican Grill Industry Average In 2006, O Charley s experienced a huge decrease in their ratio leading to a large amount of assets that was not written off during that period and not enough cash brought in from operating activities. Besides O Charley s the rest of the industry possesses no concerns for distorting items on the financial statements. Total Accruals/Sales (raw) The next ratio, total accruals divided by sales represents how much or if the total amount of accruals is supported by sales from the firm. This ratio will also indicate any distortions on the financial statements relevant to these two items. The ratio is calculated by subtracting net income from cash from operations to get total accruals. Then divide that amount by total sales for the period and the ratio is complete. Any increases in the ratio are explained by overstating expenses, and a sudden decrease in the ratio indicates the company intended on understating their expenses for that period. The reason being is that if there is a sudden decrease, then sales are decreasing faster than total accruals. If this is the case, then a firm must be understating expenses. The chart and graph representing the ratio are shown below: 126 Page

127 P.F. Chang's Bistro Cheesecake Factory O'Charley's Chipotle Mexican Grill Industry Average Based on the above results, once again the industry for the most part has kept a certain trend in regards to the ratio. This poses no possible concerns and includes no outliers for the industry. P.F. Chang s Bistro has maintained a consistent ratio for the past five years, while O Charley s has once again experience a negative ratio in This can be caused by a sudden decrease in net income for The company had a negative income for that period so the total accruals were not supported by the sales coming in for the company. For the rest of the industry, the companies have controlled 127 Page

128 a steady ratio for the past five years, which means their company has accumulated enough sales to support its total accruals. Total Accruals/Sales (change) The change form of the above ratio will indicate if the firm s total accruals are supported by the total sales for each period. There should be a direct correlation between the two items in terms of if one increase, the other should increase with it and vice versa. If there is not a direct correlation between the two values, the ratio results in a negative number raising a potential red flag for that period. The results are presented below: 128 Page

129 P.F. Chang's Bistro Cheesecake Factory O'Charley's Chipotle Mexican Grill Industry Average Based on the above results, there is still an industry trend just like the raw form of the ratio. P.F. Chang s had a negative ratio in 2005, but very slight compared to the decrease by O Charley s and Cheesecake Factory. This indicated that these two companies understated their expenses for 2008 and 2009 resulting in a decreased ratio, which means they could possibly be understating their expenses. Chipotle and P.F. Chang s consistently held a positive ratio for the past four years and maintained their industry trend just as in the raw form of the ratio. For the other two companies there could be some possible concerns in terms of distorting their financial data for 2008 and Pension Expense/SG&A The pension expense diagnostic ratio measures how much of the firms money is going to employment pension plans or sales, general, and administration expenses. This can provide information to investors and analysts to what the company does with some of its free cash. An increase in the ratio indicates that the firm might be understating their expenses for the year. If a sudden decrease in the ratio occurs, then that could pose a possible red flag for the company overstating their expenses. P.F. Chang s Bistro has a defined contribution plan also known as a 401-K. This allows the firm to benefit from expensing their money into a pension plan of defined benefit plan. Therefore, we will not need to calculate a ratio for the rest of the competitors. 129 Page

130 Other Employment Expenses/SG&A This ratio is the last of the expense diagnostic ratios, and it measures the other employment benefit costs other than the ratio above. It is then also divided by sales, general, and administrative expenses. Once again, there are no expenses that P.F. Chang s provided for their employees benefit plans, therefore we will not need to construct a ratio analysis for the rest of the industry. Expense Diagnostics Conclusion After performing all the expense ratios listed above, P.F. Chang s showed consistency in terms of flowing with the industry trend. The first ratio calculated was the asset turnover ratio, which P.F. Chang s showed the highest ratio and provided no signs of potential red flags for sudden increases or decreases. The next ratio was CFFO divided by OI, which provided information that P.F. Chang s had shown some slight increases in ratio size, but not enough to raise concerns. The change form of the ratio showed three negative sign changes, which could show the company understated their sales for three years. The CFFO divided by NOA ratio was calculated next. This ratio provided the best results in which every company performed great results and all followed an industry trend for the past five years. No possible concerns or potential red flags were found. Total accruals divided by Sales, showed that P.F. Chang s can maintain their accruals in regards to their sales. Once again no possible threats occurred. P.F. Chang s only showed one ratio that raised concerns for potential red flags and could be do due an understatement of expenses for those years. 130 Page

131 Identify Potential Red Flags Red flags are indicators within the financials of a firm that should be thoroughly checked out. Just because a company has a few red flags does not mean that it is doing anything illegal, however it should raise some concerns from an investor s point of view. Red flags are a variety of different things that are usually unexplained or unusual. Red flags range anywhere from unusual increases in inventories in relation to sales, to large fourth quarter adjustments. All the numbers are given in the 10-K of the firms to scan for these problems. Once found, it is important to go through and restate the distorted balances. Investors will have a much clearer picture of the value of the company after they have been restated. P.F. changes has a few red flags in the change form, Operating Leases When a firm is very aggressive with its operating lease accounting, a few distortions are created. If the sum of the present value of future lease payments is larger than 10 percent of long-term debt, then the company is reporting inaccurate information. In this case, they are understating their liabilities by capitalizing the leases. The next step after calculating that it is above 10 percent is to restate the financials. 131 Page

132 Operating Leases % % % % % The chart above provides the calculation of the sum of present value of future lease payments is larger than 10 percent of long-term debt. P.F. Chang's will need to restate the financials to accurately evaluate the company s financial position compared to their competitors. Even though P.F. Chang's is well over the allotted 10 percent marker, it is comparable to their competitors Lease % by Type Cheesecake P.F. Chang's Factory Chipotle O'Charley's Operating Lease 99.17% % % 94.93% Capital Lease 0.83% 0.00% 0.00% 0.05% 132 Page

133 On top of the firm being over the 10 percent marker, P.F. Chang s also uses 99 percent operating leases over capital leases. This is a very alarming number with the 10 percent marker exceeded, which is a large red flag. As indicated in the second chart, the four companies use 94 to 100 percent operating leases. P.F. Chang's is in need of restating the financials due to the significant amount of liability left off the books with the firms aggressive stance on operating leases. Undoing Accounting Distortions After all the potential red flags have been identified, the next step is to take the financial statements and sort out what is junk and restate through trial balances. This allows investors and analysts to see the clear picture of the statements and not distorted ones. By restating the financials, one can better understand where certain items should belong and to the correct amount. From the section above, there is only one distortive item on P.F. Chang s financial statements and that is operating leases. Since the operating leases have not been capitalized, the liabilities are understated and no leases have been expensed. The following amortization tables below will give a more clear view of how operating leases should be capitalized. Operating Leases Operating leases are a distortive item on P.F. Chang s Bistro financial statements. Operating leases should be capitalized and turned into assets, but the company does not account for these expenses, so the liabilities are understated. It shows that P.F. Chang s takes advantage of the amount of flexibility given by not capitalizing their leases. In order for any investor fully understand the nature of the business and where they stand in the industry, a direct and clear picture should be made with the financial statements. Restating the financial in terms of operating leases requires the firm to capitalize their fixed assets. The liabilities and assets are taken into account and formed by the 133 Page

134 present value of all future payments to the lease. The firm should recognize expenses for that period and take into account those costs each year. A discount rate is also involved with capitalizing leases, and since P.F. Chang s does not have capital leases, there is not a set discount rate used. The discount rate or cost of debt we used for our amortization was based off the present target value in which we would adjust the interest rate each year more or less. The estimated future life of the capitalized leases was 8, 9, and 10 years. The discount rate used was on average 11.5%. Provided all this information, below represents the amortization tables and includes the overall amount to capitalize lease agreements. 134 Page

135 2005 (In Thousands of Dollars) Interest Rate 11.5% PV Change in Total CL Year Period Payment FACTOR pv payment Period BB Interest Payment EB Loan Depreciation Expense $ 23, $ 21, $ 164, $ 18, $ 23,680 $ 159, $ 4, $ 2,368 $ 21, $ 28, $ 22, $ 159, $ 18, $ 28,360 $ 149, $ 10, $ 2,368 $ 20, $ 30, $ 21, $ 149, $ 17, $ 30,017 $ 136, $ 12, $ 2,368 $ 19, $ 29, $ 19, $ 136, $ 15, $ 29,605 $ 122, $ 13, $ 2,368 $ 18, $ 29, $ 17, $ 122, $ 14, $ 29,600 $ 106, $ 15, $ 2,368 $ 16, $ 29, $ 15, $ 106, $ 12, $ 29,265 $ 89, $ 16, $ 2,368 $ 14, $ 29, $ 13, $ 89, $ 10, $ 29,265 $ 70, $ 18, $ 2,368 $ 12, $ 29, $ 12, $ 70, $ 8, $ 29,265 $ 49, $ 21, $ 2,368 $ 10, $ 29, $ 10, $ 49, $ 5, $ 29,265 $ 26, $ 23, $ 2,368 $ 8, $ 29, $ 9, $ 26, $ 3, $ 29,265 $ 0.73 $ 26, $ 2,368 $ 5, (In Thousands of Dollars) Interest Rate 11.7% PV Change in Total CL Year Period Payment FACTOR pv payment Period BB Interest Payment EB Loan Depreciation Expense $ 17, $ 16, $ 188, $ 22, $ 17,913 $ 192, $ (4,167.24) $ 1,791 $ 23, $ 37, $ 29, $ 192, $ 22, $ 37,079 $ 178, $ 14, $ 1,791 $ 24, $ 37, $ 27, $ 178, $ 20, $ 37,725 $ 161, $ 16, $ 1,791 $ 22, $ 37, $ 24, $ 161, $ 18, $ 37,480 $ 142, $ 18, $ 1,791 $ 20, $ 36, $ 21, $ 142, $ 16, $ 36,929 $ 122, $ 20, $ 1,791 $ 18, $ 33, $ 17, $ 122, $ 14, $ 33,795 $ 103, $ 19, $ 1,791 $ 16, $ 33, $ 15, $ 103, $ 12, $ 33,795 $ 81, $ 21, $ 1,791 $ 13, $ 33, $ 13, $ 81, $ 9, $ 33,795 $ 57, $ 24, $ 1,791 $ 11, $ 33, $ 12, $ 57, $ 6, $ 33,795 $ 30, $ 27, $ 1,791 $ 8, $ 33, $ 11, $ 30, $ 3, $ 33,795 $ (0.68) $ 30, $ 1,791 $ 5, Page

136 2007 (In Thousands of Dollars) Interest Rate 14.0% PV Change in Total CL Year Period Payment FACTOR pv payment Period BB Interest Payment EB Loan Depreciation Expense $ 42, $ 37, $ 208, $ 29, $ 42,242 $ 195, $ 13, $ 4,224 $ 33, $ 43, $ 33, $ 195, $ 27, $ 43,479 $ 179, $ 16, $ 4,224 $ 31, $ 43, $ 29, $ 179, $ 25, $ 43,776 $ 160, $ 18, $ 4,224 $ 29, $ 43, $ 25, $ 160, $ 22, $ 43,319 $ 140, $ 20, $ 4,224 $ 26, $ 42, $ 22, $ 140, $ 19, $ 42,462 $ 117, $ 22, $ 4,224 $ 23, $ 34, $ 15, $ 117, $ 16, $ 34,141 $ 99, $ 17, $ 4,224 $ 20, $ 34, $ 13, $ 99, $ 13, $ 34,141 $ 79, $ 20, $ 4,224 $ 18, $ 34, $ 11, $ 79, $ 11, $ 34,141 $ 56, $ 23, $ 4,224 $ 15, $ 34, $ 10, $ 56, $ 7, $ 34,141 $ 29, $ 26, $ 4,224 $ 12, $ 34, $ 9, $ 29, $ 4, $ 34,141 $ 0.14 $ 29, $ 4,224 $ 8, (In Thousands of Dollars) Interest Rate 14.0% PV Change in Total CL Year Period Payment FACTOR pv payment Period BB Interest Payment EB Loan Depreciation Expense $ 48, $ 42, $ 215, $ 30, $ 48,053 $ 197, $ 17, $ 5,339 $ 35, $ 48, $ 37, $ 197, $ 27, $ 48,411 $ 176, $ 20, $ 5,339 $ 32, $ 47, $ 31, $ 176, $ 24, $ 47,070 $ 154, $ 22, $ 5,339 $ 30, $ 45, $ 27, $ 154, $ 21, $ 45,852 $ 129, $ 24, $ 5,339 $ 26, $ 42, $ 22, $ 129, $ 18, $ 42,706 $ 105, $ 24, $ 5,339 $ 23, $ 36, $ 16, $ 105, $ 14, $ 36,115 $ 83, $ 21, $ 5,339 $ 20, $ 36, $ 14, $ 83, $ 11, $ 36,115 $ 59, $ 24, $ 5,339 $ 17, $ 36, $ 12, $ 59, $ 8, $ 36,115 $ 31, $ 27, $ 5,339 $ 13, $ 36, $ 11, $ 31, $ 4, $ 36,115 $ (0.26) $ 31, $ 5,339 $ 9, Page

137 2009 (In Thousands of Dollars) Interest Rate 13.9% PV Change in Total CL Year Period Payment FACTOR pv payment Period BB Interest Payment EB Loan Depreciation Expense $ 49, $ 43, $ 205, $ 28, $ 49,635 $ 184, $ 21, $ 6,204 $ 34, $ 48, $ 37, $ 184, $ 25, $ 48,774 $ 160, $ 23, $ 6,204 $ 31, $ 47, $ 32, $ 160, $ 22, $ 47,410 $ 135, $ 25, $ 6,204 $ 28, $ 44, $ 26, $ 135, $ 18, $ 44,008 $ 110, $ 25, $ 6,204 $ 25, $ 38, $ 20, $ 110, $ 15, $ 38,833 $ 87, $ 23, $ 6,204 $ 21, $ 37, $ 17, $ 87, $ 12, $ 37,585 $ 61, $ 25, $ 6,204 $ 18, $ 37, $ 15, $ 61, $ 8, $ 37,585 $ 32, $ 28, $ 6,204 $ 14, $ 37, $ 13, $ 32, $ 4, $ 37,585 $ 0.68 $ 32, $ 6,204 $ 10, Page

138 138 Page

139 Financial Statements The financial statements of a company are released to show the health of the company. However, many companies utilize loopholes within the GAAP structure to inflate the net income of the company. In order to truly value a company, loopholes need to be scrutinized and the financials should be restated in order to reflect the accounting distortions, if any. Below are the Balance Sheets and Income Statements for P.F. Chang s from 2005 through 2009, as obtained from the required S.E.C. annual filings. In order to evaluate the potential distortions and restate the balance sheet and income statement, a trial balance was used, which can be found in the tables at the end of this report. A trial balance is an exceptionally useful tool when preparing the adjustments. The trial balance allows one to input current financial data, enter any adjustments, and ensure that the debit and credit accounts line up accordingly (balance out). The trial balance found in the tables at the end of this report contains the as-stated financial information for years 2005 to 2009, any adjustments for goodwill, research and development, and operating leases, the restated financial information after adjustments, and any carryover amount as a result of these adjustments. Analysis of P.F. Chang s annual reports showed significant use of operating leases, no use of research and development, and a small amount of goodwill. Upon ratio analysis, it was found that the ratio of goodwill over property, plant, and equipment was consistently fewer than 2%, leading to the conclusion of goodwill being immaterial to the overall financial statements, and thus does not need to be adjusted. However, due to the significant use and large dollar amount, operating leases were determined to be distortive to the financial statements, and thus have been adjusted in the trial balance, and accounted for in the restated financials, as follows. 139 Page

140 Balance Sheet The balance sheet is a statement of a company s assets, liabilities, and stockholder s equity, and displays the overall financial position of a company at that particular moment in time. The following balance sheet financial information reflects the as stated numbers and the adjusted numbers from Fiscal Year End 2005 to The changes in values can be attributed to the distortion of numbers due to the use of operating leases. The first item that must be forecasted on the balance sheet is total assets. We used net sales over total assets, which is the asset turnover ratio. After we calculated the asset turnover ratio, we used it to forecast future total assets as a ratio of total sales. It is very important to accurately forecast sales, because it is the driving factor used to forecast everything else on the balance sheet. We used a five-year period and averaged the asset turnover ratio. We found the average ratio is The next item that we forecasted on the balance sheet was the current assets. We forecasted current assets by subtracting non-current assets from our already forecasted current assets. To forecast our non-current assets, we multiplied total assets by a constant 85.4%. We found that 85.4% was the proper value to use because the value of non-current assets over the past five years has been around that value. The next step was forecasting long-term assets. GAAP states that total assets equals current assets plus long-term assets. Using this model, we subtracted are already forecasted current assets from our forecasted total assets to forecast long-term assets. Next, we forecasted the line items in the balance sheet, which include property plant and equipment (PP&E), inventory, and goodwill. We used ratios to forecast PP&E and inventory. Goodwill was just a constant value over the past five years, so we used that value for the forecast. Our inventory turnover ratio average was 60. We used this 140 Page

141 to forecast inventory for the proceeding years. Next, we used property plant and equipment turnover to forecast PP&E. We took forecasted revenues from the income statement and divided it by property plant and equipment turnover ratio. We found property plant and equipment turnover ratio to be Next, we forecasted current liabilities. We used the current ratio of.60 to find current liabilities. We took the total current assets and divided it by the current ratio. Stockholders equity was forecasted by taking 2009 s stockholders equity and adding 2010 s net income and then subtracting dividends for The dividends were forecasted by using a set rate of 45 percent of NI. We know this isn t typical, but it has been stated in a couple of conference calls that this is how the firm will compute future and current dividends. After finding total current liabilities and stockholders equity, we could forecast total liabilities. We found our total long-term liabilities by subtracting total current liabilities and stockholders equity from assets. After calculating long-term liabilities, we just added long-term liabilities to current liabilities to get our total liabilities. 141 Page

142 142 Page

143 As Stated Figures Balance Sheet (In Thousands) Assets Current assets: Cash and cash equivalents $ 31,948 $ 31,589 $ 24,055 $ 40,951 $ 63,499 Short term investments $ 34,150 $ $ $ $ Restricted short term investments $ 8,260 $ $ $ $ Inventories $ 3,461 $ 4,232 $ 4,649 $ 4,930 $ 5,291 Prepaid and other current assets $ 15,957 $ 28,995 $ 32,552 $ 51,643 $ 38,449 Total current assets $ 93,776 $ 64,816 $ 61,256 $ 97,524 $ 107,239 Capitalized Leased Assets Rights $ $ $ $ $ Property and equipment, net $ 345,864 $ 421,770 $ 520,145 $ 524,004 $ 497,928 Deferred income tax assets $ 1,938 $ $ $ Goodwill $ 6,819 $ 6,819 $ 6,819 $ 6,819 $ 6,819 Intangible assets, net $ $ 12,644 $ 22,004 $ 24,270 $ 22,241 Other assets $ 18,265 $ 7,996 $ 12,406 $ 14,746 $ 17,923 Total Non Current Assets $ 372,886 $ 449,229 $ 561,374 $ 569,839 $ 544,911 Total assets $ 466,662 $ 514,045 $ 622,630 $ 667,363 $ 652,150 LIABILITIES AND COMMON STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ 13,850 $ 15,255 $ 17,745 $ 15,203 $ 19,825 Construction payable $ 6,463 $ 9,075 $ 11,319 $ 4,358 $ 1,600 Accrued expenses $ 40,864 $ 55,848 $ 59,259 $ 71,162 $ 77,088 Unearned revenue $ 15,281 $ 18,226 $ 25,346 $ 31,115 $ 35,844 Current portion of long term debt $ 5,110 $ 5,487 $ 6,932 $ 5,753 $ 41,236 Total current liabilities $ 81,568 $ 103,891 $ 120,601 $ 127,591 $ 175,593 Long term debt $ 5,360 $ 13,723 $ 90,828 $ 82,496 $ 1,212 Capitalized Leases Liabilities $ $ $ $ $ Lease obligation $ 55,991 $ 71,682 $ 93,435 $ 113,178 $ 116,547 Other Liabilities $ $ 1,909 $ 6,710 $ 14,691 $ 18,488 Minority interests $ 29,845 $ 33,315 $ 17,169 $ 8,581 $ 4,961 Total Non Current Liabilities $ 91,196 $ 120,629 $ 208,142 $ 218,946 $ 141,208 Total Liabilities $ 172,764 $ 224,520 $ 328,743 $ 346,537 $ 316,801 Common stockholders equity: Common stock, $.001 par value, 40,000,000 shares authorized* (see note) $ 26 $ 27 $ 27 $ 27 $ 28 Additional paid in capital $ 165,355 $ 174,101 $ 196,385 $ 206,667 $ 217,181 Treasury Stock* (see note) $ $ (46,373) $ (96,358) $ (106,372) $ (146,022) Other Comprehensive Loss $ $ $ $ (755) $ (294) Retained earnings $ 128,517 $ 161,770 $ 193,833 $ 221,259 $ 264,456 Total common stockholders equity $ 293,898 $ 289,525 $ 293,887 $ 320,826 $ 335,349 Total liabilities and common stockholders equity $ 466,662 $ 514,045 $ 622,630 $ 667,363 $ 652,150 Common Stock Outstanding 26,397,366 25,373,019 24,151,888 24,114,107 22,911,054 Treasury stock 1,397,261 3,240,943 3,634,979 5,064, Page

144 Restated Figures Balance Sheet (In Thousands) Assets Current assets: Cash and cash equivalents $ 31,948 $ 31,589 $ 24,055 $ 40,951 $ 63,499 Short term investments $ 34,150 $ $ $ $ Restricted short term investments $ 8,260 $ $ $ $ Inventories $ 3,461 $ 4,232 $ 4,649 $ 4,930 $ 5,291 Prepaid and other current assets $ 15,957 $ 28,995 $ 32,552 $ 51,643 $ 38,449 Total current assets $ 93,776 $ 64,816 $ 61,256 $ 97,524 $ 107,239 Capitalized Leased Assets Rights $ 164,014 $ 164,826 $ 189,762 $ 194,291 $ 200,166 Property and equipment, net $ 345,864 $ 421,770 $ 520,145 $ 524,004 $ 497,928 Deferred income tax assets $ 1,938 $ $ $ Goodwill $ 6,819 $ 6,819 $ 6,819 $ 6,819 $ 6,819 Intangible assets, net $ 12,644 $ 22,004 $ 24,270 $ 22,241 Other assets $ 18,265 $ 7,996 $ 12,406 $ 14,746 $ 17,923 Total Non Current Assets $ 536,900 $ 614,055 $ 751,136 $ 764,130 $ 745,077 Total assets $ 630,676 $ 678,871 $ 812,392 $ 861,654 $ 852,316 LIABILITIES AND COMMON STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ 13,850 $ 15,255 $ 17,745 $ 15,203 $ 19,825 Construction payable $ 6,463 $ 9,075 $ 11,319 $ 4,358 $ 1,600 Accrued expenses $ 40,864 $ 55,848 $ 59,259 $ 71,162 $ 77,088 Unearned revenue $ 15,281 $ 18,226 $ 25,346 $ 31,115 $ 35,844 Current portion of long term debt $ 5,110 $ 5,487 $ 6,932 $ 5,753 $ 41,236 Total current liabilities $ 81,568 $ 103,891 $ 120,601 $ 127,591 $ 175,593 Long term debt $ 5,360 $ 13,723 $ 90,828 $ 82,496 $ 1,212 Capitalized Leases Liabilities $ 164,014 $ 176,410 $ 212,801 $ 202,121 $ 206,141 Lease obligation $ 55,991 $ 71,682 $ 93,435 $ 113,178 $ 116,547 Other Liabilities $ 1,909 $ 6,710 $ 14,691 $ 18,488 Minority interests $ 29,845 $ 33,315 $ 17,169 $ 8,581 $ 4,961 Total Non Current Liabilities $ 255,210 $ 297,039 $ 420,943 $ 421,067 $ 347,349 Total Liabilities $ 336,778 $ 400,930 $ 541,544 $ 548,658 $ 522,942 Common stockholders equity: Common stock, $.001 par value, 40,000,000 shares authorized* (see note) $ 26 $ 27 $ 27 $ 27 $ 28 Additional paid in capital $ 165,355 $ 174,101 $ 196,385 $ 206,667 $ 217,181 Treasury Stock* (see note) $ (46,373) $ (96,358) $ (106,372) $ (146,022) Other Comprehensive Loss $ (755) $ (294) Retained earnings $ 128,517 $ 150,186 $ 170,794 $ 213,429 $ 258,481 Total common stockholders equity $ 293,898 $ 277,941 $ 270,848 $ 312,996 $ 329,374 Total liabilities and common stockholders equity $ 630,676 $ 678,871 $ 812,392 $ 861,654 $ 852,316 Common Stock Outstanding 26,397,366 25,373,019 24,151,888 24,114,107 22,911,054 Treasury stock 1,397,261 3,240,943 3,634,979 5,064, Page

145 Balance Sheet Restatement Evaluation The as-stated and restated balance sheets shown above highlight the distortions that are caused by the use of operating leases. By reclassifying operating leases under capitalized leases, net capitalized lease asset rights increases, capitalized lease liabilities increases, and retained earnings decreases. By capitalizing the operating leases, an increase in assets and liabilities was recognized on the restated balance sheet. For the years , the total amount of assets, liabilities and owner s equity reported on the balance sheet increased by $164,014, $164,826, $189,762, $194,291, and $200,166, respectively (stated numbers are in thousands). This increase can be attributed to the differences in the accounting for leases. By capitalizing the operating leases, the balance sheets were altered to show the lease asset rights as well as the future lease liabilities, as well as the decrease in retained earnings due to the decrease in net income. The restated net income showed that P.F. Chang s was overstated by a cumulative amount of $48,428, from 2005 to They didn t overstate 2005, however, 2006 was overstated by $11,584.00, 2007 by $23,039,000.00, 2008 by $7,830,000.00, and 2009 by $5,975, Page

146 Income Statement The income statement shows a company s revenues and expenses for a particular year. The income statement is a valuable tool, which shows the overall profitability of the firm for a particular year. The income statement is closed out every year into the permanent retained earnings account, which means that at the beginning of every year, the values in the income statement begin at zero. When we calculated the income statement forecast, we first found the sales. This is the most important part of forecasting the income statement, because every other forecast falls in place behind it. P.F. Chang s has a constant growth in sales from 2004 to We took this into account when forecasting future sales. We also took into account the recession. After weighing the factors, we came up with a constant growth rate of sales over the next ten years. For the first four we have an increase of 1.06% for 2010, 3.08% for 2011, 5.00% for 2012, and a 7.05% for For the next six years we used a constant rate of 10.00% increase in sales. To calculate our future forecasts after we found our growth rate, we take the previous year s sales and multiply them by one plus the growth rate. This gave us our future forecasted sales. The next step we took was to forecast cost of goods sold. We had a constant cost of goods sold percentage of sales of around 27.00%. We decided to use 27.07%. We then multiplied the 27.07% by each year of forecasted sales to find the forecasted cost of goods sold. Next, we forecasted gross profit. To do this we took our forecasted sales and forecasted cost of goods sold. With the equation sales cogs = gross profit, we forecasted out our gross profit. 146 Page

147 Next, we forecasted operating income. We did this by subtracting selling, administrative, and impairment expenses from gross profit. Finally, we forecasted our future net income. To find this we found our net profit margin over the last six years. We decided on a profit margin of 3.7%. We decided on this number because for three consecutive years, this margin has fallen. With the recession still in full affect, we figured it is likely it will decrease next year. We held this profit margin constant for the remainder nine years. To find net income, we took the profit margin of 3.7% and multiplied it by the current years forecasted sales. 147 Page

148 As Stated Figures Income Statement (In Thousands) Revenues $ 809,153 $ 937,606 $ 1,092,722 $ 1,198,124 $ 1,228,179 Costs and expenses: Restaurant operating costs: Cost of sales $ 224,634 $ 256,582 $ 299,713 $ 325,630 $ 326,421 Labor $ 267,681 $ 310,113 $ 368,059 $ 396,911 $ 401,583 Operating $ 122,742 $ 146,409 $ 173,993 $ 198,967 $ 203,859 Occupancy $ 42,793 $ 52,457 $ 63,111 $ 69,809 $ 70,635 Total restaurant operating costs $ 657,850 $ 765,561 $ 904,876 $ 991,317 $ 1,002,498 General and administrative $ 39,181 $ 56,911 $ 66,968 $ 77,488 $ 82,749 Capitalized Operating Lease Expense $ $ $ $ Depreciation of Capitalized Leases $ $ $ $ Depreciation and amortization $ 36,950 $ 44,863 $ 56,832 $ 68,711 $ 74,429 Preopening expense $ 9,248 $ 12,713 $ 14,983 $ 8,457 $ 3,919 Partner investment expense $ 4,800 $ 4,371 $ (2,012) $ (354) $ (629) Total Costs and Expenses $ 748,029 $ 884,419 $ 1,041,647 $ 1,145,619 $ 1,162,966 Income from operations $ 61,124 $ 53,187 $ 51,075 $ 52,505 $ 65,213 Interest and other income (expense) Interest Expense from Capitalized Leases $ $ $ $ $ Interest expense $ 10 $ 100 $ 3,362 $ 1,637 Interest and other income $ 1,851 $ 1,315 Income before minority interest $ 62,965 $ 54,502 $ 50,975 $ 49,143 $ 63,576 Minority interest $ (8,227) $ (8,116) $ (4,169) $ (1,933) Income before provision for income taxes $ 54,738 $ 46,386 $ 46,806 $ 47,210 $ 63,576 Provision for income taxes $ 16,942 $ 13,133 $ 11,563 $ 12,193 $ 18,492 Income from Continuing Operations $ 37,796 $ 33,253 $ 35,243 $ 35,017 $ 45,084 Loss from Discontinued Operations, Net of Tax $ $ $ (3,180) $ $ (479) Net income $ 37,796 $ 33,253 $ 32,063 $ 35,017 $ 44, Page

149 Restated Figures Income Statement (In Thousands) Revenues $ 809,153 $ 937,606 $ 1,092,722 $ 1,198,124 $ 1,228,179 Costs and expenses: Restaurant operating costs: Cost of sales $ 224,634 $ 256,582 $ 299,713 $ 325,630 $ 326,421 Labor $ 267,681 $ 310,113 $ 368,059 $ 396,911 $ 401,583 Operating $ 122,742 $ 146,409 $ 173,993 $ 198,967 $ 203,859 Occupancy $ 42,793 $ 52,457 $ 63,111 $ 69,809 $ 70,635 Total restaurant operating costs $ 657,850 $ 765,561 $ 904,876 $ 991,317 $ 1,002,498 General and administrative $ 39,181 $ 56,911 $ 66,968 $ 77,488 $ 82,749 Capitalized Operating Lease Expense $ (23,680) $ (17,913) $ (42,242) $ (48,053) Depreciation of Capitalized Leases $ 16,402 $ 18,872 $ 20,863 $ 23,906 Depreciation and amortization $ 36,950 $ 44,863 $ 56,832 $ 68,711 $ 74,429 Preopening expense $ 9,248 $ 12,713 $ 14,983 $ 8,457 $ 3,919 Partner investment expense $ 4,800 $ 4,371 $ (2,012) $ (354) $ (629) Total Costs and Expenses $ 748,029 $ 877,141 $ 1,042,606 $ 1,124,240 $ 1,138,819 Income from operations $ 61,124 $ 60,465 $ 50,116 $ 73,884 $ 89,360 Interest and other income (expense) Interest Expense from Capitalized Leases $ $ 18,862 $ 22,080 $ 29,209 $ 30,122 Interest expense $ 10 $ 100 $ 3,362 $ 1,637 Interest and other income $ 1,851 $ 1,315 Income before minority interest $ 62,965 $ 42,918 $ 27,936 $ 41,313 $ 57,601 Minority interest $ (8,227) $ (8,116) $ (4,169) $ (1,933) Income before provision for income taxes $ 54,738 $ 34,802 $ 23,767 $ 39,380 $ 57,601 Provision for income taxes $ 16,942 $ 13,133 $ 11,563 $ 12,193 $ 18,492 Income from Continuing Operations $ 37,796 $ 21,669 $ 12,204 $ 27,187 $ 39,109 Loss from Discontinued Operations, Net of Tax $ $ $ (3,180) $ $ (479) Net income $ 37,796 $ 21,669 $ 9,024 $ 27,187 $ 38, Page

150 Income Statement Restatement Evaluation The as-stated income statements and restated income statements show the distortive effects of P.F. Chang s use of operating leases to account for restaurant property. This policy greatly distorts the net income of each progressive year. From 2006 to 2009, net income was overstated in the as-stated income statements by $11,584, $23,039, $7,830 and $5,975, respectively (numbers are in thousands). The overstatement of net income leads to an increase in retained earnings in each accounting period. However, since operating lease s present values are calculated each year, the change in retained earnings does not carry over year-over-year. In the restatement of the income statements, the interest from capitalized leases and the depreciation of capitalized leases is expensed on the income statement, resulting in a lower net income, and, as a result, a decrease in retained earnings. Conclusion The distortions in the as-stated and restated financial statements show the effects of different choices in accounting practices. P.F. Chang s choice to use operating leases rather than capitalized leases allows them to keep lease liabilities off the balance sheet, thus distorting the true amount of liabilities. This distortion of the balance sheet leads to the conclusion that P.F. Chang s is potentially less liquid than it presents itself to be on the balance sheet. The distortion of the income statement is also an important topic, as the use of operating leases leads to the earnings being reported as potentially higher than they are. The restatement of the income statement accounts for extra lease expense and interest expense, and thus decreases overall net income. P.F. Chang s use of operating leases can be attributed to the use of aggressive accounting policies. When operating leases are capitalized, the resulting effect is a reduction in stated net income for the year. This is a more conservative accounting policy, as capitalizing operating leases accounts for lease expense on the 150 Page

151 income statement, rather than off-sheet accounting. The restatement of the financial statements provides a more accurate picture of P.F. Chang s business practices, and allows for a more accurate valuation of the company. For a more detailed look at the restatement of the financials, including how the figures are obtained, please see the table of trial balances, including the adjustments and final figures, attached in the appendices. Financial Analysis, Forecasting, and Estimating Cost of Capital Estimation There are three major steps to complete when evaluating the financial status of a firm. They are financial analysis, forecasting, and estimating the cost of capital. The financial analysis is completed by using various ratios. The ratio analysis can be utilized to determine the firm s value in comparison to its competitors and the industry averages. We will use liquidity, profitability, and capital structure ratios to forecast P.F. Chang s income statement, balance sheet and statement of cash flows. By using these comparisons, we are able obtain a basis for making forecasts of future performance. Forecasting for a firm is when ratios are completed in the financial analysis and add industry intuition, knowledge, and estimations to show the possible future financial status of the firm. Once this is completed, the forecasting is used to estimate the cost of capital. The cost of capital will be estimated by utilizing the Capital Asset Pricing Model, and the cost of dent will be calculated by using the stated interest rates. The before and after tax Weighted Average Cost of Capital will be valued using the cost of debt and cost of equity estimations. After this three-step procedure is complete, we will now have the ability to value the firm s present and future performance amongst its competitors and industry. 151 Page

152 Financial Analysis Financial analysis will allows us to evaluate a firm s financial statements in order to obtain the value of a firm. We will utilize these ratios because they produce smaller and more comparable numbers, which makes it less difficult to draw conclusions about a firm s financial position. Liquidity, profitability, capital structure, and growth rate ratios are the ratios that will be calculated for P.F. Chang s and its competitors within the industry. The liquidity ratios will allow outsiders to measure P.F. Chang s and its competitor s ability to pay off its current liabilities. When computing the profitability ratios, we will able to view P.F. Chang s ability to generate profits compared to expenses in a given period. In terms of capital structure ratios, we will have the ability 152 Page