Kona Grill Inc. is a Scottsdale, Arizona based full service upscale casual dining chain which was founded in 1998 and went public in 2005. By the end of its 16Q3, it owned and operated 42 restaurants in 19 states and Puerto Rico and is laying the foundation for international expansion via a franchising model. Kona Grill restaurants offer a wide variety of freshly prepared American favorites at an affordable price, with an international influence and some 60 sushi items. Favorites include its Macadamia Nut Chicken served with shoyu-cream sauce with parmesan garlic mashed potatoes and seasonal vegetables; Miso-Sake Sea Bass served with shrimp and pork fried rice; and a seasonal vegetable and Pan-Seared Ahi with steamed white rice, baby bok choy and a sweet chili sauce. The company features frequent LTOs from its test kitchens to provide novelty for its regulars and test prospects for its core menu. The dinner daypart constitutes about 50% of revenues, while lunch and late night have contributed about 25% each. The average check is $26, which management believes offers an attractive price/value proposition and compares favorably with its casual dining peers. About 30% of revenues are derived from sales of alcoholic beverages, including slow day traffic drivers such as its 50% discount on bottle wines at its weekly “Wine Down Wednesday.”
The company has grown its restaurants at a 20% annual pace in recent years, about to be reduced materially. The stores average about 7.2K square feet (ranging from 6K to 8.5K square feet), and within their second to fourth years, are expected to achieve AUV’s of $4.5M (~$625/sqft), EBITDA margins of at least 18% to 19% and cash-on-cash returns of at least 31% to 33%. Its restaurants are principally located in high traffic, upscale lifestyle, entertainment and retail centers. All the Kona Grill locations are leased and the cash investment for a new unit is about $2.6M for leasehold improvements (net of landlord allowances ranging $0.7M-$2.2M) and equipment. In addition, cash pre-opening expense is about $450K per unit.
In 2015 the 26 units in the comp base (in operation at least 18 months) averaged $4.506K ($617/square foot) in sales, while all units averaged about $4,450K and EBITDA margins of 16.2%.
The company’s historical rapid growth development strategy aimed to first establish a presence in widely separated markets, backfilling later, rather than spreading outward through adjacent markets. Such a combination of rapid growth and thin penetration has tripped up many emerging chains which have failed to gain brand acceptance outside their home market and/or to put in place the logistics, systems and supervisory infrastructure to support the pace of growth and to manage far flung operations. The often-violent operational volatility typical of even the best of early stage rapid growers makes it difficult to gage a company’s success in meeting growth challenges, and KONA is no exception. On the plus side is the consistency of its cost of sales margins. By this measure , KONA’s TTM cost of sales margins for the last five years have averaged around 26.6%, with a narrow ±37bps band of variance, demonstrating an ability to manage the food costs of a fleet consisting of a high proportion of immature restaurants located in thinly penetrated markets. The company is also making progress in leveraging G&A costs, which had climbed to 9% in 2014 and had dropped to around 8% in 2016 YTD. On the other hand, TTM Payroll costs, averaging 34.0% over the past 5 years have always been 200-300 bps higher than peers, and, more puzzling, have not trended down with growth. In fact, at 36.2% in the TTM to 16Q3 and the 36.9% in Q3 was a record high. Occupancy costs have also been rising steadily as a percent of sales, driven by high rents, currently also at a peak at about 8.6% of revenues.
The Company sees a sizable opportunity for growth internationally and is evaluating a franchise model for that purpose. The company has signed a development agreement in Mexico and the United Arab Emirates, each of which call for development of six restaurants over the next seven years, the first store in each market expected to open in the first half of 2017. In other growth supporting initiatives, the company recently rolled out a new website and online ordering capabilities to build its take-out and catering business, which, at only 3.5% of sales currently, the company views as a sizable source for growth.
KONA has been debt free until this year, but by 16Q3 borrowing had increased to $25M, and in 16Q4 it increased its credit facility to $60M. At this level, the ratio of debt to EBITDA is 3.8X, which is over 2 turns above the 1.4X of peers with less than 10% franchised units. However, because of its high rent expense, KONA’s ratio of lease adjusted debt to EBITDAR at 6.6X is almost 3 turns above the 3.8X of its peers. Not surprisingly, given the company’s aggressive growth, cash flow after capex is negative. In the T12M through 16Q3 cash flows from “operations” were $18.0M (including $2.8M of “Accrued Expenses” and $8.5M of “Deferred rent and other long term liabilities”), which net of $42.7M cap ex, left a free cash deficit of $24.7M. Indeed, it is likely it will need to increase debt further to finance the cap ex to complete the 3 remaining under development in 2016. As further discussed below it has already announced it will reduce store growth to 7% in 2017 (below its previous long term target of 20%). KONA does not pay a dividend but did spend $9.8M on share repurchases in 16H1, completing its $10M authorization. Although the board recently voted a new $5M share repurchase authorization, considering the increasingly leveraged balance sheet , we don’t expect material further stock purchases in the near future. CEO Berke Bakay, an investment manager by background, is the company’s largest shareholder, with beneficial ownership of 12.6% of KONA’s shares, principally from the position of BBS Capital Fund, LP, his investment partnership.
Though KONA’s 16Q3 results missed on comps, revenues and earnings, and guidance was lowered for the second quarter in a row, the stock increased slightly, perhaps in relief that results weren’t worse, after plunging 25% the preceding 30 days. In explaining sales results the company said comps had been impacted 150bps by continued softness in oil-affected markets and the closing of its Baton Rouge unit for several days as a result of flooding in Louisiana. Still it argued the comps were 180bps better than the industry as measured by Knapp-Track Index. It also noted that 3 new stores whose sales had been hurt by nearby construction for the past 2 quarters, continued to impact non-comp store sales. The poor sales results contributed to poor performance below the top line. The company had already reduced new store growth to 3-4 units in 2017 (well below its torrid 20% pace in the last 3 years) to give it a much needed pause to focus on improving operations. However, management said it now planned only 3 in 2017, and had signed leases for only 2, to preserve flexibility. Management’s also guided comp sales at 1.5%-2% for the year, implying negative comps for Q4, continuing the negative traffic trends from 5 of 6 Qs to 16Q3.
On January 10, just prior to KONA’s appearance at the heavily attended ICR Conference, the Company “pre-announced” Q4 comp sales of -4.1%, compared to a positive 3.2% in ‘15. Though the announcement did not disclose P&L impacts, or the traffic trend (presumably worse than the comp number), the fourth quarter profits and cash flow numbers will no doubt be worse than previously expected. Elaborating on the reasons for the shortfall, Berge Bakay, Pres. and CEO commented, “Similar to many of our restaurant peers, same-store sales for the fourth quarter were weaker than we had anticipated as we too did not experience a post-election bounce. Weak retail traffic, inclement weather and an influx of new competition as well as continued weakness in oil-impacted markets contributed to the soft sales. In addition, we cycled over our most difficult quarterly comparison of 2016 which made achieving positive same store sales even more challenging”.
Management is working hard, well intended, and appropriately focused on improving profit margins at all stores, maximizing and growing the bottom line profits. The reduction in new store growth is the appropriate strategy, no doubt of some necessity with cash generation coming up materially short of plans, in turn requiring leverage of the balance sheet to get even to the current point of expansion. In fact, as disclosed in the Q3 10Q filing, KONA was granted a waiver on 9/26/16 applying to Q2 and Q3, relative to the “fixed charge coverage ratio”. Without details as to how the fixed charge ratio is calculated, we can’t know the whether this covenant was actually breached, but “waiver” certainly implies that this covenant was exceeded or at risk of being exceeded. Though we have no particular insight into KONA’s banking relationship with Keybanc, one has to assume that, based on Q4 results, the bank will be more concerned, rather than less.
Our view of the basic economic attractiveness of the concept goes like this: While the sales per square foot are relatively high, true (GAAP) store level profit is not. Even if KONA’s “ideal” store level operating “margin” or “profit” (excluding depreciation), as most operators like to describe it, at 20-21%, were accomplished, the bottom line net profit after taxes is not outstanding, when depreciation and corporate G&A run relatively high at 7.8% and 8.2% respectively. After subtracting these two expenses, only 4-5% is left, pretax, or perhaps 3-4% after taxes, depending on the tax rate. On $200 million of sales, that would be a theoretical profit of $8-10M after taxes, or $.75-.95/share if there were no more common stock dilution between now and then. Of course, the numbers just presented are highly theoretical, based on the best “cherry picked” locations, assuming the company wide results, at some indeterminate point in the future, can match the best of the current group of stores. Metaphorically, as a money manager, I would be pleased to report my results based only on the best picks within my portfolio and ignoring the mistakes.
Relative to the likelihood of KONA management meeting or beating the above objectives, including the 20-21% chain wide store level EBITDA. In essence….what could go right? Not enough, any time soon, in our opinion. Traffic is challenged, competition is intense, mall traffic (19/42 locations) continues to decline, the labor content at store level will be difficult to reduce materially, considering the store footprint and diverse menu, rents won’t come down, nor will depreciation. Commodity costs have been under control, but that can change at any time. Corporate G&A can be reduced, but not more than a point or so, considering the geographical spread.
Overall, while not in imminent jeopardy, we consider KONA to be an operational “show me” situation, a “workout” of sorts. We doubt that KONA is a takeover candidate, inexpensive as it seems on an enterprise value to sales basis. While management has tried to make the case that “replacement value” of stores is relevant, we argue that failing locations are not valued anywhere close to “cost”. Long term leases can have material value, but those of KONA are nowhere near a bargain, as evidenced by the high Debt/EBITAR ratio. Berge Bakay, CEO, is not the first money manager to be seduced by an operational “opportunity” within the restaurant industry, but sometimes the best of intentions, intelligent approach, and hard work cannot overcome fundamental weaknesses, both inside and outside the four restaurant walls.