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Kona Grill, Inc. (NASDAQ:KONA)

Q4 2008 Earnings Call

February 10, 2009 6:00 pm ET

Executives

Mark S. Robinow - Chief Financial Officer

Marcus E. Jundt - Chairman and Chief Executive Officer

Mark Bartholomay - Chief Operating Officer

Analysts

Matthew Difrisco - Oppenheimer & Co.

Robert Brown - Craig-Hallum Capital

Brad Whittington - KeyBanc Capital Markets

Mark Smith - Feltl & Company

[Justin Bennett - Clarke Bennett]

Christopher Donnelly - Pacific Rock Capital

Will Hamilton - SMH Capital

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Kona Grill fourth quarter 2008 earnings conference call. (Operator Instructions)

I would now like to turn the conference call over to Marcus Jundt, Chief Executive Officer, and Mark Robinow, Chief Financial Officer. Please go ahead.

Mark S. Robinow

Thank you. This is Mark Robinow. Good afternoon, everyone.

By now you should all have access to our fourth quarter earnings release. It can also be found on our website at KonaGrill.com under the Investor Relations section.

Before we begin our formal remarks I need to remind everyone that part of our discussion today may include forward-looking statements. These statements are not guarantees of future performance and therefore undue reliance should not be placed upon them. We refer all of you to our recent filings with the SEC for a more detailed discussion of the risks that could impact our future operating results and financial condition.

With that, I'd like to turn the call over to Marcus Jundt, our Chief Executive Officer.

Marcus E. Jundt

Thank you, Mark, and thank you all for joining us today.

We'd like to cover several items during this call. First, I will open with some brief comments about the fourth quarter. Mark will then discuss in detail our financial results as well as our guidance for 2009. I will then wrap up the call with some final thoughts before turning the call over for questions and answers. With that, let us being.

Fourth quarter sales were $18.6 million or $700,000 below our previous guidance due to eight fewer restaurant opening weeks and slightly lower guest traffic than projected during the period.

Same-store sales declined 9.4% in the fourth quarter and 7.2% for the full year, which were below our implied expectations of down 6.5%.

Net loss for the quarter excluding non-cash and special charges was $1.6 million or $0.25 per share, which was $0.02 below the low end of our guided range.

For the quarter, restaurant operating profit margin was 16.3% compared to 19.5% last year. Like most other restaurant companies, our margins continue to be impacted by lower sales volumes and associated deleveraging effect, along with higher labor and operating costs. We continue to offset some of this margin pressure through better management of our food costs.

Despite the same-store sales decline, our 14-unit comparable base, which represents 70% of our total operating portfolio, was able to generate restaurant operating profit margins of 18.7%, which is still a the high end of what most other restaurant companies could achieve under far more favorable conditions.

While the overall environment is likely to remain challenging for the foreseeable future, we continue to focus on those things within our control to improve our financial condition. In January we downsized and realigned certain staff at our corporate office, which we expect will save us approximately $800,000 in annual G&A costs.

As for the restaurants themselves, many new initiatives are being implemented to enhance the guest experience and ultimately improve the bottom line. Among them are improved training programs designed to improve service levels and more frequent menu updates to keep our offerings fresh and exciting.

For example, we are in the process of rolling out a new lunch promotion called Perfect Pairings, which offers guests a choice of two items from a selection of salads, soups, sandwiches and sushi. This promotion has been well received in the markets where it has been implemented thus far and we expect it will be available in all our restaurants in the first quarter.

During the fourth quarter, we opened two restaurants, bringing our total number of units to 20. In November we opened at City Place in West Palm Beach Florida. The restaurant is in an ideal location to cater to business, residential and leisure guests. Also in November we opened our fourth restaurant in our home state of Arizona at City North in northeast Phoenix. This new development features nearly 1 million square feet of specialty boutiques, restaurants, residential and office space. In January we opened our restaurant in Richmond, Virginia in West Broad Village, a lifestyle center in the upscale Short Pump area that upon completion will include retail and office space, two hotels, and nearly 900 residential units.

And with that I will turn the call over to our CFO, Mark Robinow.

Mark S. Robinow

Thanks. Marcus.

For the fourth quarter ended December 31st, restaurant sales increased 6.4% to $18.6 million, reflecting additional revenue from three restaurants opened during the year. In addition to the difficult economic environment, fourth quarter sales were also negatively affected by the Halloween and Thanksgiving calendar shifts. In all, same-store sales declined 9.4%, inclusive of a 4% increase in price year-over-year. This compares to a 0.8% decline in same-store sales in the same period last year.

Despite the weak same-store sales results, cost of sales as a percentage of restaurant sales decreased 160 basis points to 26.5% during the fourth quarter from 28.1% last year as we continue to experience better-than-expected results from the implementation of our automated food cost and inventory management system. The rollout began during the second half of 2007, so we have already lapped the initial benefits of this implementation, but remain very pleased with what it has accomplished for us so far.

Labor expenses as a percentage of restaurant sales increased 230 basis points to 34.4% during the fourth quarter from 32.1% last year. We expect continued pressure on labor as a percentage of sales until same-store sales turn positive. The January 2009 round of minimum wage increases is not expected to have a material effect on labor costs.

Occupancy expenses as a percentage of restaurant sales increased 90 basis points to 7.5% during the quarter compared to 6.6% last year. As expected, restaurant operating expenses increased as a percentage of restaurant sales as a result of higher utilities, increased repair and maintenance costs to refurbish our older units, and deleveraging of fixed operating costs. We do expect some relief on the utilities front in 2009 due to the reduction in oil prices. Combining these four line items, restaurant operating profit was $3 million or 16.3% of sales compared to 19.5% last year.

General and administrative expenses were up $650,000 to $2.5 million during the quarter. Half of this increase was due to severance costs, with the remainder attributed to higher professional fees and a one-time charge for lease cancellation. Pre-opening expenses were $883,000 in the fourth quarter compared to $757,000 last year. The majority of these costs relate to the opening of two restaurants during the fourth quarter and one restaurant during January. Our current budge for preopening expenses remains at approximately $400,000 per restaurant.

Depreciation expense as a percent of restaurant sales increased 110 basis points to 9.4% during the fourth quarter from 8.3% a year ago. The increase is primarily the result of decreased leverage on the top line.

During the quarter we evaluated the long-term prospects of those restaurants that have not been meeting sales profitability and cash flow targets. That evaluation resulted in the decision to record asset improvement charges of $3.2 million for our Lincolnshire, Illinois restaurant. This charge reduced our EPS by $0.49 after tax during the quarter. We do not plan to close the Lincolnshire restaurant and believe its financial performance can be improved. The asset improvement charge is required by GAAP and it's consistent with conservative accounting treatment.

Net loss for the quarter was $5.4 million or $0.83 per share on a weight share base of 6.5 million shares. This amount includes the assessment improvement, separation and other charges discussed earlier. Last year we posted a net loss of $883,000 or $0.14 per share on a weighted average share basis of 6.3 million shares.

We ended the quarter with $9.3 million in cash and investments. $6.5 million of this amount is held in student loan auction rate securities with a fair value of $6.6 million. During the quarter we signed a settlement agreement with our broker allowing us to put back these securities at fair value beginning in June 2010 and borrow up to $5.3 million against these securities until then. We borrowed $2.5 million against these securities at year end which, when included with the remaining balance of our equipment notes, brings our total debt to $4.5 million at the end of the year.

Net cash resources available to fund operations and future capital expenditures were $5.5 million at year end. During the fourth quarter, net cash provided by operating activities was $2.3 million. We spent $4.6 million on capital expenditures during the quarter, primarily for our three restaurants opened within the last few months.

In terms of our financial guidance, for the first quarter of 2009 we are forecasting sales of $18.3 million to $19.3 million and a loss of $1.4 million to $1.9 million or $0.22 to $0.29 per diluted share. Visibility to the 2009 economic environment is difficult to predict given the challenging U.S. economy and our first quarter guidance reflects this. Until there is more stability in the economy and discretionary consumer spending, we are suspending financial guidance beyond the following quarter.

Our current plan is to open four new restaurants this year, including the Richmond, Virginia restaurant which opened last month. We further expect to open on restaurant in each of the second, third and fourth quarters. As always, the timing of our restaurant openings depends on our ability to secure suitable financing and other factors that may be outside of our control.

I will now turn the call back to Marcus before we go to Q&A.

Marcus E. Jundt

Thanks, Mark. As a public entity, we are committed to creating long-term value for all of our shareholders.

Our Board of Directors has formed a special committee comprised of independent directors to work closely with management and the company's outside professional advisors to identify, review, and oversee the restructuring, negotiation and execution of all reasonable financing alternatives in the best interests of the company and its shareholders. We look forward to reviewing their recommendations as well as communicating the appropriate course of action to all of you on a timely basis.

Most importantly, we continue to manage our company in a manner we believe will allow us to best ride out the current economic downturn while strategically evaluating all aspects of our business to position us for long-term success.

Mark Bartholomay, our Interim Chief Operating Officer, has joined us for the Q&A portion of our call.

I would now be happy to answer any questions you might have. Operator, would you please open the lines for questions?

Question-and-Answer Session

Operator

Yes. Thank you. (Operator Instructions) Your first question comes from Matthew Difrisco - Oppenheimer & Co.

Matthew Difrisco - Oppenheimer & Co.

Mark, I think you said, if I heard right, you had cash at the end of the year of $5.5 million, though I think in the press release it says current assets of $4.7. I'm just curious, what am I missing that's not cash that shouldn't be falling into the current assets? Why is current assets lower than cash?

Mark S. Robinow

Because our auction rate securities are carried as long-term liabilities at this point.

Matt, just to clarify, we had available to us through our own investments and borrowing against our auction rate securities and our own cash balances, as I said, we had $5.5 million available in like-cash investments at the end of the year.

Matthew Difrisco - Oppenheimer & Co.

And then how much do you presume you'll need for cash needs to open these four stores?

Mark S. Robinow

We're going to need approximately - our CapEx for the year is probably $10 to $11 million range. And then we will generate our own EBITDA during the year, but we have a cash shortfall of several million dollars.

Matthew Difrisco - Oppenheimer & Co.

And then I guess the question is: What is the current strategy for financing and, I guess, what's the status of an offering? The last we heard I think it was a $1.50 offering for the million share loan. What stands out there right now or what are your strategies for financing this growth?

Mark S. Robinow

We issued a press release several weeks ago, Matt, that we are reviewing multiple avenues of financing, including equity, debt, equipment financing, bridge financing, and that is in process. We can't comment on that at this point, but we are pursuing multiple avenues of financing the company at this point in time. And as Marcus said, management is working with a special committee of the Board to complete that capital raise.

Matthew Difrisco - Oppenheimer & Co.

And then just looking also at your comp sales, I was curious if you can give us any color on how that looked as far as region. Was there any cannibalization from the Glendale opening or the fourth store opening in Arizona or does that market seem to - can you give us some color being an Arizona store? Is that city starting to floor and maybe recover now on the comp side?

Mark S. Robinow

I would say this, in terms of color and what we can probably tell you, we did not notice any cannibalization from the opening of the North Phoenix store in Scottsdale or Chandler, which is quite far away. We didn't see that. We've seen more cannibalization, actually, between Gilbert and Chandler.

And what I would say is we've seen a stabilizing in Arizona but we have not seen an upturn in sales in Arizona. And then in terms of kind of local market color, the only other thing I could say is for us, at least for Kona Grill, the first restaurant to see the downturn in sales was Las Vegas, and we actually do see improvement in the Las Vegas market, so that's probably the best news we can say about it. If there's any evidence of any kind of turnaround, it would be in Las Vegas.

Matthew Difrisco - Oppenheimer & Co.

Let's say you did have some funding issues and you needed to defer the opening of stores, what type of penalty would there be running through the income statement if there's a deferring of the openings or do you have the flexibility to stall some of these openings until later years?

Mark S. Robinow

The penalties as defined in leases is you basically pay dead rent. You pay the rent to the landlord as if the unit were open, and that's the damages that the landlord can receive for not opening a restaurant.

Now with that said, this environment has changed a lot. It's probably not in our landlord's best interest to try to force something that punitive on us. And while we haven't negotiated this, we would try to negotiate something better than full dead rent during a period where we couldn't finish a restaurant on time.

Marcus E. Jundt

One thing about the City North project in Scottsdale, on a good day of traffic it's about a half hour difference by freeway, so it's far apart, unlike Gilbert, let's say, and Chandler.

Operator

Your next question comes from Robert Brown - Craig-Hallum Capital.

Robert Brown - Craig-Hallum Capital

Could you just say what your Q1 guidance implies in terms of a comp?

Mark S. Robinow

That comp implies a little over 7% down, Rob.

Robert Brown - Craig-Hallum Capital

Okay, good, so similar or a little better than Q4. And it sounds like the Baltimore unit is not in 2009. Is that something you'd look to in 2010 and is there any CapEx or spending that that might require in 2009?

Mark S. Robinow

Well, it has been moved to 2010 and there would be at the end of '09, if we're going to go ahead and if we have sufficient financing to begin construction of that unit, it would begin the last quarter of '09.

Robert Brown - Craig-Hallum Capital

And then maybe just give a little more color on your margins. They're depressed right now. Is any of that inefficiencies from opening the new units in the quarter and do you still think you can get all the units to that 19% level that you've talked about in the past?

Mark S. Robinow

Well, we did have a lot of new unit operating weeks in the quarter, so we did see a little bit of compression from that. So I would say it's marginally from new unit openings and more from same-store sales pressure - negative same-store sales pressure.

Operator

Your next question comes from Brad Whittington - KeyBanc Capital Markets.

Brad Whittington - KeyBanc Capital Markets

I just had a couple of quick questions, one on the $500,000 of separation costs, other charges, all that. Would that all have been in G&A or would it have been in the interest and other line as well?

Mark S. Robinow

All of that was in G&A, Brad.

Brad Whittington - KeyBanc Capital Markets

And then on the loss from discontinued operations, should we expect to see maybe roughly about $60,000 a quarter in rent being paid on that closed store for the foreseeable future?

Mark S. Robinow

No. That's already been accrued for and for that you might see about $10,000 a quarter, but we don't have big expenses that we would expect to be running through discontinued operations in the foreseeable future.

Brad Whittington - KeyBanc Capital Markets

So probably less significant than the roughly 60 to hit this quarter?

Mark S. Robinow

Yes.

Brad Whittington - KeyBanc Capital Markets

And then, you know, talking about the commercial development for your new units this year, is there any concern with any of them that maybe they're not going to be finished on time - not your part of the build out but just the commercial development at all, any co-tenancy issues?

Marcus E. Jundt

Well, Woodbridge is freestanding.

Mark Bartholomay

Woodbridge is a freestanding. [Inaudible] has got an associated office building that's quite well leased out. We have not heard of any degradation there. The Tampa building, we haven't talked to the landlord in quite awhile, but the buildings are all up. The leasing was going well. We'll talk to them as we get closer to moving forward ourselves.

Mark S. Robinow

It's also a MetLife project, so it's -

Marcus E. Jundt

We could be constructing there today if we wanted to. They've got our building completely done.

Operator

Your next question comes from Mark Smith - Feltl & Company.

Mark Smith - Feltl & Company

Can you give a little bit of a breakdown on Texas? Last quarter it sounded like it was coming back and doing okay. Have you seen that business decline at all or hold its own?

Marcus E. Jundt

Well, Mark, I think Texas is market by market, but in general as a state it's our strongest performing state.

Mark Smith - Feltl & Company

Kind of on that, can you tell us if there are any standouts, any that may be comped positive in the quarter or anything that you've looked at as a region that's been more positive than others?

Marcus E. Jundt

Well, for the year we had five of our restaurants comped positive or were at flat comps for the year. We think that's a pretty strong percentage of our portfolio.

Mark Smith - Feltl & Company

Just with a new lunch type of item coming out, have you seen in the tests much of a change in the mix in day parts and also if you can comment on alcohol sales and any significant changes in trends there?

Mark Bartholomay

The Perfect Pairing lunch has been quite successful. It hasn't had a big impact yet on any shifts. We just tested in four of the restaurants started in November. Put four more in in the beginning of January. We're feeling good about the fact that the average ticket doesn't seem to have decreased a lot and sales didn't decrease a lot since it has that value, so we're hopeful that the frequency is making up for that, which would be a quicker conversion than we would have anticipated.

As far as the liquor, in the overall sense liquor has gone up in relation to food. We think some of that's driven by the value proposition of our happy hour, which remains kind of best in class and we're going to try to figure out ways to extend that to other areas of dining.

Operator

(Operator Instructions) Your next question comes from [Justin Bennett - Clarke Bennett].

Justin Bennett - Clarke Bennett

Are you willing to consider an equity in which you, [James John], [Richard Hauser] or Kona MN have no preference over existing shareholders?

Marcus E. Jundt

All financing issues are being dealt with the special committee, Justin, and they've got good legal counsel and whatever they recommend, we'll listen to them.

Justin Bennett - Clarke Bennett

But I'm asking you specifically, would you consider a deal in which you guys do not heavily participate?

Marcus E. Jundt

It's not my decision, Justin.

Operator

Your next question comes from Christopher Donnelly - Pacific Rock Capital.

Christopher Donnelly - Pacific Rock Capital

I joined the call a little bit late. I was hoping to see, Mark, if you could provide me the cash flow from operations number for the fourth quarter and then for the full year?

Mark S. Robinow

It was $2.4 million for the fourth quarter, full year $6.7 million.

Christopher Donnelly - Pacific Rock Capital

So obviously the environment has been extremely difficult. The fourth quarter numbers are obviously under pressure, but you still generated positive cash flow from operations. I guess what I'm asking, even under a very Draconian view where the economy continues to deteriorate, it seems reasonable that you guys could generate at least $6 million in cash flow from operations in 2009.

Mark S. Robinow

Well, we don't give guidance on our EBITDA numbers, but we do expect to generate significant cash flow from operations, which would allow us to be able to finance the company and take on a certain layer of debt, which would be very reasonable and very, very fundable, even in this environment.

Christopher Donnelly - Pacific Rock Capital

Okay, so just so I understand and I have my notes here correctly, CapEx, you stated, could be as high as $10 to $12 million for '09, but I think upon further conversations that CapEx could be as low as $8 million for '09, if necessary. Is that still accurate?

Mark S. Robinow

Yes. If we were to delay construction and delivery of restaurants, we could drive that number lower, absolutely.

Christopher Donnelly - Pacific Rock Capital

So what I'm getting at is at worst case scenario, maybe there is a $2 to $3 million funding gap for 2009.

Mark S. Robinow

Yes, I think I did even comment on that earlier. It's definitely in that range.

Christopher Donnelly - Pacific Rock Capital

Okay. And can you just update us again - just again for my notes, so we all understand in terms of the company's unlevered assets at this point, what would be applicable if you went to do some type of financing based on those assets? How much in assets do you have available?

Mark S. Robinow

Well, right now the only debt that the company has - exclusive of borrowings on auction rate securities, which I'll exclude because we have a put for those in June 2010, but let's throw auction rate securities out right now - basically we have $2 million of debt left to GE which is encumbered by five restaurants. We now have 21 restaurants, so we have 16 unencumbered restaurants of which to borrow against furniture and equipment.

Christopher Donnelly - Pacific Rock Capital

And what would the asset value be of those 16 restaurants?

Mark S. Robinow

It's $1 million to $1.5 million a restaurant.

Christopher Donnelly - Pacific Rock Capital

Okay, so between $16 and $20 million in unlevered assets. It's still - what I want to make sure  it's still very reasonable that you'd be able to secure some debt financing given the company's not in a levered position and you do have assets that could be put forth to secure financing?

Mark S. Robinow

That's accurate, and we also believe that any additional financing that we need this year would actually probably be less than one times 2009 EBITDA.

Christopher Donnelly - Pacific Rock Capital

And then just one last question here for my notes, in regards to if you looked at your store footprint across the U.S., if you were going to go out and actually physically rebuild those locations, can you kind of update us on what the cost would be today for those?

Mark S. Robinow

For all locations?

Christopher Donnelly - Pacific Rock Capital

Yes, if you went to go rebuild the restaurant footprint, what would that cost someone if they were starting from scratch?

Mark S. Robinow

Between $3 and $4 million a restaurant so, in round numbers, $70 million.

Operator

(Operator Instructions) Your next question comes from Will Hamilton - SMH Capital.

Will Hamilton - SMH Capital

The $10 to $11 million CapEx number, Mark, that you're providing, is that net of tenant allowances or is that before tenant allowances?

Mark S. Robinow

That's net of tenant allowances, Will, but that assumes that we would finish Tampa and also begin construction on our Baltimore unit for 2010.

Will Hamilton - SMH Capital

And you're still collecting about $1 million per store?

Mark S. Robinow

That's correct. The only exception to that is Woodbridge, New Jersey, which is a ground lease without a tenant improvement allowance.

Will Hamilton - SMH Capital

After the cuts at the corporate office, what is kind of the run rate for G&A right now? Is it a little less than $2 million?

Mark S. Robinow

Yes. I mean, yes, it should be. Basically that's about the range that we're in right now. We have quarterly fluctuations in that, but we plan to do a little less than that for the full year.

Will Hamilton - SMH Capital

And then is there any discussions with some of your landlords right now in terms of trying to get some relief on the rent front given this environment?

Mark S. Robinow

We have ongoing discussions with our landlords and that's an area that we are not able to comment on because most of our negotiations with landlords are strictly confidential.

Operator

There are no further questions in our queue at this time. I'll turn the conference back over to you, Mr. Robinow, for any final or additional remarks.

Marcus E. Jundt

This is Marcus Jundt. I want to thank everyone for participating in our fourth quarter conference call. If you have any further questions, please feel free to call us. Thank you very much.

Operator

That does conclude our conference for today. Thank you, everyone, for your participation.

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Source: Kona Grill, Inc. Q4 2008 Earnings Call Transcript

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