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Kona Grill, Inc. (NASDAQ:KONA)

Q4 2013 Earnings Conference Call

February 13, 2014 05:00 PM ET

Executives

Berke Bakay - President and CEO

Christi Hing - CFO

Analysts

Chris Krueger - Lake Street Capital Markets

Mark Smith - Feltl and Company

Justin Ruiss - Sidoti & Company

Adam Joseph - West Main Partners

Operator

Good afternoon and thank you for joining us today to discuss Kona Grill’s Results for the Fourth Quarter And Full Year Ended December 31, 2013. Joining us today are Berke Bakay, Kona Grill’s President and Chief Executive Officer; and Christi Hing, the Company’s Chief Financial Officer. Following their remarks, we’ll open up the call for your questions. [Operator Instructions]

Before I begin, I would like to remind everyone that the financial guidance the Company provides for its first quarter 2014 results, statements regarding the Company’s future growth, sales, profits and expectations regarding same-store sales are forward-looking. All forward-looking statements made during this call are based on information available to the company as of today and the company assumes no obligation to update these statements to reflect events or circumstances after the date of this call. These statements are subject to risks and uncertainties that could cause actual results to differ materially from those described in the statements. Investors are referred to the discussion of risks and uncertainties contained in the Company’s filings with the Securities and Exchange Commission.

I would now like to turn the call over to Kona Grill’s President and CEO, Mr. Berke Bakay. Sir, please go ahead.

Berke Bakay

Thanks Argus. Good afternoon and thank you all for joining us. For the fourth quarter ended December 31, 2013 we continue to outperform the industry with strong same store sales growth of 3.5%, excluding remodels and are pleased to report positive sale trends in spite of weather challenges and shortened holiday shopping season. We continue to be encouraged by these results as it demonstrates the strength of our brand and provide us with continued confidence to open new restaurants in a time when some of our peers have scaled back their growth plans.

While many in our industry segment experienced traffic declines during the quarter we continue to see guest traffic improve as a result of our innovative food and drink offerings. It is also encouraging to see traffic improve at a time when many of our competitors have resorted to discounting and marketing to drive sales. As mentioned previously same store sales increased 3.5% in the fourth quarter, reflecting a 270 basis points increase in guest traffic and 80 basis points increase in average check.

This increase in same store sales follows a 2.6% increase in Q3 and 2.5% increase in Q2. With Knapp Track reporting Q4 same store sales of negative 1.8% and traffic down 3.7% the comp [ph] sales gap between Kona Grill and the industry is now over 5% and the traffic gap has widened to over 6%. During the quarter we opened two restaurants. Our restaurant in Boise opened on October 18 with strong sales volumes that continued throughout the holiday season and our restaurant in Woodlands which opened on December 18 has also performed well.

In fact average weekly sales during the fourth quarter for the new restaurants was over $100,000, which is significantly above our system wide average of approximately 80,000. While we believe Boise had a strong honeymoon due to the opening of the new center, we continue to be pleased with its performance during Q1 despite some weather challenges. For the Woodlands, we started off a little slower given the timing of our opening but we have continued to see sales build week by week as guest awareness increases. We’re optimistic that both of these restaurants will continue to perform at or above Kona’s system wide average.

During the fourth quarter we also completed extensive remodels of both our Scottsdale and San Antonio restaurants. As mentioned on our third quarter call, the nature of these remodels was significantly more extensive than our typical remodel due to the scope of work required. For Scottsdale we essentially built a brand new restaurant by replacing the HVAC, plumbing, fire systems and electrical to comply with current code, and also replaced kitchen equipment, flooring, furniture and fixtures to be consistent with our current design palette. The remodel also included a new aquarium, broader features and updated bathrooms. The VIP party we held on December 12th to celebrate the reopening of this restaurant had over 600 guests attend and we’re pleased with the double digit increase in sales since the remodel. We believe that return on investment on this project was similar to a new restaurant and we’ll continue to provide updates throughout the course of the year.

For our San Antonio restaurant, the remodel was driven by the expansion of our patio area to seat an additional 50 guests. As we mentioned on our last call, the additional patio allows us to better serve our guests especially during busy times. Expanding the patio required us to fully reconfigure the restaurant, which included relocating the sushi bar, aquarium and restrooms. Once again the cost of building a new aquarium, installing new restrooms and building a bigger bar sushi bar are now part of our typical remodel and therefore the cost, including furniture associated with the new patio were higher than our historical models.

We believe that dollars spent are well worth it as this restaurant is comping [ph] up double digits to date and we except a high return on invested capital. I’m very proud of our entire team as we were able to handle five concurrent projects during the quarter; the construction of three new restaurants and the extensive remodel of two restaurants. This speaks volumes to the depth of our team and our ability to execute upon our growth strategy.

Now before I go further, I’d like to turn the call over to Christy who will take is through the financials for the fourth quarter and full year and provide guidance for the first quarter of 2014. Afterwards I will provide an update on our outlook before wrapping up the call with Q&A.

With that I would like to turn the call over to our CFO, Christi Hing. Christi?

Christi Hing

Thanks Berke. For the fourth quarter ended December 31, 2013 restaurant sales increased 6.4% to $24.5 million, compared to $23 million in the fourth quarter of 2012. As Berke mentioned, same-store sales excluding the remodels were 3.5% during the quarter driven largely by guest traffic which grew 2.7% during the quarter. Sales for the fourth quarter were positively impacted by $1.3 million in sales from the two new restaurants that opened during the quarter, partially offset by approximately $750,000 in lost sales due to remodel related closures.

We are pleased with the sales volumes at our new restaurants. As we mentioned on our last call, Boise opened with the second highest opening sales week in the Company’s history and sales continued to be strong throughout the fourth quarter as guests visited our new restaurant and the surrounding center. We had a great honeymoon and has seen Boise sales normalize in Q1, but we continue to be pleased with their results.

As Berke mentioned, both our Scottsville and San Antonio restaurants underwent significant remodels during the fourth quarter. Originally we had anticipated losing six full operating weeks from the remodels. However actual downtime was nine full operating weeks resulting in additional estimated loss sales for approximately $250,000.

All-in-all, we are pleased to exceed our comp guidance for the quarter and meet our sales forecast, given the weather and remodel challenges that we faced during the quarter. For 2013, sales increased 2.3% to $98.3 million compared to $96 million in 2012. Same-store sales for 2013 increased 1.4% due to higher pricing and a 20 basis point improvement in guest traffic in 2013, which left [ph] a 2.7% same-store sales increase in 2012. We are pleased with these results given the industry numbers reported by Knapp Track.

It is important to note that as we have started to open new restaurants, you will see more variability in our P&L as new restaurants open and improved their operating efficiencies as they mature, especially with managing labor and cost of goods. It is also important to point out that preopening expenses will have a significant impact on our reported net income in any given quarter. We will do our best to provide granularity between new versus existing restaurant operating performance to help investors gauge the health of our business.

With that I’ll go into some detail on our individual P&L line items for the fourth quarter and full year. Cost of sales as a percentage of restaurant sales decreased 50 basis points to 27.3%, compared to 27.8% last year. On a sequential basis cost of sales as a percentage sales declined 30 basis points. We have made great strides during the year with purchasing initiatives and kitchen efficiencies in spite of some of the inflationary pressures in items such as beef, shrimp and produce compared to last year.

We were able to mitigate some of the cost pressures on the food side with strategic buying, better management over liquor cost and a 3% price increase we took last March. For 2014 we are forecasting some cost pressure, however, due to the diversity of our menu and our 30% liquor mix we are somewhat insulated from significant increases in any single commodity materially affecting our overall cost of goods.

Labor expenses as a percentage of sales increased to 130 basis points to 35.2% during the quarter, compared to 33.9% last year. We estimate that labor dollars paid while both restaurants were closed for remodel negatively impacted labor as a percentage of sales by about a 100 basis points while higher labor hours associated with new restaurants negatively impacted overall labor costs by approximately 50 basis points.

Occupancy expenses as a percentage of restaurant sales in the fourth quarter of 2013 were flat at 7% when compared to the fourth quarter of 2012. We expect to incur about 20 basis points in higher occupancy cost in 2014 as compared to 2013 as we will fully amortize the tenant improvement allowance for certain restaurant which result in a smaller deferred rent credit each period and therefore higher occupancy expense.

Restaurant operating expenses as a percentage of sales in the fourth quarter of 2013 were also flat at 14.3% when compared to the fourth quarter of 2012. Our restaurant operating margins were 16.2% during the fourth quarter of 2013 compared to 17.1% last year. Excluding the impact from new restaurant inefficiencies and our remodeling initiatives we estimate that our four-wall margins would have been approximately 18%.

In the fourth quarter our new restaurants contributed cash flow margins of 7.5%. On an absolute dollar basis, restaurant operating profit was up 1% to $4 million in the fourth quarter of 2013 when compared to the fourth quarter of 2012. For the year, restaurant operating profit as a percentage of sales was 18.4%, which is well within our targeted range of 18% to 19%. In the fourth quarter of 2013 G&A expenses increased by $393,000 or 23.5% to $2.1 million, when compared to the same year ago quarter.

As discussed on previous calls, the increase is primarily attributed to planned human capital investments in 2013 to support our growth initiatives as well as higher G&A costs, professional fees and stock based compensation costs. For 2013, our G&A expenses were $7.9 million compared to $7 million in 2012. As a percentage of sales G&A was 70 basis points higher than 2012 due to the aforementioned human capital investments and higher stock based compensation cost associated with our increased stock price.

For 2014, we expect our G&A cost to increase as we make additional investments in development and operations personnel at the corporate level to accelerate new unit growth. Also we expect increased stock base compensation in 2014 resulting from a higher [indiscernible] valuation of stock options and likelihood that we will require a SOX 404 audit opinion on our internal controls based upon our increased market cap. However, as a percentage of sales, we expect G&A in 2014 to be comparable to that in 2013.

During the fourth quarter, we spent $765,000 or $0.09 per share on pre-opening expenses for our three newest restaurants. The spend for Boise and the Woodlands was within our targeted range of $400,000 in cash for each new restaurant opening and $50,000 to $100,000 in noncash pre-opening rent. In the fourth quarter of 2013, we recorded an income tax benefit of $140,000 compared to a benefit of $84,000 in the fourth quarter of 2012. Overall, our effective tax rate for 2013 was 5.9%, which was lower than our previous estimate. The lower tax rate is attributed to the loss on disposal of fixed assets associated with the extensive remodels of both Scottsdale and San Antonio and the bonus depreciation for new restaurants.

We reported a net loss from the fourth quarter of 2013 of $509,000 or $0.06 per share, compared to net income of $851,000 or $0.10 per share in the fourth quarter of 2012. The net loss in the fourth quarter of 2013 includes approximately $0.20 per share in pre-opening and other costs associated with operating new restaurants, lost sales and profits associated with the remodeling of two restaurants, including the write-offs of the remaining book value of furniture, fixtures and equipment that were replaced and the G&A investments we discussed earlier.

On an apples-to-apples basis, if you exclude the $0.20 in cost discussed above, earnings per share would have been $0.14. At December 31, 2013 we had $5.9 million in cash, compared to $8 million at December 31, 2012. We had $3.5 million in borrowings at the end of the year, which we used to fund the two restaurants opened during the quarter, the Scottsdale and San Antonio remodels and construction for our Fort Worth location.

In 2013, we generated $9.5 million in cash flow from operating activities compared to $7.4 million in 2012 which represents a 29% increase. In addition, we spent $14.4 million on capital expenditures for new restaurants and remodels compared to $1.8 million in 2012. The $14.4 million represents gross CapEx prior to any landlord allowances. We did not purchase any shares under our buyback program during the quarter and purchased 24,000 shares during 2013.

Looking forward to our first quarter 2014 financial guidance, we are forecasting restaurants sales of $27 million, compared to $23.5 million for the first quarter of 2013. Our Q1 sales guidance incorporates a full quarter of sales for the two restaurants that opened during Q4 and a partial quarter for the Fort Worth restaurants that opened last week.

In total, restaurant operating weeks are expected to increase 11% during the first quarter of 2014. Our Q1 guidance reflects positive same-store sales of approximately 3% as we continue to build upon a positive momentum we have generated over the past few quarters. Traffic has accelerated from 90 basis points in Q3 to 270 basis points in Q4 and to date we continue to see good traffic trends in spite of bitterly cold weather in January. As usual, our forecasted accounts are based upon sales trends to date and our outlook for the reminder of the quarter.

As mentioned on our previous calls, the timing of new restaurant openings and pre-opening expenses in particular have and will continue to significantly impact our year-over-year bottom line comparisons. In addition we anticipate that our new restaurants generally take approximately six months to achieve a majority of the operating efficiencies and therefore we expect the opening of new restaurants to impact our Four-Wall margins.

With that said, for the first quarter we are forecasting net income of $200,000 or $0.02 per share which includes approximately $0.08 to $0.10 per share in pre-opening and other costs associated with opening and operating new restaurants, the G&A investments we discussed earlier and a shift in our general manager and executive chef conference from Q2 of last year to Q1 of this year.

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

Berke Bakay

Thanks Christi. We continue to work on operational initiatives designed to enhance the guest experience, while building our business for the long term. For instance, we continue to run our highly successful food based promotions that are a great avenue for testing new menu items and during the fourth quarter we rolled out our spend that included guest favorites such as roast beef and grilled sandwich and our king crab roll. We also had a very successful holiday gift card season, especially online. We increased gift card sales by over 25% from the prior year which I believe special popularity of our brand. We will benefit from the higher gift card sales in the first quarter as guest redeem their cards and will like to thank our coworkers for the efforts in achieving another highly successful gift card season.

2013 was a great year for Kona Grill. We reignited the growth engine with the opening of two new restaurants and completed two major remodels while still delivering some of the best operating results in the industry. During 2013 we continued to build up the foundation for growth with strategic hiring at the both restaurants and corporate office level to support our commitment to build and open new restaurant successfully.

It takes each of our team members who worked so hard in 2013 to help us believe where we are today. As we look at 2014, we are very excited about what the future holds. With one new restaurant open and at least three restaurants scheduled to open in 2014, we believe that our strategy as an organization remains clear; to keep building a premier poised casual concept that is distinguished by award winning sushi and new American cuisine with a significant bar business.

We continue to work diligently to create the pipeline for new year expansion and achieve our target of doubling our sales over the next five years, which translates to a 15% compounded annual growth rate. With $4.2 million average unit volumes, operating margin in the 18% range and 30% return-on-invested capital – they’re confident that we can grow this brand over the long term. We appreciate everybody’s support and we look forward to updating again on our next call.

With that, I will like to open the call for any questions you might have. Douglas, please open the line for questions.

Question-and-Answer Session

Operator

Thank you, sir. Ladies and gentlemen, at this time we will begin the question-and-answer session. [Operator Instructions] First question is from the line of Chris Krueger with Lake Street Capital Markets. Please go ahead.

Chris Krueger - Lake Street Capital Markets

Just couple of quick questions. You talked a bit about various commodity pricing pressures. Is there any specific categories that are not in favor right now? I think last quarter you indicated the shrimp shortage was hurting. Are there things you can do to tweak your menu to take advantage of lower price commodities and things like that?

Berke Bakay

Chris thanks for the question. We are very careful of continuing to keep the integrity of our brand and not play around with it so much so to speak just for the commodity pressures. Shrimp continues to be a pressure that we’re locked in until June. We don’t really see any relief in a short term on that commodity and we’re trying to mitigate it with other strategic purchases on the other seafood items, but shrimp continues to a pressure item for us.

Chris Krueger - Lake Street Capital Markets

Then on your first quarter outlook for 3% same-store sales, everyone has been worried about retail and restaurants and the impact of the unseasonable winter weather throughout much of the country. Can you talk about that? Do you think your underlying trends would have been 2-3 points better than that if the weather is normal or are you more insulated since you more on the south?

Berke Bakay

We’re certainly not insulated. We have seen the impact of the weather. I’m really looking for it to a time period where we’re not impacted by the weather. I am not going to speculate what our sales would have been, if that – we have had better weather. We certainly have been impacted. We had the restaurant closures; we have pressure on -- always the significant pressure on patio sales on even colder nights. So I’m now really looking forward to a better, better trend on what that can do for us. And I guess just the answer is our performance and the Knapp Track and how that gap continues to widen each quarter. We’re proud of that and to me that indicates just gaining market share.

Chris Krueger - Lake Street Capital Markets

Last question. Your next restaurant opening, I don’t think you stated that in your press release. When and where is that expected to occur?

Christi Hing

Yes, Chris, it’s El Paso. That’s expected to open during the summer and then we’ll have a couple of openings scheduled for the back half of the year.

Berke Bakay

So we’re thinking either very, very late second quarter or early third quarter for El Paso.

Operator

Our next question is from the line of Mark Smith with Feltl and Company. Please go head.

Mark Smith - Feltl and Company

As we look at Q1 guidance, can you quantify all, specifically timing shift of the annual conference and what we maybe will see better in Q2 but worse here in Q1?

Christi Hing

I’d say, Mark, it’s a positive, a couple of pennies per share we’re talking about for the conference shift, that we talked a little bit about G&A investments and in order for us to accelerate growth, there is couple new additions on our team in both development and operation. So little bit added to the G&A, but as we’ve said, we expect G&A as a percentage of sales to be comparable to ’13. So we’ll get some leverage eventually but as we accelerate growth we want to make sure that we have the right people in place.

Mark Smith - Feltl and Company

Okay so far as far the impact on Q1, that’s the smaller piece. Still a bigger piece of that $0.08 to $0.10 is really the opening in new restaurants and some of the people that you’ve added.

Christi Hing

Yes. Especially we had the Fort Worth opening last week and then Woodlands; they are in weeks seven right now; seven or eight. So they are still getting their operating efficiencies up to speed.

Mark Smith - Feltl and Company

And then can you talk about remodel schedules, others that are coming up and anything we should be looking at over the next few months?

Berke Bakay

Sure, nothing in next few months and we’re planning to remodel our Las Vegas location this year and that will be towards the end of the year, and you may have a couple of remodels that are smaller in scale but nothing in very immediate future so to speak. And really like Scottsdale and San Antonio were very extensive remodels and that incorporated additional seats and/or essentially building a new restaurant in Scottsdale’s case, because of its age and where that lease was standing but we don’t have anything that major in scope that we’re looking at as we go.

Mark Smith - Feltl and Company

And I know you said you don’t like to blame weather and it’s always going to be there. But if we look at just restaurants like Carmel that I think was shut for a couple of days and even into Q1, we could still look at -- there certainly was a negative impact in Q4 and expectation in Q1, even if you don’t want to quantify it. Is that fair?

Berke Bakay

I certainly agree and I just don’t want to speculate what those sales would have been. Obviously it would have been higher it was a better chance. Everybody -- all of our competitors and all the media talking about this being one of the worst winters ever and as business that we are, that is relied upon, is relying upon patio seating even at night time and obviously we’re impacted by that, but that makes it even more impressive, I believe the results that we have put out. So I’m really looking forward to spring and what we can do.

Operator

[Operator Instructions]. Our next question is from the line of Justin Ruiss with Sidoti & Company. Please go ahead.

Justin Ruiss - Sidoti & Company

I just had a question when it comes to the new openings. I know that you mentioned it’s going to be probably sometime in the summer. Do you have the key personnel in place to help with these openings or have you selected all that of employees to look for? I mean you don’t really open a store unless you have the right people in place before you do that.

Berke Bakay

And that’s a great question and at least for our culture, for our philosophy of who we are, it is actually the most important thing. And when I look at our growth opportunities and where you see the bottlenecks, it’s really the people that we focus the most and with our management training program we basically start building our people pipeline in line with where we were basically growing our real-estate pipeline. So as a philosophy it’s a number one item for us and to me it’s one of the most important variables what will make or break a success of a restaurant. So just to answer your question, we already have the management team in place identified and it’s a combination of internal and external talent for our next opening and actually openings. So definitely we’re ahead of the game there and it is a very important area of potential success of a restaurant.

Justin Ruiss - Sidoti & Company

Great. And then just lastly I know that you mentioned the remodel in Scottsdale took somewhere around like nine weeks and I know that you said that’s kind of uncharacteristic but would there ever be anything that’s in the portfolio that has that kind of a scope to it or would you just say that if you were going to do any kind of remodels in the future, that it would be more towards like the six week or like one month scale.

Berke Bakay

Well just to clarify the nine operating loss was a combination of San Antonio and Scottsdale. So we didn’t lose all nine weeks from one or both of the restaurants. It’s just a combination of both restaurants. And for the Vegas’s case, depending on the scope of work, we will have to close the restaurant for a period of time; but again we don’t expect to be as extensive as what we have done in both of the cases here.

Operator

[Operator Instructions] Our next question is from the line of Adam Joseph with West Main Partners. Please go ahead.

Adam Joseph - West Main Partners

Couple of questions if I could. Berke what have you learned as it relates to traffic with the new layouts in both the new stores and the remodels, and specifically what is that doing on the beverage side for you?

Berke Bakay

Well again, we’re careful about identifying some of the trends because they are too early and they are subject to change. So I wouldn’t want to extrapolate but really early trends from last Fort Worth opening was the bar was on the higher size. But again we’re just talking about a week of data. I wouldn’t want to extrapolate that but certainly we will get better clarity of what traffic is new design going to do for our new restaurants because we don’t have historical data to compare to but what I can tell you from Scottsdale’s and San Antonio’s case they’re both strong double digit same store sales positive and there has been tremendous guest feedback from all social media and anecdotal at the restaurant level or during the VIP parties or local press, whatever that maybe. So definitely the feedback is very positive. The restaurants they’re appearing little bit hipper and definitely more modern on the [indiscernible] and that’s resonating with our target customers. So, so far so good, we’re very pleased.

Adam Joseph - West Main Partners

Okay. And the 80 basis points pick up in check is that -- can you get a little bit more granular on that as it relates to where you’re seeing that? Is that on the food side, the beverage side? Kind of what’s the breakdown on that?

Christi Hing

Adam I think that’s mainly a function of -- we took the 3% price hike back in March. So that’s where you see the higher check compared to year-over-year.

Adam Joseph - West Main Partners

Okay, so no, you’re not -- there is no identifiable trends this last quarter on the beverage side that you can really quantify?

Christi Hing

Nothing really. Our beverage remains 30% of total sales. So, nothing [indiscernible].

Adam Joseph - West Main Partners

Okay, and then Christi how should we think about the stock based compensation for this year? Any specifics? I know that’s a bit of a moving target. But in your prepared remarks you brought it up several times. Anything you can add on that?

Christi Hing

As far as options grants, similar levels of options grants from prior year but given that our stock price essentially has increased, doubled from last year, then you can almost expect stock based cost not to double but somewhat to be up pretty significantly.

Adam Joseph - West Main Partners

Sure. Okay. And then you drew 3.5 off of the revolver. Am I correct in understanding that additional revolver or that last revolver was $20 million?

Christi Hing

That is correct.

Adam Joseph - West Main Partners

Okay, and then so the balance, is that sufficient to meet the rest of ‘14’s goals?

Berke Bakay

Absolutely. If they operate on our plan, there is significant room in the line as our models projects for the balance of 2014.

Adam Joseph - West Main Partners

Okay. And then two other questions; kind of a second part of this, of the revolver, how do you think the board is going to look at buybacks? You were very light this year. You obviously had a great appreciation to stock. You were a little more aggressive last year. What should we think about, what’s the balance on growing the restaurants, having to pull from the revolver and how the board would possibly look at a buyback?

Berke Bakay

Sure. Well, I think the best I can answer and I can’t speak for the board. But the actions speak for themselves on how much capital we’ll spend on new restaurants versus buyback in last few quarters. And again the board can make decisions and change course at any given time. But I think the focus is pretty evident on the restaurant growth at this point in time.

Adam Joseph - West Main Partners

Okay. And finally, Christi, the labor expense, can you comment on that? Obviously that’s up expectedly a couple of hundred basis points. How should we think about that normalizing as you get more comfortable with the new openings, learning -- having learned from the previous openings as you move forward with the balance of this year? Can we expect that number to come back more near mid-30 range like we’ve typically seen?

Christi Hing

Adam, it’s also going to be a function of as we open new restaurants we have El Paso slated to open. We mentioned let Q2, early Q3. So on average we expect our new restaurants to normalize the labor after about six months or so. So on the quarter, yes, it’s going to be a little bit of function of the timing.

Operator

Thank you. At this time, this does conclude our question-and-answer session. I would like to remind everyone that this call will be available for replay later this evening. A webcast replay will also be available via the link provided in today’s press release, as well as available on the Company’s website at www.konagrill.com. Thank you, ladies and gentlemen, for joining us today. You may now disconnect.

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