Kona Grill CEO Discusses Q3 2010 Results - Earnings Call Transcript

Oct.26.10 | About: Kona Grill, (KONA)

Kona Grill, Inc. (NASDAQ:KONA)

Q3 2010 Earnings Call Transcript

October 26, 2010 5:00 pm ET

Executives

Mark Robinow – EVP, CFO and Secretary

Marc Buehler – President and CEO

Analysts

Rob Brown – Craig-Hallum

John Dravenstott – KeyBanc Capital Markets

Mark Johnson [ph] – William Blair

Mark Smith – Feltl & Company

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Kona Grill third quarter 2010 earnings conference call. During the presentation, all participants will be in a listen-only mode. Afterwards, you will be invited to participate in a question-and-answer session. As a reminder, this call is being recorded.

I would now like to turn the conference over to Mr. Mark Robinow, Chief Financial Officer. Please go ahead.

Mark Robinow

Thank you, Matt. Good afternoon, everyone. By now, you should have access to our third quarter earnings release. It may also be found on our website at konagrill.com under the Investor Relations section.

Before we begin 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’ll turn the call over to Marc Buehler, our Chief Executive Officer.

Marc Beuhler

Thank you, Mark and thank you all for joining us today. During this call, we’d like to cover several items. First, I’ll open with some comments about the third quarter and provide an update on some of our current initiatives. Mark, will then discuss in detail our financial results as well as our guidance for the fourth quarter. I will then wrap up the call with some final thoughts before turning the call over to you for some questions and answers. And with that let's begin.

Third quarter sales were $21.6 million which exceeded the high-end of our revenue guidance by about $100,000. Same-store sales were flat during the third quarter compared to down 9.9% in the third quarter last year and down 0.3% in the second quarter of 2010. Even more encouraging however is the fact that same-store sales were up 3.5% in September and this trend has continued thus far into October, as we are getting very positive guest feedback from our recently introduced new menu items which I will address shortly.

The recent quarter was also the third consecutive period that we have experienced positive traffic trends, which will, I believe will demonstrate the strength and popularity of this brand. Unfortunately guests continue to manage their check in this uncertain economic environment which resulted in the overall flat sales. We did however take minimal about 1% menu pricing near the end of the quarter that will mitigate the impact of rising commodity costs and give a boost to our average check. Our net loss for the quarter was $400,000 or $0.05 per share which also exceeded our guidance of a loss between $0.5 million and $1 million.

If we were to exclude pre-opening expenses, for the recently opened Baltimore restaurants, our bottom line would have been within $60,000 of breakeven for the quarter. Speaking of Baltimore, we opened this beautiful restaurant near the Inner Harbor in early the fourth quarter on October 5. While it has only been three weeks since the opening itself, we are very pleased with the initial sales volumes and have great confidence in the team to deliver a great guest experience to all of our new guests. This restaurant also incorporates many new design elements that we plan to incorporate in future restaurants and in remodels such as a video wall (inaudible) feature and brighter interior finishes.

From a cost perspective, we experienced sharply higher commodity costs for our core menu items during the third quarter which Mark Robinow will detail momentarily. All together we estimate that higher prices had a negative 100 basis points affect on the cost of sales. As mentioned on our last call, we have enlisted the services of an outside purchasing group to help us streamline and consolidate our supply chain and leverage our purchasing power. For the first time in our history we are working on contracting prices for certain commodities for 2011 and a negotiating savings on other products.

We will look for positive results from these efforts beginning in the first quarter of 2011 although we still foresee commodity costs as a percentage of sales to be unfavorable on a year-over-year basis given underlying trends. That said, we expect to be able to use our menu evolution process to justify at least a couple of menu price increases in 2011 which will also help mitigate higher commodity costs although this still remains to be seen.

During September, we participated in Share Our Strengths Great American Dine Out, where donations from guests, team members, board and a dollar contribution from every Berries & Cream Dessert sold raised $28,000 for the nationwide No Kid Hungry Mission. We are pleased to be involved in such a worthy cause while at the same time realizing a lot of positive PR for our company in being socially active in the communities that we serve. We look forward to continued participation in this noble effort to end childhood hunger in America by 2015.

Our Konavore loyalty program also continues its exceptional growth and in just nine months we have grown to over a 100,000 numbers. We are continuing to evaluate the potential of transitioning to a card-based program in 2011 mindful that if the program evolves, it should become even more effective. Enhancing the data collection process will also facilitate us gaining a more thorough perspective on our users so that we can target them with specific messages designed to encourage additional dining occasions.

We also continue to use Facebook, Twitter and Foursquare to communicate with our guests on a regular basis. As mentioned on our last call, we are in the midst of a comprehensive menu evolution project to improve the wild factor and enhance the flavor profile of many food items. During the quarter we raised out, we rolled out phase one and phase two of this four phase process which includes the addition of several new menu items and tweaks to existing appetizers, salads, sandwiches, pizzas, flat breads and desserts.

The guest reaction to the first two phases has been very positive and this week we're rolling out phase three to our seven test restaurants which includes the introduction of new on trades in size. We continue to measure this process with comprehensive guest feedback and data analysis with an expected system rollout before the end of the calendar year. Our alcoholic beverage program which you might be aware, accounts for approximately 31% of our total sales is also being reworked to ensure that we are forward leading with our offerings.

As part of phase two, we introduced designer cocktails and new beer offerings including local favorites. New wine and sake offerings will also be introduced in November as part of the phase three rollout which includes a broader selection of wine and flavored sake to encourage guest trials and increased usage. Taking together, our purchasing, marketing and culinary initiatives are essential building blocks in driving profitability for our company. The increased sales generated by these programs will allow us to leverage our costs and build sustainable improvements in our bottom line over time. And with that, I will turn the call back over to Mark Robinow.

Mark Robinow

Thanks Mark. For the third quarter ended September 30, restaurant sales increased 7.1% to $21.6 million, reflecting additional revenue from two restaurants opened since last September. Same-store sales comparisons continue to be impacted by the economy but as Mark mentioned, traffic trends have consistently been positive throughout the year. Same-store sales were flat during the quarter driven by a strong September. Overall, we have seen our comps improve sequentially in each of the last three quarters and are optimistic that this momentum will continue based on guest response to our recently introduced food and beverage items.

Some of these items are at higher price points than the menu items they are replacing, which leads us to believe that we will have the ability to take some price to offset higher commodity costs in the future. Cost of sales as a percentage of restaurants sales increased 140 basis points to 27.5% during the third quarter from 26.1% last year. In particular we saw a significant year-over-year increases for such staple items as beef and chicken while salmon, shrimp and sea bass prices also rose during the quarter. We continue to monitor the impact that the oil spill will have on both short and long-term commodity pricing for all seafood regardless of origin.

The commodity price increases we experienced at the back-end of the quarter were also driven in part by our culinary team as we upgrade ingredients to specifications dictated by our menu evolution. Labor expenses as a percentage of restaurant sales decreased 40 basis points to 34.9% during the third quarter from 35.3% last year. The slightly lower labor costs percentage is attributable to lower benefit costs and aligning restaurant management staff sizes the sales volumes at certain restaurants. We do not expect labor as a percentage of sales to substantially change until we are able to leverage these costs to higher sales.

Restaurant operating expenses increased 30 basis points to 15.6% during the third quarter primarily due to costs associated with the rollout of new menu items. We expect these cost to remain at similar and a similar level in the fourth quarter due to plant repair and maintenance expenses and remodeling expenditures. Occupancy expense, expenses as a percentage of restaurant sales were flat at 8.2% during both the third quarter of 2010 and 2009. Combining these four line items, restaurant operating profits held steady at $2.8 million in both periods but with (inaudible) 12.8% of restaurant sales compared to 14.1% of restaurant sales last year due to our higher revenue base this year.

The majority of the difference in the restaurant operating profit percentage is due to higher food costs in the third quarter this year. Depreciation expense as a percentage of restaurant sales decreased 250 basis points to 6.4% of restaurant sales during the third quarter from 9.0% a year ago. The reduction reflects lower depreciation expense due to the asset impairment charge we took in the fourth quarter of 2009. We will experience a positive comparison of approximately $600,000 from these 2009 impairment charges in the fourth quarter as well. Pre-opening expenses were $382,000 in the third quarter compared to $480,000 last year.

These costs relates to the October 5 opening of our Baltimore restaurant. Our cash costs for preopening expenses is approximately $400,000 per restaurant. General and administrative expenses decreased $145,000 from the prior year quarter primarily due to a reduction in legal and professional fees. As a percentage of sales, G&A decreased 120 basis points to 6.7% during the third, during the quarter compared to 7.9% last year. Net loss for the quarter was $440,000 or $0.05 per share compared to a loss of $1 million or $0.11 per share last year. We ended the quarter with $2.2 million in cash and investments, during the third quarter net cash provided by operating activities was $1 million. We spent about $1.9 million during the quarter for construction of our Baltimore restaurants and initial work on remodeling our Kansas City and Denver restaurants. For our fourth quarter financial guidance, we are forecasting sales of $20.6 million to $21.6 million and a loss of $0.6 million to $1.1 million or $0.07 – $0.12 per share. Our guidance reflects positive same-store sales of approximately 2% for the fourth quarter. I will now turn the call back over to Mark before we go to Q&A.

Mark Beuhler

Thanks Mark. Our entire team continues to be focused on delivering an outstanding guest experience, every guest, everyday and every restaurant. We believe that the marketing and menu initiatives introduced during the third quarter are working and over time will enable us to build guest loyalty and drive both topline sales and bottom-line profitability. While we have historically only offered one quarter of forward guidance, it should come as no surprise that our general outlook for 2011 is optimistic based on our recent results. While we have no lease commitments at this time, we will pursue additional leases based on significant economic opportunity and availability of affordable debt capital or sufficient cash flow from operations.

In our normal course of business we are also in discussions with lenders for equipment leases or lines of credit that will provide us with additional financial flexibility. In closing, it has been about a year since I joined Kona as CEO, and looking back at the past year we have made significant progress in many areas. But most importantly our co-workers have been energized by a renewal of the Kona spirits and culture which ultimately translates into an exceptional experience for our guests. I want to thank you for your continued support and now we will be happy to answer any questions that you might have. Matt you can open the lines for questions.

Question-and-Answer Session

Operator

Okay thank you, ladies and gentlemen the question-and-answer session will begin electronically. (Operator instructions), and now I will take the first question from Rob Brown with Craig-Hallum. Please go ahead.

Rob Brown – Craig-Hallum

Good afternoon. I just wanted to get a little more color on your margin comments around direct expense and commodity costs. I guess I wanted to understand is there, how much leverage do you see in the direct expense line and is there anything that you can take out there to offset that commodity cost increase?

Mark Beuhler

The direct expense portion was mostly attributable to small ways that will part of depleting and presentation and maybe some kitchen items that, were part of the new menu will allow Rob, so that part will be, will see a little bit of that in the fourth quarter as we go through phase three but most of the significant part of that is done. But we do have, as I mentioned we will be remodeling in the fourth quarter and a lot of that will be capital, but part of it will go to the R&M line. So our guidance is basically flat in the other operating area. And then -

Mark Robinow

I'll jump on the commodity side of that Rob. Again it was about 100 basis points and it was really in the chicken lines definitely [ph] and in the beef line. We have already made moves on the beef front and a contracted beef starting in November. It will hit probably towards the end of November in the system but will see about a month of benefit brings down our overall beef cost between 6% and 10% from where it was trending in the third quarter. We will walk in 2011 beef and we are finally at the size now of an organization where we will be able to take advantage of our distribution network to lock in contracts.

Chicken is a little more challenging. We have got a solution there and then on the seafood front, we are exploring options and again we want to lock in at the right time of the year and amped [ph] our outside consulting group is really assisting us with that and so we have some professional discipline around that, so it's going to be a hit in the short term, like I said we took a little bit of price 1% on the 22 of September, so we got eight days of benefit out of that not a lot. We do expect to be able to take price next year as we roll into some of these periods.

Rob Brown – Craig-Hallum

There was another question I had on pricing I guess, what's the key can I go in your logic on pricing it seems like in this economic environment and sort of the challenging traffic environment that the taking pricing seems to recover to the earliest, I'm not sure of that logic and are you confident that, that will not disturb traffic?

Mark Beuhler

Again, I think we have seen such great traffic all year long plus 6, 7% through the first half of the year, and then this quarter it slowed down but we also got some check average back where you had seen us lose a lot of check over the last year compared to folks that we compete against. We were able to take back a little bit of check through promotional activity and the only way we are taking price is that for giving the guest a better item. But we are not taking price on items that don't change, and that's not something that we want to do. We are very confident with the price value equation and we think that we have a strategy out there that attacks that is somewhere in the (inaudible) methodology where and we have got some great entry-level items that will continue to look at and introduce through the six to nine months. But we also have upgraded the higher end of our menu most recently with the food-based promotion wrapped around the Hawaiian Rib-Eye, a Fresh Mahi and a Tuna Tartare appetizer. We have another food-base promotion that will roll out here in another week, which does the same thing, it allows us to drive check as well, so again as we take price we are only taking it as we upgrade products, give the guests more or bring an entirely new item.

Rob Brown – Craig-Hallum

Okay, and then another question in terms of the unit margins. Are you seeing pretty consistent unit margins among units or where do you see the distribution of unit margins, that are you seeing fewer or more underperforming unit, and give some color on how many units have been performing?

Mark Robinow

I think we have seen some improvement in a few of those underperforming restaurants so we have fewer then we had. We still have a few that we have some challenges there and those have a lot of our attention and focus to get them righted. But again we have seen improvement across-the-board throughout the system. The one area of concern we still have out there is Arizona, but it looks like Arizona might have a bottom for us recently, at least that is what I'm hoping as we look at trends. But again if we pull Arizona out of the mix for the quarter, we were actually positive 1.5%.

Rob Brown – Craig-Hallum

Okay. And then, I think you mentioned October was trending better is it, I think you said it was up 3.5% in September but sort of Octobers run rate.

Mark Robinow

Very similar, offsetting units that number.

Rob Brown – Craig-Hallum

Okay and then last question I guess. On your modeling efforts what is your CapEx expectations for that in Q4 and then next year.

Mark Beuhler

We're going to, we will be about $0.5 million in Q4 Rob and then we will look for kind of, if we look at 2011 right now we're going to probably be in the $4 million range for CapEx assuming that we build a restaurant at the end of the year of 2011 and we will have more to say about that on our call in February.

Rob Brown – Craig-Hallum

Okay, just some clearance. Does the summary include the like partial CapEx for a restaurant towards the end of the year and then what’s the split that you use for modeling in the New Year opening?

Mark Beuhler

As for as the $4 million would include all of the CapEx for our restaurant in 2011.

Rob Brown – Craig-Hallum

Okay, that's good and then I guess you kind of alluded with cash kind of needs and generations a little bit but you feel like your cash flow from operations can offset and CapEx (inaudible) kind of cash going forward.

Mark Beuhler

Absolutely.

Rob Brown – Craig-Hallum

Okay thank you. I'll turn it over.

Mark Beuhler

Thanks Rob.

Operator

And we will move along to Brad Ludington with KeyBanc Capital Markets. Please go ahead

John Dravenstott – KeyBanc Capital Markets

Hi, this is John Dravenstott instead of Brad. You gave us some guidance in the July, I think is that it was down 1.5 to 2%, September about 3.5% and can you fill in the blank there of what was August.

Mark Beuhler

Right. It was right around minus 1.8 to 2%.

John Dravenstott – KeyBanc Capital Markets

Alright and with Baltimore, it looks like your, I don’t know if it was just a matter than entering account base or if we actually got improvement out of the non-comp units but, when you look at Baltimore are you thinking there are some lessons learned from the unit openings here or are we going to see a 58,000 added to be same-store in Baltimore or is it going to be close to the account base for this first year.

Mark Robinow

It is really too early to say but we certainly would not want to build one we were at $58,000 level. That was not the plan.

John Dravenstott – KeyBanc Capital Markets

Okay and, just lastly looking at the Konavore program, give us a little bit of color in the second quarter about the expenses. Was there anything you can quantify for the third quarter for that Konavore program any promotions run or anything that would have strained margins and little bit in the third quarter?

Mark Beuhler

We ran, yes we still promoted the Konavore program fairly heavily during the third quarter and saw a great response and we had about 100 to 150 basis points of discounts reflected by that plan.

Mark Robinow

I think I will note that on the analysis side of it, the Konavore program this year has generated almost $1 million in incremental sales revenue in spite of the ticket used with that program.

John Dravenstott – KeyBanc Capital Markets

Great, thanks. And just finally on the pricing you are discussing, talking about only raising prices on new items or enhanced items it almost looks like you're more about mix shift driver rather than taking pricing, am I interpreting that wrong?

Mark Robinow

We are taking some price there is a mix shift as well. We introduced a whole new category of flatbreads which is a little more gourmet in our traditional pizza offerings, we are able to sell this at a higher price point than a traditional margherita pizza, a pepperoni pizza, a barbeque chicken pizza. And we are selling a tender loin flat bread so there is some mix shift but again as we look at the pepperoni pizza we upgraded the actual pepperoni that we use on that product. We are bringing in a whole log roasting the log in-house and providing a much better experience we have upgraded the sauce to a sauce made in-house, really, done some things to improve that product, so we're able to take a little bit of price on something as simple as pepperoni pizza as well.

John Dravenstott – KeyBanc Capital Markets

All right. Thank you.

Mark Robinow

Thanks John.

Operator

And we will now move along to Mark Johnson [ph] with William Blair.

Mark Johnson – William Blair

Hey guys.

Mark Robinow

Hi, Mark.

Mark Beuhler

Hi, Mark.

Mark Johnson – William Blair

Can we just go back to the, use of cash you guys were talking about it, sounded like you looking at pursuing some additional leases later this year, and I guess my question is with the stock trading roughly half of replacement value. Have you or the board looked at the potential for share purchases kind of versus new units as you start generating that excess cash.

Mark Robinow

We are looking at all uses of cash and discussing that as the board, we have signed no leases and have nothing confirmed or tentative yet at all. And so again it is an ongoing discussions point which I think will be able to give more clarity on next time we get on the phone.

Mark – William Blair

Okay great. Thanks guys, nice quarter.

Mark Robinow

Thanks.

Operator

And we move along to Mark Smith with Feltl & Company.

Mark Smith – Feltl & Company

All questions has been answered, thanks guys.

Mark Robinow

Great. Thanks Mark.

Operator

(Operator instructions) and at this time we have no further questions in the queue, I will turn it back over to our host for any additional or closing remarks.

Marc Beuhler

Alright, thank you very much, I appreciate everybody being on call today and look forward to chatting with you soon. Have a great day.

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