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Kona Grill, Inc. (NASDAQ:KONA)

Q1 2011 Earnings Call

April 27, 2011 5:00 pm ET

Executives

Mark S. Robinow – Executive Vice President, Chief Financial Officer and Secretary Marc A. Buehler – President and Chief Executive Officer

Analysts

Lee J. Giordano – Imperial Capital, LLC

Mark E. Smith – Feltl and Company, Inc.

Mike Malouf – Craig-Hallum Capital

Will Slabaugh – Stephens

Operator

Good afternoon, everyone, and thank you for joining us today to discuss Kona Grill’s Results for the First Quarter Ended March 31, 2011.

Joining us today are Marc Buehler, Kona’s Chief Executive Officer and Mark Robinow, the Company’s Chief Financial Officer. Following the remarks, we will open the call up to your questions. (Operator Instructions)

I would now like to turn the call over to the Chief Financial Officer of Kona Grill, Mark Robinow. Sir, please proceed.

Mark S. Robinow

Thank you. Before we begin our formal remarks, I need to remind everyone that the financial guidance the Company provides for its second quarter 2011 results, statements regarding the Company’s future sales, future profit or loss, and expectations regarding same store sales are forward looking.

We have attempted to identify these statements by using forward-looking terminology such as may, will, anticipate, expects, believes, intends, should or comparable terms. 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 forward-looking statements for any reason.

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 full discussion of risks and uncertainties associated with the forward-looking statements and the discussion of risk factors contained in the Company’s filings with the SEC.

With that, I’ll turn the call over to Marc Buehler, our Chief Executive Officer.

Marc A. Buehler

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 general comments about our first quarter, then I’ll turn the call back over to Mark, who will discuss the financial details for the quarter as well as provide some guidance for Q2. I’ll then wrap up the call with an update on some of our current initiatives and then provide some final thoughts before turning the call over for Q&A. Now, with that let’s begin.

We had a strong start to 2011 with solid top line results driven by a 7.6% increase in same-store sales. This increase in same-store sales follows a 6.4% increase in the fourth quarter of last year and represents the sixth consecutive quarter of sequential improvement in our same-store sales.

We’re encouraged by the increased momentum over the past several months driven by menu improvement and marketing initiatives aimed at building awareness and guest frequency.

The recent quarter was also the fifth consecutive quarter that we experienced positive traffic trends, which we believe demonstrates the strength and popularity of the brand. During the first quarter, we were able to leverage our operating margins through higher sales volumes, although spikes in seafood and produce prices prevented us from realizing the full benefit of these higher sales volumes. We continue to believe that if current sales trends continue we will be profitable in 2011.

I would now like to turn the call back over to our CFO, Mark Robinow, who will take us through the financial details for Q1. Mark?

Mark S. Robinow

Thanks, Marc. For the first quarter ended March 31, restaurant sales increased 12.3% to $23.6 million reflecting additional revenue from the Baltimore location open last fall, higher sales for restaurants not in the comp base and a 7.6% increase in comparable restaurant sales.

The increase in same-store sales is attributed to strong guest traffic throughout the quarter and a higher average guest check. The sales increase includes about 2% pricing, which we took last fall. Going forward, we believe we have the ability take additional pricing to offset higher commodity cost. We also intend to continue rolling out new menu offerings, with high quality ingredients, which may be at higher price points.

As Marc mentioned, our comp sales improved sequentially in each of the last six quarters. We believe that we can continue strong sales momentum throughout the remainder of 2011. However, continued sequential improvement becomes more difficult as we roll over last year’s improvement.

Cost of sales as a percentage of restaurant sales increased 170 basis points to 28.2% during the first quarter from 26.5% last year.

As you are probably aware hard freezes in California, Texas and Mexico resulted in significant spikes in produce this quarter. We also experienced higher year-over-year increases for Tuna, Sea bass, Salmon, and the other seafood.

We have contracts in place for beef, shrimp, and calamari and are working with our vendors to firm up pricing for other seafood products. We are working with these vendors to ensure we get the best pricing available and reasonable delivery charges.

Labor expenses as a percentage of restaurant sales decreased to 180 basis points to 34.2% during the first quarter from 36.0% last year. The lower labor cost percentage is attributable to the leveraging of fixed management wages, hourly labor and benefit cost from the 7.6% increase in comp sales. We expect labor as a percentage of sales to improve incrementally as we leverage these costs through higher sales.

Restaurant operating expenses as a percentage of restaurant sales decreased 40 basis points to 16.0% during the first quarter from 16.4% last year. The lower operating expense percentage is primarily due to the leveraging of the fixed portion of these operating costs through higher sales volumes. We expect these costs to remain approximately 16% of sales during 2011 due to planned, repair and maintenance and remodeling expenditures for all the restaurants.

Occupancy expenses as a percentage of restaurant sales decreased 90 basis points to 7.6% during the first quarter from 8.5% last year. We continue to pursue rent abatements and rent reductions at certain of our lower volume units. Combining these four line items, restaurant operating profit increased $645,000 to $3.3 million for the first quarter.

As a percentage of restaurant sales, restaurant operating profit was 14.0% during the quarter compared to 12.6% last year. On a sequential basis, restaurant operating profit improved 200 basis points over the fourth quarter of 2010. We continue to focus on further margin improvement to reach profitability in 2011.

General and administrative expenses decreased $255,000 from the prior year quarter primarily due to a reduction in legal and professional fees associated with last year’s contested proxy solicitation and the ongoing derivative suit. As a percentage of sales G&A decreased 220 basis points to 8% during the quarter compared to 10.2% last year.

Net loss for the quarter was $92,000 or $0.01 per share compared to a net loss of $907,000 or $0.10 per share in the first quarter of 2010. Net loss for prior year quarter included $300,000 or $0.03 per share for the special charges just mentioned.

We ended the quarter with $3.4 million in cash and investment. During the first quarter net cash provided by operating activities was $1.3 million, and we spent $500,000 during the quarter for capital expenditures which includes final payments for our Baltimore restaurant and plan and remodeling costs for our older restaurants.

For our second quarter 2011 financial guidance, we are forecasting sales of $24 million to $25 million and income of $200,000 to $400,000 or $0.02 to $0.04 per share. Our guidance reflects the expectation of a positive same-store sales increase of approximately 5% for the second quarter.

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

Marc A. Buehler

Thanks Mark. We are very pleased with the progress we made this quarter in terms of same-store sales improvement. We know that we still have work to do in order to further leverage these higher sales volumes and the higher operating margins and bottom line profitability. We are working diligently to accomplish this.

As Mark reported, operating margins were affected by commodity cost increases. In March we made a change in our primary distribution network to leverage our purchasing power, better control costs and improve the service and consistency and product availability. We expect to see positive results from these efforts in Q3, although we still foresee cost of sales as a percentage of sales to be unfavorable on a year-over-year basis.

Over the past year we completed a comprehensive menu evolution project to improve the “wow” factor and enhance the flavor profile of many of our menu items. At the end of first quarter we rolled out the final phase, which included additions and enhancements to our sushi offerings. We continue to receive very positive guest feedback from these changes and believe that the changes we’ve made over the past year are responsible for building guest loyalty, driving higher frequency and lastly, increasing average check.

While we have no lease assigned for 2011 development, we are pursuing development opportunities for 2012 and beyond. In addition, our team is busy working on remodels up to five of our mature restaurants later this year. Estimated CapEx for remodels is approximately $400,000 per restaurant, with two remodels, Omaha and Carmel Indiana scheduled for the second quarter.

We are also updating the painting, artwork, music and signage at most of our other restaurants to give them a consistent new look and feel. We recently hosted parties in Las Vegas and Scottsdale to celebrate the new look of each of these restaurants.

As we continue to execute on our 2011 plan, we remain focused on delivering an outstanding guest experience, every guest, every day in every restaurant. We believe that the past year’s investments in marketing and menu development have driven top line growth and will go a long way in strengthening the foundation for a successful company.

Now with that, I’d like to open up the call for any questions that you might have.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) The first question is from Lee Giordano from Imperial Capital.

Lee J. Giordano – Imperial Capital, LLC

Thanks. Good afternoon, everybody. Can you talk a little bit more about the remodels, how are they performing relative to the rest of the chain, and are remodels included in the comp store sale base?

Marc A. Buehler

At this point we’ve only remodeled Kansas City, remodeled in November of last year. It’s exceeding our expectations and we’ve talked in our presentations about an 18-month payback for those remodels. That one is ahead of expectations. It is in the comp base because it is an older restaurant. So it is certainly helping drive the overall comp performance. It is outperforming the rest of the systems, but not by ridiculous margins.

Lee J. Giordano – Imperial Capital, LLC

Great. And then secondarily, you talked about sourcing costs and seafood costs coming up. Are there any impact from the tsunami and the nuclear disaster in Japan on sourcing seafood?

Marc A. Buehler

It hasn’t directly affected us from a sourcing standpoint. However, we know that there has been some supply disruption for other folks and that is driving cost up slightly. Right now I can’t tell you what the long-term effect is. But again, we’re working diligently with a couple of national providers right now to help us mitigate the impact.

Lee J. Giordano – Imperial Capital, LLC

Great. Thanks a lot.

Operator

Thank you. The following question is from Mark Smith, Feltl and Company. Please go ahead.

Mark E. Smith – Feltl and Company, Inc.

Hi, guys. Can you talk about the impact that gift cards may have had on the comp here in Q1?

Mark S. Robinow

Hello, Mark. I’ll answer that one. We did sell approximately 50% more gift card in the fourth quarter of 2010 versus 2009 and we have probably seen about a third of them redeem so far. The effect on our comps was probably marginal and most of our first quarter comp come from guest traffic and increased guest check.

Mark E. Smith – Feltl and Company, Inc.

All right. Probably then just still looking at the comp, any impact that you’re seeing on shift in menu especially looking at alcohol?

Marc A. Buehler

Alcohol has remained steady. What we’ve seen is shift in sushi, our sushi mix is actually up about 100 basis points and that’s outside of the impact of pricing that we’ve taken. So we’ve seen with new introductions in sushi. We’ve introduced a few higher priced items, we had a food based promotion during the quarter, which featured in Omakase, which in essence is a nice sharing plate of Sashimi items, it was a $25 item. That helped to shift the mix in the sushi, which also impacted the cost line because seafood was up significantly in the quarter.

Mark E. Smith – Feltl and Company, Inc.

So safe to say, you’re not getting any push back on the price you took in sushi?

Marc A. Buehler

No. It’s actually, we’ve gotten zero feedback on a negative basis.

Mark E. Smith – Feltl and Company, Inc.

Okay. Then last question, just looking no lease assigned to-date but if you were to get into a lease here shortly, what would the timeframe look like, what’s the soon as you could get into on new restaurant?

Marc A. Buehler

The shortest build time from it, we signed a lease today would be nine months, more likely you’re looking at 12 to 15 months.

Mark E. Smith – Feltl and Company, Inc.

Okay. Perfect. Thank you.

Marc A. Buehler

You bet.

Operator

Thank you. The following question is from Mike Malouf from Craig-Hallum Capital. Please go ahead.

Mike Malouf – Craig-Hallum Capital

Hey thanks guys, and a great quarter. I wanted to focus a little bit on the new store opening potential, can you talk, do you have a good pipeline of the leases that you’ve looked at, and if so what do you need to get to the point where you actually have set aside and which is again and what kind of financial. Can you just comment a little bit on the financial capacity that you have currently with regards to growing? Thanks.

Marc A. Buehler

Sure, absolutely. The pipeline is good; there are lots of outstanding opportunities out there. The good news is, as we did not leave the marketplace over the last 15 months, we’ve been actively pursuing great sites, and I say that it changes our development strategy a little bit from where were four or five years ago, where we were chasing sites along with several of our competitors and ended up in a lot of Greenfield projects.

The projects that we’re looking at today are built, have significant performance history behind them already. They might be re-developments of existing malls or shopping venues. We’re also very pleased with our Baltimore opening which we opened last October and the ability for us to go into a downtown urban core. So the good news is, the pipeline is strong, we are in negotiations right now on multiple sites and we’re working through the LOI process and something that we’ll continue to discuss as a management team and with our Board of Directors and move forward on a prudent basis on deals that make sense over all.

I think we talked about our model; we targeted $4.5 million average unit volume on these things after they’ve been opened for two years. We also, from an economic model, are looking for deals where the tenant allowance money from landlords is significantly higher than it’s been in the past and we haven’t seen push back there. And then from our ability to finance these things, we’re in the marketplace looking for appropriate debt capital should it be necessary. But we’re also generating cash right now, so we would have the ability to build restaurants next year with the combination of cash and debt whatever is most advantageous for our shareholders.

Mike Malouf – Craig-Hallum Capital

Great, thanks. And then as it relates to the cost, can you give us a sense as to how much of that is related to price versus traffic?

Mark S. Robinow

Traffic was up 3.3% for the quarter and guest check average was up 4.4%. Our overall pricing impact on the quarter was about 2%. And then in the last week of the quarter we took about an additional 90 to just under 100 basis points of price related to the sushi roll out. But that didn’t impact first quarter, we would see that in second quarter.

Mike Malouf – Craig-Hallum Capital

Okay. Great, thanks.

Mark S. Robinow

Super. Thank you.

Operator

Thank you. (Operator Instruction) Following question is from Will Slabaugh from Stephens. Please go ahead.

Will Slabaugh – Stephens

Hey, guys, congrats on the quarter. Whenever I look at the strong revenue performance this quarter and then the nice growth implied by your 2Q guidance, I’m having trouble keeping my EPS down to the $0.02 to $0.04 level. Are you guys just being conservative around the margin expansion and maybe the operating leverage there or is there something that I’m missing?

Marc A. Buehler

I’ll let the CFO talk about that one.

Mark S. Robinow

Well, we said Will that we’ve done something on in terms of our distribution chain. We switch to a new distributor in late March and we thought that that would take about 90 days to work the bugs out. So what we said in our last conference calls we thought we would see benefits on the food cost line in the third quarter of this year. So we haven’t modeled any of that into Q2. So, yes, because of that we’ve been conservative probably on our bottom line and feel good about our guidance and where we guided to.

Marc A. Buehler

I think there is also some unknowns out there from an economic standpoint that again causes us some concern, and we continue to just look at that. And there are some unknowns out there, there are some items that are uncontracted for us today. If we can continue the top line growth and leverage the labor numbers, leverage the operating cost, the occupancy cost that food cost line really becomes critical for us and that’s where we pick up additional earnings.

Will Slabaugh – Stephens

Great. And on the regional level margins just to get some comfort around those, thinking about where you’re now and then the kind of upper teens arrange where you said you can return. Would it be safe to assume that there are already a meaningful numbers of restaurants that are at or above that level? And then can you see a fairly clear paths that kind of hitting that company-wide goal of getting back the upper teens.

Marc A. Buehler

Our goal to get back there is next year certainly.

Will Slabaugh – Stephens

Sure.

Marc A. Buehler

Probably late in the year next year. And we see the path to get there, I think one of the most promising things that we’ve seen is the average weekly sales volume at our newer restaurants, and you will notice that in our release, the numbers there. Again, we’re closing the gap there. I think we were only about $3,000 difference between our matured restaurants and our newer restaurants.

So we’ve seen some significant improvement in those restaurants. And at this point we only have two restaurants that are in the comp base; Tampa and Baltimore. Tampa rolled into the comp base I believe during this quarter or maybe it’s in third quarter it rolls into the comp base. We’ve seen improvement, which is nice, and we’re really pleased with the results in Baltimore six months in there we haven’t enrolled into season yet. So, I think all of that combined and seeing the lower volume restaurants starts to move up is going to help push that restaurant level operating profit margin back into the high teens where we want to be.

Mark S. Robinow

So the first part of your question Will, (ph) of course we have a lot of restaurants that are already above those operating metrics in terms of restaurant operating and come in the high teens, and it’s predicated on raising the sales volume of those lower performing restaurants that will get up there overall.

Will Slabaugh – Stephens

Okay. And just lastly a couple of housekeeping questions. In our guidance here, is G&A a good run rate from this quarter for the rest of the year, and then also could you tell us the tax rate and the share count implied in your 2Q guidance?

Mark S. Robinow

The tax rate is, we really don’t have much of the tax rate because all we pay our stake tax is right now, and it’s not on a percentage basis, it’s really on a dollar basis, and we will look on that pretty much $10,000 to $20,000 per quarter during 2011 of state taxes payable and G&A is going to run between right under $2 million per quarter prior to most of the year. And then the last part of your question was –?

Will Slabaugh – Stephens

On the G&A, we had a good run rate right now for the rest of the year and also the share count implied? And thank you, guys.

Mark S. Robinow

G&A as I said just should be coming just under $2 million per quarter. It’s a pretty safe run rate for us. And the share count is right around 10 million on a profitable basis when we add in all our equivalents.

Will Slabaugh – Stephens

Great. Thanks.

Operator

Thank you. At this time this concludes our question-and-answer session. I would now like to turn the call back to Mr. Buehler, please proceed.

Marc A. Buehler

Great. Thank you very much. As always I want to thank you for joining us this afternoon and I especially want to thank you for the insightful questions and comments. We look forward to executing on our 2011 initiatives and continuing to build Kona Grill into the one of the great names in polished casual dinings. It continues to be a pleasure to work with our team, which I count among the best in the industry. We look forward to continuing this positive momentum throughout 2011. Thanks everybody.

Operator

Thank you. I would like to remind everyone that this call will be available for replay through May 27, 2011 starting later this evening. A webcast replay will also be 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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