Kona Grill Inc. Q2 2008 Earnings Call Transcript

| About: Kona Grill, (KONA)

Kona Grill Inc. (NASDAQ:KONA)

Q2 2008 Earnings Call

July 29, 2008 5:00 pm ET

Executives

Marcus E. Jundt - Chairman and Chief Executive Officer

Mark S. Robinow - Chief Financial Officer

Jason J. Merritt - Chief Operating Officer

Analysts

Matt Difrisco – Oppenheimer

[Eric Apelle] – [Apelle Capital management]

Robert Brown – Craig-Hallum

[Mark Ye] – Wedbush Morgan

Amy Greene – Avondale Partners

Unidentified Analyst – Cowen and Company

[Nikki Strauss] – [Strauss]

Operator

Ladies and gentlemen, thank you, for holding and welcome to the Kona Grill second quarter 2008 earnings conference call. (Operator Instructions) Now I would like to turn the conference call over to Mark Robinow, Chief Financial Officer. Please go ahead sir.

Mark Robinow

Thank you Kevin, and thank you everyone for joining us. By now you should all have our second quarter earnings release. It can also be found on our web site 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 risk that could impact our future operating results and financial conditions. With that, I would like to turn the call over to Marcus Jundt, our Chief Executive Officer.

Marcus Jundt

Thank you, Mark, and thank all of you for joining us today. We'd like to cover several topics during this call. First, I will open with some brief comments about the second quarter. Mark will then discuss in detail our financial results as well as our updated guidance for the remainder of 2008. I will then wrap up the call with some final thoughts along with a review of our growth strategy before turning the call over for questions and answers. And with that, let us begin.

Restaurant sales of $20.2 million were at the high end of our forecasted range for the quarter, thanks to strong performance from our restaurants in Texas, Louisiana, Colorado, Michigan, Connecticut, and Nebraska.

In our other markets, we certainly felt the effect of a very tough consumer environment during the second quarter, which contributed to our overall same store sales decline of 5.6%. For the quarter we had a net loss of $535,000, or $0.08 per share, which was within our guided range.

During June, we opened our restaurant in Gilbert, Arizona. The restaurant is located at San Tan Village, in the southeastern portion of metro Phoenix. The restaurant has benefited from a strong brand recognition we have in the Phoenix area, given our nearby locations in Scottsdale and Chandler. We are very pleased with this store's result today.

Overall, we generated restaurant operating profit margins of 18.2% during the second quarter compared to 20.3% last year. Like most restaurant companies our margin was compressed by higher labor and operating costs.

However, we were able to offset some of this margin pressure to better management of our food costs. Despite the decline in same stores sales, our comp base was still able to generate restaurant operating profit margins of 20.2%. More than anything, we think this exemplifies the inherent strength of our four-wall business model, even in an increasingly challenged economic climate. And with that, I will send the call over to our CFO, Mark Robinow.

Mark Robinow

Thanks Marcus. When the second quarter ended June 30th, restaurant sales increased 4.5% to $20.2 million reflecting additional revenue from three restaurants open since November 2007; Stanford, Baton Rouge and Gilbert.

Same store sales for the 12 restaurants in the comparable base were down 5.6%. Four restaurants in Arizona, Nevada and Missouri, experienced a decline in same store sales as a result of increased competition and the weak economy.

Kansas City is a new addition to the negative same store sales list as sales were impacted by the opening of a large-scale downtown development just minutes from the restaurant. If these four restaurants were excluded, our comp sales would have been approximately flat. Worth noting that even though these four restaurants are experiencing negative comps, they contributed almost $1 million in restaurant operating profit during the second quarter.

Cost of sales as a percentage of restaurant sales decreased 110 basis points to 27.3% during the second quarter from 28.4% last year. Cost of sales for the second quarter benefited from increased purchasing efficiency and reduced waste resulting from our newly implemented automated food cost and inventory management system.

We are experiencing great results from this initiative of 50 to 100 basis points of margin improvement, when restaurant management gains experience with the software. Roll out of this system was completed in July of '08, but we are not forecasting any further food cost margin improvements going forward as a result of this initiative.

Labor expenses as a percentage of restaurant sales increased 210 basis points to 33.0% during the second quarter from 30.9% last year. The increase as a percentage of restaurant sales is primarily due to de-leveraging of fixed salaries and increased labor expenses due to the impact of federal and state minimum wage increases.

We expect to experience continued pressure on labor costs in '08, as a $0.70 hike in federal minimum wage took affect on July 24th. Ahead of this wage increase we implemented a 3% price increase on May 1st to help mitigate its full effect.

Occupancy expenses as a percentage of restaurant sales increased 20 basis points to 6.4%, during the quarter, compared to 6.2% last year. Restaurant operating expenses as a percentage of restaurant sales increased 90 basis points to 15.1% from 14.2% last year, as a result of higher repair and maintenance, utilities and training costs.

We expect restaurant operating expenses to remain above 15% of sales throughout 2008 as we continue to refurbish our four oldest restaurants. In addition, we plan to increase marketing and advertising investments in the second half of this year as we roll out a direct mail promotion, celebrating the 10th birthday of the first Kona Grill in Scottsdale.

Combining these four line items, restaurant operating profit was 3.7 million or 18.2% of sales, compared to 20.3% last year. If current economic conditions persist throughout 2008, we can expect to face continued pressure on our restaurant operating margins compared to the year ago period.

General and administrative expenses were up 200,000 to 2 million during the quarter. Approximately 150,000 of this increase is associated with the adoption of our Shareholder Right’s Plan in May.

The opening expenses were $541,000 in the second quarter, compared to $350,000 last year. The majority of these costs relate to the opening of our Gilbert location and the planned opening of three additional restaurants later this year. Our current budget for pre-opening expenses is approximately $400,000 per restaurant.

Depreciation and amortization expense as a percentage of restaurants sales increased 70 basis points to 8.3% during the second quarter from 7.6% a year ago. The increase is primarily a result of de-leveraging of fixed depreciation cost due to a lower average sales volume.

Net loss for the second quarter was $535,000 or $0.08 per diluted share on a weighted average diluted share base of 6.6 million shares. Last year, we posted a net income of $313,000 or $0.05 per diluted share on a weighted average diluted share base of 6.2 million shares. It's worth noting that in the absence of the one time expense for the Shareholder’s Rights Plan, approximately $0.02 per share we would have reported results at the high end of Q2 guidance.

Balance sheet continues to remain strong as we ended the quarter with $14.5 million in cash and investments. 6.1 million of this amount is held in highly rated student loan-backed auction rate securities. As noted last quarter, the uncertainties in the credit market have adversely affected auction market for these types of securities, which are currently not liquid.

We have recorded a year-to-date unrealized lost of $458,000 to reflect the estimated fair value of these securities. We have the ability to borrow against these securities should we need to access these funds before the markets recover.

The total debt balance was $2.4 million at the end of the quarter. During the second quarter, net cash provided by operating activities was $1.9 million. We spent $3.1 million on capital expenditures during the quarter, primarily for the Gilbert and West Palm Beach restaurant.

We expect our average cash expenditure for new restaurants to be approximately $2.5 million net of tenant improvement allowances as pre-opening expenses. We are pleased that construction cost for new restaurant development has stabilized.

Now an update on our financial guidance. For the third quarter of 2008, we are forecasting revenue of $19.5 million to $20.5 million and a net loss of $0..6 million to $0.9 million or $0.09 to $0.13 per diluted share.

Order to-date comps are sequentially down from Q2 with our locations in Arizona, Nevada and Missouri accounting for the majority of the decrease. Our Naples, Florida restaurant, which is being challenged by both the economic down turn, as well as some location specific issues, has now been added to the comp base starting in the third quarter.

For the fiscal year 2008, we are revising our forecast given our limited visibility in the current environment. We now look for revenue between $80 million and $82 million, and a net loss of $2.8 million to $3.8 million, or $0.43 to $0.58 per diluted share.

Our revised guidance reflects two major changes. The first is a reduction in the same store sales forecast from minus 2% to minus 6% for the remainder of the year. The second is an adjusted restaurant opening schedule based on 26 less operating weeks from new restaurants in the second half of 2008. We will update these expectations as necessary, should market conditions change during the remainder of the year.

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

Marcus Jundt

Thank you Mark, before discussing our development plans, I wanted to mention that during the quarter we purchased 116,200 shares at a total cost of $1 million under our stock repurchase program. We are authorized to repurchase up to 600,000 shares of common stock, although we are not obligated to acquire any particular amount per se nor is there a time limit on the authorization itself.

As a public entity, we are committed to creating long-term value for all of our shareholders. To that end, in May, our board adopted a Stockholder Rights Plan, to help assure that our stockholders are able to realize the long-term value of their investment in our company.

We have a great deal of confidence in the long-term prospect of this brand. And we believe the adoption of this plan will help to provide a means to ensuring that our stockholders realize the full potential of our growth.

With regards to development we are on track to open four new restaurants in 2008. We are reducing our 2008 restaurant opening plan by one restaurant, which will now open early in first quarter '09. We see no reason to push a holiday opening in this tough consumer environment.

The current plan is to open our West Palm Beach restaurant at the end of September, followed by North Phoenix and Richmond during the fourth quarter. The 2009 development schedule is taking place nicely. In addition to the site in Woodbridge, New Jersey, which we just moved from fourth quarter '08 to first quarter '09, we have signed leases for restaurants in Baltimore, Maryland, Eden Prairie, Minnesota and Tucson, Arizona.

Given the current uncertainty of the commercial real estate market, it is to our advantage to be more patient in our on-site selection and the negotiation of leases. And we will therefore take the time necessary to secure terms that our most advantageous to us.

We will continue to evaluate all new restaurants development in the context of the current difficult environment, and expect to provide more specific guidance on 2009 development on our next conference call.

Jason Merritt, our COO, has joined us for the Q & A portion of our call. I will 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) First up, we have a question from Matt Difrisco - Oppenheimer.

Matthew Difrisco - Oppenheimer

Thank you, can you hear me okay?

Marcus Jundt

Yes, we can Matt.

Matt Difrisco - Oppenheimer

Okay, just curious what is the cash balance? I might have missed that if you mentioned that at the end of the quarter.

Mark Robinow

Fourteen-and-a-half-million, Matt.

Matt Difrisco - Oppenheimer

Fourteen-and-a-half-million, so you sold your corporate bonds, then?

Mark Robinow

No that balance is made up of cash and investments including auction rate securities.

Matt Difrisco - Oppenheimer

What's your cash balance?

Mark Robinow

The cash is like $6 million and some change.

Matt Difrisco - Oppenheimer

Okay, and then you have short-term investments in corporate debt securities?

Mark Robinow

They are primarily in money market funds and bank certificates of deposit.

Matt Difrisco - Oppenheimer

And how much did you have of that?

Mark Robinow

Well that’s – there’s about $400,000 of that.

Matthew Difrisco - Oppenheimer

Okay, so right now you're pretty liquid then, as far as $6 million is cash, not short-term investments?

Mark Robinow

Correct.

Matthew Difrisco - Oppenheimer

And then, $400,000 of mutual fund – money markets or corporate bonds, correct?

Mark Robinow

Bank certificates of deposits.

Matthew Difrisco - Oppenheimer

Thanks, okay. And then, can you give us the timing of – should we presume then it sounds like that, store that is falling out in '08, would be 1Q' 09 opening?

Mark Robinow

That is correct.

Matthew Difrisco - Oppenheimer

Would that be the only store coming in 1Q? I’m just trying to manage the pre-opening costs.

Mark Robinow

Probably will be – that one will probably be early Q109, and there will probably be another one at the end of Q109.

Matthew Defrisco - Oppenheimer

Okay, and then have you – where do we stand as far as – I think you mentioned commentary that the cost has come down on the structure. The investment costs have you now – what have you done to the prototype or where have you reduced the cost? Has is it been the fish tank or where are we looking to save some of the cost? Is it the smaller capacity store or is it [FF&E] things that we might not otherwise notice?

Mark Robinow

Matt, I don’t think we said that the cost went down. I think we said it stabilized. So it’s still $2.5 million net of our TI allowances.

Matt Difrisco - Oppenheimer

Okay, can you be more specific on the Kansas City challenges. Was there a specific restaurant competitor or was it an entire new retail center that's redirecting the consumer?

Jason Merritt

Matt, this is Jason. Kansas City put in a power and light district is what it's being called in the downtown area. And basically this is an $850 million development. Currently, there are 21 restaurants and bars that have opened thus far, which is basically since the first of the year.

Matt Difrisco - Oppenheimer

Okay, appreciate that detail. And then, can you just give us a little insight as far as the overall pricing that you have? I think, you said you incrementally took in May 3%. What are we – What is going to be maintained year-over-year for 3Q and 4Q?

Mark Robinow

At this point Matt, it would be a blended, a weighted average, in this quarter of 4% price and then moving, we roll off that on July 1st, which at this point would be 3% for the rest of the year, unless we elect to take price later in the year.

Matthew Difrisco - Oppenheimer

Okay, and then I just wanted lastly, can you just leave off with directionally, what are looking at as far as your specific food costs? You do have an eclectic basket versus your peers. So, we don’t get to much insight into sushi, rice, and other forms that you're exposed to versus you peers. Can you tell us what the trend has been in those more rare commodities and what you expect in '09 at this early stage? Thanks.

Mark Robinow

The trend has been blended pretty flat, and, you know, we did have a slight uptick in rice, which had an effect for about 30 or 40 basis points but we had some other fish that was declining. We are seeing other protein costs moving up and down like all other restaurants.

So that our improvement in food costs came from really three places, as partially, as we said in the script that, you know, we reduced our weight; we were able to increase our ability to buy both food and liquor more efficiently. And also we had, you know, frankly less give-a-ways at the restaurant level as a result of a tighter food cost inventory system.

Matt Difrisco - Oppenheimer

Thank you, those are all my questions.

Operator

(Operator Instructions) We have a question next from, [Eric Apelle] - [Apelle Capital Management].

[Eric Apelle] - [Apelle Capital Management]

Yes, good day gentlemen. How are you doing?

Mark Robinow

Pretty well, how are you doing?

[Eric Apelle] - [Apelle Capital Management]

Good, kind of a new shareholder. A fund had just actually just started to accumulate the stock and I was just curious, because I haven’t been on previous conference calls, so I apologize, but what is management – what has management said about the cash offer that was put on the table by one of the funds?

Marcus Jundt

Management discussed the offer with the Board. The Board hired an investment advisor. After a lengthy discussion the Board decided to turn down the offer. I’ll leave it at that.

I will tell you this, that the Board, the management team, many friends of the management team, financed the company when it was private and are substantial if not over the majority of the shareholders of the company.

[Eric Apelle] - [Apelle Capital Management]

Okay, was it – maybe you could help me out? Was it based off the price, the valuation of the enterprise value of the company, or the uncertainty of the fund actually being able to raise the financing to actually, make – to do the OBO?

Marcus Jundt

No, I think it was more of an issue of most of the investors have been involved with this company for a substantial amount of time. And that they felt that we have one of the great restaurant chains in the United States. And that it would be a shame to sell out so early in the growth phase.

Now it's our firm belief that at some point in the not to distant future we will have over 100 units. If we can do 5 million a unit with 20% operating margins, we’ve got one of the great opportunities of a lifetime in this space. And to sell out early would just be a shame.

[Eric Apelle] - [Apelle Capital Management]

Okay, fair enough. I appreciate the answer, thanks.

Operator

We'll move on to a question now, from Rob Brown at Craig-Hallum.

Robert Brown - Craig-Hallum

Thank you. You had mentioned, I think the comp trends thus far in the quarter had deteriorated a little bit. What are they kind of running at in July in terms of a number?

Mark Robinow

Well they're bouncing around a little bit, Rob, and we're looking at, you know, as we said we're looking at kind of about a 6% negative comp this quarter.

Robert Brown - Craig-Hallum

So is that – can we assume that's what they're trending thus far this month or they a little worse than that?

Mark Robinow

Well it’s a little worse than that, but trending, you know, it has been trending a little better near the end of the month. And we’ve got several days left in month also, so it’s hard to call exactly what the comp's going to be in the month of July.

Robert Brown - Craig-Hallum

Okay, and then the decision to kind of push the unit out into '09, does that imply that your '09 unit opening, sort of thoughts, does that add a unit to '09 or does that ort of slide everything up to the right?

Jason Merritt

It really hasn’t influenced our decision on how many we are going to open for '09. We could’ve opened that this year, but it just didn’t make sense to push it that hard considering we would be hiring people over the holiday season. I think we will actually save money by opening up early in the first quarter.

Robert Brown - Craig-Hallum

Okay. And I think you mentioned you got about 12 operating weeks without – because of the opening schedule. Are you seeing delays in your opening pipeline? Is there something changed there or maybe you could just explain why you pulled out operating weeks out of your opening plan?

Jason Merritt

We had a number – I guess it hasn’t changed any in that we've had delays during the permit process and also delays on certain properties of landlord deliveries. Both of those have happened and then we made the choice as Marcus said, to push back one unit from December into January, because it wasn’t – it’s not worth the extra expense to push the envelope so hard and get it open before the end of the year.

Robert Brown - Craig-Hallum

Okay, thank you.

Operator

Now a question, from [Mark Ye] - Wedbush Morgan. You may be muted Mr. [Ye]; we can’t hear you right now.

[Mark Ye] - Wedbush Morgan

Now can you guys hear me?

Jason Merritt

Yes we can, go ahead.

[Mark Ye] - Wedbush Morgan

Okay, a quick question, on alcohol sales. What was the percentage of alcohol sales as a revenue?

Mark Robinow

Alcohol sales during the second quarter was 32%, of sales.

[Mark Ye] - Wedbush Morgan

Okay so there was like a slight uptick from last quarter, right?

Mark Robinow

It was slight.

[Mark Ye] - Wedbush Morgan

Okay.

Mark Robinow

I mean year-to-date we are at 31%. So it’s not materially different.

[Mark Ye] - Wedbush Morgan

Okay, great that's all I had to ask. Thank you so much.

Operator

We'll move on now to Amy Greene - Avondale Partners

Amy Green - Avondale Partners

Hi guys, have you seen any changes in the day part mix or any shifts, you know, within the new mix or ordering?

Mark Robinow

Amy when we – most of our decline in comps is coming primarily from late night and lunch. But we have not seen any significant differences in menu mix. When people do come they seem to be ordering the same thing and at the same kind of average check.

Amy Greene - Avondale Partners

Now you mentioned the 10th anniversary promotion that you are doing around Scottsdale. Does most of the comp shift you're seeing is in those two definable day parts, have you thought about or are you doing any promotions or anything like that around those to help stimulate traffic?

Jason Merritt

The answer is yes, but we haven’t announced anything.

Amy Greene - Avondale Partners

Okay, now looking at the cost kind of the back half of this year, are there any particular – you said you're not modeling for any additional food cost benefit from the implementation of the systems. But are you seeing any material increases in any particular food items as we finish out '08?

Mark Robinow

Actually we're not. The only thing we saw during the second quarter was obviously some fuel surcharges from certain vendors that had the ability to charge us with those. But to the extent that we will see those in the third quarter, if fuel prices, diesel fuel prices, remain high we may see some of those. But our diversified commodity mix continues to bounce around and we don’t take big hits from any single commodity at this point.

Amy Greene - Avondale Partners

And do you – last one and then I will leave you guys alone. The price that you all took in May, do you feel comfortable with that can offset the wage increases we’ve seen recently, and any other kind of inflationary effects you may see over the next several months.

Mark Robinow

It will mitigate that, you know, the federal state and minimum wage increases in several of our restaurants. But where we're seeing the most pressure, frankly, on our labor line is paying higher salaries to attract more mature and qualified restaurant managers.

Amy Greene - Avondale Partners

Okay, and that's more of a sales leverage game, so there’s really no other way to save money there for the time being, I suppose.

Mark Robinow

We think it’s an investment in delivering a quality food and service as a Kona Grill experience.

Amy Greene - Avondale Partners

Okay, thanks guys.

Operator

We have a question now from Paul Westra - Cowen and Company.

Unidentified Analyst - Cowen and Company

I was actually calling in for Paul and most of our questions have been answered, but just any quantifiable impact from the July 4th weekend? And if so, have the comps kind of rebounded in July [inaudible]?

Mark Robinow

We didn’t – you know, we're on a calendar reporting basis so the July 4th weekend watch is out between the two quarters for us.

Unidentified Corporate Participant - Cowen and Company

Okay, thanks.

Operator

[Operator Instructions] We’ll move to our next question, now this is [Nikki Strauss] - [Strauss]

[Nikki Strauss] - [Strauss]

Yes, my question has been answered. Thank you.

Operator

Thank you very much. We’ll move back to Matt Difrisco for a follow-up.

Matthew Difrisco - Oppenheimer

I think the question from Cowen was in respect to the Fourth of July falling on a Friday versus a Wednesday. Did you see that weekend traffic hurt you or was that a non-event?

Mark Robinow

No, we were, I mean, weekend-over-weekend we were down from the prior year because of that, because of the shift on the holiday.

Matt Difrisco - Oppenheimer

Can you give us some numbers around that? Some other managements are saying about a 1% drag or so.

Mark Robinow

Yes, ours would be similar to that and then certainly in our 5.6% decrease for the quarter.

Matt Difrisco - Oppenheimer

Well, I mean the Fourth of July is in the third quarter, so that would be in your …

Mark Robinow

I’m sorry.

Matt Difrisco - Oppenheimer

Okay.

Mark Robinow

Third quarter.

Matt Difrisco - Oppenheimer

Okay. And then just looking at your guidance, for the $20.5 million sales number for the third quarter, the high end of your guidance, would apply an average weekly sales of something like down to over 10%, versus down 8.5% in the second quarter. So are you seeing then – is that incorporating the, I mean is that an aggregate slow down across the base or is that just the 70,000ish average weekly sale of the Gilbert store that just opened in 2Q coming into the base?

Mark Robinow

It’s based on the range of what we see as the possibility of same store sales, going, you know, moving through the quarter.

Matt Difrisco - Oppenheimer

Okay, I guess what I’m asking you is that are you seeing that as – is that a proxy for quarter-to-date trend? Or are you just being conservative, which is certainly granted given the environment were in.

Mark Robinow

As I said we – in our guidance we reflect minus 6% comps, and I think it depends, Matt, when you are forecasting new unit openings.

Matt Difrisco - Oppenheimer

Right, I’m actually being very conservative and putting it very much toward the end. That’s why I was having a hard time to get to that high end of guidance, but that negative six comp was for the second half of the year in the fourth quarter being easier lap? Or do you expecting it to accelerate the comps, so harder in the third quarter and easier in the fourth quarter, a better comp in the fourth quarter is what I’m trying to say?

Mark Robinow

No, we think it’s flat; 6% and 6%.

Matt Difrisco - Oppenheimer

Well then you can’t get to the 20.5, but I’ll talk to you off line about it on the operating weeks then. Okay, thanks.

Operator

And with that, there are no other questions holding so I will turn things back over to management for any additional or closing remarks.

Mark Robinow

Well, thank you for participating in our conference call and if you have any further questions feel free to call us privately. Thank you very much.

Operator

Ladies and gentlemen, thank you again for joining us that will conclude the call today. Have a good day.

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