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Kona Grill, Inc. (NASDAQ:KONA)

Q3 2012 Results Earnings Call

November 5, 2012 5:00 PM ET

Executives

Berke Bakay - President and CEO

Christi Hing - Chief Financial Officer

Analysts

Mike Malouf - Craig Hallum Capital Group

Susan - Feltl and Company

David Kahn - Raymond James

Conrad Lyon - B. Riley & Co

Operator

Good afternoon. And thank you for joining us to discuss Kona Grill’s results for the Third Quarter of 2012. Joining us today are Berke Bakay, Kona’s President and Chief Executive Officer; and Christi Hing, the Company’s Chief Financial Officer. Following their remarks we will open up the call for questions. (Operator Instructions)

Before I begin, I would like to remind everyone that the financial guidance the Company provides for its fourth quarter 2012 results, statements regarding the company’s future 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 to risk and uncertainties contained in the Company’s filings with the Securities and Exchange Commission.

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

Berke Bakay

Thanks, George. Good afternoon and thank you all for joining us. We’re pleased with our earning’s call this despite a more challenging sales environment compared to the last several quarters. We reported same-store sales counseled 20 basis points, which include the impact of several items such as record summer heat, the hurricane and especially advanced that the estimated affected quarterly sales by about 100 basis points.

Our positive comps during the quarter represent Kona Grill’s eight consecutive quarter of positive same-store sales and the 11th consecutive quarter of positive traffic, which we believe demonstrates the long-term strength of our brand.

On the coast side, we were still able to deliver healthy restaurant operating profit margins of 18.5%. In fact for the first nine months of the year are operating margin remains at the top of our peer group as 19.3% and we have grown our income from continue operations 179% to $4.4 million. It is also important to highlight that our full year 2012 income from continuing operations is projected to increase 123% or $5.2 million from $2.3 million last year. We believe the strong earnings are direct result of our discipline operating model and the dedication of chain at every level.

More importantly with average unit volumes of $4.2 million and 19% operating margins degenerate 23% cash on cash returns. For today’s call, Christi will take us to the financials for the third quarter and provide guidance for the fourth quarter of 2012. Afterwards I will provide an update on sum of the initiatives we are working on and then we will ramp up the call with Q&A. With that I would like to turn the call over to Christi. Christi.

Christi Hing - CFO

Thanks, Berke. For the third quarter ended September 30, 2012, restaurant sales increased 20 basically over the same year-ago period to 23.8 million. As we lasted 10.6% call from last year. The increase comp sales represents their approximate Q1 and 30 basis point increase in guest traffic during the quarter or average check declined about 200 basis point due to some of our happy hour initiative.

We did take 1.1% in pricing at the end of July. However, we remain very conscious about protecting the value proposition offered by a brand and we will continue to evaluate any future pricing opportunity. It is important to know that sales for the quarter were impacted by several items as Berke mentioned. They experienced inclement whether during the quarter including hurricane Isaac, which resulted in a temporary closure of Badawi restaurant and limited accessibility at our camp or restaurant.

In addition, record heat this summer impacted patio business at restaurants with uncovered patios or those without cooling system. We installed HVAC or improved cooling systems at two of our restaurants this year and followed significant increase in patio traffic from last. We have planned to install similar cooling systems in certain restaurant to drive additional sales when weather conditions are less than in idle for outdoor dinings.

During the quarter, we also experienced the lingering impact on sales at our Troy Michigan restaurant due to fire earlier this year. Those are improving but we were down in a single digits during quarter compared to a double digit positive run rate before the fire.

Additionally, in mid September we started an expensive remodel at our Chandler Arizona restaurant. As mentioned on previous call, we are implementing identifying the [new core pallet] at this restaurant and the scope for this remodel has resulted in lost seats as all of the booths were removed and temporary seat has been installed in the dining room.

As with any remodel, we believe that the short-term impact on sales will be recouped once the remodel is fully completed. Also during the quarter, the Olympics, political and conventions in the addition of Thursday, night NFL games since September affected traffic in a restaurant slightly more than anticipated. Despite the current economic environment in the aforementioned item, we comp positive for the quarter, which represents our eighth consecutive quarter of positive same-store sales. If you normally saw so take in to account the impact of the items noted above, we estimate our comp would have been in the 100 to 150 basis point range. On a trailing two-year basis, Q3 comps remain above 10%.

For Q4, the comp comparison continues to remain difficult as we lapped 7.6%. Cost of sales as a percentage of restaurant sales increased 50 basis points to 27.4% compared to 26.9% last year. Seafood and produce costs were lower versus the same period last year but were more than offset by higher beer and wine cost associated with Happy Hour promotions and the system wide rollout of our Wine Down Wednesday program in September.

We continue to remain firm believer and returning cost savings of with reduced marketing spend back to our guest in the form of such promotion. We continue to work diligently with our vendors to negotiate contracts that secure the best possible pricing.

As we move into the final quarter of 2012 were optimistic that improvements in seafood purchasing and other initiatives will help mitigate any material impact to food costs. Certain of our seafood contracts extended to second quarter of 2013 so our exposure to select items is mitigated by these contracts. A variety of menu items helps insulate us from inflationary pressures that some of our competitors are facing as over 54% of our sales are from alcohol and sushi.

Labor expenses as a percentage of restaurant sales increased 90 basis points to 33.7%, as we experienced deleveraging of our hourly labor costs due to softer than anticipated sales volume. We are diligently with our restaurant to schedule intelligently as we navigate the volatile economic environment.

Restaurant operating expenses as a percentage of restaurant sales decreased 80 basis points to 13.9% during the third quarter from 14.7% last year. Lower operating expense percentage of sales was primarily attributed to a 30 basis points reduction in marketing expenses, reduced credit card processing fees from the law that went in to effect last fall and reduction in utility cost from lower negotiated rates.

Occupancy expenses as a percentage of restaurant sales decreased 70 basis points to 6.6% during the third quarter. As mentioned on our previous calls, the decrease primarily reflects the amendment of the lease provisions for one restaurant. We will allow this benefit next quarter as amendment we were trying in last November.

Combining these four line items, restaurant operating profit increased 1.3% to $4.4 million for the third quarter of 2012. As a percentage of restaurant sales, restaurant operating profit improved 20 basis points to 18.5% compared to 18.3% last year.

General and Administrative expenses decreased 16.8% or $356,000 from the prior year quarter primarily due to lower executive salary and benefit costs partially offset by higher legal and professional fees associated with corporate activities. As a percentage of sales G&A was 7.4% compared to 8.9% last year, which represents a 150 basis point improvement.

Based upon current carrier results, we expect G&A to run in the low 7% range for the full year 2012. We continue to be proud of our G&A spend relative to our side and we’ll continue to remain focused in this area.

During the quarter we recognized the gain of a 101,000 or $0.01 per share resulting from insurance recoveries related to the Troy fire. The gain represents to access the fair value of the new furniture over the book value of the furniture that was replaced due to damage. We anticipate additional insurance recoveries in the coming months based upon our claims submitted for business interruption insurance. We are happy to report that the new furniture has been recently installed which should allow this restaurant to be fully operational. Income from continuing operations increased 86% to $1,370,000 or $0.16 per share, compared to $735,000 or $0.08 per share in the same quarter last year. Our strong G&A leverage and disciplined spending contributed to the higher earnings.

As previously disclosed, we entered into a settlement agreement with the landlord regarding the lease of our closed Sugar Land restaurant for $950,000. The settlement lease resulted in a charge of $386,000 during the quarter, to true up our previously estimates and related legal fees.

For the quarter we did not record any income tax provisions based upon our revised estimates of current year taxable income resulting from the timing of certain tax deductions including the Sugar Land settlement. We will use up a substantial portion of our NOLs in 2012, but we have several tax-planning strategies that we are looking at, as we plan for 2013 and beyond.

For the quarter, net income increased 67% or $396,000 to $984,000 or $0.11 per share, compared to net income of $589,000 or $0.06 per share in the prior year quarter. For Q3 repurchased and we fired a $192,000 shares at an average cost of $8.13 per share under our $5 million stock repurchase authorization. In total we have purchased 287,000 shares for $2.3 million under our current program.

We ended the quarter with $6.5 million in cash and investments compared to $6.3 million at December 31, 2011. The September 30 balance reflects $950,000 settlement payment previously mentioned and $1,562,000 in share repurchases this quarter and also $4.9 million for the year in share repurchases.

Total debt was $0.4 million at September 30, 2012 compared to $0.1 at December 30, 2011. We’ve spent $400,000 on capital expenditures for the quarter, primarily for the channel remodel and maintenance CapEx. We do not have any borrowings outstanding on our $6.5 million line of credit.

Moving on to our fourth quarter 2012 financial guidance, we are forecasting same store sales of 1% excluding the impact of hurricane Sandy on four restaurants and the effect of the remodel of our Chandler, Arizona restaurant. With the aforementioned items, we expect restaurant sales to be flat at $23.1 million, we also expect net income of about $800,000 or $0.09 per share, compared to net income of $746,000 or $0.08 per in the fourth quarter of last year.

Our guidance reflects the challenging economic environment that the industry is facing as the presidential election and other external factors affect consumer dining decisions.

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

Berke Bakay

Thanks, Christi. During the quarter, we continue to execute on various initiatives designed to drive guess traffic and increase guest frequency. We continued to keep our menu fresh and innovative with our highly successful food-based promotions.

During the quarter we introduced two new promotions, the Flare promotion introduced in July featured items with a touch of heat and produced some of the stronger sales of all-food based promotions to-date. Our Entice menu was introduced in September and featured items such as Chili Lime Shrimp Salad and grilled Hawaiian Snapper that have become guest favorites.

These food-based promotions allow us to associate guest feedback while also allowing us to evaluate new items for future menu changes such as this summer many [update] we rolled out at the end of July, which we could putting several food-based promotions favorites on the regular menu. We took 1.1% price on the menu and have not received any negative feedback to date. We are very conscious of this value proposition and we provide to our guests and we’ll only take prices warranted.

In September we rolled out our Wine Down Wednesday promotion nationwide. As mentioned on our previous calls, this promotion consists of half off bottles of wine throughout the restaurant every Wednesday. To date we have seen significant increases in the number of bottles sold on Wednesday compared to last year. Which is in addition to moderate increases in the average check, for guest ordering a bottle.

Guest feedback continues to be very favorable and we will continue to monitor the program and its impact on guest traffic and margins.

We are also testing happy hour initiatives that various restaurants that drive traffic and increase frequency of our guests. This test includes expanding happy hour to some days in select markets to help drive traffic on what is otherwise one of the slowest days of the week for us. We will continue to evaluate this program to determine their effectiveness.

Service and hospitality remain a key focus or us as we spent numerous hours training our coworkers on the new wine list, beer and sake offerings and reinforcing the Kona’s [go] service standards. We have seen improvement in our guess satisfaction scores over the past year, with higher scores than our peer group.

We take guest feedback very seriously and [accurate] behavior of that impacted our great guest experience can turn a first-time guest into a loyal returning customer.

On the development front we continue to work diligently to build our pipeline, we are evaluating sides in both and new and existing markets and are trading paper on several prospective locations. As mentioned on previous calls the market for quality real estate is very competitive, while we have no new leases signed as of today, we are confident that we are developing a strong pipeline and we’ll be in position to articulate our growth strategy in the near future. We will update you as we sign new leases.

As Christi mentioned we’re in the midst the Chandler restaurant remodeling and expect to complete this shortly. We have planned a grand reopening party for next Thursday, in which we have invited local celebrities, long-term guests and many others to come and see our new look.

This remodel utilizes our new design pallet, including updated furniture and fixtures that we believe will help keep us relevant for the years to come. We plan to use a new design as we remodel our Dallas and San Antonio restaurants in the first half of 2013.

With 4.2 million average unit volumes, 19% operating margins and 23% return on invested capital, we are confident that we can grow this brand over the long term. We have 20 restaurants in 16 states that are all cash flow positive. We believe that with these metrics, our strategy as an organization remains clear. We plan to build a premier [polished] casual concept that is disguised by award-winning sushi and new American cuisine as well as our significant bar business. We differentiate ourselves from our competitors, by successfully executing three distinct businesses and four different [day parts].

In conclusion, I firmly believe that we have a bright future ahead of us, with strong AUVs margins, and ROI metrics, we are very excited about the growth prospects of our brand. Thank you, for your continued support, now with that I would like to open the call up for any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Mike Malouf with Craig Hallum Capital Group. Please go ahead.

Mike Malouf - Craig Hallum Capital Group

Hey, thanks guys. Thanks, Berke, how are you doing?

Berke Bakay

Great, thank you.

Mike Malouf - Craig Hallum Capital Group

Good, I guess my first question would be on the openings, you mentioned that you’re "trading" paper. Are you at a point where, I mean have you just determine how many restaurants you think you want to try to get started over the next several months, I mean is this more like, one now and then one in six months or do you think you’ll sign in a few leases and just go pretty aggressively and sign – and get three started to built next year, if you could just give us a sense of that that would be great?

Berke Bakay

Sure, as I said on my prepared remarks, we are negotiating multiple different sites at the same time. And we will give you – and we hope to give you an update sooner than later, but it could be any one of those options as you articulated depending on the results of the negotiations we are currently undertaking.

Mike Malouf - Craig Hallum Capital Group

Okay, if you could just give us a sense of how the market is now. I mean have you, have you been surprised by anything either positively or negatively as you’ve gone through this over the last, three to six months?

Berke Bakay

Sure and again in last couple of calls, I made references to how competitive the quality real estate market is. Most of our competitors are willing and able to open new locations and they are in the market for the similar calls to real estate as we are. I think our primary advantage is being in 16 states with 23 different stores and having shown to the market that we can execute on the different real estate options such as small or lifestyle centers even free-standing. And we don’t have to open too many locations so to speak to move the needle. That’s our biggest advantage, all of our stores are in different geographies are cash flow positive, and we try to compensate the competitiveness of the real estate market by doing tremendous amount of work on our part to pretty much cover every single part of the country to credit quality pipeline that we can negotiate up on and hopefully create a successful pipe line for the years to come.

Mike Malouf - Craig Hallum Capital Group

And then one more question on the new openings or potential new openings. Are you looking at locations that you think would be accretive to the average store sales I mean are you looking at sales that would be 4.5 million to 5 million or these more on the smaller size maybe on the in the 3 million range?

Berke Bakay

Sure, our decisions on the real estate side, our function of return invested capital. So if you believe that we have an opportunity in the smaller market maybe we think we can get our average sales are slightly lower but we are getting at or above TI dollars and we think that the operating restaurant in that specific market is lower than our average, then that certainly will impact our decision. So we’re not fix at it to the so to speak sales levels, at we’ll come out of these restaurant, we are more interested of what comes out of our pocket and what we’ll be expect to capture in years to come. So it’s – while we’re looking at is a combination. So we are looking at some stores everything maybe on average on sales and average or above average on profitability and some that could be higher than average in sales but could be little bit pressured on the profitability side.

Mike Malouf - Craig Hallum Capital Group

Okay, great. And then moving on just a couple more questions. With regards to the environment, you mentioned a couple of times about the “challenging environment” what is the environment out there, is it getting worse in your mind, is it just remaining pretty tough or has it gotten better at all?

Berke Bakay

I wouldn’t say, it’s getting worst, but I am sure you heard from some of our competitors out there to, what I can tell you is, it was difficult to catch it trends during the quarter and even during the month so far in this quarter and really when you look at the commissions or to debates you could see the double digit negatives on the debate days, everybody that what’s call the CNN effect, we could immediate to see in our business, people be in front of TVs and watching very closely these debates. I guess, what I can tell you, I can’t wait for the elections to be over and just get a normalize business trend. But I certainly wouldn’t say that things are getting worst, it’s just been overall choppy environment which was hard to get a trend going if you will.

Mike Malouf - Craig Hallum Capital Group

Yeah, okay, all right, great. And then if you could just give us a little bit of an update on how you guys survive Sandy, and what kind of impact both structurally and perhaps of the impact as we dig out from Sandy that would be helpful? Thanks.

Berke Bakay

Sure, while first of all the most importantly [oil-fired] employees are safe, structurally we have no issues Woodbury Georgia restaurant we were happy to open that finally yesterday, so it was close for I believe seven days and other restaurants that were impacted in the area where Baltimore, Stanford and also our Richmond Virginia location was partially impacted. So Christi do you have anything also add on that but that’s really the overview.

Christi Hing

I would agree, some of our restaurants were closed the day the storm in, this with traffic being hampered airport we did see that kind of linger on throughout down the later part of last week.

Mike Malouf - Craig Hallum Capital Group

Okay, great, thanks a lot. Appreciate to help.

Berke Bakay

Sure, thank you.

Operator

Thank you. And our next question comes from the line of Conrad Lyon with B. Riley & Company. Please go ahead.

Conrad Lyon - B. Riley & Co

Hey good afternoon. Quick ask a question about development in different way just to be safe should we not expect any new units in 2013?

Berke Bakay

Well, I really can’t say anything other than my prepared comments, so I am not going to say anything on either if you should write off to achieve or not at this point.

Conrad Lyon - B. Riley & Co

Okay, and maybe this could be help also just the time you would think take though to construct and get a new unit operational does that something are we talking like six to nine months?

Berke Bakay

Well, it depends on what paces there are Conrad, there are different opportunities have you looking at that it’s either to build off from a sell perspective, it’s a substantially compete at this point so if you were to sign a lease and go forward with those opportunities between the design and contraction and you could be looking at nine months, so in other word if you see us and asking something in next few months here David still potential at theoretically we could hope in 13 but at this point we are not providing any specific guidance FBR or we are not going to new store openings in ‘13.

Conrad Lyon - B. Riley & Co

Got you. You still believe to interesting point, I know there has been some change for sale, have you ever concerned acquiring change to make LIFO that easier than quicker?

Berke Bakay

Well, in terms of are you referring to any specific opportunities or –

Conrad Lyon - B. Riley & Co

Just in general as me is to give a sight you might want I may not otherwise be available?

Berke Bakay

Look as what I will tell you, been in 16 states with 23 locations we have ample amount of organic growth opportunities within our system. But as I said repeatedly this is a public company so at any opportunities that might be out there that be may no, it is our obligation to our shareholders to export and do research and then concludes, so I would never category to rollout, such opportunities but what I would point out to is as I mentioned having different real estate options in our portfolio showing tremendous level of success with all our restaurants have been cash flow positive, I don’t want to think we are out of options and we are looking option to create it, we have a lot of opportunities that’s what has been taking sometime to get the pipeline going but as we said in our prepared remarks we’re trading paper now and we’re getting closer to where we need to be.

Conrad Lyon - B. Riley & Co

Got you. That’s fair enough, that’s helpful. Question about just to say it was more average weekly sales trend, it appears that when the stores that were closed it last year, you have sort of an addition by subtraction, the average weekly sales trend going forward looks like it’s going to be still be positive but not as strong as prior, is that just the function the choppiness you described or as we move forward how should we look at that if there is going to be any meaningful growth there or not?

Berke Bakay

Well at this point I site for many hurricanes or other natural disasters really that should be the functional same store sales because we don’t have different operating weeks it’s comparing, so it’s really I would just refer to the guidance that we have provided for the fourth quarter on just kind of try to extrapolate the average weekly sales growth.

Conrad Lyon - B. Riley & Co

Okay, last question just about commodity and inflation perhaps in the next year, it sound like there is lot initiatives in place to help, if you will mitigate some of the potential inflation next year, might you give us an idea of what you might think inflation would be next year?

Berke Bakay

Sure, I mean if you kind of break it down and we have communicated this before too, from the meat category we’re covered pretty much down of the first quarter, we feel pretty good on and shrimp and so far not come with producers have been pretty good to it, so when we internally talk about at it’s definitely an area of focusing, we feel pretty good about our ability to mitigate these increases but so you can look at it some areas maybe such as chicken we have fresher and we can mitigate up by new initiatives on the seafood side. So overall yes, we will see some inflation but it is not substantial.

Conrad Lyon - B. Riley & Co

Yeah, so I guess I look at this way, a lot of your peers are talking about 3 to 5% inflation, I would suspect you to be at the low end of that?

Berke Bakay

Yes. And 54% sushi and bar definitely help us to be on the hopefully on the lower end of that.

Conrad Lyon - B. Riley & Co

Got you, that’s helps. Thanks.

Berke Bakay

Thank you.

Operator

Thank you. (Operator Instructions) Our next question comes from the like of Mark Smith with Feltl and Company. Please go ahead.

Susan - Feltl and Company

I am Susan for Mark Smith. Just a quick question, have you guys seen any changing alcohol sales.

Christi Hing

Alcohol sales continue to remain consistent, right around 30 to 31% so really no change from previous quarters or even from prior year.

Berke Bakay

Or since our inception, it’s been pretty stable.

Susan - Feltl and Company

Sounds good, thank you.

Operator

Thank you. And our next question comes from the line of David Kahn with Raymond James. Please go ahead.

David Kahn - Raymond James

Hello Berke, nice job on the quarter. Quickly any feedback on the takeout program?

Berke Bakay

Our takeout program it’s on a small basis but it has moved up year-on-year give or take 20% on a small base, so just to be a more granular we went up from 2.2% to 2.6%, 2.7% so nothing major yet but it’s at least is going in the right direction.

David Kahn - Raymond James

Excellent, thank you.

Berke Bakay

Thank you.

Operator

Thank you. (Operator Instructions) And I am showing there are no further questions. I will turn the call back to Mr. Bakay.

Berke Bakay

Thank you, George. As always, I want to thank each of you for joining us this afternoon. And thank you for your continued support of Kona Grill.

Operator

Thank you, 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. We thank you for your participation. You may now disconnect.

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