Kona Grill: At Least 70% More Downside

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About: Kona Grill, Inc. (KONA)
by: Paperon de' Paperoni
Summary

Kona's fair value is in the $3 range. In the worst case, the company will go out of business.

Management is using debt to buy back stock.

The stock is priced as a growth stock, but growth is not self-funded, and debt is piling up.

The restaurant sector is under pressure; KONA with its thin 6.2% EBITDA margins might go out of business.

Kona Grill (NASDAQ:KONA) has been one of the highflying stocks over the past few years. Backed by a nice concept and growth strategy, the stock soared to $27.50 one and a half years ago. Since then, the investment world took a closer look at KONA's financials, and the stock is trading at $11 today. Fundamentally, the company is broken, and its fair value lies below $3 a share.

KONA is priced as a growth company with an EV/EBITDA multiple of 15.3x. I do not use adjusted EBITDA figures since the company is somewhat forced to expand given its high EV/EBITDA multiple. Pre-opening expenses are a real cost that will occur in the foreseeable future and they are relevant. They boost adjusted EBITDA figures by more than 60%. Given the thin EBITDA margins of 4.5% (in FY2016), such costs cannot be ignored.

The use of EV/EBIT would be more appropriate, but this would blow up KONA's valuation completely. DA is a real economic cost. KONA could boost FCF in the short run by curbing maintenance CAPEX, but this would reduce the quality of its restaurants and hurt customer experience. Given that gross CAPEX per new unit amounts to $3.5 mln ($2.6 mln net), DA of $220k per unit a year seems reasonable.

Management's goal was to expand rapidly. The question is if management even projected out financials in order to double check the feasibility of its previous strategy. The strategy was to grow units by 20% each year. End of FY15, the company had 38 restaurants, and will add eight in total during FY16 (five in the second half of the year). Guidance was for $33-35 mln in CAPEX. One store opening costs $2.6 mln net of landlord allowances; maintenance CAPEX per store is roughly $220k a year.

Growth is not self-financed:

According to my analysis, KONA will generate $171 mln in revenue and $8 mln in EBITDA (adjusted $13.4 mln) in FY16. Ultimately, net debt will increase by 25 mln during FY16 to $18 mln (after paying interest, debt and funding net operating capital), which corresponds to 1.7x net debt/EBITDA.

One might argue that by growing the unit base, fixed costs can be spread out over a larger base. But this is not the case: 88% of cash costs can be allocated to restaurant operations and two-third of these are fixed. Only 12% of costs are overhead. Consequently, margin improvements have to come from same-store sales growth in terms of traffic and pricing and other operating improvement on the restaurant level. However, traffic is already negative, and the company is increasing prices by 2% each quarter. This strategy is not sustainable in the long term.

Management had two options:

1) Continue expanding the number of restaurants and increase debt each year. The threshold of $60 mln will be reached in FY18 and KONA cannot continue with its plan. $60 mln in debt would correspond to 5.7x net debt/EBITDA in the same year. I am 100% sure banks will not support the company any longer.

2) Stop the silly expansion strategy and try to improve operations of the existing units. In this case, EBITDA margins will improve immediately to 7%, CAPEX spending will fall and the increase of debt will slow down dramatically to $1-2 mln each year. By slowing down burning cash, management can hope for improving macroeconomics.

Management decided to implement a strategy that is less extreme:

The new plan is to open only three units each year in the foreseeable future with the goal of improving margins at existing units. The hope is that the investment world would still accept the silly current valuation of the company. If management decided to stop expanding, the stock would have dropped in the low-single digits already.

Management announced a new buyback program of $5 million during the last CC. The business is fundamentally under water, and the CEO has no better idea than raising debt in order to support the stock price. From a financial perspective, it does not make any sense.

Another reason why management decided to slow down expansion is its desire to present slightly positive net income in 2017, thanks to lower depreciation expense. However, free cash flow will stay negative and net debt will increase each year.

One should listen to the last conference call to get a feeling about the business dynamics and how management really thinks about the future. Usually, such small-cap stocks have little coverage and conference calls are a nice marketing event. You will see that during the Q&A session, analysts do not seem to believe what they are being told. Some of the analysts attending the call are employees of KONA's underwriters, hence they have to be somewhat bullish. Consequently, they focus on slightly positive EPS and "strong" SSS and attach a multiple to the EBITDA to arrive at a roughly 20% upside.

Negative free cash flow, unfavorable industry dynamics, weak margins and negative traffic are being ignored.

Assumptions 2017 2018 2019 2020
Unit Growth # 3 3 3 3
Net CAPEX per Unit ($ mln) $2.60 $2.60 $2.60 $2.60
Man. CAPEX per Unit & Year $220k $220k $220k $220k
Units BOP 45 48 51 54
Units EOP 48 51 54 57
Unit Growth % 6.7% 6.3% 5.9% 5.6%
SSS 1% 1% 1% 1%
Revenue Growth 16.50% 7.46% 7.07% 6.72%
EBITDA margin 6.20% 6.20% 6.20% 6.20%
DA/ revenue 5.50% 5.50% 5.50% 5.50%
NOWC/Revenue -10% -10% -10% -10%
Effective Tax Rate 0% 0% 0% 0%
Interest rate 1.50% 1.50% 1.50% 1.50%
FCF in mln 2017 2018 2019 2020
NI 0.52 0.48 0.47 0.46
DA 11.02 11.84 12.68 13.53
CAPEX (17.70) (18.36) (19.02) (19.68)
NOWC (2.84) (1.49) (1.52) (1.55)
FCF (9.00) (7.53) (7.40) (7.24)

Outcome:

Net Debt $56 $63 $71 $78
Debt EOP $62 $70 $77 $84
Cash $6 $6 $6 $6
EBITDA 12 13 14 15
Net Debt/EBITDA 4.5 4.8 5.0 5.2
EV/EBITDA 13.9 13.5 13.1 12.8

In summary:

This stock has a long way to fall and a lot of upside protection:

- Unfavorable industry

- Same-store sales are under pressure

- Negative operating FCF

- EBITDA margins of 4.5% and deteriorating

- Increasing debt burden

- No real estate assets - leases with a duration of 10-20 years

My price target of this stock is $3 in the long run if management is able to manage the business in the interest of its shareholders.

Disclosure: I am/we are short KONA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.