Kona Grill (NASDAQ:KONA) reminds us of an expansion team right now. Imagine for a moment that your hometown is getting a new professional sports team. Since ownership needs to build a team from scratch, history says that the team will be horrendous in the first few years and will gradually improve. The fans don't expect to compete for a championship right away.
The same process exists when a company opens a new retail store or restaurant location. Not only does it take time for consumers to find out your location exists and to give it a try, but the expense side is also a learning experience. Since you don't really know what demand will be, it is hard at first to know how much product to have on hand and how many workers you need. As a result, most new retail-related businesses lose money in the first year (much like an expansion baseball team might have a 60-102 record their first season), start making a modest profit in year 2 and really hit their stride in years 3 and 4.
This might seem obvious and common knowledge among business people, but it is important to bring up when discussing Kona Grill because investors seem to be missing this fact when evaluating the stock right now.
Over the last two years, Kona Grill has embarked on a rapid unit growth strategy. Total locations have increased 50% during that time, from 30 at year-end 2014 to 45 at year-end 2016. The financial results from this strategy should have been obvious ahead of time. Namely, the 15 new units are going to need time to slowly ramp up over the course of several years, and as a result will earn less revenue and profit per location than the legacy 30 units which have been open for many years already. Accordingly, Kona's total revenue should be increasing as new units open, but company-wide profit margins would simultaneously be expected to decline because they are adding newer, lower margin units to the mix. Crucially, this result should be expected and not overly concerning.
So what has actually occurred? Kona Grill's total revenue rose from $119 million in 2014 to $169 million in 2016. Makes sense. The company's unit-level four-wall profit margins (excluding costs for G&A, pre-opening, depreciation/amortization, interest, and taxes) have dropped from 18% to 14%. Again, this makes sense given how new units typically start slowly and ramp up over time.
What does not make sense has been Kona Grill's stock price performance. Over the same two year period, the stock has gone from $23 to $6 per share. From what we can tell, investors are seeing revenue increasing and margins decreasing as a sign that the brand is faltering, customers are fleeing, management is poor, and the company's business model is broken.
What we see is revenue rising by 42% as units have gone up by 50% over 24 months. Given how sales typically ramp at new locations, this is hardly concerning (some would say sales should be up 50% if the new units are as well positioned as the old ones, which is true but not right away). A little basic math shows that the 4% drop in margin can be explained by the 30 legacy units maintaining their 18% margins and the 15 new units, which are only one year old on average, earning a 6% margin (for a weighted average margin of 14%). Given the age of the new units, this does not appear problematic. If those same units are still earning just 6% margins a year from now and two years from now, that would be indicative of a problem.
If this unit analysis makes sense to you, the story gets even more interesting when we look at how Kona's stock valuation looks today at the current share price of $6 per share. With just over 10 million shares outstanding and net debt of $22.5 million, Kona's equity value stands at ~$60 million (with debt included about $83 million). With 45 units currently open, investors getting each unit for $1.85 million inclusive of debt. That represents a huge 30% discount to replacement cost (Kona spends ~$2.6 million to build a unit).
To put this valuation into perspective, let's assume that Kona's existing unit base of 45 locations matures in 2-3 years and generates return in-line with the company's historical averages (~30% cash on cash returns; $750,000 of unit-level profit on a cost of $2.6 million). Total company unit profit would come out to $34 million. Subtract $14 million for corporate expenses and EBITDA would be $20 million. If you apply an industry average EV/EBITDA multiple of 8x on that cash flow, Kona's enterprise value would be $160 million, which yields a stock price more than double the current level.
Wall Street is treating Kona like an expansion team and because of an intense focus on short term results, most investors are not willing to be patient fans and let the company ramp up its operations and become leaner, meaner, profit generator. For long-term investors looking for bargains, that is music to our ears. While there is no guarantee that Kona will be able to replicate its past success with these 15 new units, the risk-reward balance appears to be solidly in the bullish camp's favor. As a result, the stock currently carries DiningStocks.com's highest rating.
Disclosure: I am/we are long 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.
Additional disclosure: At the time of publication, people affiliated with DiningStocks.com own shares of Kona Grill, either personally, on behalf of their investment management clients, or both.
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