Description

We are going to present a restaurant stock here which we are going to argue trades at around ten times free cash flow if it were not in fast growth mode.  But it is in fast growth mode and we as owners want it to be – it is growing at 25% square footage growth off a small base at a high return on capital and is also growing comps despite a very tough economic environment..  Our DCF valuation here is north of $30 per share.

We are not going to go into the concept – go to their website and spend a half an hour listening to a presentation they’ve done at conferences.  The CEO presents the concept much better than we could.  We want to focus on the economics and the opportunity at the current price.

We’re all value investors here – think about the restaurant stocks value investors buy at low multiples and most of them have one thing in common.  Saturation was an issue if not the issue.  If you’ve had the experience we had with those they generally worked but occasionally one is very disappointing  Whether Applebees or Outback or Chuck-E-Cheese – restaurant chains hit a wall when they have too many units and growth becomes very difficult, but they always try.  And those are always the ones that hit value investors’ screens.  This one does not screen as value but we consider it the cheapest stock we can find.

What if you were a venture capitalist and found a 17 unit restaurant chain, proven to work around the country.  It has an excellent management team that has worked together for ten years.  It does $5.5 million per unit in its mature stores which is on par with the best of the best in the industry like PFCB or CAKE.  Its unit operating margin of 21% is also among the best in the restaurant business.  They generate $8 million of free cash flow on those units, and they have no growth and no growth plan.  What would you do if you can get in on this at an $80 million price?  I’d drool for the chance to take that on as a VC investment and grow it.

Here we have that exact same situation.  It is already public, it is growing fast already, and doesn’t need any more outside capital to grow to wherever its going to grow to.  The last investors to get that deal just took it at $16.25 and Mr. Market has been so foolish that you can get in even below what they paid.  It is still trading at a valuation a venture capital guy would dream to buy at even though they don’t need that kind of capital any more.

Their third quarter comps were 4.9% - very different from other restaurant companies comping negative.  And more importantly, we’ve owned this for nearly two years and the free cash flow we anticipated is starting to reveal itself.  In a market where growth investors (this looks like an utterly classic Peter Lynch growth stock to us) are redlining restaurant stocks as uninvestable until they figure out whether the consumer is going to die or not. 

Kona Grill (KONA) is a $100 million market cap restaurant chain with 17 units with a very visible path to 100+ units.  Square footage growth is around 25% a year with all the room in the world to grow. There is $20 million of cash on the balance sheet which we believe is enough to get them over the hump to the point where growth becomes self funding.  In our view over the next year or two this is going to emerge as a wonderful self-funding growth story. 

[the $20 million of cash and the $100 million market cap are pro-forma for the $10 million equity private placement which closed in November.]

What interests us the most about this one is revenue of $5.5 million at a four wall profit margin of greater than 21% for their mature units, and in the third quarter they did a 21% contribution margin in aggregate.  There are very few restaurant chains at any point on the maturation curve that can claim those kind of numbers and those are concepts like Cheesecake Factory and PF Changs which were homeruns for early stage investors who paid anywhere near this kind of revenue multiple.  KONA in the 15s is trading at 1x enterprise value/revenue run rate of about $80 million.

The size relative to its saturation level also intrigues us greatly.  We have a long long long runway here.

Devo711 wrote this stock up on VIC just as it was blowing up in late December 2005 and the stock was at 8.  We were buying then too and have owned it big ever since and have gotten to know it better and better.  8 was a truly stupid price – there was 4 or 5 dollars of cash on the balance sheet at the time and the success of the concept was visible, though it is much more proven nearly two years later as we have observed management execute, and we have observed that the concept travels very well.  They only do high quality locations, but it seems to work around the country.

I was surprised to read that I expressed skepticism about management on the Q&A after Devo711’s writeup, but that was a day after finding it where all we had to go on was the IPO prospectus.  Since then the management headliner at the IPO, a former McDonalds bigwig, left suddenly six months after the IPO and the Chairman, Marcus Jundt took over as CEO.  Marcus was the financier of the concept in 1998.  The founding operator of the concept, Jason Merritt, is still aboard as the COO.  This has been a coherent team for nearly ten years, and after nearly two years watching this company, it is clear they have a strong corporate culture and we suspect the McDonalds bigwig didn’t fit into that culture so they fixed that problem early. 

I met the CEO face to face for the first time just a few days ago – my partner had met him before - and just confirmed what we’ve learned from hearing him on conference calls and phone conversations for the last two years.  He runs the business like the owner he is – he personally owns about 25% of the shares – and is very focused on long-term value creation.

They came public at a very early stage two years ago, and so far Wall Street has been fixated on quarters rather than the long-term.  There are still only 8 stores in comps – when we bought it there were only 4, so we’ve seen some volatility – although really surprisingly little when you think about it - in the metric every growth investor watches (same store sales) even as we have watched the metrics a business owner watches do exactly what we anticipated.  A snowstorm in Denver can and has messed up a quarter for investors looking at comps, which seems kind of silly if you have any kind of time horizon longer than a year.

What everybody seems to be missing is that this company can grow for a long time at a high rate at a high return on incremental capital before saturation is remotely an issue, and has management and infrastructure in place for far more units than they have (i.e. current earnings are very understated).

Numbers

Kona likely has 90% of its growth in front of it, yet is trading at a price/sales valuation similar to far more mature restaurant concepts with inferior operating numbers, which themselves are trading at trough valuations.  Just from a primitive valuation perspective that looks good.

So why isn’t it earning a lot of money?  Its G&A.  Management made a decision on becoming public to spend the money necessary to grow the concept.  That means top notch real estate capability, top notch training of staff.  It is not overpaid senior management – that’s not where that number is coming from.  They will leverage that G&A expenditure as they build out units.  We already see that G&A/sales coming down.  Long-term that’s probably 6-7%.  Today it is around 10%.  A year ago it was 13%.  For my 10 times free cash flow number I am using 8%.

OK, we’ve made a case that this is a growth stock.  At the multiples it trades at it damn well better be.  So why do we think the next ten years of growth at a high return on capital is free?

Cash flow is starting to show itself.  Cash flow exceeds earnings and will for their high growth phase (restaurants have negative working capital and depreciation on real estate doesn’t require a lot of maintenance cap-ex for a young restaurant base).

Cash from operations 9 months 2007 was $4.5 million.  That is down year over year, but dig a little deeper – there are real estate cash flows in cash from operations that belong in cash from investing.  That was a really big number last year and a small number this year on the cash flow statement.  Cash from operations was much higher than last year on a true operating basis.

We’d start with that $4.5 million cash from ops and make the following adjustments to reflect what this would look like if they had no growth.

1. Subtract $0.3 of deferred rent and add back $0.3 of change in receivables.  Those are real estate items which are expenditures for growth.  That’s a wash year to date.
2. Expenditures for 3 preopening expenditures we’d add back if they weren’t growing again.  That is about $1.0MM after tax.
3. No way G&A would be 10% of sales if they didn’t intend to grow fast.  We’d add back about $1MM to the 9 month number there, making G&A 8% of revenues.
4. Take out interest income of $0.4MM because we already took the cash balance out of the enterprise value.

That leaves us with $6.1 million of 9 months cash from operations.  And even that is conservative because the expenditures for preopenings which we backed out are now restaurants already operating and producing cash.  Annualize that nine month number to an annual rate of $8.1 million.  Take out something for maintenance cap ex if you wish, but that is a very interesting number vs. an enterprise value of $81 million at the current price.

So at an $81 million enterprise value we have an early stage, but reasonably tested, restaurant company trading at 10x free cash flow if they chose not to grow at all.

There are many other ways to look at this valuation, none of which are low trailing P/E, which look very cheap given the growth at a high return on capital in front of us here.  We just gave you one way.  You could look at EV/sales vs. sales growth for instance.   Or you could do a DCF.

We want them to grow – the last thing we want to see here is a share buyback because they need cash to grow.  Return on incremental invested capital is very high.  So it would seem clear that if it is at ten times free cash flow if they didn’t choose to grow, if they are growing at 25% and have the capital to fund that growth (we don’t think they need to raise another dime of capital to get to 100 units) intrinsic value is a lot more than that number. 

The option value of taking this from 18 units to 100 units looks free to us, and on a DCF analysis laying on that growth this looks like a $26-35 valuation today.  Do the DCF analysis yourself after getting to know the business – modeling the growth of a young restaurant chain is not hard.  Grow units 25% a year and make sure you’re capturing the difference between free cash flow and earnings which we’re already seeing.  If you come up with below $20 a share – the stock is at 15 and change - lets compare notes in the Q&A in more detail.

We see this as a 50 cent dollar at the current price.

Catalyst