Description
Thesis
Kona Grill is an early-stage casual dining restaurant with a very attractive risk / reward profile. The stock has been beaten down due to several factors that are clearly extraordinary and temporary. Their unit economics, which are among the best in the casual dining space, are exceptional – new units are targeted to have 20%+ returns on capital, with their oldest units posting 30% returns on capital. With the company poised to grow its unit base at well over 25% annually for the foreseeable future, I expect that the deployment of significant amounts of capital at high returns will prove to be a winning formula. The current cheap valuation (EV/run-rate sales of 0.5x for restaurants that post 20+% cash flow margins) offers investors a margin of safety if some of their new units fail to achieve their target economics.
Overview
Kona Grill currently operates 9 casual dining restaurants that offer a diverse, eclectic selection of dishes and sushi. Their restaurants have a bit more of an upscale ambiance than other casual dining chains, highlighted by a 2,000 gallon water aquarium. A unique characteristic of their business model is an alcohol mix of 35% that is well above the industry average. This high alcohol mix allows them to post particularly high unit margins, which are in excess of 20%, and to partially subsidize the cost of the food – allowing them to provide generous portions at reasonable prices.
Unit Economics
On average, their restaurants do $5.5 M in sales ($100-110k in weekly sales). With the exception of The Cheesecake Factory at over $11 M, these unit volumes are among the highest in the industry (McCormick & Schmicks and PF Changs both do ~$4.9 M). On average they have a 21% unit-level cash flow margin, which gives you around 1.15 M in restaurant cash flow (Cheesecake Factory, PF Chang’s, McCormick & Schmick’s all have lower unit margins). On a $2.3 M investment, net of tenant improvement allowances and pre-opening expenses, existing restaurants have been posting 50% pre-tax returns on capital (30% after-tax).
They believe that new restaurants should do at least $4.5 M in sales after an initial ramp-up period, with at least 18% cash flow margins. This would give you at least $800k in unit-level cash flow, and a 35% pre-tax return on capital (20% after-tax).
The particularly high returns on capital of existing units gives the company a margin of safety in opening new units. They can open restaurants that fall quite a bit short of 30% returns, before they fail to earn adequate returns on capital. Also, it should be noted that for the past few years, comps have been consistently positive in the low to mid single digit range. So the trend has certainly been towards increasingly better economics.
Growth
Right now the company has 9 restaurants, 2 of which were just built recently (one in August, one in September). They plan to grow their unit base at well over 25% annually for the foreseeable future, with 5 restaurants planned to open next year. Saturation for this concept in the US is over 200 units, which is clearly not an issue here.
It is important to note that they have scattered their current units in a number of different states/markets so that they can adequately test the concept before aggressive expansion. While the inability to leverage marketing has hurt them on the expense side, it gives them confidence that this restaurant concept will work in numerous markets all across the US.
What’s hurting the stock price
Two factors that are both extraordinary and temporary are currently depressing the stock. First, the company announced that one of its recently opened restaurants in Sugarland, Texas is being negatively impacted by construction at the mall. This is limiting both visibility and access to the restaurant, which has caused weekly sales to be in the $50-60k / week range, well below the $80k+ / week that they would like to see. Other tenants are apparently seeing similar weakness. While construction at the mall is not scheduled to be completed until September 2006, it will eventually be completed and unit volumes at the restaurant are likely to improve after that.
The second factor is that 3 of the restaurants that are scheduled to open next year have been delayed for a total of 26 operating weeks. All of the delays were due to the landlords. So again, while this will hurt next year’s operating performance, there is no adverse long-run impact to the business.
Although these setbacks would be insignificant to most restaurant operators, with such a small unit base, minor problems have an exaggerated impact on short-term operating results. Also, it doesn’t take much to hurt a stock like this, because it’s tough for the market to get excited about a restaurant that went public with only 7 units and won’t be profitable until 2007.
Valuation
The excellent underlying economics of this business are obscured because of a number of related factors: a) unlevered G&A due to their small size, b) unlevered marketing due to their scattered footprint, c) high preopening expenses relative to EBITDA due to their high ratio of new builds to existing restaurants, and d) high depreciation relatively to maintenance capex, due to their young unit base. So while the company does not expect to be profitable until 2007, this can be misleading, and certainly obscures what are among the best economics in the industry.
You can slice-and-dice the valuation here a number of ways, here’s just one way to look at it:
Average restaurant unit volumes should be around $5 M
Average unit margins should be around 19%.
This yields 950k in unit-level EBITDA.
Maintenance capex should be around 150k per unit.
This yields 700k in unit-level FCF (= EBITDA – maintenance capex).
With 5 more restaurants being added next year, they will have 14 restaurants in operation.
14 restaurants doing 700k in FCF yields 9.8 M in unit-level FCF
To support this base of restaurants, there should be around 5.4 M in G&A expenses.
This yields around 4.4 M in pre-tax FCF in the business.
Today the company has a market cap of 45M and an enterprise value of 22M.
Building 5 more restaurants will cost them around 11.5 M (5x 2.3M).
After allocating around 2M in total pre-opening expenses, the business should still generate around 3M in operating cash flow during that time.
To fund the expansion to achieve a 14 restaurant base, the company will have an enterprise value of around $30.5 M ($22 M + 11.5M – 3M) based on the current stock price.
The implied valuation using these figures is around 6.9x EV/EBIT (after making those adjustments).
It is important to note that this valuation still does not take into consideration either points a) or b) that were noted above. If you take a look at a competitor like PF Chang’s, for example, with around 190 units they only spend around 38 M, which works out to around 200k / unit in SG&A for their size. At 200k per unit, Kona’s pre-tax FCF would jump from 4.4M to 7 M (and the EV/EBIT would fall to 4.4x). Now that would never happen, but it helps to illustrate some of the untapped G&A leverage here.
Similarly, the unit margins of 19% that have been modeled (which is already below the 21% the company has been achieving in its older units) should benefit from leverage as the company grows. Notably, they should achieve some advertising leverage when they begin to fill-in existing markets. Also, while they have been able to decrease their food cost as a % of sales by around 1% in the past year, there is probably some more upside to be had here as they garner more scale and buying power.
Another way to look at it is that with 14 restaurants, they would do around $70 M in run-rate sales. With a $30-31 M EV, that would be 0.4x sales. Considering the particularly strong unit-level cash flow margins, this is very cheap valuation.
Altogether, the valuation of 6.9x EV/EBIT is very attractive given that they should be able to expand at 25-35% for many years at very attractive returns on capital. Although there are obvious risks in an early-stage restaurant concept, their significant success in multiple markets and a cheap valuation, particularly given the G&A leverage that they will begin to see in 2007 and beyond.
Risks
New restaurants don’t live up to the model.
Old restaurants wane in popularity.
Bar business may be more fickle.
Catalyst
Continued expansion at high returns on capital combined with expense leverage causes market to appreciate strong underlying economics.