The last time I visited the KONA story, management was involved in a proxy fight with one of their largest shareholders, creating a big distraction for the entire enterprise. While the shareholder is still one of the top holders of the stock, the dispute has, by and large, dissipated and management is now freed up to dedicate 100% of its attention on executing its business plan and generating shareholder value. With the stock having treaded water for much of the past twelve months and the future looking brighter, I decided it is time to revisit this name once again.
Our bullish thesis on the KONA is rests on four pillars:
- KONA is relatively well-positioned at this juncture because, as a higher-end concept, its core customer is demonstrating a propensity to spend over the past few quarters as our High-Low society sustains itself.
- We estimate that comparable restaurant sales are trending at approximately 4% in 1Q11, bringing the two-year average trend to 0.8% for the quarter. We expect acceleration in two-year average trends for the balance of 2011.
- Operational improvements, coupled with improving top-line trends, will allow for significant margin improvements over the next two years.
- In 2011, KONA will print its first profitable quarter since it became a public company.
I expect operational improvements implemented in 2010 to begin to flow through in 2011, along with the benefit of additional efficiency-orientated measures taken during the year. These initiatives include phase four of the menu evolution and the benefit of five new remodels. In addition, reduced litigation expenses will provide a $0.04-$0.05 tailwind for the company in 2011.
Longer-term , over the next two years, KONA will see a significant step up in profitability and also be re-accelerating unit growth, leading to improved shareholder confidence and a higher valuation. Based on our 2011 EBITDA estimate of $7.2 million, KONA is trading at 6.0x EV/EBITDA, as compared to the average casual dining company trading at 7.0x. Over the next two years, we estimate that KONA will grow EBITDA over 100% and potentially earn as much as $0.25 in 2012. Based on the price of the stock today, assuming a 7x multiple on our 2012 EBITDA estimate, KONA is worth between $7.50 and $8.00, up over 55% from current levels.
SAME-STORE SALES TRENDS
KONA entered 2011 with some strong top-line momentum; posting a 6.4% increase in same-store sales in 4Q10, up 6.4% sequentially (4Q was the fourth consecutive quarter of positive traffic trends). The top-line story for KONA has breadth and depth. While the company does not report monthly comparable restaurant sales comps for all three months of the quarter, management stated in the transcript that approximately 75% of the comparable base of restaurants is expected to report positive comparable restaurant sales growth this quarter, with many reporting double-digit growth.
The increased momentum toward the end of 2010 was driven by menu improvement and new marketing initiatives driving awareness, increasing guest frequency and marginally boosting average check. Currently, they are running 1.7% menu pricing, and will see an uptick in menu prices when the new sushi menu is rolled out in 2Q11. We expect that KONA can maintain 4% same-store sales in 1Q11 and produce mid-single digit same-store sales for the balance of 2011.
MARGIN TRENDS
As with most restaurant companies today, food inflation is the most concerning issue. In 4Q11, cost of sales increased to 28.4% (up from 26.2% last year) and will be at that same level for 1Q11, according to current guidance. KONA is experiencing significant year-over-year increases for beef, chicken and seafood. Half of the 220 basis point increase was due to higher commodity prices and the other half was driven by upgrading the quality of ingredients. In early January, KONA began to contract for certain commodities for 2011, but no contracts are available for certain seafood products.
Off-setting the some of the food inflation in 4Q10 was lower labor costs. In 4Q10, labor expenses decreased to 34.8%, as a percentage of sales, from 36.9% last year. The lower labor cost is attributable to the leveraging of fixed management wages, hourly labor and benefit costs from the 6.4% increase in comp sales. Going forward, labor costs should continue to improve incrementally as the company gains leverage from improving comparable-restaurant sales.
Restaurant operating expenses decreased to 16.7%, as a percentage of sales, in 4Q11 from 17.9% last year; lower operating expense is primarily due to lower repair and maintenance expenses and leverage over higher volumes. Looking out to 2011, KONA will see restaurant operating expenses around 15% of sales, down from 16% in 2010. Occupancy expenses decreased to 8.0%, as a percentage of sales, during the fourth quarter from 8.7% last year. KONA continues to try to squeeze landlords for abatements and rent reductions at certain lower volume restaurants. All in, restaurant operating profit margin was 12.0% in 4Q10 compared to 10.3% last and for the full year.
The G&A line is an area KONA can continue to target for improvements in 2011. In 4Q10, G&A declined $446,000 year-over-year, primarily due to a reduction in severance and legal fees partially offset by an increase in bonuses. As a percentage of sales, G&A decreased 300 basis points to 7.3% of sales versus 10.3% last year. In 2011 G&A should be roughly $7-$8m, or around 7% of sales.
KONA’s balance sheet is in great condition and the company around $2.0 million in free cash flow in 2011. Unhampered by shareholder issues or balance sheet concerns, the focus is now on store-level execution and returning to profitability. On this count, the company has initiated a plan of action that will allow for a significant improvement in profitability. A theme that runs through all of the stocks we like on the long side is the active engagement, by management, in margin enhancement efforts despite the difficult commodity environment. KONA is a good example of this and, we believe, represents an opportunity on the long side for investors.
Howard Penney
Managing Director