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    MARKET EDGES

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On the KONA 1Q08 earnings conference call, Thomas Lynch of Mill Road Capital publically flogged the management of KONA grill.  What did he accomplish?  I’m sure he feels better about himself today, but he is not living up to the investor he claims to be – a Berkshire Hathaway for small companies!  It’s very clear Thomas Lynch is no Warren Buffet! To me his behavior only highlighted that he is down $3.6 million on his initial KONA investment. 

 

In June 2008 Mill Road filed a 13D stating their belief that KONA represents an attractive investment opportunity.  Further, they thought KONA would be better able to realize its full value as a private entity and submitted a non-binding offer to acquire all the company a cash price of $10.75 per share.

 

I can tell you one thing; Mill Road does not do MACRO.  In June 2008, Mill Road Capital thought it would be a great idea to take KONA private!  Are you kidding me, they should be happy they only lost $4 million on the KONA investment.   

 

In addition to the public flogging of management, Mill Road is now causing KONA to spend hundreds of thousands of dollars in legal fees.  Again, for what purpose?  A shareholder is destroying shareholder value!  Stupid!

 

From what I have read, I don’t necessarily think management has handled everything perfectly, with respect to the capital raise.  It’s unlikely that I will ever know what the real story is, but who cares?  Mill Road Capital is bitter because they skewed up – get over it. 

 

Getting past all the nonsense and how is the business doing, is there a real opportunity?  I see three key issues, none of which have terminal consequences.  First, KONA’s market cap is small at $15 million and relatively illiquid.  Second, the capital raise and disgruntled shareholders are keeping potential shareholders away.  Third, like all Restaurant businesses, trends are soft but getting less bad - April trends confirm this thesis.   KONA currently operate 21 restaurants in 13 states, with 22% of the restaurant located in Arizona and Nevada.

 

KONA - Kona Storms are Seasonal - kona1

 

Given the current trends the company is seeing now, general industry conditions and the comparisons is 2H09, KONA same-store sales will show continued improvement during the balance of 2009.  The improvement in sales trends, coupled with lower commodity prices, will allow KONA to show margin improvement in 3Q09 and 4Q09.

 

As I see it, two of the three negatives will go diminish over time.  Once the company closes on the rights offering on May 22nd, the company capital needs go away completely.  As a result, the focus will then shift to the company ability to generate cash.  The current plans call for KONA will build out two more stores in fiscal 2009 and one in fiscal 2010.  We estimate that the company will generate $2-3 million and $5-6 million of free cash flow in 2010 and 2011, respectively.  In total the company will generate 50%+ of the current enterprise value in free cash flow over the next two years. 

 

KONA - Kona Storms are Seasonal - kona2

 

Right now, KONA is trading at 3.1x NTM EV/EBITDA; significantly below the peer group at 6.5x NTM EV/EBITDA.  Based on my estimates, every multiple improvement in KONA’s valuation represents $0.77 of upside.

 

KONA - Kona Storms are Seasonal - kona3