March 25, 2013

Company Description:

• Owns and operates 23 “polished casual” restaurants, mostly in upscale mall locations in attractive Sunbelt markets. 
• Menu focus is modern American with fresh ingredients and an emphasis on sushi. 
• High-margin bar business represents 30%+ of revenue. 
• No new store openings since late 2010 as management has focused on improving operations and financial performance. 
• Two new units planned for late 2013, in Boise and an undisclosed Texas location, probably Dallas or Austin. Further unit expansion expected in 2014 and 2015 as management believes that KONA has 100-unit potential in the USA. 

Investment Thesis:

• Proven concept; healthy per-unit cash flow, growth and margins. 
• Compelling absolute and relative valuation. Trades at 2x-3x multiple turns below peers and fully 10 turns below a close comparable, Yard House, which was sold to DRI in summer 2012. 
• FCF being allocated sensibly and productively toward share repurchases and new unit openings. 
• Growth resumes with two new units in 2013. ROI calculation on new restaurants is attractive; full cash return in 3 years. 
• CEO noted on recent earnings call that KONA had its highest-grossing day in company history in early 2013. 
• Interesting play on improving macroeconomic conditions and housing recovery, especially in Phoenix and Las Vegas, where KONA generates nearly 25% of revenue. 
• Equity shrinkage: aggressive repurchases have retired 13% of the shares since late 2011. $2 million remains on a May 2012 board authorization. 
• Inside ownership is 34% and the CEO owns controls 16%. Given the trading illiquidity, exit opportunities are limited without a sale of the company. 
• Logical M&A candidate for DRI, EAT, BJRI or private equity. 

Management:

• CEO is Berke Bakay, a former investment manager whose BBS Capital controls 16% of KONA shares. Bakay purchased his shares in 2008 and 2009, gained a board seat in 2009 and became CEO in early 2012. 
• Key KONA executive with responsibility for real estate and restaurant expansion has similar experience with PF Chang’s. 
• Balance Sheet and Capitalization at 12/31/12: 
• $8.1 million of cash; $0.3 million of debt 
• 8.686 million shares outstanding, diluted 
• $8 million of stock repurchased from 11/11 through 12/12 at an average price of $6.55 per share. 
• $2 million remaining at 12/31/12 on the May 2012 repurchase authorization; 10-K indicates that another 45,000 shares were repurchased in January and February 2013 totaling approximately $385,000.
• Remaining NOL tax shield of $2.7 million expected to be fully utilized in 2013. 

Financial and Valuation Analysis:

$ in mil, except per share data 2012A 2013E 2014E 2015E Restaurants at December 31 23 25 27 30 Average revenue per unit $4.18 $4.35 $4.50 $4.66 Revenue $96.02 $101.06 $115.60 $133.64 Restaurant-level cash flow $18.02 $18.19 $20.92 $24.06     Operating margin 18.8% 18.0% 18.1% 18.0% Corporate overhead $7.04 $7.60 $7.90 $8.23     as a % of revenue 7.33% 7.52% 6.83% 6.16% EBITDA $10.98 $10.59 $13.02 $15.83     EBITDA margin 11.4% 10.5% 11.3% 11.8% CapEx $1.79 $6.08 $6.30 $8.80 Principal/interest expense/other $0.41 $0.22 $0.17 $0.00 Cash Taxes $0.36 $0.78 $2.02 $2.71 Free cash flow $8.42 $3.51 $4.53 $4.32 Share repurchase cash allocation $5.54 $2.03 $3.00 $4.00 Shares outstanding, diluted 8.68 8.45 8.13 7.74 Balance sheet cash, net at 12/31 $7.80 $9.28 $10.81 $11.13 Share Price at 3/25/13 $8.68 Market Capitalization $75.34     Less net cash: $7.80 Enterprise Value $67.55 EV/EBITDA 6.2 6.4 5.2 4.3 EV/FCF 8.0 19.2 14.9 15.6 EV/Revenue 0.70 0.67 0.58 0.51 FCF per share $0.42 $0.56 $0.56 FCF multiple 20.89 15.58 15.55

 

Relative Valuation Metrics for Selected Restaurants:

Name	Symbol	Price	Mkt Cap	Debt	EV	2013	2014	EV/EB	EV/EB	EV/Rev	Dividend	Yield	Repurchase?
		3/25/2013				EBITDA	EBITDA	2013	2014	2012
Kona Grill	KONA	$8.68	$75	($8)	$68	$11	$13	6.38	5.20	0.70	No	0.00%	Yes
Darden	DRI	$50.38	$6,600	$2,500	$9,100	$1,119	$1,164	8.13	7.82	1.00	$2.00	3.97%	Yes
Brinker	EAT	$36.69	$2,741	$590	$3,331	$352	$370	9.46	9.01	1.21	$0.80	2.18%	Yes
Red Robin	RRGB	$45.72	$655	$113	$768	$100	$105	7.68	7.31	0.79	No	0.00%	Yes
BJ's	BJRI	$32.68	$942	($34)	$908	$93	$103	9.74	8.85	1.28	No	0.00%	No
Buffalo WW	BWLD	$85.81	$1,612	($30)	$1,582	$150	$158	10.55	10.05	1.52	No	0.00%	No
Bravo Brio	BBRG	$15.45	$320	$21	$341	$37	$39	9.21	8.77	0.83	No	0.00%	Yes
DineEquity	DIN	$69.43	$1,294	$1,141	$2,435	$243	$252	10.03	9.65	2.86	$3.00	4.32%	No
Del Frisco's	DFRG	$16.86	$401	($11)	$390	$41	$43	9.52	9.07	1.68	No	0.00%	No
Ruth Chris	RUTH	$9.69	$334	$37	$371	$50	$53	7.43	7.07	0.93	No	0.00%	No
Bloomin	BLMN	$18.00	$2,066	$1,300	$3,366	$360	$378	9.35	8.91	0.84	No	0.00%	No
Yum Brands	YUM	$70.69	$33,083	$3,500	$36,583	$2,945	$3,122	12.42	11.72	2.68	$1.34	1.90%	Yes
CEC Ent	CEC	$32.65	$568	$380	$948	$165	$165	5.75	5.75	1.18	$0.96	2.94%	Yes

Relative Valuation and Recent M&A Benchmarks: 

• 2x-3x EV/EBITDA multiple discount to the peer group. 
• Significant EV/Revenue discount to the peer group. 
• Close comparable - privately held Yard House - was acquired by Darden (DRI) in summer 2012 for $585 million, at estimated valuation multiples of approximately 16x 2011 EBITDA and 2.2x 2011 revenue. 
• Applying a 20% multiple discount to Yard House’s take-out value to account for KONA’s smaller size, KONA could be worth about $18 per share to a strategic buyer. KONA trades at an FCF multiple that approximates Yard House’s EBITDA take-out multiple. 
• Underperforming PF Chang’s was taken private by Centerbridge Partners in 2012 at nearly 9x 2011 EBITDA and 0.9x revenue. 

Risks:

• 2013 will be a year of heavier capex, lower FCF and slightly lower EBITDA margins as KONA ramps spending to support new unit openings. Market may react negatively, though share repurchases should put in a floor. 
• Execution, especially related to restaurant expansion, could underwhelm.