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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

______________

 

FORM 10-Q

 

☒

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2018

 

or

 

☐

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from to

 

Commission File Number 001-34082
____________

 

Kona Grill, Inc.
(Exact Name of Registrant as Specified in Its Charter)

 

Delaware	20-0216690
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

 

15059 North Scottsdale Road, Suite 300
Scottsdale, Arizona 85254
(480) 922-8100
(Address, including zip code, and telephone number, including area code, of principal executive offices)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒      No ☐

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    No  ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ☐	Accelerated filer ☐
Non-accelerated filer ☐	Smaller reporting company ☒
Emerging growth company ☐

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ☐      No ☒

 

As of October 31, 2018, there were 13,260,321 shares of the registrant’s common stock outstanding.

 

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KONA GRILL, INC.

TABLE OF CONTENTS

 

 

Page

PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets as of September 30, 2018, (Unaudited) and December 31, 2017	2
	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2018 and 2017 (Unaudited)	3
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended     September 30, 2018 and 2017 (Unaudited)	4
	Notes to Unaudited Condensed Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	27
Item 4.	Controls and Procedures	28
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	28
Item 1A.	Risk Factors	28
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	29
Item 3.	Defaults Upon Senior Securities	29
Item 4.	Mine Safety Disclosures	29
Item 5.	Other Information	29
Item 6.	Exhibits	30
	Signatures	31

 

 

PART I – FINANCIAL INFORMATION

 

Item 1.  Financial Statements

 

KONA GRILL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

                                                                                 

 

See accompanying notes to condensed consolidated financial statements.

 

 

KONA GRILL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

                                                                                        

 

See accompanying notes to condensed consolidated financial statements.

 

 

KONA GRILL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

KONA GRILL, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

 

 

 

 

 

 

 

 

Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto included in Item 1 of Part I of this Form 10-Q and the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2017 contained in our 2017 Annual Report on Form 10-K.

 

Certain information included in this discussion contains forward-looking statements that involve known and unknown risks and uncertainties, such as statements relating to our future economic performance, plans and objectives for future operations, expectations, intentions and other financial items that are based on our beliefs as well as assumptions made by and information currently available to us. Factors that could cause actual events or results to differ materially from those indicated by these forward-looking statements may include the matters under Item 1A, “Risk Factors” in this report, our Annual Report on Form 10-K for the year ended December 31, 2017 and other reports filed from time to time with the SEC.

 

Overview

 

We currently own and operate 44 restaurants located in 22 states and Puerto Rico. From 2013 to 2017, we grew organically through opening new restaurants and doubled the number of restaurants from 23 to 44. Our unit growth rate was 22% in 2016, with eight openings during the year and we had 23% unit growth rate in 2015 with seven restaurant openings. We opened one restaurant in 2017. We closed two underperforming restaurants during the third quarter of 2018 and are continuing to evaluate the performance of underperforming restaurants and assess for potential closure. We believe that slowing the pace of growth will allow us to focus our time and attention on restaurant operations and improving financial performance.

 

We continue to explore potential opportunities for market expansion through franchised restaurants. In 2016, we signed an agreement for the development of six Kona Grill restaurants in the United Arab Emirates, which was subsequently amended in the third quarter of 2018 to reduce the number of Kona Grill restaurants from six to three. This resulted in the recognition of $0.2 million in revenue associated with the upfront territory fees that were previously deferred. In April 2017, we signed an agreement for the development of one Kona Grill restaurant in Vaughan, Canada. The agreement allows our franchisee the right to develop additional restaurants in the Toronto market for a specified period of time following the opening of the first restaurant. Our international franchise partners in the UAE and Canada opened a Kona Grill restaurant in their respective countries in the second half of 2017 and we expect our UAE partners to open a second restaurant in 2020. Under the franchise model, we will provide training and operational support to our partners without committing or putting at risk capital for restaurant construction.

 

During the second quarter of 2018, we terminated the development and franchise agreements with our franchise partner in Mexico as a result of the franchisee ceasing to do business at the franchised restaurant. The termination of the development agreement and the franchise agreement is immediate and without prejudice to any of the Company’s rights and remedies as franchisor to obtain damages or other remedies against the developer, franchisee, and franchisee’s guarantor. As a result, we recognized $0.3 million of revenue associated with the remaining deferred upfront territory and franchise related fees during the three months ended June 30, 2018.

 

 

Cost of sales, labor, and other operating expenses for our restaurants open at least 18 months generally trend consistently with revenue, and we analyze those costs as a percentage of revenue. Our typical new restaurants experience gradually increasing unit volumes as customers discover our concept and we generate market awareness. We anticipate that our new restaurants will take up to twelve months to achieve the majority of operating efficiencies as a result of challenges typically associated with opening and operating new restaurants, including lack of market recognition and the need to hire and sufficiently train employees, as well as other factors.

 

Key Measures We Use to Evaluate Our Company

 

Same-Store Sales Percentage Change. Same-store sales percentage change reflects the periodic change in restaurant sales for the comparable restaurant base. In calculating the percentage change in same-store sales, we include a restaurant in the comparable restaurant base after it has been in operation for more than 18 months. We adjust the sales included in the same-store sales calculation for restaurant closures so that the periods will be comparable. Same-store sales growth can be generated by an increase in customer traffic counts or by increases in the per person average check amount. Menu price changes and the mix of menu items sold can affect the per person average check amount.

 

Sales per Square Foot. Sales per square foot is a measure of a restaurant’s productivity and represents the amount of sales generated for each square foot.

 

Average Unit Volume. Average unit volume represents the average restaurant sales for the comparable restaurant base.

 

Restaurant Operating Profit. Restaurant operating profit is defined as revenue minus cost of sales, labor, occupancy, and restaurant operating expenses. Restaurant operating profit does not include general and administrative expenses, depreciation and amortization, or preopening expenses. We believe restaurant operating profit is an important component of financial results because it is a widely-used metric within the restaurant industry to evaluate restaurant-level productivity, efficiency, and performance prior to application of corporate overhead. We use restaurant operating profit as a percentage of revenue as a key metric to evaluate our restaurants’ financial performance compared with our competitors. This measure provides useful information regarding our financial condition and results of operations and allows investors to assess future financial results and to compare restaurant level profitability.

 

EBITDA and Adjusted EBITDA. EBITDA is defined as net income (loss) plus the sum of interest, taxes, depreciation and amortization. Adjusted EBITDA is defined as EBITDA plus unusual or non-recurring items, such as impairment, lease termination and exit costs and write-off of deferred financing costs. EBITDA and Adjusted EBITDA are presented because: (i) we believe it is a useful measure for investors to assess the operating performance of our business; (ii) we believe that investors will find these measures useful in assessing our ability to service or incur indebtedness; and (iii) we use EBITDA and Adjusted EBITDA internally as a benchmark to evaluate our operating performance and compare our performance to that of our competitors. EBITDA and Adjusted EBITDA as presented in this report are supplemental measures of our performance that are neither required by, nor presented in accordance with, GAAP. EBITDA and Adjusted EBITDA are not measurements of our financial performance under GAAP and should not be considered as alternatives to net income, operating income, or any other performance measures derived in accordance with GAAP, or as alternatives to cash flow from operating activities as a measure of our liquidity.

 

 

Financial Performance Overview

 

The following table sets forth certain information regarding our financial performance for the three and nine months ended September 30, 2018 and 2017:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
Revenue percentage change			(15.7	)%			2.4	%			(10.8	)%			8.5	%
Same-store sales percentage change			(14.1	)%			(7.2	)%			(11.6	)%			(5.6	)%
Average unit volume (in thousands)		$	838			$	1,004			$	2,685			$	3,163
Sales per square foot (in thousands)		$	116			$	138			$	371			$	438
Restaurant operating profit (in thousands)		$	3,661			$	4,528			$	14,721			$	14,256
Restaurant operating profit as a percentage of revenue			9.8	%			10.2	%			12.1	%			10.4	%
EBITDA (in thousands)		$	(1,068	)		$	1,180			$	3,406			$	1,539
EBITDA as a percentage of revenue			(2.9	)%			2.7	%			2.8	%			1.1	%
Adjusted EBITDA (in thousands)		$	1,141			$	1,218			$	5,701			$	3,433
Adjusted EBITDA as a percentage of revenue			3.0	%			2.7	%			4.7	%			2.5	%

 

The table below sets forth a reconciliation of Net Loss to EBITDA, Adjusted EBITDA and restaurant operating profit to the most comparable U.S. GAAP measure.

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
(In thousands)
Net loss		$	(5,114	)		$	(3,323	)		$	(8,574	)		$	(11,023	)
Income tax expense (benefit)			8				21				(7	)			71
Interest expense, net			617				500				1,845				1,214
Depreciation and amortization			3,421				3,982				10,142				11,277
EBITDA		$	(1,068	)		$	1,180			$	3,406			$	1,539
Asset impairment charge			—				30				—				30
Lease termination costs and other (1)			2,210				8				2,258				1,392
Write-off of deferred financing costs			—				—				37				472
Adjusted EBITDA		$	1,142			$	1,218			$	5,701			$	3,433
General and administrative			2,534				3,297				9,158				10,013
Preopening expense			—				13				—				810
Gain on insurance recoveries(1)			(15	)			—				(138	)			—
Restaurant operating profit		$	3,661			$	4,528			$	14,721			$	14,256

 

(1)     Amounts include approximately $0.1 million of litigation settlement costs which are included in “Lease termination costs and other” in the accompanying unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2018.

 

 

		Percentage of Revenue								Percentage of Revenue
		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
Net loss			(13.7	)%			(7.5	)%			(7.0	)%			(8.1	)%
Income tax expense (benefit)			—				—				—				8.3
Interest expense, net			1.6				1.1				1.5				0.9
Depreciation and amortization			9.1				9.0				8.3				0.1
EBITDA			(2.9	)			2.7				2.8				1.1
Asset impairment charge			—				0.1				—				—
Lease termination costs and other			5.9				—				1.9				1.0
Write-off of deferred financing costs			—				—				0.0				0.3
Adjusted EBITDA			3.0				2.7				4.7				2.5
General and administrative			6.8				7.4				7.5				7.3
Preopening expense			—				—				—				0.6
Gain on insurance recoveries			—				—				(0.1	)			—
Restaurant operating profit			9.8	%			10.2	%			12.1	%			10.4	%

 

 Certain amounts may not sum due to rounding.

 

Results of Operations

 

The following table sets forth, for the periods indicated, the percentage of revenue of certain items in our financial statements:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
Revenue			100	%			100	%			100	%			100	%
Costs and expenses:
Cost of sales			25.9				27.1				25.6				27.5
Labor			37.0				36.8				36.3				36.7
Occupancy			10.9				9.4				10.3				9.1
Restaurant operating expenses			16.5				16.5				15.7				16.2
General and administrative			6.8				7.4				7.5				7.3
Preopening expenses			—				—				—				0.6
Depreciation and amortization			9.1				9.0				8.3				8.3
Asset Impairment charge			0.0				0.1				—				—
Lease termination costs and other			5.9				—				1.7				1.0
Total costs and expenses			112.0				106.3				105.5				106.8
Loss from operations			(12.0	)			(6.3	)			(5.5	)			(6.8	)
Write-off of deferred financing costs			—				—				—				0.3
Interest expense, net			1.6				1.1				1.5				0.9
Loss before income taxes			(13.6	)			(7.4	)			(7.0	)			(8.0	)
Income tax (expense) benefit			—				0.1				—				0.1
Net loss		$	(13.7	)%			(7.5	)%		$	(7.0	)%		$	(8.1	)%

 

Certain amounts may not sum due to rounding.

 

 

Three Months Ended September 30, 2018 Compared with Three Months Ended September 30, 2017

 

Revenue. Revenue decreased $7.0 million, or 15.7%, to $37.4 million during the third quarter of 2018 from $44.4 million in the third quarter of 2017. Our same-store sales decreased 14.1% year over year, driven primarily by a decrease in customer traffic compared to the prior year period as a result of our strategic reduction in happy hour times and $5 food offerings, elimination of certain other customer discounts and reducing store hours for certain of our restaurants (closing one hour earlier on weekdays). The above changes are part of the Company’s strategic initiatives to improve operating margins and drive overall profitability.

 

Cost of Sales. Cost of sales decreased $2.3 million, or 19.5% to $9.7 million in the third quarter of 2018 compared to $12.0 million in the same prior year period with the decrease primarily attributable to the reduction in revenue noted above and our continued efforts on enhancing recipes and streamlining processes to improve margins as part of the Company’s overall profitability improvement initiatives. As a percentage of revenues, cost of sales decreased to 25.9% for the third quarter of 2018 compared to 27.1% in the prior year quarter, due to strategic purchasing initiatives and an overall favorable commodities environment compared to the same prior year period.

 

Labor. Labor costs decreased $2.5 million, or 15.3%, to $13.8 million compared to $16.3 million during the prior year same quarter as a result of our continued efforts and emphasis on wage management, aligning the size of restaurant management teams to sales volume and a change in the management bonus program effective January 1, 2018. Labor expenses as a percentage of revenues increased slightly to 37.0% compared to the prior year period.

 

Occupancy. Occupancy expenses decreased $0.1 million, or 1.7%, to $4.1 million in the third quarter of 2018 compared to $4.2 million in the same prior year period. The decrease is primarily attributable to the closing of two restaurant locations during the third quarter of 2018. Occupancy expenses as a percentage of revenues increased to 10.9% in the third quarter of 2018 compared to 9.4% in the third quarter of 2017, attributable to an overall lower sales volume.

 

Restaurant Operating Expenses. Restaurant operating expenses decreased $1.1 million, or 15.9%, to $6.2 million in the third quarter of 2018 compared to $7.3 million in the same prior year period. The decrease is primarily attributable to a decrease in travel and relocation costs and variable operating expenses as a result of the lower sales volume. Restaurant operating expenses as a percentage of revenues remained flat at 16.5% for both the third quarter of 2018 and 2017, respectively.

 

General and Administrative. General and administrative expenses were $2.5 million and $3.3 million for the third quarter of 2018 and 2017, respectively. The $0.8 million decrease is primarily due to a decrease in labor and benefits from headcount reductions and a decrease in legal and consulting fees as part of the Company’s cost-savings initiatives. As a percentage of revenues, general and administrative expenses were 6.8% and 7.4% during the third quarter of 2018 and 2017, respectively.

 

Preopening Expenses. We did not record any preopening related expenses during the third quarter of 2018. Preopening expenses were $13,000 in the third quarter of 2017, attributable to the opening of one restaurant at the Scottsdale Quarter in June of 2017.

 

Depreciation and Amortization. Depreciation and amortization expense decreased $0.6 million or 14.1% to $3.4 million compared to $4.0 million in the same prior year period. Depreciation and amortization expense as a percentage of revenues was 9.1% and 9.0% for the third quarter of 2018 and 2017, respectively. The decrease was primarily attributable to the impact of fully depreciated assets during the quarter, the closure of two restaurants during the third quarter of 2018, and the decrease in certain long-lived assets as a result of the $9.3 million impairment charge recorded in the fourth quarter of 2017.

 

 

Lease Termination Costs and Other. Following an evaluation of underperforming restaurants, we decided to close two restaurants during the third quarter of 2018 and as a result recorded lease termination costs of $2.8 million, a non-cash asset impairment charge of $1.8 million, partially offset by the write-off of deferred rent liabilities of $2.5 million. Additionally, we recorded approximately $0.1 million of litigation settlement charges and insurance recoveries of $14,000.

 

Interest Expense, Net. Net interest expense, consisting primarily of interest expense on borrowings, deferred loan fee amortization and line of credit commitment fees, was $0.6 million in the third quarter of 2018 compared to $0.5 million in the third quarter of 2017. Net interest expense in the third quarter of 2018 includes interest expense on $33.5 million in borrowings under the credit line compared to $38.0 million in borrowings in the prior year period. The increase in interest expense compared to the prior year is due to an increase in interest rates as a result of increases in LIBOR over the past 12 months as well as higher loan rates as a result of the fourth amendment to the credit facility that was entered into during March 2018. We also capitalized approximately $39,000 of interest during the third quarter of 2017 as interest was incurred to fund new restaurant construction. We did not capitalize any interest expense during the third quarter of 2018.

 

Income Tax Expense. Income tax expense was $8,000 and $21,000 during the third quarter of 2018 and 2017, respectively, and related to state income tax expenses for which no state net operating loss carryforwards or other credits exist.

 

Nine Months Ended September 30, 2018 Compared with Nine Months Ended September 30, 2017

 

Revenue. Revenues decreased 10.8% to $121.8 million during the nine months ended September 30, 2018 from $136.6 million in the prior year period. Same-store sales decreased 11.6% in the first nine months of 2018 compared to a decrease of 5.6% in the first nine months of 2017 driven primarily by a decrease in customer traffic compared to the prior year period as part of a strategic reduction in happy hour times and $5 food offerings, elimination of certain other customer discounts and reducing unprofitable store hours for certain of our restaurants. This reduction in operating hours and changes in happy hour times/offerings is part of the Company’s strategic initiatives to improve operating margins and drive overall profitability.

 

Cost of Sales. Cost of sales decreased $6.4 million, or 16.9% to $31.2 million during the first nine months of 2018 compared to $37.6 million during the same period in the prior year, with the decrease primarily attributable to an overall lower sales volume. As a percentage of revenues, cost of sales was 25.6% compared to 27.5% during the same prior year period, primarily reflecting a favorable commodities environment and our continued efforts on enhancing recipes and processes to improve margins.

 

Labor. Labor costs in the first nine months of 2018 decreased $6.0 million, or 11.9% to $44.2 million compared to $50.2 million in the comparable prior year period, mainly due to the lower sales volume and our continued efforts and emphasis on wage management and recipe and process enhancements to improve labor productivity. Labor expenses as a percentage of revenues decreased to 36.3% compared to 36.7% in the prior year period.

 

Occupancy. Occupancy expenses increased $0.1 million or 0.6% to $12.5 million in the first nine months of 2018 compared to $12.4 million in the prior year period. The slight increase is attributable to our Scottsdale Quarter location which opened in the second quarter of 2017, partially offset by the closure of two restaurants during the third quarter of 2018. Occupancy expenses as a percentage of revenues were 10.3% in the first nine months of 2018 compared to 9.1% in the first nine months of 2017.

 

Restaurant Operating Expenses. Restaurant operating expenses decreased $3.0 million, or 13.6%, to $19.1 million during the first nine months of 2018 compared to $22.1 million in the same period in 2017. The decrease is primarily attributable to a decrease in advertising expenses, travel and relocation costs and professional services, as well as a reduction in variable expenses attributable to the lower sales volume, partially offset by an increase in delivery services fees and repair and maintenance related activity. Restaurant operating expenses as a percentage of revenues were 15.7% during the first nine months of 2018 compared to 16.2% in the first nine months of 2017.

 

 

General and Administrative. General and administrative expenses decreased by $0.8 million, or 8.5% to $9.2 million from $10.0 million year over year. However, general and administrative expenses as a percentage of revenues increased to 7.5% in the first nine months of 2018 compared to 7.3% in the prior year period as a result of an overall lower sales volume. The $0.8 million decrease in absolute dollars was attributable to the overall decrease in labor and benefits, including stock-based compensation expense as a result of headcount reductions and a decrease in consulting fees as part of the Company’s cost-savings initiatives.

 

Preopening Expenses. Preopening expenses in year to date 2017 were primarily attributable to the Scottsdale Quarter restaurant, which opened in June of 2017. No new restaurants have opened since June 2017.

 

Depreciation and Amortization. Depreciation and amortization expense decreased $1.2 million or 10.1% to $10.1 million compared to $11.3 million in the prior year period, primarily attributable to the impact of fully depreciated assets during the year and the decrease in certain long-lived assets as a result of the $9.3 million impairment charge recorded in the fourth quarter of 2017. Depreciation and amortization expense remained relatively flat as a percentage of revenues at 8.3% in the first nine months of 2018 and in the prior year period.

 

Lease Termination Costs and Other. We continue to monitor and evaluate our underperforming restaurants and as a result decided to close two restaurants and not pursue opening a restaurant for which we had a signed lease and entered into a lease termination agreement during the nine months ended September 30, 2018. As such, we recorded $2.6 million of lease termination costs and a non-cash impairment charge of $2.0 million offset by the write-off of deferred rent liabilities of $2.5 million. Additionally, we recorded approximately $0.1 million of litigation settlement charges offset by insurance recoveries of $137,000. In the second quarter of 2017, we recognized $1.4 million related to estimated lease termination costs and asset write-offs associated with the decision to not move forward with the construction of a restaurant.

 

Interest Expense, Net. Net interest expense, consisting primarily of interest expense on borrowings, deferred loan fee amortization and line of credit commitment fees, was $1.8 million in the first nine months of 2018 compared to $1.2 million in the first nine months of 2017. Net interest expense increased during the first nine months of 2018 as a result of the overall increase in the interest rate environment compared to the prior year period. We also capitalized approximately $135,000 of interest during the first nine months of 2017 as interest was incurred to fund new restaurant construction. We did not capitalize any interest expense during the first nine months of 2018.

 

Write-Off of Deferred Financing Costs. Effective June 30, 2017 we amended our credit facility to provide additional flexibility with financial covenants and also decreased our Revolver from $45 million to $30 million and shortened the maturity date to October 12, 2019. As a result, we wrote-off a portion of the unamortized deferred financing costs associated with the Amendment of approximately $0.5 million during the nine months ended September 30, 2017.

 

Subsequently, during March 2018 we amended our credit facility to provide additional flexibility with financial covenants and also decreased our Revolver from $30 million to $25 million and further reductions in the available credit on the Revolver to $22.5 million at June 30, 2018 and $20 million at December 31, 2018. Additionally, the Amendment extended the maturity date to January 13, 2020. As a result, we wrote-off a portion of the unamortized deferred financing costs associated with the Amendment of approximately $37,000 during the nine months ended September 30, 2018.

 

 

Income Tax Expense (Benefit). Income tax benefit was $7,000 during the nine months ended September 30, 2018 and primarily related to state tax expense offset by the prior year-end true-up associated with an over accrual of our income tax reserve. Income tax expense was $71,000 during the nine months ended September 30, 2017 and related to state income tax expenses for which no state net operating loss carryforwards or other credits exist.

 

Potential Fluctuations in Quarterly Results and Seasonality

 

Our quarterly operating results may fluctuate significantly as a result of a variety of factors, including the following:

 

●

profitability of our restaurants, especially in new markets;

●

increases and decreases in comparable restaurant sales;

●

labor availability and wages and benefits for hourly and management personnel;

●

timing of new restaurant openings and related expenses;

●

preopening costs for newly-opened restaurants and operating costs for those locations, which are often materially greater during the first several months of operation than thereafter;

●

timing of restaurant remodels and potential lost sales associated with remodel closure;

●

impairment of long-lived assets and any loss on restaurant closures;

●

costs related to any lease terminations, which could be significant, or fluctuations due to renegotiation of leases;

●

risks of execution of our franchising strategy in the U.S. as well as outside the U.S. and dependence on our franchisees to successfully open and operate their restaurants;

●

fluctuations in commodity and food protein prices;

●

changes in borrowings and interest rates;

●

general economic conditions;

●

weather conditions or natural disasters;

●

timing of certain holidays;

●

changes in government regulations;

●

settlements, damages and legal costs associated with litigation;

●

new or revised regulatory requirements and accounting pronouncements; and

●

changes in consumer preferences and competitive conditions.

 

Our business is also subject to seasonal fluctuations. Historically, sales in most of our restaurants have been higher during the spring and summer months and winter holiday season. Consequently, our quarterly and annual operating results and comparable restaurant sales may fluctuate significantly as a result of seasonality and the factors discussed above. Accordingly, results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for any year and comparable restaurant sales for any particular future period may decrease. Operating results may fall below the expectations of our investors. In that event, the price of our common stock would likely be impacted.

 

Liquidity and Capital Resources

 

Our primary liquidity and capital requirements are for new restaurant construction, initiatives to improve the guest experience in our restaurants, working capital and general corporate needs. As of September 30, 2018, we had a cash and cash equivalents and short-term investment balance totaling $4.0 million that we expect to utilize, along with cash flow from operations, and the available amounts under our credit facility, to provide capital to support our business, to maintain and refurbish our existing restaurants, to invest in technology to support our restaurants, and for general corporate purposes.

 

During our high growth phase, we required significant capital resources to construct and equip each restaurant. We have slowed the pace of growth of new restaurant development in 2018, therefore, our capital requirements are significantly less than in previous years.

 

 

Like many restaurant companies, we have been able to operate with negative working capital. Restaurant sales are primarily paid for in cash or by credit card, and restaurant operations do not require significant inventories or receivables. In addition, we receive trade credit for the purchase of food, beverage and supplies, therefore reducing the need for incremental working capital to support growth. Additionally, similar to many restaurant companies, we utilize operating lease arrangements for all of our restaurant locations. We believe that our operating lease arrangements provide appropriate leverage for our capital structure in a financially efficient manner.

 

Future Capital Requirements

 

As previously mentioned, our capital requirements, including development costs related to the opening of new restaurants, have historically been significant. Over the past two years, we funded development of new restaurants and maintenance capital expenditure primarily from borrowings under our credit facility and cash flows from operations. Our future cash requirements and the adequacy of available funds will depend on many factors, including the operating performance of our current restaurants, the pace of expansion and remodels, real estate markets, site locations, the nature of the arrangements negotiated with landlords, capital market accessibility and availability under our credit line.

 

We are focused on building sales, improving margins and generating cash flow to repay debt. We opened one restaurant at the Scottsdale Quarter in 2017 compared to eight restaurants in 2016 and seven restaurants in 2015. We have significantly reduced capital spending from $11.2 million for the nine months ended September 30, 2017 compared to $1.4 million in capital expenditures during the nine months ended September 30, 2018.

 

On May 4, 2018, the Company issued to a single investor (the “Investor”) 2,651,261 shares of the Company’s Common Stock at a purchase price of $1.785 per share, which was equal to the closing bid price of the Company’s common stock on the date of the securities purchase agreement plus a five percent (5%) premium (the “Premium Purchase Price”). Following the private placement, the Investor beneficially owns approximately 19.9% of the Company’s common stock. Additionally, Berke Bakay, the Company’s Executive Chairman of the Board of Directors, acquired 492,997 shares of the Company’s common stock in the private placement at the Premium Purchase Price such that Mr. Bakay retained his current beneficial ownership of 15.7% following the private placement. Total net proceeds from the private placement were $5.5 million.

 

As of September 30, 2018, we had a working capital deficit of $7.8 million and outstanding borrowings under our credit facility of $33.5 million. As of September 30, 2018, net availability under the credit facility was $2.2 million, subject to compliance with certain covenants. We believe existing cash and cash equivalents and short-term investments of $4.0 million, the availability on our credit facility, and cash flow generated from operations will be sufficient to fund working capital and other cash requirements over the next 12 months.

 

Any reduction of our cash flow from operations or an inability to draw on our credit facility may cause us to take appropriate measures to generate cash. Our failure to raise capital when needed could impact our financial condition and results of operations. Additional equity financing, to the extent available, would result in dilution to current stockholders and additional debt financing, if available, may involve significant cash payment obligations or financial covenants and ratios that may restrict our ability to operate our business.

 

 

Debt and Credit Agreements

 

On March 9, 2018, we entered into Amendment No. 4 to the Second Amended and Restated Credit Agreement (“Amendment No. 4”). Amendment No. 4 amends the Second Amended and Restated Credit Agreement to, among other things, reduces the available credit on the Revolver to $25 million as of the effective date of Amendment No. 4 and further reduces the available credit on the Revolver to $22.5 million at June 30, 2018 and $20 million at December 31, 2018. Thus, requiring the Company to make payments on the Revolver of $1.25 million by June 30, 2018 and an additional payment of $2.5 million by December 31, 2018. Additionally, (a) the maturity date was amended from October 12, 2019 to January 13, 2020 with no option to extend the maturity; (b) the applicable margins for base rate loans and the applicable margins for LIBOR rate loans were increased by 50 bps to 100 bps depending on the Company’s leverage ratio; and (c) the maximum leverage ratio was increased and the minimum fixed charge coverage ratio was decreased to provide increased flexibility as further described below.

 

Amendment No. 4 requires us to comply with certain covenants on a quarterly basis, including (a) a minimum fixed charge coverage ratio of (i) 1.10 to 1.00 for the fiscal quarters ending March 31, 2018, June 30, 2018 and September 30, 2018; (ii) 1.15 to 1.00 for the fiscal quarters ending December 31, 2018 and March 31, 2019 and (iii) 1.20 to 1.00 for the fiscal quarter ending June 30, 2019 and each fiscal quarter thereafter; and (b) a maximum leverage ratio of (i) 6.25 to 1.00 for the fiscal quarter ending March 31, 2018; (ii) 6.00 to 1.00 for the fiscal quarter ending June 30, 3018; (iii) 5.50 to 1.00 for the fiscal quarter ending September 30, 2018; (iv) 5.00 to 1.00 for the fiscal quarters ending December 31, 2018, March 31, 2019 and June 30, 2019; and (v) 4.25 for the fiscal quarter ending September 30, 2019 and each fiscal quarter thereafter. The Company was in compliance with the fixed charge coverage ratio and the leverage ratio at September 30, 2018.

 

We utilized $3.75 million in proceeds from the May 2018 private placement to pay down the Revolver and permanently reduced the availability on the Revolver to $22.2 million as of September 30, 2018. At September 30, 2018, we had $33.5 million in outstanding borrowings, consisting of $20.0 million under the Revolver and $13.5 million under the Term Loan. As of September 30, 2018, net availability under the credit facility was $2.2 million, subject to compliance with certain covenants.

 

Cash Flows

 

The following table summarizes our primary sources and uses of cash during the periods presented (in thousands).

 

		Nine Months Ended September 30,
		2018				2017
Net cash provided by (used in):
Operating activities		$	(868	)		$	3,597
Investing activities			(1,277	)			(11,156	)
Financing activities			1,007				7,594
Net change in cash and cash equivalents		$	(1,138	)		$	35

 

Operating Activities. Our cash flows from operating activities used $0.9 million and provided $3.6 million of net cash during the first nine months of 2018 and 2017, respectively. The year over year change in cash from operating activities is primarily due to timing of payments for accounts payable and accrued expenses and receipt of tenant allowance reimbursements during the nine months ended September 30, 2018.

 

Investing Activities. Capital expenditures for the first nine months of 2018 were $1.4 million, primarily associated with remodel, technology investments and maintenance-related capital expenditures. Capital expenditures for the first nine months of 2017 were $11.2 million, primarily associated with our Scottsdale Quarter restaurant, which opened in June 2017, remaining capital expenditures for restaurants opened during the fourth quarter of 2016, and maintenance capital expenditures.

 

 

Financing Activities. Financing cash inflow decreased $6.6 million year over year. Financing cash flow for the nine months ended September 30, 2018 consisted primarily of $5.5 million in net proceeds received from the issuance of common stock associated with our equity offering in May 2018, partially offset by $4.3 million in payments under our credit facility (including $3.75 million from the net proceeds of the equity offering) and $0.2 million for costs associated with the credit facilities amendment No. 4. Net cash provided by financing activities during the nine months ended September 30, 2017 was $7.6 million and consisted primarily of $13.5 million of borrowings and $0.3 million of proceeds from stock option exercises, partially offset by $3.6 million for the repurchase of common stock under our October 2016 stock repurchase program, $2.3 million in payments under our Credit Facility and $0.3 million for debt issuance costs associated with Amendment No.1 to our Credit Facility. 

 

Off-Balance Sheet Arrangements

 

As of September 30, 2018, we had no off-balance sheet arrangements or obligations, other than operating leases, which are not classified as debt.

 

Critical Accounting Policies and Estimates

 

Critical accounting policies and estimates are those that we believe are both significant and that require us to make difficult, subjective or complex judgments, often because we need to estimate the effect of inherently uncertain matters. We base our estimates and judgments on historical experience and various other factors that we believe to be appropriate under the circumstances. Actual results may differ from these estimates, and we might obtain different estimates if we used different assumptions or conditions. Our critical accounting policies and estimates are identified and described in our annual report on Form 10-K for the year ended December 31, 2017.

 

We had no significant changes in our critical accounting policies and estimates since our last annual report, except for the added disclosure to the revenue recognition policy as a result of the adoption of the new revenue recognition standard Topic 606. The updated revenue recognition accounting policy is as follows:

 

Revenue Recognition

 

Revenues from food, beverage, and alcohol sales are recognized when payment is tendered at the point of sale. Restaurant sales are recorded net of promotions, discounts and sales taxes. The sales tax obligation is included in “Accrued expenses” on the unaudited Condensed Consolidated Balance Sheets until the taxes are remitted to the appropriate taxing authority. We sell gift cards to our customers in our restaurants and through selected third parties. The gift cards sold to customers have no stated expiration dates and are subject to actual and/or potential escheatment rights. We recognize revenue from gift cards when: (i) the gift card is redeemed by the customer; or (ii) we determine the likelihood of the gift card being redeemed by the customer is remote (gift card breakage) and there is not a legal obligation to remit the unredeemed gift cards to the relevant jurisdiction. As the unused balances of our gift cards are subject to the escheat or unclaimed property law, we recognize gift card breakage income upon escheatment. Gift card breakage income is recorded in “Revenue” on the unaudited Condensed Consolidated Statements of Operations and amounted to $36,000 and $0.2 million during the nine months ended September 30, 2018 and 2017, respectively. Prior to redemption, the outstanding balances of all gift cards are included in “Accrued expenses” in the accompanying unaudited Condensed Consolidated Balance Sheets.

 

 

During the third quarter of 2018 the Company launched its loyalty program to encourage customers to frequent Kona Grill restaurants. The loyalty rewards program awards a customer one point for every $1 spent. When points are accumulated a reward to be used on future purchases is earned. When a customer is part of the rewards program, the obligation to provide future discounts related to points earned is considered a separate performance obligation, to which a portion of the transaction price is allocated. The performance obligation related to loyalty points is deemed to have been satisfied, and the amount deferred in the balance sheet is recognized as revenue, when the points are converted to a reward and redeemed, or the likelihood of redemption is remote. A portion of the transaction price is allocated to loyalty points, if necessary, on a pro-rata basis, based on the stand-alone selling price, as determined by menu pricing and loyalty points terms. As of September 30, 2018, the deferred revenue allocated to loyalty points that have not been redeemed is less than $0.1 million, which is reflected in “Accrued expenses” in the accompanying unaudited Condensed Consolidated Balance Sheets. The Company expects the loyalty points to be redeemed and recognized over a one-year period.

 

We execute franchise agreements for units owned and operated by third parties. Our franchise agreements typically provide for upfront payment of territory and initial franchise fees in addition to subsequent royalty and advertising fees. Royalties and advertising fees are based on a percentage of gross sales at franchise restaurants and are recognized when earned and collectability is reasonably assured. We recognize upfront territory and franchise fees received from a franchisee as revenue when the separate and distinct performance obligations associated with the fees are satisfied. We currently believe that the services we provide related to upfront fees we receive from franchisees such as territory or initial franchise fees do not contain separate and distinct performance obligations from the franchise right and thus those upfront fees are recognized as revenue on a straight-line basis over the term of each respective franchise agreement upon store opening. Upfront territory fees paid by franchisees in connection with development agreements are deferred when the development agreement includes a minimum number of restaurants to be opened by the franchisee. The deferred amounts are recognized on a pro rata basis as the franchisee opens each respective restaurant. Any such unamortized portion of fees received are presented in “Deferred rent and other long-term liabilities” in our unaudited Condensed Consolidated Balance Sheets. The unamortized portion of fees received totaled $0.3 million and $0.9 million as of September 30, 2018 and December 31, 2017, respectively. Additionally, we capitalize certain costs to obtain or fulfill a contract that represent incremental costs that can be tied directly to obtaining and executing a contract. We amortize these costs over the life of the customer relationship. Costs to obtain a contract are less than $0.1 million as of September 30, 2018 and zero as of December 31, 2017 and are presented in “Other assets” in our unaudited Condensed Consolidated Balance Sheets.

 

Upon adoption of the new revenue recognition standard, we reversed $0.3 million of franchise revenue previously recorded associated with the upfront territory and franchise related fees as a cumulative adjustment to “Accumulated deficit” effective January 1, 2018. This cumulative adjustment increased our deferred revenue balance by $0.3 million and is recorded in “Deferred rent and other long-term liabilities” on the accompanying unaudited Condensed Consolidated Balance Sheet as of September 30, 2018. In addition to the changes presented above, we have historically recognized sales commissions as a component of general and administrative expenses as they are incurred. Under the new standard, certain sales commissions will be capitalized and amortized to general and administrative expense over the expected life of the customer relationship. We recognized less than a $0.1 million cumulative effect adjustment to “Accumulated deficit” with an increase to “Other assets” as of January 1, 2018.

 

Item 3.     Quantitative and Qualitative Disclosures About Market Risk

 

Commodity Price Risk

 

Our primary market risk exposure is commodity costs. Many of the food products purchased by us can be subject to volatility due to changes in weather, production, availability, seasonality, international demand, and other factors outside our control. Substantially all of our food and supplies are available from several sources, which help to diversify our overall commodity cost risk. We also believe that we have the ability to increase certain menu prices in response to food commodity price increases.  

 

Inflation

 

The primary inflationary factors affecting our operations are food, labor costs, energy costs and labor and materials used in the construction and maintenance of our restaurants. Increases in minimum wages directly affect our labor costs. Many of our leases require us to pay taxes, maintenance, repairs, insurance, and utilities, all of which are generally subject to inflationary adjustments. These increases could impact our operating results to the extent that such increases cannot be passed along through higher menu prices. Over the past two years, inflation has not significantly affected our operating results.

 

 

Interest Rate Risk

 

We also face market risk exposure due to the variable interest rates on our credit facility. Interest on both the term and revolver loans are subject to adjustment based on changes to the Prime or LIBOR rates. Interest rate fluctuations may adversely impact our financial condition or results of operations.

 

Item 4.     Controls and Procedures

 

We maintain disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to ensure that information required to be disclosed in Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

 

As of September 30, 2018, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.

 

There were no changes during the three months ended September 30, 2018 in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

 

PART II - OTHER INFORMATION

 

Item 1.     Legal Proceedings

 

For information regarding legal proceedings, see Note 10. “Commitments and Contingencies” in the Notes to the Condensed Consolidated Financial Statements.”

 

Item 1A. Risk Factors

 

Other than the additional risk described below, there have been no material changes in our risk factors since our annual report on Form 10-K for the year ended December 31, 2017. A description of the risk factors associated with our business is contained in Part I, Item 1A, “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2017. These cautionary statements are to be used as a reference in connection with any forward-looking statements. The factors, risks, and uncertainties identified in these cautionary statements are in addition to those contained in any other cautionary statements, written or oral, which may be made or otherwise addressed in connection with a forward-looking statement or contained in any of our subsequent filings with the SEC.

 

The following risk factor is in addition to those set forth in the 2017 Form 10-K:

 

 

If we fail to properly execute our franchise program, it may have a negative impact on our financial results.

 

Our current business strategy is to utilize franchised restaurants for expansion of our business in the U.S. as well as outside the U.S. Our ability to execute on this strategy will depend on various factors, including our ability to attract and retain franchisees of adequate quality, the identification of suitable new locations and negotiation of acceptable leases or purchase terms, regulatory compliance, ability to meet construction schedules, the financial and other capabilities of our franchisees and our ability to manage this anticipated expansion. Many of these factors are beyond our control or that of our franchisees, and there is no assurance that we can successfully carry out our franchising strategy. Our growth and success also depend upon the ability of our franchisees to successfully open their restaurants and operate these restaurants to our standards and promote the Kona Grill brand. Although we will impose operating standards on our franchisees, each franchisee will operate its restaurant independently. We cannot assure you that our franchisees will be able to successfully operate Kona Grill restaurants consistent with our standards, which could reduce their sales and our franchise royalties, and could adversely affect our financial results and our ability to leverage the Kona Grill brand.

 

Item 2.     Unregistered Sales of Equity Securities and Use of Proceeds

 

Issuer Purchase of Equity Securities

 

Not applicable.

 

Item 3.     Defaults Upon Senior Securities

 

Not applicable.

 

Item 4.     Mine Safety Disclosures

 

Not applicable.

 

Item 5.     Other Information

 

Not applicable.

 

 

Item 6.     Exhibits

 

Exhibit  Number	Exhibit
10.30*	Employment Agreements, dated as of September 4, 2018, between the Company and Berke Bakay, James Kuhn and Christi Hing. Incorporated by reference to the Registrant’s Form 8-K filed on September 7, 2018
31.1	Certification of Co-Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
31.2	Certification of Co-Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
31.3	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
32.1	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.3	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101	Interactive data files pursuant to Rule 405 of Regulation S-T (i) the Condensed Consolidated Balance Sheets as of September 30, 2018 and December 31, 2017, (ii) the Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2018 and 2017, (iii) the Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2018 and 2017 and (iv) the Notes to the Unaudited Condensed Consolidated Financial Statements.

 

---

 

* Management contract or compensatory plan or arrangement in which directors or executive officers are eligible to participate 

 

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

	Kona Grill, Inc.
	/s/ Marcus Jundt
	Marcus Jundt Co-Chief Executive Officer
	/s/ Steven Schussler
	Steven Schussler
	Co-Chief Executive Officer
	/s/ Christi Hing
	Christi Hing Chief Financial Officer (Principal Accounting and Financial Officer)

 

Date: November 8, 2018

 

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