10-K 1 kona20141231_10k.htm FORM 10-K kona20141231_10k.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark one)

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

  For the fiscal year ended December 31, 2014

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.)

7150 East Camelback Road, Suite 333
Scottsdale, Arizona 85251
(480) 922-8100

(Address, including zip code, and telephone number, including area code, of principal executive offices)

 

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class

Name of Each Exchange on Which Registered

Common Stock, par value $0.01 per share NASDAQ Global Market

 

Securities registered pursuant to Section 12(g) of the Act:
None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  ☐    No  ☒

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section15(d) of the Act. Yes  ☐    No  ☒

 

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 and posted on its corporate Web site, if any, 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 and post such files). Yes  ☒    No  ☐

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☐

 

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

 

Large accelerated filer ☐

Accelerated filer ☐

Non-accelerated filer ☐

Smaller reporting company ☒

               

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ☐    No  ☒

 

The aggregate market value of common stock held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter, June 30, 2014, was $160,210,000, calculated based on the closing price of the registrant’s common stock as reported by the NASDAQ Global Market. For purposes of this computation, all officers, directors, and 10% beneficial owners of the registrant are deemed to be affiliates. Such determination should not be deemed to be an admission that such officers, directors, or 10% beneficial owners are, in fact, affiliates of the registrant.

 

As of March 6, 2015, there were 11,252,563 shares of the registrant’s common stock outstanding.

 

Documents Incorporated by Reference

 

Portions of the registrant’s definitive proxy statement for the 2015 Annual Meeting of Stockholders, to be filed with the Commission within 120 days after the end of the fiscal year ended December 31, 2014, are incorporated by reference into Part III of this report.



 

 
 

 

 

KONA GRILL, INC.
A
nnual Report on Form 10-K
For the Year Ended December 31, 2014

TABLE OF CONTENTS

 

PART I

     

Item 1.

Business

1

Item 1A.

Risk Factors

11

Item 1B.

Unresolved Staff Comments

24

Item 2.

Properties

24

Item 3.

Legal Proceedings

25

Item 4.

Mine Safety Disclosures

25

 

PART II

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

25

Item 6.

Selected Financial Data

27

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

28

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

43

Item 8.

Financial Statements and Supplementary Data

44

Item 9.

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

44

Item 9A.

Controls and Procedures

44

Item 9B.

Other Information

45

 

PART III

 

Item 10.

Directors, Executive Officers and Corporate Governance

45

Item 11.

Executive Compensation

45

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

45

Item 13.

Certain Relationships and Related Transactions, and Director Independence

45

Item 14.

Principal Accountant Fees and Services

45

 

PART IV

 

Item 15.

Exhibits and Financial Statement Schedules

45

     

Signatures

47

Index to Consolidated Financial Statements

F-1

 

Statements Regarding Forward-Looking Statements

 

The statements contained in this report on Form 10-K that are not purely historical are forward-looking statements within the meaning of applicable securities laws. Forward-looking statements include statements regarding our “expectations,” “anticipation,” “intentions,” “beliefs,” or “strategies” regarding the future. Forward-looking statements relating to our future economic performance, plans and objectives for future operations, and projections of sales and other financial items are based on our beliefs as well as assumptions made by and information currently available to us. Actual results could differ materially from those currently anticipated as a result of a number of factors, including those discussed in Item 1A, “Risk Factors.”

 

 
 

 

  

PART I

Item 1.

Business

 

Overview

 

Kona Grill, Inc. (referred to herein as the “Company” or “we,” “us,” and “our”) currently owns and operates 30 polished casual restaurants in 19 states. Our restaurants offer freshly prepared food, attentive service, and an upscale contemporary ambiance that create an exceptional, yet affordable dining experience that we believe exceeds many traditional casual dining restaurants with whom we compete. Our high-volume polished casual restaurants feature a diverse selection of flavorful American food, internationally influenced appetizers and entrees and an extensive selection of award-winning sushi. Our menu items are prepared from scratch at each restaurant location and incorporate over 40 signature sauces and dressings, creating memorable flavor profiles that appeal to a diverse group of customers. Our diverse menu is complemented by a full service bar offering a broad assortment of wines, specialty cocktails, and beers. We believe that our innovative high-quality recipes, generous portions, and flexible price points provide customers with an excellent value proposition and allow us to attract a diverse customer base.

 

Our restaurants seat an average of 294 customers and are comprised of multiple dining areas that incorporate modern design elements to create an upscale ambiance that reinforces our high standards of food and service. Our main dining area, full-service bar, indoor/outdoor patio, and sushi bar provide a choice of atmospheres and a variety of environments designed to attract new customers and encourage repeat visits from regular customers. We locate our restaurants in high-activity areas such as retail centers, shopping malls, urban entertainment districts, and lifestyle centers that are situated near commercial office space and residential housing to attract customers throughout the day.

 

We believe that the portability of our concept has been successfully demonstrated in a variety of markets across the United States (U.S.). We plan to grow organically through unit expansion, with a target of 20% unit growth annually over the next several years by strategically expanding the Kona Grill concept in both new and existing markets. Furthermore, given the broad appeal of our concept across the U.S. and the increased demand for polished casual dining concepts overseas, we believe there is a significant opportunity to expand our concept in Latin America, the Middle East and beyond over the long term.

 

Competitive Strengths

 

The restaurant business is intensely competitive with respect to food quality, price-value relationships, ambiance, service and location. We believe that the key strengths of our business include the following:

 

 

Innovative Menu Selections with Mainstream Appeal. We offer a menu of freshly prepared, high quality food that includes a diverse selection of flavorful American favorites with an international influence and award-winning sushi items to appeal to a wide range of tastes, preferences, and price points. We prepare our dishes from scratch at each restaurant location using original recipes with generous portions and creative and appealing presentations that adhere to standards that we believe are much closer to fine dining than typical casual dining. Our more than 40 signature sauces and dressings create memorable flavor profiles and further differentiate our menu items. With an average check during 2014 of approximately $25 per customer, we believe we provide an exceptional price-value proposition that helps create a lasting relationship between Kona Grill and our customers.

 

 

Distinctive Polished Casual Dining Experience. Our polished casual dining concept captures some of the best elements of fine dining including a variety of exceptional food options, attentive service, and an extensive wine and cocktail list, and combines them with the traditional casual dining attributes, like a broad menu with attractive price points and a choice of environments suitable for any dining occasion. Our creative menu, personalized service, and contemporary restaurant design blend together to create an inviting polished casual dining experience. We design our restaurants with a unique layout and utilize modern, eye-catching design elements to enhance the customer experience. Our multiple dining areas provide customers with a number of distinct dining environments and atmospheres to suit a range of dining occasions. Our open exhibition-style kitchen and sushi bar further emphasize the quality and freshness of our food that are the cornerstones of our concept.

 

 

 
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Significant Bar and Happy Hour Business. Our high-energy bar and patio offer a distinctive atmosphere where customers can enjoy our alcoholic beverage offerings. Our patio is a popular place for customers to enjoy our high-value happy hour and reverse happy hour offerings, where full portions of select items are offered at reduced price points. Our patio, which is enclosed in colder climate locations, provides a year-round sales opportunity and is a key driver in generating business during non-traditional periods. Aggregate restaurant sales during these non-peak periods accounted for 24.7% of our total sales during 2014, which we believe provides us with a competitive advantage.

 

 

Personalized Customer Service. Our commitment to provide prompt, friendly, and efficient service enhances our food, reinforces our upscale ambiance, and helps distinguish us from other traditional casual dining restaurants. We train our service personnel to be cordial, friendly, and knowledgeable about all aspects of the restaurant, especially the menu and the wine list, which helps us provide personalized customer service that is designed to ensure an enjoyable dining experience and exceed our customers’ expectations. Our kitchen staff completes extensive training to ensure that menu items are precisely prepared to provide a consistent quality of taste. We believe our focus on high service standards underscores our customer-centric philosophy.

 

 

Multiple Daypart Model. Our appetizers, flatbreads, entrees, and sushi offerings provide a flexible selection of items that can be ordered individually or shared allowing customers to dine with us during traditional lunch and dinner meal periods as well as between customary dining periods such as in the late afternoon and late night. The lively ambiance of our patio and bar areas provides an energetic social forum that attracts a young professional clientele during non-peak periods, as well as provides a unique atmosphere for all of our customers to enjoy before or after they dine with us. Our sushi bar provides another dining venue for customers while offering a wide selection of creative and flavorful menu items for our health conscious customers. We believe that our ability to attract customers throughout the day distinguishes us from many other casual dining chains and helps us maximize sales and leverage our fixed operating costs.

 

 

Attractive Unit Economics. During 2014, the average unit volume of our comparable base restaurants was $4.4 million. We believe our average unit volume helps us attract high-quality employees, leverage fixed costs, and makes us a desirable tenant for landlords. We expect the average cash investment for new restaurants to be approximately $2.5 million, net of landlord tenant improvement allowances and excluding preopening expenses. Based on historical experience, restaurants that are subject to ground leases and do not receive landlord tenant improvement allowances may require a significantly higher cash investment, but typically have lower average rental costs over the duration of the lease.

 

Growth Strategy

 

We believe that there are significant opportunities to grow our sales and increase our brand awareness throughout the United States and internationally. The following sets forth the key elements of our growth strategy.

 

Pursue Disciplined Restaurant Growth

 

We review potential sites in both new and existing markets that meet our target customer demographics, real estate, and investment return criteria. We believe the location of our restaurants plays a pivotal role in determining the long-term profitability of each restaurant and, accordingly, we spend significant time and resources to evaluate each prospective site. We utilize a disciplined site selection process involving our management team and Board of Directors. Our site selection criteria for new restaurants include locating our restaurants near high activity areas such as retail centers, shopping malls, and lifestyle and entertainment centers. In addition, we focus on areas that have above-average density and income populations, have high customer traffic throughout the day from thriving businesses or retail markets, and are convenient for and appealing to business and leisure travelers. We also focus on sites that have great visibility and ample parking to support high volumes of traffic.

 

 
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We plan to grow organically through unit expansion, with a target of 20% unit growth annually over the next several years. We achieved a unit growth rate of 20% for 2014, with five openings during the year, including the Fort Worth, Texas restaurant in the first quarter, the El Paso, Texas location in the second quarter and the Sarasota, Florida; Alpharetta, Georgia and Columbus, Ohio restaurants in the fourth quarter. We plan to open seven restaurants during 2015, which equates to 23% unit growth. We currently have twelve signed leases for new restaurant openings in 2015 and beyond and continue working diligently to build our pipeline for future growth.

 

With the acceleration of unit growth in 2014, we have incurred significant preopening expense in 2014 and expect to continue to incur such expenses in 2015 as we increase the number of new restaurant openings in 2015. We expect the opening of new units to place downward pressure on our profitability as significant preopening expenses are incurred while operating profit from the new restaurants will likely not be significant in the first few months of each new restaurant’s operation as a result of start-up inefficiencies typically associated with opening new restaurants. Although the actual preopening expenses for a particular location depend upon numerous factors, we expect to incur cash preopening expenses of approximately $425,000 per location, and non-cash preopening rent expense ranging from $50,000 to $100,000 per location.

 

Our growth strategy for developing new restaurants also includes expansion in existing markets that have the appropriate demographics to support multiple restaurants. Operating multiple restaurants in existing markets enables us to leverage our brand equity as well as gain operating efficiencies associated with regional supervision, marketing, purchasing, and hiring. In addition, our ability to hire qualified employees is enhanced in markets where we enjoy greater brand awareness and we are able to utilize existing employees in new restaurants. Our expansion plans currently do not involve any franchised restaurant operations in the U.S.

 

In addition, we have started to explore our potential expansion into international markets. Given the strength our concept has enjoyed thus far in the U.S. and the increased demand for polished casual dining concepts overseas, we believe there is a significant opportunity to expand our concept in Latin America, the Middle East and beyond. Similar to other brands with international expansion, we plan to utilize a franchise model for development outside the U.S. Under this model, we will provide training and operational support to our partners without committing, or putting at risk, capital for restaurant construction in these international markets. Our international strategy is still in its early stages as it will take time for us to identify franchise partners and negotiate franchise agreements and for our partners to find quality real estate and construct the restaurants. We will then need to train the local team on our food and hospitality standards to ensure a successful execution of our strategy. We expect to make several investments in the coming year, including developing marketing materials, obtaining trademarks in the requisite markets and incurring incremental travel and networking expenses in order to build the right foundation for our growth.

 

Grow Existing Restaurant Sales

 

Our goal for existing restaurants is to increase unit volumes through the execution of our differentiated business model and complimented with ongoing social marketing efforts as well as local market advertising and other initiatives designed to generate awareness and trial of our concept and increase the frequency of customer visits. While many segments within the restaurant industry experienced a decline in same-store sales and customer traffic during 2014, our restaurant sales for comparable base restaurants, which include those units open for more than 18 months, increased 3.8% compared to 2013. The increase reflects a 2.9% increase in customer traffic and a 0.9% increase in average check per person. Our same-store sales for 2014 successfully lapped a 1.4% same-store sales increase during 2013. We believe the strength of our differentiated concept and the appeal of our new design enables us to gain market share, as evidenced by the positive same-store sales growth in the last seven quarters and in the past 17 out of 18 quarters.

 

We also continue to focus on our four wall execution with key initiatives designed to drive traffic, increase sales and enhance the customer experience while building our business for long-term growth. Our food-based promotions, which include innovative seasonal menu items, are offered four times during the year. These initiatives are highly successful in keeping our menu fresh and exciting while also providing a great venue to test the popularity of new menu items and the opportunity to place top-selling items on our regular menu. We continue to enhance our wine list and utilize our Wine Down Wednesday offering to drive customer traffic by offering a 50% discount on bottle wines each Wednesday. Our value-driven happy hour price-points help drive incremental sales and customer traffic during non-peak hours. Our To Go program and catering services continued to gain traction and increased in absolute dollars year over year. We had record gift card sales during the holiday season, with a 38% increase year over year, driven by targeted marketing initiatives. Furthermore, we continue to focus on the quality of our service and hospitality and improve our customer satisfaction with extensive training for our service staff on our wine list, drink and menu offerings. We continue to grow our customer loyalty program, Konavore, which has grown to over 225,000 members since its inception in 2010. We utilize this e-mail based program to communicate new menu offerings, restaurant specific events, and other marketing messages to keep Kona Grill top of mind for consumers. We have also increased our presence in social marketing and interactive advertising. Furthermore, we utilize a customer satisfaction survey across the entire brand to provide valuable feedback that our management team can respond to immediately. We believe we can generate additional sales through these programs at a reasonable cost per restaurant.

 

 
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Continue Strategic Investments in Personnel and Systems

 

We believe that successful execution of our growth strategies will enable Kona Grill to be a leading polished casual dining restaurant operator in the United States. During the past two years, we have made strategic personnel investments in order to re-ignite the expansion of our concept and continue making additional investments in both operations and development personnel to support our accelerated new unit expansion and international business development initiatives. Additionally, we continue to implement information systems and tools to enhance our business while ensuring that strong financial controls are in place to minimize risks associated with our current growth strategy.

 

Expansion Strategy and Site Selection

 

We believe the location of our restaurants is critical to our long-term success and, accordingly, we devote significant time and resources to analyzing each prospective site. Our restaurant expansion strategy focuses primarily on penetrating new markets in major metropolitan areas throughout the United States and existing markets where demographic information supports the building of additional restaurants. In general, we prefer to open restaurants in high-profile sites within specific trade areas with the following considerations:

 

 

suitable demographic characteristics, including residential and commercial population density and above-average household incomes;

 

 

great visibility;

 

 

high traffic patterns;

 

 

general accessibility;

 

 

availability of suitable parking;

 

 

proximity of shopping areas and office parks;

 

 

degree of competition and the operating performance of those competitors within the trade area; and

 

 

general availability of restaurant-level employees.

 

These sites generally include high-volume retail centers, shopping malls, and lifestyle and entertainment centers.

 

We thoroughly analyze each prospective location before presenting the site to our Real Estate Committee, comprised of members of the Board of Directors, for review. Prior to committing to a restaurant site and signing a lease, our Chief Executive Officer, Vice President of Development and a member of the Real Estate Committee visit the prospective site and evaluate the proposed economics of the restaurant based on demographic data and other relevant criteria to assure that the site will meet our return on investment criteria.

 

 
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We lease all of our restaurant sites under lease terms that vary by restaurant; however, we generally lease space (freestanding or in-line) for 10 to 20 years and negotiate at least two five-year renewal options. Our rent structures vary from lease to lease, but generally provide for the payment of both minimum base rent and contingent rent based on restaurant sales. We are also generally responsible for a proportionate share of common area maintenance, property tax, insurance, and other occupancy-related expenses.

 

We believe our average unit volumes, differentiated menu and multi-daypart model make us an attractive tenant and provide us with multiple opportunities to obtain suitable leasing terms from landlords. As a result of the locations we select, which are often in new retail center or shopping mall developments, our restaurant development timeframes vary according to the landlord’s construction schedule and other factors that are beyond our control. Once the site has been turned over to us, the typical lead-time from commencement of construction to opening is approximately six months.

 

Unit Economics

 

We target a 31% to 33% net cash-on-cash return for our restaurants once they reach their mature level of operations. Maturation periods vary from restaurant to restaurant, but generally range from two to four years. During 2014, the average unit volume of our comparable base restaurants was $4.4 million, a 4.3% increase from 2013 demonstrating the strength and broad appeal of our concept. We generated restaurant-level operating profit of $21.4 million during 2014, an increase of 18.3% from prior year. Our restaurant operating margin for comparable base restaurants was 18.7% in 2014 which was at the high end of our targeted range of 18% to 19%. The cash-based performance target for our restaurant operations does not include field supervision, corporate support expenses, preopening expenses, or non-cash items such as depreciation and amortization; and does not represent a targeted return on investment in our common stock.

 

Our investment cost for new restaurants varies significantly depending upon the location of the restaurant, the type of lease entered into and the amount of tenant improvement allowance we receive from landlords. We expect the cash investment cost of our prototype restaurant on average to be approximately $2.5 million, net of landlord tenant improvement allowances averaging between $0.7 million and $1.2 million, and excluding cash preopening expenses of approximately $425,000.

 

Our ability to generate sales throughout the day is a key strength of our concept. The following table depicts the amount and percentage of contribution for each daypart of overall restaurant sales during 2014.

 

2014 Sales by Daypart

   

Sales

   

Percent

 
   

(Dollars in thousands)

 
                 

Lunch (Open to 3 p.m.)

  $ 29,025       24.4 %

Dinner (5 p.m. to 9 p.m.)

    60,622       50.9 %

Non-Peak (3 p.m. to 5 p.m. and 9 p.m. to Close)

    29,450       24.7 %

Total All Day

  $ 119,097       100.0 %

 

Menu

 

Our menu offers customers a diverse selection of flavorful American favorites with an international influence and award-winning sushi items. This diverse menu is an important factor in differentiating ourselves from other polished casual dining competitors. We offer over 40 freshly prepared signature sauces and dressings, which distinguish and complement our dishes and create delicious flavor profiles that appeal to our customers. Our menu items are prepared from scratch at each restaurant location using fresh high quality ingredients and adhere to food standards that we believe are much closer to fine dining than typical casual dining.

 

Our menu features a selection of appetizers, salads, soups, flatbreads, sandwiches, noodles, seafood, signature entrees, and desserts. We round out our menu with over 60 hand-made award-winning sushi choices. Our appetizers include socially interactive items that can be eaten individually or easily shared among customers. Our signature entrees feature various sauces and offer customers generous portions that are impressive in presentation and in taste. For example, our most popular entrée is the Macadamia Nut Chicken served with shoyu-cream sauce and accompanied by parmesan garlic mashed potatoes and seasonal vegetables. Other favorites include Miso-Sake Sea Bass served with shrimp and pork fried rice and a seasonal vegetable and Pan-Seared Ahi served with steamed white rice, baby bok choy and a sweet chili sauce.

 

 
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We are also known for our extensive assortment of sushi that includes traditional favorites as well as distinctive specialty sushi and sashimi items such as our Voodoo Roll made with spicy crawfish mix and avocado rolled inside of seaweed and topped with a habanero tuna mix and chili masago, or the Bama Roll made with crab mix, cream cheese and jalapeno in soy paper topped with tuna, avocado, fish roe and spicy mayo. Our menu, coupled with an expansive selection of sushi, offers ample choices for health conscious customers. We take great pride in providing our customers the full Kona Grill experience without compromising their dietary needs and restrictions. We offer extensive gluten-free, vegetarian and vegan menus. We also feature a bento box with a variety of selections of protein and side dishes for the enjoyment of our young customers.

 

Each of our restaurants has a dedicated kitchen staff member, whom we refer to as our saucier, to oversee the preparation of more than 40 signature sauces and dressings that are made from scratch using only high-quality ingredients and fresh products. Each sauce is designed according to a proprietary recipe for specific menu items and includes unique flavors and combinations such as our honey cilantro, shoyu-cream, and spicy aioli dipping sauces, and our sesame-soy and honey dijon dressings. We believe that these distinctive sauces and dressings provide a unique flavor profile, which further distinguishes Kona Grill from its competitors. Our flavorful sauces and dressings also enhance the overall dining experience for our customers by allowing them to not only experience new tastes but to also share their favorite sauces with others, helping to foster customer loyalty and a socially interactive dining experience.

 

The versatility of our menu enables us to provide customers with dishes that can be enjoyed outside of the traditional lunch and dinner meal periods, as well as to serve our customers’ requirements for a variety of dining occasions, including everyday dining, business lunches, social gatherings and special occasions. We also offer group dining menus and sushi platters to provide additional opportunities to service our customers. In general, our menu is consistent from location to location. We typically update our menu in the spring and the fall and make enhancements to existing items or introduce new items based on customer feedback, which helps ensure that we are meeting the needs of our customers.

 

Our restaurants also offer an extensive selection of domestic and imported bottled and draft beers, over 50 selections of wines by the glass or bottle, and an extensive selection of liquors and specialty cocktail drinks. During our weekday happy hour (3 p.m. to 7 p.m.), reverse happy hour (9 p.m. to 11 p.m.) and Sunday happy hour in select markets, we offer discounts on selected food and alcoholic beverage items. Happy hour times may vary by location due to local liquor laws. Alcoholic beverage sales represented approximately 30% of our total restaurant sales during 2014.

 

Decor and Atmosphere

 

We design our restaurants to offer our customers a unique dining experience in a setting that is relevant for today and tomorrow. Each of our restaurants is individually designed with a contemporary look that is adaptable to varying real estate opportunities while incorporating signature elements such as our saltwater aquarium, multiple dining areas and open floor plan. Our customers can expect to find a warm and inviting atmosphere that aligns with our innovative food and drink offerings and high quality service. Our design incorporates exotic veneers, various tiles and textures, vertical beveled stone, raised fabric panels, and fire and water elements. The layout of our restaurants focuses on creating multiple dining areas for our customers while maintaining an open atmosphere that allows customers to have a panoramic view of the entire restaurant and exhibition kitchen and sushi bar. Each restaurant features varying water elements, including our signature aquarium with bright and colorful exotic fish, plants, and unique under water decor. We also utilize a variety of directional lighting styles and custom design elements to add warmth to all dining spaces throughout our restaurants.

 

Regardless of the experience customers are looking for, our restaurant design offers a variety of dining experiences to fit every mood and occasion. Our indoor/outdoor patio with a full service bar incorporates a high-energy, socially interactive atmosphere for customers to enjoy appetizers or sushi while they wait to dine with us, and serves as a destination for many of our frequent customers during the late afternoon and late night periods. Our restaurant in Fort Worth, Texas features a rooftop patio with a retractable roof. We also have enclosed patios in colder climates to maximize utilization of the patio throughout the year. Alternatively, our dining room provides a warm and intimate ambience for special occasions or dinner with friends and family. For sushi enthusiasts, we showcase our highly trained sushi chefs creating their masterpieces at our expansive sushi bar.

 

 
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Food Preparation, Quality Control, and Purchasing

 

We believe that we have some of the highest food quality standards in the industry. Our standards are designed to protect food products throughout the preparation process. We provide detailed specifications to suppliers for food ingredients, products, and supplies. We strive to maintain quality and consistency in our restaurants through careful hiring, training and supervision of personnel. Our restaurant general managers and executive chefs generally receive nine weeks of training while our other restaurant managers and sous chefs receive seven weeks of training. We require annual recertification training for all employees, and each employee receives an operations manual relating to food and beverage preparation and restaurant operations. We also instruct kitchen managers and staff on safety, sanitation, housekeeping, repair and maintenance, product and service specifications, ordering and receiving products, and quality assurance. All of our restaurant managers are compliant with Hazard Analysis and Critical Control Point, or HACCP. We monitor minimum cook temperature requirements and conduct twice-a-day kitchen and food quality inspections to further assure the safety and quality of all of the items we use in our restaurants. We have a ServSafe alcohol certification program, where every front of house employee is trained and tested to ensure we are providing responsible alcohol service. Additionally, we engage a third party service provider to perform quarterly inspections at all of our restaurants to monitor and ensure compliance with required guidelines.

 

We are committed to purchasing high-quality ingredients for our restaurants at reasonable prices. We use only the freshest ingredients and, as a result, we maintain only modest inventories. We have arrangements with local produce distributors and specialty food suppliers who provide high-quality ingredients and perishable food products. We believe that competitively priced alternative distribution sources are available should those channels be necessary. We source all of our products and supplies with reputable and high-quality providers that are capable of providing consistent, reliable distribution to all of our restaurants.

 

Our goal is to maximize purchasing efficiencies and obtain the lowest possible prices for ingredients, products, and supplies, while maintaining the highest quality. Our corporate office coordinates national supply contracts, negotiates prices for food supply throughout all of our restaurants, monitors quality control and consistency of the food supplied to restaurants, and oversees delivery of food on a nationwide basis. In order to provide the freshest ingredients and products, and to maximize operating efficiencies between purchase and usage, we utilize an automated food cost and inventory system to assist each restaurant’s management team in determining daily order requirements for food ingredients, products, and supplies. The management team orders accordingly from approved suppliers, and all deliveries are inspected to assure that the items received meet our quality specifications and negotiated prices.

 

Restaurant Operations

 

Executive and Restaurant Management

 

Our executive management team continually monitors restaurant operations to assure the quality of products and services and the maintenance of facilities. Restaurant management and our corporate office institute procedures to enhance efficiency, reduce costs and provide centralized and individual restaurant support systems. Our corporate operations team and district managers have primary responsibility for oversight of our restaurants and participate in analyzing restaurant-level performance and strategic planning. We currently employ five district managers who are each responsible for overseeing the restaurants in a specific region. The district managers’ responsibilities include supporting the general managers and helping each general manager achieve the sales and cash flow targets for their restaurant as well as providing insight for decision making in such areas as food and beverage, people development, and systems to enhance the efficiency of operations and the dining experience for our customers. In addition, our corporate food and beverage team includes a vice president, a corporate chef, a corporate sushi chef, three regional culinary partners and an operations support manager who are responsible for educating, coaching, and developing kitchen personnel, implementing systems to improve the efficiency of kitchen operations, and developing new menu offerings.

 

 
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Our typical restaurant management team consists of a general manager, assistant general manager, two front-of-the-house managers, executive chef, sous chef, and head sushi chef. Our restaurants employ on average approximately 75 non-management employees, many of whom work part-time. The general manager is responsible for the day-to-day operations of the restaurant, including the hiring, training, personnel development, execution of local marketing programs, and operating results. The chefs are responsible for overseeing the preparation of menu and sushi items, maintaining product quality, and closely monitoring food costs and department labor costs. We also employ a kitchen staff member who is dedicated to the preparation of our signature sauces and dressings.

 

Training

 

In order to maintain quality and consistency in each of our restaurants, we carefully train and supervise restaurant personnel and adhere to high standards related to personnel performance, food and beverage preparation, and maintenance of our restaurants. All of our restaurant personnel participate in both initial and ongoing training programs under the direction of our director of training. Each restaurant manager completes a formal training program that is comprised of a mix of classroom and on-the-job instruction. Programs for general managers and executive chefs provide nine weeks of training. Programs for other managers provide seven weeks of training and may involve work in our other restaurants and cross training of various duties. The training covers all aspects of management philosophy and overall restaurant operations, including supervisory skills, operating and performance standards, accounting procedures, IT systems and employee selection and training necessary for top-quality restaurant operations. The training programs also involve intensive understanding and testing of our menu, learning the ingredients of various menu items, and other key service protocols. In addition, our hourly staff goes through a series of in-depth interactive training for their positions.

 

We implement these programs by hiring dedicated corporate personnel as well as designating high-performing existing restaurant personnel to assist in training. Our training personnel are involved in training for both new employees hired in anticipation of new restaurant openings as well as for ongoing training in existing restaurants. When we open a new restaurant, we provide training to restaurant personnel in every position for several weeks prior to and after the opening to assure the smooth and efficient operation of the restaurant from the first day it opens to the public.

 

Recruitment and Retention

 

Our future growth and success is highly dependent upon our ability to attract, develop, and retain qualified individuals who are capable of successfully managing our high-volume, upscale casual restaurants. We believe that our unit volume, the image and atmosphere of the Kona Grill concept, and career advancement and employee benefit programs enable us to attract high quality management and restaurant personnel. We offer restaurant management personnel competitive wages and benefits, including medical insurance and participation in our 401(k) plan with a company match. We motivate and prepare our restaurant personnel by providing them with opportunities for increased responsibility and advancement through a formal management development program. Furthermore, the management team of each restaurant shares in a bonus tied to the sales and overall profitability of their restaurant. We believe that our compensation package for managers and restaurant employees is comparable to or better than those provided by other polished casual restaurants. We believe our compensation policies help us attract quality personnel.

 

Information Systems

 

We believe that our management information systems enable us to increase the speed and accuracy of order-taking and pricing, efficiently schedule labor to better serve customers, monitor labor costs, assist in product purchasing and menu mix management, promptly access financial and operating data, and improve the accuracy and efficiency of restaurant-level information and reporting.

 

 
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We utilize an integrated information system to manage the flow of information within each of our restaurants and between each restaurant and our corporate office. This system includes a point-of-sale (POS) local area network that helps facilitate the operations of the restaurant by recording sales transactions and printing orders in the appropriate locations within the restaurant. Additionally, we utilize the POS system to authorize, batch, and transmit credit card transactions, record employee time clock information, and produce a variety of management reports. The POS is integrated with food cost and labor scheduling software as well as our financial reporting system and incorporates a redundancy and back-up emergency operating plan on a temporary basis if the system experiences downtime.

 

We transmit electronically select information that is captured from the POS system to our corporate office on a daily basis. This information flow enables senior management to monitor operating results with daily and weekly sales analysis, detailed labor and food cost information, and comparisons between actual and budgeted operating results. We anticipate continually updating both our restaurant information systems and corporate office information systems to enhance operations. We believe our information systems are secure and scalable as we continue to build our brand.

 

Advertising and Marketing

 

Our ongoing advertising and marketing strategy consists of loyalty programs, social media, grass-root local marketing, various public relations activities and word-of-mouth recommendations. We believe that these mediums are key components in driving customer trial and usage. We expect to continue to invest in marketing, branding and advertising efforts, primarily to introduce our concept in new markets and to increase comparable restaurant sales and solidify brand awareness in existing markets.

 

We implement a coordinated public relations effort in conjunction with each new restaurant opening. Approximately 60 days before a scheduled restaurant opening, we collaborate with the local media to publicize our restaurant and generate awareness of our brand. This effort is usually supplemented by targeted marketing campaigns, social media and other marketing efforts, including hosting a high profile event in which we invite local leaders and community members as part of our preopening practice activities to introduce our concept to the local market. In addition, we use our website, www.konagrill.com, to continue promoting our brand awareness.

 

Competition

 

The restaurant industry is highly competitive. Key competitive factors in the industry include the taste, quality, and price of food products and drink offerings, quality and speed of customer service, brand name identification, attractiveness of facilities, restaurant location, and overall dining experience.

 

We believe we compete favorably with respect to each of these factors, as follows:

 

 

We offer a diverse selection of flavorful American favorites with an international influence and award-winning sushi items;

 

 

We appeal to multiple demographic and psychographic profiles;

 

 

We strive to maintain quality and consistency in each of our restaurants through the careful training and supervision of restaurant personnel and adherence to high standards related to personnel performance, food and beverage preparation, and maintenance of our restaurants;

 

 

Our innovative menu with attractive price points, attentive service, and contemporary restaurant design with multiple environments blend together to create our polished casual dining experience and enables us to attract a broad customer demographic.

 

Although we believe we compete favorably with respect to each of these factors, there are a substantial number of restaurant operations that compete directly and indirectly with us, many of which have significantly greater financial resources, higher revenue, and greater economies of scale. The restaurant business is often affected by changes in consumer tastes and discretionary spending patterns; national and regional employment statistics; demographic trends; weather conditions; the cost and availability of raw materials, labor, and energy; purchasing power; governmental regulations; and local competitive factors. Any change in these or other related factors could adversely affect our restaurant operations. Accordingly, we must constantly evolve and refine the critical elements of our restaurant concept over time to protect their longer-term competitiveness. Additionally, there is competition for highly qualified restaurant management employees and for attractive locations suitable for upscale, high volume restaurants.

 

 
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Trademarks

 

We have registered the service marks “Kona Grill” and “Konavore” with the United States Patent and Trademark Office. We believe that our trademarks and other proprietary rights, such as our distinctive menu offerings and signature sauce recipes, have significant value and are important to the marketing of our concept. We have protected in the past and will continue to vigorously protect our proprietary rights. We cannot predict, however, whether steps taken by us to protect our proprietary rights will be adequate to prevent misappropriation of these rights or the use by others of restaurant features based upon, or otherwise similar to, our concept. It may be difficult for us to prevent others from copying elements of our concept and any litigation to enforce our rights will likely be costly. In addition, other local restaurant companies with names similar to ours may try to prevent us from using our marks in those locales.

 

Government Regulation

 

Each of our restaurants is subject to licensing and regulation by state and local departments and bureaus of alcohol control, health, sanitation, zoning, and fire and to periodic review by state and municipal authorities for areas in which the restaurants are located. In addition, we are subject to local land use, zoning, building, planning, and traffic ordinances and regulations in the selection and acquisition of suitable sites for developing new restaurants. Delays in obtaining, or denials of, or revocation or temporary suspension of, necessary licenses or approvals could have a material adverse impact on our restaurant development.

 

Alcoholic beverage control regulations require each of our restaurants to apply to a state authority and, in certain locations, county and municipal authorities for a license and permit to sell alcoholic beverages on the premises. Typically, licenses must be renewed annually and may be subject to penalties, temporary suspension or revocation for cause at any time. Alcoholic beverage control regulations impact many aspects of the daily operations of our restaurants, including the minimum age of patrons and employees, hours of operation, inventory control and handling, and storage and dispensing of alcoholic beverages. We have not encountered any material problems relating to alcoholic beverage licenses or permits to date. The failure of a restaurant to obtain or retain its liquor license would adversely affect that restaurant’s operations and profitability.

 

We are subject to “dram shop” statutes in most of the states in which we operate. Those statutes generally provide a person who has been injured by an intoxicated person the right to recover damages from an establishment that wrongfully served alcoholic beverages to such person. We carry liquor liability coverage as part of our existing comprehensive general liability insurance which we believe is consistent with coverage in the full-service restaurant industry. Even though we carry liquor liability insurance, a judgment against us under a “dram shop” statute in excess of our liability coverage could have a material adverse effect on our operations.

 

Our operations are also subject to federal and state laws governing such matters as wages, working conditions, citizenship requirements, and overtime. Several states have set minimum wage rates higher than the current federal level. A significant number of hourly personnel at our restaurants are paid at rates related to state and federal minimum wage laws and, accordingly, state minimum wage increases implemented during the last several years have increased our labor costs. Increases in the minimum wage rate or the cost of workers’ compensation insurance, changes in tip-credit provisions, employee benefit costs (including costs associated with mandated health insurance coverage), or other costs associated with employees could adversely affect our operating results. To our knowledge, we are in compliance in all material respects with applicable federal, state, and local laws affecting our business.

 

 
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Employees

 

As of February 27, 2015, we employed 2,743 people of whom 2,692 worked in our restaurants and 51 were corporate management and staff personnel. None of our employees are covered by a collective bargaining agreement. We have never experienced a major work stoppage, strike, or labor dispute. We consider our relations with our employees to be favorable.

 

Access to Information

 

Our website is located at www.konagrill.com. The information on our website is not part of this filing. Through our website, we make available free of charge our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, and any amendments to those reports filed or furnished to the Securities and Exchange Commission. These reports are available as soon as reasonably practicable after we electronically file these reports with the SEC. We also post on our website the charters of our Audit, Compensation, and Nominating Committees; Code of Business Conduct and Ethics and Code of Ethics for the CEO and Senior Financial Officers; and any other corporate governance materials required by SEC or NASDAQ regulations. These documents are also available in print to any stockholder requesting a copy from our corporate secretary at our executive offices.

 

Item 1A.

Risk Factors

 

Risks Related to Our Business

 

Our future operating results may fluctuate significantly due to our limited number of existing restaurants and the expenses required to open new restaurants.

 

We currently operate 30 restaurants, five of which opened during 2014, and we expect to open seven additional restaurants in 2015. The capital resources required to develop each new restaurant are significant. We estimate that the cost of opening a new Kona Grill restaurant currently ranges from $3.2 million to $3.7 million, exclusive of landlord tenant improvement allowances and approximately $425,000 in cash preopening expenses and assuming that we do not purchase the underlying real estate. Actual costs may vary significantly depending upon a variety of factors, including the site and size of the restaurant and conditions in the local real estate and employment markets. The combination of our relatively small number of existing restaurants, the significant investment associated with each new restaurant, and the average unit volumes of our new restaurants may cause our results of operations to fluctuate significantly, and poor operating results at any one restaurant or a delay or cancellation in the planned opening of a restaurant could materially affect the financial performance and perception of our company, making the investment risks related to any one location much larger than those associated with most other restaurant companies.

 

Our sales and ability to continue to be profitable could be adversely affected if comparable restaurant sales increases are less than we expect, and we may not successfully increase comparable restaurant sales or they may decrease.

 

While future sales growth will depend substantially on opening new restaurants, changes in comparable restaurant sales will also affect our sales growth and will continue to be a critical factor in generating future profits. This is because the profit margin on comparable restaurant sales is generally higher, as comparable restaurant sales increases enable fixed costs to be spread over a higher sales base. Conversely, declines in comparable restaurant sales can have a significant adverse effect on profitability due to the loss of the positive impact on profit margins associated with comparable restaurant sales increases.

 

Our comparable restaurant sales increased 3.8%, 1.4%, 2.7%, 8.8% and 0.9% during 2014, 2013, 2012, 2011 and 2010, respectively, but declined 9.3% and 7.2% during 2009 and 2008, respectively. As our units continue in operation, it may be more difficult to continue to achieve significant increases in comparable restaurant sales. Further, the impact of the factors noted below may lower our expectations for comparable restaurant sales.

  

 

changes in consumer preferences and discretionary spending, including weaker consumer spending in periods of economic difficulty or uncertainty;

 

 

 
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consumer understanding and acceptance of the Kona Grill experience and perception of the Kona Grill brand;

  

 

our ability to increase menu prices without adversely impacting customer traffic to such a degree that the impact of the decrease in customers equals or exceeds the benefit of the menu price increase;

  

 

any “trade down” by customers or other reduction in average check per person in response to price increases, which could reduce or eliminate the benefit of the price increase on comparable restaurant sales;

     
 

competition, either from our competitors in the restaurant industry, or from our own restaurants within the same market in the event customers who frequent one of our restaurants begin to visit one of our new restaurants instead;

     
 

executing our strategies effectively, including our development strategy, menu improvement initiatives and marketing and branding strategies, each of which may not have the impact we expect;

  

 

turnover of key operations and restaurant personnel; 

     
 

weather, road construction and other factors limiting access to our restaurants; and

 

 

changes in government regulation.

 

A number of these factors are beyond our control. As a result, it is possible that we will not achieve our targeted comparable restaurant sales or that the change in comparable restaurant sales could be negative. If this were to happen, sales and profitability would be adversely affected and our stock price would likely decline. Further, many of our competitors have substantially greater financial, marketing and other resources than we do to withstand prolonged periods of declines in comparable restaurant sales and regional and national restaurant companies continue to expand their operations into our current and anticipated market areas, thereby increasing competition for market share.

 

We depend upon high levels of consumer traffic at the sites where our restaurants are located and any adverse change in consumer activity could negatively affect our restaurant sales and may require us to record an impairment charge for restaurants performing below expectations.

 

Our restaurants are primarily located in high-activity areas such as retail centers, shopping malls, and lifestyle centers. We depend on high consumer traffic rates at these centers to attract customers to our restaurants. In general, such visit frequencies are significantly affected by many factors, including national, regional, or local economic conditions, anchor tenants closing in retail centers or shopping malls in which we operate, changes in consumer preferences or shopping patterns, higher frequency of online shopping, changes in discretionary consumer spending, increasing gasoline prices, or otherwise. If visitor rates to these centers decline, our unit volumes could decline and adversely affect our results of operations, including recording an impairment charge for restaurants that are performing below expectations. We may be required to record impairment charges in the future if certain restaurants perform below expectations.

 

We have a limited number of restaurants upon which to evaluate our company, and you should not rely on our history as an indication of our future results.

 

We currently operate 30 restaurants, approximately 23% of which have been operating for less than18 months. Consequently, the results we have achieved to date with a relatively small number of restaurants may not be indicative of those restaurants’ long-term performance or the potential performance of new restaurants. A number of factors historically have affected and are likely to continue to affect our average unit volumes and comparable restaurant sales, including the following:

 

 

our ability to execute effectively our business strategy;

 

 

 
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our ability to successfully select and secure sites for our concept;

 

 

the operating performance of new and existing restaurants;

 

 

competition in our markets;

 

 

hiring, training, development and retention of key operations or restaurant personnel;

 

 

consumer trends; and

 

 

changes in political or economic conditions.

 

Our average unit volume and same-store sales may not increase at the rate achieved over recent periods. In addition, we have closed three of our restaurants opened to date due to lower sales volume, including a restaurant in Naples, Florida in September 2008, a restaurant in West Palm Beach, Florida in July 2011, and a restaurant in Sugar Land, Texas in September 2011. Changes in our average unit volumes and comparable restaurant sales could cause the price of our common stock to fluctuate substantially.

 

Our future expansion in existing markets may cause sales in some of our existing restaurants to decline.

 

Our future growth strategy includes opening new restaurants in our existing markets. We may be unable to attract enough customers to our new restaurants for them to operate profitably. In addition, customers to our new restaurants may be former customers of one of our existing restaurants in that market, which may reduce customer visits and sales at those existing restaurants, adversely affecting our operating results.

 

Our ability to open new restaurants may be adversely affected by delays or problems associated with securing suitable restaurant locations and leases and by other factors, some of which are beyond our control and the timing of which is difficult to forecast accurately.

 

Due in part to the unique nature of each proposed restaurant location, we cannot predict the timing or ultimate success of our site selection process or our ability to open new restaurants on a timely basis after we have identified sites. We plan to grow organically through unit expansion, with a target of 20% unit growth annually over the next several years by strategically expanding the Kona Grill concept in both new and existing markets. We plan to open seven new restaurants in 2015 and currently have twelve signed leases for 2015 openings and beyond.

 

There can be no assurance that our unit growth goal will be realized because our ability to open new restaurants depends upon a number of factors, many of which are beyond our control, including the following:

 

 

the availability and cost of suitable restaurant locations for development and our ability to compete successfully for those locations;

 

 

difficulty negotiating leases with acceptable terms;

 

 

cash flow generated by our existing restaurants;

 

 

delay or cancellation of new site development by developers and landlords, which may become increasingly common during periods of economic uncertainty or tight credit;

 

 

difficulty managing construction and development costs of new restaurants at affordable levels, particularly in competitive markets;

 

 

labor shortages or disputes experienced by our landlords or outside contractors;

 

 

unforeseen engineering or environmental problems with the leased premises;

 

 

 
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our ability to secure governmental approvals and permits, including liquor licenses, construction permits, and occupancy permits;

 

 

the ability of our corporate staff to develop a greater number of new restaurants than our company has developed during the past several years while successfully managing existing restaurants;

 

 

obstacles to hiring and training qualified operating personnel in the local market;

 

 

inclement weather, natural disasters and other calamities; and

 

 

general economic conditions.

 

A lack of availability of suitable locations for new restaurants or a decline in the quality of the locations of our current restaurants may adversely affect our sales and results of operations.

 

The success of our restaurants depends in large part on their location. As demographic and economic patterns change, current locations may not continue to be attractive or profitable. Possible declines in neighborhoods and trade areas where our restaurants are located or adverse economic conditions in areas surrounding those neighborhoods could result in reduced sales at those locations. In addition, desirable locations for new restaurant openings may not be available at an acceptable cost. The occurrence of one or more of these events could have a significant adverse effect on our sales and results of operations.

 

Any deterioration in general economic conditions could have a material adverse impact on our landlords or on businesses neighboring our locations, which could adversely affect our revenues and results of operations.

 

Any deterioration in general economic conditions could result in our landlords being unable to obtain financing or remain in good standing under their existing financing arrangements which could result in their failure to satisfy obligations to us under leases, including failures to fund or reimburse agreed-upon tenant improvement allowances. Any such failure could adversely impact our operations. Our restaurants are generally located in retail developments with nationally recognized co-tenants, which help increase overall customer traffic into those retail developments. Some of our co-tenants have or may cease operations in the future or have deferred openings or failed to open in a retail development after committing to do so. These failures may lead to reduced customer traffic and a general deterioration in the surrounding retail centers in which our restaurants are located and may contribute to lower customer traffic at our restaurants. If these retail developments experience high vacancy rates, we could experience decreases in customer traffic. As a result, our results of operations could be adversely affected. Furthermore, the credit and lending industry continue to be restrictive. Lenders are taking a more active role in reviewing tenant leases and prospective tenancies and have been more restrictive in approving tenancies and financing. This may affect our ability to lease sites at terms as favorable as we have received in the past.

 

In addition, if our landlords are unable to obtain sufficient credit to continue to properly manage their retail centers, we may experience a drop in the level of quality of such centers where we operate restaurants. Our future development of new restaurants may also be adversely affected by the negative financial situations of developers and potential landlords. Landlords may try to delay or cancel recent development projects (as well as renovations of existing projects), which could reduce the number of appropriate locations available that we would consider for our new restaurants. Furthermore, the failure of landlords to obtain licenses or permits for development projects on a timely basis, which is beyond our control, may negatively impact our ability to implement our development plan.

  

Unexpected expenses and low market acceptance of our restaurant concept could adversely affect the profitability of restaurants that we open in new markets.

 

As part of our expansion strategy, we have opened and plan to open restaurants in markets in which we have no prior operating experience and in which our brand may not be well-known. These new markets may have different competitive conditions, consumer tastes, and discretionary spending patterns than restaurants in our existing markets. As a result, we may incur costs related to the opening, operation, and promotion of these new restaurants that are greater than those incurred in markets with longer operating history. Accordingly, sales at restaurants opening in new markets may take longer to achieve or may not achieve average unit volumes comparable with our existing restaurants.

 

 
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Our growth and our planned remodeling of our existing restaurants may strain our infrastructure and resources, which could slow our development of new restaurants and adversely affect our ability to manage our existing restaurants.

 

We plan to continue opening new restaurants and currently expect to open seven new restaurants during 2015. Further, we plan to maintain and enhance the quality of our customers’ dining experience through remodeling certain of our existing restaurants. Our continued expansion and planned remodeling will increase demands on our available cash resources, as well as demands on our management team, restaurant management systems and resources, financial controls and information systems. These increased demands may adversely affect our ability to open new restaurants and to manage and when appropriate, remodel our existing restaurants. If we fail to continue to improve our infrastructure or to manage other factors necessary for us to meet our expansion objectives, our growth rate and operating results could be adversely affected.

 

Any decision to either reduce or accelerate the pace of openings may positively or adversely affect our comparative financial performance.

 

Our preopening expenses continue to be significant, and the amount of such expenses incurred in any one year or quarter is dependent on the number of restaurants expected to be opened during that time period. As such, our decision to either decrease or increase the rate of openings may have a significant impact on our financial performance for a particular period. Therefore, if we decide to reduce our new restaurant openings, our comparable preopening expenses will be lower and the effect on our comparative financial performance should be favorable. Conversely, if the rate at which we develop and open new restaurants is increased to higher levels in the future, the resulting increase in preopening expenses will have an unfavorable short-term impact on our comparative financial performance.

  

We may require additional capital in the future as a result of changes in our restaurant operations or growth plans, and our inability to raise such capital could harm our operations and restrict our growth.

 

Changes in our restaurant operations, lower than anticipated restaurant sales, increased food or labor costs, increased property expenses, or other events, including those described in this report, may cause us to seek additional debt or equity financing on an accelerated basis. Financing may not be available to us on acceptable terms, and our failure to raise capital when needed could negatively impact our restaurant growth plans as well as our financial condition and results of operations. Additional equity financing, if available, may be dilutive to the holders of our common stock. Debt financing may involve significant cash payment obligations, covenants, and financial ratios that may restrict our ability to operate and grow our business, and would cause us to incur additional interest expense and financing costs.

 

Our new restaurants, once opened, may not be profitable, and may adversely impact the sales of our existing restaurants.

  

Historically, many of our new restaurants have opened with an initial ramp-up period typically lasting 18 months or more, during which they generated sales and income below the levels at which we expect them to operate. This is in part due to the time it takes to build a customer base in a new market or area, higher fixed costs relating to increased labor and other start-up inefficiencies that are typical of new restaurants. It may also be difficult for us to attract a customer base if we are not able to staff our restaurants with employees who perform to our high standards. If we are unable to build the customer base that we expect for new restaurant locations or overcome the higher fixed costs associated with new restaurant locations, new restaurants may not have similar results as our existing restaurants and may not be profitable.

 

 

 
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We may not be successful in our international business development, or such expansion may adversely affect our financial performance.

 

We plan to explore future expansion into international markets, including Latin America and the Middle East. Similar to other brands with international expansion, we plan to utilize a franchise model for development outside the U.S., providing training and operational support to our partners without committing, or putting at risk, capital for restaurant construction in these international markets. Our international strategy is still in its early stages as it will take time for us to identify franchise partners and negotiate franchise agreements and for our partners to find quality real estate and construct the restaurants. We will then need to train the local team on our food and hospitality standards to ensure a successful execution of our strategy. We expect to make several investments in the coming year, including developing marketing materials, obtaining trademarks in the requisite markets and incurring incremental travel and networking expenses in order to build the right foundation for our growth.

 

As we are at the early stage of exploring our international market expansion, we may not be fully aware of the significant development efforts involved and barriers to entry into these markets. Accordingly, even though we are attempting to manage the necessary capital investment through the utilization of the franchise model, we may incur more expenses than originally anticipated and our investment may take additional time to come to fruition. Furthermore, there is a risk that we may not be successful in our international business development efforts. In that case, we may not be able to recover all of the investments incurred. Further, our attempt to expand internationally could result in significant distraction or diversion of resources from our domestic unit expansion and existing operations in the U.S.

 

There is no assurance that we will find the proper franchisees and other partners to successfully expand internationally, or that the franchised restaurants in foreign markets will gain market acceptance or be able to operate on a profitable basis. Our international operations are subject to many of the same risks associated with our domestic operations, as well as a number of additional risks. These include, among other things, international economic and political conditions, and differing cultures and consumer preferences.

 

Our international expansion and global brand development efforts could negatively affect our brand or could result in sanctions or liability for violations of regulations or legal actions.

 

Our business expansion into international markets could create new risks to our brand and reputation. We believe that we will be able to select high-caliber international operating partners with significant experience in restaurant operations; however, there is risk that our brand value could be harmed by factors outside of our control, including, but not limited to:

 

 

difficulties in achieving the consistency of product quality and service as compared to restaurants we operate in the United States;

 

 

changes to our recipes required due to cultural differences;

 

 

inability to obtain adequate and reliable supplies of ingredients and products necessary to execute our diverse menu; and

 

 

differences, changes or uncertainties in economic, regulatory, legal, social and political conditions.

 

Further, as we expand our brand internationally, we will need to comply with regulations and legal requirements, including those related to the protection of our trademarks, trade secrets and other intellectual property - see “Our failure to protect our trademarks, service marks, or trade secrets could negatively affect our competitive position and the value of the Kona Grill brand” below. We will have additional exposure to foreign tax laws and regulations which currently do not affect us. Additionally, we will need to comply with both domestic laws affecting United States businesses that operate internationally and foreign laws in the countries in which we expand our restaurants, such as the Foreign Corrupt Practices Act, under which we do not currently have exposure. Failure to comply with any such legal requirements could subject us to monetary liabilities and other sanctions. Also, we may become subject to lawsuits or other legal actions resulting from the acts or omissions of our operating partners and, even though we may have taken reasonable steps to protect against such liabilities, including by obtaining contractual indemnifications and insurance coverage, there is no assurance that we will not incur liability that is not covered by such protection, or incur costs and expenses as a result of our operating partners’ conduct even when we are not legally liable. Any of these risks could harm our business, results of operations and financial condition.

 

 
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Failure to attract, retain and motivate effective leaders and the loss of key personnel could negatively impact our business.

 

Our future success is highly dependent upon our ability to attract and retain key management and operations personnel. We must be able to attract, retain and motivate a sufficient number of qualified management and operations personnel, including culinary and training personnel, district managers, general managers and executive chefs. Our executive officers provide a vision for our company, execute our business strategy, and maintain consistency in the operating standards of our restaurants. The ability of key management and operations personnel to maintain consistency in the quality and diversity of our menu offerings as well as service and hospitality for our customers is a critical factor in our future success. Any failure to attract, retain, and motivate key personnel may harm our reputation and result in a loss of business.

 

Our restaurants are subject to natural disasters and other events which are beyond our control and for which we may not be able to obtain insurance at reasonable rates.

 

We endeavor to insure our restaurants against wind, flood, and other disasters, but we may not be able to obtain insurance for these types of events for all of our restaurants at reasonable rates. A devastating natural disaster or other event in the vicinity of one of our restaurants could result in substantial losses and have a material adverse effect on our results of operations.

 

If our distributors or suppliers do not provide food and beverages to us in a timely fashion, we may experience short-term supply shortages and increased food and beverage costs.

 

We currently use a national food distribution service company and other regional distributors to provide food and beverage products to all of our restaurants. If our suppliers cease doing business with us, we could experience short-term supply shortages in some or all of our restaurants and could be required to purchase food and beverage products at higher prices until we are able to secure alternative supply sources. In addition, any delay in replacing suppliers or distributors on acceptable terms could, in extreme cases, require us to remove temporarily items from the menus of one or more of our restaurants, which also could adversely affect our business.

 

Adverse weather conditions and natural disasters could adversely affect our results of operations.

 

Adverse weather conditions can impact customer traffic at our restaurants, cause the temporary underutilization of outdoor patio seating and in more severe cases such as hurricanes, tornadoes and other natural disasters, cause temporary closures, sometimes for prolonged periods, which would negatively impact our restaurant sales. Changes in weather could result in interruptions to the availability of utilities, and shortages or interruption in the supply of food items and other supplies, which could increase our costs and negatively impact our operations.

 

Our failure to protect our trademarks, service marks, or trade secrets could negatively affect our competitive position and the value of the Kona Grill brand.

 

Our business prospects depend in part on our ability to develop favorable consumer recognition of the Kona Grill name. Although Kona Grill is a federally registered trademark, our trademarks and service marks could be imitated in ways that we cannot prevent. Alternatively, third parties may attempt to cause us to change our name or not operate in a certain geographic region if our name is confusingly similar to their name. In addition, we rely on trade secrets, proprietary know-how, concepts, and recipes. Our methods of protecting this information may not be adequate. Moreover, we may face claims of misappropriation or infringement of third parties’ rights that could interfere with our use of this information. Defending these claims may be costly and, if unsuccessful, may prevent us from continuing to use this proprietary information in the future, and may result in a judgment or monetary damages. Additionally, we do not maintain confidentiality and non-competition agreements with all of our executives, key personnel, or suppliers. If competitors independently develop or otherwise obtain access to our trade secrets, proprietary know-how, or recipes, the appeal of our restaurants could be reduced and our business could be harmed.

 

 
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Furthermore, as our international business development is still at an early stage, we have not registered all of our trademarks and service marks throughout the world as doing so may not be feasible because of associated costs or various foreign trademark law prohibitions. Our inability to effectively protect our intellectual property domestically or internationally may result in limiting our ability to globally expand our brand thereby adversely affecting our financial performance.

 

Our business could be adversely impacted if our information technology and computer systems do not perform properly or if we fail to protect our customers’ or our employees’ information. Additionally, the inappropriate use of social media vehicles could harm our reputation and adversely impact our business.

 

We rely heavily on information technology to conduct our business, including point-of-sale processing in our restaurants, management of our supply chain, collection of cash, payment of obligations and various other processes and procedures. Our ability to efficiently manage our business depends significantly on the reliability and capacity of these systems. Any material failure, interruption of service, or compromised data security, problems with maintenance, upgrading or transitioning to replacement systems or a breach in security of these systems could cause delays in customer service and reduce efficiency in our operations and could otherwise adversely affect our operations. While we take data security very seriously and expend significant resources to ensure that our information technology operates securely and effectively, any security breaches could result in disruptions to operations or unauthorized disclosure of confidential information, and significant capital investments might be required to remediate such security breaches. Further, if customer or employee confidential data is compromised, our operations could be adversely affected, our reputation could be harmed, or we could be subject to litigation or the imposition of penalties resulting from violation of federal and state laws and payment card industry regulations. As privacy and information security laws and regulations change, we may incur additional costs to ensure that we remain in compliance.

 

Additionally, we rely on search engine marketing and social media platforms to attract and retain customers as part of our marketing efforts. A variety of risks are associated with the use of social media, including the improper disclosure of proprietary information, negative comments about our company, exposure of personally identifiable information, fraud, or outdated information. The inappropriate use of social media vehicles by our customers or employees could increase our costs, lead to litigation or result in negative publicity that could damage our reputation.

  

A data security breach involving a customer’s or employee’s personal data could have a material adverse effect on our business, could adversely affect our reputation and could result in litigation against us or the imposition of penalties, which could adversely affect our financial performance.

 

We receive and maintain certain personal information about our customers and employees. For example, we transmit confidential credit card information in connection with credit card transactions, and we are required to collect and maintain certain personal information in connection with our employment practices, including the administration of our benefit plans. The collection and use of this information by us is regulated at the federal and state levels, and the regulatory environment related to information security and privacy is increasingly demanding. If our security and information systems are compromised or our employees or authorized third parties fail to comply with these laws and regulations and this information is obtained by unauthorized persons or used inappropriately, it could adversely affect our reputation and could result in litigation against us or the imposition of penalties, which could have a material adverse effect on our financial performance.

 

In addition, our ability to accept credit cards as payment in our restaurants and for on-line gift card orders depends on us remaining compliant with standards set by the PCI Security Standards Council. These standards require certain levels of system security and procedures to protect our customers’ credit card and other personal information. We utilize both internal resources and external consultants to reduce the likelihood of any security failures or breaches. However, we can provide no assurance that these security measures will be successful. If these security measures are not successful, we may become subject to litigation against us or the imposition of regulatory penalties, which could result in negative publicity and significantly harm our reputation, any of which could have a material adverse effect on our financial performance.

 

 
18

 

  

Risks Related to the Restaurant Industry

 

Changes in food and supply costs could adversely affect our results of operations.

 

Our profitability depends in part on our ability to anticipate and react to changes in food and supply costs. Like all restaurant companies, we are susceptible to increases in food costs as a result of factors beyond our control, such as general economic conditions, seasonal fluctuations, weather conditions, demand, food safety concerns, product recalls and government regulations. Although we can purchase certain commodities under contract, we currently do not use financial management strategies or have long-term contracts in place for the majority of commodities to reduce our exposure to price fluctuations. Changes in the price or availability of seafood, poultry, beef, grains, dairy or produce could affect our ability to offer a broad menu and price offering to customers and could reduce our operating margins and adversely affect our results of operations. We may not be able to anticipate and react to changing food costs through our purchasing practices and menu price adjustments in the future, and failure to do so could negatively impact our sales and results of operations.

 

Changes in governmental regulation may adversely affect our ability to maintain our existing and future operations and to open new restaurants.

 

We are subject to the Fair Labor Standards Act (which governs such matters as minimum wages, overtime and other working conditions), along with the Americans with Disabilities Act, the Immigration Reform and Control Act of 1986, various family leave mandates and a variety of other laws enacted, or rules and regulations promulgated by federal, state and local governmental authorities that govern these and other employment matters, including tip credits, working conditions, safety standards and immigration status. We expect increases in payroll expenses as a result of federal and state mandated increases in the minimum wage, and although such increases are not expected to be material, we cannot assure you that there will not be material increases in the future. Enactment and enforcement of various federal, state and local laws, rules and regulations on immigration and labor organizations may adversely impact the availability and costs of labor for our restaurants in a particular area or across the United States. Other labor shortages or increased employee turnover could also increase labor costs. In addition, our vendors may be affected by higher minimum wage standards or availability of labor, which may increase the price of goods and services they supply to us.

 

We offer eligible full-time salaried employees and eligible variable-hour employees the opportunity to enroll in healthcare coverage subsidized by us. Our employees may or may not choose to participate in our healthcare plans. However, under the comprehensive U.S. health care reform law enacted in 2010, the Affordable Care Act, changes that became effective in 2014, and especially the employer mandate and employer penalties that became effective January 1, 2015, will increase our labor costs significantly. In 2015, we adopted a qualifying plan under the Affordable Care Act for our eligible variable-hour employees, which will increase our healthcare expenses. It is also possible that even in light of recent changes in the healthcare plans we offer, healthcare plans offered by other companies with which we compete for employees will make us less attractive to our current or potential employees. And in any event, implementing the requirements of the Affordable Care Act has imposed additional administrative costs on us, and those costs may increase over time. The costs and other effects of these new healthcare requirements cannot be determined with certainty, but they may have a material adverse effect on our financial and operating results.

  

We are also subject to laws and regulations, which vary from jurisdiction to jurisdiction, relating to nutritional content and menu labeling. Compliance with these laws and regulations may lead to increased costs and operational complexity, changes in sales mix and profitability, and increased exposure to governmental investigations or litigation. We cannot reliably anticipate any changes in customer behavior if we alter our recipes to comply with such laws and regulations. This could have adverse effects on our sales or results of operations.

  

Furthermore, we are subject to federal and state environmental regulations, and although these have not had a material negative effect on our operations, we cannot ensure that there will not be a material negative effect in the future. In particular, the U.S. has increased focus on environmental matters such as climate change, greenhouse gases and water conservation. This increased focus may lead to new initiatives directed at regulating an as yet unspecified array of environmental matters. These efforts could result in increased taxation or in future restrictions on or increases in costs associated with food and other restaurant supplies, transportation costs and utility costs, any of which could decrease our operating profits and/or necessitate future investments in our restaurant facilities and equipment to achieve compliance. Further, more stringent and varied requirements of local and state governmental bodies with respect to zoning, land use and environmental factors could delay, prevent or make cost prohibitive the continuing operations of an existing restaurant or the development of new restaurants in particular locations.

 

 
19

 

  

The impact of current laws and regulations, the effect of future changes in laws or regulations that impose additional requirements and the consequences of litigation relating to current or future laws and regulations, or our inability to respond effectively to significant regulatory or public policy issues, could increase our compliance and other costs of doing business and therefore have an adverse effect on our results of operations. Failure to comply with the laws and regulatory requirements of federal, state and local authorities could result in, among other things, revocation of required licenses, administrative enforcement actions, fines and civil and criminal liability. Compliance with these laws and regulations can be costly and can increase our exposure to litigation or governmental investigations or proceedings.

 

Regulations affecting the operation of our restaurants could increase operating costs, restrict our growth, or require us to suspend operations.

 

Each of our restaurants must obtain licenses from regulatory authorities allowing it to sell liquor, beer, and wine, and each restaurant must obtain a food service license from local health authorities. Each restaurant’s liquor license must be renewed annually and may be revoked or suspended at any time for cause, including violation by us or our employees of any laws and regulations relating to the minimum drinking age, over serving, advertising, wholesale purchasing, and inventory control. Each restaurant is also subject to local health inspections. Failure to pass one or multiple inspections may result in temporary or permanent suspension of operations and could significantly impact our reputation. In certain states, including states where we have existing restaurants or where we may open restaurants in the future, the number of liquor licenses available is limited and licenses are traded at market prices. Liquor, beer, and wine sales comprise a significant portion of our sales, representing 30% of our sales during 2014. Therefore, if we are unable to maintain our existing licenses, or if we choose to open a restaurant in those states, the cost of a new license could be significant. Obtaining and maintaining licenses is an important component of each of our restaurant’s operations, and the failure to obtain or maintain food and liquor licenses and other required licenses, permits, and approvals would adversely impact our restaurants and our growth strategy.

 

Negative publicity surrounding our restaurants or the consumption of beef, seafood, poultry, or produce generally, or shifts in consumer tastes, could negatively impact the popularity of our restaurants, our sales, and our results of operations.

 

The popularity of our restaurants in general, and our menu offerings in particular, are key factors to the success of our operations. Negative publicity resulting from poor food quality, illness, injury, or other health concerns, whether related to one of our restaurants or to the beef, seafood, poultry, or produce industries in general (such as negative publicity concerning salmonella, e-coli, Hepatitis A, mercury poisoning and other food-borne illnesses), or operating problems related to one or more of our restaurants, could make our brand and menu offerings less appealing to consumers. In addition, other shifts in consumer preferences away from the kinds of food we offer, whether because of dietary or other health concerns or otherwise, would make our restaurants less appealing and adversely affect our sales and results of operations. If our restaurants are unable to compete successfully with other restaurants in new and existing markets, our results of operations will be harmed and we may not achieve profitability.

 

Litigation concerning our food quality, employment practices, liquor liability, and other issues could result in significant expenses to us and could divert resources from our operations.

 

Like other restaurants, we may receive complaints or litigation from, and potential liability to, our customers involving food-borne illness or injury or other operational issues. We may also be subject to complaints or allegations from, and potential liability to, our former, existing, or prospective employees involving our restaurant employment practices and procedures. In addition, we are subject to state “dram shop” laws and regulations, which generally provide that a person injured by an intoxicated person may seek to recover damages from an establishment that wrongfully served alcoholic beverages to such person. Recent litigation against restaurant chains has resulted in significant judgments, including punitive damages, under “dram shop” statutes. While we carry liquor liability coverage as part of our existing comprehensive general liability insurance, we may still be subject to a judgment in excess of our insurance coverage and we may not be able to obtain or continue to maintain such insurance coverage at reasonable costs, if at all. Regardless of whether any claims against us are valid or whether we are liable, our sales may be adversely affected by publicity resulting from such claims. Such claims may also be expensive to defend and may divert time and money away from our operations and adversely affect our business.

 

 
20

 

  

Labor shortages or increases in labor costs could slow our growth or adversely affect our business.

 

Our success depends in part on our ability to attract, motivate, and retain a sufficient number of qualified employees, including restaurant managers and kitchen managers, necessary to continue our operations. This ability is especially critical to our company because of our relatively small number of existing restaurants. If we are unable to recruit and retain a sufficient number of qualified employees, our business and growth strategy could be adversely affected.

 

Competition for qualified restaurant employees in current or prospective markets could require us to pay higher wages and benefits, which could result in higher labor costs. In addition, we have a substantial number of hourly employees who are paid rates based upon the federal or state minimum wage and who rely on tips for a significant portion of their income. Government-mandated increases in minimum wages, overtime pay, health benefits, or increased tax reporting and tax payment requirements for employees who receive gratuities, or a reduction in the number of states that allow tips to be credited toward minimum wage requirements, could increase our labor costs. We may be unable to generate enough operating efficiencies or increase our prices proportionately in order to mitigate these increased costs on to our customers, in which case our operating margins would be adversely affected.

 

Risks Related to Ownership of Our Common Stock

 

The market price for our common stock may be volatile.

 

Many factors could cause the market price of our common stock to rise and fall, including the following:

 

 

actual or anticipated fluctuations in our quarterly or annual financial results;

 

 

the financial guidance we may provide to the public, any changes in such guidance, or our failure to meet such guidance;

 

 

the failure of industry or securities analysts to maintain coverage of our company, changes in financial estimates by any industry or securities analysts that follow our company, or our failure to meet such estimates;

 

 

changes in the market valuations of other companies in the restaurant industry;

 

 

actual or anticipated variations in comparable restaurant sales or operating results; whether in our operations or those of our competitors;

 

 

changes in the consumer preferences or spending;

 

 

various market factors or perceived market factors, including rumors, whether or not correct, involving us, our customers, our strategic partners, or our competitors;

 

 

sales, or anticipated sales, of large blocks of our stock;

 

 

short selling of our common stock by investors;

 

 

 
21

 

 

 

additions or departures of key personnel;

 

 

regulatory or political developments;

 

 

litigation and governmental or regulatory investigations;

 

 

acquisitions or strategic alliances by us or by our competitors; and

 

 

general economic, political, and financial market conditions or events.

 

Due to the volatility of our stock price, we also may become the target of securities litigation. Securities litigation could result in substantial costs and divert our management’s attention and resources from the business as well as depress the price of our common stock.

 

Our current principal stockholders own a large percentage of our voting stock, which allows them to control substantially all matters requiring stockholder approval.

 

Two of our independent directors and our chief executive officer together currently own approximately 23% of our outstanding common stock. As a result, these investors may have significant influence over a decision to enter into any corporate transaction and may have the ability to prevent any transaction that requires the approval of stockholders, regardless of whether or not our other stockholders believe that such transaction is in their own best interests. Such concentration of voting power could have the effect of delaying, deterring, or preventing a change of control or other business combination, which could in turn have an adverse effect on the market price of our common stock or prevent our stockholders from realizing a premium over the then-prevailing market price for their shares of common stock.

 

The large number of shares eligible for public sale could depress the market price of our common stock.

 

The market price for our common stock could decline as a result of sales of a large number of shares of our common stock in the market, and the perception that these sales could occur may depress the market price. As of December 31, 2014, we had outstanding 11,209,138 shares of common stock, all of which shares are either freely tradable or otherwise eligible for sale under Rule 144 under the Securities Act of 1933. In addition, we have 1,439,887 shares available for issuance under our stock award and employee stock purchase plans. We have filed registration statements under the securities laws to register the common stock to be issued under these plans. As a result, shares issued under these plans will be freely tradable without restriction unless acquired by affiliates of our company, who will be subject to the volume and other limitations of Rule 144.

 

We may not continue to buy back shares of common stock under our share repurchase program, which could have an adverse effect on the market price of our common stock.

 

In November 2011, our Board of Directors approved a stock repurchase and retirement program under which we were authorized to purchase up to $5.0 million of common stock. We completed the 2011 authorization in February 2012, purchasing and retiring 858,663 shares. In May 2012, our Board of Directors authorized another stock repurchase and retirement program of up to $5.0 million of our outstanding common stock. As of December 31, 2014, we have repurchased and retired $3.2 million or 387,109 shares under the 2012 authorization, with $203,000 or 24,098 shares during 2013. We did not repurchase and retire any common stock during 2014.

 

The authorization of the program does not have an expiration date and it does not require us to purchase a specific dollar amount of shares. This authorization may be modified, suspended or terminated at any time. The timing and number of shares purchased pursuant to the share purchase authorization are subject to a number of factors, including current market conditions, legal constraints and available cash. If we do not continue to repurchase shares of our common stock, this could have an adverse effect on the market price of our common stock.

 

 
22

 

  

Provisions in our certificate of incorporation, our bylaws, and Delaware law could make it more difficult for a third party to acquire us, discourage a takeover, and adversely affect existing stockholders.

 

Our certificate of incorporation, our bylaws, and the Delaware General Corporation Law contain provisions that may have the effect of making more difficult, delaying, or deterring attempts by others to obtain control of our company, even when these attempts may be viewed to be in the best interests of stockholders. These include provisions on our maintaining a classified Board of Directors and limiting the stockholders’ powers to remove directors or take action by written consent instead of at a stockholders’ meeting. Our certificate of incorporation also authorizes our Board of Directors, without stockholder approval, to issue one or more series of preferred stock, which could have voting and conversion rights that adversely affect or dilute the voting power of the holders of common stock. Delaware law also imposes conditions on the voting of “control shares” and on certain business combination transactions with “interested stockholders.” These provisions and others that could be adopted in the future could deter unsolicited takeovers or delay or prevent changes in our control or management, including transactions in which stockholders might otherwise receive a premium for their shares over then current market prices. These provisions may also limit the ability of stockholders to approve transactions that they may deem to be in their best interests.

 

Since we do not expect to pay any dividends for the foreseeable future, holders of our common stock may be forced to sell their stock in order to obtain a return on their investment.

 

We do not anticipate that we will pay any dividends to holders of our common stock in the foreseeable future. Instead, we plan to reinvest any earnings to finance our restaurant operations and growth plans, or for a stock repurchase program. Accordingly, stockholders must rely on sales of their common stock after price appreciation, which may never occur, as the only way to realize any return on their investment. As a result, investors seeking cash dividends should not purchase our common stock.

 

We are considered an accelerated filer as of the end of fiscal 2014, and we will no longer be able to report as a smaller reporting company in the near future, and as a result, we have to comply with increased disclosure and governance requirements.

 

Based on our public float (market value of securities held by non-affiliates) as of June 30, 2014, we are classified as an "accelerated filer" as of December 31, 2014. Further, starting with our reports covering 2015, we no longer qualify as a “smaller reporting company.” As a non-accelerated filer and a smaller reporting company, we have been able to take advantage of certain exemptions from various reporting and governance requirements that are applicable to other public companies, including not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act.

 

As an accelerated filer and a company that will no longer considered a smaller reporting company, we are subject to higher professional expenses due to the auditor attestation requirements for SOX 404 compliance, which will adversely affect our net income. Further, we cannot predict if investors will find our common stock less attractive because we can no longer rely on these exemptions which may result in additional costs of compliance. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile. There are no assurances that investors will find our common stock more attractive, or that there will be a more active trading market for our common stock or that our stock price will be less volatile, when we are considered an accelerated filer.

 

If we are unable to maintain effective internal control over financial reporting in the future, the accuracy and timeliness of our financial reporting may be adversely affected.

 

Pursuant to Section 404 of the Sarbanes-Oxley Act, we are required to furnish a report by our management on our internal control over financial reporting. The report contains, among other matters, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management.

 

 
23

 

  

While we have determined that our internal control over financial reporting was effective as of December 31, 2014, as indicated in our Management's Annual Report on Internal Control over Financial Reporting included in this Annual Report on Form 10-K, we must continue to monitor and assess our internal control over financial reporting. If our management identifies one or more material weaknesses in our internal control over financial reporting and such weakness remains uncorrected at fiscal year-end, we will be unable to assert such internal control is effective at fiscal year-end. If we are unable to assert that our internal control over financial reporting is effective at fiscal year-end (or if our independent registered public accounting firm is unable to express an opinion on the effectiveness of our internal controls or concludes that we have a material weakness in our internal controls), we could lose investor confidence in the accuracy and completeness of our financial reports, which could have a material adverse effect on our reputation and the price of our common stock.

 

Item 1B.

Unresolved Staff Comments

 

Not applicable.

 

Item 2.

Properties

 

We currently operate 30 restaurants in 19 states. Each of our restaurants and our corporate office are located in a leased facility. As of December 31, 2014, our restaurant leases had expiration dates ranging from 2016 to 2029, typically with options to renew for at least a five-year period. The following table sets forth our current restaurant locations and corporate office.

 

State

 

City

 

Location

 

Year
Opened

 

Square
Footage

 

Number of
Seats (
1)

Arizona

 

Scottsdale

 

Scottsdale Fashion Square

 

1998

 

5,964

 

274

Arizona

 

Chandler

 

Chandler Fashion Center

 

2001

 

7,389

 

320

Missouri

 

Kansas City

 

Country Club Plaza

 

2002

 

7,455

 

248

Nevada

 

Las Vegas

 

Boca Park Fashion Village

 

2003

 

7,390

 

286

Colorado

 

Denver

 

Cherry Creek Mall

 

2004

 

5,920

 

243

Nebraska

 

Omaha

 

Village Pointe

 

2004

 

7,800

 

339

Indiana

 

Carmel

 

Clay Terrace

 

2004

 

7,500

 

356

Texas

 

San Antonio

 

The Shops at La Cantera

 

2005

 

7,200

 

295

Texas

 

Dallas 

 

North Park Mall

 

2006

 

6,890

 

296

Illinois

 

Lincolnshire

 

Lincolnshire Commons

 

2006

 

6,850

 

284

Texas

 

Houston

 

Houston Galleria

 

2006

 

7,555

 

310

Illinois

 

Oak Brook

 

Oak Brook Promenade

 

2006

 

6,998

 

291

Texas

 

Austin

 

The Domain

 

2007

 

7,000

 

298

Michigan

 

Troy

 

Big Beaver Road

 

2007

 

7,000

 

257

Connecticut

 

Stamford

 

Stamford Town Center

 

2007

 

8,197

 

309

Louisiana

 

Baton Rouge

 

Perkins Rowe

 

2007

 

7,200

 

260

Arizona

 

Gilbert

 

San Tan Village

 

2008

 

6,770

 

257

Arizona

 

Phoenix

 

City North

 

2008

 

7,510

 

370

Virginia

 

Richmond

 

West Broad Village

 

2009

 

7,000

 

282

New Jersey

 

Woodbridge

 

Woodbridge Conference Center

 

2009

 

7,000

 

281

Minnesota

 

Eden Prairie

 

Windsor Plaza

 

2009

 

7,000

 

310

Florida

 

Tampa

 

MetWest International

 

2009

 

7,500

 

338

Maryland

 

Baltimore

 

Downtown Baltimore

 

2010

 

6,972

 

280

Idaho

 

Boise

 

The Village at Meridian

 

2013

 

6,913

 

303

Texas

 

The Woodlands

 

The Woodlands Town Center

 

2013

 

8,494

 

269

Texas

 

Fort Worth

 

West 7th

 

2014

 

7,500

 

344

Texas

 

El Paso

 

Fountains at Farah

 

2014

 

6,996

 

286

Florida

 

Sarasota

 

University Town Center

 

2014

 

7,000

 

287

Georgia

 

Alpharetta

 

Avalon

 

2014

 

7,156

 

297

Ohio

 

Columbus

 

Easton Town Center

 

2014

 

5,079

 

242

Arizona

 

Scottsdale

 

Corporate Office at Scottsdale Fashion Square

 

2004

 

9,820

 

____________________

 

(1)

Number of seats includes dining room, patio seating, sushi bar, bar, and private dining room (where applicable).

 

 

 
24

 

 

Item 3.

Legal Proceedings

 

See Note 12 of Notes to Consolidated Financial Statements in Part IV of this report for a summary of legal proceedings.

 

Item 4.

Mine Safety Disclosures

 

Not applicable.

 

PART II

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Market Information

 

Our common stock has traded on the NASDAQ Global Market under the symbol KONA since our initial public offering on August 16, 2005. The following table sets forth high and low sale prices of our common stock for each calendar quarter indicated as reported on the NASDAQ Global Market.

 

   

High

   

Low

 

2014

               

First quarter

  $ 22.00     $ 14.10  

Second quarter

  $ 24.68     $ 17.80  

Third quarter

  $ 20.59     $ 16.02  

Fourth quarter

  $ 25.78     $ 17.50  

2013

               

First quarter

  $ 9.73     $ 8.15  

Second quarter

  $ 11.76     $ 8.65  

Third quarter

  $ 13.90     $ 10.87  

Fourth quarter

  $ 18.69     $ 11.48  

 

On March 6, 2015, the closing sale price of our common stock was $26.11 per share. On March 6, 2015, there were 15 holders of record of our common stock.

 

Recent Sales of Unregistered Securities

 

None.

 

Dividend Policy

 

We have not paid any dividends to holders of our common stock since our initial public offering and do not anticipate that we will pay any dividends to holders of our common stock in the foreseeable future, but instead we currently plan to retain any earnings to finance our restaurant operations and the growth of our business. Payments of any cash dividends in the future, however, is within the discretion of our Board of Directors and will depend on our financial condition, results of operations, and capital and legal requirements as well as other factors deemed relevant by our Board of Directors.

 

 
25

 

  

Issuer Purchase of Equity Securities

 

None.

 

PRICE PERFORMANCE GRAPH

 

The following line graph compares cumulative total stockholder returns for the period from December 31, 2009 through December 31, 2014 for (1) our common stock; (2) the NASDAQ Composite (U.S.) Index; and (3) the peer group. The calculations of cumulative stockholder return for the NASDAQ Composite (U.S.) Index and the peer group include reinvestment of dividends, if any. Our peer group consists of BJ’s Restaurants, Inc.; Bravo Brio Restaurant Group, Inc.; Granite City Food & Brewery Ltd.; and The Cheesecake Factory Incorporated.   Our peer group companies all compete in the polished casual segment of the restaurant industry.

 

The performance shown is not necessarily indicative of future performance. This graph is not “soliciting material,” is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference in any of our filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date hereof and irrespective of any general incorporation language in any such filing.

  

 

 
26

 

 

Item 6.

Selected Financial Data

 

The following selected consolidated financial data has been derived from audited financial statements and should be read in conjunction with the consolidated financial statements and notes thereto and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

   

Year Ended December 31,

 
   

2014

   

2013

   

2012

   

2011

   

2010

 
   

(In thousands, except per share data)

 

Statement of Comprehensive Income (Loss) Data:

 

Restaurant sales

  $ 119,097     $ 98,250     $ 96,021     $ 93,657     $ 82,735  

Costs and expenses:

                                       

Cost of sales

    32,964       26,853       26,246       25,579       22,459  

Labor

    40,336       33,166       31,968       30,896       28,640  

Occupancy

    8,061       6,702       6,253       6,573       6,523  

Restaurant operating expenses

    16,358       13,456       13,534       13,977       12,923  

General and administrative

    10,715       7,854       7,037       8,395       7,072  

Preopening expense

    2,481       1,162                   567  

Depreciation and amortization

    7,220       5,918       5,749       5,856       5,612  

Insurance recoveries and other

          32       (120 )            

Total costs and expenses

    118,135       95,143       90,667       91,276       83,796  

Income (loss) from operations

    962       3,107       5,354       2,381       (1,061 )

Write off of deferred financing costs and other

    39       66                    

Interest expense, net

    220       160       66       58       71  

Income (loss) before income taxes

    703       2,881       5,288       2,323       (1,132 )

Provision for income taxes

          169       36       9       10  

Income (loss) from continuing operations

    703       2,712       5,252       2,314       (1,142 )

Loss from discontinued operations, net of taxes (1)

                466       288       435  

Net income (loss)

  $ 703     $ 2,712     $ 4,786     $ 2,026     $ (1,577 )
                                         
Net income (loss) per share — Basic:                                        
Continuing operations   $ 0.07     $ 0.32     $ 0.60     $ 0.25     $ (0.12 )
Discontinued operations                 (0.05 )     (0.03 )     (0.05 )
Net income (loss)   $ 0.07     $ 0.32     $ 0.55     $ 0.22     $ (0.17 )
                                         
Net income (loss) per share — Diluted:                                        
Continuing operations   $ 0.07     $ 0.31     $ 0.59     $ 0.24     $ (0.12 )
Discontinued operations                 (0.05 )     (0.03 )     (0.05 )
Net income (loss)   $ 0.07     $ 0.31     $ 0.54     $ 0.21     $ (0.17 )
                                         
Weighted average shares outstanding:                                        
Basic     9,870       8,573       8,726       9,242       9,167  
Diluted     10,263       8,762       8,868       9,428       9,167  
                                         
Balance Sheet Data (at end of period):                                        
Cash and cash equivalents   $ 36,578     $ 5,881     $ 7,989     $ 6,327     $ 2,555  
Investments     178       177       177       176       174  
Working capital (deficit)     27,018       (6,476 )     1,044       (2,380 )     (4,878 )
Total assets     94,370       49,868       39,325       41,347       42,060  
Total debt           3,500       370       132       636  
Total stockholders’ equity     65,426       22,358       18,868       17,684       16,989  

_________________________

 

(1)

As a result of our decision to close two restaurants during 2011, the results of operations for these restaurants, including asset impairment, lease termination, and restaurant-level closing costs, are classified as discontinued operations for all periods presented. See Note 2 to the consolidated financial statements.

 

 

 
27

 

  

Item 7.

Managements Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes contained elsewhere in this report. This discussion contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of a variety of factors, including those set forth under Item 1A, “Risk Factors” and elsewhere in this report.

 

Overview

 

We currently own and operate 30 restaurants located in 19 states. We offer freshly prepared food, attentive service, and a contemporary ambiance that create a satisfying yet affordable dining experience that we believe exceeds the experience at many traditional casual dining restaurants with which we compete. Our high-volume polished casual restaurants feature a diverse selection of flavorful American favorites with an international influence and award-winning sushi items. Our menu items are freshly prepared and incorporate over 40 signature sauces and dressings that we make from scratch at each restaurant location, creating broad-based appeal for the lifestyle and taste trends of a diverse group of customers. We believe that our diverse menu and generous portions, combined with an average check of approximately $25 per person, offer our customers an attractive price-value proposition.

 

We plan to grow organically through unit expansion, with a goal of 20% unit growth annually over the next several years. We achieved a unit growth rate of 20% for 2014, with five openings during the year, including the Fort Worth, Texas restaurant in the first quarter, the El Paso, Texas location in the second quarter and the Sarasota, Florida; Alpharetta, Georgia and Columbus, Ohio restaurants in the fourth quarter. We plan to open seven restaurants during 2015, which equates to 23% unit growth. We currently have twelve signed leases for new restaurant openings in 2015 and beyond and continue working diligently to build our pipeline for future growth.

 

In addition, we have started to explore expansion into international markets. Given the strength our concept has enjoyed thus far in the U.S. and the increased demand for polished casual dining concepts overseas, we believe there is a significant opportunity to expand our concept in Latin America, the Middle East and beyond. Similar to other brands with international expansion, we plan to utilize a franchise model for development outside the U.S. Under this model, we will provide training and operational support to our partners without committing or putting our capital at risk in these international markets. Our international strategy is still in its early stages as it will take time for us to identify franchise partners and negotiate franchise agreements and for our partners to find quality real estate and construct the restaurants. We will then need to train the local team on our food and hospitality standards to ensure a successful execution of our strategy. We expect to make several investments in the coming year, including developing marketing materials, obtaining trademarks in the requisite markets and incurring incremental travel and networking expenses in order to build the right foundation for our growth.

 

Our same-store sales increased 3.8% year over year, with 2.9% growth in customer traffic and 0.9% growth in check average. The 3.8% same-store sales growth in 2014 was in addition to a 1.4% increase in same-store sales in 2013. We have generated positive same-store sales in each of the last seven quarters and in 17 out of the last 18 quarters.

 

We continue to focus on growing sales while remaining disciplined with our costs. The average unit volume of our comparable base restaurants increased to $4.4 million, or 4.3% in 2014 compared to $4.3 million in 2013 despite continuing cautious consumer spending and a highly competitive industry landscape. Our income from operations was $1.0 million in 2014 compared to $3.1 million in 2013 and our net income was $0.7 million in 2014 compared to $2.7 million in 2013. In each case, as described in more detail under “Year Ended December 31, 2014 Compared to Year Ended December 31, 2013,” a significant part of the year over year change was driven by preopening expense related to our growth strategy, incremental operating costs for new restaurant locations, and higher general and administrative expenses in support of our accelerated unit growth and SOX 404 compliance.

 

Our restaurant operating profit, defined as restaurant sales minus cost of sales, labor, occupancy, and restaurant operating expenses, increased $3.3 million, or 18.3% to $21.4 million in the 2014 from $18.1 million in the prior year. Restaurant operating profit as a percentage of restaurant sales of 18.0% in 2014 included operating inefficiencies of five new restaurants that opened during 2014 compared to the 2013 restaurant operating profit as a percentage of restaurant sales of 18.4% which included operating inefficiencies of the two new locations opened in the fourth quarter of 2013. Our Adjusted EBITDA, defined as income from operations plus depreciation and amortization, preopening expense and stock-based compensation, grew 6.9% year over year to $11.5 million from $10.8 million in 2013. Adjusted EBITDA as a percentage of restaurant sales was 9.7% in 2014 compared to 11.0% in the prior year, reflecting our investment in human capital to accelerate our unit growth, start-up costs for international business development as well as increased audit and professional fees associated with SOX 404 compliance and tax planning strategies. See “Key Measures” and “Financial Performance Overview” below for further information on restaurant operating profit and Adjusted EBITDA, including a reconciliation to our income from operations.

 

 
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Our cost of sales, labor, and other operating expenses for our restaurants open at least 12 months generally trend consistently with restaurant sales, and we analyze those costs as a percentage of restaurant sales. 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 approximately six 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. We expect cost of sales and labor expenses as a percentage of restaurant sales to be higher when we open a new restaurant, but to decrease as a percentage of restaurant sales as the restaurant matures and as the restaurant management and employees become more efficient in operating that unit. Occupancy and a portion of restaurant operating expenses are fixed. As a result, the volume and timing of newly opened restaurants has had, and is expected to continue to have, an impact on cost of sales, labor, occupancy, and restaurant operating expenses measured as a percentage of restaurant sales.

 

Our general and administrative costs for 2014 have increased and are expected to further increase in 2015 as we make investments in development and operations personnel and infrastructure to accelerate new unit growth and incur start-up costs for our international business development. The increase in 2014 as compared to 2013 also reflected the higher stock-based compensation expense and higher professional fees associated with tax planning strategies and being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act resulting from our higher market capitalization. Over the longer term, we expect our general and administrative spending to generally decrease as a percentage of restaurant sales as we leverage these investments and realize the benefits of higher sales volumes.

 

We incurred preopening expense of $2.5 million, attributable to the aforementioned five openings in 2014 and in preparation for the planned openings in the first half of 2015. Although the actual preopening expenses for a particular location depend upon numerous factors, we expect cash preopening expenses of approximately $425,000 per location, and non-cash preopening rent expense ranging from $50,000 to $100,000 per location. Accordingly, we expect the opening of new units to place downward pressure on our profitability as significant preopening expenses are incurred while operating profit from the new restaurants will likely not be significant in the first few months of each new restaurant’s operation as a result of challenges typically associated with opening new restaurants. We expect to open seven new restaurants in 2015.

 

On June 25, 2014, we completed a public offering of 2.6 million shares of our common stock at an offering price of $18.50 per share. We sold an aggregate of 2.3 million shares, and the remaining 0.3 million shares were sold by certain selling stockholders. Net proceeds from this offering of $40.9 million have been and will be used for new unit expansion, capital expenditures and general corporate purposes.

 

On June 30, 2014, we paid off the $3.5 million outstanding borrowings under our credit facility with existing cash on hand. On November 7, 2014, we amended the credit facility and increased the line of credit from $20 million to $35 million. Our entire $35 million credit facility was available as of December 31, 2014.

 

 

 
29

 

 

Key Measures We Use to Evaluate Our Company

 

Key measures we use to evaluate and assess our business include the following:

 

Number of Restaurant Openings. Number of restaurant openings reflects the number of restaurants opened during a particular reporting period.

 

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, primarily as a result of remodels, 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.

 

Average Weekly Sales. Average weekly sales represent the average of restaurant sales for the comparable or non-comparable restaurant base measured over the applicable operating weeks for the reported periods.

 

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 restaurant sales 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 restaurant sales 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 better determine future financial results driven by growth and to compare restaurant level profitability.

 

Adjusted EBITDA. Adjusted EBITDA is defined as income from operations plus depreciation and amortization, preopening expense and stock-based compensation. Adjusted EBITDA is presented because: (i) we believe it is a useful measure for investors to assess the operating performance of our business without the effect of non-cash items such as depreciation and amortization expenses and stock-based compensation as well as the costs of opening new restaurants; (ii) we believe that investors will find these measures useful in assessing our ability to service or incur indebtedness; and (iii) we use Adjusted EBITDA internally as a benchmark to evaluate our operating performance and compare our performance to that of our competitors.

 

Key Financial Definitions

 

Restaurant Sales. Restaurant sales include gross food and beverage sales, net of promotions and discounts.

 

Cost of Sales. Cost of sales consists of food and beverage costs and related delivery fees.

 

Labor. Labor includes all direct and indirect labor costs incurred in operations.

 

Occupancy. Occupancy includes all rent payments associated with the leasing of real estate, including base, percentage and straight-line rent, real estate taxes, and common area maintenance expense. We record tenant improvement allowances as a reduction of occupancy expense over the term of the lease.

 

Restaurant Operating Expenses. Restaurant operating expenses consist of all other restaurant-level operating costs, the major components of which are utilities, credit card fees, advertising, supplies, marketing, repair and maintenance, and other expenses. Other operating expenses contain both variable and fixed components.

 

 
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General and Administrative. General and administrative includes all corporate and administrative functions that support operations and provide infrastructure to facilitate our future growth. Components of this category include management and staff salaries, bonuses, stock-based compensation and related employee benefits, travel, information systems, human resources, corporate rent, professional and consulting fees, and corporate insurance costs.

 

Preopening Expense. Preopening expense consists of costs incurred prior to opening a new restaurant and is comprised principally of manager salaries, payroll and related training costs for new employees, including food and beverage costs associated with practice and rehearsal of service activities, and rent expense incurred from the date we obtain possession of the property until opening. We expense restaurant preopening expenses as incurred. We expect preopening expenses to commence six to eight months prior to a restaurant opening. Although the actual preopening expenses for a particular location depend upon numerous factors, our historical cash preopening expenses average approximately $425,000 per location, and non-cash preopening rent expense typically ranges from $50,000 to $100,000 per location. Our preopening costs will fluctuate from period to period depending upon the number of restaurants opened, the timing of new restaurant openings, the location of the restaurants, and the complexity of the staff hiring and training process.

 

Depreciation and Amortization. Depreciation and amortization expense consists of the depreciation of property and equipment. Depreciation and amortization expense also includes gains or losses on the disposal of fixed assets, primarily associated with remodel activities.

 

Interest Expense, net. Interest expense consists of the cost of servicing our debt obligations, the amortization of debt issuance costs and commitment fees on the line of credit. Interest expense is offset by interest earned on cash and investment balances. We capitalize interest incurred on borrowings for restaurant construction.

 

Provision for Income Taxes. Provision for income taxes represents amounts due for federal and state income taxes.

 

Discontinued Operations. Discontinued operations include the historical operating results as well as lease termination and exit costs attributable to closed restaurants.

 

Financial Performance Overview

 

The following table sets forth certain information regarding our financial performance for 2014, 2013 and 2012. There were 23 restaurants in the comparable restaurant base as of December 31, 2014, 2013 and 2012. There were seven and two restaurants in the non-comparable base as of December 31, 2014 and 2013, respectively.

 

   

Year Ended December 31,

 
   

2014

   

2013

   

2012

 
                         

Restaurant sales growth

    21.2

%

    2.3

%

    2.5

%

Same-store sales percentage change (1)

    3.8

%

    1.4

%

    2.7

%

Average weekly sales – comparable restaurant base

  $ 85,000     $ 81,700     $ 80,300  

Average weekly sales – non-comparable restaurant base

  $ 85,700     $ 101,600     $  

Average unit volume (in thousands) (2)

  $ 4,433     $ 4,250     $ 4,190  

Restaurant operating profit (in thousands) (3)

  $ 21,378     $ 18,073     $ 18,020  

Restaurant operating profit as a percentage of sales (3)

    18.0

%

    18.4

%

    18.8

%

Adjusted EBITDA (in thousands) (4)

  $ 11,519     $ 10,771     $ 11,501  

Adjusted EBITDA as a percentage of sales (4)

    9.7

%

    11.0

%

    12.0

%

  

 

(1)

Same-store sales percentage change reflects the periodic change in restaurant sales for the comparable restaurant base compared to the prior year. In calculating the percentage change for same-store sales, we include a restaurant in the comparable restaurant base the first full calendar quarter after it has been in operation for more than 18 months. We remove restaurants from the comparable base for periods in which they are closed, primarily related to remodel activities.

 

(2)

Includes only those restaurants in the comparable restaurant base.

 

(3)

Restaurant operating profit is not a financial measurement determined in accordance with U.S. generally accepted accounting principles (see reconciliation below) and should not be considered in isolation or as an alternative to income from operations. Restaurant operating profit may not be comparable to the same or similarly titled measures computed by other companies. 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. We use restaurant operating profit as a percentage of restaurant sales as a key metric to evaluate our restaurants’ financial performance compared with our competitors.

 

(4)

Adjusted EBITDA is not a financial measure determined in accordance with U.S. generally accepted accounting principles (see reconciliation below) and should not be considered in isolation or as an alternative to income from operations. Adjusted EBITDA is defined as income from operations plus depreciation and amortization, preopening expense and stock-based compensation. Adjusted EBITDA is presented because: (i) we believe it is a useful measure for investors to assess the operating performance of our business without the effect of non-cash items such as depreciation and amortization expenses and stock-based compensation as well as the costs of opening new restaurants; (ii) we believe that investors will find these measures useful in assessing our ability to service or incur indebtedness; and (iii) we use Adjusted EBITDA internally as a benchmark to evaluate our operating performance and compare our performance to that of our competitors.

 

 

 
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The following tables set forth our reconciliation of Adjusted EBITDA and restaurant operating profit to our income from operations, the most comparable U.S. GAAP measure.

 

   

Year Ended December 31,

 
   

2014

   

2013

   

2012

 
   

(In thousands)

 

Income from operations

  $ 962     $ 3,107     $ 5,354  

Depreciation and amortization

    7,220       5,918       5,749  

Preopening expense

    2,481       1,162        

Stock-based compensation

    856       584       398  

Adjusted EBITDA

    11,519       10,771       11,501  

General and administrative

    10,715       7,854       7,037  

Stock-based compensation

    (856 )     (584 )     (398 )

Insurance recoveries and other

          32       (120 )

Restaurant operating profit

  $ 21,378     $ 18,073     $ 18,020  

 

   

Percent of Restaurant Sales

 
   

Year Ended December 31,

 
   

2014

   

2013

   

2012

 

Income from operations

    0.8 %     3.2 %     5.6 %

Depreciation and amortization

    6.1       6.0       6.0  

Preopening expense

    2.1       1.2        

Stock-based compensation

    0.7       0.6       0.4  

Adjusted EBITDA

    9.7       11.0       12.0  

General and administrative

    9.0       8.0       7.3  

Stock-based compensation

    (0.7 )     (0.6 )     (0.4 )

Insurance recoveries and other

                (0.1 )

Restaurant operating profit

    18.0 %     18.4 %     18.8 %

 

Certain percentage amounts may not sum to total due to rounding.

 

 
32

 

 

Store Growth Activity

 

   

2014

   

2013

   

2012

 
                         

Beginning Restaurants

    25       23       23  

Openings

    5       2        

Total

    30       25       23  

  

Results of Operations

 

The following table sets forth, for the years indicated, our consolidated statements of comprehensive income expressed as a percentage of restaurant sales.

 

    Year Ended December 31,  
    2014     2013     2012  

Restaurant sales

    100.0 %     100.0 %     100.0 %

Costs and expenses:

                       

Cost of sales

    27.7       27.3       27.3  

Labor

    33.9       33.8       33.3  

Occupancy

    6.8       6.8       6.5  

Restaurant operating expenses

    13.7       13.7       14.1  

General and administrative

    9.0       8.0       7.3  

Preopening expense

    2.1       1.2        

Depreciation and amortization

    6.1       6.0       6.0  

Insurance recoveries and other

          0.0       (0.1 )

Total costs and expenses

    99.2       96.8       94.4  

Income from operations

    0.8       3.2       5.6  

Write off of deferred financing costs

    0.0       0.1        

Interest expense, net

    0.2       0.2       0.1  

Income before income taxes

    0.6       2.9       5.5  

Provision for income taxes

          0.2       0.0  

Income from continuing operations

    0.6       2.8       5.5  

Loss from discontinued operations, net of tax

                0.5  

Net income

    0.6 %     2.8 %     5.0 %

 

Certain percentage amounts may not sum to the total due to rounding.

 

Year Ended December 31, 2014 Compared with Year Ended December 31, 2013

 

Restaurant Sales. Restaurant sales increased $20.8 million or 21.2% in 2014, $16.3 million of which related to contributions from our five new restaurants opened during 2014 and a full year of sales for two restaurants opened in the fourth quarter of 2013. Our same-store sales increased 3.8% year over year, with a 2.9% growth in customer traffic and a 0.9% growth in check average. The 3.8% same-store sales growth in 2014 compares to a 1.4% increase in same-store sales in 2013.

 

Cost of Sales. Cost of sales increased $6.1 million, or 22.8% to $33.0 million in 2014 compared to $26.9 million in the prior year. New locations opened since the fourth quarter of 2013 accounted for $4.8 million of the total increase. As a percentage of restaurant sales, cost of sales was 27.7% compared to 27.3% in 2013, reflecting primarily new unit inefficiencies and commodity pricing pressure particularly from beef and dairy.

 

Labor. Labor expense for our restaurants increased to $40.3 million, or 21.6%, from $33.2 million in 2013. Labor costs for new locations accounted for $6.2 million of the total $7.1 million increase. Labor expenses as a percentage of restaurant sales increased to 33.9% compared to 33.8% in the prior year as the labor leverage achieved by our comparable base units on higher sales volume partially mitigated inefficiencies associated with our non-comparable base units.

 

 
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Occupancy. Occupancy expenses increased $1.4 million or 20.3% to $8.1 million in 2014 from $6.7 million in 2013. The higher occupancy expenses are primarily associated with base rent and common area maintenance charges associated with the new locations coupled with the lower benefit of tenant allowance amortization mainly at certain restaurant locations as lease options were exercised or certain lease provisions lapsed. Occupancy expenses as a percentage of restaurant sales were 6.8% in both 2014 and 2013.

 

Restaurant Operating Expenses. Restaurant operating expenses increased $2.9 million, or 21.6%, to $16.4 million in 2014 compared to $13.5 million in the prior year. Of the total increase, $2.1 million is attributable to the additional operating expenses associated with our non-comparable base restaurants. The year over year increase in absolute dollars was driven by higher utilities, credit card fees, paper and sanitation supplies, smallwares, linens, professional services, travel related training costs and repairs and maintenance expenses. The higher variable expenses were driven by year over year sales volume increase while the higher repairs and maintenance expenses reflected the additional maintenance efforts associated with the average age of certain of our locations. Restaurant operating expenses as a percentage of restaurant sales were 13.7% in both years.

 

General and Administrative. General and administrative expenses increased by $2.9 million, or 36.4% to $10.7 million from $7.9 million year over year. As a percentage of sales, general and administrative expenses increased 100 basis points to 9.0% in 2014 compared to 8.0% in the prior year. Increased costs associated with additional headcount investment to support our unit growth expansion and start-up efforts for our international franchising strategy, higher travel costs for increased real estate development activities, increased stock-based compensation expense due to our higher stock price as well as higher audit and professional fees primarily associated with SOX 404 compliance and tax planning strategies contributed to the year over year increase.

 

Preopening Expense. Preopening expense was $2.5 million in 2014 compared to $1.2 million in 2013. The year over year increase was primarily attributable to the El Paso location which opened in June of 2014, the opening of the Alpharetta, Sarasota and Columbus restaurants which opened in the fourth quarter of 2014 and expenses for restaurants scheduled to open in the first half of 2015. Preopening expense of $1.2 million in 2013 was attributable to the Boise, The Woodlands and Fort Worth locations. We opened the Boise and The Woodlands restaurants in October and December 2013, respectively, while the Fort Worth restaurant was opened in February 2014.

 

Depreciation and Amortization. Depreciation and amortization expense increased $1.3 million or 22.0% to $7.2 million in 2014 from $5.9 million in the prior year. Depreciation and amortization expense as a percentage of restaurant sales was 6.1% and 6.0% of restaurant sales in 2014 and 2013, respectively. The increase in absolute dollars was attributable to the seven new restaurants opened since the fourth quarter of 2013 and asset additions associated with two remodels in the fourth quarter of 2013 partially offsetting the impact of fully depreciated assets in 2014.

 

Write off of Deferred Financing Costs. In April 2013, we entered into a $20 million credit facility with KeyBank and Stearns Bank. We paid off the outstanding term loan balance with cash on hand and terminated the $6.5 million Stearns Bank credit facility. In conjunction with this transaction, we wrote off $66,000 in deferred loan fees related to the Stearns Bank agreement in the second quarter of 2013. In November 2014, we modified the credit facility with KeyBank, increasing the credit line from $20 million to $35 million and removing Stearns Bank as a participant in the agreement. As a result, we wrote off the remaining $39,000 Stearns Bank deferred loan fees in the fourth quarter of 2014.

 

Interest Expense, Net. Net interest expense is attributable to the amortization of deferred loan fees, the commitment fees associated with the KeyBank credit facility and interest incurred on borrowings under the credit facility partially offset by interest income earned from cash and investment balances. Interest expense increased slightly year over year driven by higher deferred loan fee amortization and higher commitment fees. We paid off all outstanding borrowings under the credit facility in June 2014.

 

Provision for Income Taxes. We recognized no income tax expense in 2014 based upon the net operating loss position resulting from our tax planning strategies conducted in 2014. We recognized income tax expense of $169,000 in 2013 as we generated taxable income in excess of our federal and state net operating loss carryforwards in the prior year.

 

 
34

 

  

Year Ended December 31, 2013 Compared with Year Ended December 31, 2012

 

Restaurant Sales. Restaurant sales increased by $2.3 million, or 2.3%, to $98.3 million in 2013 from $96.0 million in 2012, primarily attributable to a 1.4% increase in comparable restaurant sales and a $1.3 million contribution from new restaurants opened during 2013. These increases were partially offset by lost sales associated with remodels, which resulted in the closure of two restaurants for nine operating weeks. The increase in comparable restaurant sales wass driven by higher average check per person of 1.2%, largely resulting from a 3% menu price increase in March 2013. Customer traffic during the year also increased 0.2% compared to 2012.

 

Cost of Sales. Cost of sales increased $0.7 million, or 2.3%, to $26.9 million year over year from $26.2 million. Cost of sales as a percentage of restaurant sales remained flat at 27.3% as we were able to mitigate pricing pressure from produce, shrimp and beef costs and higher wine cost associated with promotional offerings during 2013 with the benefits of the 3% menu price increase at the end of March 2013, lower seafood cost from sourcing management and improved management of liquor costs year over year.

 

Labor. Labor expense for our restaurants increased $1.2 million, or 3.7%, to $33.2 million in 2013 compared to $32.0 million in 2012. The increase relates to higher wages on increased sales volume, and higher medical and workers compensation costs year over year. Labor expenses as a percentage of restaurant sales increased to 33.8% compared to 33.3% in 2012, reflecting in part higher than anticipated labor costs from the remodel closures, labor inefficiencies associated with the two new restaurant openings and higher benefit costs year over year.

 

Occupancy. Occupancy expenses increased $0.4 million, or 7.2% to $6.7 million in 2013 from $6.3 million in 2012. The increase is primarily associated with higher common area maintenance charges and the lower benefit of tenant allowance amortization at certain restaurant locations as lease options were exercised and the tenant allowance was amortized over a longer period. Occupancy expenses as a percentage of restaurant sales increased 0.3% to 6.8% in 2013 compared to 6.5% in 2012.

 

Restaurant Operating Expenses. Restaurant operating expenses decreased slightly year over year. Improved management of certain operating expenses including printing, aquarium maintenance, marketing, training and travel more than offset higher repair and maintenance, utilities, bank fees and paper supplies. Restaurant operating expenses as a percentage of restaurant sales decreased to 13.7% in 2013 compared to 14.1% in 2012.

 

General and Administrative. General and administrative expenses increased by $0.8 million, or 11.6% to $7.9 million from $7.0 million year over year. General and administrative expenses as a percentage of sales increased year over year to 8.0% from 7.3% in 2012. The year over year increase is attributable to higher salaries and benefits associated with increased staffing to support our growth strategy, higher travel costs associated with increased real estate development and lease-related activities, increased stock-based compensation expense partially resulting from higher stock prices, and the reversal of severance charges associated with a former executive officer in the 2012 period. The increase is partially offset by lower legal and professional fees in 2013 compared to 2012.

 

Preopening Expense. Preopening expense of $1.2 million in 2013 was attributable to the Boise, The Woodlands and Fort Worth locations. We opened the Boise and The Woodlands restaurants in October and December 2013, respectively, while the Fort Worth restaurant was opened in February 2014. We did not open any new restaurants in 2012.

 

Depreciation and Amortization. Depreciation and amortization expense increased $0.2 million or 2.9% to $5.9 million in 2013, primarily due to the write off of fixed assets associated with our remodels in 2013 and depreciation expense for the two new restaurants. Depreciation and amortization expense as a percentage of restaurant sales remained flat at 6.0% in both 2013 and 2012.

 

Insurance Recoveries and Other. Insurance recoveries and other in 2012 represent an insurance settlement for property and facility damage and for a business interruption claim, net of other non-recurring items incurred. We recognized a gain of $317,000 for business interruption and furniture replacement claims associated with a fire at our Troy, Michigan restaurant in 2012. We also recognized tax expense for sales tax audit matters in 2013 and 2012.

 

 
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Write off of Deferred Financing Costs. In April 2013, we entered into a $20 million credit facility with KeyBank and Stearns Bank. We paid off the outstanding term loan balance with cash on hand and terminated the $6.5 million Stearns Bank credit facility. In conjunction with this transaction, we wrote off $66,000 in deferred loan fees related to the Stearns Bank agreement in the second quarter of 2013.

 

Interest Expense. Interest expense increased $0.1 million in 2013 as compared to 2012. The increase is attributable to the amortization of deferred loan fees, the commitment fees associated with the KeyBank credit facility and interest incurred on borrowings under the credit facility. Interest expense in 2012 primarily related to debt service costs for our term loan with Stearns Bank.

 

Discontinued Operations. Discontinued operations in 2012 represent lease termination and legal costs attributable to the Sugar Land restaurant which was closed in 2011. Our loss from discontinued operations of $466,000 was attributable to the settlement of all outstanding lease termination obligations for the Sugar Land location in the third quarter of 2012.

 

Provision for Income Taxes. We recorded a provision for income taxes of $169,000 and $36,000, respectively, during 2013 and 2012. The year over year increase in the provision wass attributable to higher federal and state taxes for the year as we generated taxable income in excess of our federal and state net operating loss carryforwards.

 

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:

 

 

timing of new restaurant openings and related expenses;

 

fluctuations in commodity and food protein prices;

 

preopening costs for our 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 closures;

 

labor availability and costs for hourly and management personnel;

 

profitability of our restaurants, especially in new markets;

 

increases and decreases in comparable restaurant sales;

 

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

 

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.

  

 
36

 

 

Quarterly Results of Operations

 

The following table presents unaudited consolidated statement of comprehensive income (loss) data for each of the eight quarters in the period ended December 31, 2014. We believe that all necessary adjustments have been included to present fairly the quarterly information when read in conjunction with our annual financial statements and related notes. Certain reclassifications of prior year’s financial statement amounts have been made to conform to the current year presentation. The operating results for any quarter are not necessarily indicative of the results for any subsequent quarter.

 

    Quarter Ended  
    2014     2013  
    Mar 31     Jun 30     Sept 30     Dec 31     Mar 31     Jun 30     Sept 30     Dec 31  
    (In thousands, except per share data)  

Restaurant sales

  $ 27,616     $ 29,886     $ 30,037     $ 31,558     $ 23,496     $ 25,796     $ 24,507     $ 24,451  

Costs and expenses:

                                                               

Cost of sales

    7,510       8,210       8,385       8,859       6,453       6,968       6,755       6,677  

Labor

    9,426       9,900       10,128       10,882       7,866       8,408       8,277       8,615  

Occupancy

    1,843       2,001       2,063       2,154       1,615       1,697       1,691       1,699  

Restaurant operating expenses

    3,848       4,023       4,109       4,378       3,171       3,401       3,382       3,502  

General and administrative

    2,576       2,443       2,584       3,112       1,875       2,010       1,905       2,064  

Preopening

    390       509       534       1,048             41       356       765  

Depreciation and amortization

    1,687       1,717       1,850       1,966       1,429       1,412       1,395       1,682  

Insurance recoveries and other

                                              32  

Total costs and expenses

    27,280       28,803       29,653       32,399       22,409       23,937       23,761       25,036  
                                                                 

Income (loss) from operations

    336       1,083       384       (841 )     1,087       1,859       746       (585 )

Write off of deferred financing costs and other

                      39             66              

Interest expense, net

    60       64       60       36       3       41       52       64  

Income (loss) before income taxes

    276       1,019       324       (916 )     1,084       1,752       694       (649 )

Provision (benefits) for income taxes

    25             (25 )           80       195       34       (140 )

Net income (loss)

  $ 251     $ 1,019     $ 349     $ (916 )   $ 1,004     $ 1,557     $ 660     $ (509 )
                                                                 
Net income (loss) per share:                                                                
                                                                 

Basic

  $ 0.03     $ 0.12     $ 0.03     $ (0.08 )   $ 0.12     $ 0.18     $ 0.08     $ (0.06 )

Diluted

  $ 0.03     $ 0.11     $ 0.03     $ (0.08 )   $ 0.12     $ 0.18     $ 0.08     $ (0.06 )
                                                                 

Weighted average shares outstanding:

                                                               

Basic

    8,609       8,770       10,984       11,117       8,543       8,567       8,585       8,598  

Diluted

    8,882       9,081       11,273       11,117       8,643       8,692       8,778       8,598  
                                                                 

Comprehensive income (loss)

  $ 251     $ 1,019     $ 349     $ (916 )   $ 1,004     $ 1,557     $ 660     $ (509 )

 

 

 
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Liquidity and Capital Resources

 

Currently, our primary capital requirements are for new restaurant development and remodeling of existing restaurants. 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. We are typically required to expend cash for leasehold improvements, furniture, fixtures and equipment to construct and equip each restaurant. We also require capital resources to maintain our existing base of restaurants, including remodeling, and to further expand and strengthen the capabilities of our corporate and information technology infrastructures.

 

The following tables set forth, as of the dates and for the periods indicated, a summary of our key liquidity measurements (amounts in thousands):

 

   

December 31,

 
   

2014

   

2013

 

Cash and short-term investments

  $ 36,756     $ 6,058  

Net working capital (deficit)

    27,018       (6,476 )

  

   

Year Ended December 31,

 
   

2014

   

2013

 

Cash provided by operating activities

  $ 14,744     $ 9,460  

Capital expenditures

    21,855       14,445  

 

Future Capital Requirements

 

Our capital requirements, including development costs related to the opening of new restaurants, have historically been significant. Over the past year, we funded development of new restaurants and remodels primarily from cash flows from operations, borrowings under our credit agreement and funds raised in our public offering of stock. 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 and the capital market accessibility.

 

We plan to grow organically through unit expansion, with a goal of 20% unit growth annually over the next several years. We achieved a unit growth rate of 20% for 2014, with five openings during the year. We plan to open seven restaurants during 2015, which equates to 23% unit growth. We plan to remodel five restaurants during 2015 and incur maintenance capital expenditures for existing restaurants and our corporate office. We also are diligently working on our real estate pipeline and expect to incur capital expenditures during 2015 for restaurants scheduled to open during the first half of 2016. We expect to spend approximately $40 million in capital expenditures in 2015, exclusive of tenant improvement allowances, for the planned construction and remodel of these restaurants.

 

In addition, we have started to explore expansion into international markets. Similar to other brands with international expansion, we plan to utilize a franchise model for development outside the U.S. Under this model, we will provide training and operational support to our partners without committing, or putting at risk, capital for restaurant construction in these international markets. We expect to make several investments in the coming year, including developing marketing materials, obtaining trademarks in the requisite markets and incurring incremental travel and networking expenses in order to build the right foundation for our growth.

 

On June 25, 2014, we completed a public offering of 2.6 million shares of our common stock at an offering price of $18.50 per share. We sold an aggregate of 2.3 million shares, of which 0.3 million shares were sold pursuant to the underwriters’ exercise of their option to purchase additional shares. The remaining 0.3 million shares were sold by certain selling stockholders. The aggregate net proceeds received for the offering totaled $40.9 million, reflecting gross proceeds of $43.4 million, less underwriting discounts and expenses of $2.2 million and other offering costs of $0.3 million. Net proceeds from the offering are being used for new unit expansion, capital expenditures and general corporate purposes.

 

 
38

 

  

On June 30, 2014, we paid off the $3.5 million outstanding borrowings under our credit facility with existing cash on hand. On November 7, 2014, we amended the credit facility and increased the line of credit from $20 million to $35 million. Our entire $35 million credit facility was available as of December 31, 2014.

 

As of December 31, 2014, we had working capital of $27.0 million and no borrowings under the credit facility. We believe existing cash and short-term investments of $36.8 million, the ability to draw on our $35 million credit facility and cash flow from operations will be sufficient to fund property additions for new restaurants and planned remodels of existing restaurants over the next several years.

 

Any reduction of our cash flow from operations or an inability to draw on our credit facility may cause a delay or cancellation of future restaurant development or remodels of existing restaurants. Financing to construct new restaurants or remodels for amounts in excess of our current cash and short-term investments and the line of credit availability may not be available on acceptable terms, or at all, and our failure to raise capital when needed could impact our growth plans, financial condition, and results of operations. Additional equity financing may result in dilution to current stockholders and 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 April 19, 2013, we entered into a Credit Agreement for a $20 million revolving line of credit maturing on April 19, 2017 with KeyBank National Association (“KeyBank”) and Stearns Bank National Association (“Stearns Bank”). On November 7, 2014, we entered into an Amended and Restated Credit Agreement (the “Amended Credit Agreement”) with KeyBank to (i) increase the credit facility from $20 million to $35 million, and (ii) extend the maturity date of the credit facility to November 7, 2019. The credit facility is secured by our personal property and assets. Certain of our wholly owned subsidiaries have also guaranteed the credit facility.

 

The interest rate under the Amended Credit Agreement is KeyBank’s prime rate or LIBOR, at our option, plus an applicable margin depending on our leverage ratio. The LIBOR margins range from 1.5% to 2.5% and the base rate margins range from 0.5% to 1.5%. Payments on the credit facility are interest only, payable quarterly with respect to each base rate loan and at varying times with respect to LIBOR rate loans, with outstanding principal and interest due at maturity. Prepayment is permitted at any time without penalty, subject to certain restrictions on the order of repayment or prepayment. We are obligated to pay a commitment fee at an annual rate of 0.175% to 0.350%, depending on our leverage ratio, times the unused total revolving commitment of the credit facility based on the average daily amount outstanding under the credit facility for the previous quarter. The commitment fee is payable quarterly in arrears.

 

During the fourth quarter of 2013, we borrowed $3.5 million against the credit facility at the one-month LIBOR rate of approximately 3.4%, including the LIBOR margin. We paid off all outstanding borrowings under the credit facility with existing cash on hand on June 30, 2014. The entire $35 million under the credit facility was available at December 31, 2014.

 

During 2014, 2013 and 2012, we incurred gross interest expense of $269,000, $171,000 and $67,000, consisting primarily of loan fee amortization of $104,000, $79,000 and $16,000 in 2014, 2013 and 2012, respectively, and commitment fees of $91,000 and $70,000 in 2014 and 2013, respectively. We also capitalized $29,000 and $7,000 of interest costs in 2014 and 2013, respectively.

 

Fees incurred to establish the credit facility totaled $198,000 and $356,000 in 2014 and 2013, respectively. Unamortized loan fees of $403,000 at December 31, 2014 are being amortized over the life of the credit facility and included in other assets in the consolidated balance sheet.

 

The credit facility also requires us to comply with certain covenants, including (a) a minimum fixed charge coverage ratio of less than 1.50 and (b) a maximum leverage ratio of 5.0 to 1.0 through March 31, 2016 and 4.75 to 1.0 from April 1, 2016 through the maturity date. As of December 31, 2013, there was a technical event of default related to a default judgment and accordingly, all borrowings under the credit facility were classified as a current liability at December 31, 2013. The default judgment was subsequently set aside on April 7, 2014. We were in compliance with all covenants at December 31, 2014.

 

 
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Prior to closing on the credit facility, we had loan agreements with Stearns Bank for a $0.5 million term loan and a $6.5 million credit line. We did not have any borrowings under the Stearns Bank credit line prior to its termination in April 2013. We utilized existing cash to pay off the outstanding balance on the Stearns Bank term loan on April 19, 2013 and wrote off $66,000 in deferred loan fees related to the prior loan agreements during the second quarter of 2013. In conjunction with the modification of the credit facility in November 2014, we wrote off the remaining Stearns Bank deferred loan fees of $39,000 in the fourth quarter of 2014.

 

Stock Repurchase and Retirement Program

 

In November 2011, our Board of Directors approved a stock repurchase and retirement program under which we were authorized to purchase up to $5,000,000 of common stock. We completed the 2011 authorization in February 2012, purchasing and retiring 858,663 shares.

 

In May 2012, our Board of Directors authorized another stock repurchase and retirement program of up to $5,000,000 of our outstanding common stock. As of December 31, 2014, we have repurchased and retired $3.2 million or 387,109 shares under the 2012 authorization, with $203,000 or 24,098 shares during 2013. We did not repurchase and retire any shares during 2014.

 

The authorization of the program does not have an expiration date and it does not require us to purchase a specific dollar amount of shares. This authorization may be modified, suspended or terminated at any time. The timing and number of shares purchased pursuant to the share purchase authorization are subject to a number of factors, including current market conditions, legal constraints and available cash.  

 

Cash Flows

 

      The following table summarizes our primary sources and uses of cash during the past three years:

 

   

2014

   

2013

   

2012

 
   

(In thousands)

 

Net cash provided by (used in):

                       

Operating activities

  $ 14,744     $ 9,460     $ 7,352  

Investing activities

    (21,858

)

    (14,536

)

    (1,776

)

Financing activities

    37,811       2,968       (3,914

)

Net increase (decrease) in cash and cash equivalents

  $ 30,697     $ (2,108

)

  $ 1,662  

 

Operating Activities. We generated $14.7 million, $9.5 million and $7.4 million of operating cash flows in 2014, 2013 and 2012, respectively. The increase in each comparative period was primarily due to the timing of payments for accounts payable and accrued expenses and an increase in deferred rent as a result of recording tenant improvement allowances for new restaurants, partially offset by lower net income.

 

Investing activities. We fund the development and construction of new restaurants and remodels primarily with cash flows from operations, borrowings under our credit facility and funds we raised in a 2014 public offering of our common stock. Capital expenditures in 2014 increased to $21.9 million, or over 50% from 2013, driven by the additions of leasehold improvements, equipment and furniture and fixtures for five restaurants opened during 2014, maintenance capital expenditures for existing restaurants as well as expenditures for restaurants scheduled to be opened in 2015. Capital expenditures in 2013 were $14.4 million consisting of architecture and design fees, general contractor costs, furniture and equipment purchases and other construction related costs associated with our Boise, The Woodlands and Fort Worth locations, the significant remodel of our Scottsdale and San Antonio restaurants as well as maintenance capital expenditures for existing restaurants.

 

Financing Activities. We generated $37.8 million of cash flows from financing activities in 2014, consisting mainly of $40.9 million of net proceeds from our offering of 2.345 million shares and $0.6 million from stock option exercises and employee stock purchases. The cash inflow partially offset a $3.5 million debt repayment on the KeyBank credit facility borrowings and $0.2 million in fees incurred for the KeyBank credit facility upsizing in November 2014. Net cash provided by financing activities was $3.0 million in 2013, primarily attributable to the $3.5 million borrowings from our KeyBank Credit Facility, $0.1 million in excess income tax benefits from stock option exercises and $0.3 million in proceeds from employee stock option exercises and employee stock plan purchases, partially offset by $0.4 million in payments on the Stearns Bank term loan, $0.4 million in fees for the KeyBank Credit Facility and $0.2 million for the purchase and retirement of our common stock under the May 2012 authorization.

 

 
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Aggregate Contractual Obligations

 

The following table sets forth our contractual commitments as of December 31, 2014 (in thousands).

 

   

Payments Due by Period

 

Contractual Obligations

 

Total

   

Less than

1 year

   

1-3 years

   

3-5 years

   

More than

5 years

 

Operating leases

  $ 103,386     $ 9,512     $ 24,512     $ 21,359     $ 48,003  

 

The table above reflects obligations for all leases signed for restaurants to be opened but does not include obligations related to lease renewal option periods even if it is reasonably assured that we will exercise the related option. We have evaluated and determined that we do not have any purchase obligations.

 

Off-Balance Sheet Arrangements

 

We had no off-balance sheet guarantees or off-balance sheet arrangements as of December 31, 2014.

 

Critical Accounting Policies

 

Critical accounting policies are those that we believe are most important to the portrayal of our financial condition and results of operations and also require our most difficult, subjective or complex judgments. Judgments or uncertainties regarding the application of these policies may result in materially different amounts being reported under various conditions or using different assumptions. We consider the following policies to be the most critical in understanding the judgment that is involved in preparing our consolidated financial statements.

 

Property and Equipment

 

We record property and equipment at cost less accumulated depreciation, and we select useful lives that reflect the estimated economic lives of the underlying assets. We amortize leasehold improvements over the shorter of the useful life of the asset or the related lease term. We calculate depreciation using the straight-line method for financial statement purposes. We capitalize improvements and expense repairs and maintenance costs as incurred. We are often required to exercise judgment in our decision whether to capitalize an asset or expense an expenditure that is for maintenance and repairs. The useful life of property and equipment and the determination as to what constitutes a capitalized cost versus a repair and maintenance expense involves judgment by management, which may produce different amounts of repair and maintenance or depreciation expense if different assumptions were used.

 

We evaluate property and equipment for impairment whenever events or changes in restaurant operating results indicate that the carrying value of those assets may not be recoverable. Factors considered include, but are not limited to, significant underperformance relative to expected historical or projected future operating results; significant negative industry or economic trends; and significant changes in laws and regulations, legal factors or in the business climate. The assessment of impairment is performed on a restaurant-by-restaurant basis. The recoverability is assessed by comparing the carrying value of the asset to the undiscounted cash flows expected to be generated by the asset. This assessment process requires the use of estimates and assumptions regarding future cash flows and estimated useful lives, which are subject to a significant degree of judgment. If indicators of impairment are present and if we determine that the carrying value of the asset exceeds the fair value of the restaurant assets, an impairment charge is recorded to reduce the carrying value of the asset to its fair value. Calculation of fair value requires significant estimates and judgments which could vary significantly based on our assumptions.

 

We continue to monitor the operating performance of each individual restaurant. We may be required to record impairment charges in the future if certain restaurants perform below expectations.

 

 
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Leasing Activities

 

We lease all of our restaurant properties. At the inception of the lease, we evaluate each property and classify the lease as an operating or capital lease in accordance with applicable accounting standards. We exercise significant judgment in determining the estimated fair value of the restaurant as well as the discount rate used to discount the future minimum lease payments. The term used for this evaluation includes renewal option periods only in instances in which the exercise of the renewal option can reasonably be assured and failure to exercise such option would result in an economic penalty. All of our restaurant leases are classified as operating leases.

 

Our lease term used for straight-line rent expense is calculated from the date we take possession of the leased premises through the lease termination date. There is potential for variability in our “rent holiday” period which typically begins on the possession date and ends on the store open date. Factors that may affect the length of the rent holiday period generally include construction related delays. Extension of the rent holiday period due to delays in restaurant opening will result in greater rent expensed during the rent holiday period.