10-K 1 kona20161231_10k.htm FORM 10-K kona20161231_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, 2016

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

Common Stock, par value $0.01 per share

Preferred Stock Purchase Rights

Name of Each Exchange on Which Registered

NASDAQ Global Market

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, 2016, was $72,500,000, 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 February 28, 2017, there were 10,081,444 shares of the registrant’s common stock outstanding.

 

Documents Incorporated by Reference

 

Portions of the registrant’s definitive proxy statement for the 2017 Annual Meeting of Stockholders, to be filed with the Commission within 120 days after the end of the fiscal year ended December 31, 2016, are incorporated by reference into Part III of this report.



 

 
 

 

 

KONA GRILL, INC.
Annual Report on Form 10-K
For the Year Ended December 31, 201
6

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

28

Item 7.

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

29

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

43

Item 8.

Financial Statements and Supplementary Data

43

Item 9.

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

43

Item 9A.

Controls and Procedures

44

Item 9B.

Other Information

44

     

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 45 upscale casual restaurants in 23 states and Puerto Rico. 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 upscale casual restaurants feature a global menu of contemporary American favorites, award-winning sushi and specialty cocktails. 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 approximately 290 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, 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 and by strategically expanding the Kona Grill concept in both new and existing markets. We continue to execute our strategy for international market franchise expansion. Given the strength our concept has enjoyed thus far in the U.S. and the increased demand for upscale casual dining concepts overseas, we believe there is a significant opportunity to expand our concept in Latin America, the Middle East and beyond through franchising.

 

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 contemporary American favorites 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 2016 of approximately $26 per customer, we believe we provide an exceptional price-value proposition that helps create a lasting relationship between Kona Grill and our customers.
     
     
 

Distinctive Upscale Casual Dining Experience. Our upscale 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 upscale 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.

 

 
1

 

 

 

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 24.0% of our total sales during 2016, 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, 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 2016, the average unit volume of our comparable base restaurants was $4.5 million. We believe our high 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 $2.6 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.

 

 
2

 

 

We achieved a unit growth rate of 22% for 2016, with eight openings during the year and grew 23% during 2015 with seven restaurant openings. We plan to open three restaurants in 2017. We are adjusting our projected growth rate for 2017 below our previously targeted growth rate of 20%. We believe that a more moderate growth rate will provide us the flexibility to allocate capital resources, increase our earnings and strengthen our balance sheet as well as, to focus our time and attention on new restaurant operations and performance.

 

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. We continue working diligently to build our pipeline for future growth.

 

In addition, we continue to execute our strategy for international market expansion. Given the strength our concept has enjoyed thus far in the U.S. and the increased demand for upscale 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 an international presence, we are utilizing a franchise model for development outside of 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. During the first half of 2016, we announced agreements for the development and franchising of six Kona Grill restaurants in Mexico and six restaurants in the United Arab Emirates over the next seven years. We expect each of our international franchise partners to open a Kona Grill restaurant in their respective country during 2017.

 

Grow Existing Restaurant Sales

 

Our goal for existing restaurants is to increase unit volumes through the execution of our differentiated business model and complemented 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. We believe the strength of our differentiated concept and the appeal of our new design enables us to gain market share, as evidenced by positive same-store sales growth in each of the last six years. Our restaurant sales for comparable base restaurants, which include those units open for more than 18 months, increased 0.5% compared to 2015. The increase reflects a 2.4% increase in average check per person customer partially offsetting a 1.9% decrease in customer traffic.

 

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. We have enhanced our cocktail and wine list and continue to 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. We offer online ordering for the convenience of our customers and have also partnered with several companies for delivery services to drive incremental sales growth.

 

Furthermore, we continue to focus on the quality of our service and hospitality 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 280,000 members. 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 social software platform to aggregate feedback posted by our customers on various social media sites to ensure that our management team can review and respond to our customers’ comments immediately. We believe we can generate additional sales through these programs at a reasonable cost per restaurant.

 

 
3

 

 

Continue Strategic Investments in Personnel and Systems

 

We believe that successful execution of our growth strategies will enable Kona Grill to be a leading upscale casual dining restaurant operator in the U.S. During the past three years, we have made strategic personnel investments in order to build the foundation for the expansion of our concept and will continue making incremental investments to support our new unit expansion and international business development initiatives. Additionally, we continue to implement software and tools to enhance our business while ensuring that strong financial controls are in place to minimize risks associated with our 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 U.S. 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 at least one member of the Real Estate Committee visits the prospective site and evaluate the proposed economics of the restaurant based on demographic data and other relevant criteria to assure that the site meets our criteria for anticipated return on investment.

 

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 attempt to 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.

 

 
4

 

 

We believe our high 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 lifestyle 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 30% 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. Our targeted margin for mature restaurants ranges from 18% to 19%. The cash-based performance target for our operating 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 $2.6 million, net of landlord tenant improvement allowances averaging between $0.7 million and $1.2 million, and excluding cash preopening expenses of approximately $450,000.

 

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 2016.

 

2016 Sales by Daypart

   

Sales

   

Percent

 
   

(Dollars in thousands)

 

Lunch (Open to 3 p.m.)

  $ 41,987       24.8 %

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

    86,849       51.2 %

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

    40,687       24.0 %

Total All Day

  $ 169,523       100.0 %

 

Menu

 

Our menu features a selection of appetizers, salads, soups, flatbreads, sandwiches, noodles, seafood, signature entrees, and desserts. 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.

 

We also offer an 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. Sushi sales accounted for 25.6% of our total restaurant sales during 2016.

 

 
5

 

 

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.

 

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 catering, 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 29% of our total restaurant sales during 2016.

 

Decor and Atmosphere

 

We design our restaurants to offer 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 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. 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. Certain of our locations offer private dining rooms for parties, special occasions and business events. Additionally, three of our restaurants feature a rooftop patio and we enclose 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.

 

 
6

 

 

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 extensive training 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, requirements. 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. Further, to monitor and ensure compliance with required guidelines, we evaluate all of our employees on their ability to maintain sanitary conditions in their respective restaurants. Restaurants are subjected to six mandatory inspections annually, including two from the local state, county or municipal inspector and four quarterly inspections from an independent third party service provider.

 

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. We have arrangements with national and local distributors and specialty food suppliers who provide high-quality ingredients and perishable food products. These distributors and suppliers are required to comply with food safety guidelines mandated by HACCP, the Food & Drug Administration and local statutes and regulations of the particular state, county or municipality. Additionally, our corporate food and beverage team performs site visits and periodic inspections of the distribution centers to verify that the conditions of their infrastructure and delivery fleet comply with our operational cleanliness requirements.

 

Our goal is to maximize purchasing efficiencies and obtain the lowest possible prices for ingredients, products, and supplies, while maintaining the highest quality. 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 believe that competitively priced alternative distribution sources are available should those channels be necessary. 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 six 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 process improvements 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 and three regional culinary partners who are responsible for educating, coaching, and developing kitchen personnel, implementing process enhancements to improve the efficiency of kitchen operations, and developing new menu offerings.

 

 
7

 

 

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 kitchen 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 at one of our certified training restaurants that is comprised of a mix of online 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 high 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 upscale casual restaurants. We believe our compensation policies help us attract quality personnel.

 

 
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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.

 

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 accounting 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 have invested, and 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 global menu of contemporary American favorites, award-winning sushi items and specialty cocktails;
     
 

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 upscale casual dining experience and enables us to attract a broad customer demographic.

 

 
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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 or negative publicity relating to food safety 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.

 

Trademarks

 

We have registered the service marks “Kona Grill” and “Konavore” with the United States Patent and Trademark Office and “Kona Grill” in certain foreign jurisdictions. 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.

 

 
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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.

 

Employees

 

As of February 24, 2017, we employed 4,066 people of whom 3,996 worked in our restaurants and 70 were employed at our corporate office. 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; Code of Ethics for the Chief Executive Officer and Senior Financial Officers; Insider Trading Policy 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

 

Changes in general economic conditions, including economic uncertainty, have adversely impacted our business and results of operations and may continue to do so.

 

Purchases at our restaurants are discretionary for consumers and we are therefore susceptible to economic slowdowns. We believe that consumers generally are more willing to make discretionary purchases during favorable economic conditions. Economic and political uncertainty, financial market volatility and unpredictability, and the oversupply of restaurants in the U.S can all negatively affect customer traffic and sales throughout our industry. If the economy experiences a downturn or continued uncertainties, our customers may further reduce their level of discretionary spending, impacting the frequency with which they choose to dine out or the amount they spend on meals while dining out.

 

There is also a risk that if uncertain economic conditions persist for an extended period of time or worsen, consumers might make long-lasting changes to their discretionary spending behavior, including dining out less frequently. The ability of the U.S. economy to handle this uncertainty is likely to be affected by many national and international factors that are beyond our control. These factors, including national, regional and local politics and economic conditions, disposable consumer income and consumer confidence, also affect discretionary consumer spending. Continued uncertainty in or a worsening of the economy, generally or in a number of our markets, and our customers’ reactions to these trends could adversely affect our revenues and cause us to, among other things, reduce the number and frequency of new restaurant openings, close restaurants and delay remodeling of existing locations.

 

 
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Our sales and ability to generate profits could be adversely affected if comparable restaurant sales 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 have increased over the past six years. However, 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;

 

 

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;

 

 

negative publicity relating to food safety or quality;

 

 

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

 

 

changes in government regulation.

 

 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.

 

 
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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 have required us to record an impairment charge for restaurants performing below expectations, and may result in future impairments.

 

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, changes in demographic and economic patterns in neighborhoods and trade areas where our restaurants are located, higher frequency of online shopping, changes in discretionary consumer spending, changes in gasoline prices, or otherwise. If visitor rates to these centers decline, our unit volumes could decline and adversely affect our results of operations. We recorded long-lived asset impairment charges of $12.5 million, for the year ended December 31, 2016. Such amounts are included in "Asset impairment charge" in the Consolidated Statement of Comprehensive Income (Loss). (See Note 2 in the Notes to the Consolidated Financial Statements for further details on the impairment charges). We may be required to record impairment charges in the future if certain restaurants perform below expectations.

 

Our failure to satisfy financial covenants and/or repayment requirements under our credit facility could harm our financial condition which could materially adversely affect our financial performance.

 

We have a secured credit facility consisting of a $45 million revolver and a $15 million term loan with a conditional increase feature that could provide for an additional $25 million in available credit (collectively, the “Credit Facility”) The Credit Facility requires us to maintain certain financial covenants. At December 31, 2016, we were in compliance with these covenants. However, any failure to maintain these debt covenants or have sufficient liquidity to repay the then outstanding balance at the expiration of the Credit Facility, or upon violation of the covenants, would materially adversely affect our financial condition and performance. Although we were in compliance with all covenants as of December 31, 2016, there is a high likelihood that we will not be in compliance with the leverage ratio requirement at March 31, 2017.  As a result, we have engaged KeyBank, as lead bank, to enter into an amendment of the Credit Facility by March 31, 2017. We believe it is probable that an amendment will be executed and we will be in compliance with all covenants at March 31, 2017. However, in the event that we do not enter into any such amendment as expected by March 31, 2017, we will be in default of our covenants and the lenders have various remedies which could materially adversely affect our financial condition and performance.

 

Our future growth depends in part on our ability to open new restaurants and operate them profitably, and if we are unable to successfully execute this strategy, our results of operations could be adversely affected.

 

Our financial success depends in part on management’s ability to execute our growth strategy. One key element of our growth strategy is opening new restaurants. We opened eight restaurants during 2016 and expect to open three additional restaurants in 2017. Our ability to open new restaurants and operate them profitably is dependent upon a number of factors, many of which are beyond our control, including:

 

 

finding quality sites, competing effectively to obtain quality sites and reaching acceptable agreements to lease sites;

 

 

complying with applicable zoning, land use and environmental regulations and obtaining, for an acceptable cost, required permits and approvals;

 

 

having adequate capital for construction and opening costs and efficiently managing the time and resources committed to building and opening each new restaurant;

 

 

timely hiring and training and retaining the skilled management and other employees necessary to meet staffing needs;

 

 

successfully promoting our concept and competing in new markets;

 

 
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acquiring food and other supplies for new restaurants from local suppliers; and

 

 

addressing unanticipated problems or risks that may arise during the development or opening of a new restaurant or entering a new market.

 

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. 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.

 

Additionally, a new restaurant typically experiences a “ramp-up” period of approximately 18 months or more before it achieves our targeted level of performance. This is due to the costs associated with opening a new restaurant, as well as higher operating costs caused by start-up and other temporary inefficiencies associated with opening new restaurants. For example, there are a number of factors which may impact the amount of time and money we commit to the construction and development of new restaurants, including landlord delays, shortages of skilled labor, labor disputes, shortages of materials, delays in obtaining necessary permits, local government regulations and weather interference. Once the restaurant is open, how quickly it achieves a desired level of profitability is impacted by many factors, including the level of market familiarity and acceptance when we enter new markets, as well as the availability of experienced staff and the time required to negotiate reasonable prices for services and other supplies from local suppliers. Our business and profitability may be adversely affected if the “ramp-up” period for a new restaurant lasts longer than we expect.

 

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 over the next several years by strategically expanding the Kona Grill concept in both new and existing markets. We plan to open three new restaurants in 2017.

 

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;

 

 

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;

 

 

obstacles to hiring and training qualified operating personnel in the local market, especially in highly competitive hiring environment;

 

 

inclement weather, impact of climate change, natural disasters and other calamities; and

 

 

general economic conditions.

 

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.

 

Our domestic and international growth and planned remodeling of 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 three new restaurants during 2017. 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 along with supporting our international franchise partners with their new restaurant openings 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.

 

Due to our limited number of existing restaurants and the significant expenses required to open new restaurants, any decision to either reduce or accelerate the pace of openings may cause our future operating results to fluctuate significantly and 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. We expect the cash investment cost of our prototype restaurant on average to be approximately $2.6 million, net of landlord tenant improvement allowances averaging between $0.7 million and $1.2 million and excluding approximately $450,000 in cash preopening expenses. 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 sales volumes of our new restaurants may cause our results of operations to fluctuate significantly. Further, 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 for a particular period and perception of our company, making the investment risks related to any one location more significant than those associated with larger restaurant companies who have substantially greater financial and other resources. 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.

 

 
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We may not be successful in our international franchise initiative or such expansion may adversely affect our financial performance.

 

We are expanding into international markets, initially in Mexico and the United Arab Emirates where we have executed development agreements. Similar to other brands with an international presence, we are utilizing a franchise model for development outside of 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. It takes 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 then need to train the local team on our food and hospitality standards to ensure a successful execution of our strategy.

 

As we continue to pursue 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. Additionally, 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; however, there is risk that our brand value or financial results 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 U.S.;

 

 

changes to our recipes 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 U.S. 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 have not had exposure prior to our international expansion. 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.

 

Adverse weather conditions, impact of climate change and natural disasters could adversely affect our results of operations. Additionally, we may not be able to obtain insurance at reasonable rates for natural disasters and other events which are beyond our control.

 

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. Increasing frequency and unpredictability of adverse weather conditions due to climate change may result in decreased customer traffic. 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.

 

Additionally, although we insure our restaurants against wind, flood, and other disasters, 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.

 

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, 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.

 

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. 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. 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.

 

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. As privacy and information security laws and regulations change, we may incur additional costs to ensure that we remain in compliance, which could have a material adverse effect on our financial performance.

 

 
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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. We adopted a qualifying plan under the Affordable Care Act for our eligible variable-hour employees, which has increased and is expected to increase our labor costs significantly. However, our employees may or may not choose to participate in our healthcare plans. It is also possible that the recent changes in the healthcare plans we offer could make us less attractive to our current or potential employees. Additionally, 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 29% of our sales during 2016. 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.

 

A failure to maintain food safety throughout the supply chain and food-borne illness concerns may have an adverse effect on our business.

 

Food safety is a top priority, and we dedicate substantial resources to ensuring that our guests enjoy safe, quality food products. However, food safety issues could be caused at the point of source or by food suppliers or distributors and, as a result, may be out of our control. In addition, regardless of the source or cause, any report of food-borne illnesses such as E. coli, hepatitis A, trichinosis or salmonella, and other food safety issues including food tampering or contamination, at one of our restaurants could adversely affect the reputation of our brand and have a negative impact on our sales. Even instances of food-borne illness, food tampering or food contamination occurring solely at restaurants of our competitors could result in negative publicity about the food service industry generally and adversely impact our sales and could result in stricter government regulation, which could increase our costs. The occurrence of food-borne illnesses or food safety issues could also adversely affect the price and availability of affected ingredients, resulting in higher costs and lower margins.

 

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.

 

 
20

 

 

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.

 

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 and other 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 menu prices proportionately in order to mitigate these increased costs, 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 and growth projections we may provide to the public, any changes in such guidance and projections, or our failure to meet such guidance and projections;

 

 

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;

 

 
21

 

 

 

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

 

 

changes in 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, including short selling by investors;

 

 

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 25% 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, 2016, we had outstanding 10,452,030 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 1,753,068 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 stock repurchase program, which could have an adverse effect on the market price of our common stock.

 

We completed the $10 million stock repurchase program in June 2016 with the purchase and retirement of 832,937 shares under an authorization by our Board of Directors in November 2015. We completed an additional $5 million stock repurchase program in February 2017 with the purchase and retirement of 532,376 shares under an authorization by our Board of Directors in October 2016. Any further stock purchase authorizations, and the timing and number of shares purchased under such authorizations, 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. Delaware law also imposes conditions on the voting of “control shares” and on certain business combination transactions with “interested stockholders.” In addition, our certificate of incorporation 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. These provisions may also limit the ability of stockholders to approve transactions that they may deem to be in their best interests.

 

We have a stockholder rights plan (known as a “poison pill”) which could affect our common stock price and make it more difficult for a potential acquirer to purchase a large portion of our securities, to initiate a tender offer or a proxy contest, or to acquire us.

 

In September 2016, our Board of Directors adopted a Stockholder Rights Plan, commonly known as a “poison pill,” with a term through September 2019. This poison pill may discourage, delay or prevent a third party from acquiring a large portion of our securities, initiating a tender offer or proxy contest, or acquiring us through an acquisition, merger or similar transaction even if our stockholders might receive a premium for their stock over the then-current market price in the event of such transaction.

 

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 may not purchase our common stock.

 

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 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.

 

While we have determined that our internal control over financial reporting was effective as of December 31, 2016, 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.

 

 
23

 

  

Item 1B.   Unresolved Staff Comments

 

Not applicable.

 

Item 2.     Properties

 

We currently operate 45 restaurants in 23 states and Puerto Rico. Each of our restaurants and our corporate office are located in a leased facility. As of December 31, 2016, our restaurant leases had expiration dates ranging from 2017 to 2029, typically with options to renew for at least a five-year period. The average interior square footage of our restaurants is approximately 7,300 square feet. Many of our restaurants also have outdoor patios that are utilized when weather conditions permit. The following table sets forth our current restaurant locations and corporate office.

 

 

State

 

 

City

 

 

Location

 

Year
Opened

Arizona

 

Scottsdale

 

Scottsdale Fashion Square

 

1998

Arizona

 

Chandler

 

Chandler Fashion Center

 

2001

Missouri

 

Kansas City

 

Country Club Plaza

 

2002

Nevada

 

Las Vegas

 

Boca Park Fashion Village

 

2003

Colorado

 

Denver

 

Cherry Creek Mall

 

2004

Nebraska

 

Omaha

 

Village Pointe

 

2004

Indiana

 

Carmel

 

Clay Terrace

 

2004

Texas

 

San Antonio

 

The Shops at La Cantera

 

2005

Texas

 

Dallas

 

North Park Mall

 

2006

Illinois

 

Lincolnshire

 

Lincolnshire Commons

 

2006

Texas

 

Houston

 

Houston Galleria

 

2006

Illinois

 

Oak Brook

 

Oak Brook Promenade

 

2006

Texas

 

Austin

 

The Domain

 

2007

Michigan

 

Troy

 

Big Beaver Road

 

2007

Connecticut

 

Stamford

 

Stamford Town Center

 

2007

Louisiana

 

Baton Rouge

 

Perkins Rowe

 

2007

Arizona

 

Gilbert

 

San Tan Village

 

2008

Arizona

 

Phoenix

 

City North

 

2008

Virginia

 

Richmond

 

West Broad Village

 

2009

New Jersey

 

Woodbridge

 

Woodbridge Conference Center

 

2009

Minnesota

 

Eden Prairie

 

Windsor Plaza

 

2009

Florida

 

Tampa

 

MetWest International

 

2009

Maryland

 

Baltimore

 

Downtown Baltimore

 

2010

Idaho

 

Boise

 

The Village at Meridian

 

2013

Texas

 

The Woodlands

 

The Woodlands Town Center

 

2013

Texas

 

Fort Worth

 

West 7th

 

2014

Texas

 

El Paso

 

Fountains at Farah

 

2014

Florida

 

Sarasota

 

University Town Center

 

2014

Georgia

 

Alpharetta

 

Avalon

 

2014

Ohio

 

Columbus

 

Easton Town Center

 

2014

Puerto Rico

 

San Juan

 

Mall of San Juan

 

2015

Texas

 

Plano

 

West Plano Village

 

2015

Virginia

 

Arlington

 

Rosslyn-Ballston Corridor

 

2015

Florida

 

Miami

 

Dolphin Mall

 

2015

Ohio

 

Cincinnati

 

Liberty Center

 

2015

Nevada

 

Las Vegas

 

Fashion Show Mall

 

2015

Texas

 

Friendswood

 

Baybrook Mall

 

2015

Alabama

 

Huntsville

 

Bridge Street Town Centre

 

2016

Hawaii

 

Honolulu

 

International Market Place

 

2016

Tennessee

 

Franklin

 

CoolSprings Galleria

 

2016

Virginia

 

Fairfax

 

Fair Oaks Mall

 

2016

Minnesota

 

Minnetonka

 

Ridgedale Center

 

2016

California

 

Irvine

 

Irvine Spectrum Center

 

2016

Florida

 

Winter Park

 

Lakeside Crossing

 

2016

Texas

 

San Antonio

 

North Star Mall

 

2016

Arizona

 

Scottsdale

 

Corporate Office at Scottsdale Fashion Square

 

2004

 

 
24

 

 

Item 3.

Legal Proceedings

 

See Note 9 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

 

2016

               

First quarter

  $ 16.71     $ 12.09  

Second quarter

  $ 14.08     $ 10.34  

Third quarter

  $ 14.09     $ 9.99  

Fourth quarter

  $ 13.50     $ 10.05  

2015

               

First quarter

  $ 28.42     $ 22.26  

Second quarter

  $ 27.66     $ 18.50  

Third quarter

  $ 21.23     $ 15.75  

Fourth quarter

  $ 17.58     $ 12.32  

 

On February 24, 2017, the closing sale price of our common stock was $7.90 per share. On February 28, 2017, there were 16 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

 

In November 2015, our Board of Directors authorized a repurchase program of up to $10 million of our outstanding common stock. We completed the $10 million stock repurchase program in June 2016 with the purchase and retirement of 832,937 shares under the 2015 authorization.

 

In October 2016, our Board of Directors authorized an additional stock repurchase of up to $5.0 million of outstanding common stock. We completed the $5 million stock repurchase program in February 2017 with the purchase and retirement of 532,376 shares.

 

 

 

Period

 

Total Number of

Shares

Purchased

   

Average Price

Paid per Share

   

Total Number of

Shares

Purchased as

Part of Publicly

Announced Plan

   

Approximate

Dollar Value of

Shares that May

Yet Be Purchased

Under the Plan

 

November 2016

    136,790     $ 10.42       136,790     $ 3,573,000  

Total

    136,790     $ 10.42       136,790          

 

 
26

 

 

PRICE PERFORMANCE GRAPH

 

The following line graph compares cumulative total stockholder returns for the period from December 31, 2011 through December 31, 2016 for (1) our common stock; (2) the NASDAQ Composite (U.S.) Index; (3) the old peer group; and (4) the new 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 old peer group consists of BJ’s Restaurants, Inc.; Bravo Brio Restaurant Group, Inc.; Granite City Food & Brewery Ltd.; and The Cheesecake Factory Incorporated. The new peer group includes the addition of J. Alexander's Holdings, Inc. Our peer group companies all compete in the upscale 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.

 

 

 
27

 

 

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,  
      2016       2015       2014       2013       2012  
      (In thousands, except per share data)  
Statement of Comprehensive Income (Loss) Data:                                        

Restaurant sales

  $ 169,523     $ 143,023     $ 119,097     $ 98,250     $ 96,021  

Costs and expenses:

                                       

Cost of sales

    45,314       38,803       32,964       26,853       26,246  

Labor

    62,027       50,187       40,336       33,166       31,968  

Occupancy

    13,754       10,528       8,061       6,702       6,253  

Restaurant operating expenses

    24,740       20,293       16,358       13,456       13,534  

General and administrative

    13,272       12,612       10,715       7,854       7,037  

Preopening expense

    4,533       4,746       2,481       1,162        

Depreciation and amortization

    14,421       9,966       7,220       5,918       5,749  

Asset impairment charge

    12,454                          

Other

          161             32       (120 )

Total costs and expenses

    190,515       147,296       118,135       95,143    

 

90,667  

Income (loss) from operations

    (20,992 )     (4,273 )     962       3,107       5,354  

Write off of deferred financing costs

                39       66        

Interest expense, net

    571       180       220       160       66  

Income (loss) before income taxes

    (21,563 )     (4,453 )     703       2,881       5,288  

Income tax expense

    66       43             169       36  

Income (loss) from continuing operations

    (21,629 )     (4,496 )     703       2,712       5,252  

Loss from discontinued operations, net of taxes (1)

                            466  

Net income (loss)

  $ (21,629 )   $ (4,496 )   $ 703     $ 2,712     $ 4,786  
                                         

Net income (loss) per share — Basic:

                                       

Continuing operations

  $ (2.00 )   $ (0.40 )   $ 0.07     $ 0.32     $ 0.60  

Discontinued operations

                            (0.05 )

Net income (loss)

  $ (2.00 )   $ (0.40 )   $ 0.07     $ 0.32     $ 0.55  
                                         

Net income (loss) per share — Diluted:

                                       

Continuing operations

  $ (2.00 )   $ (0.40 )   $ 0.07     $ 0.31     $ 0.59  

Discontinued operations

                            (0.05 )

Net income (loss)

  $ (2.00 )   $ (0.40 )   $ 0.07     $ 0.31     $ 0.54  
                                         

Weighted average shares outstanding:

                                       

Basic

    10,791       11 264       9,870       8,573       8,726  

Diluted

    10 791       11 264       10,263       8,762       8,868  
                                         

Balance Sheet Data (at end of period):

                                       

Cash and cash equivalents

  $ 3,476     $ 9,055     $ 36,578     $ 5,881     $ 7,989  

Investments

    178       178       178       177       177  

Working capital (deficit)

    (10,545 )     (5,466 )     27,018       (6,476 )     1,044  

Total assets

    108,383       101,844       94,370       49,868       39,325  

Total debt

    26,633                   3,500       370  

Total stockholders’ equity

    31,575       62,691       65,426       22,358       18,868  

_________________________

 

(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 the applicable periods presented.

 

 
28

 

 

Item 7.

Management’s 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 currently anticipated 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 45 restaurants located in 23 states and Puerto Rico. Over the past three years, we have grown organically through opening new restaurants. We achieved a unit growth rate of 22% for 2016, with eight openings during the year and 23% unit growth in 2015 with seven restaurant openings. We plan to open three restaurants during 2017, which is below our previous targeted growth rate of 20%. We believe that a more modest growth rate will provide us the flexibility to allocate capital resources, increase our earnings and strengthen our balance sheet as well as to focus our time and attention on new restaurant operations and performance.

 

We continue to execute our strategy for international market expansion. Given the strength our concept has enjoyed thus far in the U.S. and the increased demand for upscale casual dining concepts overseas, we believe there is a significant opportunity to expand our concept in Latin America, the Middle East and beyond. In February 2016, we announced an agreement for the development of six Kona Grill restaurants in Mexico and in April 2016, we signed an agreement for the development of six Kona Grill restaurants in the United Arab Emirates. We expect each of our international franchise partners to open a Kona Grill restaurant in their respective country during 2017.

 

We continue to focus on growing sales and successfully opening new restaurants. Our same-store sales increased 0.5% year over year, with 2.4% growth in check average partially offsetting a 1.9% decrease in customer traffic. We have generated positive same-store sales in each of the past six years.

 

Our restaurant operating profit, defined as restaurant sales minus cost of sales, labor, occupancy, and restaurant operating expenses, increased to $23.7 million or 2.0% from $23.2 million in 2015. Restaurant operating profit as a percentage of restaurant sales of 14.0% in 2016 included new restaurant operating inefficiencies for 12 locations that opened since October 2015. Restaurant operating profit as a percentage of restaurant sales of 16.2% in 2015 included new restaurant operating inefficiencies for 10 locations opened since October 2014. See “Key Measures” and “Financial Performance Overview” below for further information on restaurant operating profit and Adjusted EBITDA, including a reconciliation to income (loss) from operations.

 

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 up to twelve months to achieve the majority of operating efficiencies as a result of challenges typically associated with opening and operating new restaurants, including lack of market recognition and the need to hire and sufficiently train employees, as well as other factors. 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 which we expect will continue until these restaurants mature.

 

 
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.

 

Operating Weeks. Operating weeks represent the number of weeks that our restaurants were open during the reporting period.

 

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

 

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

 

Restaurant Operating Profit. Restaurant operating profit is defined as 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.

 

EBITDA and Adjusted EBITDA. EBITDA is defined as net income (loss) plus the sum of interest, taxes, depreciation and amortization. Adjusted EBITDA is defined as EBITDA plus preopening expense, asset impairment charge, stock-based compensation, and unusual or non-recurring items. EBITDA and Adjusted EBITDA are presented because: (i) we believe it is a useful measure for investors to assess the operating performance of our business 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 EBITDA and 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.

 

 
30

 

 

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.

 

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, 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 $450,000 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.

 

Income Tax Expense. Expense for income taxes represents amounts due for federal and state income taxes.

 

Financial Performance Overview

 

The following table sets forth certain information regarding our financial performance for 2016, 2015 and 2014:

 

      Year Ended December 31,  
      2016       2015       2014  

Restaurant sales growth

    18.5

%

    20.1

%

    21.2

%

Same-store sales percentage change

    0.5

%

    2.0

%

    3.8

%

Average unit volume (in thousands)

  $ 4,531     $ 4,506     $ 4,433  

Sales per square foot

  $ 630     $ 625     $ 627  

Restaurant operating profit (in thousands)

  $ 23,688     $ 23,212     $ 21,378  

Restaurant operating profit as a percentage of sales

    14.0

%

    16.2

%

    18.0

%

EBITDA (in thousands)

  $ (6,571   $ 5,693     $ 8,143  

EBITDA as a percentage of sales

    (3.9

)%

    4.0

%

    6.8

%

Adjusted EBITDA (in thousands)

  $ 11,678     $ 11,963     $ 11,519  

Adjusted EBITDA as a percentage of sales

    6.9

%

    8.4

%

    9.7

%

 

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

 

    Year Ended December 31,  
   

2016

   

2015

   

2014

 
   

(In thousands)

 

Net income (loss)

  $ (21,629 )   $ (4,496 )   $ 703  

Income tax expense (benefit)

    66       43        

Interest expense, net

    571       180       220  

Depreciation and amortization

    14,421       9,966       7,220  

EBITDA

  $ (6,571   $ 5,693     $ 8,143  

Preopening expense

    4,533       4,746       2,481  
Asset impairment charge     12,454              

Stock-based compensation

    1,262       1,363       856  

Other

          161        

Write-off of deferred financing costs

                39  

Adjusted EBITDA

    11,678       11,963       11,519  

General and administrative

    13,272       12,612       10,715  

Stock-based compensation

    (1,262 )     (1,363 )     (856 )

Restaurant operating profit

  $ 23,688     $ 23,212     $ 21,378  

 

   

Percent of Restaurant Sales

 
   

Year Ended December 31,

 
   

2016

   

2015

   

2014

 

Net income (loss)

    (12.8 )%     (3.1 )%     0.6 %

Income tax expense (benefit)

    0.0       0.0        

Interest expense, net

    0.3       0.1       0.2  

Depreciation and amortization

    8.5       7.0       6.0  

EBITDA

    (3.9     4.0       6.8  

Preopening expense

    2.7       3.3       2.1  
Asset impairment charge     7.3              

Stock-based compensation

    0.7       1.0       0.7  

Other

          0.1        

Write-off of deferred financing costs

                0.0  

Adjusted EBITDA

    6.9       8.4       9.7  

General and administrative

    7.8       8.8       9.0  

Stock-based compensation

    (0.7 )     (1.0 )     (0.7 )

Restaurant operating profit

    14.0 %     16.2 %     18.0 %

 

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

 

Store Growth Activity

 

   

2016

   

2015

   

2014

 
                         

Number of Restaurants at Beginning of Year

    37       30       25  

Openings

    8       7       5  

Total

    45       37       30  

 

 
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Results of Operations

 

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

 

      Year Ended December 31,  
      2016       2015       2014  

Restaurant sales

    100.0 %     100.0 %     100.0 %

Costs and expenses:

                       

Cost of sales

    26.7       27.1       27.7  

Labor

    36.6       35.1       33.9  

Occupancy

    8.1       7.4       6.8  

Restaurant operating expenses

    14.6       14.2       13.7  

General and administrative

    7.8       8.8       9.0  

Preopening expense

    2.7       3.3       2.1  

Depreciation and amortization

    8.5       7.0       6.1  

Asset impairment charge

    7.3              

Other

          0.1        

Total costs and expenses

    112.4       103.0       99.2  

Income (loss) from operations

    (12.4 )     (3.0 )     0.8  

Write off of deferred financing costs

                0.0  

Interest expense, net

    0.3       0.1       0.2  

Income (loss) before income taxes

    (12.7 )     (3.1 )     0.6  

Income tax expense

                 

Net income (loss)

    (12.8 )%     (3.1 )%     0.6 %

 

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

 

Year Ended December 31, 2016 Compared with Year Ended December 31, 2015

 

Restaurant Sales. Restaurant sales increased 18.5% to $169.5 million during 2016 from $143.0 million in 2015, primarily due to a 24% increase in the number of operating weeks and same-store sales growth of 0.5% year over year. The increase is primarily due to restaurant sales generated by eight restaurants opened during 2016 and a full year of sales for seven restaurants that opened during 2015.

 

Cost of Sales. Cost of sales increased $6.5 million, or 16.8% to $45.3 million in 2016 compared to $38.8 million in 2015, with the increase primarily attributable to our new locations opened since the beginning of the fourth quarter of 2015. As a percentage of restaurant sales, cost of sales was 26.7% compared to 27.1% in the prior year, primarily reflecting improved kitchen efficiencies and favorable commodity pricing for poultry, produce and dairy products compared to 2015.

 

Labor. Labor expense for our restaurants increased to $62.0 million from $50.2 million in 2015, an increase of 23.6%, primarily due to the twelve new restaurants opened since the beginning of the fourth quarter of 2015. Labor expenses as a percentage of restaurant sales increased to 36.6% compared to 35.1% in the prior year, reflecting labor inefficiencies from our newly opened locations, increased wage costs due to certain state or local mandated minimum wage increases and a competitive labor market, and higher benefit costs. We expect labor cost as a percentage of sales to typically trend higher upon opening and gradually improve as our new restaurant management and employees become more efficient in operating their restaurants.

 

Occupancy. Occupancy expenses increased $3.2 million or 30.6% to $13.8 million year over year, primarily associated with base rent and common area maintenance charges for twelve new locations opened since the beginning of the fourth quarter of 2015. Occupancy expenses as a percentage of restaurant sales were 8.1% in 2016 compared to 7.4% in 2015.

 

 
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Restaurant Operating Expenses. Restaurant operating expenses increased $4.4 million, or 21.9%, to $24.7 million in 2016, primarily due to the additional operating expenses for twelve new restaurants opened since the beginning of the fourth quarter of 2015. Restaurant operating expenses as a percentage of restaurant sales were 14.6% and 14.2% in 2016 and 2015, respectively. The year over year increase was driven in part by higher repair and maintenance costs, marketing expenses, professional services and training-related travel costs.

 

General and Administrative. General and administrative expenses increased in absolute dollars by $0.7 million, or 5.2% to $13.3 million from $12.6 million year over year; however, these expenses decreased as a percentage of sales to 7.8% in 2016 compared to 8.8% in the prior year. Increased payroll, benefit costs and recruiting fees associated with additional headcount to support our unit growth expansion, higher audit fees and increased legal and professional fees contributed to the year over year increase in absolute dollars, partially offset by lower incentive compensation.

 

Preopening Expense. Preopening expense was $4.5 million in 2016 compared to $4.7 million in 2015, including non-cash rent of $1.1 million and $1.2 million, respectively. Preopening expense in 2016 related to our Irvine, Fairfax, and Minnetonka restaurants opened in the second quarter of 2016, the Nashville, and Waikiki restaurants opened in the third quarter of 2016, and the Huntsville, Winter Park, and San Antonio locations opened in the fourth quarter of 2016, in addition to non-cash rent for two openings scheduled for the first half of 2017. Preopening expense in 2015 related to our San Juan restaurant opened in the first quarter of 2015, the Plano and Arlington restaurants opened in the second quarter of 2015, the Miami, Cincinnati, Las Vegas and Friendswood locations opened in the fourth quarter of 2015 and preparations for openings in the first half of 2016.

 

Depreciation and Amortization. Depreciation and amortization expense increased $4.4 million or 44.7% to $14.4 million year over year, primarily attributable to the incremental depreciation expense for eight restaurants opened during 2016 and a full year of depreciation expense for seven restaurants that opened during 2015 as well as depreciation expense associated with the Boca Park and Kansas City remodels. Depreciation and amortization expense as a percentage of restaurant sales was 8.5% and 7.0% of restaurant sales in 2016 and 2015, respectively.

 

Asset Impairment Charge. During 2016, we recorded a non-cash asset impairment charge of $12.5 million related to the write-down of certain long-lived assets associated with five underperforming restaurants. The asset impairment charges were based upon an assessment of each restaurant’s historical operating performance combined with expected cash flows for that restaurants over the respective remaining lease term. We have no plans to close any of these restaurants; however, we will continue to evaluate each of these restaurants to determine whether operating performance can be improved.

 

Other Expenses. Other expenses of $0.2 million in 2015 primarily related to an expected settlement of a state use tax audit.

 

Interest Expense, Net. Interest expense increased to $0.6 million year-over-year due to borrowings under the credit facility. We used the majority of the borrowings to fund new restaurant construction and remodel activities in 2016. We did not borrow from the credit facility during 2015.

 

Income Tax Expense. We recorded income tax expense of $66,000 and $43,000 for 2016 and 2015, respectively. Income tax expense for 2016 and 2015 relate to state income tax expense for which no net operating loss carryforwards or other credits exist partially offset by refunds primarily associated with previous year state income tax. We did not recognize any federal income tax benefit in 2016 or 2015 due to projected net operating loss carryforwards expected to be generated from tax planning strategies and available credits to offset taxable income.

 

 
34

 

 

Year Ended December 31, 2015 Compared with Year Ended December 31, 2014

 

Restaurant Sales. Restaurant sales increased $23.9 million or 20.1% in 2015, primarily attributable to a 19.4% increase in the number of operating weeks. Our same-store sales increased 2.0% year over year, with a 2.6% growth in average check resulting from a 1.5% menu price increase in April 2015 and a shift in menu mix partially offset by a 0.6% decrease in customer traffic. The 2.0% same-store sales growth in 2015 compares to a 3.8% increase in same-store sales in 2014.

 

Cost of Sales. Cost of sales increased $5.8 million, or 17.7% to $38.8 million in 2015 compared to $33.0 million in 2014, with the increase primarily attributable to our new locations opened since the beginning of the fourth quarter of 2014. As a percentage of restaurant sales, cost of sales was 27.1% compared to 27.7% in the prior year, primarily reflecting improved kitchen efficiencies for both our comparable and non-comparable restaurants and favorable commodity pricing on chicken, pork and shrimp compared to 2014.

 

Labor. Labor expense for our restaurants increased to $50.2 million, or 24.4%, from $40.3 million in 2014 primarily attributable to the nine new restaurants opened since the beginning of the fourth quarter of 2014. Labor expenses as a percentage of restaurant sales increased to 35.1% compared to 33.9% in the prior year, reflecting labor inefficiencies from our newly opened locations, increased overtime hours associated with staffing shortages from a tight labor market and higher benefit costs. We expect labor cost as a percentage of sales to typically trend higher upon opening and gradually improve as our new restaurant management and employees become more efficient in operating their restaurants.

 

Occupancy. Occupancy expenses increased $2.5 million or 30.6% to $10.5 million year over year, primarily associated with base rent and common area maintenance charges for new locations opened since the beginning of the fourth quarter of 2014. Occupancy expenses as a percentage of restaurant sales were 7.4% in 2015 compared to 6.8% in 2014.

 

Restaurant Operating Expenses. Restaurant operating expenses increased $3.9 million, or 24.1%, to $20.3 million in 2015, primarily due to the additional operating expenses for the new restaurants opened since the beginning of the fourth quarter of 2014. Restaurant operating expenses as a percentage of restaurant sales were 14.2% and 13.7% in 2015 and 2014, respectively. The year over year increase was driven by higher utilities, marketing expenses, professional services and training-related travel costs.

 

General and Administrative. General and administrative expenses were $12.6 million and $10.7 million, or 8.8% and 9.0% as a percentage of sales, in 2015 and 2014, respectively. The increase in absolute dollars reflects human capital investment and additional travel costs to support our unit growth expansion and start-up efforts for our international business development, as well as higher stock-based compensation expense.

 

Preopening Expense. Preopening expense was $4.7 million in 2015 compared to $2.5 million in 2014, including non-cash rent of $1.2 million and $0.4 million, respectively. Preopening expense in 2015 related to our San Juan restaurant opened in the first quarter of 2015, the Plano and Arlington restaurants opened in the second quarter of 2015, the Miami, Cincinnati, Las Vegas and Friendswood locations opened in the fourth quarter of 2015 and preparations for openings in the first half of 2016. Preopening expense in 2014 related to the Fort Worth restaurant opened in the first quarter of 2014, the El Paso location opened in the second quarter of 2014, the Alpharetta, Sarasota and Columbus restaurants opened in the fourth quarter of 2014 and expenses for restaurants scheduled to open in the first half of 2015.

 

Depreciation and Amortization. Depreciation and amortization expense increased $2.7 million or 38.0% to $10.0 million year over year, primarily attributable to new restaurants opened since the beginning of the fourth quarter of 2014, accelerated depreciation expense associated with the remodel of our Denver restaurant and disposal losses associated with the replacement of a portion of our smallwares and remodel activities. Depreciation and amortization expense as a percentage of restaurant sales was 7.0% and 6.1% of restaurant sales in 2015 and 2014, respectively.

 

 
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Other Expenses. Other expenses of $0.2 million in 2015 primarily related to an expected settlement of a state use tax audit.

 

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

 

Income Tax Expense. Income tax expense in 2015 relates to state income tax expense for which no net operating loss carryforwards or other credits existed partially offset by refunds primarily associated with prior year federal income tax. We did not recognize any income tax expense in 2014 due to projected net operating loss carryforwards expected to be generated from tax planning strategies and available credits to offset taxable income.

 

 

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;
 

profitability of our restaurants, especially in new markets;

 

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 closure;

 

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

 

increases and decreases in comparable restaurant sales;

 

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

 

fluctuations in commodity and food protein prices;

 

changes in borrowings and interest rates;

 

general economic conditions;

 

weather conditions or natural disasters;

 

timing of certain holidays;

 

changes in government regulations;

 

settlements, damages and legal costs associated with litigation;

 

new or revised regulatory requirements and accounting pronouncements; and

 

changes in consumer preferences and competitive conditions.

 

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

 

 
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, 2016. 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. The operating results for any quarter are not necessarily indicative of the results for any subsequent quarter.

 

      Quarter Ended  
      2016       2015  
      Mar 31       Jun 30       Sept 30       Dec 31       Mar 31       Jun 30       Sept 30       Dec 31  
      (in thousands, except per share data)  

Restaurant sales

  $ 39,277     $ 43,296     $ 43,358     $ 43,592     $ 32,807     $ 36,225     $ 35,925     $ 38,066  

Costs and expenses:

                                                               

Cost of sales

    10,501       11,213       11,602       11,998       9,062       9,678       9,812       10,252  

Labor

    14,118       15,479       16,005       16,425       11,388       12,396       12,687       13,716  

Occupancy

    3,249       3,258       3,499       3,748       2,357       2,501       2,638       3,032  

Restaurant operating expenses

    5,639       6,065       6,269       6,767       4,608       4,978       5,238       5,469  

General and administrative

    3,516       3,337       3,127       3,292       3,283       3,143       3,101       3,085  

Preopening

    711       1,302       1,430       1,090       817       1,106       1,379       1,444  

Depreciation and amortization

    3,121       3,380       3,837       4,083       2,184       2,290       2,471       3,021  

Asset impairment charge

                      12,454                          

Other

                                  (161 )            

Total costs and expenses

    40,855       44,034       45,769       59,857       33,699       36,253       37,326       40,019  

Income (loss) from operations

    (1,578 )     (738 )     (2,411 )     (16,265 )     (892 )     (28 )     (1,401 )     (1,953 )

Interest expense, net

    53       72       138       308       45       46       42       46  

Income (loss) before income taxes

    (1,631 )     (810 )     (2,549 )     (16,573 )     (937 )     (74 )     (1,443 )     (1,999 )

Income tax expense (benefit)

    25       25       6       10       (12 )     19       25       12  

Net income (loss)

  $ (1,656 )   $ (835 )   $ (2,555 )     (16,583 )   $ (925 )   $ (93 )   $ (1,468 )   $ (2,011 )

Net income (loss) per share:

                                                         

Basic

  $ (0.15 )   $ (0.08 )   $ (0.24 )   $ (1.58 )   $ (0.08 )   $ (0.01 )   $ (0.13 )   $ (0.18 )

Diluted

  $ (0.15 )   $ (0.08 )   $ (0.24 )   $ (1.58 )   $ (0.08 )   $ (0.01 )   $ (0.13 )   $ (0.18 )
Weighted average shares outstanding:                                                                

Basic

    11,258       10,932       10,500       10,474       11,235       11,271       11,277       11,271  

Diluted

    11,258       10,932       10,500       10,474       11,235       11,271       11,277       11,271  

Comprehensive income (loss)

  $ (1,656 )   $ (835 )   $ (2,555 )   $ (16,583 )   $ (925 )   $ (93 )   $ (1,468 )   $ (2,011 )

 

 
37

 

 

Liquidity and Capital Resources

 

Currently, our primary ongoing 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, to further expand and strengthen the capabilities of our corporate and information technology infrastructures and for approved stock repurchase programs.

 

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,

 
   

2016

   

2015

 

Cash and short-term investments

  $ 3,654     $ 9,233  

Net working capital (deficit)

    (10,545

)

    (5,466 )

 

   

Year Ended December 31,

 
   

2016

   

2015

 

Cash provided by operating activities

  $ 20,887     $ 10,294  

Capital expenditures

    41,900       38,077  

 

Future Capital Requirements 

 

Our capital requirements, including development costs related to the opening of new restaurants, have historically been relatively significant. Over the past year, we funded development of new restaurants and remodels primarily from cash flows from operations, funds raised in our 2014 public offering of stock and borrowings under our credit facility. 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 capital market accessibility.

 

We plan to grow organically through unit expansion. We opened eight restaurants during 2016 for a unit growth rate of 22%. We spent $29.5 million in capital expenditures in 2016, net of tenant improvement allowances, for the planned construction and remodel of our restaurants. We are adjusting our projected growth rate for 2017 below our previously targeted growth rate of 20% and believe that a more moderate growth rate will provide us the flexibility to allocate our capital resources, to increase our earnings and to strengthen our balance sheet as well as to focus our time and attention on new restaurant operations and performance.

 

As of December 31, 2016, we had a working capital deficit of $10.5 million and outstanding borrowings under our credit facility of $26.8 million. We believe existing cash and cash equivalents and short-term investments of $3.7 million, the ability to draw additional borrowings under our recently amended $60 million credit facility, subject to compliance with certain covenants, and probable future amendments to our credit facility, and cash flow from operations will be sufficient to fund property additions for new restaurants and planned remodels of existing restaurants during 2017.

 

During 2016, we repurchased $11.2 million of common stock by completing our November 2015 $10.0 million stock repurchase program and repurchased and retired $1.4 million or 136,790 shares under the October 2016 $5.0 million stock repurchase program. We completed the October 2016 stock repurchase program in February 2017 with the purchase and retirement of 532,376 shares.

 

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, to the extent available, may result in dilution to current stockholders and additional debt financing, if available, may involve significant cash payment obligations or financial covenants and ratios that may restrict our ability to operate our business.

 

 
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Debt and Credit Agreements

 

On October 12, 2016, we entered into the Second Amended and Restated Credit Agreement (the “Second Amended Credit Agreement”) with KeyBank and Zions First National Bank to (i) increase the credit facility from $35 million to $60 million, comprised of a $45 million revolver (“Revolver”) and a $15 million term loan (“Term Loan”), and (ii) extend the maturity date of the credit facility to October 12, 2021. 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 Second 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 1.75% to 2.75% and the base rate margins range from 0.75% to 1.75%. Payments on the Term Loan are due quarterly and subject to acceleration upon certain events as defined in the Second Amended Credit Agreement, while borrowings on the Revolver 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.

 

The credit facility also requires us to comply with certain covenants, on a quarterly basis, including (a) a fixed charge coverage ratio of not less than 1.50 and (b) a maximum leverage ratio of 4.25 to 1.0 through the maturity date. We were in compliance with all covenants at December 31, 2016. We may from time to time request that the total revolving credit commitment under the Second Amended Credit Agreement be increased up to an amount not to exceed $85 million. Any such increase is subject to agreement of the respective lenders in the lending syndicate or new lenders in certain circumstances. Any such increase, which may be for a lesser amount than requested by us, is also subject to certain other terms and conditions as provided in the Second Amended Credit Agreement. Subsequent to Decmeber 31, 2016, we borrowed an additional $8 million on the Credit Facility to fund working capital and the share repurchase program. There is a high likelihood that we will not be in compliance with the leverage ratio requirement at March 31, 2017.  As a result, we have engaged KeyBank, as lead bank, to enter into an amendment of the Credit Facility by March 31, 2017. We believe it is probable that an amendment will be executed and we will be in compliance with all covenants at March 31, 2017. However, in the event that we do not enter into any amendment as expected by March 31, 2017, we will be in default of our covenants and the lenders have various remedies which would materially affect our financial condition. See “Debt and Credit Agreements” in Note 4 of the Notes to the Consolidated Financial Statements for further discussion on our debt and credit agreements. 

 

Cash Flows

 

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

 

   

2016

   

2015

   

2014

 
   

(In thousands)

 

Net cash provided by (used in):

                       

Operating activities

  $ 20,887     $ 10,294     $ 14,744  

Investing activities

    (42,033

)

    (38,215

)

    (21,858

)

Financing activities

    15,567       398       37,811  

Net increase (decrease) in cash and cash equivalents

  $ (5,579

)

  $ (27,523

)

  $ 30,697  

 

Operating Activities. We generated $20.9 million, $10.3 million and $14.7 million of operating cash flows in 2016, 2015 and 2014, respectively. The change in each comparative period was primarily due to the timing of payments for accounts payable and accrued expenses and the change in deferred rent as a result of recording tenant improvement allowances for new restaurants, offset by variation in our net income (loss).

 

 
39

 

 

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 2016 were $41.9 million, primarily associated with our eight new restaurant openings, costs for our Boca Park restaurant remodel, residual payments from restaurants opened during the fourth quarter of 2015 as well as construction, architecture and design costs associated with planned new restaurant openings and remodels for the first half of 2017 and maintenance capital expenditures. Capital expenditures in 2015 were $38.1 million, primarily associated with seven new restaurant openings, our Denver restaurant remodel, maintenance capital expenditures for existing locations as well as architecture, design and construction-related costs associated with new restaurants opened in the first half of 2016. Capital expenditures in 2014 were $21.9 million, 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 opened in early 2015.

 

Financing Activities. Net cash provided by financing activities for 2016 consisted of $29.5 million of borrowings under our revolving credit facility and term loan and $0.7 million of net proceeds from stock option exercises, partially offset by $2.7 million in repayments on both the revolving credit facility and term loan, in addition to, $11.2 million in cash outflows for the repurchase of our common stock, $0.2 million for withholding tax payments from net settled option exercises and $0.5 million of debt issuance costs. Net cash provided by financing activities during 2015 consisted of $0.6 million of proceeds from stock option exercises partially offsetting a $0.2 million purchase and retirement of our common stock under the November 2015 authorization. Net cash provided by financing activities during 2014 consisted of $40.9 million of net proceeds from our public offering of 2.345 million shares of common stock and $0.6 million from stock option exercises and employee stock purchases. The cash inflow was partially offset by 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.

 

Aggregate Contractual Obligations

 

The following table sets forth our contractual commitments as of December 31, 2016 (in thousands).

 

      Payments Due by Period  
Contractual Obligations     Total      

Less

than 

1 year

     

1-3 

years

     

3-5

 years

     

More

than 

5 years

 

Debt (1)

  $ 26,813     $ 750