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Kona Grill’s (KONA) CEO Berke Bakay on Q4 2016 Results – Earnings Call Transcript

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Kona Grill, Inc. (NASDAQ:KONA)

Q4 2016 Results Earnings Conference Call

February 27, 2017, 04:30 PM ET

Executives

Berke Bakay – President and CEO

Christi Hing – CFO

Analysts

Nick Setyan – Wedbush Securities

Mark Smith – Feltl & Company

Robert Derrington – Telsey Advisory Group

Alex Silverman – Special Situations Fund

Chris Krueger – Lake Street Capital Markets

Mike Tamis – Oppenheimer & Company

Alex Marty – Raymond James

Chris O’Cull – KeyBanc Capital Markets

Operator

Good afternoon, thank you for joining us to discuss Kona Grill’s results for the fourth quarter and year ended December 31, 2016.

With us are Berke Bakay, Kona Grill’s President and Chief Executive Officer, and Christi Hing, Chief Financial Officer. Following their remarks, we’ll open the call for your questions. [Operator Instructions]

Before we begin, I would like to remind everyone that the financial guidance provided by the company, including statements regarding future growth, sales and profitability are forward-looking statements. All forward-looking statements made during this call are based on information available to the company as of today, and the company assumes no obligation to update these statements to reflect events or circumstances after the date of this call. These statements are subject to risks and uncertainties that could cause actual results to differ materially from those described in the statements. Investors are referred to the discussion of risk and uncertainties contained in the company’s filings with the Securities and Exchange Commission.

And now, your host for today’s call, Kona Grill’s President and CEO, Mr. Berke Bakay. Mr. Bakay, please go ahead, sir.

Berke Bakay

Thank you, operator. Good afternoon and thank you all for joining us. As we previously announced, restaurant sales for the fourth quarter increased 14.5% to $43.6 million, driven by 23% growth in restaurant operating weeks and negative same-store sales of 4.1%.

Weak mall traffic, inclement weather, increased competition and the continued impact of lower oil prices on some of our Texas locations, impacted our fourth quarter results. We also lapped our most difficult comparison of the year as we generated positive same-store sales of 3.2% in the fourth quarter of 2015.

While our quarterly sales were disappointing, we did finish the year with same-store sales up 50 basis points, which marks our sixth consecutive year of growth and enviable track record of accomplishment given current industry trends. We also increased our revenues by 18.5% during 2016 as strong year-over-year growth rate, we expect to repeat in 2017 given the backend loaded openings in 2016.

Now moving on to operational initiatives, we recently partnered with a national advertising agency to expand brand awareness and reach new guests to digital, social and other forms of media. This campaign includes specific initiatives such as building our loyalty base, driving new guests trial and growing catering and to grow sales.

We continue to test delivery in certain markets using UberEATS and Postmates, and recently rolled out Amazon’s delivery service in a handful of markets. We currently are testing delivery in 80 markets, which represents approximately 50% of our restaurants. Delivery and online ordering represents a growing part of our off-premise sales.

Current deliver, online ordering and traditional [to go] orders represent about 5% of total sales. We were also encouraged to see strong holding gift card sales during the quarter, including gift card sales to our recent partnership with Cosco. We would expect to see a good portion of those gift cards redeem in the first half of the year and look forward to welcoming new guests to our brand.

Our catering initiative remains a strong focus for 2017 and we have hired additional catering managers to build more premise sales and believe that our menu offerings are a great fit for office lunches, parties and other events. Although off-premise sales are still a small percentage of our sales mix, we see this as a big opportunity to leverage our kitchens, capture incremental business and service our dining occasions and broaden our reach to book the guests that have never visited our restaurants.

From my inception in 1998 to today, we’ve dedicated ourselves to providing quality food and drink offerings in a modern and appealing environment. During 2017 we plan to streamline our menu to enable our service staff to focus on providing an exceptional experience to every guest that walks into our dollars. We are reducing the number of food offerings by about 15% and trimming our wireless to improve execution and reduce waste while also allowing for more buying power from increased span on fewer items.

We will also be rolling out a [lump age] menu with our Spring menu update in April to incorporate all food and drink offerings on one vehicle. In terms of operating results, we remain pleased with the restaurant operating margins at our comparable base restaurants. 31 out of our 45 restaurants grown the comp base as of yearend and five restaurants entered a comp base during 2016.

While we expect margins to be in the mid teen range, when restaurant enter the comp base, we are pleased to report that overall comp base margins increased during 2016 and grow within our targeted range of 18% to 19% despite a challenging sales and labor market.

Overall company margins for the fourth quarter were affected by negative same-store sales and lower than expected sales volumes at several newer restaurants. The newness of our restaurants affected margins as we opened eight restaurants within the past five months, including three restaurants during the fourth quarter.

To remind everyone, we expect our new restaurants to lose money in their first, one to three month of operation, due to labor and COGS inefficiencies, breakeven in months four and six and then gradually increase profits and be in the 7% to 10% cash flow range at month 12.

During the fourth quarter, we recorded non-cash asset impairment charges of $12.5 million for five restaurants. Accounting rules dictate that if projected cash flows order remain there off the lease, unexpected to cover the current book value, than impairment charges recorded to right down the restaurant assets to their fair value.

We presently have no intention to close any of these restaurants and are actually encouraged by recent sales trends at two of these locations as we continue to invest in local marketing and other initiatives to build brand awareness. We will continue to evaluate these restaurant’s performance, while being disciplined in our future capital deployment.

Now turning to development, we completed our 2016 development plans with the opening of three restaurants during the fourth quarter in Huntsville, Alabama; Winter Park, Florida and San Antonio, Texas. These restaurants are off to a good start and we are optimistic that sales will continue to build in all eight restaurants of our 2016 class as we foster awareness and develop a loyal guest base in each of these markets.

We are also making progress in our international franchise initiative, by working diligently with our partners to develop Kona Grill brand outside of the United States. We expect each of our partners to open the first Kona Grill in their respective countries during 2017, resulting in at least two openings during the year. We also have signed a Letter of Intent for the development of a restaurant in Toronto, Canada. We are in active negotiations with potential partners for additional international franchise locations.

With that, I’ll now like to turn the call over to Christi, who will take us through the financials for the fourth quarter and full year. Christi?

Christi Hing

Thanks, Berke. For the fourth quarter, restaurant sales increased 14.5% to $43.6 million compared to $38.1 million last year. The increase was primarily driven by eight restaurants that opened during 2016, partially offset by a 410-basis point decline in same-store sales. Lower cash traffic, along with a negative mix shift was partially offset by pricing during the quarter.

As Berke mentioned, the newness of our restaurants impacted results for the fourth quarter and 2016 and this is reflected in many of our P&L cost lines. Operating weeks from our non-comp based restaurants comprised 29% of total operating weeks during the quarter and 28% for the year.

After sales increased 60 basis points during the quarter to 27.5% compared to 26.9% last year. The increased costs is attributed to higher sea food costs, particularly and damage and [sea vest] as well as new restaurant operating inefficiencies from five restaurants opened since August of 2016.

Labor costs as a percentage of sales increased to 170 basis points to 37.7% during the quarter, compared to 36% last year. The increase was primarily due to hourly labor costs associated with our eight restaurant openings during the year, wage inflation in many markets and the deleveraging of fixed labor costs.

Because of weaker than expected mall holiday traffic and inclement weather during the month of December, we experienced higher labor cost as it was difficult to forecast sales and allowing labor to match these sales.

Still, our overall restaurant operating margins were disappointing at 10.7% during the fourth quarter compared to 14.7% last year. Again, our margins reflect a larger proportion of non-comp based restaurants in this year’s number, including 12 restaurants that opened since October 2015. These 12 restaurants had an average age of about seven months as of December 31.

On an absolute dollar basis, restaurant operating profit decreased by 16.8% to $4.7 million. G&A expenses were $3.3 million during the fourth quarter, compared to $3.1 million last year. Increased headcount partially offset by lower incentive and accruals were the primary drive for the increased G&A expenses.

As a percentage of sales, G&A decreased by 60 basis points to 7.5% as compared to 8.1% last year. Preopening cost were $1.1 million during the quarter, primarily for three restaurant openings. During the fourth quarter, we recorded non-cash asset impairment charges of $12.5 million or $1.19 per share for five restaurants.

The charges based upon the comparison of projected future cash flow versus each restaurant’s net book value. The future cash flows aren’t expected to cover the net book value then accounting rules require that these assets to be written down to their fair value.

Now turning to full year results, sales increased 18.5% in 2016 to $169.5 million. EBITDA increased 3.3% in 2016 to $5.9 million. While these results fell short of our expectations, we were able to leverage G&A as a percentage of sales by 100 basis points to 7.8% which demonstrates our ability to leverage corporate infrastructure costs as our revenue base grows.

We had $26.8 million in debt outstanding at December 31, 2016. As mentioned on our last call, during October, we entered into a five-year amended credit agreement with KeyBank National Association and Zions First National Bank providing for revolving and term credit facilities totaling $60 million.

Their managed facilities allow for available borrowings of $60 million compared to $35 million under the old facility and continues an accordion feature that include increased availability by an additional $25 million for total availability of $85 million. The amendment provides little flexibility to allocate capital for future growth, share repurchases and other corporate initiatives.

During 2016 we have CapEx spending net of TI of $32 million in line with the low end of our guidance. We spent $11.2 million during the quarter on share repurchases and we hired 952,000 shares for about 9% of our outstanding shares. Subsequent to the fourth quarter, we completed the October 2016 $5 million authorization with the repurchase and retirement of an additional 396,000 shares. This brings our outstanding shares to approximately 10.1 million as of today.

Now turning to our 2017 guidance. For 2017, we are forecasting restaurant sales of $200 million, which represents growth of 18%. The increase in restaurant sales will be driven by operating weak growth primarily from restaurants opened during the second half of 2016 as well as three planned restaurant openings for 2017. The guidance assumes flat same-store sales.

We would expect restaurant operating margins to be leverage relative to 2016 as our non-comparable restaurants build efficiencies as they mature, while our comp based restaurant should be relatively stable despite some cost-of-sales and labor headwinds that we are addressing through menu simplification and other initiatives.

We have taken price in a handful of markets to address recent minimum wage increases including Arizona where the tipped wage increased 38% on January 1, although we will have to absorb some of these costs to maintain our value proposition. We would also expect modest G&A leverage in 2017 with only three openings projected for 2017.

Preopening expenses will be significantly reduced from the amounts incurred in 2015 and 2016. With all of these factors taken into account, we are forecasting EBITDA of $11.5 million representing 95% year-over-year growth.

Quarter-to-date trends are down about 3%. We are lapping leap day in 2016 and therefore all these one sales day in comparison with Q1 of last year, but this will hurt our comps by about 70 basis points. We are seeing better comp numbers in recent weeks and expect to be flattish in February excluding the extra last year after a slow January.

We are cautiously optimistic that good weather in March will lead to the full year’s patios and shrunk sales. Finally, we project capital expenditures net of tenant allowances to range of $16 million to $18 million for 2017 primarily related to new restaurant development and remodeling initiatives.

Our CapEx forecast include three new restaurant openings, four remodels, payments CapEx and technology initiatives designed to improve the guest experience.

I will now turn the call back to Berke for some additional remarks before we go to Q&A. Berke?

Berke Bakay

Thanks Christi. We’re focused on the future as doing what is in the long-term best interest of our shareholders.

Through our first 15 years. We built 23 restaurants from October 2013 to December 2016 we essential double our unit count with the opening of 22 restaurants in three plus years. This fast growth pace has allowed for many rewarding moments as we create over 2,000 jobs in U.S. and expanded the Kona Grill brand into dozen new markets across the country.

The focus for 2017 is to build sales and improve the operating margins of our 12 non-comparable base restaurants. As Christi mentioned, these restaurants had an average age of seven months as of yearend. We’re working diligently to increase operational efficiencies at our new restaurants and push these margins closer to our comp base average of 18%.

We’re planning to open three restaurants in 2017. We also have plan to remodel four restaurants in Dallas, Houston, Austin and Stamford. We expect each of our international franchise partners to open up restaurants in their respective countries during the year. In total, between domestic and international units, we expect our unit growth rate to be in the double digits during 2017.

With that, I would like to open the call up for any questions you might have. Operator, please open the line for questions?

Question-and-Answer Session

Operator

Thank you, sir. [Operator Instructions]. And for our first question we go to Nick Setyan with Wedbush Securities.

Nick Setyan

Hi thanks for taking my question. Can you guys just break out the traffic versus price mix and then what kind of a price menu price we expect going forward.

Christi Hing

For Q4, traffic was down about 3.5%. We had pricing of about 2%. So, that leads to a negative mix of about 2.5% and then in terms of, go ahead Nick?

Nick Setyan

And then just your plans for pricing going forward?

Christi Hing

So, for pricing going forward, we have about 2% that we have in place right now. Overall, about a percent of that going forward. And as mentioned we took a little bit of pricing in select markets on our Happy Hour menu to deal with some of the minimum wage increases that we’re dealing with but we’re being cautious given the current market environment right now.

Nick Setyan

Got it. In terms of the negative mix, clearly there is some promotional activity going on there. Is that something that we should expect to continue?

Christi Hing

Look, I think we’ve been positive mix the last several quarters. So, we were lapping some of the happy hour initiatives, meaning bringing on some higher price sushi items, upgrading our drink offerings. So, I would attribute a little bit to that. As far as we took a little bit of pricing on that, but that’s something that we continue to evaluate as we streamline our menu look at different offerings going forward.

Nick Setyan

And Berke, you mentioned that through the five units you’re happy with, I guess more recent trends, what’s your thinking around the other three units and what’s the plan with those three units right now?

Berke Bakay

Sure. So, two units out of five as I mentioned they’re seeing very strong trends and they are not in the comp base yet. So, they will get into the comp base on the second half of this year. So, we’re very pleased and frankly we’re incorporating some of the initiatives that we have done in the two units that have seen the positive momentum to the other three and hoping that it will result in similar results and that just start happening few days ago

And that has a lot to do with local marketing initiatives, expanding the happy hour times and even having some special limited time offerings to drive guest that have never been in these restaurants to our restaurants and slowly get our feet of the gas pedal so to speak on that promotional activity and hopefully that business being sticking around for the future. So, that’s what we’re planning to do on the other three.

Nick Setyan

And is there like a timeframe, is there like a timeframe like hey based on 2017 we don’t see an improvement results, we consider some other subsidiaries options for those units?

Berke Bakay

Yeah, there are timeframes, but I am not about to disclose, what they are on the call.

Nick Setyan

Got it. And then just kind of lastly, would you be able to disclose kind of what the margins were for the units ex those five underperforming units?

Christi Hing

Nick, we’re not prepared to discuss that, but obviously, you can assume that those restaurants were negative because of our asset impairment charge. That charge calculates the projected future cash flows compared to the book value. So, I guess it’s a safe assumption that those restaurants were negative.

Nick Setyan

Okay. Thank you.

Berke Bakay

Thank you.

Operator

And for our next question, we go to Mark Smith with Feltl & Company.

Mark Smith

Hi, guys. First up, Berke can you walk us through which restaurants were that were impaired or some common attributes to see in these restaurants…

Berke Bakay

Yeah, Mark we haven’t disclosed

Mark Smith

Can you give us any of the common attributes on what type of units it is that have caused problems and how you avoid that going forward?

Berke Bakay

Yeah look in the past, we have discussed on some of our earnings calls that we haven’t got in the traction that we expected to see in some of tourist locations. We talked about that a little bit and so and if you look at our script, we talk about challenges in some of the oil related markets. So, I think you can assume what those are, but we’re not disclosing these units that were impaired.

Mark Smith

Okay. And then just can you just tell us timing of new openings this year, you still expecting one in the first half and then you said you expect the franchise unit open as well, would be great?

Berke Bakay

Yeah, so one in the second quarter, one in the third quarter and one in the fourth quarter. That’s for the corporate locations and for the franchise locations, I would expect one in the late first half and you know the other one on the kind of late second half.

Mark Smith

Okay. And then Christi, I think in your comment and I apologize that I missed, you talked a little bit about your outlook for the restaurant operating profit. Can you walk us through that again or any insight that you can give us into what’s broken into your guidance?

Christi Hing

We said EBITDA guidance of $11.5 million. Our comp based margins continue to remain strong. It’s really a lot of the newer restaurants that are bringing down the overall profitability of the company. So, that’s really what 2017 is for, is for focusing on building those margins of the non-comp units.

Currently we have 12 units that are non-comp. So, we mentioned those restaurants are average age of about seven months as of yearend and so in our kind model we expect restaurants to breakeven in months four through six and gradually get up to that 7% to 10% range. So, call it we’re very, very early on in that maturity curve. So, that’s kind of the guidance we are giving without giving specific comp and non-comp base margins guidance.

Mark Smith

Okay. And then lastly Berke you talked quite a bit of off premise sales and I know it’s a small number, but can you quantify what that was in 2016?

Berke Bakay

Our total for the category is 5% Mark off premise sales, but we think there is a significant growth in front of us. We’re seeing some of the — again the rollout is new every month. We adding in one or two new markets depending on where our partners are growing so to speak and then, we’re seeing those number growing nicely in the last few months.

Mark Smith

Okay. Thank you.

Berke Bakay

Thanks.

Operator

And for our next question, we go to Robert Derrington with Telsey Advisory.

Robert Derrington

Typically, you would give us, we talk about adjusted EBITDA and now we’re talking about EBITDA per se, just little bit of clarity on the preference there the change?

Christi Hing

Yeah, Bob I think, we’ve eluded to it little bit on our third quarter earnings call. The SEC has called it crack down a bit on the non-GAAP measures and so we eluded to, although EBITDA is not a GAAP measure, it’s one step closer to GAAP than adjusted EBITDA and I think it’s more common metric used within our industry. So, that’s really the reason for the switch.

Robert Derrington

Got you. Okay. And can you give us a little bit of color on the comp store margins? I know you gave us some color for the year, but can you give us some color for the fourth quarter per se?

Christi Hing

I’ll give you a little bit of color. Again, our preference when we made this switch was to try to focus on total company results as a whole. So yeah, margins still remained strong. Although you can imagine with being down 4.1%, you would have seen a little bit of deleverage during the fourth quarter. But overall, we were still in that 18% range, so still very pleased. Although when you do have negative same-store sales, you deleverage your fixed occupancy and management salaries.

Robert Derrington

As your new stores are coming into the comp base, is it reasonable given some of the underperformance or some of those newer stores that we would expect that that piece of the business that comp store margins to come down because of that?

Berke Bakay

Bob, not necessarily. Just as an example, if you look at when we start our growth with the [Boyze]. So, going from unit 23 to 45, we already added eight new restaurants that were in the non-comp based versus comp based but our comp base continue to lead the industry despite adding the units.

I think the challenge you’re seeing right now like Christi alluded in her remarks, you’ve got a dozen of restaurants with several months of average life and if you look at our own guidance, we would expect them to either lose money or come to right breakeven.

So, you add basically one fourth of your company or more than that in that class breaking even. We believe that just aging those group of restaurants for a year and the operational focus that we have given that we’re not opening as many restaurants as we had last year is going to result in great restaurant efficiencies from a forward restaurant margin perspective.

Robert Derrington

Okay. That’s fair and one other if I may. On the remodels, Berke you talked about four, are these broad extensive, can you give us some color on those?

Berke Bakay

They’re not as extensive as you’ve seen in Denver and Las Vegas and that’s always reflected in our CapEx budget because in there, there is a maintenance, there is opening of three new units and four-day model. So, we do believe like we have seen in the past that once the remodels are done, they would help us with the same-store sales like we have seen in other times, but from a captain span perspective, not as extensive as you’ve seen with Denver and Las Vegas.

Robert Derrington

Okay. And Christi one last one if I may. On the — can you give a bogey to work on D&A for the year?

Christi Hing

So, for 2017, obviously, the asset impairment charges impact that D&A number. So, I guess to give you some guidance, we’re probably a little bit north of $15 million range and that’s again just assuming the guidance that gave today with the three restaurant openings with the four remodels, we’re a little bit north of 15.

Robert Derrington

Terrific. Super. Thank you. I appreciate it.

Operator

For our next question, we go to Alex Silverman, with the Special Situations Fund.

Alex Silverman

Hi most of my questions have been answered. Can you just help us with what opening three new restaurants might cost you in terms of preopening for 2017?

Christi Hing

Typically, our preopening has been about $450,000 in cash preopening cost. And then anywhere from $50,000 to $150,000 in the non-cash piece of it just depending on we when we have to take possession of upon signing that lease which is the rent piece, but typically I guess if you just assume 550 or so per location times three, that gets you to about little over $1.6 million.

Alex Silverman

Okay. That’s helpful. And then how many of those 12 enter the comp base in 2017?

Christi Hing

So, we just had I guess I was already assuming that we had two restaurants that enter the comp based on January 1. So, that does not include the we’re referenced in the 12. We will have four restaurants.

Alex Silverman

I’m sorry, two of the 12 entered?

Christi Hing

Let me back up. So, we had I guess as of December 31, there were 14 non-comp based restaurants, two of which on January 1, and then four will enter the comp base in the third quarter.

Alex Silverman

Got it, that’s helpful. And then just to walk through your comments earlier, it takes four to six months to breakeven and soon thereafter you’re getting to a 10% restaurant level margin and at maturity it’s something closer to 18%?

Christi Hing

Yes, let me just clarify. So, we say by the end of their first year for month 12, they’re in the 7% to 10% range.

Alex Silverman

Okay.

Christi Hing

So, we have our restaurants enter the comp base in their first full quarter after 18 months. So, we don’t expect them to be at the 18% range more so in the mid teen, and then you refer to maturity. Maturity we can range anywhere from two to four years, but that’s we would expect them to be in that 18% range.

Alex Silverman

Got it. That’s really helpful. Thank you very much.

Christi Hing

Okay.

Operator

[Operator Instructions]. And for our next question, we go to Chris Krueger with Lake Street Capital Markets.

Chris Krueger

Good afternoon, guys. Just two quick ones. I know you talk about the rapid expansion in the last three years and what markets have worked better than others and leaning as you go. One question I had kind of on that topic is, can you talk a bit about how your new units and brand new markets are — how they’ve fared versus new units where you’re filling in, where there is somewhat of a presence as far actual sales levels or awareness levels?

Berke Bakay

Sure. I can talk about that a little bit Chris. So if you look at the last 22 opening and kind of look at the learnings, obviously as I mentioned few times we learned that the tourist markets became different than other more regular markets and once theory that we have is even though you have and that’s what we were trying to figure out what the disconnect is with great op reviews and other — a good operational performance, but not seen the ramp up, is obviously the frequency of average guests that goes to a tourist market is different than frequency of an average guest in a smaller market that maybe going to that center on a weekly basis.

So, you may not to reap the benefits of your good execution in a short period of time, but it may take longer. So, we’ve certainly seen that.

Another area of a slower ramp up is, when we went to a market that had an established center and we would just be another restaurant and joining the other six or seven in that market, and if it was a brand new market with no brand recognition, those have been the challenging ones because than you’re talking about not having the brand recognition and having to change the usage patterns of the other guests that go to that center and give it try.

And again, as I said two markets we’re already seeing great results, working of a smaller base, but certainly they’re going to helpful when they get into our comp base on the second half of the year and we’re working with some of our other markets that as I mentioned, but those have been the learnings from the real estate experience last three four years.

Chris Krueger

Okay. Than the other question, in general more big picture question on the restaurant industry, we’ve seen — we know it’s been a tough goal for most companies and most competitors of yours and recent earnings releases indicate a similar kind of tough fourth quarter and kind of uncertainty in the current quarter we’re in.

Several of these have also pulled back on their unit growth at least for this year. Just wondering is there any thought out there that this category, a polished casual or something similar to that has may even rapidly over build in recent years and is that playing a role in all this?

Berke Bakay

Yes, certainly it is and when you see me on the remarks speaking competition, that’s really tied into that and one of the challenges is you have unfortunately a retail industry that is pulling apart. Every day we read about a different brand that goes bankrupt and as that’s happening, gross leasable areas for more than the live stocks centers are still there.

So, they need to be leased to somebody else right and usually the restaurants or other users like Gems or Whole Foods of the world or movie theaters are some of the users of that. So, there is a disproportionate square footage addition of the restaurants that are coming in through the industry and certainly to your point about being over saturated and our comments about competition increasing.

Chris Krueger

Okay. That’s all I got. Thanks.

Berke Bakay

Thank you.

Operator

Again, for our next question, we go to Brian Bittner with Oppenheimer and Company.

Mike Tamis

Great. Thanks. This is Mike Tamis on for Brain. So just a quick clarification first. Did you say, you expect to leverage restaurant margins in ’17 versus ’16?

Christi Hing

Yes, I think the nature of us having fewer opening fills a restaurant we opened during 2016 to have another year under the belt. That’s where the leverage will come from.

Mike Tamis

Perfect. Thanks for the clarification and then I think you mentioned that February same-store sales will be flattish prior to the leap day after soft January and I think a lot of the restaurant industry is sort of seeing the servicing opposite. So, I am just wondering if you can maybe talk about that what you’re seeing maybe what you changed or why do you think that maybe bucking a trend.

Christi Hing

I think for us a lot of us has to do with I guess some recent weather I would say for the last two weeks with markets like Chicago being 16 degrees. People want to get out and sit in our patios and so I think some of the call it the strength in February is attributed to some of that weather because over half of our business comes from our barn patio. So, that definitely is a finer place to be at when the weather is nice.

Mike Tamis

Got you. makes sense and then you guys have talked about previously trying to do positive EPS in ’17 and I think that that probably gets pushed out a bit, but can you maybe talk about any goals for that or timeline or maybe what that maybe look like for now?

Christi Hing

I think Mike a bit of it is going to be a function of our growth. Obviously, we’re slowing growth. You’re talking preopening expenses that have been in the $4.5 million range down to $1.6 million. So, the timing of profitability will depend a bit on our growth.

Berke Bakay

Also, the international, in our prepared remarks we talked about, we expect that we were talking to different regions and markets, so to the extent that we get them on Board and ramp those up or that’s a very high profitable, highly profitable part of our business.

Mike Tamis

All right. Great. Thank you.

Berke Bakay

Thanks.

Operator

And we go next to Alex Marty with Raymond James.

Alex Marty

Hey guys, this is Alex filling in for Brian, just a few quick ones, can you revisit the fourth quarter store margins and on the last call you provided your comp base margins. Would you be willing to disclose that for the fourth quarter?

Christi Hing

As we mentioned, we’re trying to focus on total company results. So, we gave a little bit of color just for the full year, but as far as fourth quarter, we assume given our negative same-store sales, you can expect a little bit lower than that 18%, but we’re not — again we’re trying to get away from the specific focus on comp base, non-comp base margins. So, what we’re disclosed is what we’re prepared to provide at this time.

Alex Marty

Understood and in terms of the factors impacting your fourth quarter, one you mentioned, was increased competition and the first time we really heard that specifically, can you possibly provide some more color on what you’re seeing there and broadly how you’re adjusting your site selection criteria that you alluded to in the press release?

Berke Bakay

Sure, well I can give a specific examples, if you look at one up our restaurants like Austin, that is an extremely successful restaurant and it has been that way since our last 10 years or so, you look at expansion of the domain that’s on this project and there are literally couple of dozen if not more restaurants and bars that open within half a mile or walking distance from our restaurants.

So, I don’t think we have seen anything like that in last five years the amounts of the restaurants and as I mentioned on the previous — as an answer to the previous question, usually you used to see a more balanced retail restaurant mix coming into a new GLA, right now we’re seeing just the restaurant seats.

So [Austin] is another strong market that we have seen handful of restaurants coming in and we talked about a trial like when competition is always going to happen and it’s not an excuse, but when two dozen operators open within half a mile and impacting your sales, I’ll give you another example of a very strong market for us El Paso Texas, that you had in the same quarter or in the three, four months, you had P. F. Chang’s, Ruth’s Chris and Chewy opening literally next door to us versus we were the only restaurant or one of their few restaurants in the center.

So, those are just three that I can think on top of my head and it’s not so much adjusting the type of real estate for that, but to the extent where the industry is going and maybe the oversaturation of the seat is what that driving the situations in my opinion.

Alex Marty

Yeah, thanks Berke, that’s great color and one last one on the 2017 guidance, what does that assume in terms of food and labor inflation?

Christi Hing

So, we expect I think as many of our competitors, we definitely labor inflation, as we mentioned in jour prepared remarks, just even in our home state of Arizona, we had a 38% increase in the tip wages for our servers and bar tenders. So overall for labor inflation I would say, somewhere in the 5% range.

Commodes, which have been favorable to us in 2016 we expect modest inflation to stay in somewhere around the 1% that we said at this point in time.

Alex Marty

Outstanding. That’s all I had. Thanks guys.

Berke Bakay

Thank you.

Operator

[Operator instructions] And for our next question, we go to Robert Derrington with Telsey Advisory.

Robert Derrington

Yeah, thanks Christi on the inflation, the modest inflation in 2017 of about 1%, when we look at the COGS line, how much of that is influenced by new store development? Should we see some economies that offset that inflation, we actually see cost of sales go down year-over-year, is it reasonable?

Christi Hing

I think that definitely the new stores have impacted our commodity cost just our overall cost of goods sold line. Always when we do our budgets, we do try to factor in some of the increased efficiencies, increased buying power. So, can we offset the inflation with efficiencies, that’s definitely we’re hoping to do. So, trying to hold the COGS line relatively flat compared to 2016 when it’s all said and done.

Robert Derrington

Sure. And then one other piece if you could, on the franchise contribution, Berke, how should we think about whatever you gain through either a franchise upfront fee or development fee? What kind of dollars in sense are we talking about and ultimately how do we think about the royalty?

Berke Bakay

Right. So, Bob we’ve never specifics of what those numbers are, but I am going to let Christi describe the revenue recognition of the initial piece and I’ll take it from there.

Christi Hing

So, Bob I think that probably you’re familiar with the two pieces there is the territory fee, which we have the agreement signed from Mexico and the UAE. We haven’t recognized the color of that. So, on a prorate basis, as each new restaurant opens, we’ll recognize in this case for Mexico, we sign for six units. We’ll recognize one sixth of that territory fee and then we’ll also recognize the franchise fee upon opening.

And then obviously, we’ll start recognizing the royalty fees, which we haven’t disclosed what they were.

Robert Derrington

But I assume this is a license fee as opposed to a franchise royalty?

Christi Hing

It’s going to be our percentage of sales. So, a percentage of the partner sales they’ll pay to Kona Grill. So, it’s probably fairly typical with some of the other call it casual dining or polished casual dining royalty fee that you may have seen.

Robert Derrington

Got you and will you have another line or the revenue line Christi that breaks that out?

Christi Hing

We’re looking at our competitors, we really haven’t seen others break that out. We will include that just in our restaurant net revenue line item and I think that’s consistent with the treatment of many of our other I guess peers.

Robert Derrington

Got you. Okay. Thank you.

Operator

And we go next to Chris O’Cull with KeyBanc.

Chris O’Cull

Thanks, Berke would you describe how you guys tested some of the menu changes you’re planning like the 15% reduction in items?

Berke Bakay

Sure, it is. First of all, let me talk about — let me give you a little bit detail on what we’re trying to accomplish here. So, the goal is improving the execution obviously on the restaurant level and taking out menu items that and that to answer your question on that not selling as well as others rights.

So, focusing on the items that are typical 8020 rule and pruning our menu to improve execution also drive more COGS efficiencies and training efficiencies through that. And what this is going to enable us to do, which I’m personally excited about is to reduce our menu to basically a single page where on the front you’ll have our kitchen and sushi items and the back you’ll have alcoholic beverages instead of having another beverage book.

And that obviously reduces the whole store our servers to potential forget to bring out beverage books. Everything you need is in one piece and it’s front of you and we get to focus on our basically our items that actually do the heavy lifting in terms of sales. So, that’s what we’re going to be doing.

Chris O’Cull

Did you say that you’ve tested this in any of the store so far?

Berke Bakay

No, we’re taking out items that have low sales. So, we already have the data so to speak on what is not telling and we’re pruning the menu.

Chris O’Cull

Okay. Okay. Fair enough. And then you mentioned that the comp was I think you said, down 3% quarter to date, but it improved here in recent weeks and it sounds like you have less pricing in the menu or you think it sounds like you’re going to have less pricing soon in the menu.

So, are you seeing improvements in traffic or do you expect when that pricing rolls off if it hasn’t already said the comp will step down at all?

Christi Hing

Chris, I’ll say our comp has been flattish for February. That would imply some traffic improvements. As we’ve kind of gone through the quarter, but in terms of pricing, we’ll roll off I don’t remember exactly when we did our spring menu update last year, but we’ll roll off the 1%, but we have some slight pricing on the happy hour in certain states that we took.

Berke Bakay

Chris, one thing to add to this we have about in my opinion, six different drivers of comps and those are obviously the four remodel units that are going to impact the comps for the year and two of the units that we mentioned on our call that are seeing significant year-over-year improvements but are not in the comp base yet.

So, to the extent that there is some weakness because we’re not pushing the price, I think those six things are going to be more than enough to make up for the rest of the year.

Chris O’Cull

Okay. Okay. And then it sounds like the menu mix may have gotten a little better too as you’re lapping some promotions in the fourth quarter, it sounded like.

Christi Hing

I guess in terms of mix, I think just with some of them, we were lapping kind of our happy hour changes that we’ve done over the last call it year or 18 months with upgrading our sushi offerings, upgrading instead of just doing happy ROI and we started doing $2 off cost of wine. So maybe we’re lapping a little bit of that.

Chris O’Cull

Okay. And then just lastly, Christi, were the five units the only ones of the 12 or were the only ones not tracking to the margin maturation targets that you laid out earlier?

Christi Hing

It’s really too early. We have eight restaurants that we opened in 2016. I guess you could always it’s probably safe to assume that we didn’t maybe those restaurants, but given that five of those opened since August of 2015, it’s really early to really understand how those restaurants are ultimately going to turn out. So…

Chris O’Cull

Okay. Fair enough. Thanks guys.

Berke Bakay

Thank you.

Operator

And ladies and gentlemen, this will conclude our question-and-answer session. I would like to remind everyone that this call will be available for replay later this evening. A webcast replay will also be available via the link provided in today’s press release as well as available on the company’s website at www.konagrill.com.

Thank you, ladies and gentlemen, for joining us today. You may now disconnect.

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