Kona Grill, Inc. – Unhappy Hour as Themed Restaurant Chain Files Chapter 11, Citing Waning Consumer Appetite and Binge Growth Strategy

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May 1, 2019 − Kona Grill, Inc. and eight affiliated Debtors (“Kona Grill” or the “Debtors”) filed for Chapter 11 protection with the U.S. Bankruptcy Court in the District of Delaware, lead case number 19-10953. The Company, which owns and operates restaurants serving contemporary American favorites, sushi, and alcoholic beverages throughout the United States and Puerto Rico, is represented by James E. O’Neill of Pachulski Stang Ziehl & Jones. Further board-authorized engagements include (i) Piper Jaffray as investment banker and (ii) Alvarez & Marsal ("A&M") as restructuring advisor (with A&M's Jonathan Tibus and Chris Wells to serve as the Debtors' chief executive officer and chief restructuring officer, respectively). 

The Company’s petition notes between 10,000 and 25,000 creditors, estimated assets of $53.6mn and estimated liabilities of $74.0mn. Documents filed with the Court list the Company's three largest unsecured creditors as (i) JFC ($572k trade payable), (ii) Dolphin Mall Associates, LLC ($500k lease termination settlement) and (iii) Scottsdale Quarter Reit ($327k trade payable).

Kona Grill trades at KONA (OTCMKTS). On April 25, 2019 Kona Grill was suspended from Nasdaq for failure to pay fees required by Listing Rule 5250(f).

Events Leading to the Chapter 11 Filing (the end of Happy Hour)

In a declaration in support of the Chapter 11 filing (the “Wells Declaration”), Christopher Wells, the Debtors’ chief restructuring officer, detailed a story of over aggressive, and capital intensive, growth that could not be sustained in the face of declining consumer appetite for its upscale culinary experience; and an increasingly accelerated operational decline as the Debtors struggled to reverse that waning consumer appetite while simultaneously pursuing an aggressive cost cutting program. The overall effort certainly not helped by a revolving door management, sudden strategy changes and as against a backdrop of restaurant closings almost as sudden as the Debtors’ openings just two years earlier. Although neither the Debtors' recent SEC filings nor the current bankruptcy Court filings provide much insight as to why customer numbers began falling from 2017, it is not hard to see how the whiff of failure might dampen the buzz in 300-seater restaurants selling a vibrant, edgy eating experience (the Debtors' website trailer here). One (rare) insight in the Debtors' 2018 10-K was the importance of changes to Kona Grill's happy hour strategy, which the Debtors cited as the primary cause for a same-store sales decrease of 12.3% in 2018. The decision to reduce happy hour times and $5 food offerings, intended to improve margins by disincenting cheap drinkers, clearly backfired (presumably because those lubricated, lower margin customers had been providing some of the feel good factor in large restaurants) with the 10-K also noting the Debtors' second thoughts on the subject: "we have expanded our happy hour and reinstated certain discounts and food and drink offerings in an effort to drive traffic." Perhaps the right strategy all along given that (again the 10-K) "Aggregate revenue during these non-peak periods [ie happy hours] accounted for 22.4% of our total sales during 2018."

The Wells Declaration states, “Over the past several years, the Debtors made several operational decisions that increased borrowings and restricted cash, leading to the need to commence these Chapter 11 Cases. 

The Debtors aggressively doubled their restaurant base from 2013 to 2017, increasing its footprint from 23 restaurants to 46 restaurants by the end of 2017. This rapid expansion required a significant amount of capital, as the average restaurant investment exceeded $4 million.

Beginning in 2015, after five years of increased traffic, the Company began to experience negative traffic and declining average unit volume of its restaurants. The Company's liquidity position deteriorated further when the Company utilized $15 million in capital for its stock repurchase program in 2016 and 2017.

In July 2017, the Company decided to discontinue developing new restaurants and to focus its efforts on improving the sales and profitability of its existing restaurants. The slowdown in new unit growth was also intended to conserve cash resources, while also allowing the Company to focus on discussions with its landlords for rent abatement and to evaluate certain unprofitable restaurants for closures. To that end, the Debtors decided not to move forward with the development of two restaurants previous planned to open in 2017 and 2018. The Company also decided to close four unprofitable restaurants.

In addition to restaurant closures in 2018, the Debtors engaged in rapid cost-cutting efforts Company-wide to offset the effects of declining revenues. Corporate headcount was reduced, which decreased restaurant level support, training programs, and culinary innovation. Store management staffing levels were also reduced, which negatively impacted guest experiences and restaurant-level standard operating procedures. Additionally, the Debtors significantly decreased their marketing efforts and presence in the community. Although store-level profitability improved in the short-term, the reductions in staffing, marketing, and customer-focused initiatives were unsustainable to counterbalance decreasing revenue trends.

By March 2019, liquidity was so severely impacted by declining trends that the Debtors decided to engage Piper Jaffray as their investment banker to assist in the evaluation of strategic alternatives, including the sale of the Company, refinancing, or other alternatives, including the closure of additional restaurants. Beginning in 2019 through the Petition Date, the Debtors closed an additional 15 locations after being unsuccessful in their negotiations with landlords concerning rent concessions. Considering all the events previously detailed, ongoing litigation costs, lease termination and exit costs for shuttered restaurants, and limited liquidity to pursue strategic alternatives outside of the bankruptcy process, the Company decided to seek protection under chapter 11 of the Bankruptcy Code and commenced these Chapter 11 Cases.

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