Why This Casual-Dining Company Could Become the Next Restaurant Giant

Most casual-dining restaurants aren't doing well because they are losing customers and can't find the right locations to house their operations. Kona Grill has done well on these two counts, which makes it a candidate for next big thing in the industry.

Jun 11, 2014 at 12:57PM

Casual-dining restaurants haven't done well in the past few years, as budget-conscious consumers opt for fast-casual choices and the affluent stick to fine-dining options. Kona Grill (NASDAQ:KONA), an American grill and sushi bar, has been an outlier among casual-dining chains. For the past three years from 2011 to 2013, Kona Grill has consistently delivered same-store sales growth above 5% on average, while the casual-dining industry at large has been struggling with flat same-store sales growth over the same period.

What are the reasons for Kona Grill's success and how does it compare with peers such as Bravo Brio Restaurant (NASDAQ:BBRG) and Ignite Restaurant Group (NASDAQ:IRG)?

Sticky customer base
Restaurant operators constantly worry about the low switching costs of fickle-minded diners, who are always keen to try new concepts. In contrast, Kona Grill's customer base seems differentiated. Based on its internal surveys, those who patronize Kona Grill tend to be well-educated (graduate school and beyond), health-conscious high earners (household incomes above $70,000).

More importantly, a significant number of Kona Grill's customers dine there often. About 17% of Kona Grill's diners visit its restaurants more than nine times per year, compared with the casual-dining industry average of 10%-15%. Guests who visit the same restaurant between four to eight times each year account for 37% of Kona Grill's customer base; in contrast, such diners only make up 16%-30% of a typical casual-dining restaurant's client base.

A few factors keep Kona Grill's customers constantly coming back for more.

Firstly, Kona Grill calls itself a 'differentiated upscale, polished casual' restaurant for a reason. While it's hard to differentiate one's menu offerings from those of peers, Kona Grill works on creating distinct and memorable flavors instead, as it boasts more than 40 signature sauces and dressings. Moreover, its exhibition-style kitchen & sushi bar gives customers greater confidence in the quality and freshness of its food offerings.

More importantly, this hasn't come at a hefty price premium. Kona Grill offers an attractive price-value proposition with an average customer check of $25.00. This is comparable to the average check of $25.22 for Bravo Brio Restaurant's BRIO Tuscan Grille ("BRIO"), which is positioned as an upscale, affordable Italian food concept.

Secondly, Kona Grill has the well-being of health-conscious consumers in mind. It has an extensive selection of gluten-free, vegetarian, and vegan menus as well as lower-calorie menu options for its customers. Bravo Brio Restaurant also provides low-calorie menu combinations under a section called 'The New Lighter Side.' Customer acceptance has been encouraging with close to a fifth of BRIO's customers ordering from the New Lighter Side menu.

Thirdly, Kona Grill initiated an email-based loyalty program called Konavore in 2010 that now boasts more than 200,000 members. Aside from sending discount coupons to members on their enrollment and birthdays, Kona Grill also keeps members engaged with email updates on new menu offerings and events.

Similarly, Bravo Brio Restaurant has its MyBRIO Loyalty Program, which allows members to accumulate 'Rewards' for redemption in the future. Bravo Brio's members will also receive a complimentary entree valued up to $15 in the month of their birthdays.

Flexible real estate options
One of the key bottlenecks for restaurant unit growth is the lack of suitable real estate locations. This problem is often exacerbated by the fact that most restaurants are quite rigid in terms of their site selection. This isn't the case with Kona Grill.

Kona Grill is equally comfortable with lifestyle & entertainment centers, upscale retail centers, & shopping malls as well as mixed-use commercial/retail centers and freestanding locations. This doesn't mean that Kona Grill compromises on the quality of locations. In fact, Kona Grill requires its locations to have significant daytime populations and they must meet its internal ROI target of 30%.

For example, one of Kona Grill's restaurants is located at a Lifestyle Center in Alpharetta and another is located at Dolphin Mall in Miami.The Lifestyle Center in Alpharetta is a mixed-use development comprised of shopping, dining, and Class A office space, located in an area with attractive demographics where 63% of the population within a seven-mile radius have household incomes above $75,000. Similarly, the Miami Dolphin Mall is situated in an area which boasts 200,000 people in the vicinity with household incomes above $75,000.

Another company which has capitalized on flexible real estate options is Ignite Restaurant Group. With multiple restaurant concepts -- Joe's Crab Shack, Brick House Tavern + Tap, and Romano's Macaroni Grill -- Ignite has the ability to shift its different restaurant concepts around its restaurant locations to fine-tune its strategy. It has converted three Joe's restaurants into Brick House restaurants and two Brick House restaurants into Joe's restaurants in the past three years.

Ignite estimates that converting a restaurant produces around $500,000 in cost savings in comparison with starting one from scratch. Ignite acquired Romano's Macaroni Grill in April 2013 and plans to convert certain of its underperforming Romano's Macaroni Grill restaurants into other concepts under its umbrella.

Foolish final thoughts
A restaurant chain has great potential to grow, as long as it retains customers and has a pipeline of suitable locations for further expansion. This is exactly the story with Kona Grill. With a footprint of only 26 restaurants, Kona Grill has a significant growth runway. Looking ahead, Kona Grill has four new store openings planned for 2014 and two leases signed for 2015.

In the first quarter of 2014, Kona Grill achieved outstanding results as its top line and same-store sales expanded by 17.5% and 6.2%, respectively. This further validates my confidence in the stock.

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Mark Lin has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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