Kaitensushi (回転寿司), Kura Sushi US
(Deep Dive, Edition 4, July 2021)
Deep Dive, Edition 4, July 2nd 2021
I have decided to make this month’s write-up non-paywalled and accessible to every Investment Talk reader.
This piece is part of the monthly recurring write-up segment of my newsletter, where I share one new business introduction each month to paying subscribers.
If you wish to download the full report as a PDF, follow this link.
If you wish to read this as a webpage, and not an email, then follow this link.
Kaitensushi (回転寿司), Kura Sushi US
In this edition of the Deep Dive series, I wanted to break away from the larger-cap, and well-covered companies that I have previously been writing about. The likes of Etsy, Redfin, and Pinterest are all relatively well known and have market caps that range from $5 to $50 billion dollars.
Each of those businesses is already somewhat proven, and it’s up to the individual to decide if they are, indeed, great businesses or not.
Instead, today’s piece will focus on something which is not yet proven. Something which is considerably smaller in value, at a market cap of ~$325 million at the time of writing, and something which is lesser-known to the broader investing public.
Most importantly, and most abstract from other editions, is that Kura Sushi is potentially not a great business.
Kura Sushi, today’s subject of discussion, is a Japanese sushi franchise based in the United States. Below, you can see an image of one of their stores in California.
At present, there operate just 32 Kura Sushi stores in the United States after the initial launch in 2009 with a maiden store based in Irvine, California.
By 2015, there were 8 stores in the United States. Store count doubled by 2018 (17) and was expected to double again by 2020, where internal estimates guided for 29 stores by year-end.
After raising $39 million in its 2019 IPO, the company had the funding the accelerate its expansion efforts.
However, in the wake of the coronavirus epidemic, the company were forced to curtail their expansion efforts and ended 2020 with just 25 stores.
With such a small base of stores in the United States, the company’s growth strategy is tailored to four core areas:
• The acquisition of new (and attractive) lots to build stores
• Delivering consistent comparable-restaurant sales growth
• Improving profitability, and
• Heightening their overall brand awareness in the United States
These were the goals prior to covid. Obviously, the business had to alter its operations somewhat during that time, with a noticeable uplift in off-premises sales during 2020.
Off-premise sales, facilitated mainly through Grubhub and Square, reached as high as 31% of total sales In December of 2020. More on that later.
Awareness & Unit Acquisition
Two of those goals, for the time being, are largely correlated to one another.
With such a small base of stores in the United States, most of which are concentrated across California and Texas, one of the most efficient ways for Kura Sushi to generate awareness is through opening stores in new States.
During the most recent earnings call (Q2 FY21) CEO, Hajime “Jimmy” Uba, stated (this was translated by Investor Relations director, Benjamin Porten) that:
“Given how few units we have, we think that the best way for the country get to know us is by going around the country”.
During an investor presentation hosted on January 2020 (again, before covid) management highlighted the underpenetrated nature of their existing markets as well as the potential that exists within new markets as their most promising reinvestment runway.
In this presentation, they suggested that there is potential for a total of 87+ stores within their existing markets, as well as the potential for 184+ new stores in new markets (Unexplored States).
In total, they suggested there is a national opportunity for over 295 Kura Sushi stores.
From the ending period of the fiscal year 2019, management declared intent to increase store count at a 20% CAGR over the following 5 years.
The corona epidemic obviously put a damper on that goal. As noted, the original guidance was for 29 stores by 2020. Instead, they ended the year with just 25.
However, it appears that the goal is back on track, and by FY24 we could see 57+ Kura Sushi stores in the US.
That seems like peanuts in comparison to something like Starbucks, which has well over 18,000 locations in their Americas segment. Or perhaps McDonald’s, where there are over 13,000 locations in the United States.
We are not talking about hamburgers or coffee here. We are talking about Sushi.
Whilst the United States might have an abundance of fried, sugary, carb-loaded, food and beverage providers, the Sushi market is relatively small. This mostly true across the Western world.
What you will find is that the United States is largely populated with smaller Japanese Sushi chains that are big in Japan, and are trying out their luck in the West. Most of which only operate between one to ten stores.
There are some outliers, who operate hundreds of sushi bars, but there is no “Starbucks of Sushi” or “McDonald’s of Sushi” in the United States.
That may well be for a good reason. Perhaps American tastebuds are simply not excited about the prospect of eating raw fish and the rest of the menu items that Sushi chains have to offer.
Data suggests otherwise.
In 2011, the market size for sushi restaurants in the United States was close to $15.3 billion.
After ten years of sequential increases (excluding the anomaly of 2020), it is reported (by IBIS) that the market size is closer to $22.5 billion today, up ~47%, with well over 20,000 sushi restaurants across the nation.
So, for this nation, with ~330 million inhabitants, the entire market size is $22.5 billion.
In Japan, where there are ~126 million inhabitants and over 30,000 sushi restaurants, the culture of sushi consumption is embedded within the heritage of the Japanese people. The annual revenue of Sushi restaurants, alone, is estimated to be ¥1.5 trillion (~$14 billion) as of 2020.
Think of the US restaurant industry as an amalgamation of full-service and limited-service store types.
A full-service restaurant would be your typical sit-down meal with the full front of house staff and the slower-paced dining experience that most people are accustomed to when they head out for breakfast, lunch, or dinner.
A limited-service restaurant would then be a format in which there is some element of self-service, or perhaps a focus on high customer turnover. You can sit and eat, but all the bells and whistles of a full-service establishment are absent.
Kura sits somewhere between the two, offering the experience and food quality of a full-service restaurant and the speed of service of a limited-service restaurant.
Kura primarily competes with other full-service restaurants and faces significant competition from an array of locally-owned restaurants and national chain restaurants offering both Asian and non-Asian cuisine, as well as takeaway options from grocery stores (cold packaged sushi).
“We believe that we compete primarily based on product quality, dining experience, ambience, location, convenience, value perception, and price. Our competition continues to intensify as competitors increase the breadth and depth of their product offerings and open new restaurants.” - Kura Sushi, 10-K Filing
The Kura Sushi franchise has a robust pipeline for new store construction and leases over the next two fiscal years. There are currently six locations with wheels in motion and a further batch of prospects across new and existing States.
By the end of FY22, we should expect an additional 8 stores, on top of their current 32 in the United States.
Store Pipeline For Fiscal Years 2021 and 2022
Profitability & Comparable Sales Restaurant Growth
With respect to their other two growth funnels, profitability and comparable sales growth, these should benefit from economies of scale.
As the number of units grows, the fixed overheads can be spread across a larger number of stores.
Comparable Sales restaurant growth, which represents the year-over-year sales for restaurants open for at least 18 months prior to the start of the accounting period presented, is likely the most difficult metric to excel in, and we are going to come back to this when we visit the ‘Business Overview’ segment.
Now, I was not entirely forthcoming with the full picture in the initial introduction to this company.
Part of the potential appeal (to me at least) is that Kura Sushi is the child of a much larger parent organisation, known as Kura Corporation, based in Japan.
There are five major conveyor belt sushi companies in Japan, Akindo Sushiro, Kura Sushi, Hama Sushi, Genki Sushi and Kappa Sushi.
Kura, who own more than 450 stores in the country, are one of the pioneers of conveyor-belt sushi and have a big presence in Japan.
Both Kura Sushi USA and Kura Sushi Asia (Taiwan operations) are the subsidiaries of the parent company.
This appears to be a common set-up amongst the larger Japanese sushi chains, with each of the aforementioned companies having international subsidiaries across the United States, Europe, and Asia.
At the time of writing, the Taiwan subsidiary currently operates 33 stores across the country, after having opened 11 new stores in 2020 alone. They generated ~$86 million in revenue last year, and are profitable.
The Japanese parent earned ~$1.2 billion in revenues during 2020, and the US subsidiary we are assessing today, reported sales of $45 million last year, down from $64 million in 2019. Typically, Kura USA is a profitably run organisation.
In a Nutshell
Kura Sushi is a technology-enabled, revolving sushi restaurant with 32 stores located in the United States. As a subsidiary to a much larger Japanese parent, Kura Corporation, Kura USA relies heavily on their parent for IP, resources, and external financing.
Managed by a team of operators who have decades of experience within the Kura Corporation, the US business is signalling an expansion opportunity of ~300 stores nationwide.
It would appear that the trough for earnings is past us and that the business should face considerably easy comps over H2 FY21 and FY22.
The company exhibits favourable payback periods for new stores. At $3.5M Average Unit Volumes (pre-covid) within ~18 months, the $1.8M cost of each new store is quickly recouped.
Pre-Covid, Kura operated in a consistent and profitable manner.
Kura has an efficient cash conversion cycle. Kura can buy from vendors on credit, and receive cash for those goods weeks before they are due to pay vendors for those inventories.
The company does appear to have considerable wiggle room for gross margin expansion through incremental price per plate increases, as well as operating margin expansion through the leveraging of costs across a broader base of stores. Kura possesses the opportunity to operate on a cost-leadership basis, due to the automation of their service, as well as the opportunity of pricing power in the future.
The business has a unique store concept, low-cost & high-quality food, and includes a gamification aspect to their restaurants, ensuring a pleasurable and affordable dining experience.
Kura USA has the ability to take on favourably rated, non-covenant, loans from their parent organisation to fund their expansion.
Store count (32) can be reasonably expected to double by FY24/FY25.
The current market price appears to offer little risk/reward on even the most bullish growth estimates.
Likely a ‘good business’ trading at a ‘questionable price’.
From licensing of IP to the availability of favourable term borrowing, as well as a host of other items, Kura USA relies heavily on their Japanese parent, Kura Corporation. Kura Corporation controls 80% of the voting rights.
Kura is currently an Emerging Growth Company (EGC), thus the reporting quality is cast in doubt (as EGCs are exempt from certain disclosures). Subsequently, this also casts doubts on earnings quality.
Kura’s high-quality ingredients are crucial to their success but are sourced from two vendors at ~86% of total food & beverage cost. This is up from 44% in 2017 and carries significant counterparty risk.
Whilst the executive team does have a rich understanding of the Kura brand, the team is inexperienced in running a public US entity.
Kura faces considerable complications through their decision to lease real estate, as opposed to owning it.
The Brief History of Kura Sushi & Kura Sushi US
The origins of Kura Sushi actually begin with the revelation of Kaitensushi (回転寿司) which literally means “turnover sushi” but roughly translates into “conveyor belt sushi”.
Yoshiaki Shiraishi was the man who is acknowledged with increasing worldwide sushi consumption after his idea to create a conveyor belt system for sushi delivery in 1958 when he opened his first revolving sushi restaurant in Osaka.
Sushi, when made by hand, is a delicate, and time-consuming offering to create, with a huge variety of potential matches between fish, meat, rice, and various condiments and compliments.
As such, it was often expensive and was limited to the capacity of the chefs. You would struggle to fling out sushi orders like McDonald’s do with hamburgers. Sushi was once a luxury dining experience.
It was said that, back in the 1950s, Shiraishi took inspiration from watching beer bottles pass through the assembly line in a brewery.
Applying similar technology, he created a system whereby sushi could be prepared in advance and placed onto a rotating, self-service, conveyor belt in order to facilitate more orders.
Through this mass-production approach to sushi, Shiraishi could cut costs on waiters, serve more customers, lower costs to attract lower-income portions of the population, and turn sushi from a luxury dining experience, into an affordable staple in the Japanese diet.
Many traditional members of the industry scoffed at this revelation, claiming that it diluted the appeal and grandeur of this delicate art.
Customers, however, loved it.
When conducting my research into the background of this industry, I stumbled across a great piece titled ‘The Tale of Sushi: History and Regulations’, written by Cindy Feng, conducted as a study in 2012.
In this piece she wrote:
“In the past few decades, the consumption of sushi has adopted both versatility and diversity; sushi is now available in the most elegant epicurean settings as well as in convenience stores, university cafeterias, and worldwide airport kiosks. But in Japan, what ultimately transformed sushi from a luxury reserved for special occasions to a casually accessible popular cuisine was the introduction of kaitenzushi, or conveyor belt sushi.”
She continues to explain the cycle of small booms that were experienced across the 20th century in Japan, starting in the 1950s with Shiraishi of course, before booming once again in the 1970s, 1980s, and 1990s as society and technology shifted:
“The conveyor belt sushi boom commenced in the 1970s after a conveyor belt sushi stall was installed at the Osaka World Exposition and attracted thousands of curious sushi aficionados. Another boom was witnessed in the mid-1980s when eating out became a popular middle-class societal phenomenon in Japan.
Ironically, the final boom of the conveyor sushi popularity was triggered by the burst of the Japanese economic bubble in the late 1990s, when inexpensive restaurants became immensely popular amidst middle class and young professional restaurant-goers who were on a limited food budget.”
She continues to touch upon the international expansion demand after much success domestically. Kura Corporation (The Japanese Parent to Kura Sushi USA) worked with game giant Sega Corporation to develop the touch-panel ordering system that we now see in those restaurants today.
This would allow customers to order from their seat, as well as through picking items from the conveyor belt and incorporated a game whereby a certain number of plates must be consumed before a prize is given to diners.
“The attractiveness of the new high-tech kaitenzushi machines is 2-fold: it not only serves to attract customers who are intrigued by the appealing new technology that animates and diversifies the dining experience, the new machines also reduce wastefulness at the restaurants by precisely tracking orders.”
So, that was the origins of the way in which the product is delivered, which Kura Sushi incorporates today.
Kura Sushi Corporation actually started out life in 1977 as an ordinary, non-conveyor-belt, Sushi restaurant in Sakai City, Japan owned by a Mr Kunihiko Tanaka.
Mr Tanaka (below), still serves as the parent company’s President today.
His message to employees, shareholders, stakeholders, and customers is that Kura Sushi is fighting to “restore Japanese tradition and culture” through their insurance of traditional Japanese cuisine, prepared free from additives or preservatives.
He paints an interesting tale about his time as a child and the importance of ensuring you treat others with care. I won’t share the whole thing, as it’s quite long, but you can find it here.
In response to his disappointment with the industry’s reliance on poor quality food production and outsourcing, he notes that:
“Our foodservice industry has the same problem. Companies keep increasing their sales with television commercials. However, the job of making their products is mostly outsourced. Managers in those companies would not eat their own products, but dare to make and sell such products.
Many sushi restaurants are similar to this. They dare to outsource the vinegar for sushi rice, which is the most important part of making sushi. They use chemical seasonings, artificial colourings, artificial sweeteners, or artificial preservatives. They would not care or feel anything even if the customers feed themselves with chemicals as long as the restaurant does not violate the laws.
They believe it is good enough because the Ministry of Health and Welfare decided the standards. Can you give such doubtful and suspicious products to your loving children in everyday’s life? It is said that mites are the reason for the growing number of atopy patients. Is that really true? Shouldn’t we suspect the food product also?
We give great efforts to the point that most customers do not notice often. We think that is the true Japanese virtue. For us, it is time to reconstruct the wonderful Japanese tradition through sushi, a representative of the food culture in Japan, and proudly announce our tradition to the whole world.”
I thought that was interesting to gain some insight into the culture of this organisation.
Back to where we left off now, in 1997.
After 7 years, in 1984 Tanaka decided to open his first revolving sushi restaurant, in the same city and would call it “Revolving Sushi Kura”.
Tables would be situated next to a revolving belt with two levels, the lower half being circulated constantly with a range of menu items, and the upper half is reserved for specific orders to each table.
It would later be renamed “Kura-Zushi” in March of 1990, and incorporated into Kura Corporation in 1995.
Over the next ten years, many of the staples which Kura is known for today were created.
This started in 1999, where the company introduce their table-side automatic plate-collecting system (see below). When customers are finished with a plate, they deposit it down the shoot at their table. This plate would then travel down an automated delivery system to be cleaned and recycled back into the network of rotating dishes.
Not only did it disappear to be cleaned, but thanks to QR code technology, implemented in 1997, the plate would also be counted through a barcode and added to the user’s bill automatically. These QR codes, today, act as the bedrock which allows managers to monitor the freshness, product mix, and location of each of their plates on the belt.
In 2000, the company introduced “Bikkura Pon” machines beside each table, featuring their company mascot “Muten-Maru”. This little mascot, funnily enough, has almost 750K followers on Twitter.
These prize machines would work in tandem with the QR codes on the plates that were sent down the shoot to be cleaned and would release a prize after a certain number of plates had been eaten.
The following year, Kura would bolster this with a new touchpad ordering system, called “Touch de Pon”, which would act as POS for customer orders, and also share animated videos of Muten-Maru after a certain number of plates were deposited.
Customers could now order directly from their table, after which the orders would come to them on the upper shelf of the conveyor belt. The Bikkura Pon machines and the POS are still huge portions of the dining experience today (see above image).
Later that year, Kura listed on the JASDAQ exchange (Formerly known as NASDAQ Japan) and within five years would have opened their 100th store in the Kansai region of Japan.
By 2008, they had opened their 100th store in the Kanto region of Japan, for a total of 223 stores nationwide.
At this point in time, Kura had begun to consider international expansion. The American appetite for Sushi had shown strong adoption over the latter portion of the 20th century.
Cindy Feng, in the piece I referenced earlier, noted that:
“Sushi as a modern cuisine saw its most dramatic and intense development and transformation in the 20th century. Japanese cuisine has become one of the most popular choices for restaurant goers in America. Between 1988 and 1998, the number of sushi restaurants in the U.S quadrupled.” - Cindy Hsin-I Feng, 2012
They would later form Kura Sushi USA, in 2008, asking Hajime Uba to serve as CEO (still serves as CEO today). Mr Uba had joined Kura Corporation in 2000.
In 2009, they opened their first US store, in Irvine California, after incorporating Kura Sushi USA as a subsidiary. We will come back to discuss the relationship between the subsidiary and the parent, as well as management in a later segment.
Kura would then continue to expand domestically and across the States, reaching 8 US stores by 2014, for a total global store count of 351 by year-end.
Then, in December of 2014, they would enter their third market through the creation of a Taiwanese subsidiary called Kura Sushi Asia. Here, they would launch their maiden store in Shmgiang Namjimg.
Both subsidiaries would be run as separate businesses, but with the luxury of having the wealth of resources to tap into from the Japanese parent. That relationship still exists today.
In 2019 Kura Sushi USA was listed on the Nasdaq Exchange, and the following year Kura Sushi Asia was listed on the Taipei Exchange.
As discussed, both subsidiaries now have 32 and 33 stores in their respective regions, with the Japanese parent operating in excess of 450 stores domestically.
In this piece today, we are going to be focussing on the US subsidiary and will be making reference to the Kura Corporation and Kura Sushi Asia if and when necessary.
Kura Sushi USA Business Overview
The Kura Sushi business model is fairly simple. They are a technology-enabled sushi restaurant, that benefits from the automation of certain aspects of their service style.
The business currently operates 32 stores within the United States, with just over 1,030 employees.
The longer-term goal is largely orientated towards increasing their reach across the United States, attracting a brand following, and ensuring that the food is low-cost, fresh, and good enough to encourage repeat custom.
I will be covering the business overview but would like to conclude this segment with some discussion on what might drive the business forward, as opposed to focussing on what the business looks like today.
I think with something like Kura Sushi, it can be beneficial to actually witness the store format, and appreciate the feel for the restaurant to better visualise the discussion we are about to embark upon.
So, in light of that, I have compiled a list of four good quality Youtube videos, of visitors documenting their experiences with Kura Sushis across New Jersey, Las Vegas, Texas, and California.
The first video is a company-sponsored advertisement for their newest Florida store.
I would highly advise watching the first video, and maybe one or two of the visitor experiences before moving on. They are actually quite fun to watch.
Kura Sushi USA
Kura Sushi is a chain of conveyor belt sushi restaurants that serves seasonal authentic Japanese cuisine.
The business emphasises the high-quality ingredients that are free from artificial seasonings, sweeteners, colourings, and preservatives, as well as their desire to make sushi an affordable part of the American diet.
In addition to serving a rotating belt of items that are often priced under $3 per plate, the stores have an ancillary menu where diners can order specific plates at a higher cost.
The seasonality of their menu (which typically sees partial menu rotation 3 to 4 times per year) enables Kura to continually refresh their menu and attract and retain customers. Whilst core favourite menu items are a benefit, one of the issues that businesses in this industry faces are tired tastebuds. At times, customers can become bored of what items a restaurant has to offer and seek alternatives.
At Kura, they are able to combat that by rotating their menus as the seasons alternate and highlighting new menu items on a recurring basis. Each store typically has well over 140 menu items at any given time.
The dining experience is fun and, to the American consumer, likely quite novel.
The sight of sushi plates whizzing around a room is exciting, but part of the appeal (to an investor and a consumer) is the gamification of the dining experience.
Diners are encouraged to fill their boots in order to win small prizes from the Bikkura Pon machines by entering 15 plates into the plate shute. This is assisted and encouraged with the animations on the touchpad beside each table.
At the very least, one can imagine that this is a great place to take your children. I recall, as a child, that part of the appeal to visiting a McDonalds was the toys that were provided upon the purchase of a happy meal.
Like McDonald’s, Kura brand the prizes with Kura Sushi logos, and alter the contents of their prizes on a regular basis. This can include partnerships with other brands such as anime series and a Lego-like product called “sushi block”.
One of the more recent collaborations was a partnership offering with Hello Kitty (see below). Through their release of limited-edition partnership items, Kura creates a sense of collectability and exclusivity for frequent restaurant-goers. This isn’t exactly a bull thesis, but it is an interesting way to offer recurring new reasons to take your kids to the stores.
This is a tried and tested business, with over 450 stores in Japan in a business that has over 35 years of operating history.
Dining experience aside, Kura offers high-quality food items at a low cost.
Part of the reason they can afford to extend a menu consisting of $3 plates is their cost savings from their service model.
Each table is largely self-serving (picking items from the belt) with the table-side touchpad facilitating the majority of the ordering (which are also delivered via the belt). As such, the expense for front-of-house staff is minimal.
Whilst I can not be sure that, at this stage, this is a competitive advantage, it certainly demonstrates cost-leadership potential, through lower-cost operations. That can be hard to compete with.
When I first embarked upon the study of Kura Sushi, there was a lot of emphasis on the fact they are “technology-enabled” or “driven by technology”, however you want to spin it. At first, I figured this was just marketing.
After all, Starbucks are technology-enabled, and so are McDonald’s.
However, it would appear that Kura Sushi’s technology is part of what makes their business unique from a competitive point of view.
Not so much so that I would dare call them a technology company, nor would I say that any of their technology acts as a severe barrier to entry into the market.
I think it would be more appropriate to say that it gives them a small edge in terms of cost savings of labour, as well as operating efficiencies.
Each Kura store utilises a computerised management information system to record a table’s food consumption. The point of sale system is used to tally food consumption, produce the final bill, and process credit cards. Transaction data is then used to generate customisable reports that restaurant managers, the operations team, and senior management use to analyse sales, product mix, and average check.
Kura Japan owns a number of patents and trademarks (which Kura USA licence), as well as a host of operational practices that streamline their operations from their rice makers to their automated plate washing system (that I alluded to earlier).
As well as automating the dishwashing process through the plate-shutes, the QR barcodes on the plates allow chefs to monitor what variety of sushi is selling most frequently, allowing them to optimise the quantities of sushi they are making in the kitchen.
There are two patents in particular that stood out to me, and it’s important to note that the bulk of Kura USA’s IP is licenced from Kura Japan.
Revolving self-service sushi restaurants place dishes onto a plate and typically cover them with some form of covering to prevent the drying of the sushi, the spread of germs, and to keep the dish fresh. You can see (below) that this is typically a basic plastic shelter, as taken from Yo! Sushi, a popular European brand of conveyor belt sushi.
The problem here is that despite keeping the sushi fresh, it is still isn’t the most efficient or hygienic process. In this case, the chef still has to handle to cover, placing it onto the plate, and requires that the customer handle the cover when taking the plate off the belt.
Both the chef and the customer are handling the plate cover. These covers then take up a considerable amount of space on the diner’s table, which is often a small cubicle sized station.
Kura Sushi’s food plate carrier (below) removes the need for either the chef or the customer to handle the protective covering.
The ‘pop-action’ design of the Kura plate cover means that only the plate is ever handled by the chef or the consumer. As the plate is slid into the mechanism, the cover pops open, and when in place, shuts closed. When the customer wishes to remove the plate from the below, they pinch the plate and pull it towards them, at which point the cover opens and remains on the belt.
The chips inside the device alert the kitchen that the sushi has been taken, and will subsequently be removed (automatically) from circulation.
This way, the cover remains on the belt, is not handled by either party and doesn’t congest the table by taking up space.
This plate carrier system, titled ‘Mr Fresh’, also contains a chip within the covering that alerts chefs when sushi is taken from the dome, as well as monitoring how long the plate has been on the belt (ensuring items remain fresh). Plates can remain on the belt for as long as two hours, at which point they will be removed from circulation by a robotic arm.
“Under the circumstances, according to a related art, for example an IC tag is attached to each plate on which the food is served and the data written in the each IC tag of the plate conveyed is read out by a reader, so that the contents of the food eaten are discriminated on an as-needed basis by a controller and then are informed to the kitchen, to provide an improved efficiency of the kitchen work, or the food remain ing in excess of a predetermined time can be discriminated from the foods fed on the conveyor line so that it can be removed from the conveyor line.” - Patent 9193535B2
In effect, Kura is utilising a range of patented sensors to control the observation, status, and freshness of their product that is rotating around the belt. Despite being a cause for great quality control, the minimisation of cross-contamination is especially pertinent in today’s post-covid era.
So, with a high-volume restaurant model, paired with efficient and scalable operations this bodes well for some interesting restaurant-level economics.
Kura cites their flexible real estate as a core component of these attractive unit economics. They claim to “have a flexible restaurant model which has allowed us to open restaurants as small as 1,600 square feet and as large as 6,800 square feet”. Adding that they “believe this allows us to maximize our sales per square foot.”
Store Design, Expansion and Selection
This brings onto an important point.
Aside from the quality of the food and dining experience, an integral piece to Kura’s growth trajectory relies on its ability to source and acquire good stock of locations for its new units. This ties in with their goals to increase brand awareness and pursue new restaurant development.
I must state that Kura does not own these stores, instead opting to lease them. More on that later.
Each Kura store (below) ranges from between 1,600 and 6,800 square feet, require between 30 and 70 staff members, and will be placed into varying ‘kinds’ of outlet space, whether that be a strip mall, a small detached storefront, inside a mall, or adjoined to other neighbouring businesses.
On average, a Kura store is 3,400 feet and can seat 120 guests at a time.
Using a network of brokers, Kura is primarily searching for “high-traffic retail centres” which exhibit diverse populations and above-average income households.
The selection criteria will typically consider:
Residential and commercial population density
Space for curbside pickup and off-premise delivery
Availability of suitable parking
Proximity to highways, universities, shopping areas and office parks
The degree of competition within the market area, and
General availability of restaurant-level employees
As noted in the opening remarks, Kura attacks its expansion efforts through a two-pronged position, simultaneously opening in existing and new markets (whitespace). Management is intending to fund a study on the opportunity within the whitespace, which is expected to be commissioned soon.
Typically with new markets, and you will see this if you revert back to the store map, Kura will launch one unit in order to create a proof of concept, and then, if successful, will expand outwards into the market. Washington, New York, and Florida currently have one store.
In order to support these isolated stores, Kura deploys a “remote management system” which includes the installation of between 20 to 30 cameras in each unit, to maintain operational quality and minimise inefficiencies whilst there is a lack of economies of scale.
Considering how small the Kura unit base is, each additional new store generates a considerable impact on the operating business. Back in 2020, management remarked that it costs the company ~$1.8 million in cash to build out a new restaurant, net of tenant allowances and pre-opening costs.
There is obviously a lot of deviation here, depending on the size of the property, and the marketplace it is opened in, but that’s the average cost.
Prior to the corona crisis, Kura was generating in excess of $2.5 million in revenues per store. This would be calculated simply by taking the sales for the year and dividing by the number of stores.
However, Kura tends to lay emphasis on a non-GAAP measure called ‘Average Unit Volumes’ (AUV), which instead focuses on the stores that have been open longer than 18 months, to account for the lag in ‘steady state’ sales for each new unit.
I would be in agreement that this is likely a more accurate picture of the unit sales economics for the business. If we are dividing revenues by, say, 32 stores and 5 of them were only open for one month, then it’s not an accurate representation.
Using AUV, it would appear that Kura generated around $3.45 million per store (pre-covid) that has been opened longer than 18 months.
So, covid aside, the payback period looks good here.
Costing $1.8 million to build, and taking between 4 to 5 months on average, a store can reasonably be expected to almost double that figure in sales within 18 months.
Hold that thought, as we are going to come back to this in the following segment, where I attempt to make a reasonable assumption as to how these unit economics will look by 2030.
Digital Consumption and Marketing
The marketing efforts of Kura are pretty typical for a small entity. They are present on most social media platforms, and their primary form of advertising is digital.
There is some small argument for the ‘shareability’ of the dining experience, which can result in guests posting live or recorded videos and images of their experience and sharing them organically. But there is nothing extraordinary here. This is the case for many businesses. However, at such a small size, it is a tool for Kura.
Kura Sushi also, like most companies these days, offer an app to consumers which allows them to collect rewards and points, claim coupons, see live insights into the capacity and wait times for stores, and order deliveries for pick-up or delivery.
Rewards programmes are no-brainers for brand-orientated franchises.
Back in May 2021, in a piece titled ‘Starbucks is Back, and with a Strong Digital Presence’ I wrote the following when explaining why Starbucks’ meteoric uptick in loyalty members was important:
“The increase was complimented by a meaningful uptick in conversions, with more app downloads advancing to member activations.
Why is this even important?
Well, the typical rewards member visits a store, or purchases an item, on average, 2 times to 3 times more often than a non-rewards customer.
Expand the user base, increase the conversion, and increase the engagement in-store.”
The digital presence proved to be crucial during the mid-point to the tail-end of 2020 as cities in the United States began to lockdown. Off-premise sales (those comprised of pick-up and delivery) were once low single digits of the total sales mix.
During the peak of the lockdowns, this composition soared to mid-single digits, peaking as high as 30% in December 2020.
These delivery services are primarily facilitated through Square and GrubHub.
As the quarters droned on, it was apparent that management (my perception of the earnings calls over that time) were becoming accustomed to the possibility that off-premise could constitute high single-digits to low double-teens of their total sales volumes going forward.
Something which would have been unimaginable pre-covid.
It was acknowledged, in the most recent earnings call, that space for curbside pick-up and delivery would now factor into the decision making process for new stores, but would not be a deciding factor.
“While off-premises is important, it's really just one factor in terms of our decision-making. We're not going to be deciding which states we're going to enter or not enter based off of the off-premises opportunity. We're not going to be building our market strategies around this, but it will just be a standard part of every decision-making process in our site selection going forward.” - Jimmy Uba, Q2 FY21 Earnings Call
The Kura Sushi app, which is still relatively nascent should streamline those off-premise sales efforts somewhat. With the combined rewards and app userbase of 100,000 members, there is still a long way for that tiny ecosystem to go.
Sharing Resources with Japan
Being a subsidiary, Kura Sushi USA has considerable exposure to their parent organisation. As well as owning the majority of voting rights, and the entirety of Kura USA’s class B shares (which hold 10 votes per share), the Japanese parent is on hand to offer the US subsidiary considerable resources.
Whilst still an independent business, the US operations are able to tap into:
“Certain strategic, operational and other support services, including assigning certain employees to work for us as expatriates to provide support to our operations, sending its employees to us on a short-term basis to provide support for the opening of new restaurants or renovation of existing restaurants, and providing us with certain supplies, parts and equipment for use in our restaurants.”
In addition to this, Kura USA provides Kura Japan with certain market research data and translational services.
This is all through their shared services agreement, signed in mid-2019.
As part of the agreement, Kura USA pays a 0.5% royalty fee (based on net sales) to Kura Japan in exchange for all of the IP that they utilise in their operations.
The relationship between the two entities is a recurring theme, which we are going to come back to a few times in this piece. As well as a shared services agreement, Kura USA benefits from a friendly credit line from their parent organisation, allowing for much needed, and fairly priced, borrowing.
KPIs and How Kura Sushi Generates Revenue
The way in which Kura generates revenue is pretty intuitive. We don’t have to spend a great deal of time here. Where I shall spend the majority of the time in this segment, is in the discussion of their Key Performance Indicators (KPIs).
On the whole, Kura record one line item for revenues, and that relates to the sales which they generate through the offering of food and beverage items within their restaurants.
Sales are largely influenced by the number of stores they operate and the respective growth of store count, as well as traffic within those units, and the average check size.
The largest costs for this business relates to food, beverage and labour, but we will get to that later.
Key Performance Indicators
The core KPIs for this business largely relate to the quantity and relative profitability of their store count. As they are in the expansion phase, this is to be expected.
Kura is nowhere near a steady-state, where they can be assessed on current assets or operations. With aspirations of almost 300 stores nationwide, the business is currently only 10% of the way there.
Sales, EBITDA, and Adjusted EBITDA
Fairly straightforward, the company are looking to generate an ever-increasing surplus of sales as they continue to expand across the United States. Obviously, the coronavirus was a huge headwind on that effort.
After-sales grew 40% in FY18 and a further 23% in FY19, sales cratered 30% in FY20 after the onset of the lockdowns in the United States.
Reaching a trough in Q3 FY20 ($3M), quarterly sales began to slowly regain pace in Q4 FY20 ($6M) growing 100% sequentially, and a further 33% the quarter after that.
It is worth highlighting here that for the entity of Q1 and Q2 FY21, Kura’s largest market, California, had none of their 16 CA stores open for inside seated dining. In Q3, all 16 stores were fully open to the public.
Based on YoY comps, and the fact that management alluded to $5.1 in sales for the first month of Q3, I am expecting triple-digit YoY comps for both Q3 and Q4 FY21.
During the peak in 2019 ($64M), Kura had just 23 stores, running at an AUV of $3.45 million.
Pending any further disruption from covid, all 32 stores are now open in the US and (assuming AUV reaches ~$3.2M in FY22) I would expect annual revenues to reach ~$85M+ by the end of the fiscal year 2022, keeping in mind that AUV only accounts for stores open for 18 months or more.
Kura typically earns an adjusted EBITDA margin of ~8% (pre-covid) which backs out interest, taxes, depreciation, impairments, and SBC from their net income.
They believe that both EBITDA (Interest, Tax, Depreciation) and adjusted EBITDA (which includes that plus other non-cash expenses) are a useful measure of assessing the business from an operational level.
Number of Restaurant Openings
Management has a goal of 20% CAGR in units from FY19 to FY24. I shared the chart for that earlier, which would reason that Kura has ~57 stores by FY24.
If we assume that they open no more stores this year (currently 32) then we could estimate that they open an additional 8, 7, and 10 stores across the next three years. Obviously, there will be some variation there. Management might choose to selectively expand heavily in one year, versus another if the environment and liquidity are more conducive to that goal at the time.
Quite simply, increasing the store count will enable the business to generate higher revenues through incremental unit volumes (sales) as well as stretching their brand recognition in a compounding manner as they enter new markets.
Additionally, the operating costs not associated with individual restaurants, think marketing and G&A (marketing is included in G&A for Kura), should, in theory, be able to be leveraged across a wider base of units. Whilst operating costs such as labour and food & beverage will scale with unit growth, there are certain expenses that should offer some upside in operating margin as the business grows.
Prior to covid, operating margins oscillated between 2.6% and 4.1%, showing considerable room for improvement.
The upside might be less than one might expect, however, as the Japanese parent, who own over 450 mature stores, typically generate operating margins of between 5% and 6% on a given year.
I am not sure how this will translate into US market environments, as one has to remember that Sushi is vastly more competitive in Japan, which might be why margins are so low.
Then consider that the bulk of Kura’s food is ordered from Japan, whereas the Japanese stores have those resources based domestically. This is something we will discuss in due course.
Restaurant-level Operating Profit and Operating Margin
With respect to the nature of Kura’s business, they break down their operating incomes and margin in a way that more so captures the picture of the operations from a restaurant level.
Essentially they are splitting the costs associated with the business as a whole, that are not directly related to any, one, individual store, such as G&A.
Restaurant-level Operating Profit is defined as operating income (or loss) plus:
Depreciation and amortization
Stock-based compensation expense
Preopening costs and general and administrative expenses which are considered normal, recurring, cash operating expenses and are essential to support the development and operations of restaurants
Non-cash lease expense
Closure costs and restaurant impairments
Less corporate-level stock-based compensation expense recognised within general and administrative expenses
They are basically adding back all of the expenses that are not directly related to individual restaurants and are, instead, more conducive to the costs of running the business on a consolidated level.
The restaurant-level operating margin is simply restaurant-level operating income (contribution) divided by sales.
“We believe that Restaurant-level Operating Profit and Restaurant-level Operating Profit margin provide useful information to management and investors regarding certain financial and business trends relating to our financial condition and operating results, as this measure depicts normal, recurring cash operating expenses essential to supporting the development and operations of our restaurants” - Kura Sushi, 10-K Filing
Whilst not a perfect metric (nor it is compliant with GAAP) it does provide useful insight into the core operations of the business, without the murky cloud of non-restaurant related items.
For instance, you will note that from 2018 to 2019 consolidated operating income declined from $1.86 million to $1.66 million. Over the same period, revenues had grown from $52 million to $64 million.
On a restaurant level, store operating profit grew from $10.38 million to $12.94 million, whereby the margin remained flat at 20.1%.
Here we can identify that there was no material impact on margin across the core operations (the restaurants), but instead, it was the result of a higher amount of spending across non-core expenditure.
Also, note that 2020 and 2021 YTD lines (2021 contains two-quarters of data). For the majority of 2020, Kura stores were partially closed, as such on the restaurant level the business failed to generate operating income.
In 2021, despite consolidated operating losses, the restaurants (now mostly back open by late Q2) were once again generated margins of 18.7%. Based on the YTD, it is pleasing to see that margins are getting back to where they once were.
Average Unit Volumes (“AUVs”)
Not all KPIs are born equal.
I would probably flag AUVs as one of the most important metrics for Kura.
Simply, the revenues generated per unit, for all units opened within the last 18 months. It is my opinion that looking at a simple revenue over units metric is useless whilst the business continues to grow stores at a 20% CAGR. We need to account for catch up.
Prior to covid, Kura was kicking out ~$3.45 million per unit. Recall that we said each store typically costs ~$1.8 million to build. This is a pretty sweet payback period in my opinion.
Back in the Q1 FY21 earnings call, Steven Benrubi (CFO) remarked that from a $3.5M AUV base, a store would need to earn ~50% of that sales volume to break even on a restaurant-level cash flow basis.
When accounting for the chain as a whole (including new restaurants opened less than 18 months which have higher non-recurring start-up costs) that level comes closer to 65% of that sales volume to breakeven.
Then, taking it a step further, and thinking about the entire business (including all operating expenses) that looks closer to 100% of that pre-covid AUV. This is why operating margins for the consolidated business are so small right now.
This is something that Kura will ideally work to reduce as the business continues to scale and they can leverage those operational costs across a broader base of stores.
The AUV is a great indicator of the demand for the aggregate portfolio of stores. I would suspect there is an upper limit to AUV, considering that, as time passes, there will be an increasing number of stores from which to draw this average.
I would imagine that the composition of size (the average square feet of the portfolio), as well as, of course, demand for their restaurants, plays the largest influence here.
Comparable Restaurant Sales Growth
Like the AUV metric, the base of stores that are considered “comparable restaurants” are those which have been opened for 18 months or more.
As you will see, the comparable sales base (yellow) is always considerably smaller than the total unit base. Kura is still small, so the influence of one additional new comparable is significant.
As the business continues to scale the impact of new comparables into the base will exhibit more dilutive tendencies.
Management has suggested that annual comps should ideally be within the 3% to 5% range each year.
The comparable base for the 6 months of 2021 is currently 20 units, and the comp stands at (-55.2%). Clearly, not great.
Typically I would anticipate a steady YoY growth rate in this metric, as presumably each year the total comparable sales base grows.
In 2018 (+2 units) we saw 2.9% growth followed by 6.2% of growth in 2019 after an additional 2 units were added to the base.
Despite including an additional 4 stores (twice the typical average) in 2020, comparable sales growth fell 38%. Unsurprising, given the circumstances.
Both Q3 and Q4 of FY20 were the two quarters that were hit the hardest from covid for Kura, so I would expect the latter half of the year to be an ‘easier’ comp now that all stores remain open for Q3 and Q4 of FY21.
Furthermore, the comparable sales growth should get back on track in FY22 as it looks to comp over a disrupted year.
There is likely going to be a lot of warp for the next 18 months.
With respect to those KPIs, I wanted to spend a moment discussing how we can utilise these metrics to get a better sense of what Kura may look like in the future.
Please note, that this is “back of the napkin” type stuff, more so to give you an idea of what these metrics can tell us about the future growth of the business.
Take the store count growth, which is one of the more focal points of the business for now, as they continue to expand. Kura is no way near maturity in the States. I think that’s obvious.
Let’s assume that they meet their 20% CAGR goal and by 2024 they have 57 stores.
From that point, we would then have to make a fair estimate for what the next X years looks like in terms of CAGR. Clearly, as the total number of stores grows, the relative YoY growth becomes more difficult. This would be partially offset by a larger pool of operating income from which they can continue to funnel back into the business.
Taking a base of 57 stores by FY24 (which is already a huge ‘IF’) I have mapped out the expected store count by 2030 should unit growth follow a CAGR of:
20% for 3 Years, followed by 15% for 3 Years
This would leave Kura with a store count of somewhere between 101 (based on the 10% CAGR) and 170 (based on the 20% CAGR).
These are just percentages, so the below graph shows what this would look like in terms of net additions to the store count base.
Based on Kura’s historic rate of new store openings, the 10% CAGR outcome looks like the most reasonable assumption. However, this looks accurate when we compare that to the current rate of new store openings, for the business which exists today. A business that has never surpassed $70 million in annual revenues.
By 2025, it is likely that Kura will have revenues that stretch, potentially, into the $150 million to $200 million range. Then consider that operating margins should begin to climb higher as the company are spreading their non-restaurant-level costs across 57 stores, instead of 32.
To get to that revenue range, I am again, making a boat-load of napkin assumptions, more to highlight a point, than to make any assertions.
In 2019 Kura generated $64 million in sales from a base of 23 stores. Here, I have assumed that they generate $16 million for Q3 and Q4 of FY21, which in my opinion is a low ball. They may end the fiscal year with similar revenues to 2020.
Then, using 2019 as a base, consider that Kura would run into FY22 with a base number of 32 stores, versus 17 at the beginning of 2019.
I use 2019 as the base, as both 2020 and 2021 were significantly impacted by closures and the exclusion of in-door dining.
During the course of 2019, Kura opened 6 stores and ended the year with 23.
In 2022 they may open ~8 stores, and end up with ~40 stores.
With that in mind, and assuming an uninterrupted year, Kura should see considerable growth in their top line in FY22.
In the quarters leading up to covid, Kura was generating between $17 and $19 million per quarter with 25 stores.
Suggesting they can muster $21.25 million per quarter from a base of 32 stores is not much of a stretch, in my opinion.
Conclude that with two 30%+ growth years, on the back of an additional 17 store openings over 2 years, and we get to ~$150 million by FY24.
Not a perfect example, but there it is.
When I conducted research into Starbucks a number of years ago, there came a pivotal moment in their history where store expansion began to accelerate considerably.
Back in 1997 Starbucks, who earned $975 million in sales that year, opened just shy of 400 stores to reach 1,412 stores.
The following year, they opened 474 more. The year after that, 612. In the year 2000, they opened 1,003 stores.
Store openings began to accelerate as the business continued to scale and prosper from an ever-increasing base of stores from which to generate revenue.
Just look at the track record of Starbucks and their comparable sales growth. From 1996, only three years have witnessed a YoY decline, with the most recent being a factor of the covid environment.
This is compounding at its finest. Kura Sushi should be looking to emulate that.
It is useful, for me, to dig back into Starbuck’s operating history, as they are the poster-child for what makes a great long-run growth story for a franchise. I doubt Kura Sushi will ever reach 18,000 US stores, however.
Anyway, before I get too far off-track, I think assuming the 10% CAGR rate of store growth from FY25 may be too conservative, or perhaps too backwards-looking.
I would be surprised if Kura were to grow at 10% post-2024 (assuming they are still a going concern).
Suggesting that they grow their store count at a similar cadence to what they are doing now, but in 4 years time, seems overly conservative.
Making the assumption that Kura reaches $200 million in total AUV by FY24 (57 stores multiplied by $3.5 million AUV), from that base if we were to plot out their $3.5 million AUV across each respective CAGR of store count growth, it would appear reasonable that Kura surpassed their current market cap in AUV (~$300 million) by 2026 to 2029.
AUV doesn’t take into account the more recently opened stores, most of which will be far below the $3.5 AUV line.
If we were to take a FY24 revenue base of $150 million and attach those same CAGRs, then Kura’s sales would end up between $266 million to $450 million by FY30.
Again, super napkin work here.
Considering that (pre-covid) the business traded at ~3 times sales (right now it’s upwards of 10 times, but skewed by covid) if we applied that multiple in FY30, Kura might trade somewhere around $800 million to $1.3 billion.
Worth noting, the current market valuation (~$325M) does not appear to offer considerable r/r there.
That could imply between 2.5x to 4x over the next 9 years for a CAGR of between 10% and 17%.
That’s attractive to me, but for some, it may be a poor risk/reward at the current price.
I will stop here and say, again, this is me making a boat-load of assumptions and largely superficial projections.
I continually profess that I am more so a business analyst than I am a security analyst. I have next to no idea what a stock price will do over the short or long term.
My assumptions for my investing process typically gravitate around the idea that buying good businesses at fair prices equals long term shareholder return.
The reality is that 90% of my assumptions will be wrong.
Kura could fail to crack the US market or appeal to the US consumer. They could also scale far more rapidly than I am assuming.
It might be such that Kura is a good business, trading at an undesirable price.
I am more or less trying to paint a picture of what could unfold, not trying to assert what will likely unfold.
The Starbucks example is somewhat flawed, as their operating margins were closer to 8% in the 90s, before reaching 12% by the end of 2010 and as high as 18% by 2016.
With Kura, I am yet to understand, based on limited operating history, if there is considerable room for margin expansion.
This is part of the dismal science of investing, however, and something I am comfortable with. I am perfectly comfortable acknowledging that I have no idea what margins will look like in 10 years. How can I know that?
What I can understand, is that there is scope for margin expansion through the leveraging of operating costs across a broader base of stores.
Moreover, Kura’s gross margin appears to be suppressed. In 2018 the company reported 15.7% GM, and the following year, it was 14.8% before falling off a cliff in 2020.
The parent company typically supports a consistent gross margin of 50%+, so I would imagine that there is a potential upside to the operating margin as gross margin matures for the US subsidiary.
Purely based on the parent’s operating margin (~5%) I have that in mind for the mid to near term expectation of operating margin for now. The rest will become clearer as the company matures.
It’s difficult to place the value on a small franchise that has lofty aspirations like this.
It seems to be a case of something which only becomes obvious as it happens.
I was not around when Starbucks was a young public entity in the 90s, but even then it was considerably larger than Kura is today, with well over North American 700 stores in 1995.
Back then, the company was valued at close to $1.5 billion on $465 million in sales.
For much of its young life, Starbucks commanded a lofty premium on the common stock, but we are paid nothing for hindsight.
Investors are paid (through their returns) for foresight, and sometimes a helping of luck.
It is my opinion that Kura represents an interesting promise of national expansion, partnered with a reasonable level of gross and operating profit margin in the coming decade, as they extend beyond 100 to 150 units.
They state that they are looking at ~300 potential locations across the United States, which is not quite as huge as Starbucks’ 18,000, but it’s a different dining experience entirely. Coffee is something you consume daily, sushi is typically not.
So, realistically, when I am considering the 5 to 10-year outlook for this business, I am more or less considering the possibility that Kura can become a low to mid-digit billion-dollar valuation. Not necessarily a $10 to $50 billion business.
From a base of ~$325 million, that represents a fair amount of upside, but perhaps not at the same level of the enchantment of a potential world-beater. Especially considering the risk profile of this business.
Equally, at the current valuation, it appears prudent to wait for a better risk/return.
Disclosure, I own a small amount of Kura Sushi, sized accordingly to reflect my opinion on valuation (~1% weighted). If Kura were closer to a $150 million stock, it would likely be a 3% position for me.
In these cases, a little is all you need (if the stock does well) and a little is all you want (if the stock does badly).
What I consider the most important factors to Kura’s growth:
Bring AUV back to the $3.5 Million level
Compound the unit base at an attractive CAGR
Expand operating margin through scale, ideally above 5%
Nail down a consistent gross profit base, and experience incremental margin expansion
Demonstrate consistent comparable stores sales of 4% to 6% each year
Pre-covid (and I feel like I am saying that a lot in this piece) Kura was a profitable business, generating gross margins in the mid-teens, with a razor-thin operating margin, and a positive bottom line.
Despite a reduction in operating expenses in 2020, the decline in sales was too great, and Kura reported negative gross, operating, and bottom-line margins. I would assume that all three are transitory, and should be back to full strength by FY22.
As discussed, Kura generates revenues through the sale of food items and beverages through their stores. This is fairly self-explanatory.
The cost of those sales, however, is of monumental importance in this business. In a typical, non-covid, year, traditional operational costs (such as G&A, depreciation, and impairments) account for less than 15% of the company’s OpEx.
The composition of what Kura call ‘restaurant operating costs’ is far larger, typically accounting for the other 85% of costs. This includes food, beverage, labour, occupancy, and other expenses. These are the items that are invested in to generate those sales, thus for all intents and purposes can be treated as the cost of goods sold.
With these costs being so high, relative to the size of the organisation, gross margins are fairly tight, typically oscillating in the mid-teens range in normal conditions.
Is it precise? Should occupancy costs (the rental payments for units and associated taxes) be included as COGS? I don’t really care, nor do I want to be pedantic.
The more important focal point is that the majority of these costs are variable and will have to be scaled as the size of the business grows in an almost equal proportion.
Whether a small or larger store, the steady-state revenues will reflect the size and capacity of that store, much as the costs will.
A new 3,500 square feet store is opened, with 40 employees?
Well, that store needs X inventory, Y employee expenses, and Z occupancy costs.
Other costs, which includes utilities, repairs and maintenance, credit card fees, royalty payment, will also scale with each additional unit.
Clearly, the up-front cost of each new unit creates a significant imbalance for the first 18 months, before the store accumulates a sales base to recoup that cost.
The beauty of food, however, is that expenses here can be adjusted as per the demand of the marketplace. In 2020, Kura was able to cut food & beverage expenditure by $6.3 million (~30% YoY) in wake of the store closures.
In the 6 months of FY21 (ended Feb 28th) food & beverage expenditure was only $6.2 million compared to $11.8 million over the same period in FY20. Right before the covid outbreak. That’s closer to 35% of sales (with ~200bps of spoilage).
Perhaps more interestingly, is that Kura appears to have ‘some’ level of pricing power here. Part of Kura’s appeal is that all of its conveyor belt items are priced at $3, which is an attractive proposition to the consumer.
Obviously, that works like a sliding scale, whereby a $0.50 increase in the average plate of sushi adds to the gross margin without impacting any other aspect of the operational cost. Gross margins would expand and, absent any further OpEx, so too would the operating margin.
Uba was asked about this in the most recent quarterly earnings call after an analyst noticed subtle increases in conveyor belt pricing across their Californian stores. The question pertained to whether or not Kura felt that pricing was a lever they look to use in the future.
Uba responded by noting that they typically only increase prices to offset increases in the minimum wage, noting that “we haven't used it to increase margin”.
He followed up by acknowledging that:
“One real advantage that we have is that we have a small plates menu. So the pricing that we take is on an order of $0.05, $0.10, $0.25.
It's not like a traditional entree-based meal, where you've got this big protein at the centre of the plate that's gone from $40 to $60 or $40 to $50. We've really had minimal pushback in the past, as demonstrated by -- we've never seen a drop in traffic as a result of pricing. And as far as we can go from our March results, the same as held true for the most recent pricing.”
He later explained that Kura’s mission is never to price any consumer out and that they want to remain an affordable alternative. Perhaps more importantly, he did open up to the fact that pricing could be a lever they will use in the future:
“In terms of pricing, we're ready to sort of reevaluate market by market what the appropriate pricing is. In the past, our pricing has purely been a response to minimum wage increases, but we're thinking, going forward, there might be other occasions for us to take pricing as well.”
Unfortunately, labour and occupancy costs are less flexible in that respect. However, Kura has taken advantage of employee retention credit under the CARES Act, which allowed them to recognise a few $million in credits this year.
Occupancy costs continue to climb as Kura build out new stores, partially offset by deferrals of rent payments with some of their lenders as part of the covid relief support.
One area where there is an opportunity for some economies of scale is their G&A.
Whilst G&A is expected to scale as revenues and store count grows, the return on marketing dollars should also become more favourable as Kura spread across the United States and create more “endpoints” for their target market to then follow through and consume.
However, this appears to be a number of years away. For now, the G&A is likely to continue to scale with a heavier weighting towards the development of new units, SBC, and other corporate costs associated with running the business.
There also remains that uncertainty of their off-premise sales mix, which we touched on earlier. Once a nothingburger, off-premise now accounts for ~a mid-teens percentage of sales.
A few things to bear in mind here.
As of February 2021, there were zero Californian stores open for indoor dining. Of the total 16, 12 were open for off-premise and outdoor, 1 was off-premise only, and 2 were closed.
By April, the midpoint of Q3, all 16 stores were fully operational.
California is by and large Kura’s most busy market, it’s the location they are most well known and have the strongest brand presence.
Whilst average ticket for off-premise appears to be higher (low $30s versus a ticket of $20s for indoor) this is more than likely a factor of the behaviour of consumers in off-premise. People ordering together, for larger parties, and so on.
I mentioned earlier that management expects off-premise to remain steady post-closures, but won’t be a priority of the expansion. More so a consideration.
What is interesting, is that during the Q2 call, Uba remarked that, now stores are open again, consumer behaviour has begun to shift back to normal.
“Right now, all of our restaurants are open with a full Kura experience. And we really haven't seen too much change in consumer behaviour, whether we're talking about menu preferences or the mix between things that are taken off the belt versus things that are ordered through the touch panel, how long guests have been -- how long guests take to finish their meals. It's been surprisingly stable.”
Whilst I am personally not sure what effect off-premise has on margin, I am led to understand (through my research into other companies who have embraced off-premise) that offering both off-premise and instore dining in tandem, increases output on the aggregate.
So far this year Kura has recorded sales of $18.5 million, down from $36.8 million last year. (I am anticipating sales of ~$12 to $15 million in Q3)
Operating losses stand at $10.1 million, up from losses of $1.6 million, and net losses are $10.2 million, up from $1.35 million.
This directly comps a 6 month period in which the covid impacts had not yet fully penetrated the business, so going forward Kura have far easier comps.
For instance, in the Q3 FY20 quarter, Kura generated just $2.8 million in sales. Followed by $5.5 million in Q4 FY20 and two subsequent $9 million quarters in Q1 and Q2 of FY21.
We got word that March sales (first month of Q3 FY21) came in at ~$5.1 million, so expect a triple-digit comp for sales in the coming weeks.
Liquidity & Cash Flows
So, a few things to note about Kura Sushi’s liquidity. Right now, it’s not great.
The company raised ~$39 million from their IPO during the fourth quarter of their fiscal year 2019. That’s around August time, which is usually associated with Q3, in case you were wondering.
This provided ample cushion to the balance sheet which, at the time, had zero outstanding debt.
In the below chart, I have highlighted cash, current liabilities, and short-term debt, as well as revenue to demonstrate the severity of the impact of lockdowns in Q3 FY20.
Kura essentially burned through their cash reserves over the next 12 months and relied upon loans to finance their operations.
In April 2020, Kura USA signed a revolving credit agreement with their Japanese parent, allowing them to withdraw up to $20 million in funds. In September, they amended this agreement to extend the capacity up to $35 million, and in May of 2021, they extended it further, to $45 million in a second amendment.
This is one of the perks of having a considerably larger parent. The parent organisation has a healthy balance sheet at present and extends these loans to Kura USA with a favourable interest rate, and there are no covenants on these loans, allowing for breathing space and flexibility.
You will see the facility titled ‘Loan from Affiliate’ in the non-current liabilities, as well as the ‘due from’ and ‘due to’ line items in the current assets and liabilities.
At present, Kura has withdrawn $12 million (1.1% interest rate) of its credit facility, as of February 28th, and later withdrew a further $2 million (after the date of the 10-Q filing period), leaving $31 million left in the tank.
This comes after tapping $3 million in Q1 FY21, a further $9 million in Q2 FY21, and a minimum of $2 million in Q3 FY21. Kura releases Q3 earnings in a number of weeks, so we should get more colour on that then.
Back in Q1 FY21, Steven Benrubi, CFO, noted that total borrowing for the end of FY21 could reach between $20 million and $22 million.
I would suspect we see Kura raise further debt, from their parent, during the remainder of this year to support their business whilst sales recover.
The bulk of Kura’s asset base, right now, is construed of PP&E and Operating lease assets.
PP&E is mostly made up of leasehold improvements and furniture and fittings for their stores, and also includes other leases assets, computer equipment, vehicles, software, and construction in progress.
Leases are classified based on whether the arrangement is a financed purchase of the underlying asset (finance lease) or not (operating lease).
In plain English, a finance lease is when a lessor purchases the asset and leases it to the lessee (Kura). Kura will then make payments to the lessor throughout the useful period of the asset’s life, and then at the conclusion of the contract, they can opt to roll the lease over, return the asset to the lessor or sell the asset to a third party on behalf of the lessor. In these circumstances:
The core difference between a finance lease and an operating lease is that under the finance lease substantially all of the risks and rewards of ownership of the asset to the lessee. Almost as though they own it, which includes all of the economic risks and rewards.
The vast majority of Kura’s leases are operating leases, however. Ownership of the asset remains with the lessor and the asset will either be returned at the end of the lease period when the leasing company will either extend the lease or sell it to release some residual value.
The weighted average remaining lease terms for Kura’s operating leases is 15.9 years and for their finance leases is 2 years.
This leasing situation is something we are going to discuss in more detail in the Key Risks segment.
The gradual recovery of Kura’s Days Inventory Outstanding and Days Sales Outstanding is noticeable, but it’s worth noting that management cited a reasonable level of inventory spoilage that has occurred over the 6 months of FY21, which would reduce inventory levels and impact these metrics somewhat.
Prior to covid, Kura exhibited the ability to operate under healthy cash conversion cycles, meaning they can purchase inventory on credit, sell those goods and receive inflows, all before paying their creditors.
Magnified by the extension in Days Payables Outstanding (61.1 days), the current cash conversion cycle suggests they can receive payments for the inventory they purchase a full 32 days before paying their creditors. I would assume that as they recover the CCC draws closer to pre-covid norms.
The extension in Days Payables Outstanding could imply that Kura was able to work out more favourable repayment terms/windows with their suppliers during 2020, but equally might suggest weakness on their part, with respect to their ability to pay.
However, typically the biggest sign of weakness is a severe contraction of the Payables window, suggesting that creditors are looking to reduce the length/period of credit extension to Kura, in light of their concern over the company to pay their outstanding balance.
However, it is likely warped by covid. I am yet to make a full conclusion on how I view this activity, but for now, I am leaning on the positive side. So long as the company are churning out inflows from the inventory they purchase at a rate that is ahead of the deadline for which they have to pay suppliers, that appears to be a positive note.
I would suspect Days Payables Outstanding draws back to ~30 days as normality resume, in line with typical conditions.
“Our working capital position benefits from the fact that we generally collect cash from sales to guests the same day, or in the case of credit or debit card transactions, within several days of the related sale, and we typically have at least 30 days to pay our vendors.” - Kura Sushi USA, 10-K Filing
In the absence of any free cash flows, the Kura business is largely supported by their operating cash flows and their cash balance. At least, this has been the case historically.
Cash flows from operations were positive prior to covid, where the company generated $6 million from a $64 million revenue base in 2019. This was the same year that the company raised $39 million through their IPO.
In their first quarter as a public entity, management suggested that “based on our current growth front, we believe our steady cash flows from operations and the balance of the IPO proceeds will be sufficient to fund our capital expenditure needs for the foreseeable future.”
They were not anticipating something as ravenous as covid to rear its head only a few months later.
After these funds were depleted, Kura tapped the revolving credit facility they have to the tune of $14 million in 2021 ($2 million not included in filings, as outside of period).
It remains to be seen when Kura will be in a place to support its growth internally through the utilisation of free cash flow. CapEx has steadily increased YoY, with $9.8 million already allocated so far in 2021.
Despite the technicalities of 2020, Kura continued to press on with CapEx for new store openings, despite only managing to open 2 new stores during the year.
This will likely be offset (partially) this year as those delayed openings were able to open in the first half of 2021.
When we assess the last 21 months of quarterly cash flows, it becomes a little more evident that Kura is solely relying on financing to support its working capital and liquidity needs.
Back in 2019, with a base of 23 stores at $3.35 million AUV, Kura was profitable on an operating basis, and with respect to the bottom line. In this year, they generated a ~9.3% yield on sales in their operating cash flow.
I would hope that this level of operating efficiency returns as the business rolls over in FY22 and the stores are open, and relatively undisturbed from lockdowns. That’s a huge “IF” however. Covid is not over yet.
I think there are a few important points to draw from this:
1) Kura does not have the operational capacity to self-finance its growth
- I would think this is fairly obvious. The business relied heavily on its IPO proceeds at first. Prior to the IPO, Kura would typically open ~3 stores per year. Post-IPO that number doubled, to 6 in 2019, and, ignoring 2020, looks set to be between 8 to 10 new stores per year for the next three years.
In order to continue growing at such a pace, Kura needs capital. In the absence of attractive internal cash flow, they are likely to continue raising external funds.
2) Kura are in a favourable position to borrow
- Having the parent company as a “safety net” from which to draw low-cost, favourable term, debt is crucial here. With no covenants on the credit facility, Kura has the capacity to borrow up to $45 million to fuel their growth (currently $31M left).
We have seen multiple instances where Kura amend the agreement to scale the capacity of their borrowing cap, and may well see further instances of this in the future. Management has said so, during earnings calls, that this is likely the case. The relationship between the two entities is good.
As it is within the interests of the Japanese parent for Kura USA to prosper, I would imagine there are mutual incentives here.
Thankfully, it appears that Kura has not yet been majorly dilutive to shareholders with equity issuance. They do have a shelf registration process that allows them to sell up to $50 million worth of common stock at any given time, however. So that might crop up in the future.
3) Kura has a strong cash collection model
- Covid aside, Kura’s business exhibits a strong cash collection. Due to the shelf-life and nature of the food that Kura sells, inventory is turned over fast, typically within 4 days. Cash from those sales are typically collected on-premise and are absorbed either at the time of purchase or within a few days through credit.
Kura typically has up to 30 days to pay their vendors. This way, multiple batches of inventory can be converted into cash long before the proceeds are due to vendors.
When restaurants are shut down, demand falls, and inventory spoils, as it did in 2020, this is not ideal. Nor was it for any manner of business operating in a similar fashion.
But, in the usual consumer environment, this is a superpower for Kura Sushi and one which should resume as we head into FY22.
My conclusion would be that overall, liquidity is not great right now, working capital needs to get back to levels it was pre-covid.
Kura’s growth aspirations are certainly outpacing their fundamental reality but with the ability to raise external finance and get a little bit flirty with leverage, I feel they are not at risk of failure to remain a going concern as things stand.
It would appear that the trough of their liquidity woes has already come in, and from here, things should begin to recover.
As for when the business will be able to self-support its growth, I candidly have no idea. I think we are years away from that.
Once we get to FY24 and learn more about what pace management consider adjusting their 20% unit CAGR to, it may become clearer.
Management & Board of Directors
The core executive suite for Kura Sushi USA is reasonably small and consists of three core members, whereby the roles of a President, CEO, CFO, and temporary COO are fulfilled.
The main man at the helm is Mr Uba (age 43), known as “Jimmy” Uba in the West. It would appear that he is the perfect man for the role after having spent almost a decade working from the trenches of the parent organisation up to increasingly more senior roles.
Uba joined the parent organisation in 2000, where he spent three years as a manager at a Kura store before becoming a regional manager in 2004.
From 2004 to 2008, Uba headed the operations department for Eastern and Western Japan and was responsible for the expansion of the brand across these regions. Over those four years, he managed in excess of 100 restaurants.
In 2008, Uba was assigned the role of President and CEO of the US subsidiary and has remained at the helm ever since.
Uba also currently acts as a temporary chief operating officer, in the place of former COO, Manabu Kamei, who was a temporary assignment provided by the parent organisation. I would imagine they are looking for a new COO in due course.
During the earnings calls, you will often hear Benjamin Porten (IR Director) act as the primary translator for Uba, given that English is not his first language.
Uba clearly has extensive knowledge of all factors of the Kura business model, in addition to a rich understanding of their history and values.
In November 2020, former CFO, Mr Koji Shinohara, resigned in wake of a new candidate, Steven Benrubi, who was announced three days after his resignation.
It appears that Shinohara was another temporary assignment, brought in for the IPO process, which is not uncommon for newly public companies.
Koji served from 2017 until 2020, and his own words states that:
“I joined Kura to help the company for the initial public offering on NASDAQ.
I strengthened the accounting team, established fundamental internal controls, selected law firms, underwriters, auditors and consulting firms to build an effective IPO team”
Benrubi previously served as CFO for Drybar, a lifestyle salon famous for their “blow-out” craze, where he observed the expansion of well over 100 Drybar franchises across the States and was an influential figure in their subsequent sale in 2020.
Prior to Drybar, he served as CFO and VP of The Wet Seal for seven years and also has a history of working in senior executive roles at CKE Restaurants and Dominos Pizza.
First of all, I should state that Hideto is no longer an executive member. In November 2020, as part of the Exchange Act Rule 3b-7, which states:
“The term executive officer, when used with reference to a registrant, means its president, any vice president of the registrant in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy making function or any other person who performs similar policy making functions for the registrant.”
Mr Sugimoto was not performing these functions at the time and was thus removed from the executive suite and granted the title of Director of System and Menu Development as of February 2021.
After joining the parent company in 2004, Sugimoto served as a senior member of the operations team in Japan before being selected to join Kura USA in 2008, where he oversaw 11 new store openings from 2011 to 2016.
Another seemingly “temporary” employee gifted to the USA subsidiary from the parent. I can’t be sure how long he will remain with the company. As per the proxies, there is no written employment agreement with Sugimoto and he is granted no severance pay.
That’s about all I could find on the senior management team. It appears to be quite concentrated, small, and subject to new additions over the coming years as they scale.
The introduction of Benrubi as CFO was likely an attempt to get some domestic talent in the door to assist with the, mostly Japanese, management team. Perhaps someone who assist with the nuances of cultural differences. Although, Kura seem to be doing a good job already.
But rest assured, this management team has little experience in running US public entities.
Board of Directors
The BOD is also fairly tight-knit with just five members (4 male, 1 female).
Overall, the BOD is populated with a range of consulting service providers, as well as one member of the parent organisation, Kura Corporation.
I must be candid and state that I am not super familiar with the typical construction of smaller company’s boards. It would appear that, like the executive suite, the BOD is subject to change as they scale.
We know who Uba is by now, and Mr Uba currently serves as the Chairman of the board after having joined in 2017.
Mr Asako was appointed in 2019 and he is currently serving as the founder and CEO of Bulldog Advisory, a California-based professional firm specialising in board and executive consulting services.
Ms Ellis also joined in 2019 and currently serves as a development consultant at Artizen Advisors, a commercial retail advisory services firm that works with private equity back growth brands looking for “market feasibility, market penetration, and asset management”.
Interestingly, Ellis was once VP at Panda Restaurant Group, where she led the expansion of Panda Express across 500 locations.
Mr Ishii joined in 2018, prior to the IPO, and is the founder and CEO of a Japanese consulting services firm, named IIOSS KK.
Mr Okamato joined in 2020 and has served as the Chief Communications Officer at Kura’s parent company since 2018. Prior to that, he served 6 years in a similar role for Ezaki Glico Co Ltd, a Japanese food manufacturing company.
Insider & Institutional Ownership
Kura Sushi has an interesting ownership structure, whereby ~60% of the outstanding shares are held by one public entity. That single entity is Kura Corporation.
Institutions hold 28.5%, followed by the public who owns 7.2%, and then insiders who own 4.8% of the outstanding shares.
Kura operates a dual-share class structure with Class A shares (of which there are 7,417,556) and Class B shares (of which there are 1,000,050).
Class A shares are granted 1 vote, and Class B shares are granted 10 votes.
Kura Corporation, the parent entity to Kura USA currently, as of May 2021, own 54% of the outstanding Class A shares and 100% of the outstanding Class B shares.
As such, the company owns a considerable 80% of the total voting power of the outstanding shares. This item will be brought back up in the next segment, key risk factors.
The latest Proxy is dated December 2020, so is partially out-of-date now considering the changes to management.
Most of the executive team took a 9-month compensation cut of between 15% to 30% during covid, which is nice to see, but not super telling, as most executive teams did this in 2020.
I would think that management is paid fairly for the size of the business. New CFO, Steven Benrubi, will be paid a base salary of $300,000.
Compensation follows a tri-layered mixture of base salary, annual cash incentive and long-term incentives.
The annual cash incentive, adjusted annually, was not met in 2020 (obviously).
Longer-term incentives typically include rewards of cash and equity grants for meeting strategic objectives.
The ownership of Class A shares for the senior management and directors of the board can be found below. Obviously not a huge deal of ownership.
There was nothing too awry in the proxies from what I could make out.
Key Risk Factors
In this segment, I have excluded a number of the more obvious risks, that are apparent in any public entity. As such, any risks pertaining to the common stock is assumed. Moreover, any discussion pertaining to the competitive environment is assumed too.
Here, I will share some of the most business-specific risks that I feel are most important to the understanding of Kura Sushi.
Please note that this list is not exhaustive, and I prefer to leave to more obvious risks associated with the business out.
1) Commodity Prices, Labour & Inflation
A fairly obvious one (yes I know I said I’d avoid obvious ones), but one that should be highlighted. Food and beverages are Kura’s ‘bread and butter’. These costs typically eat up between 32% to 35% of sales.
Thus, Kura’s profitability directly relates to its ability to anticipate the changes in prices of its core operating resources. As far as I am aware, the only tools Kura have used to offset these changes have been subtle price increases and the adjustment of other operating expenses.
One rebuttal to that notion, that I touched upon earlier, is that because Kura’s menu items are so low cost, increases in menu pricing are unlikely to deter consumers.
A 10% increase in the $3 conveyor belt line, only amounts to an additional $0.30 per plate. Each plate typically contains a small quantity of meat or fish, and consumers tend to pick up 5-10 plates each, where the incremental cost will be less apparent to the consumer.
Compare that to, say, one large dish, with a protein-rich centre food item, and the perceived inflation would be far more noticeable.
On the labour side, Kura pays the majority of their staff at rates close to, or in line with, the federal minimum wage, or state minimum wage, per hour. As such, increases in the minimum wage on a federal or state level could significantly impact their labour expenses. which, combined with food and beverage, can take up between 60% to 70% of revenues.
This is especially pertinent as their labour force is distributed unevenly across the country. The majority of their labour force is based in CA, thus any policy changes there would have an outsized impact on their labour cost.
I imagine the ‘risk’ of one state policy change will be mitigated as Kura continue to reduce their concentration to California and open stores across the nation.
2) Supplier Concentration is Considerable
Kura focuses on high-quality ingredients, free from the typical preservatives that other chains utilise to save costs. As such, they source the majority of their goods from trusted vendors, two of whom they have had good relationships with for a number of years in their parent organisation.
Both JFC International and Wismettac Asian Foods are Japanese-related food distributors and are the subsidiaries of the Kikkoman Corporation and Nishimoto Co Ltd, respectively.
Orders through these two distributors accounted for approximately 44%, 75%, 83%, and 86% across fiscal years 2017, 2018, 2019, and 2020.
That is a huge reliance on two businesses, which encourages a significant amount of counterparty risk should either of those organisations cease to remain a going concern, have operational difficulties, or simply cease trading with Kura for whatever reason.
To make matters worse, Kura appears to be in no rush to dilute its supplier concentration going forward.
Kura state that if they are :
“no longer able to source through any of our suppliers, [they] intend to replace the supplier with a different source, but there can be no assurance that any such replacement will provide goods at the prices and level of quality of our current suppliers.”
There is no language pertaining to the need to diversify their suppliers. More so, an emphasis on what they would do if those relationships broke down. This seems reactionary, as opposed to being proactive.
It is also worth noting that as Kura scales, the quantities of goods demanded from their suppliers will also scale. There is no certainty that they will be able to deliver increasing numbers of supplies to Kura.
3) 85% of Stores are Concentrated in Two States
Right now, ~85% of Kura stores are located within California and Texas, which carries a significantly weighted impact from any new law changes, policy updates, or guidelines for operating a business within either state.
We saw the direct impact of this during COVID, where cases were so severe in California that inside dining for Kura was halted for almost two quarters, whilst they remained partially open in other States.
Thankfully, the composition of these States is declining, having dropped from 90% last year, and should continue to fall as they open in new markets.
4) A Huge Reliance on Kura Japan
Kura Sushi USA is a ‘controlled company’ in that their parent is hugely influential to their success. Owning more than 80% of the voting power, and the entirety of the Class B shares, there is no doubt as to who has the power here.
From IP to capital needs, Kura is hugely reliant on their parent.
Should Kura look to seek third-party financing, the terms may not be at such favourable rates, or they may be unable to raise funding. Moreover, the fact that Kura has this relationship with Kura Japan, limits their ability to engage in M&A with other public or private entities.
The IP which is so essential to Kura USA’s business is owned by and licensed from, Kura Japan. Should, for whatever reason, they decide to terminate those agreements, Kura Sushi would be decimated.
Moreover, the senior executive team at Kura have little experience in running a public US entity, with the exception of the new CFO. The current internal infrastructure may be inadequate for their increasing reporting obligations, and they may find difficulty hiring, training, or retaining staff members who can support that effort.
5) Kura Does Not Own Any Real Estate
McDonald’s is a fine case study on the genius of a franchise business model in which the company purchases real estate and leases it back to the franchise owner. McDonald’s are as much a real estate business, as they are a hamburger business.
Sadly, that’s not in the wheelhouse of every company.
Kura does not own real estate and, instead, opt to operate under a range of leases, typically signed for 20 years at the inception of a contract. Occupancy costs are a significant portion of their operating expenses and will continue to scale so long as the company open new stores on a lease basis.
Most of Kura’s leases require a fixed annual rent which generally increases each year, and some require the payment of additional rent if restaurant sales exceed a negotiated amount. These leases are ‘net leases’, which requires Kura to pay all the costs of insurance, taxes, maintenance and utilities.
These variety of leases are typically non-cancellable .
This creates a host of complications.
For one, if a new store turns out to be a dud, Kura is still tied into the lease whether or not the store continues to operate. Among other things, this means they will be forced to pay the base rent for the maturity of the contract.
Secondly, as each existing lease expires, Kura will have to negotiate an extension. Should they fail to do so, they may incur increased costs related to the relocation of that store. This would include closure costs, moving costs, as well as impairments to PP&E.
Here is my capitalist pig take:
- Buy real estate, open up the brand to a franchise model, lease the real estate to the franchise operator, collect rents, scale the franchise like a maggot in an apricot plant farm.
I am not sure about the nature of Japanese operators and would assume Kura Corporation won’t do this.
6) Expansion of Brand is Hard
Quite simply, there are reams of complications with attempting to expand a brand orientated franchise across the United States. Many have tried, and few have succeeded.
Some have become public, only to be consumed by other companies, or placed back into the private sector after a few years.
Whilst the current batch of stores are proving to be popular and the brand does well in Japan and Taiwan, there is no assurance that the Kura brand will resonate with the US population.
Kura currently operates in just a handful of States, so venturing into ‘white space’ could result in slower than expected sales growth. Honestly, I am waiting for the whitespace whitepaper to be commissioned by Kura so I can get a better sense of how they are looking to tackle their nationwide expansion.
Right now, they appear to dip their toe into a new state with one store, let it ride for a year, and then decide if it’s worth adding another.
Moreover, the business is currently small. Thus, each additional unit, and the costs associated with that unit, have an outsized impact on both cost and sales.
Operating results are likely to be volatile for the next 3/5 years at a minimum.
7) Emerging Growth Company Status
Kura Sushi is currently an “Emerging Growth Company”.
Back in 2012, in an attempt to boost the number of companies going public, the JOBS act allowed for certain procedural and reporting advantages for “Emerging Growth Companies,” which are defined in the Act as companies within 5 years of their IPO and with revenues less than $1 billion across the most recent fiscal year.
Companies under this designation are not subject to the full brunt of reporting and disclosure requirements that typical public firms are, for as long as 5 years post-IPO.
This means that Kura management has a considerable amount of discretion with respect to disclosure.
For instance, the reporting of the soundness of internal controls of financial reporting does not have to be attested/verified by an external auditor until the date Kura are no longer an EGC.
When that time comes, Kura may need to undertake various actions, such as implementing new internal controls and procedures and hiring additional accounting or internal audit staff. In addition, they may identify material weaknesses in their internal control over financial reporting that they might not be able to remediate in time to meet the applicable deadline imposed upon them for compliance with the act.
Should something like this happen, investors may lose confidence in the reporting quality of the business.
The act also allows EGCs to delay the adoption of certain new accounting standards until the time in which those changes are also applicable to private companies (typically some delay there).
Kura elected not to take part, and have expressed willingness to conform to any new accounting standards as and when they are applicable to the broader body of non-EGC public entities.
In relation to the following benefits of being an EGC, Kura has stated they “may take advantage of these exemptions until we are no longer an emerging growth company”.
The exemption from the auditor attestation requirements with respect to internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act
The exemptions from say-on-pay, say-on-frequency and say-on-golden parachute voting requirements and (iii)
Reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements
Obviously, as investors, we want to be assured that both the reporting quality and the earnings quality are strong.
Without reporting quality, there can be no strong assumption of earnings quality, as poor reporting practices cast aspersion on the legitimacy of earnings.
Something to consider there.
Guidance for the Upcoming Quarter
There was minimal guidance provided by management for the upcoming third quarter of FY21, which is understandable.
Kura is due to report Q3 earnings on July 13th, so you can expect me to write a follow-up around that time.
We did hear that management is anticipating to shift from a “relatively defensive position to a more aggressive strategy” as they move into the second half of the year, in an attempt to build a ramp-up for FY22.
The only numeric guidance we were granted was:
• Weekly CapEx spend during Q3 and Q4 to be $250,000, allowing Kura to accelerate the opening timeline for the fiscal 22 unit pipeline.
• Weekly G&A spend to be $300,000 to $310,000, exclusive of expected employee retention credits as Kura scale the organisation in preparation for new units and growing system size.
I did reach out to IR to ask about the opening of any new units this fiscal year, and received a response:
“We'll be sharing more store opening news soon!”
I would not be surprised to see one or two additional store openings over the next 6 months as there are currently ~5 leases under execution.
All eyes on that as I am anticipating ~8 new store openings from now until FY22 (6 quarters).
It’s really difficult to grasp much else at this stage. It appears like the worst of the results are over, and after two sequential quarters of $9 million revenues, a, now, fully operating store count with one additional new unit, the summertime period, and an easing of covid restrictions… I am imagining Q3 will be a ‘Good’ one relative to the two that went before it.
With $5.1 million in sales suggested for their first month of Q3, I am anticipating a return to double-digit revenues.
A lot of emphasis is placed on what makes a “good business”, but less importance is placed on what is a “good price”.
Typically, for an investor to earn a sufficient return in the market, they want to be buying good businesses at good, or fair, prices.
At the moment, I think Kura maybe represents a potentially good business, and a less than ideal price.
Potentially Good Business
As exciting as Kura’s expansion plans are, life doesn’t follow a path of expected outcomes. But then, that is what investing is all about. Making a wager on the likelihood of those outcomes.
Kura’s cash conversion cycle is attractive, as is their store economics. The brand and store format is also appealing and placed delicately between a full-service and partial-service restaurant.
It seems like a business that can scale modestly over the next decade.
There is room for margin expansion, both on the gross and operational sides. There is also the added benefit of their low-cost operating model (with respect to their automation, rather than F&B, Labour and occupancy) and some potential for pricing power in later years.
On the contrary, there is a significant list of factors that would make an investor uncomfortable in owning this stock. The voting regime is, for all accounts, non-democratic. The company are at the whimsy of the Japanese parent. Their entire lifeblood relies on the extension of IP and external funding from the Japanese parent too.
The set of tools with which a normal company can use in public markets (external funding, M&A) is limited to whatever is in the parent' company’s best interests. At times, the two entities may have conflicting ideas about what is best for Kura Sushi USA.
It would be considerably easier to be bullish on the long-term prospects of the business if this was an independent enterprise, which had its own IP, and complete freedom with respect to how they choose to scale.
But then, part of the appeal of Kura is that safety net, and the licenced branding and technology they take from the parent. This was a business earning $11.66 (FY19) in revenues per share pre-covid (up from $6.55 in FY18 and $$4.72 in FY17).
Thus, it appears that Kura have the potential to be a good business, but I am not entirely satisfied that they are a good business just yet.
Less than Ideal Price
Simply put, the valuation that Kura USA trades at today (~$325 million) appears to be inflated and has already “priced-in” the most bullish of recoveries. It appears likely there is a more opportune moment to take a stake if one was interested in doing so.
The price is not surprising to me, however.
If you observe the business in 2019, you can see the signs of a good business. If you observe it from 2020 to the current day, you can see how devastating covid was to this small entity.
Assuming it recovers back to pre-covid operating strength, now with a larger base of stores and a $31 million capacity for borrowing, the near-term looks to be quite positive for Kura.
However, that tells us more about the business, than it does to the attractiveness of the valuation.
Before the 2020 crash, Kura traded at close to $200 million, bottoming out at ~$50 million in March.
Pre-covid, Kura was generating attractive ROIC, sales were growing in the mid-double-digit range, store count was blossoming, and then in 2020, it came to a halt.
You might ask: “What drives this stock higher over the next year?”
My response would be: “I have no idea at this valuation, but I have more insight into what might take the business to the next level”.
When I find myself struggling to ascertain what drives the stock price in the medium term, it often means that the current price is perhaps too steep.
There is typically some form of catalyst that I feel can drive the price higher over the medium-term, whether that’s a re-rating, some underappreciated new product, or a pivot of some sort. With Kura, I struggle to identify anything of that nature.
It seems to be that the market will be more or less checking in to see if they recover well. The thought of being “priced to perfection” springs to my mind.
In these circumstances, quarterly earnings are typically there to confirm some underlying thesis. If there is a roadblock, the price/sentiment is typically quite sensitive in its reaction.
2021 will likely be another lacklustre year before the light begins to shine whereby Kura can operate through a ‘full strength’ year in FY22.
Thus, in my mind, it’s more so about monitoring that recovery and trying to find an attractive entry point. Because, right now, the valuation rests upon the recovery, which is effectively priced-in to the fullest extent.
Lead Analyst at Occasio Capital Ltd