KRUS: A 2022 Story, with a Price Tag
(Kura Sushi US Q4 2021 Earnings Review)
In last quarter’s memo, I stated that Kura Sushi KRUS 0.00 was a 2022 story. The end of 2021 would be about observing signs of recovery and 2022 would be the year we see a full set of post-pandemic results, assuming restrictions are not brought back.
By and large, this was a fantastic Q4 for Kura. The company, which has been plagued throughout 2020 and 2021 has been quietly building momentum behind the numbers. From 25 (2020) to 33 (Q1 2022) stores, and an additional 8-10 set to open across the coming fiscal year, management is guiding for revenues to expand over 100% in 2022 and claim that their whitespace (ie, the 300 stores they plan to build across the US) has never looked more attractive. In fact, the company are set to commission a new white space study to identify if the space has expanded.
Armed with fresh capital from their perfectly timed stock issuance, Kura now paid down the entirety of their debt facility with enough leftover to execute on their expansion across 2022.
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Kura Sushi US is a position I currently hold in my portfolio (weighted at ~2%).
Section 1: Thoughts from the Quarter - My commentary on Kura’s fourth quarter, and the recovery.
Section 2: Liquidity & Cashflow - A brief overview of Kura’s balance sheet as of the fourth quarter.
Section 3: Guidance - Commentary around Kura’s audacious 2022 guidance.
Section 4: Concluding Remarks - My final remarks, as well as some discussion on my Kura position.
Section 1: Thoughts from the Quarter
Revenues of $27.9M were up 51% from the prior quarter, which is particularly impressive considering that, for the first half of June, Kura’s core store cluster (California, where over 55% of stores are located) still operated under partial capacity.
The tailwind behind the impressive sales is two-fold. One, the demand for Kura is showing no signs of deceleration, even in the face of rising delta variant cases beginning in August. Jimmy Uba shared that monthly sales had continued to show resistance with $10.3M in revenue for October (first quarter of Q1 2022) carrying on the momentum from September ($9.6M) and August ($9.9M).
Two, at the beginning of September, Kura rolled out a high single-digit figure price hike to offset inflationary pressure. Despite this, Kura remains substantially more cost-effective than most peers in the sushi business. Traditionally, Kura has only increased prices in line with inflation, but last quarter we did hear Jimmy suggest they may begin to exercise pricing power to benefit margins also.
Despite demonstrating considerable sales leverage on the top line, total restaurant-level operating costs increased sequentially to 84% (from 71%). However, this is more or less in line with pre-covid levels.
Most importantly, restaurant-level operating margins are showing resurgent strength. Currently sitting at 16.4%, and up 1,060bps sequentially. On an annual basis, margins sit at 4.9% (heavily skewed from Q1 to Q2) with Benrubi suggesting they “don't see any reason why we can't completely recover back to the kind of restaurant-level margins that we had in the business pre-pandemic”.
I think viewing the income statement on an annual basis does wonders for visualising the story here. The juxtaposition of pre and post-covid results, with Q4 being the light at the end of the tunnel which should pour over into 2022.
For next year, I am eager to see if:
Restaurant-level operating costs can soften, through greater sales leverage.
Restaurant-level operating margins can get back to the high-teens.
AUV can cross the $3.2M threshold.
Comparable sales can reach the high single-digit to mid-teens.
Operating and net margins are not overly important to me at this stage. Something which I will explain throughout the duration of this memo, but mostly in sections two and three.
Q1 2022 already looks promising with one new store under the belt (a total of 33), as well as $10.3M in sales for the month of October. During the call, Benrubi highlighted that for Q4, sales comps (from a 2019 base) showed 4.9% growth (contrary to the 2020 to 2021 growth rate of 16.2%) with California down by 6.8%, largely due to the early June capacity restrictions, and Texas market up by 17.2%.”
However, the first two months of Q1 2021 show total comps of 22.2%, with California up by 13.6% and Texas up by 31.6%.
On Off-Premise and Digital
The off-premise business blossomed from the disruption of Covid. Prior to that, this would represent ~1% of total sales, it would peak at 30% in December 2020, and now currently sits at ~5% as of Q4, down 500bps from last quarter.
The decline occurring as a natural response to the re-opening of the full Kura indoor experience, and management hold strong on their assumption that off-premise will continue to be a mid-single-digit composition of revenue going forward.
Some interesting commentary around the cost structure of the off-premise business.
If I have learned one thing from following companies like Starbucks, it’s that loyalty programs create highly engaged customers who typically exhibit a higher propensity to spend, and more readily frequent the business in which they are a rewards member. Kura’s combined rewards members and app users now total 240,000, for a 65% upstep from last quarter.
The app is still a tad bug-prone and doesn’t have the greatest of reviews, but with Kura’s hiring in the tech department (hired first IT director in Q4) I am looking forward to seeing how they can better leverage the app in a similar fashion to other great chain brands.
On Store count
As noted, Kura now sits on 33 total stores after the opening of the Bellevue, WA, store in Q4 and one subsequent San Francisco, CA, store in Q1 2022. Both CA and TX continue to be the most dominant markets.
The biggest takeaway being there are between 8 to 10 new stores expected in 2022 (assuming this includes the 1 already opened), and that Uba suggests the whitespace has never looked more appealing.
Note: Jimmy later corrected the 7 leases to 9 leases.
With 9 leases already set in motion, management is flexible with its real estate strategy.
On Labour Supply and Efficiencies
There was a great deal of talk surrounding inflation, pricing, labour, and margin in the quarter’s call. I will focus on labour and efficiencies today.
As a reminder, each new store will require between 30 to 70 new employees to run the unit effectively. With 7 new stores launched in fiscal 2021, we have seen Kura’s employee base climb by 770 members (75%) to 1,800.
Benrubi would remark that despite considerable demand (on Kura’s side) for new members to populate their new stores, they have not faced the degree of hiring issues that are prevalent across the rest of the industry.
He did acknowledge that the influx of new members, and their composition relative to the existing workforce, has resulted in Kura hosting a large number of fresher faces in the business. They are re-assessing training/onboarding protocols as a result.
Jimmy would expense his breath remarking about the potential for table site and touch panel drink ordering as one method to reduce redundant work from servers, and potentially expand margins through sales leverage.
Given that Kura already has a large Japanese parent, which works through these efficiencies at scale domestically, there are not many “low hanging fruits” to expand margin in the US business. Most of them will include minor advances like table-side ordering, or new technology passed through from the parent (see below snippet about automated dishwashing robots). Sales leverage and scaling the US business, and the economies of scale that come with that, are the greatest opportunity in my humble opinion.
However, smaller initiatives that increase turnover will certainly help with those extensive waiting times that most Kura customers are facing at the moment. A positive sign on the demand front, but not great for the consumer.
On Hiring and Team Building
After the acquisition of Sean (COO) in Q3, Kura would hire Arlene Petokas as the Chief People Officer in October. Arlena spent a number of years in the industry working with Del Taco, CKE, and Farmer Boys.
The team also hired their first Director of IT, as I mentioned earlier. This should help their ambitions with table-side ordering, the Kura app, and other projects.
Elsewhere, a great deal of attention is being afforded to ensuring historically low retention remains stable, through building out greater transparency about career development at Kura.
Section 2: Liquidity and Cash Flow
The most notable difference for Kura this quarter is that the cash balance expanded from $4.7M to $40.3M after the company successfully raised over $53M from an exquisitely timed stock issuance. I wrote a memo back in July explaining why I thought this was a perfectly executed move.
The second notable alteration is the disappearance of their borrowings ($17M in Q3 2021) that have now been fully paid down. This $45M revolver, afforded by the parent company, was an invaluable crutch that allowed Kura US to ride the Covid storm.
In Q2 2021, Benrubi suggested the total borrowing could reach between $20M to $22M by year-end. We are now there, and the Kura balance sheet is absent of any debt, with plenty of capital left over to fund their store expansion plans for the coming year. With 8-10 new stores coming in 2022, at a Net CapEx outlay of ~$2.1M per store, that’s between $17M and $21M (net), which Kura have more than enough cash to allocate.
Consider that a new store costs ~$2.1M (up slightly from the $1.8M cited back in 2020). Within 18 months (the time frame allocated for them to be considered in the AUV metric) these new builds (pre-covid) typically generated an average of ~$3.5M in annual unit volumes. Back in Q1 2021, Benrubi would suggest that a store only needs 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 is closer to 65% of that sales volume to breakeven.
Despite AUVs for 2021 being up 10% from last year, the reality is that they are down 38% from 2019. However, it’s apparent that much of this has to do with the fact the first three quarters of fiscal 2021 were rampant with disruption from covid.
I am fairly confident that by the end of 2022 (restrictions permitting) we see the AUV climb back up to the $3.2M+ levels, and the attractive payback period on each unit come back to the fore.
Cash flows have been fairly distorted over the past two years on account of the sequential years of net losses and financing arrangements that Kura undertook to secure their status as a going concern.
In pre-covid years, Kura’s CapEx largely outweighed its operating cash flows in pursuit of store growth. Whilst I suspect this is going to be the case for a number of years, whilst the business scales, positive operating cash flow should become a fixture in 2022’s operating results.
Negative free cash flow, in this case, is deceptive and not a concern for me. Again, the company has ample cash to burn through in 2022 to fund that store expansion. And let us not forget the business has favourable terms with their parent, from whom they can readily tap capital from, via revolver, when needed.
Section 3: Guidance for 2022
Kura’s guidance was far in excess of my most optimistic projection. Candidly, perhaps I underestimated the potential here in my earlier assessment.
Full Year Fiscal 2022 Guidance
Revenues: Between $130M and $140M, representing growth upwards of 100% from 2021 and 2019 levels.
Store Openings: Expect to open between 8 to 10 new stores, with a net CapEx per unit of $2.1M.
G&A Expense: To be ~17% of total sales. So, between $22.1M and $23.8M.
The G&A would represent between 40% and 51% YoY growth from 2020. Pre-covid, G&A would typically account for low-teens as a percentage of revenue with restaurant-level OpEx accounting for ~85%. At this time, Kura was marginally profitable on both operating and net margin.
Should restaurant-level OpEx (as a percentage of revenue) stabilise in 2022 and float back down to pre-covid levels, it may be possible that Kura returns to operating profitability in 2022, but the margin is likely going to be razor-thin. However, with inflationary pressures across both raw materials and labour, I am not certain.
Some context on the ramp-up in G&A. The company is getting bigger. With a larger company, the roles in upper-level management typically undertake greater responsibility. As Jimmy said in the call, that translates to greater hiring rates. Management suggested that the acceleration in 2022 is being executed in order to build a team that can serve for a “multiyear period” and to “handle things for a while”.
When asked whether or not they plan to increase the 8-10 annual store opening rate in 2023 and beyond, Uba would remark that the 2022 G&A plans assist with that goal.
Post-2022, G&A growth should decline back to more modest levels. I can relate. I would rather Kura reinvest into the business (store count via CapEx and personnel via OpEx) at this stage in order to expand the brand domestically before focussing exclusively on margins.
As a reminder to readers, management has a 20% store count CAGR goal from 2019 to 2024. A growth rate that should see them target ~57 stores in three years time. With 40+ stores expected by the end of 2022, I think it’s likely they surpass the goal.
Section 4: Concluding Remarks
No surprises. I conclude that this was a great quarter for Kura Sushi. One which sets up 2022 well. I’ve mostly been discussing the business up until now, ignoring the valuation, by design.
I originally bought Kura Sushi on May 4th for ~$37 per share, at a market cap of $316M. Today, Wednesday 17th before the market open, it trades at $76 (market cap of $733M). That’s up over 100%.
Right now it trades at ~15x revenues, or ~5x FY23 revenues, which for a dinky sushi chain is still optically expensive. I had thought that the stock was expensive back in May too. This, and the fact I have a general reluctance to size smaller cap names, led me to open a smaller 1.5% position in Kura. That now equates to 2.3% of the portfolio.
Something to acknowledge here is that the dramatic incline in revenues for 2022 (guidance) is really just the result of a build-up of ~18 months worth of suppressed sales from store closures and consumer mobility disruption. The store count continued to chug away during that period and so in 2022, alongside several new stores, the revenue will look explosive.
Moments like these, where one has to wear both the business analyst hat and security analyst hat, are something I hope to get better at solving in the future. The business itself looks considerably healthier than it did when I picked it up. The stock, however, appears to be horrendously stretched, even if we are pricing it on FY23 numbers.
Not an apples to oranges comparison, but at the height of the dot.com bubble, Starbucks would reach heights of 10x sales, with 20%+ operating margins, profitability, sales growing upwards of 30% annually, and total revenues in the low billions. The company would never trade at such high sales multiples ever again.
I am not suggesting sales multiples are to be observed in isolation. More so demonstrating my point. As optimistic as I am about the future of Kura Sushi, I struggle to believe they will ever open a fraction of the number of stores that Starbucks has. Or, put differently, I don’t think they will the “Starbucks” story of sushi. Totally different ball game, despite the seeming similarities of being a consumer-facing, commodity-dependent, restaurant-chain model with great branding.
So, I am at a point of conflict.
On the one hand, it may be prudent to take the returns and move on. A double of capital in 6 months is not to be baulked at.
Conversely, I am not someone who likes to sell when the only compelling rationale is valuation. If the bet is a multiyear venture, then why I am pressed to make decisions after only 6 months? I will admit that I am not going to be surprised if the stock gets cut in half, but attempting to forecast when that happens is market timing.
The ideal scenario is holding onto a business throughout its replication phase, reaping the uninterrupted returns along the way. But this concept is often romanticised and subject to survivorship bias. Not every company makes it, some are zeros, and the mentality to hold over that length of time is not a trait gifted to every investor.
Given the size of the position, it makes the decision a little easier, as it’s not a needle mover and I like to make the assumption that “a little is all you want, a little is all you need” should the stock do well/badly. I will hold for now.
However, I think that for most investors, now would be a prudent time to sell or trim. Most disagreement in this game tends to revolve around the time horizon. Making an assessment of Kura’s stock price over a 1Y period, I find it hard to imagine where the upside is. But for me who, perhaps mistakenly, is more so concerned with how the business will look in 5 years time, I am content with riding volatility.
No changes as of the last report.
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