KRUS: "Thriving in an Inflationary Environment"
Kura Sushi US Q3 2022 (NASDAQ:KRUS)
By this point, I have documented my thoughts on each of the last five Kura Sushi KRUS quarters, covering the trough of their pandemic performance, recovery, and the re-acceleration phase. For the sake of brevity, I will stick to only the essential takeaways from Kura’s Q3 earnings, released on July 7th, with more to say when the company closes its fiscal year next quarter. Readers who are looking for more context can find the older memos, ordered by recency, here → (“KRUS: Kura's Roll Keeps Rolling”, “KRUS: Kura’s Pricing Power”, KRUS: A 2022 Story, with a Price Tag”, “A Turnaround Story for Rotating Sushi”, “Kaitensushi (回転寿司)”.
Raised Guidance & No Softening Demand
Kura ended the quarter with another record sales figure, just shy of $38M. There are now 37 stores across the United States, with a further 3 stores (bringing the year’s total to 8) expected in Q4, as well as a minimum of 2 stores which are expected to open in Q1 2023 (previously assumed to open in Q4). The company flashed a rare glimpse of profitability but more importantly continued to show that they have a handle on their COGS, with the two primary expenses (Food & Beverage and Labour) declining as a percentage of revenue both sequentially and YoY. Impressive, given that we are in an inflationary environment.
Whatsmore, the company boasted an impressive 22.5% restaurant-level operating margin, with full-year margins expected to be in the 20%+ range. Operating cash flows look to be in better shape, the balance sheet continues to be devoid of any debt, and the $36M cash on hand is a healthy surplus to cover CapEx needs and the $24M in obligations due within the year.
Further, the company appear to be ahead of schedule with respect to its three-pronged initiative to roll out table-side payment, touch panel drink ordering, and the addition of robot servers; all of which were completed in May. The rewards program, now close to 500,000 members, will also be getting a facelift, with the team shifting their rewards program to Punch, an AI-assisted loyalty platform that will enhance both the data and efficiency of the Kura Sushi rewards experience. Topping all of that off, was an unexpected upgrade to full-year revenue guidance. Initially guiding for between $130M and $140M in revenue, Kura now expects to end the year with between $140M and $147M in sales as we head into their, historically, strongest quarter.
This all sounds quite wonderful, but there are a few things to consider. A healthy bout of sales leverage is one factor in the improvement of Kura’s margins, but so too are the further pricing hikes that management decided to take in July.
Thriving in an Inflationary Environment
Whilst much of this industry has faced headwinds in terms of both staffing (shortages and labour costs) and input cost inflation, Kura has thus far managed to bring its COGS as a percentage of revenue down in a period where most are struggling to offset inflation. In prior quarters, the company took small pricing events, purely to offset inflation. Having such a small amount of protein on each plate, as well as a diverse menu of food and beverage items, and one of the lowest-priced offerings on the street, consumers barely noticed Kura passing on inflation to the consumer.
In the past, Uba remarked that they noticed no softening of demand from their consumers and that they are not close to hitting any pivotal point of elasticity. There’s more stretch left to be stretched. Despite the previous pricing hike being “enough to offset inflationary pressures through the third quarter” the company would take another pricing hike, this time ~6%. Naturally, if Kura are expecting its consumers to absorb pricing once again with little attrition, then the ~6.2% increase in mid-level guidance for sales marries up with their ~6% pricing event. What strikes me with intrigue, however, is that this pricing event appears to be opportunistic. AKA, it didn’t really have to be enacted. This comes at a time when Uba suggests staffing levels are very close to being optimal with no shortages or quarantining. I acknowledge that this may be a pre-emptive move to combat future inflation or perhaps test the limits of their consumer elasticity in an effort to expand margin. But what struck me as odd, is that Uba has previously (as recently as last quarter) stated that they “don't like to drive margins through pricing”. Here is what Uba said in Q2, after a more modest 1.8% price hike.
“We don't like to drive margins through pricing. What we know is that delivering a great value has always been core to our brand. And in spite of the pricing that we're taking, the purchasing power of the rest of the sushi industry being so fragmented is just not nearly on the same scale as we are. And so the mom-and-pops are having to take far more price than we are. And so in spite of the pricing that we're taking, value delta continues to grow. So, I think we're pretty happy with our position right now.”
So this feels somewhat contradictory. Over the years I have been following Kura’s earnings calls, Uba had stressed that Kura would only increase prices to offset inflation, and never for margin. In the latest earnings call, one analyst would touch on that, asking why they continue to push margin through pricing. Uba would retort that “the goal isn't to drive margin by taking price” and that consistency of Labour and COGS was the impetus, adding that “the growth in margin is more from just greater sales leveraging combined with that seasonal boost”. Either way, I don’t think this is a major red flag, more so an observation to make note of. I don’t think it ultimately threatens Kura’s position as one of the lowest-cost/great-quality operations in the market right now whilst the rest of the world inflates prices.
The quarter yielded some great progress on execution, and verified that the bull case for the business remains on course. That’s all great, but what about the valuation? In last quarter’s memo, I concluded that Kura was simply too expensive ($53 per share at the time) to be interesting, stating that “whilst I am more than content to continue owning this business, I haven’t found an attractive point of re-entry just yet”. Shortly after, the share price declined to around $31, and I managed to add ~40% to the position at $32 per share.
At the time of writing, Kura is trading in pre-market for ~$61 per share, so once again it is grossly overvalued. The position currently accounts for ~3% of my invested assets and I am comfortable like I have done several times already, riding through the volatility. I find that each quarter Kura tends to smash earnings and undergo an exaggerated bout of upside, before trickling back to reality. The stock often reaches the upper realms of ludicrously, but seldom floats into the depths of depravity. I admit that paying ~$300M for this business is still on the premium end of the spectrum, but so far as things stand, I remain optimistic that this is a business that could, within the decade, be operating between 100 and 130 units across the country. I am sure, ceteris paribus, that within that period of time there will be opportunities to acquire shares at more favourable prices.
As far as factors that could derail this business, nothing has changed from what I shared last quarter. Liquidity, a weaker than expected adoption of sushi in the US, the controlled ownership, etc, all remain prominent risks. There was the announcement of the CFO, Steven Benrubi, resigning in May who was brought on two years ago to help with the IPO process that raised a brow. However, it would appear that Mr Benrubi, aged 55, will be retiring from corporate life altogether, which somewhat relieved my initial fears. Of course, now the company must replace him with another high-quality executive.
Being a small-cap, one that is oft priced in excess of its realistic value, I feel that Kura may be overlooked often by investors seeking value in the small-cap space. Whatsmore, the level of coverage has not improved in the years I have followed the company. I would imagine most find the stock when it trades in an expensive bucket, decide it’s not worth looking at and pass it over. Conversely, others might short it. There have been several occasions when Kura Sushi has been a great short. However, ignoring the market cap for a moment, I think there is something unique about Kura Sushi, and seek to benefit from the moments where it trades at more reasonable levels.
In the upcoming quarter, we will learn what the company’s average unit volumes (AUVs) have been for the 2022 fiscal year. Whilst the “opportunity to exceed historical AUVs” discussed last quarter remain more of a 2023 prospect, the AUVs of 2022, a year essentially without pandemic disruption, are going to be a proof-in-the-pudding moment for this business.
I await those results and will have more to say then.
Thanks for reading.