To The Moon

Summary

• Kura Sushi has outperformed its micro-cap peers over the past two years and has been firing on all cylinders operationally with industry-leading unit and strong traffic growth.
• Meanwhile, the company noted that June performed above expectations with accelerating comp sales because of a highly successful collaboration, suggesting a strong Q4 on deck.
• In this update, we'll look at the stock's valuation, traffic trends & see where KRUS' updated low-risk buy zone lies ahead of what should be another robust quarter in Q4.

Xsandra

Roughly two years ago, I wrote on Kura Sushi (NASDAQ:KRUS), noting that while the stock was doing an exceptional job growing its business, there was no way to justify paying for the stock at $80.00. This is because it was trading at over 5x forward sales and it was one of the most overbought stocks among its small-cap peers, up 180% in just nine months heading into the new year (2022). Since then, the stock has suffered a 60% plus drawdown, but against all odds has continued to make new highs, an impressive feat considering the carnage in the iShares Micro-Cap ETF (IWC). Hence, while I may have been right to not chase the stock at $80.00, it was certainly outperformed my expectations, and has continued to fire on all cylinders operationally.

In fact, despite development/permitting delays, the company grew units at 25% last year, and is on track for another year of 25% growth, trouncing the growth rates of its highest-growth restaurant peers. Meanwhile, the company successfully implemented three key initiatives aimed at improving speed of service and or margin improvement, and is confident it has another ace in the hole with the potential for a robot dishwasher. That said, while there's lots to like about the company's growth, its improved cash position and its ability to claw back lost margins that others haven't from sticky wage inflation, industry-wide traffic worsened considerably from August through October to date and even trade-down options have seen deceleration, suggesting a negative change in consumer behavior. Let's take a look at the recent results below and see whether the stock is worthy of investment:

Recent Results & Fiscal Q4 Estimates

Kura Sushi released its fiscal Q3 results in July and exceeding my expectations given the tough macro backdrop, reporting revenue of $49.4 million, a 30% increase year-over-year. Notably, this industry-leading growth was up against difficult comparisons (lapping 106% growth in the year-ago period), and was driven by comparable sales growth of 10.3%, made up of 3% traffic growth and 7.3% of price and mix. Meanwhile, June comp sales accelerated to an incredible 14.7% despite soft traffic industry-wide, benefiting from what the company called one of its best guest responses to date from a collaboration (We Bare Bears), giving it confidence in its ability to deliver on future collaborations (like DC Comics planned in August).

Kura Sushi - Quarterly Revenue - Company Filings, Author's Chart

Digging into the results a little closer, the company also shared that these collaborations have helped it to add new rewards members, and its new WaitList App that's been rolled across the system is providing more accurate wait times which could be a tailwind to traffic with less faulty times that may have otherwise shown significantly longer waits than usual. In addition, the company noted that it saw minimal check management, and it improved its balance sheet in the quarter (albeit with ~12% share dilution), by selling ~1.26 million shares at $54.00. These developments are positive, and the stronger balance sheet has given the company to flexibility to make any key hires needed to support its rapid growth, with Kura Sushi on track for another year of 25% growth in 2023 based on its guidance of 9-11 new restaurants (7 opened year-to-date, and 7 in construction currently with half to be opened in FY2024).

Kura Sushi Waitlist App - Apptopia

Finally, from a margin standpoint, the company saw higher food costs with commodity inflation offsetting pricing, but gained leverage on labor costs with labor down 180 basis points to 29.2% as a percentage of sales with the benefit of menu pricing, the full benefit of robot servers and additional technology offset by higher wage rates. And one key take-away from the call was that the positive impact from a robot dishwasher (if implemented across its system) would be bigger than its past three initiatives combined (table-side payment, robot services, touch-panel ordering all estimated at 50-60 basis points of labor), suggesting that a robot dishwasher could lead to 70 basis points of labor savings. This is because dishwashers aren't eligible for tips so it's one of the highest paid back-of-house positions, and this would certainly be a nice boost to margins medium-term if rolled out to help offset sticky labor inflation and consistently rising wages in California.

Robot Servers Kura Sushi - RobotLab Group

Overall, this solid quarter resulted in $5.1 million in adjusted EBITDA ($4.4 million when including stock-based compensation), with the $5.1 million figure up ~60% year-over-year. In addition, the company exited the quarter with over $70 million in cash, and while it has continued to grow at a rapid pace, it shared that it ultimately believes its long-term potential domestically could be over 300 restaurants vs. the 300 restaurant potential referenced previously. So, while this is one growth story that is sustaining incredible momentum while improving margins in an unprecedentedly tough environment (restaurant level margins up 100 basis points year-over-year), this is still the early innings for the story. And with the benefit of a better than expected promotion in fiscal Q4, it's possible the company could beat sales estimates of $55 million.

Industry Wide Trends & Recent Developments

As for industry-wide trends and recent developments, one area of improvement has been commodity inflation, which has cooled off after a very difficult 2022 (double-digit commodity inflation). In addition, applicant flow and retention appear to be improving (judging by commentary in Q2 2023 from many brands). This suggests less of a headwind from paying overtime and hiring/training costs than we saw following the "Great Resignation" post-COVID-19, which hit restaurants especially hard. It also suggests better guest satisfaction and productivity potentially, given that longer-tenured team members and those coming into jobs with higher experience (companies able to choose vs. take whatever is available) should perform better than those in training. However, wage inflation has remained sticky and most quick-service names in California will suffer with minimum wages set to rise ~20% to $20.00 next April.

Fortunately, Kura Sushi is better positioned given its ability to lean into technology in what's already a unique concept with a revolving sushi bar. Second, the company doesn't appear to be seeing the same traffic hit as some of its peers, and it may have slightly less competition given that it's a more unique concept, meaning it could perform a little better in what's become a more promotional environment in casual dining. Finally, the traffic outperformance is a great sign and suggests Kura should be able to continue to take price in a measured fashion to help with margins vs. some Mom & Pop diners and other less iconic brands that may struggle to compete and take price when they need to find ways to reverse a trend of declining traffic. Therefore, while Kura may not be immune, its collaborations and execution to date is certainly noteworthy, and it has bucked the trend to date for negative traffic.

Seated Dines Growth - OpenTable

All that being said, while traffic was weak in fiscal Q3 (March through May) for Kura, it has not improved in H2 according to data on seated diners and traffic industry-wide consistently decelerated following what was a strong July. Hence, although Kura may buck the trend again with its well-executed collaboration, it's not clear whether this will be the case in fiscal Q1 2024/fiscal Q2 2024 or if DC will perform as well. And while the stock may be down substantially from its highs, it's hard to argue that it's priced for any misses at current levels. Hence, while I see less risk in missing fiscal Q4, which will be reported next month, putting up similar beats in fiscal Q1/fiscal Q2 could be tough, especially with some price rolling off. Let's take a closer look at the valuation below.

Valuation

Based on ~11.2 million shares and a share price of $66.20, Kura trades at a market cap of ~$740 million and an enterprise value of ~$770 million. This makes it one of the smaller capitalization names in the restaurant space despite its incredible growth rates (25% unit growth last year), with a similar market to names like Chuy's Holdings (CHUY), BJ's Restaurants (BJRI), and Denny's (DENN). However, from a valuation standpoint, the stock trades at a significant premium to these peers, sitting at ~35x FY2024 EBITDA estimates of $22 million, giving it one of the highest multiples sector-wide, in line with that of high-growth franchised concepts like Wingstop (WING) and over double the multiple of Restaurant Brands International (QSR), another franchisor model generating significant free cash flow. And while I think a premium is justified given the considerable white space, industry-leading growth, solid execution, and room for further margin expansion, I don't see enough margin of safety here despite the sharp correction.

Using what I believe to be a fair multiple of 28.0x EV/EBITDA to adjust for its incredible growth and even being generous and using FY2025 EBITDA estimates of ~$30 million, I see a fair value for the stock of ~$840 million or $74.30 per share to its 2-year price target. And while this fair value estimate points to a 13% upside to fair value, I am looking for a minimum 30% discount to fair value for non cyclical names trading at sub $1.0 billion valuations for starting new positions, and ideally 35%. So, even if we use the less conservative end of this range, KRUS' ideal buy zone comes in at $52.00 or lower. Hence, although the stock may be down substantially from its highs, it's hard to argue that it's cheap, and it remains extended above its long-term uptrend-line (current support at ~$50.00) with unfilled gaps below. Therefore, I see the reward/risk as balanced short-term, making it hard to justify chasing the stock above $67.00 ahead of earnings next month.

KRUS Weekly Chart - Worden

Summary

Kura Sushi has massively outperformed the industry this year regarding traffic, and fiscal Q4 should benefit from what's been a highly successful collaboration with We Bare Bears that ran from June to July (first two quarters of fiscal Q3), followed by DC comics in August (free randomized DC x Kura Sushi Bikkura Pon prize for every 15 sushi plates). That said, this promotion will come up against a sharp turn lower in casual dining traffic, which also leaked into quick-service traffic, a negative divergence from what we've seen previously. Hence, while fiscal Q4 could beat estimates, it could be a tougher setup for fiscal H1 2024 (Sept. 2023 through Feb. 2024). And while this wouldn't be a big deal if Kura Sushi was sitting near multi-year support and offering a margin of safety, I think it's hard to argue for there being an adequate margin of safety here at over 35x forward EV/EBITDA.

So, although I see KRUS as one of the better growth stories in the space, I continue to see better value in names like Aritzia (ATZ:CA) also enjoying industry-leading growth, but at less than 7.0x FY2024 EV/EBITDA estimates.