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Kona Grill Inc (NASDAQ:KONA) is an undervalued asset situation with a potential acquirer raising its stake in the company through November. Mill Road Capital made a cash offer in March to acquire KONA for $10.75 when the stock was trading at around $8.76. Since the offer was rebuffed by KONA in April the stock has slumped 85% to close yesterday at $1.31. Mill Road Capital has continued to buy stock, raising its stake to 10% in November from 8.2% in June. At $1.31, KONA has a market capitalization of just $7.9M. We estimate that its assets in liquidation are worth around $14.8M or $2.47 per share. With KONA trading at a discount of nearly 50% to its liquidating value and Mill Road Capital continuing to buy stock, we believe it is an attractive opportunity.

About KONA

KONA owns and operates 18 restaurants located in 12 states in the United States. The restaurants feature a selection of mainstream American dishes, as well as a range of appetizers and entrees with an international influence, including a selection of sushi. The menu items also incorporate over 40 signature sauces and dressings that Kona Grill makes from scratch, creating appeal for the lifestyle and taste trends of a diverse group of guests. The menu offerings are complemented by a full service bar offering an assortment of wines, specialty drinks and beers. Effective September 14, 2008, the Company closed its restaurant in Naples, Florida. KONA’s investor relations website is here.

The value proposition

According to the most recent 10Q, KONA has been consistently generating positive cash flow from operating activities. In the year ending December 31, 2007, the company generated $5.7M and has continued to generate positive operating cash flow each quarter for the last year. The company continues to consume cash, however, as it invests in new restaurants. While we believe that KONA has value as a going concern, our analysis demonstrates that the market is pricing its stock  at a substantial discount to its liquidating value (the “Carrying” column shows the assets as they are carried in the financial statements, and the “Liquidating” column shows our estimate of the value of the assets in a liquidation):

KONA’s value lies in its restaurants, carried on the balance sheet in its $53.7M in net property, plant and equipment. Discounting that figure by a third to $36M equates to $5.99 per share in value. Deducting all liabilities from the discounted assets leaves a liquidating value of around $14.8M or $2.47 per share.

The catalyst

Mill Road Capital is seeking to take KONA private. This 13D filing details Mill Road Capital’s investment thesis for KONA:

[Mill Road Capital] acquired shares of the Common Stock based on their belief that the Common Stock represents an attractive investment opportunity. [Mill Road Capital] further believe that [KONA] would be better able to realize its full value as a private entity.

On March 28, 2008, Mill Road Capital sent to Kona a non-binding offer to acquire all of KONA at a cash price of $10.75 per share:

Re: Notice of Acquisition Proposal

Ladies and Gentlemen:

Mill Road Capital, L.P. (“Mill Road”) is a substantial shareholder of Kona Grill, Inc. (“Kona” or the “Company”), currently owning approximately 325,000 shares or 4.9% of the Company. Mill Road has closely followed Kona since 2006, and we are extremely impressed with management and the Company. We believe that the public market does not adequately value small companies such as Kona, and by staying public, the Company will continue to be subject to undue regulatory burdens and pressure to maximize short-term results at the expense of long-term performance. We believe Kona will be better able to realize its full potential value as a private entity and are, therefore, making an offer to acquire all of the outstanding shares of the Company.

Mill Road is pleased to submit a non-binding offer to acquire all shares of the Company’s stock at a cash price of $10.75 per share. This represents a 23% premium to the closing price of $8.76 as of March 27, 2008. We would anticipate that the transaction would be accomplished through a merger of a company organized by Mill Road with and into the Company, as a result of which all stockholders of the Company would be entitled to this cash consideration.

Mill Road is a Greenwich, Connecticut based investment firm with approximately $250 million of committed equity capital. Our limited partners include a prominent and highly respected group of state pension funds, foundations, endowments and insurance companies. The investment professionals of Mill Road are a core group of former Blackstone professionals who have successfully completed more than 20 control transactions in which more than $600 million of equity capital was deployed with total transaction value of several billion dollars. Additionally, we have significant industry experience as a substantial investor in many public restaurant companies and through my position on the Board of Directors of Panera Bread Co. (NASDAQ: PNRA) from 2003 to 2006.

Our industry and transaction experience will allow us to quickly complete due diligence and definitive documentation. Considering the amount of our investable capital, Mill Road can readily fund the entire transaction contemplated by this acquisition proposal.

We are prepared to commence negotiations immediately with respect to this acquisition proposal and wish to close this transaction as soon as possible. We look forward to the opportunity to discuss our proposal in more detail with the Board of Directors and management. It would be our pleasure to meet in person at a location of your choice.

You may contact me directly at (203) 987-3501. I look forward to discussing our proposal at your earliest convenience.

Sincerely,
Mill Road Capital L.P.

By: Mill Road Capital GP LLC
Its General Partner

By:

Thomas Lynch
Senior Managing Director

KONA responded to Mill Road Capital on April 18, 2008 indicating that the letter had been distributed to KONA’s board for discussion at its next board meeting. On May 1, 2008, KONA told Mill Road Capital that it was not interested in pursuing the transaction.

Mill Road Capital has continued to purchase KONA stock, paying between $1.85 and $6.91 according to the latest amendment to their earlier 13D. As of November 14, 2008, Mill Road Capital controlled 10% of KONA.

Conclusion

KONA is an undervalued asset situation with a catalyst in the form of a potential takeover from Mill Road Capital. Given the deterioration in KONA’s stock price since the rejection of Mill Road Capital’s initial bid, we would not expect Mill Road Capital to offer $10.75 again. We do believe, however, that any bid would be at a premium to the current stock price. If we are wrong and a bid does not materialize from Mill Road Capital or some other acquirer, the down side should be limited because KONA is already trading at a substantial discount to its value in a liquidation.

KONA closed Friday at $1.31.

The S&P 500 closed Friday at 879.73.

[Disclosure: We do not presently hold KONA.  This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only.]

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