Kura Sushi USA, Inc. (NASDAQ:KRUS) operates a rotating sushi bar in the United States with a brand already well known in Japan. The company is trying to improve the customer experience through technology, including robots. servers and QR payment on table. The company is rapidly expanding nationwide with its relatively well-received restaurant concept and plans to enter several new states in the coming quarters, as noted in the June 2024 report. investor presentation.
Since its IPO in 2019, the stock has seen impressive performance as Kura Sushi has aggressively pushed new store growth. Yet profitability consistently lags behind the break-even point, and capital expenditure make Kura Sushi’s cash flow very negative. Naturally, the company does not pay a dividend due to its growth strategy.
Restaurant chain’s aggressive expansion continues
As the number of Kura Sushi units increased from just 14 in 2017 to around 63-64 in 2024, revenues grew at a CAGR. by 30.7% from fiscal 2017 to current revenues in the second quarter of fiscal 2024. In the last quarter, growth continued at the healthy level of 30.4%. The company opened five new restaurants during the quarter, also fueling growth for future quarters. Kura Sushi reaffirmed its slim guidance range of $243 million to $246 million in fiscal 2024 revenue in its second-quarter report.
Growth requires a large amount of capital. From the company working capital is negative, but capital expenditures consume a significant amount of capital – over the last twelve months, capital expenditures are $47.6 million. For the construction of just one new location, Kura Sushi is planning capital expenditures of $2.5 million, and the new units expected in FY 13-14 involve investments of $32.5 million to $35 million. dollars, excluding maintenance investments. Compared to the current current depreciation of just $9.7 million, cash flow remains very low relative to earnings as growth continues.
Kura Sushi’s future profitability in question
Kura Sushi’s historically balanced operating profit of -$1.0 million makes future margin improvement crucial. Fueling growth naturally eats into short-term profitability, and newly opened restaurants only increase traffic, gradually improving their profitability as the restaurant base matures. Still, Kura Sushi’s future margin potential needs to be examined critically.
The restaurant industry is very competitive and even many well-established national restaurant brands struggle to generate very healthy margins. For example, Shake Shack’s (SHAKE) the current operating margin amounts to 1.3%, that of Cheesecake Factory (CAKE) at 4.5%, and Papa John’s (PZZA) at 7.6%. Often, being a franchiser seems to be the most profitable operating model in the restaurant industry, with Kura Sushi owning all of its locations. Kura Sushi’s margin potential appears to be quite limited for the foreseeable future, as evidenced by low gross margins, currently at 18.7%, and the industry’s generally low margin profile for smaller restaurant chains such as Kura Sushi .
Growth investments make it important to achieve sufficient profitability. Cash flow is currently very negative, and a longer growth trajectory presents funding risk if margins do not gradually rise. The balance sheet includes $62.8 million in cash and short-term investments combined after the second quarter, allowing for a few years of ongoing growth investments with current earnings at -25.0 free cash flow millions of dollars. I don’t view funding risk as too great a threat, but there is still something worth noting: investors should closely monitor cash flow and improving profitability over the medium term.
The stock price is not sustainable
After the stock’s price multiplied post-IPO, the stock’s valuation appears significantly overvalued relative to the current earnings profile. The stock trades on EV/EBITDA futures of 52.4 and a current price to book value of 5.8, incorporating a very rapid rate of future growth.
To demonstrate valuation and estimate an approximate fair value, I constructed a discounted cash flow (DCF) model. In the model, I estimate continued strong growth with 31% in FY 2024, 27% in FY 2025, and continued gradual slowdown thereafter. From FY 2023 to FY 2033, revenue growth estimates represent a CAGR of 15.0%.
I estimate that the margin profile and cash flow will begin to improve as growth slows, with a final EBIT margin level of 9.0%. I think the margin estimate is quite courageous given the current financials and represents successful brand growth and good traffic. Cash flow is expected to remain negative over the next few years due to rapid investment, but it should eventually improve to a good level with slower growth.
Instead of a perpetual growth estimate that I usually use, I instead estimated the terminal value with an exit EV/EBIT multiple of 15.
Estimates place Kura Sushi’s fair value at $45.20, 45% below the stock price at the time of writing. The stock appears to be on a very aggressive growth trajectory with more impressive margins than I consider appropriate to estimate in a competitive industry. With potential financing risk that could also limit future growth, the investment has a very low risk/reward ratio in my opinion.
A weighted average cost of capital of 11.11% is used in the DCF model. The WACC used is derived from a capital asset valuation model:
Kura Sushi has no long-term interest-bearing debt and I estimate that financing will continue entirely from equity. To estimate the cost of equity, I use the US 10-year bond yield of 4.24% like the risk-free rate. The 4.60% equity risk premium is that of Professor Aswath Damodaran latest estimate for the United States, updated on 5th of January. Seeking Alpha estimates Kura Sushi’s beta at 1.44. Finally, I add a liquidity premium of 0.25%, creating a cost of equity and WACC of 11.11%.
Risks for the bearish thesis
Despite my base case scenario showing a return, the stock could still prove very profitable for investors. Most notably, in my opinion, significantly higher profitability than I anticipate could make the stock worth more than its price – if the store concept continues to attract increasing numbers of customers to comparable restaurants and if the technological features restaurants offer significant benefits. In terms of cost-effectiveness, EBIT margins could turn out to be more positive than the DCF model suggests, thus invalidating the bearish thesis.
Another upside risk is the potential for mergers and acquisitions that could ultimately create shareholder value for Kura Sushi shareholders. A larger company in the industry might have better resources and financing to fuel Kura Sushi’s growth and be incentivized to acquire the fast-growing restaurant chain. However, I don’t think the likelihood of an acquisition or merger is very high.
The stock’s strong long-term momentum and the potential for more aggressive growth than expected also pose potential threats to my bearish thesis.
Take away
Kura Sushi continues to aggressively expand the technology-based restaurant concept in the United States. The company plans 13 to 14 new units in fiscal 2024, continuing revenue growth at historical levels of approximately 30% per year. However, the growth story is not without caveats: Growth requires a large amount of capital, and Kura Sushi has yet to achieve highly profitable operations with near-breakeven operating profit. The balance sheet should be able to finance growth for a few years, but possible improvements in profitability are essential both to fuel growth and to make investment attractive. Generally, low industry profitability for smaller restaurant chains like Kura Sushi, currently weak earnings and cash flow, and an incredibly optimistic valuation make the stock unattractive at present. As such, I am introducing Kura Sushi to Sell.