Item 1. Consolidated Financial Statements

KONA GRILL, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and notes thereto included in Item 1 of Part I of this Form 10-Q and the audited consolidated financial statements and notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2011 contained in our 2011 Annual Report on Form 10-K.

Certain information included in this discussion contains forward-looking statements that involve known and unknown risks and uncertainties, such as statements relating to our future economic performance, plans and objectives for future operations, expectations, intentions and other financial items that are based on our beliefs as well as assumptions made by and information currently available to us. Factors that could cause actual events or results to differ materially from those indicated by these forward-looking statements may include the matters under Item 1A, “Risk Factors” in this report, our Annual Report on Form 10-K for the year ended December 31, 2011 and other reports filed from time to time with the SEC.

Overview

We own and operate 23 restaurants located in 16 states. We offer freshly prepared food, attentive service, and a contemporary ambiance that create a satisfying yet affordable dining experience that we believe exceeds many traditional casual dining restaurants with which we compete. Our high-volume upscale casual restaurants feature a diverse selection of mainstream American favorites as well as a variety of appetizers and entrees with an international influence, including an extensive selection of sushi items. Our menu items are freshly prepared and incorporate over 40 signature sauces and dressings that we make from scratch, creating broad-based appeal for the lifestyle and taste trends of a diverse group of guests. We believe that our diverse menu and generous portions, combined with an average check of approximately $25 per guest, offers our guests an attractive price-value proposition.

The restaurant industry is significantly affected by changes in economic conditions, discretionary spending patterns, consumer confidence, and other factors. Customer traffic and sales patterns have shown improvement since 2010 to date as evidenced by our positive comparable restaurant sales for the previous eight quarters and eleven consecutive quarters of positive guest traffic. For the quarter ended September 30, 2012, our comparable restaurant sales grew 0.2% from the prior year period, improving on same store sales that had shown 10.6% growth from the 2010 period. For the first nine months of 2012, our same store sales grew 3.6% from the prior year period, improving on same store sales that had shown 9.2% growth from the 2010 period. We believe continued improvement in consumer confidence and spending in general, will be important and necessary catalysts to drive guest traffic and higher guest check averages in casual dining restaurants in general and our restaurants in particular.

We closed our West Palm Beach, Florida and Sugar Land, Texas restaurants during the third quarter of 2011. We settled all lease termination costs for the West Palm Beach and Sugar Land locations in the third quarter of 2011 and 2012, respectively. The decision to close these restaurants was based on these restaurants' past operating performance. The closures enable us to focus on our existing restaurant portfolio while also allowing us to concentrate on developing new restaurants. As a result of the restaurant closures, all historical operating results as well as lease termination and exit costs attributable to these restaurants are reflected within discontinued operations in the consolidated statements of comprehensive income for all periods presented.

We target our restaurants to achieve an average annual unit volume of $4.5 million following 24 months of operations. Our typical new restaurants experience gradually increasing unit volumes as guests discover our concept and we generate market awareness.

We experience various patterns in our operating cost structure. Cost of sales, labor, and other operating expenses for our restaurants open at least 12 months generally trend consistent with restaurant sales, and we analyze those costs as a percentage of restaurant sales. We anticipate that our new restaurants will take approximately six months to achieve operating efficiencies as a result of challenges typically associated with opening new restaurants, including lack of market recognition and the need to hire and sufficiently train employees, as well as other factors. We expect cost of sales and labor expenses as a percentage of restaurant sales to be higher when we open a new restaurant, but to decrease as a percentage of restaurant sales as the restaurant matures and as the restaurant management and employees become more efficient in operating that unit. Occupancy and a portion of restaurant operating expenses are fixed. As a result, the volume and timing of newly opened restaurants has had, and is expected to continue to have, an impact on cost of sales, labor, occupancy, and restaurant operating expenses measured as a percentage of restaurant sales. The majority of our general and administrative costs are fixed costs. We expect our general and administrative spending to decrease as a percentage of restaurant sales as we leverage these investments and realize the benefits of higher sales volumes.

Key Measures We Use to Evaluate Our Company 

Key measures we use to evaluate and assess our business include the following:

Number of Restaurant Openings. Number of restaurant openings reflects the number of restaurants opened during a particular reporting period.

Same-Store Sales Percentage Change. Same-store sales percentage change reflects the periodic change in restaurant sales for the comparable restaurant base. In calculating the percentage change in same-store sales, we include a restaurant in the comparable restaurant base after it has been in operation for more than 18 months. Same-store sales growth can be generated by an increase in guest traffic counts or by increases in the per person average check amount. Menu price changes and the mix of menu items sold can affect the per person average check amount.

Average Weekly Sales. Average weekly sales represents the average of restaurant sales measured over consecutive Monday through Sunday time periods.

Average Unit Volume. Average unit volume represents the average restaurant sales for the comparable restaurant base.

Sales Per Square Foot. Sales per square foot represent the restaurant sales for our comparable restaurant base, divided by the total leasable square feet for such restaurants.

Restaurant Operating Profit. Restaurant operating profit is defined as restaurant sales minus cost of sales, labor, occupancy, and restaurant operating expenses. Restaurant operating profit does not include general and administrative expenses, depreciation and amortization, or preopening expenses. We believe restaurant operating profit is an important component of financial results because it is a widely used metric within the restaurant industry to evaluate restaurant-level productivity, efficiency, and performance prior to application of corporate overhead. We use restaurant operating profit as a percentage of restaurant sales as a key metric to evaluate our restaurants' financial performance compared with our competitors. This measure provides useful information regarding our financial condition and results of operations and allows investors to more easily determine future financial results driven by growth and allows investors to more easily compare restaurant level profitability.

Key Financial Definitions

Restaurant Sales. Restaurant sales include gross food and beverage sales, net of promotions and discounts.

Cost of Sales. Cost of sales consists of food and beverage costs.

Labor. Labor includes all direct and indirect labor costs incurred in operations.

Occupancy. Occupancy includes all rent payments associated with the leasing of real estate, including base, percentage and straight-line rent, property taxes, and common area maintenance expense. We record tenant improvement allowances as a reduction of occupancy expense over the initial term of the lease.

Restaurant Operating Expenses. Restaurant operating expenses consist of all other restaurant-level operating costs, the major components of which are utilities, credit card fees, advertising, supplies, marketing, repair and maintenance, and other expenses. Other operating expenses contain both variable and fixed components.

General and Administrative. General and administrative includes all corporate and administrative functions that support operations and provide infrastructure to facilitate our future growth. Components of this category include management and staff salaries, bonuses, stock-based compensation and related employee benefits, travel, information systems, human resources, training, corporate rent, professional and consulting fees, and corporate insurance costs.

Depreciation and Amortization. Depreciation and amortization expense consists of the depreciation of property and equipment.

Interest Income and Other, Net. Interest income and other, net consists of interest earned on our cash and investments and any gains or losses on our investments.

Interest Expense. Interest expense includes the cost of servicing our debt obligations, net of capitalized interest.

Discontinued Operations. Discontinued operations include the historical operating results as well as lease termination and exit costs attributable to closed restaurants.

Financial Performance Overview

The following table sets forth certain information regarding our financial performance for the three and nine months ended September 30, 2012 and 2011.

The following tables set forth our calculation of restaurant operating profit and reconciliation to income from operations, the most comparable GAAP measure.

Certain percentage amounts may not sum to total due to rounding.

The following table sets forth changes in the number of restaurants opened for the periods indicated:

Results of Operations

The following table sets forth, for the periods indicated, the percentage of restaurant sales of certain items in our financial statements:

Certain percentage amounts may not sum to total due to rounding.

Three Months Ended September 30, 2012 Compared with Three Months Ended September 30, 2011

Restaurant Sales. Restaurant sales increased slightly to $23.9 million during the third quarter of 2012 from $23.8 million in the third quarter of 2011. Comparable restaurant sales growth year over year was 0.2%, with higher guest traffic partially offset by a lower average guest check.

Cost of Sales. Cost of sales increased $0.1 million, or 2.1% to $6.5 million during the third quarter of 2012 compared to $6.4 million during the prior year period. The increase was primarily attributable to higher beer and wine costs associated with our happy hour promotions and the company-wide rollout of the Wine Down Wednesday program. The increase was partially offset by lower seafood and produce costs year over year. Cost of sales as a percentage of restaurant sales was 27.4% and grew 0.5% year over year, reflecting mainly the impact of the aforementioned programs.

Labor. Labor costs for our restaurants increased $0.2 million, or 2.9% to $8.0 million during the third quarter of 2012 compared to $7.8 million in the prior year quarter. Labor expenses as a percentage of restaurant sales increased 0.9% to 33.7% during the third quarter of 2012 from 32.8% during the prior year period as a result of deleveraging of hourly labor costs due to softer than anticipated sales volumes.

Occupancy. Occupancy expenses decreased $0.2 million, or 9.9% to $1.6 million during the third quarter of 2012 from $1.7 million during the same quarter in 2011. The lower occupancy expenses are primarily associated with an amendment in our lease agreement for one restaurant that was entered into during the fourth quarter of 2011. Occupancy expenses as a percentage of restaurant sales decreased 0.7% to 6.6% in the third quarter of 2012 compared to 7.3% during the prior year period. The decrease in occupancy costs as a percentage of sales reflects the impact of the aforementioned changes in lease provisions.

Restaurant Operating Expenses. Restaurant operating expenses decreased $0.2 million to $3.3 million year over year. Restaurant operating expenses as a percentage of restaurant sales decreased to 13.8% during the period compared to 14.7% during the third quarter of 2011, driven by lower marketing expenses, reduced credit card fees and a reduction in utilities from lower negotiated rates.

General and Administrative. General and administrative expenses decreased by $0.4 million, or 16.8% from $2.1 million year over year. General and administrative expenses decreased as a percentage of sales by 1.5% to 7.4% in the third quarter of 2012 compared to 8.9% in the prior year period. The year over year decrease in general and administrative expenses in absolute dollars and as a percentage of sales is driven by lower executive compensation and benefits partially offset by higher legal and professional fees associated with corporate activities.

Gain on Insurance Recoveries. We recognized $0.1 million gain from insurance recoveries associated with a restaurant fire in the previous quarter. The gain represents the excess of fair value over net book value of replacement furniture as a result of smoke damage from the fire.

Depreciation and Amortization. Depreciation and amortization expense decreased $0.1 million to $1.4 million in the third quarter of 2012 compared to $1.5 million in the prior year period. Depreciation and amortization expense as a percentage of restaurant sales decreased 0.4% to 5.8% from 6.2% year over year.

Discontinued Operations. Loss from discontinued operations of $386,000 and $146,000 in the third quarter of 2012 and 2011, respectively, represents the historical operating results as well as lease termination and exit costs attributable to the two restaurants closed during the third quarter of 2011. In the third quarter of 2012, we settled with the landlord of the Sugar Land location for $950,000 and recognized the incremental lease termination costs and related attorney fees. See Note 2 to the Unaudited Consolidated Financial Statements.

Provision for Income Taxes. We did not record any income tax provision in the third quarter of 2012 due to a revised estimate of current year taxable income resulting from the timing of certain tax deductions, including the Sugar Land settlement noted above. Income tax expense for the third quarter of 2011 was minimal due to the utilization of our federal and state net operating loss carryforwards in prior year.

Nine Months Ended September 30, 2012 Compared with Nine Months Ended September 30, 2011

Restaurant Sales. Restaurant sales increased $2.4 million, or 3.5% to $73.0 million during the first nine months of 2012 from $70.6 million in the same prior year period. The sales increase is attributable to a 3.6% increase in comparable restaurant sales, driven by higher guest traffic volume of 3.5%.

Cost of Sales. Cost of sales increased $0.5 million, or 2.7% to $19.8 million during the first nine months of 2012 compared to $19.3 million during the same period in prior year. The increase was primarily attributable to incremental food and liquor costs associated with higher sales volumes and promotional offerings partially offsetting the benefits of stabilizing produce costs in the current year. As a percentage of restaurant sales, cost of sales decreased 0.2% to 27.2% year over year, reflecting the leverage of higher sales volume as well as the lower produce costs year over year.

Labor. Labor costs in the first nine months of 2012 grew by $0.8 million, or 3.6% to $24.2 million compared to $23.4 million in the comparable prior year period. The increase was attributable to increased staffing to support the year over year sales growth during 2012. Labor expenses as a percentage of restaurant sales, however, remained flat at 33.1% in both 2012 and 2011, due to our ability to leverage fixed management wages and hourly labor expenses to support the comparable restaurant sales growth year over year.

Occupancy. Occupancy expenses decreased $0.5 million, or 9.3% to $4.6 million in 2012 year to date from $5.1 million during the first nine months of 2011. The lower occupancy expenses are primarily associated with an amendment in our lease agreement for one restaurant. Occupancy expenses as a percentage of restaurant sales decreased 0.9% to 6.4% in 2012 compared to 7.3% in prior year, reflecting the benefits of the aforementioned changes in lease provisions as well as the increased leverage of the fixed portion of these costs from higher average weekly sales.

Restaurant Operating Expenses. Restaurant operating expenses decreased $0.3 million to $10.2 million during the first nine months of 2012 on higher sales volume compared to $10.5 million in the same period in 2011. Lower marketing, credit card fees and utilities more than offset higher repair and maintenance costs and increased training, travel and recruiting expenses. Restaurant operating expenses as a percentage of restaurant sales also decreased 0.9% to 14.0% during the first nine months of 2012 compared to 14.9% for the same period in 2011.

General and Administrative. General and administrative expenses decreased by $0.8 million, or 12.7% from $6.1 million year over year. General and administrative expenses decreased as a percentage of sales year over year by 1.4% to 7.3%. The decrease in general and administrative expenses in absolute dollars and as a percentage of sales is mainly attributable to lower executive compensation and benefits during 2012 partially attributable to severance and related costs for former executives in the prior year.

Depreciation and Amortization. Depreciation and amortization expense decreased $0.1 million or 2.5% to $4.3 million in 2012 year to date. Depreciation and amortization expense as a percentage of restaurant sales decreased 0.4% to 5.9% from 6.3% year over year reflecting leverage of these fixed costs from higher average weekly sales.

Discontinued Operations. Loss from discontinued operations of $433,000 and $288,000 in 2012 and 2011, respectively, represents the historical operating results as well as lease termination and exit costs attributable to the two restaurants closed during the third quarter of 2011. In the third quarter of 2012, we settled with the landlord of the Sugar Land location for $950,000 and recognized the incremental lease termination costs and related attorney fees. See Note 2 to the Unaudited Consolidated Financial Statements.

Provision for Income Taxes. We recorded a provision for income taxes of $120,000 and $44,000, respectively, during 2012 and 2011 year to date. The year over year increase in the provision is attributable to federal and state taxes on higher projected taxable income for the year partially offset by the utilization of federal and state net operating loss carryforwards.

Potential Fluctuations in Quarterly Results and Seasonality

Our quarterly operating results may fluctuate significantly as a result of a variety of factors, including the following:

Our business is also subject to seasonal fluctuations. Historically, sales in most of our restaurants have been higher during the spring and summer months and winter holiday season. Consequently, our quarterly and annual operating results and comparable restaurant sales may fluctuate significantly as a result of seasonality and the factors discussed above. Accordingly, results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for any year and comparable restaurant sales for any particular future period may decrease. In the future, operating results may fall below the expectations of our investors. In that event, the price of our common stock would likely decrease.

Liquidity and Capital Resources

Currently, our primary capital requirements are for new restaurant development and remodeling of existing restaurants. Similar to many restaurant companies, we utilize operating lease arrangements for all of our restaurant locations. We believe that our operating lease arrangements provide appropriate leverage for our capital structure in a financially efficient manner. We are typically required to expend cash to perform site-related work and to construct and equip each restaurant. The average investment cost for our restaurants depends upon the type of lease entered into, the amount of tenant improvement allowance we receive from landlords, and whether we assume responsibility for the construction of the building. We expect the cash investment cost of our typical restaurant to be approximately $2.5 million, net of landlord tenant improvement allowances of between $0.7 million and $1.2 million, and excluding cash preopening expenses of approximately $0.4 million. We expect these costs will vary from one market to another based on real estate values, zoning regulations, permitting requirements, labor markets and other variables. Restaurants that are subject to ground leases and do not receive landlord tenant improvement allowances typically require a significantly higher cash investment. We also require capital resources to maintain our existing base of restaurants and to further expand and strengthen the capabilities of our corporate and information technology infrastructures.

The following tables set forth, as of the dates and for the periods indicated, a summary of our key liquidity measurements (amounts in thousands):

Future Capital Requirements

Our capital requirements, including development costs related to the opening of new restaurants, have historically been significant. Over the last several years, we funded development of new restaurants primarily from the proceeds of equity financing and cash flows from operations. Our future cash requirements and the adequacy of available funds will depend on many factors, including the operating performance of our current restaurants, the pace of expansion, real estate markets, site locations, the nature of the arrangements negotiated with landlords and the credit market environment.

Our current operations generate sufficient cash flow to fund operations and general and administrative costs. We believe existing cash and short-term investments of $6.5 million, the ability to draw on our recently amended $6.5 million credit facility and cash flow from operations will be sufficient to fund development of new restaurants and planned remodels of existing restaurants. Any reduction of our cash flow from operations may cause a delay or cancellation of future restaurant development or remodels of existing restaurants. As of September 30, 2012, we had working capital of $0.6 million, a $3.0 million improvement from December 31, 2011 primarily as a result of higher earnings during the first nine months of 2012. Our ability to generate higher cash flow from operations and cost containment efforts over the previous quarters have been instrumental in reducing the working capital deficit experienced in prior years. Financing to construct new restaurants for amounts in excess of the line of credit availability may not be available on acceptable terms, or at all, and our failure to raise capital when needed could impact our growth plans, financial condition, and results of operations. Additional equity financing may result in dilution to current stockholders and debt financing, if available, may involve significant cash payment obligations or financial covenants and ratios that may restrict our ability to operate our business.

Credit Facility

On February 8, 2012, we entered into loan agreements with Stearns Bank National Association (“Stearns”) for a term loan and a line of credit (collectively, the “Loans”). The Loans are secured by commercial security agreements executed by us and each of our subsidiaries granting the lender a security interest in all of the consolidated assets of the Company.

We obtained a term loan in the aggregate principal amount of $0.5 million (the “Term Loan”). The Term Loan matures on February 7, 2015 and requires monthly principal and interest payments of $15,000. Interest on the Term Loan is calculated at the greater of 1% over the Wall Street Journal Prime Rate (the “Index”) or 5.75% per year. Proceeds of the Term Loan were used to pay off the remaining balance of our equipment loans and to pay expenses associated with the Loans. The outstanding balance on the Term Loan at September 30, 2012 was $410,000.

We also obtained a credit line to borrow up to an aggregate principal amount of $5.0 million (the “Credit Line”). The final maturity date for all installments under the Credit Line is February 7, 2021. Interest on the loans will initially be 6.25% per year and will be adjusted each time the Index changes and on each such date, the interest rate will equal the greater of the Index plus 1% or 6.25% per year. There is no non-usage fee associated with the Credit Line. Borrowings under the Credit Line can be used for capital expenditures for existing and new restaurant units, provided that we match each disbursement dollar for dollar and the amount of any such disbursement could not exceed $1.5 million per location.

On July 24, 2012, we amended certain terms of the Credit Line with Stearns. The amendment allows us to increase the aggregate principal amount under the Credit Line to $6.5 million from $5.0 million, under which we can borrow up to $2.5 million at the greater of 1% over the Index or 5.75% per year for our stock repurchase program. The amendment also allows us to reduce the interest floor on the Credit Line from 6.25% to 4.95% per year on borrowings for restaurant remodeling and new construction projects. We have not drawn any amounts to date under the Credit Line, and the entire $6.5 million balance was available at September 30, 2012.

Fees incurred for the Loans totaled $152,000. These fees are included in Other Assets in the consolidated balance sheet at September 30, 2012 and such fees are being amortized over the life of the Loans. The unamortized fees totaled $141,000 as of September 30, 2012.

The Loans also require us to comply with certain covenants, including (a) a fixed charge coverage ratio greater than 1.25%, (b) a maximum Interest Bearing Debt/EBITDA ratio of 3:1 and (c) a debt to tangible net worth of equal or less than 3:1. We were in compliance with such covenants at September 30, 2012.

Cash Flows

      The following table summarizes our primary sources and uses of cash during the periods presented (in thousands).

Operating Activities. Our cash flows from operating activities, as detailed in the Unaudited Consolidated Statements of Cash Flows, provided $4.4 million of net cash during the first nine months of 2012. Cash generated from operating activities remained constant year over year and is primarily the result of higher net income partially offset by greater use of cash for accrued expenses, specifically, the settlement of our Sugar Land lease in the third quarter of 2012.

Investing Activities. Capital expenditures during the first nine months of 2012 were $1.1 million, primarily attributable to remodeling costs for existing restaurants and infrastructure investments at the Corporate office. Investing activities for first nine months of 2011 of $1.2 million included contractor payments for our Baltimore, Maryland restaurant that opened during October 2010 and remodeling costs for existing restaurants.

Financing Activities. Net cash used in financing activities during the first nine months of 2012 totaled $3.3 million, consisting of $4.9 million for the purchase and retirement of our common stock and $0.2 million debt repayment for our equipment loans and term loan. We also paid $0.2 million in fees in conjunction with the credit facility. Cash receipts from financing activities during the first nine months of 2012 consisted of $0.5 million from term loan borrowings and $1.5 million in proceeds from stock option and warrant exercises and employee stock plan purchases. Net cash provided by financing activities was $0.1 million during the first nine months of 2011, reflecting $0.4 million in equipment loan principal payments offsetting the $0.5 million in proceeds from stock issued as part of our stock option and employee stock purchase plans.

Critical Accounting Policies

Critical accounting policies are those that we believe are most important to the portrayal of our financial condition and results of operations and also require our most difficult, subjective, or complex judgments. Judgments or uncertainties regarding the application of these policies may result in materially different amounts being reported under various conditions or using different assumptions. There have been no material changes to the critical accounting policies previously reported in our Annual Report on Form 10-K for the year ended December 31, 2011.

Item 3.     Quantitative and Qualitative Disclosures About Market Risk

The following discussion of market risks contains forward-looking statements. Actual results may differ materially from the following discussion based on general conditions in the commodity markets.

Primary Market Risk Exposures

Our primary market risk exposure is commodity costs. Many of the food products purchased by us can be subject to volatility due to changes in weather, production, availability, seasonality, international demand, and other factors outside our control. Substantially all of our food and supplies are available from several sources, which help to diversify our overall commodity cost risk. We also believe that we have the ability to increase certain menu prices in response to food commodity price increases.

Item 4.     Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. We have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.

Changes in Internal Control over Financial Reporting

During the quarterly period covered by this report, there have not been any changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1.     Legal Proceedings

We are engaged in various legal actions, which arise in the ordinary course of our business. Although there can be no assurance as to the ultimate disposition of these matters, it is the opinion of our management, based upon the information available at this time, that the expected outcome of these matters, individually or in the aggregate, will not have a material adverse effect on the results of operations or financial condition of our company.

Sugar Land Lease Termination Costs

During the third quarter of 2011, we closed our Sugar Land restaurant and recognized $616,000 associated with estimated lease termination costs. These costs were included in Accrued Expenses on our consolidated balance sheets. On April 18, 2012, the landlord, Sugar Land Mall, LLC, commenced an action against us in the District Court for Fort Bend County, Texas, seeking outstanding rent and charges for the remaining term of the lease, attorney fees, clean-up and other expenses associated with the re-letting of the premise, as well as unspecified damages. In September 2012, we entered into a mediated settlement agreement with Sugar Land Mall, LLC, pursuant to which we agreed to pay $950,000 and recognized the incremental lease termination costs and related attorney fees in the third quarter of 2012. These charges were included in loss from discontinued operations.

Item 1A. Risk Factors

A description of the risk factors associated with our business is contained in Part I, Item 1A, “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2011. These cautionary statements are to be used as a reference in connection with any forward-looking statements. The factors, risks, and uncertainties identified in these cautionary statements are in addition to those contained in any other cautionary statements, written or oral, which may be made or otherwise addressed in connection with a forward-looking statement or contained in any of our subsequent filings with the SEC.

Item 2.     Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchase of Equity Securities

In May 2012, our Board of Directors authorized a stock repurchase and retirement program under which we are authorized to repurchase up to $5.0 million of common stock in the open market, pursuant to Rule 10b5-1 trading plans or in private transactions at prevailing market prices. Previously, in February 2012 we had completed a stock repurchase and retirement program under which we purchased and retired 858,663 shares at an average cost of $5.82 per share. During the second quarter of 2012, we purchased and retired 95,500 shares at an average cost of $7.93 per share under the 2012 authorization. In the third quarter of 2012, we made the following purchases at a total cost of $1,562,000:

Item 3.     Defaults Upon Senior Securities

Not applicable.

Item 4.     Mine Safety Disclosures

Not applicable.

Item 5.     Other Information

Not applicable.

Item 6.     Exhibits

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date:  November 5, 2012

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