**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **WASHINGTON,
        D.C. 20549**
 ______________
  **FORM
        10-Q**
  **x**
              **QUARTERLY
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934**
  **For
        the quarterly period ended June 30** **,
        2006**
  or
  **o**
              **TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934**
  Commission
        File Number 000-51491
 **____________**
  **Kona
        Grill, Inc.**
 *(Exact
        Name of Registrant as Specified in Its Charter)*
  **Delaware**
              
              **20-0216690***(State
                  of Incorporation)*
              
              *(I.R.S.
                  Employer Identification No.)*
  **7150
        East Camelback Road, Suite 220**
 **Scottsdale,
        Arizona 85251**
 **(480)
        922-8100**
 *(Address,
        including zip code, and telephone number, including area code, of principal
        executive offices)*
  Indicate
        by check mark whether the registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period that the registrant was required
        to file such reports), and (2) has been subject to such filing requirements
        for
        the past 90 days.  Yes S No £
  Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
        one):
  Large
                  accelerated filer£
              Accelerated
                  filer£
              Non-accelerated
                  filerS
  Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act). Yes £ No S
  As
        of
        August 1, 2006, there were outstanding 5,799,488 shares of the registrant’s
        common stock, par value $.01 per share.
  
  
  **TABLE
        OF CONTENTS**
 **PART
        I**
 **FINANCIAL
        INFORMATION**
 **Page**
  Item
                  1.
              
              Unaudited
                  Consolidated Financial StatementsConsolidated
                  Balance Sheets as of June 30, 2006 and December
                  31, 2005
              
              2Consolidated
                  Statements of Operations for the Three and Six
                  Months Ended June 30, 2006 and 2005
              
              3Consolidated
                  Statements of Cash Flows for the Six Months
                  Ended June 30, 2006 and 2005
              
              4Notes
                  to Consolidated Financial
                  Statements
              
              5Item
                  2.
              
              Management’s
                  Discussion and Analysis of Financial Condition and
                  Results of Operations
              
              11Item
                  3.
              
              Quantitative
                  and Qualitative Disclosures About Market
                  Risk
              
              20Item
                  4.
              
              Controls
                  and Procedures
              
              20**PART
                  II****OTHER
                  INFORMATION**Item
                  1.
              
              Legal
                  Proceedings
              
              21Item
                  1A.
              
              Risk
                  Factors
              
              21Item
                  2.
              
              Unregistered
                  Sales of Equity Securities and Use of
                  Proceeds
              
              21Item
                  3.
              
              Defaults
                  Upon Senior Securities
              
              21Item
                  4.
              
              Submission
                  of Matters to a Vote of Security
                  Holders
              
              21Item
                  5.
              
              Other
                  Information
              
              21Item
                  6.
              
              Exhibits
              
              21
  1
 *Table
            of Contents*
  **PART
        I - FINANCIAL INFORMATION**
 
 **Item
                1.**
              **Unaudited
                  Consolidated Financial
                  Statements**
 
 **KONA
        GRILL, INC.**
 **CONSOLIDATED
        BALANCE SHEETS**
 **(in
        thousands, except share data)**
  **June
                  30,**
              
              **December
                  31,****2006**
              
              **2005**(Unaudited)
              
              (Note
                  1)**ASSETS**Current
                  assets:Cash
                  and cash equivalents
              
              $
              1,431
              
              $
              4,466Investments
              
              
              19,679
              
              
              24,200Receivables
              
              
              2,145
              
              
              97Inventories
              
              
              484
              
              
              403Prepaids
                  and other
              
              
              517
              
              
              161Total
                  current assets
              
              
              24,256
              
              
              29,327Other
                  assets
              
              
              404
              
              
              387Notes
                  receivable
              
              
              59
              
              
              87Property
                  and equipment, net
              
              
              31,666
              
              
              22,617Total
                  assets
              
              $
              56,385
              
              $
              52,418**LIABILITIES
                  AND STOCKHOLDERS’ EQUITY**Current
                  liabilities:Accounts
                  payable
              
              $
              3,545
              
              $
              1,599Accrued
                  expenses
              
              
              2,966
              
              
              2,327Current
                  portion of equipment notes
              
              
              606
              
              
              729Total
                  current liabilities
              
              
              7,117
              
              
              4,655Equipment
                  notes
              
              
              3,061
              
              
              3,313Deferred
                  rent
              
              
              9,667
              
              
              7,139Total
                  liabilities
              
              
              19,845
              
              
              15,107Commitments
                  and contingenciesStockholders’
                  equity:Preferred
                  stock, $0.01 par value, 2,000,000 shares authorized, none issued
                  at June
                  30, 2006 and 20,000,000 shares authorized, none issued at December
                  31,
                  2005
              
              
              —
              
              
              —Common
                  stock, $0.01 par value, 15,000,000 shares authorized, 5,794,632
                  shares
                  issued and outstanding at June 30, 2006 and 40,000,000 shares authorized,
                  5,706,420 shares issued and outstanding at December 31,
                  2005
              
              
              58
              
              
              57Additional
                  paid-in capital
              
              
              40,903
              
              
              40,467Accumulated
                  deficit
              
              
              (4,404
              )
              
              (3,213
              )Accumulated
                  other comprehensive loss
              
              
              (17
              )
              
              -Total
                  stockholders’ equity
              
              
              36,540
              
              
              37,311Total
                  liabilities and stockholders’ equity
              
              $
              56,385
              
              $
              52,418
  See
        accompanying notes to the consolidated financial statements.
  2
 *Table
            of Contents*
  **KONA
        GRILL, INC.**
 **CONSOLIDATED
        STATEMENTS OF OPERATIONS**
 **(in
        thousands, except per share data)**
 
 **Three
                  Months Ended June 30,**
              
              **Six
                  Months Ended June 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005****(Unaudited)**Restaurant
                  sales
              
              $
              11,877
              
              $
              8,919
              
              $
              22,071
              
              $
              16,930Costs
                  and expenses:Cost
                  of sales
              
              
              3,299
              
              
              2,554
              
              
              6,194
              
              
              4,889Labor
              
              
              3,578
              
              
              2,558
              
              
              6,731
              
              
              5,067Occupancy
              
              
              812
              
              
              591
              
              
              1,518
              
              
              1,173Restaurant
                  operating expenses
              
              
              1,480
              
              
              1,032
              
              
              2,926
              
              
              2,007General
                  and administrative
              
              
              1,625
              
              
              1,177
              
              
              3,639
              
              
              2,391Preopening
                  expense
              
              
              689
              
              
              100
              
              
              980
              
              
              107Depreciation
                  and amortization
              
              
              823
              
              
              538
              
              
              1,553
              
              
              1,049Total
                  costs and expenses
              
              
              12,306
              
              
              8,550
              
              
              23,541
              
              
              16,683(Loss)
                  income from operations
              
              
              (429
              )
              
              369
              
              
              (1,470
              )
              
              247Nonoperating
                  income (expense):Interest
                  income
              
              
              246
              
              
              3
              
              
              483
              
              
              5Interest
                  expense
              
              
              (75
              )
              
              (179
              )
              
              (154
              )
              
              (363
              )(Loss)
                  income before provision for income taxes
              
              
              (258
              )
              
              193
              
              
              (1,141
              )
              
              (111
              )Provision
                  for income taxes
              
              
              45
              
              
              18
              
              
              50
              
              
              18Net
                  (loss) income
              
              $
              (303
              )
              $
              175
              
              $
              (1,191
              )
              $
              (129
              )Net
                  (loss) income per share :Basic
              
              $
              (0.05
              )
              $
              0.12
              
              $
              (0.21
              )
              $
              (0.09
              )Diluted
              
              $
              (0.05
              )
              $
              0.10
              
              $
              (0.21
              )
              $
              (0.09
              )Weighted
                  average shares used in computation:Basic
              
              
              5,793
              
              
              1,463
              
              
              5,762
              
              
              1,463Diluted
              
              
              5,793
              
              
              2,975
              
              
              5,762
              
              
              1,463
  See
        accompanying notes to the consolidated financial statements.
  3
 *Table
            of Contents*
  **KONA
        GRILL, INC.**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 **(in
        thousands)**
  **Six
                    Months Ended June 30,****2006**
                
                **2005**(Unaudited)**Operating
                    activities**Net
                    loss
                
                $
                (1,191
                )
                $
                (129
                )Adjustments
                    to reconcile net loss to net cash provided byoperating
                    activities:Depreciation
                    and amortization
                
                
                1,553
                
                
                1,049Compensation
                    expense for issuance of stock options and accelerated vesting
                    of stock
                    options
                
                
                402
                
                
                197Amortization
                    of debt discount
                
                
                —
                
                
                67Change
                    in operating assets and liabilities:Receivables
                
                
                (2,048
                )
                
                424Inventories
                
                
                (81
                )
                
                37Prepaids
                    and other current assets
                
                
                (356
                )
                
                (37
                )Deferred
                    offering costs
                
                
                —
                
                
                (378
                )Accounts
                    payable
                
                
                394
                
                
                (374
                )Accrued
                    expenses
                
                
                639
                
                
                (145
                )Deferred
                    rent
                
                
                2,528
                
                
                569Net
                    cash provided by operating activities
                
                
                1,840
                
                
                1,280**Investing
                    activities**Purchase
                    of property and equipment
                
                
                (9,050
                )
                
                (4,730
                )Repayment
                    of notes receivable
                
                
                28
                
                
                21Increase
                    in other assets
                
                
                (17
                )
                
                (18
                )Net
                    proceeds on purchase and sale of short-term investments
                
                
                4,504
                
                
                —Net
                    cash used in investing activities
                
                
                (4,535
                )
                
                (4,727
                )**Financing
                    activities**Proceeds
                    from issuance of notes payable
                
                
                —
                
                
                1,095Repayments
                    of notes payable
                
                
                (375
                )
                
                (271
                )Proceeds
                    from issuance of common stock
                
                
                35
                
                
                —Net
                    cash (used in) provided by financing activities
                
                
                (340
                )
                
                824Net
                    decrease in cash and cash equivalents
                
                
                (3,035
                )
                
                (2,623
                )Cash
                    and cash equivalents at the beginning of the period
                
                
                4,466
                
                
                3,098Cash
                    and cash equivalents at the end of the period
                
                $
                1,431
                
                $
                475**Supplemental
                    disclosures of cash flow information**Cash
                    paid for interest
                
                $
                154
                
                $
                296**Noncash
                    investing activities**Increase
                    (decrease) in accounts payable related to property and equipment
                    additions
                
                $
                1,552
                
                $
                (249
                )
 See
        accompanying notes to the consolidated financial statements.
  4
 *Table
            of Contents*
  **KONA
        GRILL, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
 
 **1.**
                **Basis
                    of Presentation**
 
 Kona
        Grill, Inc. (referred to herein as the “Company” or “we,” “us,” and “our”) owns
        and operates upscale casual dining restaurants under the name “Kona
        Grill.”  We completed our initial public offering during August 2005,
        issuing 2,875,000 common shares at an offering price of $11.00.  As part of
        the offering, all outstanding preferred stock was converted into shares of
        common stock.  Our common stock trades on the NASDAQ National Market under
        the symbol “KONA.”
 
 The
        accompanying unaudited consolidated financial statements have been prepared
        in
        accordance with U.S. generally accepted accounting principles for interim
        financial information and with the rules and regulations of the Securities
        and
        Exchange Commission (“SEC”). Accordingly, they do not include all of the
        information and footnotes required by U.S. generally accepted accounting
        principles for complete financial statements. In our opinion, all adjustments
        (consisting of normal recurring accruals) considered necessary for a fair
        presentation have been included. Operating results for the three and six
        month
        periods ended June 30, 2006 are not necessarily indicative of the results
        that
        may be expected for the year ending December 31, 2006.
 
 The
        consolidated balance sheet at December 31, 2005 has been derived from the
        audited consolidated financial statements at that date, but does not include
        all
        of the information and footnotes required by U.S. generally accepted
        accounting principles for complete financial statements. Accordingly, these
        financial statements should be read in conjunction with our Annual Report
        on
        Form 10-K for the year ended December 31, 2005.
 **2****.**
                **Summary
                    of Significant Accounting
                    Policies**
  ***Cash***
 
 Cash
        and
        cash equivalents consist of cash, money market funds, and highly liquid
        short-term fixed income securities with a remaining maturity of 90 days or
        less
        when acquired. Amounts receivable from credit card processors are also
        considered cash equivalents because they are both short-term and highly liquid
        in nature and are typically converted to cash within one day of the sales
        transaction. Under the Company’s cash management practices, when there is no
        legal right of offset against cash balances in a specific financial institution,
        uncleared checks are classified as accounts payable. Uncleared checks totaling
        $90,000 were included in accounts payable as of June 30, 2006.
 
 ***Deferred
        Rent***
 
 We
        lease
        our restaurant locations under operating lease agreements with initial terms
        of
        approximately 10 to 15 years. Most of these agreements require minimum
        annual rent payments plus contingent rent payments based on a percentage
        of
        restaurant sales which exceed the minimum base rent. Contingent rent payments,
        to the extent they exceed minimum payments, are accrued over the periods
        in
        which the liability is incurred. Rent expense associated with these contingent
        payments is recorded prior to the achievement of specified sales levels if
        exceeding such amount is considered probable and is estimable. The lease
        agreements typically also require scheduled increases to minimum annual rent
        payments. For leases that contain rent escalations, we record the total rent
        payable over the initial lease term (including the construction period) on
        a
        straight-line basis over the life of the initial lease term. Any difference
        between minimum rent and straight-line rent is recorded as deferred rent. Deferred
        rent also includes tenant improvement allowances which are amortized as a
        reduction of rent expense on a straight-line basis over the initial term
        of the
        lease.
 
 For
        leases that commenced subsequent to January 1, 2006, straight-line rent expense
        incurred from the date of possession to the restaurant opening date is recorded
        as preopening expense in accordance with Financial Accounting Standards Board
        (“FASB”) Staff Position No. 13−1, *Accounting
        for Rental Costs Incurred During a Construction Period* (“FSP
        FAS
        No. 13-1”). For leases that commenced prior to January 1, 2006, rent expense
        incurred from the date of possession through the completion of construction
        was
        capitalized and included in property and equipment and amortized over the
        initial life of the lease.
  5
 *Table
            of Contents*
  **KONA
        GRILL, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
 
 ***Preopening
        Expense***
 
 Preopening
        expense, consisting primarily of manager salaries, advertising, travel, food
        and
        beverage, employee payroll and related training costs incurred prior to the
        opening of a restaurant, are expensed as incurred. Also, as a result of the
        adoption of FSP FAS No. 13-1 on January 1, 2006, straight−line rent recorded for
        the period between the date of possession and the restaurant opening date,
        which
        generally approximates five months, is included in preopening expense. As
        a
        result of the adoption of FSP FAS No. 13-1, our preopening costs were increased
        by approximately $154,000 and $225,000 during the three and six months ended
        June 30, 2006, respectively.
 
 ***Net
        Income (Loss) Per Share***
 
 In
        accordance with the provisions of Statement of Financial Accounting Standards
        (“SFAS”) No. 128, *Earnings Per Share* ,
        basic
        net income (loss) is computed by dividing net income (loss) by the weighted
        average number of common shares outstanding during the period. Diluted net
        income per share includes the dilutive effect of potential warrant and stock
        option exercises calculated using the treasury stock method.
 
 **Three
                  Months Ended**
              
              **Six
                  Months Ended****June
                  30,**
              
              **June
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**(In
                  thousands, except per share data)Numerator:Net
                  (loss) income
              
              $
              (303
              )
              $
              175
              
              $
              (1,191
              )
              $
              (129
              )Interest
                  and amortization expense related to convertible subordinated promissory
                  note, net of tax
              
              
              —
              
              
              108
              
              
              —
              
              
              —$
              (303
              )
              $
              283
              
              $
              (1,191
              )
              $
              (129
              )Denominator:Weighted
                  average shares — Basic
              
              
              5,793
              
              
              1,463
              
              
              5,762
              
              
              1,463Effect
                  of dilutive securities:Stock
                  options and warrants
              
              
              —
              
              
              178
              
              
              —
              
              
              —Convertible
                  shares
              
              
              —
              
              
              1,334
              
              
              —
              
              
              —Weighted
                  average shares — Diluted
              
              
              5,793
              
              
              2,975
              
              
              5,762
              
              
              1,463Net
                  (loss) income per share:Basic
              
              $
              (0.05
              )
              $
              0.12
              
              $
              (0.21
              )
              $
              (0.09
              )Diluted
              
              $
              (0.05
              )
              $
              0.10
              
              $
              (0.21
              )
              $
              (0.09
              )
 
 At
        June
        30, 2006, there were
        521,157 stock options
        outstanding and 250,000 warrants outstanding for which the effect of issuing
        these options and warrants were excluded from the calculation of diluted
        net
        loss per share because they were anti-dilutive. For the six months ended
        June
        30, 2005, approximately 1,470,000 shares of common stock issuable upon
        conversion of the convertible promissory note, Series A convertible preferred
        stock and stock options and warrants outstanding were excluded from the
        calculation of diluted net loss per share because they were anti-dilutive.
 
 ***Recent
        Accounting Pronouncements***
 
 During
        December 2004, the FASB enacted SFAS No. 123-revised 2004 (“SFAS 123R”), *Share-Based
        Payment* ,
        which
        replaces SFAS No. 123, *Accounting
        for Stock-Based Compensation* ,
        and
        supersedes Accounting Principles Board Opinion (“APB”) No. 25, *Accounting for Stock Issued to Employees* .
        SFAS
        123R requires the measurement of all share-based payments to employees and
        directors, including grants of employee stock options, using a fair-value-based
        method and the recording of such expense in our consolidated statements of
        operations. The accounting provisions of SFAS 123R are effective for reporting
        periods beginning after December 15, 2005. We adopted SFAS 123R on January
        1,
        2006. See Note 5 for discussion of the impact of adopting SFAS 123R.
  6
 *Table
            of Contents*
  **KONA
        GRILL, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
 
 In
        July
        2006, the FASB issued FASB Interpretation No. 48, *Accounting
        for Uncertainty in Income Taxes* (“FIN
        48”). FIN 48 is an interpretation of FASB Statement No. 109, *Accounting
        for Income Taxes* ,
        and it
        seeks to reduce the diversity in practice associated with certain aspects
        of
        measurement and recognition in accounting for income taxes. In addition,
        FIN 48
        requires expanded disclosure with respect to the uncertainty in income taxes
        and
        is effective for our 2007 fiscal year. We are currently evaluating the impact,
        if any, that FIN 48 will have on our financial statements.
  **3.**
                **Investments**
 The
        following is a summary of available-for-sale securities at June 30, 2006 (in
        thousands):
 
 **Adjusted
                  Cost**
              
              **Gross**
                **Unrealized**
                **Losses**
              
              **Estimated
                  Fair**
                **Value**Auction
                  rate municipal securities
              
              $
              14,050
              
              $
              —
              
              $
              14,050Government
                  bonds
              
              
              3,000
              
              
              (14
              )
              
              2,986Corporate
                  securities
              
              
              2,646
              
              
              (3
              )
              
              2,643$
              19,696
              
              $
              (17
              )
              $
              19,679
 
 The
        original maturity date for our government bonds and corporate securities
        is one
        year or less. Although original maturities of our auction rate securities
        are
        generally longer than one year, we have the right to sell these securities
        each
        auction date subject to the availability of buyers. The original maturity
        dates
        for these investments ranged from
        2029
        to 2044 at June
        30, 2006. At December 31, 2005, there were no unrealized gains or losses
        on our
        available-for-sale securities.
 **4.**
                **Accrued
                    Expenses**
 
 Accrued
        expenses consisted of the following (in thousands):
 **June
                    30,**
                  **2006**
                
                **December
                    31,**
                  **2005**Accrued
                    payroll
                
                $
                866
                
                $
                798Severance
                    and related costs
                
                
                378
                
                
                —Gift
                    cards
                
                
                289
                
                
                395Sales
                    tax
                
                
                318
                
                
                299Accrued
                    rent
                
                
                181
                
                
                126Other
                
                
                934
                
                
                709$
                2,966
                
                $
                2,327
 **5.**
                **Stock-Based
                    Compensation**
 
 We
        maintain stock option plans which provide for discretionary grants of incentive
        stock options and non-qualified stock options to our employees, consultants,
        and
        non-employee directors. These plans authorize the granting of stock options,
        restricted stock, and other types of awards consistent with the purpose of
        the
        plans. The number of shares authorized for issuance under our plans as of
        June
        30, 2006 totals 802,642 of which 281,485 shares were available for future
        issuance. Stock options granted under these plans are granted with an exercise
        price at or above the fair market value of the underlying common stock at
        the
        date of grant and generally expire five or ten years from the date of
        grant. Employee and consultant stock options generally vest 25 percent on
        the date of grant and 25 percent on each annual anniversary date
        thereafter. Non-employee director options vest 100 percent on the date of
        grant.
  7
 *Table
            of Contents*
  **KONA
        GRILL, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
 
 Prior
        to
        January 1, 2006, we accounted for our stock-based compensation in accordance
        with APB No. 25, *Accounting for Stock Issued to Employees* ,
        and
        related interpretations and adopted the disclosure−only provisions of SFAS No.
        123, *Accounting
        for Stock−Based Compensation.* In
        accordance with APB No. 25, no stock-based compensation expense was recognized
        in our prior year net loss for grants of stock options to employees because
        we
        granted stock options with an exercise price equal to the fair market value
        of
        the stock on the date of grant. However, share-based compensation expense
        of
        $151,000 was recognized for the six months ended June 30, 2005, as a result
        of
        the accelerated vesting of all outstanding unvested employee stock options.
 
 Had
        we
        used the fair value method required by SFAS No. 123 for the three and six
        months ended June 30, 2005, our net income (loss) and net income (loss) per
        share would have been increased to the pro-forma amounts illustrated as follows
        (in thousands, except per share data):
 
 **Three
                  Months Ended**
                **June
                  30, 2005**
              
              **Six
                  Months Ended**
                **June
                  30, 2005**Net
                  income (loss), as reported
              
              $
              175
              
              $
              (129
              )Add:Stock-based
                  compensation expense included in reported earnings, net of related
                  tax
                  effect(a)
              
              
              —
              
              
              151Deduct:
                  Total stock-based compensation expense determined under fair value
                  based
                  method for all awards,
                net
                  of related tax effects(a)
              
              
              (7
              )
              
              (344
              )Pro
                  forma net income (loss)
              
              $
              168
              
              $
              (322
              )Net
                  income (loss) per share:Basic,
                  as reported
              
              $
              0.12
              
              $
              (0.09
              )Basic,
                  pro forma
              
              $
              0.11
              
              $
              (0.22
              )Diluted,
                  as reported
              
              $
              0.10
              
              $
              (0.09
              )Diluted,
                  pro forma
              
              $
              0.09
              
              $
              (0.22
              )
 
 (a)  Income
        taxes have been offset by a valuation allowance. See Note 7 of Notes to
        Consolidated Financial Statements.
 
 Effective
        January 1, 2006, we adopted the fair value recognition provisions of SFAS
        123R, *Share-Based
        Payment,* using
        the
        modified prospective transition method. Under this transition method,
        compensation cost recognized in the three and six months ended June 30, 2006
        includes compensation cost for all share-based payments granted subsequent
        to
        January 1, 2006, based on the grant date fair value estimated in accordance
        with
        SFAS 123R. All options granted prior to January 1, 2006 were fully vested.
        The
        adoption of SFAS 123R increased our three and six months ended June 30, 2006
        reported operating loss, loss before income taxes and net loss by $211,000
        and
        $402,000, respectively, and increased basic and diluted net loss per share
        by
        $0.04 per share and $0.07 per share, respectively.
 
 Results
        of prior periods do not reflect any restated amounts and we had no cumulative
        effect adjustment upon adoption of SFAS 123R under the modified prospective
        method. Our policy is to recognize compensation cost for awards with only
        service conditions using a graded vesting schedule on a straight line basis
        over
        the requisite service period for the entire award.
 
 The
        fair
        value of each option award is estimated on the date of grant using the
        Black-Scholes option pricing model and is affected by assumptions regarding
        a
        number of highly complex and subjective variables. These variables include,
        but
        are not limited to the actual and projected employee stock option exercise
        behavior. The use of an option pricing model also requires the use of a number
        of complex assumptions including expected volatility, risk-free interest
        rate,
        expected dividends, and expected term. Expected volatility is based on the
        historical volatility of a peer group of companies over the expected life
        of the
        option as we do not have enough history trading as a public company to calculate
        our own stock price volatility. We utilize historical data to estimate option
        exercise and employee termination behavior within the valuation model. The
        risk-free interest rate is based on the U.S. Treasury yield curve in effect
        at
        the time of grant for the expected term of the option. SFAS 123R also requires
        us to estimate forfeitures at the time of grant and revise these estimates,
        if
        necessary, in subsequent periods if actual forfeitures differ from those
        estimates. We estimate forfeitures based on historical experience. The
        weighted-average grant date fair value of employee stock options granted
        during
        the three and six months ended June 30, 2006 was $4.44 and $4.23 per share,
        respectively, and was determined using the following weighted-average
        assumptions:
  8
 *Table
            of Contents*
  **KONA
        GRILL, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
 
 **Three
                  Months Ended**
                **June
                  30, 2006**
              
              **Six
                  Months Ended**
                **June
                  30, 2006**Dividend
                  yield
              
              
              0.0
              %
              
              0.0
              %Expected
                  volatility
              
              
              36.5
              %
              
              40.3
              %Risk-free
                  interest rate
              
              
              5.0
              %
              
              4.9
              %Expected
                  life (in years)
              
              
              3.9
              
              
              4.3
 
 A
        summary
        of our stock option activity as of June 30, 2006, and changes during the
        six
        months then ended is presented in the following table:
 
 **Shares
                  Under Option**
              
              **Weighted
                  Average Exercise Price**
              
              **Weighted
                  Average Remaining Contractual Term**
              
              **Aggregate
                  Intrinsic Value**Outstanding
                  options at December 31, 2005
              
              
              475,879
              
              $
              5.56Granted
              
              
              228,000
              
              
              10.98Forfeited
              
              
              (97,564
              )
              
              5.05Exercised
              
              
              (85,158
              )
              
              5.00Outstanding
                  options at June 30, 2006
              
              
              521,157
              
              $
              8.12
              
              
              6.32
                  years
              
              $
              2,543,000Exercisable
              
              
              373,907
              
              $
              6.80
              
              
              6.93
                  years
              
              $
              2,319,000
  As
        of
        June 30, 2006, there was approximately $509,000 of total unrecognized
        compensation cost related to unvested share-based compensation arrangements
        that
        is expected to be recognized over a weighted average period of 1.31 years.
        The
        intrinsic value of options exercised during the six months ended June 30,
        2006
        was $392,000.
  **6****.**
                **Comprehensive
                    Income (Loss)**
 Comprehensive
        income (loss) is defined as the aggregate change in stockholders' equity,
        excluding changes in ownership interests. It is the sum of net income (loss)
        and
        changes in unrealized gains or losses on available-for-sale securities. The
        components of comprehensive income (loss), net of related tax, for the three
        and
        six months ended June 30, 2006 and 2005 were as follows (in
        thousands):
 
 **Three
                  Months Ended June 30,**
              
              **Six
                  Months Ended June 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Net
                  (loss) income
              
              $
              (303
              )
              $
              175
              
              $
              (1,191
              )
              $
              (129
              )Net
                  unrealized losses on available-for-sale securities
              
              
              (2
              )
              
              —
              
              
              (17
              )
              
              —Total
                  comprehensive (loss) income
              
              $
              (305
              )
              $
              175
              
              $
              (1,208
              )
              $
              (129
              )
  **7.**
                  **Income
                      Taxes**
 For
          the
          three months ended June 30, 2006 and 2005, we recorded income tax expense
          of
          $45,000 and $18,000, respectively. For the six months ended June 30, 2006
          and
          2005, income tax expense of $50,000 and $18,000, respectively, was recorded.
          Tax
          expense results from state income taxes due to our operations in states
          where no
          state net operating loss carryforwards are available. We have recorded
          valuation
          allowances for the full amount of our net deferred tax assets (including
          net
          operating loss and tax credit carryforwards) given that the “more likely than
          not” recoverability criteria has not been met in management’s
          opinion
  9
 *Table
            of Contents*
  **KONA
        GRILL, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
 
 **8.**
                **Commitments
                    and Contingencies**
 
 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 our results
        of
        operations or financial condition.
  10
 *Table
            of Contents*
  **Item
                2.**
              ***Management's
                  Discussion and Analysis of Financial Condition and
                  Results of Operations***
 
 This
        information should be read in conjunction with the unaudited consolidated
        financial statements and notes thereto included in Item 1 of Part I of this
        Quarterly Report 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, 2005 contained in our
        2005
        Annual Report on Form 10-K. The following discussion contains forward-looking
        statements that involve risks, uncertainties, and assumptions. Forward-looking
        statements include statements regarding our “expectations,” “anticipation,”
“intentions,” “beliefs,” or “strategies” regarding the future. Forward-looking
        statements relating to our future economic performance, plans and objectives
        for
        future operations, and projections of revenue and other financial items that
        are
        based on our beliefs as well as assumptions made by and information currently
        available to us. Our actual results may differ materially from those anticipated
        in these forward-looking statements as a result of a variety of factors,
        including those set forth under Item 1A, “Risk Factors” in our Annual Report on
        Form 10-K for the year ended December 31, 2005 and other reports filed from
        time
        to time with the Securities and Exchange Commission.
 
 **Overview**
 
 We
        currently own and operate eleven restaurants located in eight states. We
        offer
        freshly prepared food, personalized service, and a warm, contemporary ambiance
        that creates an exceptional, yet affordable dining experience that we believe
        exceeds many traditional casual dining restaurants with whom we compete.
        Our
        high-volume upscale casual restaurants feature a diverse selection of mainstream
        American dishes and award-winning sushi as well as a variety of flavorful
        appetizers and entrees. 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. Our menu is standardized for all of our restaurants allowing us to
        deliver consistent high-quality meals. We believe that our offerings and
        generous portions offer our guests an attractive price-value
        proposition.
  We
        continue to follow a disciplined growth plan focused largely on expanding
        our
        presence in new markets. To date, we have funded our restaurant development,
        working capital, and general corporate needs with cash flows from operations,
        loans from affiliates, the sale of common and preferred stock, receipt of
        landlord tenant improvement allowances, and borrowings under equipment term
        loans. We opened new restaurants in Dallas, Texas; and Lincolnshire, Illinois
        during April 2006 and June 2006, respectively. We plan to open an additional
        three restaurants during 2006, which will expand our presence in new and
        existing markets. Our goal is for our new restaurants to generate annual
        unit
        volumes of $4.5 million within 24 months of opening. We believe our typical
        new
        restaurants experience gradually increasing unit volumes as guests begin
        to
        discover our concept and we begin to generate market awareness. Our restaurants
        are also subject to seasonal fluctuations. Despite our limited operating
        history, we have identified that sales in most of our restaurants typically
        are
        higher during the spring and summer months and winter holiday
        season.
  We
        experience various trends in our operating cost structure. Cost of sales,
        labor,
        occupancy, 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 generally take several months to achieve operating efficiencies
        and planned sales levels due to challenges typically associated with 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 decrease as a percentage of restaurant sales as the
        restaurant matures and as the restaurant management and employees become
        more
        efficient operating that unit. The majority of our general and administrative
        costs are fixed costs. We expect our general and administrative spending
        to
        increase as we add executive management, corporate personnel, and infrastructure
        to support our growth and the requirements associated with being a public
        company. Thereafter, we expect our general and administrative costs to decrease
        as a percentage of restaurant sales as we begin to realize economies of scale.
  11
 *Table
            of Contents*
  **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 Growth.* Same
        store sales growth reflects the periodic change in restaurant sales for the
        comparable restaurant base. In calculating same store sales growth, 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
        Unit Volume.* Average
        unit volume represents the average restaurant sales for all of our restaurants
        open for at least 12 months before the beginning of the period
        measured.
  *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,
        and 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. We use restaurant operating profit as a key metric to evaluate
        our
        restaurants’ financial performance compared with our competitors.
  *Sales
        Per Square Foot.* Sales
        per square foot represents the restaurant sales for our restaurants open
        for at
        least 12 months, divided by the total square feet for such
        restaurants.
  **Key
        Financial Definitions**
  *Restaurant
        Sales.* Restaurant sales includes gross food and beverage sales, net of promotions
        and
        discounts.
  *Restaurant
        Cost of Sales.* Restaurant cost of sales consists of food and beverage costs.
  *Restaurant
        Labor.* Restaurant labor includes all direct and indirect labor costs incurred in
        operations.
  *Restaurant
        Occupancy.* Restaurant 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, 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.
  *Preopening
        Expense.* Preopening expense consists of costs incurred prior to opening a new restaurant
        and is comprised principally of manager salaries and relocation, payroll
        and
        related training costs for new employees, including practice and rehearsal
        of
        service activities, and rent expense incurred during construction. We expense
        restaurant preopening expenses as incurred, and we expect preopening expenses
        to
        be similar for each new restaurant opening, which typically commences five
        months prior to a restaurant opening.
  12
 *Table
            of Contents*
  *Depreciation
        and Amortization* .
        Depreciation and amortization expense consists of the depreciation of property
        and equipment and gains and losses on disposal of assets. We currently have
        no
        intangible assets or goodwill recorded on our consolidated balance
        sheet.
  *Interest
        Income.* Interest
        income consists of interest earned on our cash and investments.
  *Interest
        Expense.* Interest
        expense includes the cost of servicing our debt obligations, including the
        amortization of debt discounts.
  **Financial
        Performance Overview**
 
 The
        following table sets forth certain information regarding our financial
        performance for the three and six months ended June 30, 2006 and
        2005.
 
 **Three
                  Months Ended June 30,**
              
              **Six
                  Months Ended June 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Restaurant
                  sales growth
              
              
              33.2
              %
              
              59.6
              %
              
              30.4
              %
              
              55.9
              %Same
                  store sales growth(1)
              
              
              5.8
              %
              
              4.3
              %
              
              6.0
              %
              
              5.3
              %Average
                  unit volume (in thousands)(2)
              
              $
              1,331
              
              $
              1,457
              
              $
              2,545
              
              $
              2,815Sales
                  per square foot (2)
              
              $
              190
              
              $
              207
              
              $
              364
              
              $
              399Restaurant
                  operating profit (in thousands) (3)
              
              $
              2,708
              
              $
              2,184
              
              $
              4,702
              
              $
              3,794Restaurant
                  operating profit as a percentage of sales (3)
              
              
              22.8
              %
              
              24.5
              %
              
              21.3
              %
              
              22.4
              %
 
 (1)
              Same
                  store sales growth reflects the periodic change in restaurant sales
                  for
                  the comparable restaurant base. In calculating same store sales
                  growth, we
                  include a restaurant in the comparable restaurant base after it
                  has been
                  in operation for more than 18
                  months.
  (2)
              Includes
                  only those restaurants open for at least 12 months before the beginning
                  of
                  the period measured.
  (3)
              Restaurant
                  operating profit is not a financial measurement determined in accordance
                  with generally accepted accounting principles and should not be
                  considered
                  in isolation or as an alternative to (loss) income from operations.
                  Restaurant operating profit may not be comparable to the same or
                  similarly
                  titled measures computed by other companies. The table below sets
                  forth
                  our calculation of restaurant operating profit and a reconciliation
                  to
                  (loss) income from operations, the most comparable GAAP
                  measure.
  **Three
                  Months Ended June 30,**
              
              **Six
                  Months Ended June 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**(In
                  thousands)Restaurant
                  sales
              
              $
              11,877
              
              $
              8,919
              
              $
              22,071
              
              $
              16,930Costs
                  and expenses:Cost
                  of sales
              
              
              3,299
              
              
              2,554
              
              
              6,194
              
              
              4,889Labor
              
              
              3,578
              
              
              2,558
              
              
              6,731
              
              
              5,067Occupancy
              
              
              812
              
              
              591
              
              
              1,518
              
              
              1,173Restaurant
                  operating expenses
              
              
              1,480
              
              
              1,032
              
              
              2,926
              
              
              2,007Restaurant
                  operating profit
              
              
              2,708
              
              
              2,184
              
              
              4,702
              
              
              3,794Deduct
                  - other costs and expensesGeneral
                  and administrative
              
              
              1,625
              
              
              1,177
              
              
              3,639
              
              
              2,391Preopening
                  expense
              
              
              689
              
              
              100
              
              
              980
              
              
              107Depreciation
                  and amortization
              
              
              823
              
              
              538
              
              
              1,553
              
              
              1,049(Loss)
                  income from operations
              
              $
              (429
              )
              $
              369
              
              $
              (1,470
              )
              $
              247
  13
 *Table
            of Contents*
 
 **Percentage
                  of**
                **Restaurant
                  Sales**
              
              **Percentage
                  of**
                **Restaurant
                  Sales****Three
                  Months Ended June 30,**
              
              **Six
                  Months Ended June 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Restaurant
                  sales
              
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %Costs
                  and expenses:Cost
                  of sales
              
              
              27.8
              
              
              28.6
              
              
              28.1
              
              
              28.9Labor
              
              
              30.1
              
              
              28.7
              
              
              30.5
              
              
              29.9Occupancy
              
              
              6.8
              
              
              6.6
              
              
              6.9
              
              
              6.9Restaurant
                  operating expenses
              
              
              12.5
              
              
              11.6
              
              
              13.2
              
              
              11.9Restaurant
                  operating profit
              
              
              22.8
              
              
              24.5
              
              
              21.3
              
              
              22.4Deduct
                  - other costs and expensesGeneral
                  and administrative
              
              
              13.7
              
              
              13.2
              
              
              16.5
              
              
              14.1Preopening
                  expense
              
              
              5.8
              
              
              1.1
              
              
              4.5
              
              
              0.6Depreciation
                  and amortization
              
              
              6.9
              
              
              6.1
              
              
              7.0
              
              
              6.2(Loss)
                  income from operations
              
              
              (3.6
              )%
              
              4.1
              %
              
              (6.7
              )%
              
              1.5
              %
   **Six
                  Months Ended**
                **June
                  30, 2006**
              
              **Year
                  Ended**
                **December
                  31, 2005****Store
                  Growth Activity**Beginning
                  Restaurants
              
              
              9
              
              
              7Openings
              
              
              2
              
              
              2Closings
              
              
              —
              
              
              —Total
              
              
              11
              
              
              9
  **Critical
        Accounting Policies and Estimates**
  There
        have been no material changes to our critical accounting policies and estimates
        from the information provided in Item 7, “Management’s Discussion and Analysis
        of Financial Condition and Results of Operations,” included in our Annual Report
        on Form 10-K for the year ended December 31, 2005, except as
        follows:
 
 ***Accounting
        for Stock Options***
  Effective
        January 1, 2006, we adopted the fair value recognition provisions of Statement
        of Financial Accounting Standards 123-revised 2004 (“SFAS 123R”), *Share-Based
        Payment,* using
        the
        modified prospective transition method. Under this transition method,
        compensation cost recognized in the three and six months ended June 30, 2006
        includes compensation cost for all share-based payments granted subsequent
        to
        January 1, 2006, based on the grant date fair value estimated in accordance
        with
        SFAS 123R. All options granted prior to January 1, 2006 were fully vested.
        The
        adoption of SFAS 123R increased our three and six months ended June 30, 2006
        reported operating loss, loss before income taxes and net loss by $211,000
        and
        $402,000, respectively, and increased basic and diluted net loss per share
        by
        $0.04 per share and $0.07 per share, respectively.
 
 The
        fair
        value of each option award is estimated on the date of grant using the
        Black-Scholes option pricing model and is affected by assumptions regarding
        a
        number of highly complex and subjective variables. These variables include,
        but
        are not limited to the actual and projected employee stock option exercise
        behavior. The use of an option pricing model also requires the use of a number
        of complex assumptions including expected volatility, risk-free interest
        rate,
        expected dividends, and expected term. Expected volatility is based on the
        historical volatility of a peer group of companies over the expected life
        of the
        option as we do not have enough history trading as a public company to calculate
        our own stock price volatility. We utilize historical data to estimate option
        exercise and employee termination behavior within the valuation model. The
        risk-free interest rate is based on the U.S. Treasury yield curve in effect
        at
        the time of grant for the expected term of the option. SFAS 123R also requires
        us to estimate forfeitures at the time of grant and revise these estimates,
        if
        necessary, in subsequent periods if actual forfeitures differ from those
        estimates. We estimate forfeitures based on historical experience. The
        weighted-average estimated value of employee stock options granted during
        the
        three and six months ended June 30, 2006 was $4.44 and $4.23 per share,
        respectively.
  14
 *Table
            of Contents*
 
 See
        Note
        5 to the consolidated financial statements, “Stock-Based Compensation,” for a
        more detailed discussion of the effects of SFAS 123R on our results of
        operations and financial condition. If factors change and we employ different
        assumptions in the application of SFAS 123R in future periods, the compensation
        expense that we record under SFAS 123R may differ significantly from what
        we
        have recorded in the current period.
 
 **Results
        of Operations**
  The
        following table sets forth, for the periods indicated, the percentage of
        restaurant sales of certain items in our financial statements.
  **Three
                  Months Ended June 30,**
              
              **Six
                  Months Ended June 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Restaurant
                  sales
              
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %Costs
                  and expenses:Cost
                  of sales
              
              
              27.8
              
              
              28.6
              
              
              28.1
              
              
              28.9Labor
              
              
              30.1
              
              
              28.7
              
              
              30.5
              
              
              29.9Occupancy
              
              
              6.8
              
              
              6.6
              
              
              6.9
              
              
              6.9Restaurant
                  operating expenses
              
              
              12.5
              
              
              11.6
              
              
              13.2
              
              
              11.9General
                  and administrative
              
              
              13.7
              
              
              13.2
              
              
              16.5
              
              
              14.1Preopening
                  expense
              
              
              5.8
              
              
              1.1
              
              
              4.5
              
              
              0.6Depreciation
                  and amortization
              
              
              6.9
              
              
              6.1
              
              
              7.0
              
              
              6.2Total
                  costs and expenses
              
              
              103.6
              
              
              95.9
              
              
              106.7
              
              
              98.5(Loss)
                  income from operations
              
              
              (3.6
              )
              
              4.1
              
              
              (6.7
              )
              
              1.5Nonoperating
                  income (expense):Interest
                  income
              
              
              2.1
              
              
              —
              
              
              2.2
              
              
              —Interest
                  expense
              
              
              (0.6
              )
              
              (1.9
              )
              
              (0.7
              )
              
              (2.2
              )(Loss)
                  income before provision for income taxes
              
              
              (2.1
              )
              
              2.2
              
              
              (5.2
              )
              
              (0.7
              )Provision
                  for income taxes
              
              
              0.4
              
              
              0.2
              
              
              0.2
              
              
              0.1Net
                  (loss) income
              
              
              (2.5
              )%
              
              2.0
              %
              
              (5.4
              )%
              
              (0.8
              )%
 
 ***Three
        Months Ended June 30, 2006 Compared with Three Months Ended June 30,
        2005***
  *Restaurant
        Sales.* Restaurant
        sales increased $3.0 million, or 33.2%, to $11.9 million during the second
        quarter of 2006 compared to $8.9 million during the second quarter of 2005.
        The
        sales increase is primarily a result of a $2.6 million increase associated
        with
        the opening of two new restaurants during the second quarter of 2006 and
        two
        restaurants during the third quarter of 2005 and a $0.4 million increase
        related
        to a 5.8% increase in same store sales. The increase in same store sales
        benefited from a price increase of approximately 1.5% implemented during
        March
        of 2006 and a price increase of approximately 1.3% taken in September of
        2005.
  *Cost
        of Sales* .
        Cost of
        sales as a percentage of restaurant sales decreased to 27.8% during the second
        quarter of 2006 from 28.6% during the prior year period. The reduction in
        cost
        of sales as a percentage of restaurant sales was primarily the result of
        continued focus on efficient operations and realization of economies of scale
        in
        the purchasing of food and beverage products as well as more favorable seafood
        and meat pricing.
  *Labor* .
        Labor
        expenses as a percentage of restaurant sales increased to 30.1% during the
        second quarter of 2006 from 28.7% during the second quarter of 2005. This
        increase was primarily due to the impact of our newer restaurants which
        historically have lower sales and higher labor costs than our more mature
        restaurants and our Sugarland restaurant which currently has lower sales
        and
        higher labor costs than our other restaurants.
  15
 *Table
            of Contents*
 
 *Occupancy* .
        Occupancy expenses as a percentage of restaurant sales increased 0.2% to
        6.8%
        during the second quarter of 2006 from 6.6% during the prior year period.
        The
        slight increase as a percentage of restaurant sales was primarily due to
        our
        Sugarland location which has lower sales and higher occupancy expenses as
        a
        percentage of sales compared to our other restaurants.
  *Restaurant
        Operating Expenses* .
        Restaurant operating expenses as a percentage of restaurant sales increased
        0.9%
        to 12.5% during the second quarter of 2006 from 11.6% during the second quarter
        of 2005. The increase is primarily the result of increased costs for utilities
        and higher operating expenses as a percentage of restaurant sales for our
        recently opened restaurants.
  *General
        and Administrative* .
        General
        and administrative expenses increased by $0.4 million to $1.6 million during
        the
        second quarter of 2006 from $1.2 million during the prior year period. The
        $0.4
        million increase was primarily attributable to $0.2 million, or 1.8% of
        restaurant sales, of stock-based compensation attributed to the expensing
        of
        stock options upon adoption of SFAS 123R in 2006. General and administrative
        expenses also increased $0.2 million related to the addition of infrastructure
        to support our growth strategy and the reporting and compliance requirements
        of
        being a public company.
  *Preopening
        Expense* .
        Preopening expense was $0.7 million during the second quarter of 2006 compared
        to $0.1 million during the second quarter of 2005. The increase in preopening
        expense primarily relates to the opening of our Dallas, Texas restaurant
        in
        April 2006 and our Lincolnshire, Illinois restaurant in June 2006, and
        preparations to open our Houston, Texas and Oakbrook, Illinois restaurants
        which
        are scheduled to open in the third and fourth quarters of 2006, respectively.
        Preopening expense also includes approximately $0.2 million of rent expense
        required to be expensed under Financial Accounting Standards Board Staff
        Position No. 13-1, *Accounting
        for Rental Costs Incurred During a Construction Period.* Prior to
        2006, rental costs incurred during a construction period were capitalized
        and
        amortized over the initial term of the lease agreement.
 
 *Depreciation
        and Amortization* .
        Depreciation and amortization expense increased $0.3 million to $0.8 million
        during the second quarter of 2006 from $0.5 million during the prior year
        period. The increase was principally the result of the additional depreciation
        and amortization on two restaurants opened during the third quarter of 2005
        and
        the Dallas, Texas restaurant opened in April 2006. Depreciation and amortization
        expense as a percentage of restaurant sales increased 0.8% to 6.9% during
        the
        second quarter of 2006 from 6.1% during the second quarter of 2005. The
        percentage increase was primarily due to the impact of higher average capital
        expenditures for our newer restaurants and lower sales volume at our Sugarland
        location.
 
 *Interest
        Income.* Interest
        income of $0.2 million during the second quarter of 2006 increased $0.2 million
        from the second quarter of 2005 primarily due to interest income earned from
        the
        investment of proceeds from our initial public offering completed in August
        2005.
  *Interest
        Expense.* Interest
        expense decreased $0.1 million to $0.1 million during the second quarter
        of 2006
        compared to $0.2 million during the prior year period. The decrease is primarily
        due to the reduction of interest on our convertible subordinated promissory
        note
        that was converted into common stock prior to our initial public offering.
  *Provision
        for Income Taxes* .
        During
        both the second quarter of 2006 and 2005, we did not incur a federal income
        tax
        liability; however, we recorded state income taxes of $45,000 and $18,000
        during
        the second quarter of 2006 and 2005, respectively, for states in which no
        state
        net operating loss carryforwards exist.
  16
 *Table
            of Contents*
  **Six
        Months Ended June 30, 2006 Compared with Six Months Ended June 30,
        2005**
  *Restaurant
        Sales.* Restaurant
        sales increased by $5.2 million, or 30.4%, to $22.1 million during the first
        six
        months of 2006 from $16.9 million during the first six months of 2005 primarily
        as a result of a $4.3 million increase associated with the opening of four
        new
        restaurants since the third quarter of 2005 and a $0.9 million increase related
        to a 6.0% increase in same store sales. The increase in same store sales
        also
        benefited from a price increase of approximately 1.5% implemented during
        March
        of 2006 and price increases of approximately 0.7% and 1.3% taken in April
        and
        September of 2005, respectively.
  *Cost
        of Sales* .
        Cost of
        sales as a percentage of restaurant sales decreased to 28.1% during the first
        six months of 2006 from 28.9% during the prior year period. The reduction
        in
        cost of sales as a percentage of restaurant sales was primarily the result
        of
        continued focus on efficient operations and purchasing leverage as well as
        more
        favorable seafood and meat pricing.
  *Labor* .
        Labor
        expenses as a percentage of restaurant sales increased to 30.5% during the
        first
        half of 2006 from 29.9% during the first half of 2005. This increase was
        primarily due to the impact of our Sugarland restaurant which currently has
        lower sales and higher labor costs than our other restaurants.
 
 *Occupancy* .
        Occupancy expense as a percentage of restaurant sales remained consistent
        at
        6.9% during both the first six months of 2006 and 2005.
  *Restaurant
        Operating Expenses* .
        Restaurant operating expenses as a percentage of restaurant sales increased
        1.3%
        to 13.2% during the first six months of 2006 from 11.9% during the first
        six
        months of 2005. The increase is primarily the result of increased costs for
        utilities, higher repairs and maintenance costs and higher operating expenses
        as
        a percentage of restaurant sales for our recently opened
        restaurants.
  *General
        and Administrative* .
        General
        and administrative expenses increased by $1.2 million to $3.6 million during
        the
        first half of 2006 from $2.4 million during the prior year period. The $1.2
        million increase is primarily attributable to approximately $0.4 million
        of
        separation costs related to the retirement of our former president and chief
        executive officer and $0.6 million related to the planned addition of
        infrastructure to support our growth strategy and the reporting and compliance
        requirements of being a public company. Also, the first half of 2006 includes
        $0.4 million of stock-based compensation attributed to the expensing of stock
        options upon adoption of SFAS 123R as discussed previously. The first half
        of
        2005 included $0.2 million of stock-based compensation expense related to
        the
        acceleration of vesting of outstanding options.
  *Preopening
        Expense* .
        Preopening expense was $1.0 million during the first six months of 2006 compared
        to $0.1 million during the first six months of 2005. The increase in preopening
        expense primarily relates to the opening of two restaurants during the first
        half of 2006 as compared to none in the first half of 2005, in addition to
        $0.2
        million in preopening expense for restaurants scheduled to open in the second
        half of 2006. Preopening expense also includes approximately $0.2 million
        of
        rent expense required to be expensed under FSP FAS No. 13-1, as discussed
        previously.
 
 *Depreciation
        and Amortization* .
        Depreciation and amortization expense increased $0.5 million to $1.5 million
        during the first half of 2006 from $1.0 million during the prior year period.
        The increase was primarily the result of the additional depreciation and
        amortization on four restaurants opened since the third quarter of 2005.
        Depreciation and amortization expense as a percentage of restaurant sales
        increased 0.8% to 7.0% during the first six months of 2006 from 6.2% during
        the
        first six months of 2005. The percentage increase was primarily the result
        of
        higher average capital expenditures for our recently opened restaurants and
        the
        impact of our Sugarland restaurant which is experiencing lower sales volumes
        than our other restaurants.
 
 *Interest
        Income.* Interest
        income of $0.5 million during the first six months of 2006 increased $0.5
        million from the first six months of 2005 primarily due to interest income
        earned from the investment of proceeds from our initial public offering
        completed in August 2005.
  17
 *Table
            of Contents*
  *Interest
        Expense.* Interest
        expense decreased $0.2 million to $0.2 million during the first half of 2006
        compared to $0.4 million during the prior year period. The decrease is primarily
        due to the reduction of interest on our convertible subordinated promissory
        note
        that was converted into common stock prior to our initial public offering.
  *Provision
        for Income Taxes* .
        During
        both the first six months of 2006 and 2005, we did not incur a federal income
        tax liability; however, we recorded state income taxes of $50,000 during
        the
        first six months of 2006 and $18,000 during the first six months of 2005
        for
        states in which no state net operating loss carryforwards exist.
  **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:
  ·
              timing
                  of new restaurant openings and related
                  expenses;
  ·
              restaurant
                  operating costs and preopening costs for our newly-opened restaurants,
                  which are often materially greater during the first several months
                  of
                  operation than thereafter;
  ·
              labor
                  availability and costs for hourly and management
                  personnel;
  ·
              profitability
                  of our restaurants, especially in new
                  markets;
  ·
              increases
                  and decreases in comparable restaurant
                  sales;
  ·
              impairment
                  of long-lived assets and any loss on restaurant
                  closures;
  ·
              changes
                  in borrowings and interest rates;
  ·
              general
                  economic conditions;
  ·
              weather
                  conditions or natural disasters;
  ·
              timing
                  of certain holidays;
  ·
              new
                  or revised regulatory requirements and accounting
                  pronouncements;
  ·
              changes
                  in consumer preferences and competitive conditions;
                  and
  ·
              fluctuations
                  in commodity prices.
  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.
  18
 *Table
            of Contents*
  **Liquidity
        and Capital Resources**
 
 Our
        primary liquidity and capital requirements have been for new restaurant
        development, working capital, and general corporate needs. We believe the
        proceeds from our initial public offering in August 2005 and cash generated
        from
        operations will be sufficient to meet our capital requirements through 2006.
        Beyond 2006, additional financing may be needed to fund working capital and
        restaurant development. Changes in our operating plans, acceleration of our
        expansion plans, lower than anticipated sales, increased expenses and costs
        of
        construction, or other events, including those described in Item 1A, “Risk
        Factors” of our Annual Report on Form 10-K for the year ended December 31, 2005
        may require us to seek additional debt or equity financing on an accelerated
        basis. Financing may not be available on acceptable terms, or at all, and
        our
        failure to raise capital when needed could impact negatively our growth plans,
        financial condition, and results of operations. Additional equity financing
        may
        be dilutive to the holders of our common stock and debt financing, if available,
        may involve significant cash payment obligations or financial covenants and
        ratios that restrict our ability to operate our business.
  ***Equipment
        Loans***
  As
        of
        June 30, 2006, we had six
        equipment term loans with lenders; each collateralized by restaurant equipment.
        The outstanding principal balance under these loans aggregated $3.7 million.
        The
        loans bear interest at rates ranging from 7.0% to 8.5% and require monthly
        principal and interest payments aggregating approximately $88,000. The loans
        mature between October 2006 and June 2012. The loans also require us to maintain
        certain financial covenants calculated at the end of each calendar year,
        and we
        were in compliance with all such financial covenants as of December 31, 2005.
  ***Cash
        Flows***
  The following table summarizes our primary sources of cash during the periods
        presented (in thousands).
 
 **Six
                  Months Ended June 30,****2006**
              
              **2005**Net
                  cash provided by (used in):Operating
                  activities
              
              $
              1,840
              
              $
              1,280Investing
                  activities
              
              
              (4,535
              )
              
              (4,727
              )Financing
                  activities
              
              
              (340
              )
              
              824Net
                  decrease in cash and cash equivalents
              
              $
              (3,035
              )
              $
              (2,623
              )
 
 *Operating
        Activities.* During
        the first six months of 2006, net cash provided by operating activities was
        $1.8
        million consisting of approximately $3.7 million in net cash used for our
        net
        loss, an increase in tenant improvement allowance receivables, prepaids and
        other current assets, and inventories offset by $5.5 million in net cash
        generated from the amortization of deferred rent, depreciation and amortization,
        an increase in accounts payable and accrued expenses, and non-cash stock-based
        compensation expense. During the first six months of 2005, net cash provided
        by
        operating activities was $1.3 million consisting primarily of depreciation
        and
        amortization, amortization of deferred rent, collection of tenant improvement
        allowances and non-cash compensation expenses, partially offset by payments
        of
        accounts payable and accrued expenses and expenditures advanced for our initial
        public offering.
 
 *Investing
        activities.* We
        fund
        the development and construction of our new restaurants primarily with cash
        and
        short-term investments. Net cash used for investing activities was $4.5 million
        for the first half of 2006, reflecting $9.0 million for the funding of
        construction in progress and the purchase of property and equipment, the
        majority of which related to new restaurant openings and planned restaurant
        openings. Investing activities also include $4.5 million from the sale of
        investments to fund this construction. Net cash used for investing activities
        was $4.7 million for the first half of 2005, primarily related to funding
        construction in progress and the purchase of property and equipment for the
        Sugarland and San Antonio restaurants. We expect the cash investment cost
        of our
        prototype restaurant to range from $3.2 million to $3.8 million, excluding
        landlord tenant improvement allowances and excluding preopening expenses
        of
        approximately $0.4 million.
  19
 *Table
            of Contents*
 
 *Financing
        Activities.* Net cash
        used in financing activities was $0.3 million for the six months ended June
        30, 2006 principally consisting of $0.4 million of principal payments on
        our
        equipment loans, partially offset by proceeds from the issuance of common
        stock
        under our employee stock purchase plan. Net cash provided by financing
        activities was $0.8 million during the six months ended June 30, 2005 as a
        result of proceeds from equipment loans less related principal payments.
  **Off-Balance
        Sheet Arrangements**
  In
        September 2003, we sold the assets of Saki’s Pacific Rim Café. We continue to be
        financially responsible for the lease payments in the event the purchaser
        defaults on the lease. The lessor has obtained certain personal guarantees
        of
        the lease payments from the purchaser’s owners should they fail to perform under
        the lease. The total remaining lease payments due under the lease approximated
        $90,000 at June 30, 2006. The lease expires in January 2007.
 
 **Item
                3.**
              ***Quantitative
                  and Qualitative Disclosures about Market
                  Risk***
  ***Investments***
  A
        change
        in market price exposes us to market risk related to our short-term investments.
        We held approximately $19.7 million in available-for-sale securities as of
        June
        30, 2006. A hypothetical 10% decline in the market value of those securities
        would result in a $2.0 million unrealized loss and a corresponding decline
        in
        their fair value. The hypothetical decline would not affect our cash flows
        unless the securities were disposed of.
  ***Primary
        Market Risk Exposures***
  Our
        primary market risk exposures are in the areas of commodity costs and
        construction costs. Many of the food products purchased by us are affected
        by
        changes in weather, production, availability, seasonality, and other factors
        outside our control. In addition, we believe that almost all of our food
        and
        supplies are available from several sources, which helps to control food
        commodity risks. We have exposure to rising construction costs, which may
        impact
        our actual cost to develop new restaurants. Although the cost of restaurant
        construction will not impact significantly the operating results of the
        restaurant, it would impact the return on investment for such
        restaurant.
  ***Inflation***
  The
        primary inflationary factors affecting our operations are food, labor, and
        construction costs. A large number of our restaurant personnel are paid at
        rates
        based on the applicable minimum wage, and increases in the minimum wage directly
        affect our labor costs. Many of our leases require us to pay taxes, maintenance,
        repairs, insurance, and utilities, all of which are generally subject to
        inflationary increases. We believe inflation has not had a material impact
        on
        our results of operations in recent years.
  **Item
                4.**
              ***Controls
                  and
                  Procedures***
  We
        have
        evaluated, with the participation of our Chief Executive Officer and Chief
        Financial Officer, the effectiveness of our disclosure controls and procedures
        as of June 30, 2006. Based on this evaluation, our Chief Executive Officer
        and
        Chief Financial Officer have each concluded that our disclosure controls
        and
        procedures are effective to ensure that we record, process, summarize, and
        report information required to be disclosed by us in our quarterly reports
        filed
        under the Securities Exchange Act within the time periods specified by the
        Securities and Exchange Commission’s rules and forms. 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.
  20
 *Table
            of Contents*
  **PART
        II - OTHER INFORMATION**
  **Item
                1.**
              **Legal
                  Proceedings**
  Not
        applicable
  **Item
                1A.**
              **Risk
                  Factors**
  Not
        applicable
  **Item
                2.**
              **Unregistered
                  Sales of Equity Securities and Use of
                  Proceeds**
  Not
        applicable
  **Item
                3.**
              **Defaults
                  Upon Senior Securities**
  Not
        applicable
  **Item
                4.**
              **Submission
                  of Matters to a Vote of Security
                  Holders**
  We
        held
        our annual meeting of stockholders on May 4, 2006. The following items were
        voted on by our stockholders:
 
 For
              
              Against
              
              Abstain1.Ratification
                  of the election of one director(Marcus
                  E. Jundt) to serve as Class I member of our Board of Directors
                  for a term
                  expiring in 2009
              
              
              5,211,635
              
              
              17,767
              
              
              —2.Proposal
                  to amend the Company’s Certificate of Incorporation to decrease the number
                  of authorized shares of common stock from 40,000,000 to 15,000,000
                  and to
                  decrease the number of authorized shares of preferred stock from
                  20,000,000 to 2,000,000
              
              
              3,380,958
              
              
              3,481
              
              
              1,3003.Proposal
                  to approve the ratification of the appointment of Ernst & Young LLP as
                  the Company’s independent auditors for the fiscal year ending December 31,
                  2006
              
              
              5,227,902
              
              
              100
              
              
              1,400
 
 **Item
                5.**
              **Other
                  Information**
  Not
        applicable
  **Item
                6.**
              **Exhibits**
  (a)
              Exhibits
  31.1
              Certification
                  of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule
                  15d-14(a),
                  promulgated under the Securities Exchange Act of 1934, as
                  amended.31.2
              Certification
                  of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule
                  15d-14(a),
                  promulgated under the Securities Exchange Act of 1934, as
                  amended.32.1
              Certification
                  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
                  906 of
                  the Sarbanes-Oxley Act of 2002.32.2
              Certification
                  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
                  906 of
                  the Sarbanes-Oxley Act of 2002.
  21
 *Table
            of Contents*
  **SIGNATURES**
  Pursuant
        to the requirements of the Securities Exchange Act of 1934, this report has
        been
        signed below by the following persons on behalf of the registrant and in
        the
        capacity and on the dates indicated.
  **KONA
                  GRILL, INC****.**/s/
                  Marcus E. JundtMarcus
                  E. Jundt*Chairman
                  of the Board, President, and Chief Executive
                  Officer*/s/
                  Mark S. RobinowMark
                  S. Robinow*Executive
                  Vice President, Chief Financial Officer, and Secretary (Principal
                  Accounting and Financial
                  Officer)*
 
 Date:
        August 4, 2006
   22