Cosi, Inc. owns, operates and franchises a chain of 141 fast casual restaurants (107 owned and 34 franchised as of December 31, 2007) that sell high-quality sandwiches, salads, soups, pizzas, desserts and beverages, including a full liquor bar. Cosi restaurants prominently feature an open flame stone hearth in which it bakes its signature flatbread throughout the day. Cosi restaurants are located in the Northeast, Mid-Atlantic and Midwest regions of the country, and management plans to expand in the West.
The restaurants are decorated in a contemporary, upscale design to attract Cosi's three target demographics: 1) adults 18-34 without children, 2) upscale suburbanites of all ages, 3) metro elites of all ages. Cosi terms this segment the "Premium Convenience" market, referring to consumers with higher disposable income, and more sophisticated food tastes who want fast food without sacrificing quality. The menu is priced to appear as an "affordable luxury" with an average check of $8.81.
Cosi's management believes there is market potential for 1,900 Cosi restaurants in the top 75 markets, about 13 times its current portfolio 1,400 of those are targeted at the top 25 markets. Currently, the company operates full-size restaurants in just six of the top 50 U.S. markets, and is just one-eighth the size of its largest competitor, Panera Bread, leaving ample room to grow, in our opinion. Much of the company's near-term growth will come from franchisers.
Cosi was created in October 1999 through the merger of Xando Coffee and Bar and Cosi Sandwich Bar, which served similar customers but focused on different parts of the day. There were five Cosi restaurants at that time. Three years later, Cosi went public at $7 per share ($33 million net proceeds), with intentions to accelerate the chain's growth from 15 new units in 2001 to 30-35 in 2002, and 50-59 in 2003, while boosting average unit volumes (AUV) by introducing new products, and growing Cosi Catering. The plan failed, however, as restaurants opened in the second half of 2002, and first quarter of 2003 underperformed. The Board responded in the first quarter of 2003 by recruiting William Forrest, a turnaround specialist, as Chairman, from the investment banking firm, Gleacher & Co. Months later Forrest brought in CEO, Kevin Armstrong (who retired in March 2007). Strapped for cash, management announced at the same time that it was changing its growth strategy by developing a franchise program, and slowing the growth of its company-owned stores, enabling it to immediately layoff employees. Soon thereafter, management shut down several underperforming units. Since then, the company has returned to the capital markets three times to raise money: a rights offering in December 2003, followed by a private placement in 2004, and a secondary public offering in June 2005.
Under the new management, Cosi's restaurant cash flow margins increased from 9.5% in 2003 to 17% for the fiscal year ended 2006, as growth accelerated the chain grew 22% in 2006 to 110 company-owned, and 13 franchise-operated restaurants, and 14.6% in 2007 to 107 company-owned, and 34 franchise-operated restaurants.
Accelerating Growth Poisons Margins
Cosi's rapid growth proved uncontrolled. In 4Q06, restaurant cash flow margins tumbled 500 basis points to 11.9% (from 16.9% in 3Q06 and 21.6% in 2Q06) as traffic declined for the third straight quarter. In the 1H07, traffic and cash flow margins deteriorated further, and 3Q07 results show traffic declined for the sixth consecutive quarter. Restaurant operating cash flow margin shrank 500 basis points to 12.1% in 3Q07 from 17.1% in 3Q06. We note, however, that pricing has remained strong, and coupled with mix shifts, the average check rose an average of 3.3% year over year per quarter in 2006, and 2.1% in 3Q07, offset by an overall decline in guest traffic.
Cosi's management acknowledged that in trying to satisfy Wall St's expectations for unit openings, it opened units, which it shouldn't have, without having maintained adequate operational controls. In fact, management is pinning its volumes declines on many of the restaurants opened in 2H06. Management analyzed the problems, and came up with a variety of issues: traffic count (in location), signage, and parking. The underperforming restaurants had numerous technical problems including a service defect rate that soared in 2H06. Management is closing these non-performing restaurants. During 3Q07 and 4Q07, the company closed six remaining locations operated inside Macy stores as well as two underperforming company-owned locations and one franchise restaurant.
Is Patchwork Repair Enough or Will Major Surgery be Required?
To address the problem, management hired new people many new general managers and is giving them proper support and training to do better. It is reviewing the site selection model, and tightening some of the elements in its model. In addition, management is addressing Cosi's restaurants' interior design, which has become sterile, by warming their tone and furnishings. There are currently 53 locations of 141 system-wide that incorporate the new design.
While the chain's numerous issues are resolved, Cosi is slowing growth slightly, with plans to open fewer company-owned restaurants in 2007. It does however plan to grow many of the upcoming openings through franchises, thereby investing less capital and boosting ROIC. In 2007, the company opened 21 franchise locations, and expects to open 25 35 more in 2008, effectively doubling the current franchise base totaling 34. Management expects strong financial returns without much capital investment from the franchise restaurants. The plan is for each franchisee to open, and ramp one or two restaurants, and then the run rate speeds up. We note that some of Cosi's problems stem from franchises that were poorly run and maintained. Therefore, we question the company's plan to aggressively add more franchise units while the company lacks a firm grip on its system. We would prefer to see all unit growth slow down until improved staffing, and maintenance training boosts traffic, and restaurant cash flow margins improve.
G&A Expense Outsized
A longer-standing issue is Cosi's heavy corporate overhead. At over 15% of sales, Cosi's general and administrative expenses are double the industry average. They have recently improved from over 17% last year, but with revenue growth slowing down, will not likely show further meaningful improvement for many quarters.