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In 2008 and 2009, the company spent significant time rightsizing the cost structure of the business and resetting the business model to improve profitability.  When operated and run properly, COSI participates in a very attractive segment of the restaurant industry - the fast casual segment.  For more than two years, COSI has been an operational disaster and has experienced a significant decline in same-store sales and in its catering business (not surprisingly, PNRA has made this a big initiative). 

Part of the cleaning house process requires fixing the operating model in order to capture incremental sales dollars.  In addition to closing stores, COSI has taken the past 2 years to right-size its economic model.  With that in the REAR VIEW, the focus on incremental customer visits is now the priority.


At the end of 4Q09, COSI had cash and cash equivalents of approximately $4.1 million, and little funded debt.  With the recent sale of 13 restaurants in the Washington D. C. market to Capitol C Restaurants LLC for $8.4 million, announced on April 27, the balance sheet and the operating model were further enhanced.  Capitol C has entered into a development agreement to open six additional COSI restaurants in D.C.  Under the terms of the Asset Purchase and Sale Agreement, $6.4 million of the purchase price was paid in cash at closing, $1.4 million is to be paid pursuant to a three-year note and the balance of $0.6 million is being held in escrow subject to the satisfaction of certain conditions.


The refranchising of the D.C. restaurants is a strong indicator that COSI has turned the operational corner and raised the likelihood that COSI will see accelerating franchised revenue growth over the next 12 months.  COSI opened six franchise locations in 2009 and is looking to accelerate franchise unit growth in 2010.  Specifically, management stated on its 4Q09 earnings call that there has been a lot of interest on the part of potential franchise partners over the past 6-9 months.  To that end, the company said it would begin to make “specific contacts to individuals in various markets” in April and May.  Based on the refranchising of slightly more than half of the company’s D.C. market in late April, those plans are coming to fruition. 

The company’s focus on reducing its cost structure has helped on the food and labor cost lines and these benefits have flowed through to the franchisees.  As margins and returns continue to get incrementally better, franchise growth will follow as the capital markets allow for franchisees to get incremental financing.  With COSI operating 68% of the store base at the end of 2009 (closer to 60% in 2Q10, adjusting for the partially refranchised D.C. market), there are further opportunities to refranchise more stores, thereby raising cash and enhancing the business model.


As of the 4Q09 conference call, management expected to complete the month of March with positive system-wide same-store sales, reflecting positive growth at both company and franchise locations.  For reference, COSI’s 4Q09 call took place on March 29, 2010 so management had good visibility on March results.  Like every other restaurant company, COSI’s trends were “derailed in February” due to the record snow and weather that the company experienced in 100% of its company markets.  It should be noted that the improvement in same-store trends is due largely to increased operational focus as the company recalibrated its marketing calendar for 2010.  COSI shifted its marketing dollars away from the extreme weather months of 1Q and added it to the balance of the fiscal year.  COSI’s 2Q will see the benefit of additional and refocused marketing dollars.  That being said, I would not expect to see a significant pick up in 2-year average trends until the second quarter, though my 1Q10 -1% company same-store sales estimate assumes a moderate sequential improvement in 2-year trends (big improvement on a 1-year basis from 4Q09’s -6.6% as the year ago comp is much easier).  Also helping 1Q10 is the fact that management stated, relative to catering, that it has “started to see some recovery in early 2010 from the economic turbulence of ’09.”  It is important to remember that declining catering sales (-24% in 2009) have put increased pressure on the company’s average check.




Historically, COSI has never done any meaningful marketing outside of an in-store focus on its most loyal customer base.  Management recognized that it must now attempt to broaden the concept’s appeal by extending brand awareness.  The driver of revenue growth over the next year will be (1) increased marketing (2) new day parts and new products (3) focused operations and (4) a new coffee program.    

INCREASED MARKETING - One of the biggest potential drivers of incremental l traffic is increased marketing dollars and a more efficient use of current marketing spending.   With a new advertising agency in place, COSI will increase spending on “out-of-store” media to increase awareness of the brand and drive incremental traffic.  COSI also has a newly designed website, menu boards and a new social media team in place to drive the marketing effort.  The company’s newly revamped website (completed in late 2009) will have the capabilities to roll out online ordering, online catering, and social media promotions in 2010.

CATERING - While catering sales started to recover in 4Q09 (only -13.5% versus -27.5% in the prior two quarters), there is a very large opportunity in catering.  The products and menu are a good fit for catering.  Operationally, COSI has consolidated its catering call center and is now focused on the logistics of improving ordering, packaging, and delivery.  In addition, COSI is going to launch a catering loyalty program in 2010. The company also plans to expand its direct sales efforts, particularly in its urban markets, in order to drive incremental catering sales.  As I stated earlier, management suggested that it experienced sequentially better catering trends in early 2010.

OPERATIONAL FOCUS – At lunch, management is working to simplify its operations in an effort to serve more guests during the high demand lunch hours of the day.  Specifically, management is working toward reducing wait times.  Management commented that its recent initiatives to increase speed have translated into recent sales lifts and an increase in positive responses from its guest feedback tools.

GROWING DAY PARTS AND NEW PRODUCTS- COSI launched 3 new breakfast wraps on March 29 (so more of a 2Q10 sales driver) to help expand the breakfast day part.  The company’s breakfast menu also includes steel-cut oatmeal, breakfast sandwiches; Squagels, unique to COSI and Fruit Parfaits.  In the coming months, COSI is also working to capitalize on its coffee platform and improve its grab-and-go beverage products, which could potentially drive both traffic and margin growth. 


Operating margin declined 170 bps in 2009, excluding asset impairment, store closure and lease termination costs.  The company’s efforts to reset its cost structure, primarily on the cost of goods sold, labor and G&A expense lines, stemmed further declines.  G&A expense, alone, declined nearly 25% in 2009 and 200 bps as a percentage of sales.  With company-owned same-store sales -10.8% in FY09, COSI experienced significant deleveraging during the year on the labor and occupancy expense lines, despite management’s cost cutting initiatives.  To that end, COSI will need to see a return to positive same-store sales growth before we can really see the magnitude of the benefit to the company’s P&L.

As I said earlier, I would expect same-store sales to get better in 1Q10, but the benefit from the increased and redirected marketing spending, combined with the recently launched breakfast wraps, will not materialize until the second quarter.  The YOY operating margin comparison, however, is much easier in the first quarter than in 2Q10, and I would expect COSI to report a nearly 200 bp improvement in margin (though still negative).  It will be important to see how much leverage the company achieves in 1Q10 with significantly better top-line trends (on a 1-year basis).  From there, it will be easier to measure the impact on margins for the remainder of the year based on my assumption for positive same-store sales trends and to gauge what it will take for COSI to return to profitability.  Regardless, I would expect margins to improve in FY10 with the second quarter being the most difficult from a YOY comparison standpoint.

COSI’s FY10 margin will also be helped somewhat by the fact that the company has no plans to open company-owned units, relative to 2 in FY09 and 1 in FY08.  The company has reduced its new unit growth over the last couple of years from 21 in FY06 and 6 in FY07 as it has worked to reset its cost structure and improve in-store unit economics. 

Thoughts on valuation due out shortly…

Howard Penney

Managing Director