I believe the market is valuing Cosi based on hope and that the true value will be proven to be only a fraction of the current market cap of $170 million.   I believe shorting the stock could lead to gains of 50% to 75% over the next couple years.  Natey1015 recently did write-up Cosi suggesting it as a long opportunity.  That write-up provides some good additional background on the company.

 

What do you get for $180 million?  A restaurant company that operates in the fast, casual dining arena that has never made money.   Over the last five years share count has gone from 17 million (accounting for conversion of preferred stock) to 38.2 million.  In 2002 Cosi produced operating losses of $15 million on $84 million in sales.  In 2006 Cosi produced operating losses of $13.8 million on $126 million in sales.   They had losses every year in between too.  The point is that the Cosi restaurant concept is not working.  The market is hoping Cosi is another Panera Bread, but it’s not.  The numbers prove that fact. 

 

On an EBITDA basis Cosi has lost approximately $28 million in five years through 2006 before cumulative net asset impairments of $10 million and stock based compensation of $11.7 million.  I would also argue that depreciation is 100% real in a restaurant business that leases all its stores.  Total depreciation for the five years was $35 million.   I also think that stock comp and asset impairments are a real burn of shareholder wealth.  Therefore, my thinking is that Cosi has lost approximately $85 million of shareholder money over the last five years.  In total Cosi has paid in capital of $271 million and cumulative losses of $223 million.  I think if you agree with this way of analyzing the business then one may conclude that Cosi is an exercise in burning away shareholder money.  

 

So what’s the company worth?  In liquidation, next to nothing.   Cosi’s only real balance sheet asset, net of payables and other liabilities, is $48 million of leasehold improvements housed in leased stores.  Those leaseholds might be worth about 10 cents on the dollar in liquidation.   This is before $100 million in operating lease obligations. 

 

Some restaurant operator might take a crack at turning this thing around, but anyone sane, I think, might look at it as follows.  Currently Cosi’s EBITDA run rate is approximately negative $5 million.  Industry casual fast dining EBITDA margins for those few that can be successful are generally in the range of 10% to 15%.  Let’s say another management could turn Cosi’s margin around by 14 points from negative 4% to positive 10%.  That would produce about $13 million in EBITDA.  Private market multiples for restaurants historically have been in the range of 4 to 7 times EBITDA.  Currently restaurants are trading at the top end of historical multiples.  At a multiple of 6, Cosi would be worth $78 million or about $2 a share.  But would you be willing to pay $78 million for something that’s worth $78 million after you’re done fixing it?  So to a buyer I think one would have to purchase these assets at say $40 million for all their time and capital.  All of this, I think is on the side of an optimistic scenario and assumes that the business model can be changed into something that it has never been in the past.  In this scenario one could argue Cosi is worth somewhere between $1 and $2 per share which would create a gain 55% to 75% from current price. 

 

If you look at comps such as Panera you would notice that it’s trading at an EBITDA multiple of 9.   Panera however is two companies in one.  It’s a restaurant company trading at a multiple of 6 to 7 times EBITDA and a franchise company trading at an EBITDA multiple of 11 to 13 times.  This makes sense, franchise companies have very little in the way of real depreciation. Almost all of cash flow is free cash flow.  Restaurants are very different.  Long term free cash flow is operating cash less depreciation (I am ignoring taxes, stock comp. etc for simplicity of the argument here). 

 

But what about Cosi’s nascent franchising effort?  Cosi’s franchise revenue is currently in range of $2 million.  Over time it may create value, but now, I don’t think the franchise business is worth much.  Maybe franchise operators will be able to do something that Cosi itself cannot do in the stores –make money, but that is a leap.  I know that a franchisee in Minnesota that recently opened two Cosi’s is losing money and looking for someone to come in and take over the leases.  My guess is that Cosi’s franchise effort will “hit the wall” sometime in the next two years as many stores don’t perform as projected.  Certainly Minnesota is not working out as projected. 

 

So why doesn’t the concept work?  Cosi’s signature product is a flat bread product that is made fresh on-site.  The flatbread is tasteless.  They also make pizza crust in the same “hearth” style oven.  The pizza crust is also tasteless and dry.  Like all failed restaurant concepts do before they go broke, they think they can fix it by offering more products.  Cosi which started out as a sandwich and salad shop now offers bagels and coffee for breakfast and pizza and chopped up chicken in a casserole for dinner.  The problem is that they don’t do anything very well.  Bagels are better at Brueggers. Coffee is better at  Starbucks.  Lunch sandwiches are better at Panera and Au Bon Pain and dinner is better at dozens of other places.   What you are left with is mediocre food all day long at Cosi.  It does not work!