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With this Retailer's Operations Astray, Will the Competition Play?

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Cosi (NASDAQ: COSI), an owner, operator, and franchiser of 136 convenience-driven dining restaurants around the nation, continues to trade down more than 2.5% after-hours following a 4% per share value drop during the day’s trading.   As the market’s reaction suggests, the corporation, selling a wide variety of fresh foods from wraps, sandwiches, salads, and soups, continues to show its weakness in attracting and maintaining a captive consumer base.

Offering a variety of different menu items to attract consumers during all day parts, including the increasingly popular breakfast category, Cosi is very reminiscent of a scaled down version of larger competitors like McDonald’s (NYSE: MCD), Panera (NASDAQ: PNRA), and Starbucks (NASDAQ: SBUX).  Despite the seeming ability to be able to control a close-knit base of loyal consumers with its relatively niche-focused footprint, the lack of size has only acted to completely drown Cosi’s ability to efficiently operate in the quick-serve restaurant space.  The retailer tends to focus its operations in high traffic urban areas that are prone to significant walk-by consumers, and has nearly half of its locations in higher rent areas including New York City, Washington D.C., Chicago, and Boston. 

The growth plan has created problems on multiple levels:

Limited Ability to Stand Out

Constructing stores in high traffic urban areas may seem like an excellent idea on paper – certain areas in the aforementioned cities have thousands of consumers walking by during the day, all of which are subject to try a given restaurant selection at least once during their travels.  Without a deep penetration approach like that used by Starbucks (which is in and of itself a risky growth strategy), however, an isolated restaurant in a high traffic area is not likely to stand out among the multitude of other alternatives within walking distance.  Unless a given restaurant has an extremely compelling offer – which, as the -6.7% sales CAGR over the past five years indicates Cosi does not – being located in a high traffic urban area is not a stand-alone competitive advantage. 

Limited Ability to Reap Economies of Scale Efficiency Gains

Cosi’s limited national footprint also prevents the corporation from dramatically reducing its variable cost structure on a per sale basis.  As a percentage of revenue, the corporation’s costs to man each restaurant (hourly labor costs and employee benefits plus labor costs plus general/administrative expenses) is well above the comparable figure in alternative quick serve restaurants.  Whereas nearly 50% of the corporation’s sales are consumed by such expenses, McDonald’s, Panera, and Starbucks enjoy considerably lower personnel expenses near 26%, 33%, and 37% of sales, respectively (calculated over trailing twelve month period, figures rounded to nearest percentage point). 

Cosi would almost be better off if it was heavily consolidated in one given urban area (New York City, say) as opposed to having a relatively weak presence in multiple areas around the nation.  Such an effort would significantly reduce its overall headcount, as it would not need overlapping positions in different cities, and would act to further streamline logistics and boost its operating margins.  The corporation’s average operating loss over the past three years has been nearly $7 million per year, while McDonald’s, Panera, and Starbucks have posted 30.9%, 11.5%, and 11.3% average operating margins over the same time period, respectively.  

Despite the corporation’s shortcomings, there may be some value underneath the rubble in terms of a possible buyout scenario.  Panera, which has tripled its nationwide footprint over the past ten years, could reap the benefits of an effective leap into Cosi’s key urban markets in buying out the ailing retailer.  Despite its rather swift growth throughout the 2000s, Panera management has always focused on steady growth in suburban marketplaces and has yet to take a significant stab at certain bustling urban zones.  Citing difficulty in finding competitive locations, the company has only recently opened its first Manhattan outlet. 

Given the corporation’s vast popularity – it ranks #13 on the QSR 50 list and has enjoyed an unprecedented 23% ten year sales CAGR – and the efficient dynamics that already characterize its existing store base, however, it would undoubtedly make much more effective use out of the valuable Cosi locations than could the existing Cosi retail concept.  

Panera CEO Ron Shalch’s recent interview on CNBC’s Mad Money has made it known that the corporation is not opposed to using its heaping $222 million cash pile to make an accretive acquisition. 

Currently valued at around $55 million, Cosi’s enterprise value has fallen by almost 75% from pre-recessionary levels.  With the continued pessimism surrounding the Cosi brand, it could very well be an attractive buy-out opportunity for Panera, giving the corporation the leverage to adapt its popular concept into some of the higher-traffic urban zones.  Panera did, after all, purchase a 51% stake in Phoenix-based Paradise Bakery in 2006 for $21.1 million (nearly $900,000 per store).  At current market valuations (enterprise value/store count), the Cosi footprint is half as expensive as this similar growth-focused transaction.    

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