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Two weeks ago COSI reported earnings for 2Q 2015. We remain bullish on the turnaround story, and we have been adding to our long position at current prices. But...

Our thesis, which we started building about a year ago, hinges on the ability of the current CEO and former franchisee RJ Dourney to turn around the aging stores and make the company profitable again. You can read our latest, detailed thesis here. With each earnings report, we get information to assess the progress relative to our targets. Key takeaways are as follows:

Revenues are increasing slowly at existing stores, and costs are showing signs of improvements.
The store refresh has begun, with 6 stores complete to date. Another 10-20 are targeted for 2H15, with the balance (55 total stores) scheduled by end of 1Q16.
Cash may not be sufficient to guarantee management’s claim that no additional capital is needed in the next 12 months.
Management remains positive on the results and the progress to date.

In the 2Q earnings report and conference call, there were a few key points:

First, top-line revenues were $24mm, a 20% increase over the prior year period ($20mm). The increase represents $5.3mm contribution from Hearthstone, offset by a $1.7mm decrease in revenues from stores closed since last year, plus an increase in revenues from existing stores of about $0.7mm. Revenues are increasing at existing stores, although the pace is not as rapid as we wanted to see.

Second, COSI recognized positive cash flow at the store level system-wide. Specifically, stores made an average profit of 1.6% of revenues. Diving deeper, here is a breakdown of costs in 2Q 2015 compared to both 2Q 2014 -also positive cash flow without Hearthstone- and sequentially to 1Q 2015 -a dismal performance. We were expecting a much bigger improvement.

	COSI 2Q 2014		COSI 1Q 2015		COSI 2Q 2015
Revenue	$20		$17.207		$24.027
Food Costs	5.122	25.61%	4.844	28.15%	6.514	27.11%
Labor	7.432	37.16%	7.097	41.24%	8.558	35.62%
Occupancy	7.078	35.39%	6.637	38.57%	8.532	35.51%
Gross Profit	$0.368	1.84%	$-1.371	-7.97%	$0.423	1.76%

We note an increase in food costs as a % of revenues relative to last year. We think this represents an increase in the quality of the food, which we hope will translate to customer loyalty and better pricing power down the road.

We see a fairly significant decrease in labor costs, which the team tells us is due partially to an increase in labor efficiency and partially to a decrease in the cost of medical benefits. Our stated target is 30% of revenues, so there is still plenty of room for improvement. We expect this number to decline as labor efficiencies work their way through the system, although we note the potential for risk in this area if New York passes a minimum wage increase.

Headline occupancy costs are slightly higher, although we are told there was a 1.5% decrease in direct occupancy costs, offset by a larger increase in “other” costs lumped in this bucket (including credit card fees and equipment for the coffee program). Our target here is 20%, but we expect much of the improvement to come from spreading these fixed costs over a larger revenue base.

Turning now to progress on the refresh. 6 stores have been refreshed to date. On the call, RJ explicitly said he is seeing a 10% increase in sales already in those locations, with 40% flow through at a cost of $20k to $150k per store. The plan is to complete another 10 to 20 units by year end, with all stores slated for refresh done by March ‘16.

There are a lot of moving parts making the forecasting of financials (already always hard to do) even harder. We have Hearthstone impacting total revenue, store count changing, refreshed stores impacting growth, and “non-refresh” organic growth. Since we want to be able to measure progress on a baseline when the 3Q report comes out, we developed the following baseline 3Q numbers:

Item	$mm or %
2014 3Q Revenue, actual:	18.6
+ Hearthstone	5.3
- Closed Stores	-1.7
Base Comparison Revenue	22.2

% of stores refreshed (6/78):	7.69%
Growth on Refresh:	10%
Expected Refresh Growth:	0.2

Organic Growth:	1%
Expected Organic Growth:	0.2

Total Growth:	0.4
Total Revenue:	22.6

	Target 3Q 2015

Revenue	22.6
Food Costs (fixed in %)	6.1	27%
Labor (fixed in %)	7.9	35%
Occupancy (fixed in $)	8.5	37.8%

Gross Profit	0.0	0.21%

Essentially, we are looking for COSI to be flat to marginally profitable on a four wall basis in the third quarter.

Finally, we turn to liquidity. Key takeaway is that the cash position is good at $13.9mm, but it may not be sufficient.

$13.9mm as of June 30 plus $5 million in restricted cash.
$8.4mm cash burn, 3 quarters at current cash burn rates, until end of March which is when RJ said the refresh would be done
$3.7mm to refresh all the remaining 49 stores (55 total - 6 done) at $20k to $150k, $75k average
That leaves a budget of just $1.8mm for a marketing campaign and or slippage in those forecasts. Without including restricted cash, it is tight. Which means that unless the refresh is sufficient to drive growth of 10% or more they may need to raise capital.

Management remains extremely positive on the outlook for sales and the results of the refresh. I have yet to meet (thankfully) the management team with a negative attitude, but we are cognizant that RJ and team have access to the numbers for the first month and a half of Q3. At this point, we have confidence that the right team is in place. But that being said, here is a timeline of management’s expectations over the last year and a half and the reality:

Cosi’s Statements

Spring 2014: “We know how to fix it, we know what needs to be done.”
Spring 2015: “Will be cash flow positive by Q4 2015”
Spring 2015: “We will implement new streamlined menu Boards”
Spring 2015: “New York City refreshes will be completed by second week of July”
Summer 2015: “We will not need to raise capital in the next 12 months.”

Reality

Q2 earnings should have shown improvement at the unit level without the refreshes and without the Hearthstone contribution based on “We know how to fix it”.
On the Q2 Call, it became obvious that Cosi won’t be cashflow positive in Q4.
New Menu Boards were introduced in May and June but the were overcrowded and very hard to read. New menu boards have arrived on August 18 and they look much better. Finally!
We toured the NYC locations during the second week of July and we were disappointed with the refresh cadence in NYC.
There is no certainty and we doubt that the performance improvement will be sufficient to cover the cash needed up to the first half of 2016.

While disappointed, we know that this is the nature of a turnaround. It takes time and it is usually much slower than what is represented by management. It is just the way it is. We are happy to participate in the early part of a turnaround because we view our role as an agent for change and welcome our participation in catalyzing the situation. Early participation gives us a front row seat for learning about how management thinks at time zero which is essential to benchmark progress against our thesis.

Now, the ball is clearly in the management team’s court and they must execute. We need to see propagation of the Hearthstone metrics through the entire system in addition to the benefit of the refreshes. It is that simple.

P.S. We welcome COSI's Directors and management recent stock purchases.

Jennifer Galperin. Follow me on Twitter and Stocktwits.

Michael Bigger. Follow me on Twitter and StockTwits.