COSI Conference Call Notes 5/14/2015

Some notes from the call: 

• Refreshes will be completed by 2016 Q1.
• 3 components to refreshes: Physical, efficiencies, Hearthstone leverage.
• Early indication...double digit comp growth after a full refresh.
• Hearthstone merger will contribute $2.4mm in incremental cash flow to COSI in 2015.
• They will remodel 55 of the 64 stores.
• Cash flow + target in Q4 2014 intact.
• Fully diluted # shares 47.805399mm shares.
• No more capital raise needed.
• Menu refresh should be complete by end of May. 
• Menu count should drop by 25%.
• From that base they will experiment with new additions and substractions.
• New entrants into fast casual space not causing real concerns because fast casual is such a small piece of the overall pie however it makes acquiring real estate much harder.
• Both traffic and average check size increased in the first quarter.
• All three cost categories (food, labor, and occupancy) went up in the first quarter.  This is disappointing.  We have written about the need to cut labor and occupancy costs, and we are looking for signs that these costs are turning.  RJ indicated that this is happening in Q2.
• RJ is getting things in place that have been long neglected: Management team, technology.

Of interest: Cosi Investment Thesis

Jennifer Galperin. Follow me on Twitter and Stocktwits.

Michael Bigger. Follow me on Twitter and StockTwits. 

Updated Investment Thesis: Cosi

This post was amended on May 5th, 2015 to correct a mistake we made about the level of Hearthstone indebtness on the acquisition date. We increased the amount of debt by about $6 million. 

Price: $2.72 (4/14/2015)

Enterprise Value: $107mm

Debt: $12.6mm

Cash: $29.3mm calculated as:

• $21.6mm on the balance sheet as of 12/29/14

• + $10.8mm ($15.5mm Cash Proceeds from Secondary, less $4.7mm Debt Paydown)

• - $3 mm burned in Q1

Shares Outstanding: 47.8mm

Summary

• We project a goal of $14.5mm in annualized EBITDA in the medium term based on improved revenues and gross margins.  

• We believe COSI has medium-term upside to $4.30.  The stock price could get to $6.27 using metrics closer to the Hearthstone metrics for the overall system.  

Background

COSI Restaurants is a brand that resonates with many busy office workers in cities like New York and Boston.  The food is good, the bread is fresh, and it smells fantastic.  But management has struggled to grow the company profitably, and the stock has declined dramatically since its peak of about $45 in 2006.  We have been following the company for quite a while, looking for an opportunity when a turnaround might be imminent.  

We first started blogging about COSI in June of last year, shortly after RJ Dourney took over as CEO in March of 2014. It took no time to convince ourselves we were on to something and we started buying the stock at about $1.10 and have since increased our position at much higher prices.

RJ is a veteran of the restaurant industry with experience growing Applebees and Chili’s, and turning around Au Bon Pain.  Dourney began his relationship with COSI in 2005 as a franchisee and quickly developed a formula for operating his restaurants successfully.  His company, Hearthstone, grew from 5 to 13 profitable locations in and around Boston by 2014. This is quite an accomplishment since the parent company has accumulated more than $300mm in net negative earnings over its lifetime.  So when Dourney took the reins at COSI, we knew we needed to meet him.  After literally stumbling and breaking my leg, I finally organized the trip in August 2014, the day after Janus bought 20% of the company.  We think RJ is the right leader to turnaround the fortunes of COSI at the corporate level and turn it into the next PNRA or CMG.  With Janus on the shareholder list, our conviction got even stronger.

Market

Cosi operates in the fast casual dining market. This is a great space for two reasons.  First, fast casual is a growing area filling the void between low-quality fast food and higher quality restaurants that require a full hour for lunch.  At Cosi (and competitors Panera and Chipolte, to name a few), customers can get a delicious lunch in just a few minutes. Second, Americans are moving toward high-quality, healthy food. Cosi makes all its bread in-store, which means the bread contains simple ingredients and tastes fresh.  Most people could eat at Cosi almost 5 days a week due to the large variety of healthy menu options.  Check out this video to see what we mean: youtu.be/-A0eG0s2x9Q.  

So, we establish that Cosi has a great brand with an experienced, motivated management team in place and a business model that is proven in Boston.  The task ahead is to implement the model system-wide and, once the company is profitable, to gain operational leverage by expanding the number of restaurants.  

Financials - Updated as of 12/29/2014 - 10K Filing

COSI has 64 company-owned locations (58%) and 47 franchises locations, for a total of 111 restaurants.  Here is a breakdown of revenues and costs for the company-owned stores:

	Cosi 2014			Cosi 2013			Cosi 2012
	$mm	% of revenues		$mm	% of revenues		$mm	% of revenues
Revenue	75			83			95
Food Costs	20.1	26.80%		21	25.30%		22	23.16%
Labor	29	38.67%		32	38.55%		34	35.79%
Occupancy	27.7	36.93%		29	34.94%		30	31.58%
Gross Profit	-1.80	-2.40%		1	1.20%		9	9.47%

A few things are interesting about the numbers, and in particular the trends.  To state the obvious, revenues have been declining.  In our view, this is merely a statement of the problem.  Poor management and limited capital investment have led to significant deterioration of the culture, physical stores and brand image.  

In addition, COSI has steadily been closing stores.  COSI began 2012 with 80 company-owned stores.  By the beginning of 2013, that was 75 stores, and by the beginning of 2014 just 70 stores.  At the end of 2014 there were only 64 company-owned stores, or 80% of the January 2012 store count.  So a 21% decrease in company-owned store revenue is not surprising given the 20% decrease in store count.  But we think there is a ton of potential to increase improve the culture at the employee level, refresh the stores, and restore what is truly a great brand.   

When Dourney took over Au Bon pain in 2000 the AUV was $1.1mm and 5 years later it reached $1.7million. In our previous post, we discussed how each of RJ’s Boston franchise stores are generating about $1.75mm in AUV.  Currently the company-owned stores are generating about $1.2mm in AUV.  If he and his team can successfully implement the Hearthstone formula system-wide, even at $1.6mm AUV * 64 company-owned restaurants =  $102mm in top-line revenues.  We don’t expect this to happen overnight, but with patience we expect current Cosi restaurants to reach this goal.  Add to that the 15 Hearthstone restaurants, of which 13 are standalone locations (2 are kiosks) at current $1.75mm AUV per standalone location for a contribution of $23mm to top-line.  So total potential of $125mm revenue from company stores system-wide. Moving over to the costs, we see an increase in all 3 cost categories as a percentage of sales from 2012 to 2014.  Food Costs, Labor Costs, and Occupancy cost (in %) all increased during the time period.  In order to be profitable, these costs will need to decrease as a percent of revenues.  Now, 2014 really was a transitional year for COSI.  RJ Dourney made a lot of changes to the team, culture, and systems.  Change is never without friction, so we expect costs to go up temporarily as part of the transition.  Based on RJ’s comments in presentations and earnings calls, it seems he feels much better positioned in early 2015 for success.  So we will be very focused on the cost components to see if we start to see an inflection point where they start to move down.  

In our previous post, we discussed our medium- to long-term targets for each of these cost categories in percentage terms and our reasoning behind those targets.  We think food costs should come down slightly to 25% of revenues, labor costs can come down significantly to 30%, and occupancy costs can also come down significantly to 25%.  

So the goal is set at $125mm in revenue from company-owned stores on current store count with the following cost breakdown:  

	$mm	% of revenues
Revenue	125
Food Costs	31.25	25.00%
Labor	37.5	30.00%
Occupancy	31.25	25.00%
Gross Profit	25	20.00%
G&A	12.5	10.00%
EBITDA	12.5	10.00%

For comparison, Hearthstone generated 16% of economic EBITDA margin (grossed up for the franchise fee) in 2014, making our 10% EBITDA margins quite conservative.  Even our most aggressive best-case margin assumption of 12% is conservative relative to the Hearthstone TTM numbers.

Cash and Capitalization

One of the biggest issues facing turnaround candidate companies is cash flow.  Change costs money, and companies with negative cash flow are typically tight on cash.  While management has implemented many changes, there is still substantial work to be done in terms of improving and updating the look of the restaurants.  These improvements will cost money.  In 2014, the team successfully raised over $25mm in debt and equity capital.  As a result, the company had over $21mm in cash on the balance sheet as of year end.

• On May 20, the company placed a $2.5mm note with AB Opportunity Fund and AB Value Partners.  

• On August 19, COSI issued equity in a $4.5mm private placement transaction to Janus and an existing shareholder.

• On December 12, the company completed a rights offering that raised $19.7mm from existing shareholders.

When we wrote our original thesis back last June, we believed that additional capital was needed for COSI to clean up its act outside Boston.  Clearly management agreed.

Hearthstone Acquisition

On April 1, 2015, COSI announced completion of the acquisition of RJ Dourney’s company, Hearthstone Associates.  The merger was originally discussed as part of his sign-on package.  The owners of Hearthstone (RJ, his wife, and CFO Richard Bagge) get a total of 1.79mm shares of COSI in exchange for Hearthstone, plus COSI assumes $10.7mm in Hearthstone debt.  

On April 10, the company raised $15.5mm of cash via an equity private placement.  The company used $4.7mm of the proceeds to pay down debt acquired in connection with the acquisition, for a net raise $10.8mm. We participated in this round.

We believe the acquisition serves to align RJ’s interests with shareholders, as RJ is trading his interest in a cashflow positive private company with a smaller share in a much riskier cashflow negative COSI corporate entity.  With 10 years experience with COSI as a franchisee and a long career in the chain / franchise restaurant industry, he is in a good position to evaluate the risks.  His decision was to take the opportunity. This gives us comfort with our long position. 

Balance Sheet

As of the 12/29/14 B/S, the company had $21.6mm in cash on the balance sheet and $6.6mm in debt.  In early April 2015, the acquisition of Hearthstone closed and the company raised over $15mm in new capital. Here is how we believe the balance sheet will look: 

Balance Sheet, $ in thousands	12/31/2013	9/29/2014	12/29/2014	Projected 3/31/15	Pro-Forma for Hearthstone & Equity Issuance
Cash	$6,021	$6,113	$21,560	$18,560	$29,327
A/R	$594	$799	$581	$581	$717
Inventories	$779	$768	$825	$825	$1,018
Other Current	$1,899	$1,005	$1,830	$1,830	$1,635
Total CA	$9,293	$8,685	$24,796	$21,796	$32,698
FFE	$8,195	$6,768	$7,308	$7,308	$9,021
Other LA	$1,115	$1,411	$1,327	$1,327	$1,327
Total LA	$9,310	$8,179	$8,635	$8,635	$10,348
Total Assets	$18,603	$16,864	$33,431	$30,431	$43,046
A/P	$2,462	$3,023	$1,519	$1,519	$1,875
Accrued Exp	$9,088	$6,591	$9,336	$9,336	$9,336
Current Portion	$214	$515	$195	$195	$0
Total SL	$11,764	$10,129	$11,050	$11,050	$11,211
Long-term Debt	$0	$6,154	$6,623	$6,623	$12,623
Deferred Franchise Revenue	$1,931	$1,966	$1,724	$1,724	$1,724
Other LL	$2,189	$1,530	$1,663	$1,663	$1,663
Total LL	$4,120	$9,650	$10,010	$10,010	$16,010
Common Stock	$181	$245	$383	$383	$383
APIC	$297,181	$303,571	$323,256	$323,256	$332,723
Treasury Stock	-$1,198	-$1,198	-$1,198	-$1,198	-$1,198
Retained Earnings	-$293,445	-$305,533	-$310,070	-$313,070	-$316,084
Total E	$2,719	-$2,915	$12,371	$9,371	$15,824
Total L+E	$18,603	$16,864	$33,431	$30,431	$43,045
Shares Out (mm)			38.4	38.4	47.8

Notably, there is cash available for the capital improvements we know are necessary.  

Valuation

Pulling it all together, we take our medium-term target numbers:

Restaurant Net Sales: $125mm

Gross profit margin: 20%

Gross Profit from Company-Owned Stores: $25mm

Franchise Revenue: $2.0mm ($2.8mm less $0.8mm from Hearthstone)

Total Gross Profit: $27mm

General & Administrative Expenses: $12.5mm

Projected EBITDA: $14.5mm

Competition’s EV/EBITDA multiples are at 11x for PNRA and 28x for CMG. If we use a conservative EV/EBITDA multiple of 10x, you get an EV of $145mm for the combined entity.  Total debt: $12.6mm      

Total Cash: $29.3mm

Market cap = EV - Debt + Cash: $161.7mm.  

NOL’s of $225mm: $44mm (Assuming 50% haircut to valuation)

Total Value: $206mm

Shares Outstanding 47.8mm   

Stock price of $4.30 with reasonable / conservative assumptions.  And that is without expanding store count at all.

Boundary Condition Valuation:

We have made some conservative assumptions.  Let’s now push it to the limit and see what the valuation looks like if RJ can get the rest of COSI to look exactly like Hearthstone in terms of AUV and EBITDA margin:

Restaurant Net Sales @ $1.75mm AUV: $135mm

EBITDA Margin: 12%

EBITDA from Company-Owned Stores: $16.2mm

Franchise Revenue @ $1.75mm AUV: $3.4mm

Total EBITDA: $19.5mm

EV @ 10x EV/EBITDA Ratio: $195mm

Total Debt: $12.6mm

Total Cash: $29.3mm

Market cap = EV - Debt + Cash: $212mm

NOL’s of $225mm (no haircut): $88mm

Total Value: $300mm

Shares Outstanding 47.8mm

Stock Price (incl. NOL’s): $6.27

So it is theoretically possible for the stock to get to $6.27 without any expansion of store count.

How Big Can Cosi Become?

Now let’s talk about growing store count.  This is the fun part of the analysis because we get a glimpse into the long-term potential for the company.

Now, the first priority for RJ and team is to get the current store base in order, and get to both the revenue and EBITDA margins goals we discuss above.  But in the long-term, there is huge potential for growth.  Cosi has 111 stores currently with a mix of 70% company-owned / 30% franchise post-Hearthstone acquisition.  Panera has 1810 locations with a mix of 50% company-owned stores and 50% franchise locations as of July 2014.  RJ believes there are about 2000 potential locations nationwide.  So long-term, with a profitable operating model at the store level, there is significant room for expansion in terms of store count.  

Even with 10x = 1110 total stores and the current 70/30 split between company-owned and franchise, the company could be worth a multiple of our projected numbers.  It is going to take time and capital to get there, but the team is already laying the groundwork for this type of success.

We think the Cosi team will focus on implementing the Boston processes throughout the organization over the next year. Once all of Cosi is ready to serve up an amazing experience, we believe RJ will press the pedal to the metal from a public relations and marketing standpoint.

Conclusion

As you can see, we believe there is tremendous opportunity in COSI if RJ and team can right the ship and get it headed in the correct direction.  Based on our meetings and discussions with management, we feel confident in their ability to do so.

We exercised our rights to purchase shares in the December rights offering, and we participated in the April 2015 deal.  

Of interest: New CEO Lights a Fire in the Ovens at Cosi 

Jennifer Galperin. Follow me on Twitter and Stocktwits.

Michael Bigger. Follow me on Twitter and StockTwits. 

Disclaimer: Bigger Capital and related entities are long a sizable position in COSI. COSI is in a turnaround mode and it is not suitable for the majority of investors. The likely outcome of an investment is a loss of principal. Take our opinions with a grain of salt. If you find yourself relying on our views to make an investment decision it means you definitely did not do your homework about this situation.

RMG Networks Investment Thesis

 

Stock Price: $1.50 (Deal Price $1)

Shares Outstanding (Assuming Conversion): 37.2mm

Market Cap: $56mm

Debt: $2.2mm

Cash: $14.7mm + $5.5mm for Media Biz

EV: $38mm (includes $5.5mm for the sales of the media business and no allocation for Q4 and Q1 cash burn)

Sales: About $62mm on a TTM basis. $46 mm not including media business.

Summary

• Stock price down about 90% in about 18 months.  

• Impressive customer list including 70 of the Fortune 100 and about half of the S&P500.

• New, experienced, motivated CEO.

• Earnings Power = 15% EBITDA margin

• Debt significantly reduced due to recent equity financing.

Investment Thesis

RMG Networks (RMGN) operates in two distinct segments, Media and Enterprise Software .  In Media, they focus on the airline seatback content delivery space.  In Enterprise Software, RMG provides video tools for production analytics and internal communications for corporate uses in 5 distinct sectors.  RMG’s impressive Enterprise Software customer list includes 70 of the Fortune 100 companies, and about 70 percent of the S&P 500.  

Roth Capital Partners recently introduced us to Bob Michelson, the President and CEO of RMG Networks. Michelson took over as CEO in the summer of 2014.  He has a background in operations and strategy for Sterling Capital Partners, and came on board to return the company to profitability and growth.  As an aside, we know Sterling from a previous investment in Select Comfort (SCSS) in 2009. We rode SCSS from $.90 to $24 in just a few years (Article). Needless to say, we are impressed by how Sterling transformed SCSS. Michelson could transform RMGN into a real winner for us.

Michelson quickly identified several issues that he believes contributed to the company’s losses.  For each, he devised a solution that could be implemented quickly.  

First, he feels the Enterprise Software division lacks focus.  He identified 3 of the 5 operating sectors to focus on, and essentially eliminated the remaining 2 non-core sectors.  Michelson  will focus on 1) Supply Chain,  2) Call Centers, and 3) Internal Communications.  He eliminated the Retail and Hospitality sectors, although he plans to continue to service existing customers in these areas.  

Second, Michelson felt RMG had not delivered innovation to its customers which degraded the salesforce narrative.  Specifically, RMG had introduced zero new products to the market in 3 years.  He challenged the company to roll out 6 new products in 6 months, by generalizing some of their best one-time customer solutions.  To date he has rolled out 3 products in 3 months, including software to facilitate office hoteling.

His other turnaround solutions included rethinking the global expansion strategy, developing a new marketing strategy focusing on the value proposition of the key products, and improving the sales leadership structure. In addition, on March 19th, RMG disclosed that it signed a non-binding letter of intent to sell its media business for $5.5mm.

Strategically, RMG is moving Enterprise Software more towards a Software-As-A-Service (SAAS) model and away from the traditional licence purchase model.  While revenues may experience a decline during the transition, we feel the move will improve the sales experience and provide more smooth, consistent revenues for RMG.

In 2014, the company recorded total revenues of $61.8mm (including $14.8mm from the media business). RMG plans to be cashflow positive by the third quarter of 2015 through implementation of the turnaround initiatives.  According to Michelson, the supply chain business has the most near-term opportunity for revenue growth.  That business line generated less than $1mm of the total 2014 revenue, but the current pipeline in this channel is $8mm and the potential for this market is in the range of $50mm / year medium-term.  

If Michelson and team can successfully execute on his turnaround initiatives, a rough income statement looks something like this on an annual basis, medium-term (2-3 years out):

Revenue: $100mm ($50mm current from call centers + $50mm potential from supply chain)

EBITDA: $15mm (15% margin) (source: management)

EV @ 10x EBITDA: $150mm

Debt: $0

NOL’s Valued at: $10mm ($30mm of NOL’s valued conservatively at $10mm)

Total Value: $160mm

Shares Out: 37.2mm

Share Price: $4.30

If Michelson and team can increase call center revenues beyond the 2014 numbers, there is additional upside in our projections.  

On March 9, RMG announced that it expects sequential adjusted revenue growth to exceed 30% in the fourth quarter with stable adjusted gross margin and improved adjusted EBITDA. Michelson is already making a big impact.

On March 25, the company announced a new financing which goes a long way in shoring up RMG’s balance sheet and eliminating its debt.  We are happy to participate in the deal.

Overall, we are very excited about the opportunity to invest in a cheap company with an impressive client list including 70% of the Fortune 100.  We think there is tremendous upside potential.  While there is downside risk, we think the stock price is at a level where the risk / reward analysis is quite favorable.

Written by Jennifer Galperin and Michael Bigger.

Disclaimer: Bigger Capital and Bachelier, LLC are participating in the preferred shares transaction. RMGN is a highly distressed situation and it is not suitable for the majority of investors. The likely outcome of an investment is a loss of principal. In other words, the probability of losing all your investment in this situation is very high. 

BIGGER CAPITAL WARNS AGAINST STANDARD GENERAL CONFLICTS OF INTEREST AT AMERICAN APPAREL

BIGGER CAPITAL WARNS AGAINST STANDARD GENERAL CONFLICTS OF INTEREST AT AMERICAN APPAREL

Notes That As a Result Of Interest Payments In Stock, Possible Charney Default And Lender Status, Standard General Has Every Incentive To Hold Out On a Sale Of The Company

Cautions against Standard General-Dominated Board Failing to Capitalize on Acquisition Interest in American Apparel Contrary to the Best Interests of ALL Shareholders

New York, NY – January 23, 2015 – Bigger Capital Fund, LP, Bachelier, LLC and the Bigger Family, significant shareholders since 2011 of American Apparel, Inc. (NYSE: APP) (“American Apparel” or the “Company”), today announced that they have delivered a letter to American Apparel’s Board of Directors.  The full text of the letter is included below: 

January 23, 2015

Board of Directors

American Apparel, Inc.

747 Warehouse Street

Los Angeles, California 90021

Dear Members of the Board of American Apparel:

The Bigger Capital Fund, LP, Bachelier, LLC and the Bigger Family (together, “Bigger Capital”) is a significant shareholder of American Apparel, Inc. (NYSE: APP) (“American Apparel” or the “Company”).  We are a long-term investor in the Company and we have followed closely and with great concern the haphazard developments at American Apparel over the past years  and the loss of value that has resulted from them.  We write to you today to register our grave concerns over the serious conflicts of interest between Standard General L.P. (“Standard General”) on the one hand, and the rest of the American Apparel shareholders, on the other, which given Standard General’s de facto control in the boardroom may cause the Company’s Board of Directors (the “Board”) to make decisions that are contrary to the best interests of all American Apparel shareholders. 

In July, Standard General negotiated the right to replace five of the seven directors on the Board with three of its own designees and two designees mutually agreed upon by Standard General and the Company under a Nomination, Standstill and Support Agreement, dated as of July 9, 2014, between Standard General, Dov Charney and the Company (the “Agreement”).  This Board composition arrangement gives disproportionate power to Standard General and for all practical purposes, effective control over critical decisions for the Company and all its shareholders.

Moreover, according to public filings, Standard General owns 1,540,000 shares of American Apparel and has a security interest in an additional 74,560,813 shares owned by Dov Charney pursuant to their agreement dated June 25, 2014 (the “Charney Agreement”).  Under the Charney Agreement, Standard General purchased 27,351,407 shares of American Apparel and then sold them to Mr. Charney after providing him with a loan to purchase such shares, which bears an interest rate at 10% per annum, payable to Standard General in American Apparel shares.

In short, the Charney Agreement is structured so that with the passage of time, Standard General’s ownership position increases from the interest payments in shares and in the event of a default by Dov Charney, Standard General will become entitled to receive another sizable chunk of American Apparel shares pledged under the Charney Agreement.  Given Mr. Charney’s recent comments in the media that he is down to his last $100,000 a default appear quite possible if not likely.  As a result, the Charney Agreement creates every incentive for Standard General to resist any sale of the Company regardless of the price offered at least until Standard General has collected the full benefits of its deal with Dov Charney.  Needless to say, it does not appear that Standard General will be a very motivated seller.

While Standard General has no interest to sell out, not so for the rest of American Apparel’s embattled shareholders.  Most of us who have remained invested in the stock over the long-term have seen our stakes diminish dramatically in value with the tumultuous events over the past year or so.  Uncertainty about the Company’s leadership and strategic direction as well as questions about American Apparel’s prospects as a standalone business have significantly depressed the Company’s stock price.  This undervaluation has made American Apparel a very attractive acquisition target.  For example, as reported on December 18, 2014, Irving Place Capital approached American Apparel regarding a potential transaction valuing the Company at as much as $1.40 per share, a 103% premium from the previous day’s closing price of $0.69, causing American Apparel shares to soar nearly 45%.  We believe other interested potential acquirors may emerge as well.  It is clear to us, that the timing is right to capitalize on the acquisition interest in American Apparel and pursue a value-maximizing transaction to unlock value for shareholders.

Not only are the interests of Standard General in conflict with those of the other shareholders in terms of the upside to a prompt sale of the Company, but also Standard General does not face the same downside from missing value-maximizing opportunities as other shareholder do.  Standard General is also a lender to the Company. On July 16, 2014, Lion/Hollywood L.L.C. (“Lion”) assigned its rights and obligations as a lender under its Credit Agreement, dated as of May 22, 2013 with the Company to Standard General. As disclosed in the Company’s Quarterly Report filed on November 10, 2014, nearly $9.9 million was outstanding under the Credit Agreement as of September 30, 2014.  This means that even if the stock were to become worthless, Standard General will have the right to be repaid its loan in any liquidation or similar proceeding.  This effectively caps Standard General’s downside risk from the loss of value of American Apparel’s stock.

These conflicting interests between Standard General and the other American Apparel shareholders put the Standard General-dominated Board in a delicate position but with only one responsible course of action.  The Standard General-dominated Board must comply with its fiduciary duty to serve the bests interests of all shareholders and must resist the temptation to do what is best for Standard General alone to the detriment of other shareholders.  The coming days will be the true test to the Board’s fulfillment of its duties.

We will also closely monitor Standard General for any attempt to inappropriately interfere with the governance of American Apparel to extract unique benefits for itself that other shareholders do not share.  As a de facto controlling shareholder, Standard General, too, has important duties and responsibilities to the minority shareholders.  Bigger Capital has every intention of remaining alert and focused on the actions of the American Apparel’s Board, Standard General and its representatives on the Board and will consider all actions it deems necessary to protect the interests of the minority shareholders of American Apparel.

Sincerely,

Michael Bigger

Bigger Capital Fund, LP

Bachelier, LLC

631-987-0235 

Investment Thesis: COSI

Price: $2

Enterprise Value: $63mm

Debt: $6.1mm

Cash: $23mm

EBITDA: -$12MM

 

Summary

●     We project $15.3mm in EBITDA based on improved revenues and gross margins. 

●     We believe COSI has medium-term upside to $5.10 with our best case-case scenario calling for a stock price of $7.28 using the Hearthstone metrics for the overall system. 

Background

We have been closely following Cosi ($COSI) since RJ Dourney took over as CEO in March of 2014. Dourney is a successful COSI franchisee, making profits at 13 locations in and around Boston. This is quite an accomplishment since COSI has accumulated more than $300mm in net negative earnings over its lifetime, a testimony to poor management of the parent company over that time period.

I first spoke to RJ back in June and in one conversation, I had confidence that he is the right guy to turn around COSI’s fortunes.  After we met him and his team and toured some of his Boston locations on August 20, it became clear to us that RJ has a formula for success in the fast casual arena.  His locations are clean, efficient, and profitable.

RJ Dourney began his relationship with COSI as a franchisee in 2005.  At that time he chose COSI because he believed there is a unique brand essence, with fresh baked bread and healthy menu options.  He and his corporate entity, Hearthstone, opened 5 stores in Boston and grew to 13 locations by 2014.  All of the Hearthstone locations are operating successfully and profitably.  In March of last year, Dourney became the new CEO of the company.

Dourney is wasting no time integrating his successful strategy into the company-owned locations. He mixes together fresh ingredients, clean and organized locations, and an efficient labor force to bake up profits. Long-term, if RJ and team are successful, COSI’s growth trajectory could match the growth of Chipotle ($CMG) and Panera ($PNRA).  This situation has strong potential.

RJ hit the ground running with his turnaround plan for COSI corporate.  In just a few short months, he hired a new VP of HR, an operations expert, and an  IT manager.  He began to implement the operating system from the Boston locations across the company-owned stores.  He is reviewing the culinary component and is happy with the results so far.  He moved the corporate office from a 27,000 sqft facility outside of Chicago to a 6,000 sqft facility near Boston.  He hired HILCO to help the company get out of some of it’s bad leases.

RJ’s formula for operational success at COSI involves cleaning up the stores, increasing labor efficiency, and making the brand more current in line with the Boston model. 

Market

Cosi operates in the fast casual dining market. This is a great space for two reasons.  First, fast casual is a growing area filling the void between low-quality fast food and higher quality restaurants that require a full hour for lunch.  At Cosi (and competitors Panera and Chipolte, to name a few), customers can get a delicious lunch in just a few minutes. Second, Americans are moving toward high-quality, healthy food. Cosi makes all its bread in-store, which means the bread contains simple ingredients and tastes fresh.  Most people could eat at Cosi almost 5 days a week due to the large variety of healthy menu options.  Check out this video to see what we mean: youtu.be/-A0eG0s2x9Q. 

Anecdotally, Cosi recently rolled out a more high-quality chicken product along with with a price increase to cover the cost. RJ said that not one single customer complained about the higher price.  They noticed it, but are more than willing to pay for the uptick in quality.  So clearly there is a need for high quality, fast, healthy food. 

So, we establish that Cosi has a great brand with a great management team in place and a business model that is proven in Boston. 

Financials

COSI currently has 66 company-owned locations (58%) and 47 franchises locations, for a total of 113 restaurants.  Here is a breakdown of revenues and costs for the company-owned stores during the first half of 2014:

COSI 1H2014:

	$mm	% of revenues
Revenue	38
Food Costs	9.5	25.00%
Labor	14.5	38.16%
Occupancy	14	36.84%
Gross Profit	0.00	0.00%

Compare that to Chipotle and Panera 1H2014:

	CMG			PNRA
	$mm	% of revenues		$mm	% of revenues
Revenue	1954			1091
Food Costs	675	34.54%		302	27.68%
Labor	436	22.31%		298	27.31%
Occupancy	321	16.43%		227	20.81%
Gross Profit	522	26.71%		264	24.20%

A quick glance of the numbers shows you that Cosi's Labor and Occupancy costs are significantly above that of the competition, while food costs are significantly below.  RJ and team are focused on increasing labor efficiency as a critical piece of their turnaround strategy.  If they can get labor costs down to 30%, the picture looks like this:

COSI Target Labor Costs:
	$mm	% of revenues
Revenue	38
Food Costs	9.5	25.00%
Labor	11.4	30.00%
Occupancy	14	36.84%
Gross Profit	3.10	8.16%

Now let's talk about Occupancy costs.  COSI is spending 35% of revenues on occupancy costs, this should be closer to 25%.  Now, occupancy costs are at least partially a fixed cost, so the problem can be broken out into (a) revenues per restaurant are too low, and (b) lease costs are too high.  RJ and team are clearly aware of both issues.  Let's start with revenues. 

COSI operates 63 restaurants and has an additional 47 franchise restaurants.  If RJ and team can successfully bring the Hearthstone (RJ’s corporate entity) AUV numbers to the entire organization, AUV would go from $1.1mm to $1.75mm system-wide.  That means $110mm in annual top-line revenues, plus another $4.1mm in franchise revenue, for a total of $114mm in revenues.  This is a 48% increase over the $77mm in annualized revenue based on the nine months ended September of this year.  Even if AUV increases to $1.6mm / store, that means $100mm in annualized revenues.

Now, to address (b), they hired a real estate workout company to help them terminate and / or renegotiate some leases and there is likely some wiggle room.  Between increasing revenues per store and renegotiating leases, management believes a long-term run rate for occupancy cost should be closer to 25% of revenues:

	COSI Target Occupancy Costs
	$mm	% of revenues
Revenue	100
Food Costs	25	25.00%
Labor	30	30.00%
Occupancy	25	25.00%
Gross Profit	20	20.00%
G&A	10	10.00%
EBITDA	10	10.00%

Now, how does this compare to the numbers Hearthstone is generating?  According to the Hearthstone numbers disclosed in the S-1 for the rights offering:

Hearthstone financials, $mm

$mm		9mo through 9/30/2014	12mo through 12/31/2013
Revenue		$12.6	$16.6
EBITDA		$0.5	$0.9
Franchise Fees	6%	$0.76	$1.0
Pre-Opening Expenses		$0.08
Legal Fees		$0.065
Pro Forma Contribution to Company EBITDA, 13 Stores		$1.4	$1.9
EBITDA Margin		11%	12%

So 11% to 12% EBITDA margin is where RJ is with Hearthstone.  Our target of 10% EBITDA margin for COSI corporate is reasonable.

When Dourney took over Au Bon pain in 2000 the AUV was $1.1mm and 5 years later it reached $1.7million. We expect a similar trajectory for current Cosi restaurants.

Additional Metrics

Here are some metrics that management has shared with our group. The High Street Boston location has an average peak transaction of 500 transactions an hour compared to 300 for the whole Hearthstone. The rest of COSI does a peak of 185-200 transactions an hour. A rock and rolling Chipotle peaks of 260 transactions per hour.

The Hearthstone average unit volume (AUV) is $1.75mm a year. the rest of COSI does $1.1mm.

The industry average employee turnover is 150% while Hearthstone has a turnover of 38%. The industry average management turnover is 35% while the Hearthstone turnover is 11%.

Cash and Capitalization

One of the biggest issues facing turnaround candidate companies is cash flow.  Change costs money, and companies with negative cash flow are typically tight on cash.  RJ views these capital expenditures as an investment in the future of the company, but he needed to get capital from somewhere.  In 2014, the team (led by CFO Scott Carlock) successfully raised over $25mm in debt and equity capital. 

●     On May 20, the company placed a $2.5mm note with AB Opportunity Fund and AB Value Partners. 

●     On August 19, COSI issued equity in a $4.5mm private placement transaction to Janus and an existing shareholder.

●     On December 12, the company completed a rights offering that raised $19.7mm from existing shareholders.

When we wrote our original thesis we believed that sufficient capital was needed for COSI to clean up its act outside Boston.  Clearly management agreed.

Balance Sheet

As of the 9/30/14 B/S, the company had $6.1mm in cash on the balance sheet and $6.1mm in debt.  Given proceeds of $20mm from the rights offering and an estimated quarterly cash burn of $3mm, they should have about $23mm in cash on the balance sheet at year end.  Here is the 9/30 balance sheet.

 

As of 12/31/14, the company will have another $20mm in cash from the rights offering, less cash burn of about $3mm.  We project the balance sheet will look something like this:

Balance Sheet, $mm	12/31/2013	9/29/2014	Projected 12/31/14	Projected 3/31/15 With Hearthstone
Cash	$6,021	$6,113	$23,113	$20,113
A/R	$594	$799	$799	$799
Inventories	$779	$768	$768	$768
Other Current	$1,899	$1,005	$1,005	$1,005
Total CA	$9,293	$8,685	$25,685	$22,685
FFE	$8,195	$6,768	$6,768	$10,226
Other LA	$1,115	$1,411	$1,411	$2,808
Total LA	$9,310	$8,179	$8,179	$13,034
Total Assets	$18,603	$16,864	$33,864	$35,719
A/P	$2,462	$3,023	$3,023	$3,023
Accrued Exp	$9,088	$6,591	$6,591	$6,591
Current Portion	$214	$515	$515	$515
Total SL	$11,764	$10,129	$10,129	$10,129
Long-term Debt	$0	$6,154	$6,154	$16,575
Deferred Franchise Revenue	$1,931	$1,966	$1,966	$1,966
Other LL	$2,189	$1,530	$1,530	$1,530
Total LL	$4,120	$9,650	$9,650	$20,071
Common Stock	$181	$245	$245	$245
APIC	$297,181	$303,571	$323,571	$323,571
Treasury Stock	-$1,198	-$1,198	-$1,198	-$1,198
Retained Earnings	-$293,445	-$305,533	-$308,533	-$317,099
Total E	$2,719	-$2,915	$14,085	$5,519
Total L+E	$18,603	$16,864	$33,864	$35,719

Notably, there is ample cash available for the capital improvements we know are necessary. 

Hearthstone Acquisition

As part of the deal to sign RJ as CEO of COSI, an acquisition of Hearthstone was contemplated.  The acquisition terms say that RJ gets 1.79mm shares of COSI in exchange for Hearthstone, plus RJ transfers anywhere between $6.9mm and $9.2mm in debt (depending on which paragraph of the S-1 you read).  Hearthstone has book assets of $4.85mm.  Total forecasted EBITDA of $2.3mm (pro forma for consolidation and 2 new restaurants). 

To value Hearthstone, we use EV / EBITDA ratios. PNRA trades at 11x and others are around 10-15.  We take a haircut to those valuations and use 7x $2.3mm EBITDA = $16mm EV.  Let's say $10mm in debt, which means the equity is valued at $6mm.  That corresponds to a “purchase” price for RJ of $3.40 / share.  In addition, RJ will receive both time-based and performance-based shares.  The time-based component consists of a total of 414,582 shares, 25% at each anniversary of his start date.  The performance-based component consists of 414,582 shares, 25% at each of $2, $2.50, $3, and $4 share prices.

We believe the deal serves to align RJ’s interests with shareholders, as RJ is trading his interest in a cashflow positive private company with a smaller share in a much riskier cashflow negative COSI corporate entity.  With 10 years experience with COSI as a franchisee and a long career in the chain / franchise restaurant industry, he is in a good position to evaluate the risks.  His decision was to take the opportunity.  This gives us comfort with our long position.

Valuation

Pulling it all together, we take our projected numbers:

Restaurant Net Sales:	$100mm
Gross profit margin:	20%
Net Profit from Company-Owned Stores:	$20mm
Franchise Revenue:	$3.0mm ($3.8mm less $0.8mm from Hearthstone)
Total Gross Profit:	$23mm
General & Administrative Expenses:	$10mm
EBIT:	$13mm
Corporate EBITDA:	$13mm
Hearthstone EBITDA:	$2.3mm
Total Projected EBITDA:	$15.3mm

Competition’s EV/EBITDA multiples are at 11x for PNRA and 28x for CMG.

EV/EBITDA multiple:	10x
EV:	$153mm
Total debt (corporate):	$6.1mm
Hearthstone debt:	$10mm
Total debt:	$16.1mm
Total Cash:	$23mm
Market cap = EV - Debt + Cash:	$160mm.
NOL’s of $225mm:	$44mm (Assuming 50% haircut to valuation)
Total Value:	$204mm
Shares Outstanding:	40mm

Stock price of $5.10 with reasonable / conservative assumptions.  And that is without expanding store count at all.

Boundary Condition Valuation:

We have made some conservative assumptions.  Let’s now push it to the limit and see what the valuation looks like if RJ can get the rest of COSI to look exactly like Hearthstone in terms of AUV and EBITDA margin:

Restaurant Net Sales @ $1.75mm AUV:	$110mm
EBITDA Margin:	12%
EBITDA from Company-Owned Stores:	$13.2mm
Franchise Revenue @ $1.75mm AUV:	$4.1mm
Hearthstone Contribution:	$2.3mm
Total EBITDA:	$19.6mm
EV @ 10x EV/EBITDA Ratio:	$196mm
Total Debt (incl. Hearthstone):	$16.1mm
Total Cash:	$23mm
Market cap = EV - Debt + Cash:	$203mm
NOL’s of $225mm (no haircut):	$88mm
Total Value:	$291mm
Shares Outstanding:	40mm
Stock Price (incl. NOL’s):	$7.28

So it is theoretically possible for the stock to get to $7.28 without any expansion of store count.                                                               

How Big Can Cosi Become?

Now let’s talk about growing store count.  This is the fun part of the analysis because we get a glimpse into the long-term potential for the company.

Now, the first priority for RJ and team is to get the current store base in order, and get to both the revenue and EBITDA margins goals we discuss above.  But in the long-term, there is huge potential for growth.  Cosi has 113 stores currently with a mix of 60% company-owned / 40% franchise.  Panera has 1810 locations with a mix of 50% company-owned stores and 50% franchise locations as of July 2014.  RJ believes there are about 2000 potential locations nationwide.  So long-term, with a profitable operating model at the store level, there is significant room for expansion in terms of store count. 

Even with 5 x = 1130 total stores and the current 60/40 split between company-owned and franchise, the company could be worth multiple of our projected numbers.  It is going to take time and capital to get there, but the team is already laying the groundwork for this type of success.

We think the Cosi team will focus on implementing the Boston processes throughout the organization over the next year. Once all of Cosi is ready to serve up an amazing experience, we believe RJ will press the pedal to the metal from a public relations and marketing standpoint.

Conclusion

As you can see, we believe there is tremendous opportunity in COSI if RJ and team can right the ship and get it headed in the correct direction.  Based on our meetings, we feel confident in their ability to do so.

We have exercised our rights to purchase shares in the December rights offering.  In addition, we plan to increase our position opportunistically.

Abandon Your Intuition

I am reading Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations by Tobias E. Carlisle (Amazon Link). I came across this passage that I want to share with you. Enjoy!

 

Tobias Carlisle granted permission to Michael Bigger to publish this excerpt (click image to enlarge):

American Apparel Books and Records Request

Books and Records Request

Bigger Capital Delivers Second Letter To American Apparel's Board of Directors

Bigger Capital Delivers Second Letter To American Apparel's Board of Directors

States That the Board Must be Immediately Reconstituted to Replace Directors Danzinger and Mayer

Calls for Direct Representation of Minority Shareholders on the Board

NEW YORK, Nov. 14, 2014 /PRNewswire/ -- Bigger Capital Fund, LP, Bachelier, LLC and the Bigger Family, significant shareholders, collectively owning more than 2 million shares, of American Apparel, Inc. (NYSE: APP) ("American Apparel" or the "Company"), today announced that they have delivered a letter to American Apparel's Board of Directors.  The full text of the letter is included below:

November 14, 2014

Board of Directors
American Apparel, Inc.
747 Warehouse Street
Los Angeles, California 90021

Dear Members of the Board of American Apparel:

The Bigger Capital Fund, LP, Bachelier, LLC and the Bigger Family collectively own more than 2 million shares of American Apparel, Inc. (NYSE: APP) ("American Apparel" or the "Company"), which represents an ownership position significantly larger than the aggregate ownership of all members of the Company's Board of Directors (the "Board"), the CEO and the CFO.  We write to you to express our serious and growing concerns with the Company and provide the basis for our conviction that the Board must be immediately reconstituted to replace David Danzinger and Allan Mayer with direct representatives of American Apparel's minority shareholders.

In our letter to you of July 17, 2014, we demanded the immediate resignations of David Danzinger and Allan Mayer from the Board.  We did so because we believe that the lapses in judgment that led to the massive and continuing destruction of shareholder value following the abrupt ouster of the Company's former CEO Dov Charney, have discredited all the members of the prior Board.  Accordingly, Messrs. Messrs. Danzinger and Mayer must be held responsible and should not be allowed to serve as our representatives on the Board. 

We renew our call for the resignations of Messrs. Danzinger and Mayer for a number of reasons.  In the first instance, although we continue to be supportive of the replacement of five directors with three designees of Standard General L.P. and its affiliates ("Standard General") and two designees mutually agreed upon by Standard General and the Company, we are becoming increasingly concerned that the new Board, led by Co-Chairmen Danzinger and Mayer, is not as committed to protect the interests of all shareholders as we had hoped.  For example, this Board never bothered to respond to our July 17th letter or address our concerns in any form.  At a time when the Company is suffering ever widening losses, is embroiled in a much publicized investigation of its former CEO, is still absorbing changes in its senior executive team, and the stock is taking a beating, the Board has a heightened responsibility to soothe shareholder concerns and assure us that all is being done to protect our investment.  Such disregard of minority shareholders especially at this critical time is inexcusable.

We were concerned by Co-Chairman Mayer's statement in a CNBC interview that "The irony is the ally [Standard General] he [Charney] found…turned out to be our [Mayer and Danzinger] ally." We remind our representatives on the Board that their fiduciary duties are to serve the best interests of all shareholders.  In our view, this means addressing the concerns of shareholders like us.  It also means that the Board ought to provide full and fair disclosure of all material events to all shareholders.  There are a lot of questions about the state and the future of the Company and this Board has not done a good job of providing answers.

As things currently stand, American Apparel is continuing to sustain massive losses and erosion of shareholder value persists.  The Company has massively underperformed peers on a profitability basis for years.  For example, while American Apparel's Adjusted EBITDA margin is at 6%, its most comparable companies have significantly higher EBITDA margins on a trailing basis as follows:

Company	EBITDA Margin*
American Eagle Outfitters, Inc.	9%
The Buckle, Inc.	26%
The Gap, Inc.	16%
Hanesbrands Inc.	16%
Urban Outfitters, Inc.	17%
Zumiez Inc.	14%

^* Source: S&P Capital IQ

We believe American Apparel stock is deeply undervalued because the Company has a terrific franchise capable of generating superior EBITDA margins.  Our analysis of the underlying value of American Apparel leads us to conclude that, absent all the uncertainty and extraneous factors that have impacted the stock negatively, the Company's shares could be worth more than $2 per share.  The Company's Board and management need to take a sober look at the valuation gap and the causes for value erosion and provide an honest account to themselves and to all the Company's shareholders of the actions within their control that can unlock value. The market's negative reaction to the latest earnings release is an indication that the market has no faith that the Board as led by Co-Chairmen Danzinger and Mayer would unlock this value.

Perhaps most outrageously the Company spent $5.3 million in legal fees in connection with the ongoing investigation into alleged misconduct by Dov Charney (the "Charney Investigation").  It is of great concern that the Board and its Sustainability Committee have failed to complete the Charney Investigation to date.  The Suitability Committee was supposed to use its reasonable best efforts to conclude the investigation no later than 30 days from July 9, 2014 (subject to extensions that the Suitability Committee determines in good faith are reasonably required).  Four months later no conclusion has been communicated and shareholders remain entirely in the dark regarding the status of the investigation.  The uncertainty surrounding the investigation, the role, if any, of Dov Charney with the Company going forward, as well as the composition of the leadership team, generally, have deeply depressed the price of the Company's stock.  Every day that this Board roils in indecision and fails to provide firm answers is a day that shareholders lose money – both in the markets and as a result of the exorbitant costs associated with the investigative process.  This situation is unsustainable and unacceptable. 

The continued Charney Investigation is not only unduly expensive but is also, in our view, clearly compromised.  We had previously expressed our outrage that Co-Chairman Danzinger, who directly participated in the controversial ouster of Dov Charney was named as one of the three members of the Sustainability Committee conducting the Charney Investigation.  In short, there is undisputed evidence that Danzinger's judgment regarding this matter has been compromised and that he should not in any way be involved in what is intended to be an unbiased and fair investigation. Further, Co-Chairman Mayer has gone on record publicly stating that he will resign if Mr. Charney is proven not guilty in the investigation.  American Apparel's shareholders deserve fair and quick answers to end the uncertainty and stop the value destruction.

It is apparent to us that addressing the issues facing American Apparel requires that the following actions be immediately taken by the Board:

1. The two directors remaining from the prior discredited Board, Messrs. Danzinger and Mayer must immediately tender their resignations.  Messrs. Danzinger and Mayer, together with their fellow directors at the time, directly caused enormous economic and reputational harm to the Company and must take responsibility.
2. The Board must promptly invite direct representatives of the Company's minority shareholders to join the Board and fill the resulting vacancies from Messrs. Danzinger and Mayer's resignations.
3. The Sustainability Committee must act with the utmost sense of urgency to complete the Charney Investigation without further delay.

In summary, we want to stress our conviction that at this critical time for the Company, it is imperative that the Board must conduct itself in accordance with the highest governance standards, representing fairly and vigorously the interests of allshareholders, providing transparency and full disclosure of all material events and addressing the concerns of all its shareholders.  Our expectation is that the Board will immediately engage with us to work constructively towards a solution along the lines laid out in this letter.  Should the Board disregard us again, we stand fully prepared to pursue all available courses of action that we believe necessary to protect shareholder rights and value, including seeking the election of director candidates on the Board of American Apparel.  We look forward to a productive dialogue with the Board.

Sincerely,

Michael Bigger

Bigger Capital Fund, LP
Bachelier, LLC
631-987-0235

Oppenheimer on Experimentation

In Something Incredibly Wonderful Happens, Frank Oppenheimer and the World He  Made Up, Frank Oppenheimer discusses the importance of play and experimentation:

So much time is spent just playing around with no particular end in mind," he wrote: "One sort of mindlessly observes how something works or doesn't work or what its features are, much as I did when, as a child, I used to go around the house with an empty milk bottle pouring a little bit of every chemical, every drug, every spice into the bottle to see what would happen. Of course, nothing happened. I ended up with a sticky grey-brown mess, which I threw out in disgust. Much research ends up with the same amorphous mess and is or should be thrown out only to then start playing around in some other way. But a research physicist gets paid for this 'waste of time' and so do the people who develops exhibits in the Exploratorium. Occasionally though, something incredibly wonderful happens."

 "He asked his friend Bob Karpus, a physicist at the University of California at Berkeley, if he thought there was anything a young person must learn before it is too late, and Karpus's answer was: "play."

Cosi: This Turnarnaround is Fully Baked

We first wrote about $COSI back in June after the first quarter earnings call.  In that post, we described the situation, our small trading position, and our desire to investigate the situation further.

At that time we decided to go to Boston to meet the Cosi team. We wanted to feel how the Cosi experience in Boston differs from what we are experiencing in New York. We wanted to determine if the concept is exportable outside of Boston. In addition, we wanted to determine how much capital the company needs to be funded to success.

We had already determine that if we were satisfied with our investigation we would approach the company to invest $1M directly into the company if it raised an additional $4M.

Unfortunately, our visit was delayed because a member of our team broke her leg. We rescheduled the meeting to August 20th.

On August 19th, the company announced that Janus and a then current shareholder invested $4.5M in the company directly at a price of $1.15 a share. We are happy for the company but bummed out for not having a chance to invest on the same terms...Especially after getting more comfortable that the company meets our criteria for a situation worthy of an investment.

We met RJ Dourney, CEO of Cosi, and many members of his executive team at the Cosi office in Boston on August 20th. Overall we were very impressed with RJ, his team, and the Boston Cosi locations we visited.

RJ joined Cosi as CEO back in March of this year. Prior to that, he was the most successful Cosi franchisee. He owns the rights to the Boston area and approximately 15 locations.  It is now clear to us that RJ has a formula for success in the fast casual arena. His locations are clean, efficient, and profitable. A hedge fund manager told us that he met RJ a few years ago, when RJ was an independent Cosi franchise operator.  He was so impressed by RJ’s franchise business in Boston that he offered to invest directly into RJ's corporate entity, Heartstone. RJ declined. Now that RJ manages Cosi corporate, the opportunity to make an investment in his leadership is available to all of us.

In his few months as CEO of Cosi, RJ has taken aggressive action to move the company towards profitability. He replaced almost the entire executive team, and moved the corporate office from the suburbs of Chicago to downtown Boston.  

RJ’s formula for success in Cosi involves cleaning up the stores, increasing labor efficiency, and making the brand more current in line with the Boston model.  Making these improvements costs money, and the most recent financing round goes a long way toward meeting that goal.  In addition, the capital infusion from Janus made it clear to us that RJ and new CFO Scott Carlock can raise capital to fund this turnaround.  

Overall, Cosi is in a great space for two reasons.  First, fast casual is a growing area filling the void between low-quality fast food and higher quality restaurants that require a full hour for lunch.  At Cosi (and competitors Panera and Chipolte, to name a few), customers can get a delicious lunch in just a few minutes. Second, Americans are moving toward high-quality, healthy food. Cosi makes all its bread in-store, which means the bread contains simple ingredients and tastes fresh.  Most people could eat at Cosi almost 5 days a week due to the large variety of healthy menu options (I don’t think the same could be said for CMG).  Check out this video to see what we mean: youtu.be/-A0eG0s2x9Q

Anecdotally, Cosi recently rolled out a more high-quality chicken product along with with a price increase to cover the cost. RJ said that not one single customer complained about the higher price.  They noticed it, but are more than willing to pay for the uptick in quality.  So clearly there is a need for high quality, fast, healthy food.  

So, we establish that Cosi has a great brand with a great management team in place and a business model that is proven in Boston.  

Currently there are 113 restaurants.  66 of them are company-owned, or 58%.  The balance, 47 restaurants are franchises.  Here is a breakdown of revenues and costs for the company-owned stores during the first half of 2014:

COSI 1H2014:

	$mm	% of revenues
Revenue	38
Food Costs	9.5	25.00%
Labor	14.5	38.16%
Occupancy	14	36.84%
Gross Profit	0.00	0.00%

Compare that to Chipotle and Panera 1H2014:

	CMG			PNRA
	$mm	% of revenues		$mm	% of revenues
Revenue	1954			1091
Food Costs	675	34.54%		302	27.68%
Labor	436	22.31%		298	27.31%
Occupancy	321	16.43%		227	20.81%
Gross Profit	522	26.71%		264	24.20%

A quick glance of the numbers shows you that Cosi's Labor and Occupancy costs are significantly above that of the competition, while food costs are significantly below.  RJ and team are focused on increasing labor efficiency as a critical piece of their turnaround strategy.  If they can get labor costs down to 35% (slightly below the current 38% but a bit closer to PNRA's 22% and CMG's 27%), the picture looks like this:

COSI Target Labor Costs:
	$mm	% of revenues
Revenue	38
Food Costs	9.5	25.00%
Labor	11.4	35.00%
Occupancy	14	36.84%
Gross Profit	1.2	3.16%

Now let's talk about Occupancy costs.  COSI is spending 35% of revenues on occupancy costs, this should be closer to 25%.  Now, occupancy costs are at least partially a fixed cost, so the problem can be broken out into (a) revenues per restaurant are too low, and (b) lease costs are too high.  RJ and team are clearly aware of both issues.  Let's start with revenues.  Each company-owned store is currently generating about $1.1mm to $1.25mm per year in revenues.  RJ’s Boston franchise stores are doing about twice that, closer to $2.25 or 2.5mm.  If company-owned store revenues can increase by around 30% to about $1.5mm / store (so a significant increase but still pretty far away from the Boston stores), we get to $100mm annualized in top-line revenues.

Now, to address (b), they hired a real estate workout company to help them terminate and / or renegotiate some leases and there is likely some wiggle room.  Between increasing revenues per store and renegotiating leases, management believes a long-term run rate for occupancy cost should be closer to 25% of revenues:

	COSI Target Occupancy Costs
	$mm	% of revenues
Revenue	100
Food Costs	25	25.00%
Labor	35	35.00%
Occupancy	25	25.00%
Gross Profit	15.00	15.00%

That puts gross profits a little closer to the competition, with about 10% additional room to improve even from there.

Given that the current market cap is $25mm, It seems like a tremendous opportunity to invest in a company with potential gross profit of $15mm from company stores + another $3mm of franchise revenues = $18mm.  And that is on the same store count, before we even consider growing store count.

Now let’s talk about growing store count.  Now, the first priority for RJ and team is to get the current store base in order.  But in the long-term, there is huge potential for growth.  Cosi has 113 stores currently with a mix of 60% company-owned / 40% franchise.  Panera has 1810 locations with a mix of 50% company-owned stores and 50% franchise locations as of July 2014.  RJ believes there are about 2000 potential locations nationwide.  So long-term, with a profitable operating model at the store level, Cosi could expand to rival Panera’s size in terms of number of locations.  Even with 10 x = 1130 total stores and the current 60/40 split between company-owned and franchise, the potential is huge:

	$mm	% of revenues
Revenue	1000
Food Costs	250	25.00%
Labor	350	35.00%
Occupancy	250	25.00%
Gross Profit	150.00	15.00%

$150mm in gross profit from company-owned stores + $30mm in franchise revenues (10x current $3mm) is $180mm in total gross profit.  Even if net profit is half that, so $90mm, at a P/E of 10x (PNRA is at 20x), the company could be worth $900mm in the long-term.  That is about 30x the current market cap.  It is going to take time and reinvestment capital to get there, but the team is already laying the groundwork for this type of success. We think the Cosi team will focus on implementing the Boston processes throughout the organization over the next year. Once all of Cosi is ready to serve an amazing experience, we believe RJ will press the pedal to the metal from a public relations standpoint. It might take a year or two to bring revenues closer to its potential. At that point, we think Cosi will start expanding aggressively. This is a five years story at a minimum before the full bloom.

As you can see, we believe there is tremendous opportunity in COSI if RJ and team can right the ship and get it headed in the correct direction.  Based on our meetings, we feel confident in their ability to do so. Unfortunately, we are not the only ones confident in RJ and team based on the >100% run-up in the stock from $1.12 when we first started buying to above $1.80.  We plan to build our position over time at the right prices through open-market acquisitions and / or participation in a secondary offering if the opportunity arises.

Do you think Cosi's turnaround is fully baked?

Disclaimer: Bigger Capital and related entities own a small trading position in COSI which we plan to build. COSI is a highly distressed situation and a microcap stock, and therefore it is not suitable for the majority of investors. The likely outcome of this type of investment is a loss of principal. In other words, the probability of losing your entire investment in this situation is very high.

Written by Jennifer Galperin.  Follow me on Twitter and Stocktwits.