Getting Cosi With Down and Out Restaurants

NEW YORK (TheStreet) -- The restaurant business is notorious for many things; among them long hours, thin margins, huge sensitivity to both labor and input costs, and being prone to changing consumer tastes. Rising commodity costs, which worry me in general at this point, can wreak havoc.

Success among publicly traded restaurant names is often fleeting, save for a handful that have had true staying power throughout the years. McDonald's ( MCD) is perhaps the greatest success story, with its long storied history and net profit margins in the 20% range, which makes it look more like a pharmaceutical name than a restaurant. I can still order the same things from the McDonald's menu that I did as a child; although the company has added much to the menu over the years, the basics are still the same.

Other, "newer" names, such as Panera ( PNRA), Yum Brands ( YUM) and Darden ( DRI) have also shown great successes over their histories in the public markets, while concept names such as Buffalo Wild Wings ( BWLD) have also made a splash.

Then there's Chipotle ( CMG), which had a massive run and was a veritable "ten bagger" between late 2008 and early 2012. While it has pulled back substantially in the past year, Chipotle has been the poster child for new restaurant concepts, and the most talked about name in the sector the past few years. It's also a great example of what happens when expectations are too high. This may end up being one of the greats, but it was priced for perfection, and fell about 45% between last April and October.

As a value investor, I'm not wired for the growth stories, or the high multiples that come along with great expectations. I am wired to look for the down and out names that are ignored by the market, exhibit some characteristics that suggest a potential turnaround, and are mispriced (in my opinion, anyway.)

While it is a dangerous game to buy down and out restaurant names, I've had some success the past several years with names like Denny's ( DENN), Cracker Barrel ( CBRL) and Krispy Kreme ( KKD). I've also had disappointment with Wendy's ( WEN).

My current restaurant reclamation project is Cosi ( COSI), which actually got some press yesterday when Roth Capital put a buy rating and $2 target price on the stock. This company has been the epitome of a bad experience for investors. Cosi has been in the black (from operations) just one quarter in its 10-plus years as a publicly traded company. While the food has been very good (at least as long as I've been a patron) the operating costs have been extremely high, and the menu way too complicated. COSI Chart COSI data by YCharts

This was a name that I would not touch with a ten foot pole; that is until late 2011, when a major shareholder, Brad Blum of the Blum Growth Fund (7% stake) began making some waves as an activist. Blum, former CEO of Burger King ( BKW), offered to step in as CEO to right the ship. He got a chilly response from the company's board of directors, but ultimately, Cosi brought in a new CEO Carin Stutz, and Blum ended up dropping his activist campaign, and came onboard as a consultant.

While it's still too early to say with certainty that Cosi can be saved, the company reported its first ever profit for the second quarter of 2012. It was a small profit at that, just $77,000, but it was a start. New management has taken steps to reduce the number of items on the menu, and shorten waiting times. More recently, Cosi has been experimenting with new menu items, and a new restaurant design.

It will be a tough road for Cosi, but the company ended last quarter with $16 million in cash, partially the results of a rights offering, and no debt. Cosi bought itself some time, but now has to demonstrate that it has a place in the extremely competitive restaurant landscape, and that it can be consistently profitable.

A tall order, for sure.

At the time of publication the author is long KKD, COSI.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Jonathan Heller, CFA, is president of KEJ Financial Advisors, his fee-only financial planning company. Jon spent 17 years at Bloomberg Financial Markets in various roles, from 1989 until 2005. He ran Bloomberg's Equity Fundamental Research Department from 1994 until 1998, when he assumed responsibility for Bloomberg's Equity Data Research Department. In 2001, he joined Bloomberg's Publishing group as senior markets editor and writer for Bloomberg Personal Finance Magazine, and an associate editor and contributor for Bloomberg Markets Magazine. In 2005, he joined SEI Investments as director of investment communications within SEI's Investment Management Unit.

Jon is also the founder of the Cheap Stocks Web site, a site dedicated to deep-value investing. He has an undergraduate degree from Grove City College and an MBA from Rider University, where he has also served on the adjunct faculty; he is also a CFA charter holder.

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