Cosi Still Half-Baked

With Cosi (Nasdaq: COSI  ) trading at near 50-week lows, investors appear to be ready to accentuate the positive. Shares of the company were up almost 6% in recent trading in the wake of its second-quarter earnings release. While the restaurant operator did reach a milestone in the quarter, even this limited success has to be qualified, and the firm's long-term prospects remain hazy.

The company's "achievement" was reporting its first profitable quarter, but the $300,000 profit excludes new accounting rules requiring the expensing of stock-based compensation. Including that cost, Cosi recorded a net loss of $700,000, which admittedly was an improvement versus the $1.9 million loss the company posted in last year's second quarter.

Also to the company's credit, it held expenses down. Food and beverage and general and administrative expenses actually fell versus last quarter, while labor costs declined as a percentage of revenue.

Unfortunately, disciplined operations go only so far. Revenue growth of 6.2% stemmed largely from the addition of 15 locations in the quarter; comparable-restaurant sales increased an anemic 0.1%. In a shift in tone from just a month ago when the company projected improving second half sales, Cosi now sees soft performance in the rest of the year.

In line with the new outlook, 2006 earnings guidance was brought down. Excluding expense for stock-based compensation, Cosi now expects to book earnings between $0.05 to $0.08 per share, versus prior expectations of between $0.06 and $0.11. The reduced forecast itself is disappointing, but it must be said that others in the restaurant space are experiencing headwinds. Cheesecake Factory (Nasdaq: CAKE  ) , for instance, recently warned about stalled sales, and Motley FoolStock Advisor recommendation Starbucks' (Nasdaq: SBUX  ) July same-store sales growth was its lowest since 2001.

Cosi's plans for an aggressive expansion, though, might just compound its problems. Cosi expects 28 new restaurants to open in the remainder of the year, bringing its total number of locations to 131. With established restaurants showing very little sales growth, it's clearly conceivable that new locations might underperform. Furthermore, the rapid build out could strain operations, leading to margin deterioration.

All this is not to say Cosi doesn't have a viable concept. The company still has a good shot at becoming a solid performer in the premium convenience restaurant area. But now might not be a good time to indulge in Cosi.

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Fool contributor Brian Gorman does not own shares in any the companies mentioned.


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