Is This the Worst-Run Restaurant in the U.S.?

Back when I was working in Washington, DC, I used to bemoan the fact that there were few, if any, places to go to grab lunch or an early dinner near the school where I taught. Then, in 2007, it was as if a savior arrived: a Cosi (NASDAQ: COSI) just around the corner.

Source: Cosi. 

Without looking at any financial statements, if someone were to ask me if Cosi was a top franchise, I'd say yes without thinking twice. And the beginning investor might say the same thing as soon as they saw that the company's stock has doubled in just three months time.

But a little digging reveals a company -- and a stock -- that should be approached with extreme caution by investors and potential franchisees alike.

An awful operating history
When Cosi went public in 2002, it offered up a split-adjusted 1.4 million shares for $1.75 apiece. Since then, I would argue you'd be hard-pressed to find a restaurant -- or any public company, for that matter -- that has done as poorly by their shareholders as Cosi has.

Let's walk through all three of these tabs.

First, we have net income. When I saw this, I was floored. Cosi has been publicly traded for 12 years and not once has it turned a profit. "Well," I thought, "sometimes earnings can be misleading, and the company could be bringing in lots of free cash flow that, for some reason, isn't making onto the income statement."

But then I went ahead and checked the free cash flow -- the second tab -- and was astounded with what I found. As a public company, Cosi has burned through an amazing $144 million and has just about nothing to show for it. Even in 2010, the only year where I calculated the company as having positive free cash flow, it was the result of a $6.4 million cash influx from selling some of their locations.

You may ask how in the world can a company stay solvent with a business model like this. The answer: share dilution. What was once a company with 1.4 million shares outstanding is now an entity with over 18 million shares outstanding. That means your right to the company's (non-existent) cash flows has decreased by over 90% in the past 12 years.

That's concerning.

Just what, exactly, is going on here
So why has the store suffered so much? There are tons of explanations, from a complicated food menu that requires laborious preparation to an overly aggressive expansion plan at the turn of the millennium. Historically, company owned stores -- which were at one point the majority of locations -- significantly underperformed franchises.

Whatever the reason for the struggles, the result is the same: customers simply don't come back to Cosi on a regular-enough basis to help the restaurant turn a profit.

As you can see, business was actually improving at a steady clip for the first few years that Cosi was a public company. Even then, however, it wasn't able to turn a profit. Investors were willing to wait for a profit at that time because Cosi was rapidly expanding its base of stores.

By 2006, however, the growth in same-store sales came to a screeching halt, and the company experienced a painful 10.8% decline in 2008. While it looked for a while like things might be improving, Cosi has once again taken a turn for the worse in the past two years.

Chance for a turnaround?
By far the most oft-cited reason for Cosi's struggles is a lack of strategic vision. Shep and Jay Wainright -- two twenty-something brothers fresh out of college and looking to duplicate a café/bakery that they found while traveling through France -- started the company.

But shortly after the Cosi's IPO, both were ousted. One look at the company's revolving CEO door, and its easy to see why a lack of vision is such a problem.

With Dourney at the helm, Cosi just might have a chance to climb out of the doldrums. Unlike past CEOs, Dourney has successfully run 15 profitable Cosi locations in the greater Boston area. He claims to understand, better than anyone else, what the Cosi brand represents, and what it can be in the future. That future involves a shedding of company-owned stores, and an intense focus on franchises.

Wall Street has apparently liked what it's heard -- even if results haven't filtered in yet: the stock has doubled in just three months time.

Investors who think Dourney could turn Cosi around could reap huge gains. But the company's stock could just as easily decline, as people are only willing to help finance a losing brand for so long.