The highly competitive restaurant industry constantly deals with changing consumer tastes. When a company also has a leveraged balance sheet and management misses new trends, the phrase "look out below" comes to mind.
But brand name can often be enough to revive a company from the depths of despair, and the ensuing turnarounds often last long enough to provide opportunities for investors to take part in very tasty returns. Two denizens of the nether regions that have clawed their way back into the light are Cosi (NASDAQ:COSI) and Denny's (NASDAQ:DENN). Let's see whether either company is worth a closer look.
For Cosi, things got ugly quickly after the company went public in late 2002 and disaster recovery ensued. Cosi is often viewed as the poor investor's Panera Bread (NASDAQ:PNRA). But with a number of unique menu items -- like its addictive s'mores dessert -- both eateries have plenty of reasons to entice patrons to visit. Quality same-store sales have been a part of Cosi's entire tenure as a public company, and to ensure financing for future growth, the company began a franchising program in 2003 and a secondary stock offering in 2004 that raised $20 million. But by that point, the stock was already trading at more than $5 after reaching a low of $0.95.
Since 2004, the stock has again doubled. So we should have bought shares, right? Not necessarily. Cosi is still losing a considerable amount of money and will continue to do so this year. In addition, a secondary stock offering in 2005 further diluted shares.
Currently, Cosi's market cap falls between those of restaurant peers Red Robin (NASDAQ:RRGB) and Motley Fool Hidden Gems recommendation Buffalo Wild Wings (NASDAQ:BWLD). Considering that both of these companies have positive income and less leveraged balance sheets, I cannot possibly justify buying shares of Cosi over either of them. With many years of growth already baked into Cosi's price, I'm not a big fan. The luck of current shareholders could run out very soon.
Our second eatery of interest is Denny's. The near-demise of the home of the Original Grand Slam -- a filling meal for any time of day or night -- was a result of poor management. But thanks to some prudent decisions from the company's new management, the stock has recovered from a low of $0.23 in 2003 and has been trading at around $5. Upgrades to existing stores have fueled the recovery and resulted in strong same-store sales and sound debt restructuring. But investors' attention should have been drawn to the $1.50 per share of real estate assets that the company had on the balance sheet. With more than $500 million in debt at the time, Denny's couldn't exactly say that a free restaurant chain was being thrown in with your real estate purchase. However, those assets made it much easier to refinance and make the necessary improvements. Furthermore, interest expense has decreased significantly over the past two years, allowing the company to expect profitability in 2006.
But as with Cosi, a secondary offering (this one in July 2004) caused significant dilution. Although this move provided much-needed cash, creating enough profits to go around to all of the shareholders will be a formidable task -- even if net profit margins exceed the industry average. The 1,578 existing stores will make it more difficult to expand the existing store base, which becomes an important issue as the company transforms from a turnaround play into a slow-growth company. At this point, Denny's stock may have a bit more room to grow if the assets on the balance sheet are undervalued. However, the opportunities for market-beating returns are probably in the past.
While neither Cosi nor Denny's seems to be an attractive investment at this point, multibagger turnarounds do abound in the restaurant industry. Some pretty big names have found themselves on that list the past five years, including McDonald's (NYSE:MCD), Friendly's (AMEX:FRN), and CKE Restaurants (NYSE:CKR), operator of the Hardee's and Carl's Jr. franchises. No turnaround opportunities are evident at the moment, but I have a feeling I may be writing about one or two in the near future.
Fool contributor John Bluis knows restaurant turnarounds can be quite rewarding, especially when it requires a sampling of the fare. He has also sampled shares of Buffalo Wild Wings but has no financial interest in any other stock mentioned in this article.
