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Executives

Bill Koziel - CFO

Jim Hyatt - President and CEO

Analysts

Brian Moore - Wedbush

Nicole Miller - Piper Jaffray

Amy Greene - Avondale Partners

Cosi Inc. (COSI) Q4 2007 Earnings Call March 17, 2008 5:00 PM ET

Operator

Welcome to the quarter four 2007 Cosi Incorporated Earnings Call. My name is Nikita and I will be your coordinator for today. (Operator Instructions)

I would now like to turn the presentation over to your host for today's call, Mr. Bill Koziel, CFO. Please proceed, sir.

Bill Koziel

Thank you, Operator. Good afternoon. This is Bill Koziel, Chief Financial Officer. I would like to welcome you to Cosi's 2007 fourth quarter and full year results conference call. Joining me today on the call is Jim Hyatt, Cosi's President and Chief Executive Officer.

Cosi's earnings release was issued today at market close and is available in the Investor Information section of our website at www.getcosi.com. During the call, we will be referencing supplemental materials, which are also available in the Investor Information section of our website. If you have not already done so, please access the supplemental materials at this time.

Part of our discussion today will include forward-looking statements. These statements are not guarantees of future performance and are inherently subject to risks and uncertainties. You should not place undue reliance on these forward-looking statements. We refer all of you to our filings with the Securities and Exchange Commission for more detailed discussion of the risks and uncertainties that may have a direct bearing on our operating results, our performance and our financial condition.

For today's call, Jim will begin with some initial thoughts regarding the fourth quarter. I will then review the financial and development results for the quarter and the full year and Jim will conclude by discussing our work and plans around specific components of our business. We will then open the call for questions. Jim?

Jim Hyatt

Thanks, Bill, and good afternoon, everyone. Let me start by saying that we are pleased with the progress that we've seen so far in the execution of our plans to improve Cosi's business performance. Cosi is showing resilient traction with our guests improving operations discipline in our restaurants and making good progress in corporate expense control. From 2007 we saw the positive sales trends of the third quarter carry into and throughout the fourth quarter and we continue to see this momentum building into 2008. Our positive traction in our comp sales has translated into a better overall system-wide comp performance and some of our competitors indicating we are advancing.

These positive sales and traffic trends have persisted despite adverse external factors, such as the recent major snowstorms in the Midwest along with the very challenging year-over-year weather throughout the entire Midwest, mid-Atlantic, and Northeast where all of our company restaurants are located. The increase sales trends have resulted for menu initiatives, daypart work, but so far mostly from improvements in guest satisfaction and throughput improvements from our operations advances.

So the patterns that we have seen demonstrate that when we are focused on improving the day-to-day operations of our business, streamlining the performance of our restaurants, and providing the superior experience and service our guests have come to expect, we reap rewards. We have a lot of work left to do. We are going into the right direction to capitalize on this very strong concept and brand.

After Bill takes you through the P&L, we are going to spend some time before the Q&A to talk with you about our work and our plans as they pertain to revenues, expenses, operations and our business development.

Now I will turn it back over to Bill for the financial discussion.

Bill Koziel

Thank you, Jim. I will begin by reviewing our detailed financial and operational performance for the fourth quarter and full year 2007. Pages four to seven of the supplemental information will guide you as I go through my remarks. For the fourth quarter, we reported a net loss of approximately $6.2 million or $0.16 per share. This is compared with the 2006 fourth quarter net loss of approximately $4.8 million or $0.12 per share. Included in the net loss for the fourth quarter of 2006 was a loss from discontinued operations of $400,000 or $0.01 per share, compared to a loss from discontinued operations of $600,000 or $0.01 per share in the 2006 quarter.

The 2007 fourth quarter loss from discontinued operations resulted from our decision to sell the asset of the three underperforming company-owned locations in Seattle, Washington. In addition to the Seattle locations, the loss from discontinued operations in the 2006 fourth quarter also includes the impact of the six restaurants operated inside Macy's stores that we closed in August of 2007. Importantly, we reduced our 2007 fourth quarter operating loss compared with the year earlier period by 38% to approximately $3.1 million from about $5.1 million, excluding impairment provisions, closed store costs, lease termination costs and benefits, and gains on sales of assets.

We recorded charges of $2.7 million or $0.07 per share in the 2007 fourth quarter related primarily to asset impairment provisions for seven company-owned restaurants locations largely from the 2006 class of restaurant openings which as we've shared with you previously have underperformed Cosi system-wide restaurants due mainly to site selection. In contrast to the charges we recorded in the 2007 quarter, we recorded a net gain of about a $0.5 million or $0.05 per share in our 2006 fourth quarter operating results.

For the year, we recorded a net loss of approximately $20,800,000 or $0.53 per share, compared with a net loss of approximately $12,300,000 or $0.32 per share in 2006. Our full year 2007 operating loss totaled $17.7 million versus approximately $12.4 million in 2006.

Continuing through the P&L, based on continuing operations, total revenues for the quarter, including franchise fees and royalties, grew 7.9% to $33.1 million compared with $30.7 million in the 2006 fourth quarter. The constitution of franchise fees and royalties more than doubled to $694,000 compared with $336,000 in the previous year's quarter, indicating an important trend line and source of earnings leverage for the future.

For the year, total revenues, including franchise fees and royalties, grew 8.8% to $135 million from $124 million in 2006. Franchise fees and royalties more than doubled for the year to $2.1 million from $850,000 in 2006. The additional contributions of franchise fees and royalty income for the quarter and the year further supports the planned transition from a company development strategy to a predominantly franchise development strategy supported by modest growth in a strong base of company-owned restaurants.

As we saw in the third quarter, some of the royalty increase for the fourth quarter was the result of year-over-year sales increase from franchise restaurants that have entered their 16th month of operation and have qualified to enter the comparable sales base. In the fourth quarter, we saw a comparable sales increase of 12% from franchise locations in operations more than 15 months, and for the full year an increase of 16.4% from comparable franchise locations.

At the end of the fourth quarter, there were 141 Cosi restaurants of which 34 were operated by franchisees compared to 123 Cosi restaurants at the end of 2006 of which 13 were operated by franchisees. At the end of the fourth quarter, there were 95 locations in the comparable restaurant base compared to 81 at the end of 2006.

As previously announced, company-owned comparable restaurant sales in the fourth quarter saw a 1.3% increase as measured for restaurants in operation for more than 15 months. The comparable sales increase was the result of a 2.3% increase at average check, driven by higher catering sales year-over-year, as well as a favorable shift in sales mix coming from menu items like our new flatbread pizza and holiday LTO offerings, but partially offset by a 1% decline in transactions.

System-wide, our comparable sales increase was 2.1% for the fourth quarter. For the year comparable sales for company-owned restaurants showed a modest increase of 0.2%, while our system-wide comparable sales increase was 1.4% for the year fueled by the strength of our performance in the third and fourth quarters.

As Jim said, we are pleased with the improving trend of our comparable sales performance, especially among our franchise-operated locations. Moreover, our improving sales trends were not the result of taking price increases, which creates further opportunity for comparable sales lift going forward. We'll talk about pricing a little later in our discussion of our plans as they pertain to driving revenues.

Turning to slides four and six, cost of food and beverage for the fourth quarter was 24.1% of restaurant net sales compared to 23.4% in the previous year's quarter. These costs were up on the full year to 23.4% compared with 22.9% for fiscal 2006. The increases were due primarily to higher commodity prices year-over-year on certain products including wheat, dairy and dairy-related items, the impact of the sales decline in higher margin beverage products, and slightly higher promotional discounts as compared to the prior year.

One note regarding commodity costs. Like many others in the industry, we are feeling the margin impact of commodity price increases, primarily in wheat and dairy and diary related products. As it relates to wheat, because we prepare and bake our bread entirely on the premises, utilizing a vast production model, we may have a somewhat better ability than some of our competitors to match bread supply with demand. And so, we believe fluctuations in wheat costs may have a less significant impact on our bottom line than on some others in the premium convenience sector.

For the fourth quarter, restaurant operating expense as a percentage of restaurant net sales was 65.1% compared with 63.9% in the 2006 quarter. For the year restaurant operating expense was 63.7% of restaurant net sales, up from 59.3% for 2006. Labor and related benefits expense as a percentage of restaurant net sales was flat on the quarter at 35.2%, reflecting the impact of our focus on properly managing the deployment of labor during peak and non-peak hours of operations, but up a 150 basis points on the full year to 34.7% from 33.2% in 2006, reflecting the de-leveraging impact of the comparable sales decline in the first six months of 2007, as well as labor inefficiencies associated with certain new restaurants.

Occupancy and other direct operating costs were 29.9% of restaurant net sales for the fourth quarter 2007 compared to 28.7% in the 2006 period. For the full year, these costs came in at 29% of restaurant net sales compared with 26.1% for the full year 2006.

The increase in occupancy and other direct operating costs was primarily due to higher restaurant maintenance expense as well as slightly higher paper and packaging costs. Total restaurant cash flow for the 2007 fourth quarter was approximately $3.5 million, resulting in a cash flow margin rate of 10.8% versus 12.7% in the 2006 fourth quarter. For the full year, cash flow was approximately $17.1 million, resulting in a cash flow margin rate of 12.9% versus 17.8% in the 2006 year.

The higher expenses and margin pressures were partially offset in the quarter by continued progress in corporate expense control. General and administrative expense improved by 670 basis points for the quarter, representing 12.5% of total revenues for the quarter, compared to 19.2% of total revenues in the 2006 fourth quarter, primarily due to labor savings achieved as we scaled our support infrastructure to better align with our current trends and including the reversal of discretionary bonus expense based on our performance for the year.

For the year, general and administrative expense improved 210 basis points to 15.6% versus 17.7% for the full year 2006. Cash, cash equivalents and short-term investments were approximately $6.3 million as of December 31, 2007 and Cosi had virtually no debt.

On slides five and seven, we have provided a reconciliation of the non-GAAP measures from slides fours and six to our reportedly quarterly and full year results respectively.

In summary, we are pleased with our progress, but believe we still have a long way to go. The current macroeconomic situation has created a difficult environment in this industry, on both the consumer and commodity cost fronts. However, we are seeing positive momentum and are encouraged by the increase in system-wide revenues, the continued improvements in comparable restaurant sales from both company and franchise operations without an increase in prices, and the improvements we've made in scaling corporate and general administrative expense.

Regarding development, during the 2007 fourth quarter we opened one company-owned location in Stamford, Connecticut, as we previously communicated, and closed one underperforming location in Baltimore, Maryland, which was an original Xando coffee bar location opened in 1998.

We opened the total of six company-owned locations for 2007. We currently have leases signed for two locations for 2008, one of which is already under construction. We intend to seek only real estate sites that are of an A type quality for our company-owned restaurant development.

As to franchise development, we are pleased that our franchise partners continue to demonstrate their enthusiasm for Cosi's concept with initial and subsequent openings despite the current challenges in the consumer and financing environment. Cosi franchisees opened seven locations during the fourth quarter, including our second international location in the United Arab Emirates. Eight additional franchise locations have opened year-to-date subsequent to the close of the fiscal year.

As you know, this year we emphasize franchise development and have strengthened the level of support we provide to our franchise partners. For the year 22 franchise locations were opened. For 2008 we continue to expect that franchisees will open between 25 to 35 locations. We currently have commitments from 31 franchise area developers for 332 locations not including the 42 already opened, reduction of 22 locations from our previously announced total of 396 (inaudible) termination of the commitment of one of our area developers.

Now I will turn the call back over to Jim for some further thoughts. Jim?

Jim Hyatt

Thanks you, Bill. Last quarter I laid out for you my impressions of my first two months at Cosi. I spent a great deal of time learning the business and identifying what I thought were some core strengths. I explained three main reasons why I was so exited to be part of this team. First, the fast casual segment in my view, the most exiting segment in the restaurant business today, and I believe that what Cosi offers to its guests positions this brand incredibly well in this space. Second, Cosi has a tremendously strong brand with great food and variety which has driven guest loyalty. Third, with these strengths, the company has attracted a quality group of experienced franchise area developers, especially important as we continue to transition our growth from company-owned and operated development to more franchise development, a key driver of long-term value at Cosi.

In the fourth quarter, we surgically started fixing the performance issues and we got down to serious business. We started implementing initiatives to enhance our financial performance and our operations performance. We made very good progress in many of these areas and I'm pleased with the adoption of the turnaround initiatives in the restaurants and the improvement trends by the operations teams.

We started our focus early in the quarter on listing sales, and with those efforts, we posted a respectable sales comp increase. Benchmarked against the competition and our previous trends at Cosi, it shows that we can have an immediate impact on the business. The Q4 sales lift, I want to clarify was accomplished without taking any price increases. So we are learning in delivering better guest excellence in our restaurants and the rewards of delivering on that obligation can be seen in Q4 and goes forward with us into 2008.

We still have a lot of ground to cover, but we are step-by-step working a wellness program and working with our restaurant teams to understand Così's expectation of delivering guest excellence on a very consistent basis.

So later in the quarter, we were able to calibrate and implement restaurant-specific financial controls. That started to move our margins back to where we expected them. I continue to believe that our first and second quarter results of 2008 will show clear evidence of the work that we have been doing to strengthen Cosi's operations and cash flow. I am proud of the progress the teams have made on margins as we work through Q1, and I expect to see them continue. And as I communicated to you on my first call, Q2 is my target to have things back on track.

We will take a little time to get everything calibrated, but we are experiencing very good improvement trends. My right promise over deliver commitment to you feels very good right now. And I spoke last quarter about brining a culture of accountability to Cosi. I believe that culture of accountability will help drive our success and the teams at Cosi or on the Board with the turnaround initiatives. So I would like to spend time now addressing four areas that Cosi's management team will be held accountable for in 2008; revenues, expenses, operations and business development.

Let's start with revenues. Being accountable to deliver guest excellence, thus increasing the likely to return and the likely to recommend attributes has become one of our jobs in our restaurants. Our increased performance in guest excellence has been fueling our sales and traffic trends in Q4 and now into 2008. Our restaurant teams are showing muscle memory now in service skills, and I'm proud of their progress, but we have just passed Mile Marker 2 of 12 for the year.

Beyond the guest excellence focus at the restaurants generating the sales lift, I want to also discuss the business opportunity we have to optimize the brand's positioning, and then I want to address the headroom that we have in pricing power. We are reworking six opportunity levers for our business related to revenue. They are lunch, catering, breakfast, kids, dinner and beverage. We need to properly pace these adjusted revenue levers into the business to get the results that we're after and we need to deploy them, and they'll be sequenced throughout 2008 and 2009.

To pace the restaurants workload and their focus on these revenue levers, we have parallel path working now on the first lever being lunch and the second lever of catering, which are already in play at the restaurants, while at the support center, teams work through the third lever being breakfast and the fourth lever being kids menu optimization and deployment. We will stage the initiatives in by calendar and by restaurant execution capability, but only after consumer testing tell us we have it right.

So related to the first lever, lunch, we are working on procedure simplification and capacity improvements to serve more guests in those power hours of the days. Shorter lines are possible through faster throughput and we're working hard to achieve that. We have a lunch menu that customers crave. So we need to learn to serve more of them at lunch and our improvements in this lever are being felt in our sales and from positive responses from our guest feedback tools.

Catering is the second of the six levers. And with a great menu already available for our catering business, we are specifically focused on this lever around logistics. Better oversight of catering logistics is where we can help the teams immediately. This area will give us a lot of punch as we move into the spring and the summer. And we now have a catering leader for the organization, and we are providing best practice training to the restaurants and now to the franchisees.

Development and staging the fourth lever, breakfast, is underway led by the chef and our product development team. We see great opportunity to provide customers with better menu options with the quick convenience required by the morning rush of breakfast time. In short, we want to make our breakfast lines food to Cosi's premium convenience position.

And we've not been getting our fair share of the breakfast day part. We see lost opportunity in this day part due to operations execution shortcoming, which we're fixing, and lost opportunity due to the need for some product innovation and menu architecture. We're on it and more on that next time.

The other three of the six revenue levers are kids, dinner and beverage. We are revamping our kids menu to include four or five menu meals, with crowd pleasing staple such as mac and cheese and peanut butter and jelly, so we can offer options for the family.

Related to the fifth lever, dinner, we're working on optimizing and expanding our dinners from the Hot Concept, which was launched last year in an effort to drive evening traffic in our neighborhood locations by providing variety to compliment our signatures sandwiches and pizza and to tap into the take-home business. We have a unique cooking platform here at Cosi that's not easily replicated by others, and we want to power up on our made fresh, high quality food offerings.

And the sixth lever is beverage. Cosi needs to do a better job capitalizing on our opportunities around coffee and our beverage counter space. The opportunities for both margin and traffic growth demand are that we revitalize this business opportunity. Beverage is a powerful lever, and we need to play offensively on this and recapture the previous revenue levels that we enjoyed at Cosi in the years past.

So those are six tactical levers that we're working to improve our revenue. Now let me talk about revenue as it relates to pricing, a seventh lever, if you will. Cosi last took price in May of 2006. Yes, I did say 2006, and that is 21 months of standing still. We see revenue opportunity in pricing to assist in our revenue goals for the year, but this will also help correct the margin erosion we have seen at Cosi through 2007 with commodity pricing.

Our margin erosion had two issues, commodity increases and poor controls at the restaurant. We have controls in place now and improvements to show from Q1, but let me communicate our pricing plans. We have a three step price strategy underway for 2008. Step one was made on February 26th. Cosi took a price increase in 40% of our restaurants as we move from having four different price tiers among the restaurants to two price tiers, providing a 90 basis point system-wide impact or increase.

So 40% of our restaurants took a small increase and the other 60% have not taken any price. We will do a step two price adjustment that is planned for all restaurants in Q2. Step two will be around a 200 basis point increase for all restaurants. And a third step in price for Cosi is not in our restaurant menu pricing but is related to our catering menu items for restaurants with catering business.

And a price comparison with our competition related to catering, we are much underpriced. Further we feel we have the better food quality so we immediately raised price for our catering business. We plan adjust our catering price in April to correct our disadvantage and capture revenue and margin results. After our review of catering in Q4, we found another connection to those margin losses of 2007, and is due to the cost of goods for catering which was 6% higher than for base business, and restaurants with growing catering sales are gaining farther and farther from their cost of goods margin targets. So we have our fix staged and it will be corrected in April.

So let me recap the effect on our system for our pricing adjustments. The blended system impact is 0.9 or 90 basis points for the February 26th adjustment. The step two price change projected for Q2 would represent around a 2%, 200 basis points increase for a then combined 2.9% increase in our everyday core menu. I might add that we've not had any negative reaction from gas related to the February 26th increase, nor have we had any push back on our guest feedback tools.

Now, an additional 1% system-wide effect will be felt when we adjust the catering price for our catering restaurants. So we are forecasting a run rate of around 4% in price once all of these adjustments are made, which will help us move into the summer. Now our recent comparable sales trends, traffic performance trends coupled with the price increases by the competition in the restaurant segments have demonstrated to us that we have permission to raise prices and in light of the commodity price increase, we are being responsible to do so.

I will turn now from revenue opportunities to expense and operations, which I see is being two sides of the same coin. If we operate in a discipline, in a cannibal manner across our organization, we'll reduce expenses. Now every component of the P&L is fair game. My priorities have been in three dominant areas; cost of goods sold, labor and G&A, but every line item is being evaluated on a routine basis. And you've heard from Bill, the dramatic improvement we made in G&A on a year-over-year basis. And as our revenue improves to our potential for the year, the margin will continue to right size itself and we are much improved in this area but still improving as we focused on the highest and best use of our G&A.

And our cost of goods sold is improving, however other significant room is there to improve as we should move better for our targets. We'll be there very soon based on the performance trends of the last 12 weeks.

Certainly Cosi is affected by the upward pressure on food and commodity prices in general. However, we can mitigate those increases and call back loss margins due to poor restaurant controls and accountability. We've done a lot of hard work in January with our district managers and general managers in skill training, sharing best practices, standardizing processes and discussing accountability. I have seen improvements already, but there are gaps in food cost controls versus theoretical that provide meaningful improvements to the restaurant economics and we're focused on closing those gaps.

One recent step we've taken toward this end is implementing a new inventory system that is helping our GMs take better accountability for their inventories and overall their cost of goods, as they balance the theoretical and budgets as well as now having action steps to help them fixed identified gaps.

Now related to labor margins, we deployed new allowances to the restaurants in December based on volumes, restaurant types service modes and also provided other coaching tools to help the managers execute against those new lower allowances. The teams have been calling back margins in this area without stalling any of the sales opportunities. Workload balance, daypart targets and other tools that we provided are working for us now, moving from Q4's introductions to these changes, then teaching and coaching sessions in January have allowed us to course correct and our margins are improving. I think you will be pleased with our results when we communicate with you on Q1, and as I've stated before, we should be in a right promise over delivery positions as we mature our skills in Q2.

As I said expenses and operations are two sides of the same coin, and so I want to spend a few moments on what we've been doing to strengthen our operations. And to no surprise, it comes back to accountability. Before we can hold people accountable, we need to make sure that they clearly understand what they're responsible for, what their specific role is and how it contributes to the organization's overall goals and that's what we've done.

We have worked as a team to get all of the general managers and district managers on the same page. We have and continue to delineate exactly what is expected of each player in the organization, so that there is no question about responsibility and accountability, and we are spending a lot of time now on recognition as results and best-ever trends are materializing.

So in my first full quarter, we provided the organization, both company and franchise, with an improvement plan outlined for 2008 and began to discuss this execution with everyone in our organization. We identified the four business plans with leadership accountability in order to have everyone play their positions and contribute their expertise to the improvement plans that we're deploying.

Those four business plans go after the promise and positioning of the brands of the consumer, the execution and delivery of those brand promises, the consistency of our brand day-to-day, restaurant-to-restaurant, operator-to-operator in the eyes of our guests, and then the measurement and accountability of getting results and having a profitable growth business.

In January, I spent time visiting every market, touring restaurants and to meet with all district managers and restaurant general managers in small groups to outline how each restaurant would achieve the improvements and performance that was striving for, in what timeline, and maybe most importantly, how we would help them.

We also put in place in December an operations excellence team focused on the development, implementation and the execution of an operations plan, sharing best practices across the system from both company-owned and franchise locations that we know will give us improved revenue and improved profitability.

Finally, we are focused on reducing our manager turnover rates. As many of you know, turnover in the restaurant business has a direct impact on restaurant margins. We can improve our training, but if we lose the people we train then we're back to square one and we lose all the equity in that management scale and guest excellence. We think people like working in a setting where expectations are clear and there is accountability, including reward for performance.

So the face-to-face time with our district mangers and our general managers in January was very helpful to ensure we all understand this is a people business first and we win with results. So we're very focused on our talent, our need to build skill, and our need to become one of the best places to work.

Now the fourth area that I said I wanted to discuss with you today after revenues, expenses and operations is business development. We are accountable to you to drive long-term growth in value and a primary driver in growing this business for the foreseeable future is franchisee development.

We continue to focus on developing partnerships and building relationships with well qualified franchise area developers as we continue to grow revenues from franchise and royalty fees. And as we've said, we plan to see between 25 and 35 new locations open this year and 8 have already opened in Q1.

We have limited plans for our company-owned locations this year with two leases signed to build two locations in 2008. From the company restaurant perspective, our focus is getting our already opened Cosi restaurants up to revenue, expense and guest excellence.

We have more to gain right now by running the restaurants that we already have right versus spending or spreading ourselves out further over the next 12 months on new company restaurants. We are, however, building a support infrastructure for our franchisees to help them grow. And as I see the company restaurants are now working the plan we've put in place for their profitability, we will be spending more attention to support the growth and performance of our franchise operators.

Frankly, for Q1 and Q4, my best support to the franchisees and our shareholders was to get the company business right, the support structure right, and then we can best support our franchisees and their plans for growth and profitability. We continue to interview potential franchisees on a monthly basis, and we believe we will continue to attract talented franchise developers to the Cosi concept and brand, and in turn, drive more shareholder value.

As I stated last quarter, Cosi's decisions related to the quality of the real estate, and then the lack of an operations culture that was built for guest excellence and profitability had disappointed us over the last couple of years. An operations culture built for guest excellence and profitability is ceded now and showing comparable sales lift and margin improvements. Now the quality of our real estate going forward will be a discipline of only improving and on boarding A quality sites. We will not approve anything, but A quality sites. So we are putting significant oversight into site selection, time line leadership and opening support to ensure that our new Cosi restaurants pull the brand up, not sideways or as we know happened in 2006 and 2007, they put a strain on the business and pulled us down. So you will see elevated and a very hands-on focus with real estate support to our franchisees beginning Q2.

In closing, despite operating in a difficult macroeconomic environment, we are seeing improvements in our operations as well as comparable sales growth momentum that have given us confidence that we are on the right track. We expect to see continue challenges from external factors including commodity headwinds in '08. However, we believe we can offset these higher costs by improving in many other areas. I continue to expect our focus on accountability and execution to yield hard benefits to the bottom line from both the cost and the revenue side of the ledger.

For 2008 with the two toughest months behind us related to our seasonal, or our lowest index revenue volume months, and our new ability to generate cash from operations in those months, are signs that we are on or slightly ahead of schedule in our improvement plans. I am very proud of the restaurant teams and the restaurant support center teams for the improvement and trends they are posting as we move into 2008.

Now, I don't want to get ahead of ourselves by looking too much into Q1, but I do want to indicate the adjustments that we made in course correcting the business in Q4 are showing measured results as we move into 2008. I have a lot of confidence in our new business foundation to drive guest, revenue and expense excellence. And the six revenue levers of lunch, catering, breakfast, kids, dinner, and beverage will have a meaningful impact on our business as we work them into 2008 and 2009. I have a lot of confidence in the Cosi team, the franchisees that we have in a system and the improvements that we are making together.

So Bill, let's take time for questions.

Bill Koziel

This concludes our brief presentation portion this afternoon. We look forward to answering all of your questions. Operator, please open the line to questions.

Question and Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Brian Moore of Wedbush. Please proceed, sir.

Brian Moore - Wedbush

Good afternoon.

Bill Koziel

Hey, good afternoon Brian.

Jim Hyatt

Hi, Brian.

Brian Moore - Wedbush

First question would be I guess I think you said roughly 4% price increase for '08 as well as the quality customer servicing issues you're going to have in place. How might we think about restaurant level margins on a full year basis? And then if you could also give some more color on your wheat exposure as well as other commodities that are contracted or not contracted and speak to the absolute level of food inflation this year that you expect?

Jim Hyatt

All right. Very good. Well, let's take the commodity one first, I mean as a benchmarking, the cost of our flour is a wrong ingredient, it comes in the back door in a bag to benchmark that January of '07 the price per bag was $12, January of this year it's $16, so its up $4. And then going into April, May, June, there is about a four-month window where that bag is going to jump into the 20s. The effect of that on the restaurant will be about $500 to $550 a month per restaurant for about four months.

Now we have a contract in place that levels that price and we think we are going to return back to some normal state going into the summer but with our price increase we have that covered. Now other margins or other parts of the cost of goods we also have been working on as an example we have favorable cost this year in our soup contracts, our chicken contracts and some others. So we have been able to lever and make improvements in other areas so that the flour impact does not have an impact as it probably is with our competition or other businesses that have a different food delivery system, if you will.

Now the margin impact that we communicated to you before on our last call was that we would make a about a 70 basis point improvement in our margins on cost of goods and I still feel very good about that. I think we closed 2007 with a 23.4, we are looking to post around 22.7 for 2008. So we are going to take a little bit a headwind, we are going to claw back a bit of performance and we are going to do other good work on our commodity costs working through there. All right.

Brian Moore - Wedbush

Okay. I guess then given the labor wage inflation as well as higher other costs on an absolute basis restaurant level margin, will we think about it as being higher or lower?

Bill Koziel

You're going to see our labor cost come down. We've been leveraging against that. The groups had made some excellent progress over the last 12 weeks of bringing down labor without affecting our ability to catch the sales lift. We think we've had basically a lack of controls in the restaurants and a lack of support on infrastructure to make those decisions at the restaurants, and we're doing better at that from a leadership perspective here in the ops teams. The BMs are doing a great job right now balancing out the labor which is, again, the labor and the food are our two biggest expenses, so we're very much on both of those items. You're going to see our hourly labor put back in shape, leverages it back to where we really left 2006 and early 2007. So we feel very good about the margins on the hourly.

Some of the others margins I might highlight would be our R&M. We seem to have been over the last few years in a catch-up mode with maybe some deferred maintenance activity from the '06 and '05 years. So, Cosi spent a little bit extra in '06 and '07 on R&M at a rate of about 1.7%. We think what we can do to perform this year as to get it back now where we think it belongs at around a 1% rate.

So I think, Brian, overall, every line item, as I mentioned earlier, is pure game, and we're going after all of the opportunities that we think exists at Cosi, because really not enough support structure and guidance and leadership are at the restaurant. So, we feel pretty confident about bringing back our margins.

Brian Moore - Wedbush

Great. Thanks for that color. Let me ask a few sales question. Can you first remind us, I guess, what your average check is and how many transactions happen during that average check?

Bill Koziel

The average check, Brian, is hovering around slightly over $9 per check.

Brian Moore - Wedbush

Okay. And then, also, I guess, Bill, on same-store sales growth, I missed the past about the franchise units that fell into the comp base, can you give us some color on the comparisons year-over-year and how you produced that double-digit comp as well as maybe what the targeted AUV might be going forward?

Bill Koziel

Sure. To the first part of your question, it is a relatively small comparable base of locations on the franchise that will start to grow as we move into 2008. So, for the fourth quarter, we had basically five comparable locations on the franchise side ending up with seven by the end of the quarter, two came in during the fourth quarter. So it's seven locations that are making up that annualized number for franchise growth, because we only opened five in 2005 and early 2006, and then you'll start to see it build as we move out into 2008.

As it relates to AUV, our system-wide average has been around a 1.3 million, 1.4 million I think that the expectation is as we move forward that will be our minimum threshold for wind open a franchise location. Again, as to Jim's point, Brian, we're focused now on A type quality real estate sites, sites that are going to deliver the expected average unit volume that we've laid out as we've talked about our prototype overtime. So it would be in that 1.4 million or plus better range.

Brian Moore - Wedbush

Okay. Thank you. And then, in terms of, I guess, the improvement year-to-date that you intimated, how might we think about that in terms of magnitude, is it 2x, 3x versus Q4 comps, I guess, for company stores at least?

Bill Koziel

No. As it relates to the Q1 of 2008, we want to be careful to give you some impression of what the fact that we think the initiatives we took put in place in Q4 were realizing benefits of those in Q1, but we're not going to give guidance as to a number.

Brian Moore - Wedbush

Okay. That's fair. In terms of procedure simplification, any metrics on lunch months on ticket time, what's the trend been there?

Jim Hyatt

Yeah, good question. We have some very significant lunch volumes in these city locations. And our upside opportunity is to get the lines a little shorter with faster service. So if we can move them from five and six minutes pizza service down to four and five, we'll be creating a lot of this extra headroom, if you will, to get these other transactions in at lunch. The restaurants in New York needed guidance and help on organization, shift readiness, and those type of things allowed them to be really ready from 12 to 1. And I think we're reaping some benefits out of that. And as part of our 2.1% comp I think that we posted in Q4, we were able to help them be better prepared for lunch and satisfy guests.

Brian Moore - Wedbush

Great. And then I guess just two more questions, I think you said two company store openings or signed leases for 2008, where might those be in terms of geography and city, new existing markets?

Jim Hyatt

Well, Brian, I'll tell you, we signed two leases. One is under construction, and I will tell you where that ones at is, it's at Crystal Drive in Virginia. The second line has not begun the bubbling yet, so we won't cite where that location is at.

Brian Moore - Wedbush

That's Arlington, Virginia? Okay. And then the final question, can you maybe give an update on kind of your balance sheet outlook, maybe speak of alternative sources of financing, whether it be a credit facility, equity, equipment financing, how might we think about that for the full year '08?

Jim Hyatt

Sure, well to start off, we ended the year with $6.3 million of cash and as we look forward to 2008, we believe that the cash we came into the year with is adequate to execute our business plan as we see it today. And so, we are really not, we don't need any more cash to execute the plan we have in hand. So we haven't contemplated if things would change, we would change our business plan for 2008, we would then have to seek out some additional sources of financing, but that is not the case. We believe we have more than adequate cash to execute against the business plan as we see it today.

Brian Moore - Wedbush

Great, thank you very much.

Jim Hyatt

You are welcome. Thanks Brian.

Operator

Your next question comes from the line of Nicole Miller of Piper Jaffray. Please proceed, ma'am.

Nicole Miller - Piper Jaffray

Good afternoon.

Jim Hyatt

Hi, Nicole.

Nicole Miller - Piper Jaffray

Hi, what percent of flour has the good fold please?

Bill Koziel

As a percentage of the base cost of goods?

Nicole Miller - Piper Jaffray

Either sales or cost of goods sold, it doesn't matter.

Bill Koziel

I don't have that off of the top of my head. I will look that up and will get it after you offline.

Nicole Miller - Piper Jaffray

Okay. And then on the development strength, I know you are guiding the company on stores versus six priors, do I have that right, I mean, am I understanding that?

Bill Koziel

Yeah, Nicole, we never guided in 2008 any number. What we are telling you is we have two leases assigned, one under construction, and our goal process, our thought process is to look at only eight type quality real estate sites for company-owned development. So, we don't have a set number in mind. As we see opportunities, we will look at those opportunities and we act accordingly.

Nicole Miller - Piper Jaffray

Okay. And then the stores that have opened today, is that one company in seven franchise locations?

Jim Hyatt

It's eight franchise locations year-to-date for Q1.

Nicole Miller - Piper Jaffray

And zero company, okay they are all franchise.

Jim Hyatt

Right.

Nicole Miller - Piper Jaffray

Okay. And then I guess some I am sorry I missed this, but you are seeing 1.3% company comp, 2.1 system comp and then did you give us the franchise comp?

Bill Koziel

Yeah, it was 12.1% in Q4.

Nicole Miller - Piper Jaffray

12.1%.

Bill Koziel

Right.

Nicole Miller - Piper Jaffray

Okay. And how much of that 1.3% was price, is that zero?

Bill Koziel

Zero. Right, we haven't taken prices since May of 2006.

Nicole Miller - Piper Jaffray

Okay. So that's all traffic, and how about on the franchise side of the same thing?

Jim Hyatt

I think mostly they had stayed where we were corporately and they were moving into the same price adjustment window in that February 26th area that we were doing. So I think generally they've held the same as us from May through their openings of '06 all the way until February of 2008.

Nicole Miller - Piper Jaffray

And can you clarify how many comp stores, what region that all the comp stores are in?

Jim Hyatt

The comp base when you get?

Nicole Miller - Piper Jaffray

Just on the franchise comp base?

Jim Hyatt

In Northeast, I think would be primarily the Northeast.

Nicole Miller - Piper Jaffray

Are the Minneapolis stores in there?

Jim Hyatt

No.

Nicole Miller - Piper Jaffray

No.

Jim Hyatt

None of the Minneapolis stores were in the comp base?

Nicole Miller - Piper Jaffray

I am sorry to go back and forth on the two developments, the two stores sign there, the two leases, you signed leases so obviously, are any of those under construction or what quarter should they, should we look for those to open?

Jim Hyatt

One is currently under construction in Virginia and the second one is the final construction that has not yet begun. So you can expect the one that's under construction currently to open in Q2.

Nicole Miller - Piper Jaffray

Okay. And just remind me if you guys have pre-released quarterly results and if not, can you give us an indication if not the number but you tell how things are going in the first quarter on the top line?

Jim Hyatt

We'll tell you about first quarter Nicole is that we are feeling good from the momentum we've seen coming out of Q4 and Q1. And given that we had positive comp performance in Q3 and positive comp performance in Q4; you can draw your own conclusions as to what our positive feeling is and momentum for Q1. Although we won't give you a number. We believe the initiatives put in place in Q4 will start to see traction on those in Q1 not only at the sales line but also on operating margin and so I think we will leave it at that and update you on the Q1 earnings call.

Nicole Miller - Piper Jaffray

Okay. And there won't be pre-releases this year or there will be?

Jim Hyatt

We will pre-release the sales information as we have historically as well as the development information. And then we will do the earnings call subsequent to the earnings release.

Nicole Miller - Piper Jaffray

Okay, great. Thank you very much.

Jim Hyatt

Thanks, Nicole.

Operator

Your next question comes from the line of Amy Greene of Avondale Partners. Please proceed, ma'am.

Amy Greene - Avondale Partners

Hi guys.

Jim Hyatt

Hi Amy.

Bill Koziel

Hi Amy.

Amy Greene - Avondale Partners

Just wanted to ask you a couple of questions about the various levers that you were discussing. Can you give us a little idea about some of the timing that you are seeing, that you are planning on kind of the pieces in the middle around breakfast etcetera and when we should start seeing, expecting to see you guys really start tweaking the menu?

Jim Hyatt

Yeah, I don't want to tip my hand too much. There are a lot of people listening. So I want to be a little careful. But I would say the first two are obviously lunch and catering. Really because our menu for lunch and the build up of those menu items in the catering allow us to not have any hesitation on doing work there. What was needed was operational support, logistic support around catering and so forth. Now when I get into kids, what Cosi traditionally has done is walk very softly because of the various city and urban behavior around Cosi's development and not so much built up against kids and now that we are into the suburbs and the franchisees are moving into those areas, we feel like we need to build up a better menu offering for the kids which we have, maybe in Q2 we should be able to deploy what we have framed up around the kids menu.

For breakfast, we as well aren't very far away from enhancing our breakfast menu architecture a bit, adding a little variety in there, but also making sure that it's very quick to the grab and go behavior around breakfast. So we're not far away from that one either. Now, on the beverage and the dinner, we're looking more into the latter half of the year to engage in those two levers.

Amy Greene - Avondale Partners

Okay.

Bill Koziel

Hopefully that helps you, Amy. We can talk a little more offline, I think.

Amy Greene - Avondale Partners

Yeah, I know. And that's good. I just wanted to get an idea of how you're going to plan on staging it out. What are you thinking? I know you've told us what you are looking at as far as cost of goods sold for the year and the improvements there, but if I were to look at it, just from in the grand scan, look at just unit level margins for the year, are you all targeting accumulative improvement that you all want to talk about yet or are we still just going to look at some of the pieces?

Bill Koziel

Amy, I think we're going to really see the traction in the business in Q2, as Jim stated. So I think it's a little premature for us to start to set targets out. I think what you can look at is the performance of 2007 where we have restaurant margins roughly at 13%. If you go back to 2006 and 2005, you can see that we were up in the 17%, 18% range in margin opportunity.

So I think we're in a recovery mode, and I think we're going to see some traction as we move through 2008 away from where we were at in 2007 and more closely aligned to prior year's performances.

Amy Greene - Avondale Partners

I guess that's what I was trying to get at is, is that, I mean, you don't see anything structurally different with the concept that would prohibit you from getting back to the levels that you've seen before, not eventually looking to exceed them.

Jim Hyatt

I think to meet and exceed them is right. And I think, as we see the momentum in the sales activity that we have right now, and then knowing our ability to call back the labor that they are already showing great strides in, and then the other is calling back all of the mismanagement, if you will, on cost of goods and bouncing a little bit against the commodities, I think we're right back to the 18% and so that Bill was talking about just a second ago. So a little more downstream, I think, as we get a better command of all of our flow-through margins as we work the business up.

Amy Greene - Avondale Partners

Okay. Thanks guys.

Operator

It appears there are no further questions. I will now turn the call over to Mr. Bill Koziel for closing remarks.

Bill Koziel

Thank you, operator. I want to thank all of you for joining us on today's call. And again, we look forward to continuing to update you on our progress as we move forward through 2008. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.

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Source: Cosi Inc. Q4 2007 Earnings Call Transcript
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