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Executives

Scott Bonikowsky - Vice President of Investor Relations

Paul D. House - Executive Chairman, Chief Executive Officer, President and Member of Executive Committee

Cynthia Jane Devine - Chief Financial Officer, Principal Accounting Officer and Executive Vice President of Finance

Analysts

Irene Nattel - RBC Capital Markets, LLC, Research Division

Matthew J. DiFrisco - Lazard Capital Markets LLC, Research Division

Peter Sklar - BMO Capital Markets Canada

Michael Van Aelst - TD Securities Equity Research

Joseph T. Buckley - BofA Merrill Lynch, Research Division

James Durran - Barclays Capital, Research Division

Michael Kelter - Goldman Sachs Group Inc., Research Division

John S. Glass - Morgan Stanley, Research Division

Christopher T. O'Cull - KeyBanc Capital Markets Inc., Research Division

John W. Ivankoe - JP Morgan Chase & Co, Research Division

Keith Howlett - Desjardins Securities Inc., Research Division

Kenric S. Tyghe - Raymond James Ltd., Research Division

Tim Hortons (THI) Q1 2013 Earnings Call May 8, 2013 2:30 PM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Q1 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded Wednesday, May 8, 2013. I would now like to turn the conference over to Scott Bonikowsky. Please go ahead, sir.

Scott Bonikowsky

Great. Thanks, operator, and welcome, everyone, to the Tim Hortons First Quarter 2013 Conference Call.

We released our results earlier this morning before the market opened. To access our earnings material and the presentation supporting today's discussion, please visit the Investor Relations website section of our website and click on the Events and Presentations tab. And we'll have the material there available for about 1 year.

Paul House, our Executive Chairman, President and Chief Executive Officer; along with Cynthia Devine, our Chief Financial Officer, will be joining the call this afternoon as always. We'll be pleased to take questions after our prepared remarks.

Please note that we may provide forward-looking statements or information this afternoon within the meaning of the Private Securities Litigation Reform Act of 1995 and Canadian securities laws, which include discussions about future performance, results and outlook based on our current expectations and information. Forward-looking statements are based on a number of assumptions, contain risks and uncertainties, and our actual results could differ materially from these statements.

Please refer to the company's 2012 annual report on Form 10-K filed on February 21, 2013, and our quarterly report on Form 10-Q filed earlier today. These include detailed information regarding risks and uncertainties, which could impact our ability to perform as expected, as well as material assumptions underlying the expectations described in our forward-looking statements. Please read our full Safe Harbor statement on our Investor website and in our presentation supporting today's call.

I'll remind you that all Tim Hortons' results are presented in accordance with U.S. GAAP and reported in Canadian dollars, unless we've indicated otherwise. Today's discussion and supporting presentation include 2 non-GAAP financial measures, adjusted operating income and adjusted debt to EBITDAR. Reconciliations of non-GAAP measures and their most directly comparable GAAP financial measures and other information relating to our use of non-GAAP measures is included in the presentation.

So with that, I'm going to turn it over to Paul House. Paul?

Paul D. House

Thanks, Scott, and good afternoon, everyone. This morning, along with our first quarter results, we are pleased to have announced the culmination of our comprehensive CEO succession process, with the appointment of Marc Caira as the President and CEO. Marc's appointment is effective July 2, and it's also our plan for him to stand for election as Director of the board at our Annual Shareholders Meeting being held tomorrow.

Marc will become the fourth CEO in the history of Tim Hortons, and I believe he is ideally suited to lead the company into the future. Until last week, he was global CEO of Nestlé Professional and a member of the executive board of Nestlé, the world's largest food and beverage company.

Nestlé Professional is the world's largest organization focused on the out-of-home food services and beverage industry. Marc led a 10,000-people organization, which operates in approximately 100 countries.

Among the roles Marc held prior to his most recent position, which he was appointed to in 2006, was President and CEO of Parmalat North America, Chief Operating Officer of Parmalat Canada and President, Food Services and Nescafé Beverages for Nestlé Canada.

The Nestlé Professional global out-of-home business was created in 2006. And under Marc's leadership, the business underwent a dramatic and very successful strategic transformation and worldwide expansion in the hot and cold beverage and food sectors. Marc also helped Parmalat's North American businesses successfully navigate during a time of significant adversary -- adversity in its parent company. He recapitalized the Canadian business and ensured the continuation of a large, viable and very profitable business.

Quite simply, Marc has an outstanding track record of success and leadership that spans 3 decades. I consider him to be one of the most knowledgeable food service and beverage executives there is.

While he has literally traveled the world in building the Nestlé Professional business, Marc also has extensive knowledge about out-of-home beverage and food service industry in North America.

Equally important, he has a long-standing history with the Tim Hortons business and the knowledge of our brands through his various roles. As a Canadian, he understands the unique role of Tim Hortons in Canada and the great trust we enjoy. As a global food service executive, he has an excellent grasp on the strategic opportunities and challenges in front of the company and our industry.

And as I said in our announcement, I am confident the organization is in great hands. After Marc joins us in early July, I will become Chairman of the company. This appointment was one of the several exciting strategic developments that we believe will help set the stage for our continued growth and progress across our markets.

As expected, it was a soft quarter for us, in which we experienced a slight decline in same-store sales. But we are taking important steps designed to help drive growth in the short term, as well as the longer term.

We reached another important milestone in our international strategy with the announcement of our entry into the Saudi Arabian market. Saudi Arabia has about a population of over 25 million and a GDP that ranks in the top 25 globally. We have signed an area development agreement with Apparel Group to develop up to 100 multi-format restaurants in Saudi Arabia over the next 5 years. The Saudi market has a number of major restaurant brands and has high consumer demand for coffee. We believe there's a good opportunity to develop the Tim Hortons brand in the major urban markets there.

This agreement is a natural extension of our existing agreement with Apparel to develop up to 120 Tim Horton restaurants in the other Gulf Cooperation Council states. This new agreement is incremental to that initial one and establishes a roadmap for us to reach 220 restaurants across the GCC. The new agreement for Saudi Arabia includes further opportunity for the development beyond the initial 100 locations.

We currently have 27 restaurants in the GCC, and our early experience has exceeded our expectations. Apparel has done an incredible job in building, marketing and operating the restaurants and our guest offerings. We continue to evaluate other markets in various regions around the world, with a view to further expanding our international presence over time.

This morning, we also announced the next step in the execution of our single-serve coffee strategy. As you know, we launched our first single-serve offering last fall based on Kraft's TASSIMO system. Our T DISC product has been well received, and TASSIMO enjoys a strong position in Canada and provides us access to about half the market.

We had indicated to investors with our launch that it was our intention to make Tim Hortons Coffee available on each of the major single-serve platforms our guests wish to brew it on. We have chosen to complement our TASSIMO launch with the Mother Parkers RealCup platform. This system employs a unique filter design that is compatible with K-Cup brewers, but is not affiliated with K-Cup or Keurig. The product will be available by early summer in our restaurants and online.

Access to K-Cup compatibility formats represents close to half of the market in Canada and a much larger share in the United States. We look forward to further success in this small but rapidly growing segment of the hot beverage market.

During the quarter, we made continued progress on other important strategic priorities, particularly those focused on the ongoing expansion and improvement of our system. We plan to continue to expand the systems this year through the development of over 250 restaurants systemwide. While the first quarter is typically a slower one for construction projects, we opened 35 restaurants as part of our 2013 development plans.

In 2013, we also plan to renovate over 300 restaurants in Canada and then to enhance over 1,000 of our drive-thru locations by relocating order stations, introducing double-order stations and changing menu books.

These investments will help us to increase capacity where we need it and improve further the guest experience. We are also pursuing shorter-term growth initiatives to help address some of the challenges we are seeing in the operating environment.

In the first quarter, we launched several new menu items. These included the flatbread Breakfast Panini, which is new to our Canadian restaurants and further strengthens our position in the breakfast daypart.

As a category extension, it makes use of the equipment our owners have installed for the Panini sandwich platform and has proven very successful in our U.S. markets.

We have also introduced vanilla bean lattes in our expanding hot beverage selection, and we introduced the Thick Cut Bacon across all our dayparts. And we are planning further category extensions throughout the year.

On the marketing side, Roll Up the Rim, our signature program ran in the first quarter and is a great way to reward our guest for their loyalty, and we gave away over $50 million of prizes this year.

Other promotions in Q1 focused on grilled cheese Panini with sun-dried tomato soup, coffee and doughnut combos and valued breakfast options. And we have a very busy promotional calendar planned for the coming quarters.

For example, earlier this week, we announced new contest called Chill to Win, designed to promote sales of our Iced Capp beverages. In the first quarter, these initiatives were not enough to overcome some of the broader headwinds we faced. Economic conditions remain challenging in both Canada and the United States. And in fact, 53,000 jobs were lost in Canada in March alone.

We believe the macro level environment has impacted consumer confidence and constrained their discretionary spending. The difficult conditions have also led to an intensified competitive environment in our sector over the past several quarters, characterized by more aggressive discounting and bundling.

Furthermore, we faced very challenging prior year compatibilities -- comparables in Q1, which were aided by highly favorable weather conditions last year. The timing of statutory holidays also had a negative impact.

Against this backdrop, we recorded a slight same-store sales decline of 0.3% in Canada and 0.5% in the United States. We also experienced a slight decline in systemwide transactions. Now these results are very unusual for Tim Hortons, but in the current environment, they have not been uncommon in the restaurant sector.

There were bright spots, including Panini sandwiches and single-serve coffee. Our guest responses to both products was encouraging, but it was outweighed by the softness in other areas. The menu, promotional and operational initiatives I've described are designed to help us adapt to the current operating environment and grow our business.

Our history is one of continued adaptation to meet changing needs. Our U.S. expansion strategy in particular has continued to evolve. So I'd like to spend a moment on that topic.

Our approach to the development of U.S. market has changed considerably over the past decade, and we expect it to continue to evolve. We initially seeded a number of local markets and now have restaurants in 11 different states. More recently, we have been deploying our capital into our highest growth U.S. markets to increase the density of our restaurant footprint.

This approach allows us to leverage advertising scale and enables guests to visit more frequently and equates opportunity for increased average unit volumes. While we have achieved systemwide sales progression in our U.S. business, we believe there are opportunities to derive better returns in the United States market through a less capital-intense development approach. We have indicated one potential opportunity is working with well-capitalized franchisees, with the resources to develop and operate multiple locations.

Working with such franchisees would enable us to deploy less capital while enhancing development and brand awareness in various markets.

This is an approach we are actively considering to complement our existing development efforts in conjunction with our ongoing reviews of how we develop the markets.

Now let me be very clear on this point. We are pleased with our systemwide sales progression in the United States. There are growth -- the growth patterns we are seeing in the U.S. are no different than we saw in the early days of development markets in Canada. As we develop those markets, we reach the density and the sales volume necessary to generate strong returns.

We are committed to the United States market for those reasons and continue to believe it holds great potential for us. However, we believe we can and should be achieving improved returns, remain open to additional avenues to further build and develop the brand in the United States.

I'll close by noting that we completed the implementation of our new structure in the first quarter. We've been pleased with the focus and commitment of the organization to the transition to the new structure. And we believe it is the right one to take this company forward. And Cynthia will now provide further details on our financial and operating performance in the first quarter. Cynthia, if you would, please.

Cynthia Jane Devine

Thanks, Paul, and good afternoon, everyone. As Paul outlined a few minutes ago, our sales were soft in the first quarter, as we indicated they would be on the last conference call. Systemwide sales grew 3.2% in the first quarter on a constant currency basis. The growth was driven by new restaurant development as same-store sales declined in both Canada and the U.S.

We believe the biggest cause of the softness in our sales has been the challenging economic climate and the resulting intensified competitive environment, along with the less favorable weather compared to last year.

Also, the timing of the fiscal calendar resulted in both New Year's Day and Easter weekend falling in the first quarter of 2013, whereas neither of those impacted our results in Q1 last year. Holidays tend to be slower sales days for us, and many of our nonstandard locations are actually closed.

In addition, we had very strong comparables, as Paul mentioned, in Q1 last year, which benefited from strong promotional activity in the unseasonably warm weather that we had. This year's winter was much more typical, meaning we had a number of softer sales days as a result of heavy snowfall in many of our markets.

In Canada, our same-store sales declined 0.3%. We grew average check through both pricing and favorable product mix, but this was offset by a decrease in transaction. The Panini rollout and the single-serve coffee both had a positive impact on same-store sales, while hot beverage had not been an impact.

On the hot beverage side, we had a very active first quarter last year in terms of both promotion and product innovation, so we were facing challenging comparables.

In the U.S. segment, same-store sales declined 0.5%. Higher average check, driven mainly by pricing, was offset by a decline in same-store transactions. The colder weather had a negative impact in the U.S., particularly on sales of our cold specialty drinks and our Cold Stone Creamery ice cream products.

The revenues for the first quarter increased by 1.4% over Q1 2012. This growth rate was below our systemwide sales. Distribution sales, which is the largest component of our revenues, declined by 2% as a result of lower commodity costs, particularly related to coffee. Because of the fixed dollar markup that we typically apply to our products that we distribute, we essentially pass cost changes on to our restaurant owners. Our margin percentages, as a result, moved around a little bit, but our overall margin dollars tend to grow along with systemwide sales, excluding the impact of pricing.

Our supply chain activities are central to our business model, an important means of supporting our business units in meeting the needs of our restaurant owners. In managing our supply chain activities, we are able to leverage our considerable scale in Canada to create efficiencies, build competitive advantage and provide quality cost-competitive products and timely deliveries to our restaurant owners while generating strong returns for our shareholders.

Less than 10% of our fixed assets are invested in our distribution operations. In situations where we're not able to leverage our scale or create warehousing or transportation efficiencies, such as in the U.S. market and in certain parts of Canada, we typically still manage and control the supply chain using third-party warehousing and transportation.

As you can see on Slide 14 of our presentation, all of the other components of our revenue were up from last year, including rents and royalties, the second largest component, which increased by 4% driven by our systemwide sales growth.

So now I'll move to the costs and expenses, which are shown on Slide 15. In terms of costs in the quarter we had a notable increase in 2 line items. One was our operating expenses, which grew mainly due to higher depreciation and rent expenses associated with more properties being added to the system and higher property maintenance costs. We also had higher depreciation related to our ad fund's digital menu board program.

The other cost item is the corporate reorganization expense of $9.5 million. So we're pleased to have completed the reorganization in the fourth -- in the first quarter.

Two of our major expense items decreased from Q1 of last year. Cost of sales was down slightly due to the lower commodity costs. And general and admin expense decreased by 6.7% due to lower salaries and benefits due in part to vacancies arising from the reorganization work that will be filled as the year progresses.

So now I'll turn to earnings which is on Slide 16 of our presentation. Operating income of $127.9 million was down 2.8% from Q1 of 2012. The decrease can be attributed to the corporate reorganization expense. So when we backed that out, adjusted operating income grew by 4.4%. Just as a reminder, adjusted operating income is a non-GAAP measure, and we reconcile that back to operating income on Slides 23 and 24 of the presentation.

Net income attributable to Tim Hortons was down 2.9%, which was roughly the same percentage decrease as our operating income. Earnings per share was flat at $0.56, as the decline in net income was offset by a 2.5% reduction in our share count as a result of our share repurchase program.

So excluding the $0.05 impact of the reorganization charge, EPS would've grown by 8.1%.

So at this point, I'll discuss the performance of our operating segments. So this quarter, we revised our segment reporting to correspond to our new organization structure. As a result, we now have 3 reportable segments: the Canadian business unit; the U.S. business unit; and corporate services. The Canadian and U.S. business units comprise substantially all restaurant-related operations, including rents and royalties, sales of products through our supply chain and an allocation of supply chain income based on the units' respective systemwide sales. It also includes franchise fees in corporate restaurants.

These segments also include business unit-related general and administrative expenses. Each of the Canadian and U.S. business units includes the result of all of their respective restaurants, but excludes the consolidation effect of variable interest entities, or VIEs.

Corporate services consist of services supporting the business units, including general and administrative expenses in manufacturing and distributing activities. Corporate services also includes the results of our international operations.

The distribution component of our business encompasses managing our supply chain, the physical warehousing and delivery services. While an allocation of supply chain income remains within our Canadian and U.S. business units, warehousing and delivery or our distribution services is now included in corporate services, along with our manufacturing activities. We provide further detail in the MD&A about the changes to our segment reporting.

Slide 18 summarizes the performance of our operating segments for the first quarter. In Canada, operating income decreased 1% to $145.8 million. While systemwide sales growth drove increased rent and royalty revenues, this was offset by higher operating expenses. In the U.S., operating income of $0.9 million was down by $0.7 million from a year ago. Here as well, systemwide sales growth had a positive effect on rent and royalty revenues, but it was offset by relief provided to newer restaurants and higher operating expenses.

The corporate services segment had an operating loss of $10.7 million. This was an improvement of $8.1 million compared to last year. The reduced operating loss was due to operational improvements at our distribution centers, lower general and admin expenses and the timing of certain items, as well as a onetime gain from a corporate property sale.

This morning, we announced that the board has approved a $0.26 per share quarterly dividend based on the continuing strong cash flows of our business. Slide 19 shows some highlights of our cash position.

So with that, I'll turn my discussion to capital allocation. Our first priority in relation to our business model and capital allocation philosophy has always been to reinvest in the business to drive growth and success of our system in order to create long-term value for our shareholders. Given our significant financial strength, we regularly review opportunities for creating value and maximizing shareholder returns.

Last quarter, I addressed the topic of real estate investment trusts, or REITs, given that they have become a popular investment choice and business model. We have evaluated the possibility of transferring real estate under our control to a REIT structure, as we have in the past, given the number of recent REIT transactions.

Our conclusion is that the establishment of a REIT structure would not create significant value for a number of reasons. These reasons include the number of leased sites in our system and the fact that there is a portion of income we derive from real estate under our control, which may not be considered qualifying income for REIT purposes.

However, we believe there may be greater value-creation potential in adding leverage. This is especially relevant in light of the historically low interest rate environment that has persisted for some time now and the financial flexibility afforded us by the strength of our balance sheet.

Assessment of the optimal capital structure of the company is an area we are actively exploring in light of this current interest rate environment. Our assessment needs to take into consideration a few key factors. These factors include our debt capacity to maintain an investment-grade credit rating and the tax implications of our complex cross-border corporate structure.

On debt capacity, access to capital markets is important to us given the nature of our business model and the investments we make to drive future growth. Our rating agencies include the impact of operating leases when looking at our debt ratios relative to our credit rating.

In our slide presentation, we have provided some information on the ratios that the credit rating agency uses to evaluate us.

Regarding our corporate structure, substantially, all of our free cash flow is generated from our Canadian operations, and it passes through a U.S. holding company before distribution to the Canadian public company and ultimately, our shareholders. This means that the Canadian earnings are subject to U.S. income and withholding taxes. Our structure was inherited from our spin-off from Wendy's in 2006 and subsequently modified in 2009.

In addition to providing operational and administrative efficiencies, our effective tax rate was approximately 8% lower in 2012 than it otherwise would've been had we not undertaken the reorganization. Our effective tax rate is now closer to the lower Canadian statutory rate, where substantially all of our income is earned.

Given these factors, adding leverage is not as simple as it may appear on the surface. That said, we do believe there may be additional potential to add debt to our balance sheet as part of our review of the optimal capital structure. This additional debt could be used for several purposes, including potential share repurchases and other potential uses of capital.

We are working on various alternatives to address the constraints embedded in our current corporate structure. Addressing these constraints is an important consideration for us as we evaluate the potential benefits associated with any particular capital allocation strategy. It is also important in maintaining our lower effective tax rate over the longer term.

We continue to actively explore these and other ideas designed to drive value and return for our shareholders. There can be no assurance at this time about what decisions we may ultimately make or the timing of those decisions. As we continue these activities, we will provide further updates.

We have had considerable ground to cover this quarter, including the exciting strategic developments that Paul shared with the announcement of a new CEO and the new development agreement for Saudi Arabia and our next single-serve coffee offering.

We face difficult comparable periods in the first half of the year, but that headwind eases as we go forward. The macro conditions have remained stubbornly persistent. But as Paul outlined, we continue to adapt and innovate to respond to those conditions.

So with that, I'll turn it back over to Scott.

Scott Bonikowsky

Okay. Thanks, Cynthia, and operator, we're now ready to begin our Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from line of Irene Nattel with RBC Capital Markets.

Irene Nattel - RBC Capital Markets, LLC, Research Division

Thank you, by the way, for clarifying many things on this call, but one of the things I'm wondering about, Cynthia, or whomever wants to answer this question, is the assessment of optimal capital structure and what you may or may not have to change in order to add some leverage on to your balance sheet. Wondering how long that process might take, whether we should expect a resolution within the context of the 2014 strategic plan or whether that might be sooner? And the related question of do we have to wait for all of that to see a resumption of the share buyback?

Cynthia Jane Devine

Thanks for your question, Irene. With regards to -- as we said in my prepared remarks, we're actively looking at this right now. And so we hope to be able to get back to the market in a reasonable period of time if we make any decisions to do anything differently. I think in the context of the announcement of the new CEO, you would certainly want a new CEO to be involved in that decision as well. So that is also a factor. With regards to our share repurchase activity, we did begin our automatic trading, starting at the beginning of April and we will -- it is our intention to continue our share repurchase program and continue buying shares in the back half of the year.

Operator

Our next question comes from the line of Matthew DiFrisco with Lazard Capital Markets.

Matthew J. DiFrisco - Lazard Capital Markets LLC, Research Division

I wonder if you could just touch a little bit more on the reference that you made to competition. Where are you seeing that? Is it more -- it sounds like in the remarks, you might be seeing that actually in some of the beverages, not just some of your food items. I guess, when you look at the comp, is there somewhere you could see where there might be incremental competition on hot coffee? Or is it the sandwich items that you're seeing some competition on? If you can give us a little more color.

Paul D. House

Okay. I wouldn't say it's new. It's just continued activity in the marketplace that probably everybody in the industry right today is running $1 beverage somewhere, somehow, some type. So that's -- that was a normal activity a couple of years ago before we hit these current economic headwinds. So I wouldn't call it new, but there's all kinds of competitive competition taking place out there.

Matthew J. DiFrisco - Lazard Capital Markets LLC, Research Division

Is there -- is that a reference then that you are losing share in the market? Or is the market also -- the Canadian market negative as far as how you look at it and what you'd categorize as your competitive set?

Cynthia Jane Devine

Overall, I would say, no, our share is relatively flat overall in terms of traffic. But I would say the market itself is not really that robust in terms of growth. We're seeing that the growth that we used to see 3 and 4 years ago in terms of the overall market just in the last little while hasn't been there.

Operator

Our next question comes from the line of Peter Sklar with BMO Capital Markets.

Peter Sklar - BMO Capital Markets Canada

The reported loss year-over-year was substantially less you rate the number of contributors to that. You talked about the timing of certain expenses, commodity timing. I think you mentioned the corporate asset sale. Could you talk about what the positive impact was at the corporate asset sale? And maybe elaborate a little bit further on some of these issues and what the repeatability is?

Cynthia Jane Devine

Peter, we missed the first part of your comment. I don't know whether it was kind of muted. I can answer the last part, but the first part of your comment, I missed.

Paul D. House

Maybe, Peter, if you can [indiscernible].

Peter Sklar - BMO Capital Markets Canada

Just on the corporate services segment where you reported substantially lower -- smaller loss versus last year, I just wonder if you could elaborate on some of the factors and provide the actual effect of the corporate asset sale?

Cynthia Jane Devine

The asset sale was essentially -- if you look at the change in our other income, it was essentially, for the most part, a portion of that. So our change in other income expense was about $1.2 million for the year and the corporate asset sale was about $700,000 of that. There was foreign exchange and some other factors that were in that number as well. So that's the component that went through corporate services.

Peter Sklar - BMO Capital Markets Canada

Okay. And can you elaborate just on some of the other factors that you've highlighted? You highlighted there commodities, timing of certain expenses. Can you just talk a little bit more about that and what the repeatability of that is going to be?

Cynthia Jane Devine

Yes, those are more in the normal course of business and things that we contemplated. For the most part, none of those things are surprises for us and we took them into account in our targets for the year. But it's from time-to-time, I think we've talked about this before as there's some variability as it relates to our purchases of certain commodities. And we worked with our restaurant owners off a fixed price for a longer period of time. So sometimes, you have either upsides or downsides related to that commodity impact that may extend beyond the quarter. And our pricing to our restaurant owners is fixed for that period of time. So that is just -- and what's gone through that for the quarter, and so it's nothing really unusual. It just happens to stand out in this quarter, and we would expect it to have some -- to some of that to have a reversing effect in the back half.

Operator

[Operator Instructions] Our next question comes from the line of Michael Van Aelst with TD Securities.

Michael Van Aelst - TD Securities Equity Research

Sorry, can you clarify again in layman's terms what you're implying about the restrictions on paying out capital or leveraging your balance sheet? Are you suggesting that if you were to pay out or leverage your balance sheet at this point in time that your tax rate would go up significantly?

Cynthia Jane Devine

Yes. Today, if we were to add significant leverage to the balance sheet without any adjustments to our corporate structure, there is -- yes, that would be one of the impacts. So some of the things that we need to work out and it really depends on the size of the leverage. The larger the additional leverage that you would take on, obviously, the more impact it would have on the tax rate.

Michael Van Aelst - TD Securities Equity Research

Can you give us any kind of thresholds that might be important?

Cynthia Jane Devine

That's really -- that's the analysis that we're working through right now, Mike. And that's really what we want to get back to everyone with once we've had a well-thought out kind of strategy for any changes there at the optimal capital structure for the company. But that's exactly the exercise we're working through.

Michael Van Aelst - TD Securities Equity Research

Okay. And as far as the appointment of Marc, it's clear that he has a vast experience in managing large corporations and -- in the food service or supplying products to the food service industry. But can you maybe give us some or help us understand Marc's direct experience in dealing with the North American QSR industry?

Paul D. House

Well, Marc's been around our company from his early days in Nestlé and directly involved with us in the development of a lot of products, and from our some a lot of our soups and a lot of other things that Nestlé have developed for our chain over time. I've known Marc for a number of years. He has got a very in-depth knowledge of the food service industry and particularly, in the hot and cold beverage. And certainly, in his last few years traveling worldwide, he's got a very global outlook on the industry and what needs it has and so forth. And he's -- trust me, he has an in-depth knowledge of Tim Hortons. He has been a student of our brand for probably 25 years or so.

Operator

Our next question comes from the line of Joe Buckley with Bank of America.

Joseph T. Buckley - BofA Merrill Lynch, Research Division

I guess 2 quick follow-ups and then maybe a question, if I can. So you bought no stock in the first quarter. Was there a reason for that? You said you have started buying stock again here in this quarter. But was there a reason for no repurchases in the first?

Cynthia Jane Devine

Well we have 2 components of our program, Joe. We have a discretionary component, and we have an automatic trading. As a said, the automatic trading began at the beginning of April. With regards to our discretionary purchases during the quarter, we didn't make any discretionary purchases, and that's really -- we look at internal and external factors and make a determination of the discretionary component. We did not execute it during the first quarter. But as I said, it is our intention to complete our share repurchase in -- at the balance of the program, which is expected to be completed by February of 2014.

Joseph T. Buckley - BofA Merrill Lynch, Research Division

Okay. And then in the consideration about debt, you mentioned the corporate structure, but you are pursuing the debt idea. Is it possible the corporate structure changes again?

Cynthia Jane Devine

Which corporate structure are you talking about?

Joseph T. Buckley - BofA Merrill Lynch, Research Division

I wish I knew. The corporate structure that would prohibit leveraging the balance sheet.

Cynthia Jane Devine

You're talking about the actual companies, not our people reorganization. Okay.

Joseph T. Buckley - BofA Merrill Lynch, Research Division

That's right. Yes. I'm sorry, yes.

Cynthia Jane Devine

Is it possible that we'll reorganize again? That's work that we're doing right now in order to kind of optimize the capital structure of the company. We are a Canadian public company, and I wouldn't expect to see that change. But in order to try to facilitate changes to the capital structure, you're always looking at your corporate structure and looking for ways to make it as efficient as possible.

Joseph T. Buckley - BofA Merrill Lynch, Research Division

Okay. And then -- and last but not least, the talk about concentrating in the U.S. markets doesn't sound like it's new. So but have -- has your performance in the most penetrated U.S. markets been much better than the market as a whole?

Paul D. House

I would say so, Joe. Yes, that's where we've been putting our investments. As we said, when we restructured, if not -- I don't want to use that word again. At the U.S. business, we decided to concentrate our capital into those markets that were further along developed and that way, we get better return on our capital over a shorter period of time. And we've been very happy with that progression. But to be very frank with you, as the whole industry found in the last 6 to 9 months, things have cooled out a bit in the business in the United States. And a year ago, we had great results, and we're very, very, very positive about the business, and we still are very positive. And we see our competitors not doing as well in current times. But we still feel very, very positive, and we're going to concentrate with our capital into our existing markets that we're well penetrated.

Operator

Our next question comes from line of Jim Durran with Barclays.

James Durran - Barclays Capital, Research Division

Just wanted to turn back to the comp store sales performance in the quarter. You had sort of warned us coming out of Q4 that Q1 was starting off weak. Given that sort of revised expectation, would you view the quarter as having come out as you would've expected or did it get worse?

Paul D. House

I don't know. I think the quarter just pretty much -- we knew going into the quarter before that because of the strong quarter we had last year, the great weather that we had, and that it was going to be a tough quarter for us. And I would say it has performed the way we expected, unfortunately. I would like to have been surprised.

Cynthia Jane Devine

In March, we continued to still get weather. So when we last spoke to you in February and you would hope that most of your issues were behind you from a weather standpoint, we still got hit with a few -- we don't like to blame the weather, but it's the facts. And so I think that was maybe a little bit of a factor, still in March. But you can't -- you don't really know in February whether it's going to be one of those beautiful Marches or a heavier winter.

James Durran - Barclays Capital, Research Division

And any improvement since March has now past?

Paul D. House

Well, we're -- we've got a really good marketing calendar. We've -- certainly, weather gets a lot more -- it's getting a lot more favorable and certainly with the amount of cold drinks and stuff we sell and the promotions that we're doing. So we're looking forward to a stronger quarter. That's for sure.

James Durran - Barclays Capital, Research Division

Okay. And then last question just now with the new CEO in place, can you give us some idea as to what timing we would expect for the strat plan exercise to unfold, such that we'd know about it in the public market?

Paul D. House

Yes. Well, as we said in the announcement, Marc will not be joining us until July 2. He still resides in Switzerland and so it's going to take him time to get relocated here. And so I'm the best you've got at the moment. And -- but we're doing work on strategy here continuously. So it's the development of the new strategic plan, I'm sure, will be in due course. And we are going to put together a new strategic plan, and we've got a lot of initiatives and work underway in that area. So can't give you an exact timing. That will be up to Marc when he looks at things and what timetable he wants to develop for it.

Operator

And our next question comes from the line of Michael Kelter with Goldman Sachs.

Michael Kelter - Goldman Sachs Group Inc., Research Division

When you guys think about leverage, and I know you still have a lot of work to do here, but conceptually, do you guys think of yourselves more like McDonald's, which has a similar model as you, only carries 2, 2.5 turns of adjusted net debt-to-EBITDAR? Or you think more like Dunkin' and Domino's, the fully franchised companies, which are 4x or higher? If you take the corporate structure stuff out, how do you think of yourselves? And then on that same topic, I mean, how do you think about buybacks versus special dividends?

Cynthia Jane Devine

I think we think of ourselves not necessarily on credit metrics in that, but when we look at our business model, think of ourselves much more aligned to McDonald's. And probably the access to capital would be similar to what McDonald's would have, given our investment in real estate and other components of the business. So I think we would see ourselves as a bit more on that as the comparable. We also look at our Canadian peers, companies like Shoppers Drug Mart, Canadian Tire, Loblaw, Sobeys, Metro, all those types of companies, as well in the Canadian landscape because that's a lot of our investors look at those as well. So those are companies that we also consider as part of our peer group. Does that help?

Michael Kelter - Goldman Sachs Group Inc., Research Division

Yes. And the buybacks versus special dividends?

Cynthia Jane Devine

We looked at both of them. I would say we have definitely shown more of a bias towards share repurchases. I think you get a benefit of share repurchases over a longer time period. I mean, simple math, you reduce the denominator, you get the benefit for a long period of time as opposed to a special dividend that rewards somebody on a particular day. So I would say our bias has been, but that's up for the consideration of the board and the management team over time to make sure that assumption is still valid.

Michael Kelter - Goldman Sachs Group Inc., Research Division

And then on the REIT structure, I mean, given what you said having evaluate it -- evaluating it and you decided it didn't create enough shareholder value, do you consider the matter closed or are you still exploring some potential opportunities?

Cynthia Jane Devine

I really -- I mean, we have done a lot of work on this, Michael. And I mean, it's always good to never close anything off if it became -- if something in the business model completely changed or you're acquiring something where you had a lot more owned sites or anything like that, then a REIT might make a lot more sense. But at this time for our business, I think the upside value of it is very limited for the complexity that you add to the structure. So I probably wouldn't spent a lot of time on that. And as I said, I think there's more value on looking at our -- the optimal capital structure and making sure that we're leveraging the strength of our balance sheet to the extent that we can.

Michael Kelter - Goldman Sachs Group Inc., Research Division

And then one last thing -- I mean, one of the last things you said in the prepared remarks was that you faced difficult compares in the first half of the year. And I just want to make sure I understood where you're coming from because same-store sales compares were very difficult in the first quarter when you're up against the 5.2, but they actually get much easier in the second quarter when you're up against the 1.8. So when you said the first half of the year, your comps -- or compares were difficult, what is it about the second quarter that you feel is difficult to go up against?

Cynthia Jane Devine

It's probably a fairer comment to say that the remainder of the year and fourth quarter was a bit stronger actually. I think it's fair point in terms of second quarter in Canada at least was a little bit easier. The U.S. is probably more in the context of that comment.

Operator

Our next question comes from the line of John Glass with Morgan Stanley.

John S. Glass - Morgan Stanley, Research Division

If you could just talk about -- going back to the leverage question, is there a specific business rationale for remaining investment-grade? Or is that more of an investor concern in your mind? And if it's a business rationale, what exactly is it? And how much -- on your definition of investment-grade, how much incremental debt could you take on and remain investment-grade?

Cynthia Jane Devine

I think from a business standpoint, we feel that being investment-grade really provides us with a fair bit of financial flexibility to operate our business. We do make significant capital investments in our business, and so we think that being able to raise capital at investment-grade level attractive rates is important for us. We also -- and we talked about this before is that it's really a financially strong franchisor is important for our franchisees. As they invest in the business, then they seek their own financing, we think it's an important criteria. And with regards to what constitutes -- what level could we go to with regards to maintaining investment-grade, that's work that we have underway right now and would be coming back to the market with some definitive thoughts on that. But again, there's 2 components of this, right? The investment-grade part of it is important. But equally important is the complexity of our structure. I think that's fundamental to take that into account that our earnings and cash flows are all kind of in the Canadian part of the structure at the bottom, and then you have a U.S. structure in between and then a Canadian public company. That's equally important in terms of the size of the debts that you could efficiently and effectively have as part of the business.

John S. Glass - Morgan Stanley, Research Division

And just as aside, is that a legacy issue from being a U.S. company at one point that kind of profits go through Canada and come back in?

Cynthia Jane Devine

It is. So we inherited a part of our structure through the spinoff of Wendy's. As you'll recall, we were spun off as a distribution of our shares. And so we were a U.S. public company in the spinoff. And then in 2009, we reorganized the company to become a Canadian public company, and that was -- we did it -- there were a number of operational and other administrative efficiencies, but on top of that, it really allowed us to align our tax rates with Canadian statutory tax rates that have historically and continue to be much lower than U.S. tax rate. So it created great advantage for us from an effective tax rate perspective, but it does add complexity and in terms of moving money through our structure.

John S. Glass - Morgan Stanley, Research Division

Okay. And I guess just one last business question in the U.S. Your average unit volumes in the U.S. are over $1 million. That's as good as Dunkin' brands. It's as good as Starbucks or at least nearly as good as it. And you don't make as much money as those companies, I think, based on your reported numbers. So why is that? In other words, those volumes should produce strong returns for you and your franchisees. Why don't they? Should -- is there a move to rethink your business model in the U.S. so that you do make money at the million-dollar EV?

Paul D. House

Well you remember that, that's an average. And so it's our lows that hurt the overall average and so -- but our model is because of the types of restaurants we build and so forth that we do require higher volumes than Starbucks and Dunkin's. But we are looking at the model. We are looking at smaller stores where we can get the breakeven down lower and so we're looking at other alternatives to make us more profitable for sure.

Operator

Our next question comes from the line of Chris O'Cull with KeyBanc.

Christopher T. O'Cull - KeyBanc Capital Markets Inc., Research Division

Cynthia, I think you said that the distribution manufacturing business is less than 10% of fixed assets, implying about $120 million to $150 million of assets. Is that in the ballpark?

Cynthia Jane Devine

Yes.

Christopher T. O'Cull - KeyBanc Capital Markets Inc., Research Division

Does the segment revenue reflect market-based pricing in your opinion? And what I'm getting at is I'm trying to understand what I'm missing here because it appears the company is producing a couple of hundred million of annual pretax income on $150 million in assets.

Cynthia Jane Devine

So you can't really split it out that way as easily as that, but there is a portion of the supply chain that's allocated to the business units, and there's a portion that relates to the distribution services that are in corporate. The actual revenues for that component of the business are in the business unit segment as opposed to corporate.

Christopher T. O'Cull - KeyBanc Capital Markets Inc., Research Division

Okay, okay. Is there any way to understand what the free cash flows of that business or that segment of the business is? What kind of free cash flow or capital requirements it has?

Cynthia Jane Devine

Well, in terms of the capital requirements, we break that out every year. From time to time, we invest in new distribution assets, and we opened a new distribution center in Kingston. We spent just under $40 million on that facility. There's -- over the years, we continue to reinvest in it. But we needed to, I guess, call it out in the context of our overall balance sheet. The bulk of our -- the assets on our balance sheet are related to restaurant level assets. But what we do -- with our supply chain component of our business and that -- those -- your revenues and profits are used to reinvest back in the business. We do a lot from an R&D perspective. We manage all of the vendor relations. We are -- when we are carrying inventory levels, we're looking at product write-offs and things like that. So we do a lot and make a lot of reinvestment back with that supply chain component of our business.

Christopher T. O'Cull - KeyBanc Capital Markets Inc., Research Division

Okay, okay. And then just one last one. Paul, what are the next steps in the move -- if you were to decide to move towards a different franchise model in the U.S.? What are kind of the next steps that you need to take to do that?

Paul D. House

Well, I guess it depends what you're asking. If you're talking about a capital light model, we have had and continue to have inquiries from some people that are well financially suited that would like to do development in a particular area and employ their capital, as far as construction of the restaurants and so forth. So they want to do area development agreements and stuff like that. So there is opportunity for that, and we think that we talked for years about getting the chain to a critical size. And I think that we're getting near that size, where we show on the radar now. And we can start to leverage some of these relationships and some of these people that have interest in the brand. So this has been something that I've been talking about on the road, talking to investors in the last 3 or 4 months. And it's something that we've been looking at for the last few months and talking to a number of people for the last probably couple of years. That's one way that we're looking at reapproaching the business. And the smaller models that I talked about in some of that, in nontraditional business we think there's great opportunities, we've had a lot of inquiries in those areas, where we don't have to deploy a lot of capital. And we can do a number of locations. So there's lots of opportunities for us to do different things as we expand the brand.

Operator

Our next question comes from the line of John Ivankoe with JPMorgan.

John W. Ivankoe - JP Morgan Chase & Co, Research Division

The question just getting back, again, to kind of debt-to-EBITDAR and why that's an important metric for you. I mean, firstly, there's kind of a lot of different estimates out there of how much additional leverage you could put on your debt-to-EBITDAR and remain investment-grade. I think a lot of people are -- the consensus is somewhere around 1.5 turns, I just wanted to see if that's something in the ballpark of what you think is right? And secondly, your business is obviously built on very substantial rent spreads, your lease commitments versus your franchisees' lease commitments to you on stores that are highly, highly profitable and therefore have fairly little chance of defaulting, especially on any kind of significant basis. So I mean, is there way to kind of unlock that rent spread as the value in the credit markets that maybe the rating agencies themselves don't necessarily recognize?

Cynthia Jane Devine

Are you talking about in form of a REIT or something? Or...

John W. Ivankoe - JP Morgan Chase & Co, Research Division

Well not necessarily that. I mean, what I'm curious and it's -- I mean, I wondered this for McDonald's for many years as well, is that the rating agencies kind of put one value on the paper as your liability of rent is capitalized, but you're not giving an offsetting credit for the asset that the franchisees are paying you in terms of that rental spread. And I think a lot of people are asking you a question in different way that looking at a Domino's or a Dunkin', I mean they're able to get very, very low interest rates without necessarily an investment-grade credit rating. So that's -- to a very large extent, I mean, the question that people want to know is why is -- considering you know the cash flows of your business, you know your access to capital, the ability of you to borrow, not necessarily in traditional high-grade markets, but slightly untraditional markets, including whole business securitization, for example, why that doesn't make sense for you?

Cynthia Jane Devine

Sorry, it is something that we have looked at as well. We'll continue, as we said. We're actively looking at this today. I would say whole business securitizations are not typically done in a Canadian market. In order to do something in the U.S. market for our business, you'd have to be able to swap that back to Canadian dollars and because we would have a significant hedging issue otherwise. So that does add complexity to it. So -- but there's still work to be done, obviously, and looking at some of these ideas. But your point with regard to how the rating agency currently looks at us with regards to the rent components. It's the reality of what exists today, but we'll continue looking at that and see if there's a more meaningful way that we can be looked at. We definitely recognize that the earnings that we have from our rent and royalty business are very important part of it and -- of our business and are obviously, generate significant income for us and should be valued that way. But we have to do it in the context of how rating agencies look at the company as well.

John W. Ivankoe - JP Morgan Chase & Co, Research Division

Understood, of course. And then my first question, I apologize -- for it being as long as it was, how much debt -- I mean, is 1.5 turns just in terms of traditional debt-to-EBITDAR as you laid out in the appendix, is that ballpark of what we think -- of what you think you could put on the balance sheet and still maintain investment-grade, the corporate structure and the tax implications notwithstanding?

Cynthia Jane Devine

Well, today, as we had in the slide, we're at 1.7x now. So you're asking what additional...

John W. Ivankoe - JP Morgan Chase & Co, Research Division

Yes, exactly.

Cynthia Jane Devine

That's exactly the exercise we're going through right now in order to determine how much capacity do we have left. We believe, there's capacity in terms of where we are today because we're at a low and where we could get to and still maintain investment-grade. That's exactly the exercise we're going through.

Operator

Our next question comes from the line of Keith Howlett with Desjardins Capital Markets.

Keith Howlett - Desjardins Securities Inc., Research Division

Yes, I had a question on executive personnel. First is whether you've made headway in getting your Chief Marketing Officer for the time when Bill Moir steps down? And secondly, I was wondering what the retention agreements mentioned in the MD&A related to?

Paul D. House

In response to Bill, that's we had always -- from my perspective was to leave that to the new CEO, and that person was appointed. We did come to the arrangement with Bill that we would look at that as this trend took place. And so I would anticipate, as Marc gets onboard here, he will start to look at that because of those age and so forth. But we still expect Bill to be around and participating in the brand for some time. So that's -- as far as that's concerned, as far as the retention agreements, they were put in place some time ago to keep our key executives with us. We've got a great team of people. I think the important thing there is that the team knew for some time that as you did, that we were going outside to select a new CEO. And so we've -- the team has been very cooperative, and we worked great as a team, and they're enthused about Marc coming on board.

Keith Howlett - Desjardins Securities Inc., Research Division

And then just on the distribution business versus the franchised restaurant business, what would be a ballpark spread on the return on capital employed between those businesses?

Cynthia Jane Devine

We haven't really broken it out that way. So I'm not sure I could answer that question for you. But I think overall, if you look at the return on assets of the company, that's kind of -- we see it as we have multi-streams of earnings, and you can't really parse them apart. They're very -- they're all important for the investments that we make in the business and to help our restaurant owners. So for us, it's really the total returns that we have are very strong and when we compare them to top 25 companies in the restaurant industry, we outperform them on those return type metrics. And so it really is on an overall basis that we're looking at it.

Operator

And our final question comes from the line of the Kenric Tyghe with Raymond James.

Kenric S. Tyghe - Raymond James Ltd., Research Division

If I can just follow up on the single-serve extension, the rationale both for the sort of K-Cup compatible versus the actual K-Cup. And secondly, perhaps a more longer-term or strategic question would relate to the possibility, if any, of coming to agreement for single-serve in retail or in grocery as it is for a lot of your competitors, to the extent you can comment on either, please?

Paul D. House

Sure. Well, we chose the K-Cup because -- or the Mother Parkers version because we just feel the quality of the product, the technology that they employ, and we have a long-standing relationship with Mother Parkers. In fact, they were the original supplier to run Tim many, many years ago. And giving with them is more -- is not bringing on a new supplier. They've got some great production equipment here right here in the city. And so there's a number of reasons. But the overall quality of the product, we are extremely impressed with that. And probably at the end of the day, that's weighted more than anything else. As far as whether we'll go into other distribution system such as grocery and so forth, we made the commitment that when we brought this to the market with our franchise community, that we would only sell it in their stores until we learn more about the marketplace, and we're still in that learning timeframe. And I'm sure as Marc comes on board and time goes on, the team will look at whether it's worthwhile to take it out beyond our stores or just to leave it within our existing restaurants.

Operator

And I will now turn the call back to you, Mr. Bonikowsky.

Scott Bonikowsky

Okay, great. Thanks, operator, and thanks, again, everybody. We didn't get to everybody in the queue, and I know some other people want to get back in but are out of time now. Thanks, again, for joining us for the conference call. And as always, feel free to get me a shout at (905) 339-6186 if for any follow-up. Thank you. Have a great day.

Operator

Ladies and gentlemen, that does conclude the conference call for today, and we thank you for your participation and ask that you please disconnect your line. Have a good day, everyone.

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