Hortons Hears A Hedge Fund

May.22.13 | About: Restaurant Brands (QSR)

For the vast majority of people in the United States, the name Tim Hortons (THI) means absolutely nothing. However, talk to a Canadian and if they aren't smitten with the chain, their family, friends and neighbors probably are. THI develops and franchises restaurants serving coffee, espresso, cappuccino and other specialty beverages along with donuts/baked goods, Paninis, soups, sandwiches and other delectable fare. Founded in 1964, as of December 31st, 2012, THI owns or franchises 4,264 restaurants: 3,436 in Canada, 804 in the U.S. and 24 in the Gulf Cooperation Council (the political/economic union of countries primarily on the Arabian Peninsula).

While THI is a dominant player in its home market, with one restaurant for every 10,000 Canadians (McDonald's (NYSE:MCD) by comparison has one restaurant for every 24,500 Canadians), the company has experienced trouble translating this success south of the border. By the company's own estimates, Canadian expansion is near its limit; the saturation point being 4,000 units according to management. With 3,436 at the end of 2012, expansion into the U.S. is a necessity for future growth.

THI began its U.S. expansion in 1985 with the opening of a location in Buffalo, NY. By the time Wendy's bought the chain in 1995, there were only around a dozen U.S. locations. In 2006, Wendy's spun off THI and over its 11 years of ownership, the long-touted American expansion didn't quite go as planned. Although 270 U.S. locations existed at the end of Wendy's ownership, 45 were the result of purchasing a small New England doughnut chain which didn't pan out (not surprising! When was the last time you saw McDonald's purchase a small burger chain to expand?). Thus, most of these acquired locations were closed due to poor performance.

As mentioned earlier, THI now has 804 locations in the U.S. as of the end of 2012. According to this article on THI from macleans.ca (Tim's takes on America), it appears that THI had 398 American locations at the date of publication, March 12th, 2008. A quick calculation using the assumption of 398 locations open at the beginning of 2008 and 804 open at the end of 2012 shows that over the five year span, 406 new U.S. locations were opened or an average of 81 per year. Although this is a very simplistic number not taking into account store closings each year, it gives some idea of THI's current growth in the U.S., which appears to be taking hold. That is, ignoring the 57 store closings in 2010, 52 of which were in New England as a result of the chain acquisition, only two restaurants were closed in 2011 and eight in 2012. This is not bad considering the weak consumer environment.

While some analysts have argued that the growth is still subpar within the U.S., I would actually disagree. The hyper-competitive nature of the U.S. quick service restaurant space filled with the likes of Dunkin Donuts (NASDAQ:DNKN), Starbucks (NASDAQ:SBUX), McDonald's, etc. means that THI is better off discovering what works in the U.S. markets it currently operates in and replicating this success over time. THI locations in the U.S. are located primarily in New York, Ohio, Pennsylvania, Michigan, Indiana, West Virginia and Maine. The old adage slow and steady wins the race applies here (think Krispy Kreme (NYSE:KKD)). THI management appears to be establishing a primarily Northeastern regional presence first with the intention to move South and West in the future.

However, what distinguished the brand to so many Canadians, in essence being quintessentially Canadian (Tim Horton was an NHL All-Star defenseman for one), won't fly with the American consumer. What THI needs to do is intentionally forge ties with U.S. customers, ties that happened almost by accident in Canada. In Canada, Tim Hortons franchises serve as a central part of towns and communities, supporting local causes, sponsoring local events, etc. in addition to being a town square. THI should mandate franchisees to do the same thing in the U.S., whether sponsoring the local baseball or soccer team, holding weekly cars and coffee meets, etc. Whatever will make THI standout from its competitors.

THI can be a success in the States. It just needs to think outside of the box to ensure that success.

Highlands Capital

On April 30th, Reuters reported that Boston-based hedge fund Highfields Capital, which owns about 6% of the outstanding shares, was pushing for management to "maximize" shareholder value by borrowing $3.4 billion dollars to repurchase shares (at $59/share, its 52 week high as of March 21), curb its U.S. expansion to focus on its Canadian operations as well as spin off or sell its distribution business, create a REIT to house THI's real estate assets and elect new board members with more "financial" experience.

Upon reading the news reports, I couldn't help but find the audacity of Highfields Capital impressive. Usually, as you very well know if you are reading articles on SA, a hedge fund will push for change at a struggling company or one that has some serious problems. But Tim Hortons? From the date of its IPO on March 24, 2006, the stock has doubled and management has increased the dividend consistently. The company finally appears to be on track with its American expansion and management is generally regarded as competent, conservative (CEO Paul House is handing over the reins to Marc Caira, formerly of Nestle (OTCPK:NSRGY)) and focused on the long-term.

While some of Highfields' ideas have merit, such as borrowing at these low interest rates to purchase back shares (the company did announce a repurchase program of up to 15 million shares in February and purchased 1.27 million in a private third part transaction last week), such a recommendation may have made more sense several years ago, when the shares were trading near the IPO price. However, nearly tripling the debt of the company to do so is foolish especially considering the price of the stock. Also, focusing on a market that the company already dominates and by its own measures has basically saturated doesn't sound like a long-term plan.

While management can't take its Canadian dominance for granted and must continually strive to strengthen it, THI must also look south to grow like I mentioned earlier. If THI doesn't cement its presence in the American market now, competitors such as Starbucks (always vulnerable in my opinion) and Dunkin Donuts (holding a mountain of debt after its private equity spinoff but pushing to double its U.S. store count from 7,000) will continue to do so.

As far as the other value-enhancing ideas that Highfields Capital has suggested, I don't really know of each one's merit. I am not a shareholder so I won't spend more of my time delving into them either. However, it seems to me that Highfields is on the wrong track with its demands. Hopefully, management ignores them. Shareholders will benefit in the long run.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.