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Tim Hortons Inc. (NYSE:THI)

Q3 2009 Earnings Call Transcript

October 30, 2009, 10:30 am ET

Executives

Scott Bonikowsky – Vice President, Investor Relations

Donald B. Schroeder – President and Chief Executive Officer

Cynthia J. Devine – Chief Financial Officer

Analysts

Irene Nattel – RBC Capital Markets

Jim Durran – National Bank Financial

Steven Kron – Goldman Sachs

Peter Sklar – CIBC World Markets

Michael Van Aelst – TD Newcrest

Keith Howlett – Desjardins Securities

Operator

Ladies and gentlemen thank you very much for standing by. And welcome to the 2009 Third Quarter Tim Hortons Earning Conference Call. During this presentation, all participants will be in a listen-only mode. (Operator Instructions) As a reminder this conference is being recorded. It's now my pleasure to turn the conference over to Scott Bonikowsky, Vice President of Investor Relations at Tim Hortons. Please proceed sir.

Scott Bonikowsky

Thanks, [Thelma] and good morning everyone. Thanks for joining us for our third quarter 2009 conference call this morning. Earlier this morning, we issued our third quarter earnings results and as always we have slides that support today's discussion and they're available on our website at timhortons-invest.com and if you just click on the Investment Presentations tab you'll see it there, it will be there for a period of about a year.

Both Don Schroeder, our President and CEO; and Cynthia Devine, our Chief Financial Officer join me as usual this morning on the call, and after their remarks, we will be pleased to take your questions.

Before we begin, please note that we may provide forward-looking statements this morning within the meaning of the Private Securities Litigation Reform Act of 1995 and this includes discussions about future performance based on our current expectations and information. Various risks and uncertainties could cause the Company's results to differ materially from those expressed in our forward-looking statements, which speak only as of the date and time made. We do not intend to update our forward-looking statements after today except as required by actual law.

More detailed information about the risks and uncertainties affecting our future performance is included in our 2008 end report on Form 10-K, which is filed on February the 26th 2009. This is also available on our website under the Regulatory Filings tab, other public securities filings, and in our Safe Harbor statement, which are also located on the website.

I would remind you that all of our results are presented in accordance with U.S. GAAP and reported in Canadian dollars unless we otherwise note.

So, with I'm going to turn the call over to Don Schroeder, President and CEO of Tim Hortons. Don?

Donald B. Schroeder

Thanks Scott and good morning everyone. Tim Hortons delivered a very strong quarter with same-store sales growth of 3.1% in Canada, and 4.3% in the U.S. Operating income grew 5.4% and adjusted operating income was up 8% year-over-year, excluding the anticipated impact of our public company reorganization. So, I'm pleased to report that we had good operating income growth in our Canadian business and a substantial $3.2 million year-over-year profit improvement in our U.S. segments.

Performance was delivered in a tough operating environment that continued to be framed by persistently high unemployment levels as well as other pressures in the North American economy. We grew transactions in Canada and slightly increased the average check, demonstrating our position as an industry leader able to grow sales in tough operating conditions.

Our scale competitive advantage in our developed markets and brand position standing for quality products at reasonable prices continues to result in positive operating results. Consensus heading into 2009, generally pointed toward gradual economic recoveries by the second half of the year. Well, I think it's certainly obvious to most of absorbers that economic recovery has been a challenge and meaningful recovery has not been seen to this point.

One of the greatest challenges is the high levels of unemployment we have seen in both countries. In the U.S., the unemployment rate reached nearly 10% in September, and as high as 17% in Detroit, which is one of our key U.S. markets. In Canada, unemployment levels vary, but was persistently high in the key Ontario market at 9.2% in September and was also high in other markets such as British Columbia. By reinforcing the value we represent and by focusing on restaurant fundamentals such as our always-fresh philosophy, speed of service, and the overall customer experience, we are committed to remain at the first choice for our loyal customers.

Grew system-wide sales by 6.2% on a constant currency basis in the third quarter, a strong financial position allows us to take advantage of prudent market opportunities, as we continue to grow our system by developing new restaurants. And to demonstrate, our system-wide growth was supported by 233 net restaurant openings since the third quarter of last year. And that number includes both for serve and self-serve restaurants. In the third quarter of 2009, we opened 36 locations in Canada and 20 in the U.S.

A solid same-store sales growth are outlined and our ongoing initiatives and support of menu innovation and marketing programs contributed to our overall performance. This past quarter, we focused our advertising and promotional activities on product specific news, and on reinforcing the everyday value we provide to the customers. As an illustration, we offered the popular sausage and a biscuit product in both Canada and the U.S., at very attractive price points. We continue to put marketing weight behind our popular Ranch and Barbecue Chicken Wrap Snackers, targeted at the key snacking and lunch day parts. We also had a $1.99 Iced Cappuccino promotion in our U.S. market.

In Canada, we had another national free sample day, offering our hash browns free with the purchase of any breakfast sandwich. And we also introduced a very successful Blueberry-themed promotion, including Blueberry Bloom donuts, Blueberry Glazed donuts, and Whole Blueberry muffins, along with well, you guess it is Blueberry Timbits.

Late in the quarter on August 31st to be exact, we also took pricing on certain products, primarily in the Ontario market. This region had significant cost pressures, mostly related to labor and key commodity cost. And our storeowners in all of our markets including Ontario have been disciplined in holding the line on raising prices to the extent possible in order to help our customers cope with these very difficult economic times.

As part of our ongoing pricing review process, subsequent to the quarter, decisions have been made to implement select pricing increases in Eastern Canada, Quebec, and Manitoba. And while the increases vary across the regions byproduct mix, on average the increase amounts to about a 3% increase in these markets. But again, I am very proud of a storeowners for the disciplined in holding off so long in taking price, as they face continuous cost pressures over the last couple of years. Now, I'm going to spend a few minutes on each of our business segments.

As I mentioned earlier, our solid Canadian sales growth was driven by menu and promotional activity, which helped drive an increase in transactions that weather the slight mountain average check. The Canadian segment also grew revenue and operating income. The latter of which was up 5.9% year-over-year. We had 12 Cold Stone Creamery, co-branded locations open in Canada during the quarter and continued to be pleased with consumer response and the overall results.

Subsequent to the quarter, we also reached an agreement that secures our ability to exclusively expand Cold Stone Creamery development in Canada. The timing and extended further expansion will be evaluated annually in conjunction with our overall development strategies together with our storeowners, but we felt it important to give ourselves complete flexibility for future growth in the co-branding concept given the positive results that we have seen in both markets to date.

In our U.S. segment, we had a healthy performance from both the sales and earnings perspective. Beginning with sales, our 4.3% same-store sales growth performance was I believe among the strongest we have seen in the U.S. restaurant sectors so far this quarter. Our Cold Stone Creamery co-branding initiative continues to contribute significantly to same-store sales in our U.S. segments. And this initiative works on many levels, allowing us to expand our product offering to customers, attract new customers, drive less developed day parts and improve the economics for our storeowners.

Now, while the ice cream selling season went down during the quarter, the initiative overall has surpassed our expectations at this point. At the end of the quarter we had 65 co-branded Cold Stone Creamery allocations including two Cold Stone Creamery sites re-branded to feature Tim Hortons product. I would note that our U.S. same-store sales growth was positive without the benefit of Cold Stone Creamery contributions, as customers continue to respond favorably to our focus on freshness and value. And as I indicated earlier we promoted value price points with our sausage and biscuit and Iced Cappuccino products in the U.S. along with our ongoing menu initiatives. And in addition to menu initiatives our U.S. marketing and operation teams have been highly focused and active in building awareness and trial across our US markets.

Our entry into the New York City market generated national media attention and those locations have been well received by our customer since they opened. More recently we signed an agreement with the Army and Air Force exchange services to open a restaurant in Fort Knox. IN this location, home to more than 23,000 military service personnel, their families and civilians expands in our existing presence in Kentucky and demonstrates our complementary growth strategy of opening non-standard locations to support our brand awareness.

I'm also happy to say that this new location is near to our Tim Hortons Children's Foundation Camp, Kentahten in Campbellsville, Kentucky. We have also locked up a renew agreement in several of our more developed US markets and most recently you may have seen scenes from the popular TV sitcom, How I met your mother, that prominently featured Tim Hortons product. And this product placement raised over eight million viewers during this particular episode. So I'm pleased with the sense of forward momentum our team has been generating in our U.S. markets.

From an earnings perspective for the second consecutive quarter, we have seen significant improvement in year-over-year profitability. The team achieved a $3.2 million profit turnaround compared to last year, recording operating income of $1.1 million. As the last quarter several factors came together this quarter to drive such a significant improvement and Cynthia will outline the points after a few minutes. So this is a very positive earnings improvement and we were pleased to see this continued progress. We continue to work hard and outside of the box to gain momentum in our U.S. markets. Our management team is encouraged by the continued progress we are making in the U.S. market and we believe that we are gaining real attraction.

The last object I would like to touch on is our recent reorganization as a Canadian public company. We believe the reorganization, which brings us closer to our routes and is a historic moment for the company and certainly for our family of storeowners also has very positive benefits for our shareholders.

We were very encouraged that 99% of those who voted did so in favor of the reorganization. The reorganization had significant impacts on our results this quarter that we previously announced and which Cynthia will review with you shortly. But in the long-term we believe the changed positively positions us to both grow more efficiently and to take greater advantage of the lower tax, statutory tax rates here in Canada, in a place where we certainly conduct the majority of our business. So overall given the challenging environment in which we were operating we were pleased with the quarter. And with that I will turn it over to Cynthia.

Cynthia J. Devine

Thanks, Don and good morning everyone. As Don mentioned we were very pleased with our strong performance during the quarter given the persistent economic challenges, which existed. Before I discuss the major components of our financial performance for the quarter I am going to outline the various impacts that the public company reorganization had on our results. As a reminder we held a special meeting of stockholders on September 22 and then subsequent to the quarter on September 28 the transaction became effective.

On slide 12 of the presentation we outlined the sequencing and market information on the first day of trading in new THI shares in the third quarter we’re incurred $3.2 million in professional advisory fees and shareholders related transaction cost as a result of the reorganization, and we have incurred 7.3 million on a year-to-date basis. So in the third quarter that reduced our operating income growth by about 2.6%. We grew our operating income by 5.4% to 129.2 million and adjusting for the impact of the reorganization our adjusting operating income growth was 8%.

As the adjusted operating income number is a non-GAAP measure. Please refer to our reconciliation slide at U.S. GAAP operating income for additional information on that. As we previously outlined 19.9 million in discrete tax items related to the public company reorganization impacted our effective tax rate, which climbed from 32.5% in the year earlier quarter to 50.5%, and substantially all of this charge was non-cash. The reorganization related impact amounted to $0.13 per share in our EPS number.

Now moving to our underlying operations on slide 14 and 15, we outlined the top line picture during the quarter. We grew our system wide sales a healthy 6.2% on a constant currency basis and 6.9% on an adjusted basis. The total revenues grew 10.7% to just under 564 million. Sales comprised almost entirely of distribution sales with the largest factor in the year-over-year increase up about 11.8% versus the prior year. Our revenues also benefited from higher rents and royalties due to our solid system wide sales growth during the quarter. Our distribution sales out paced our system growth due to a variety of factors. These included new products managed through the supply chain and higher commodity cost mostly driven by higher underlying coffee cost and currency fluctuation which all know that they have a corresponding impact on our cost of sales.

We were down to 23 company operated restaurants at the end of the third quarter with 18 of those in Canada and five in the U.S. As result of our successful efforts to convert company operated restaurants to owner operated sites we had lower revenues from these company operated locations. We also had lower sales from non-owned consolidated restaurants. But for those of you who follow such things I would note that these restaurants used to be classified as FIN 46R restaurants but this terminology has changed due to recent accounting code changes and are now labeled as ASC 810 for accounting purposes. So we try to simplify things, you might not find it as simply but we try to simplify it and we are now referring to them as non-owned consolidated restaurants going forward.

Rents and royalties grew by 7.5% this quarter slightly higher than our system wide sales growth of 6.9% unadjusted for currency. We have indicated franchise fees. They are relatively small portion of our business and subject to some volatility quarter-to-quarter. Well that was surely the case this quarter as franchise fees were up 16.9% compared to last quarter when they were down 9.3%. The third quarter increase in franchise fees seen mostly higher number of re-sales and non-standard unit sales compared to 2008.

Now we return to the cost side of things. You'll find that outlined starting on slide 16 in the presentation. Starting with cost of sales, we saw an increase of 11.9% in the third quarter driven mostly by new products managed through our supply chain and the increased distribution cost spending from higher system wide sales. Higher commodity cost particularly coffee also contributed to the increase.

Fewer company operated restaurants and lower cost of sales from non-owned consolidated restaurants partially offset from the cost of sales growth this quarter compared to last year. Our operating expenses were up 10.2% in the quarter with the increase mostly due to higher number of restaurants in the system compared to the third quarter of 2008 plus percentage of increases on variable contracts on certain properties that we have.

Third quarter franchise fee cost grew 9.6% compared to 2008, mostly attributable to the increase in re-sales and higher non-standard unit noted sales noted previously in my commentary on franchise fee revenues. I outlined the impact of the 3.2 million incurred on the reorganization cost this quarter. Our general and administrative costs were up 17.9% this quarter due to the transaction related cost, which added about 10% to overall G&A increase. Equity income came in flat in the quarter compared to last year and that was really a slight decline in our bakery joint venture, which was offset by slight gain in other joint ventures that we have.

Now turning to slide 17 in the presentation, let me spend a minute or two on earnings. I've already indicated our operating income growth for the quarter. So to add some color to theses results, our underlying operating income benefited from the higher system wide sales that we talked about which generated higher rents and royalties and higher distribution sales and from higher franchise fees and finally the improvement in our operating income in the U.S. segment.

Net income attributable to Tim Hortons declined to 61.2 million, the decline driven entirely by the $23.1 million net income impact, due to reorganization transaction. Lower net interest expense slightly offset the net income decline associated with restructuring. The diluted earnings per share attributable to Tim Hortons were $0.34 per share compared to $0.43 per share in the same quarter of 2008. This result includes the $0.13 per share impact of the public company reorganization.

EPS also benefited from 1% fewer shares outstanding compared to third quarter of last year. So, now I am going to move into the segment information, which you can find on the slide 18. The Canadian segment operating income was up by about 5.9% to $140.8 million in the quarter. The improvement was due mostly to the system-wide sales growth that we've referred to, higher distribution sales, and higher franchise sales revenue. And this is partially offset by higher commodity cost going through our distribution cost of sales. As Don indicated, we had a $3.2 million operating income improvement in our U.S. segment, which recorded operated income of $1.1 million in the third quarter compared to $2.1 million loss a year ago. In addition to higher same-store sales our operating income in the U.S. benefited from several factors similar to last quarter.

Our closure of certain underperforming at company operated restaurants almost all of which were closed in 2008 and the related market asset impairment charge resulted in improvement in our company operated restaurant losses this quarter compared to last year and reduced depreciation and rent expense as well. These factors accounted for $1.2 million of the $3.2 million operating income improvement in the U.S. segment this quarter. Higher distribution sales, lower G&A or general and administrative costs in contributions from vertical integration in the segment also benefited our performance.

Higher release in the quarter offset further profit improvement, mostly due to restaurants that we converted from company operated locations to owner operator sites, as well as restaurants that have been opened for less than 12 months. I would like to now turn to our expectations for the remainder of the year in two specific areas. The first one, based on our year-to-date performance to the end of the third quarter, we expect to be at the low end or slightly below our target of 3% to 5% same-store sales growth in Canada.

Although we are optimistic about the strength of our menu and our marketing activities in the remainder of the year, our year-to-date growth to the end of the third quarter and the continued economic challenges in certain regions we'll make attainment of the 3% to 5% Canadian same-store sales growth target, a challenge for us. We are pleased with the continued same-store sales growth we have achieved in Canada, which is certainly among the industry leaders in light of a sustained economic weakness.

We would like to note that we remain confident in our ability to meet our operating income target of 11% to 13%, which excludes the impact of the public company reorganization. Remember this target is 6% to 8% after you strip out the impact of the Q4 2008 store closure and impairment charges and the 2009 reorganization impact. I am going to wrap up the discussion now with a look at our financial positions, which continues to be strong giving us tremendous flexibility and confidence. You can find additional information about our balance sheet and cash flow highlight on slides 20 and 21 of the presentation. We currently have about 240 million of cash on hand in both cash and cash equivalent and given the previous deferral of the share re-purchase program our cash balance is higher than typical at this point in the year.

Our business growth is self-funded through cash flow generated from our operations and we only have about 396 million in long term debt and capital leases. Our capital expenditures in the quarter totaled $42.6 million and depreciation and amortization for the quarter was $24.7 million. Given our financial strength and financial flexibilities, I am pleased to report that our board has approved the resumption of our share repurchase program in an amount up to 150 million between now and March 1, 2010 when the program ends. As a remainder, we had spent about 16.7 million on share repurchases as part of this program, before the program was put in hold in May earlier this year.

Finally, our board declared a $0.10 per share quarterly dividend keeping with in our policy obtained, a total of 20% to 25% of prior year normalized net earnings in dividends each year. So to wrap up, third quarter was quite positive from many perspective and we remain pleased with our performance given the prevailing conditions that exist. With that I will turn it back over to Scott.

Scott Bonikowsky

Thanks Cynthia and Thelma we’ll now begin our Q&A session. To the extent possible, if you try to stick to one question, in the last call I tried out that, but if you can try to honor that that would be great till everybody gets into the queue. And after your questions, we’ll get back to, with some final comment. So, with that I will turn it back to you operator to start the Q&A.

Question-and-Answer Session

Operator

Absolutely, sir. Ladies and gentlemen we’ll now proceed to the question-and-answer session. (Operator Instructions) And our first question comes from the line of Irene Nattel. Please proceed with your question.

Irene Nattel – RBC Capital Markets

Thanks and good morning everyone. First question is really around Canada, at the end of Q2 or when you release your Q2 results you still expressed confidence in your ability to generate that 3% to 5% target for same-store sales growth. And I'm just wondering, what has changed since that time or what didn’t happen that you thought might happen to get you to that level and the second part of this question is just a point of clarification, Don. You mentioned something about funding exclusive arrangement with Cold Stone in Canada, and I'm just wondering whether that – we should interrupt that to you and then you could possibly open Cold Stone only branded units in Canada?

Donald B. Schroeder

Okay. First of all, with respect to your first question around the 3% to 5% growth for this year and in fact that we think we'll probably in the low-end or may be mix up slightly. I think the real reason for that is just as I said with respect to the economy everyone projected by the third quarter of this year that we will probably see some real recovery. There is some in some parts of the country. But at best it's sluggish to date and therefore given those economic challenges I just want to put everyone on notice. I want to be conservative here and where we think we'll probably come out at the end of the year.

Irene Nattel – RBC Capital Markets

And then just on the Cold Stone, Don if you could clarify please?

Donald B. Schroeder

The Cold Stone, again given the test results that we've experienced in the U.S. and in Canada we are very optimistic about what that offers to us in both countries. And that's why we thought that it was important to get control of the situation in Canada by having this exclusive arrangement. Now we have complete flexibility in terms of how we will develop it. As you say conceivably we could open Cold Stone on their own I can tell you that it's not in the plans. At this point in time what we are really concerned about doing at this point is just continuing on with the test, we have a lot to learn with respect to the impact of the Cold Stone operation on our business both here and in Canada. So we're working with our store owners and the initial test I can tell you that we will look to expand that test in Canada together with our storeowners. Again with a view to learning more about it, we've already learned that, you know we can't sell Cold Stone through the drive through. But the real question is and before we would move forward as we want to know, is this something that can enhance the overall performance of our Tim Hortons here in Canada and make sure that it doesn't negatively impact their core business. So again we'll work closely with our storeowners trying to answer those questions over this winter and throughout next year.

Irene Nattel – RBC Capital Markets

But at this point there are no plans to introduce Cold Stone units excluding Tim Hortons?

Donald B. Schroeder

No we want to put this on identifying what is the opportunity for Cold Stone within the Tim Hortons locations.

Irene Nattel – RBC Capital Markets

That’s great. Thank you.

Operator

And thank you, our next question comes from the line of Jim Durran. Mr. Durran your line is open. Thank you.

Jim Durran – National Bank Financial

Okay. Thank you. Just kind of follow up on Irene's question first on Cold Stone in the U.S., we were supposed to have 50 Cold Stones with Tim Hortons offering in it by spring. We are now at two. What's the problem with that side of the equation? Is it the Cold Stone franchisees not warming up to the Tim Hortons opportunity or what is the dynamics that’s slowing that progress?

Donald B. Schroeder

I think at this point there is no question that putting the Cold Stone into Tim Hortons is having a positive impact on the same-store sales growth there. When you look at the Cold Stone and the type of operations that the standalone Cold Stone are there, significantly different for the most part than Tim Hortons. We for the most part has drive through's. Because of the average unit volumes that we would do in a typical Tim Hortons we are able to really go into more A Type locations whereas Cold Stone with the smaller AUV's their model work in B sites. So those B site are not as supportive of putting a Tim Hortons into that location although the Cold Stone operators are interested we have found at this point that the real benefit is focusing on putting the Cold Stone inside Tim Hortons and in the very high profile Cold Stone locations then it does work to put Tim Hortons in there.

Jim Durran – National Bank Financial

And would you say you've seen any change in consumer spending in the Canadian marketplace or it's really a continuation of Q2 into Q3?

Donald B. Schroeder

Well again, as we indicated we were able to drive traffic and drive the check in the second quarter, so that's a positive sign. But there's no question the consumers right across the country and in the U.S. continue to be under pressure, and so we continue to focus on finding ways to meet their needs and to draw them into our locations.

Jim Durran – National Bank Financial

Okay. Thanks, Don. I'll come back later.

Operator

Thank you. Our next question comes from the line of Steven Kron. Please go ahead sir. Your line is open.

Steven Kron – Goldman Sachs

Hi thanks. Good morning. I guess just a couple of follow-ups and then a quick question. The first one, can you just give us a little bit more detail on the same store sales and how they track through the quarter? Where they might be kind of quarter-to-date in October, given the comments and given in light of the revisions if you did on the Canadian same-stores sales guidance? And the second related to that, I think Don in your prepared remarks you mentioned Cold Stone in the U.S. obviously very important driver to the same-store sales equation, but you did indicate without it, you would still be positive in the U.S. Can you, maybe tell us how much of an effect is Cold Stone having on that same-store sales number?

Cynthia J. Devine

Hi Steven, with respect to your first question on the sales progression throughout the quarter, we were fairly consistent, we always see some volatility month-to-month in our sales results and that's really primarily why we stick to quarterly reporting, but they were fairly consistent across the quarter. With respect to, talking about October, it's typically not something that we talk about as forward-looking information on that. So, with that I will pass it over to Don with respect to the Cold Stone.

Donald B. Schroeder

As we said, it is playing a very important role in the same store sales growth. We don't really break it down in detail, but it is significant and that's why we want to continue to expand the test in the U.S. and in Canada.

Steven Kron – Goldman Sachs

I guess, we are always done with that Don it seems as though without the Cold Stone, maybe the core business has seen same store sales deterioration, I don't know if that's the case. If you are able to pass through the data like that, that's the kind of the color that I was looking for. What's the base business doing excluding the Cold Stone?

Donald B. Schroeder

I'm sure you'll agree that the economic situation in the U.S. is dramatically worse than here in Canada and I think given the climate, I talked about the fact that we have 17% unemployment in the Detroit area, which is a key market for us in the U.S. And notwithstanding that we still have positive same-store sales growth in that market. So, in that I know from your experience and looking at other operations, you'll know that's at the top of the list compared to what most chains are doing and with the performance that most chains would love to see.

Steven Kron – Goldman Sachs

Sure, sure.

Cynthia J. Devine

Just to add to that Steven is the fact that there was no pricing in the U.S. market at all and the growth that we had there is all really organic growth.

Steven Kron – Goldman Sachs

Is there a price going forward?

Cynthia J. Devine

At this point in time, there has been no announced pricing.

Steven Kron – Goldman Sachs

Okay. And just last point, Cynthia, a question for you. Just given that the business model is pretty unique in that, you are pretty vertically integrated, you have the warehouse distribution business. One thing that strikes me is that the strength in your same-store sales that you're getting is not flowing through to drive margin expansion and a part of that seems to be or a big piece of that seems to be a revenue mix shift towards the lower margin warehouse distribution business. Is that right? Is there a fair assessment and if that's the case does that mean that -- as that business continues to build and obviously sell more products through to your franchisees that the EBIT margins are probably going to be coming down from here overtime?

Cynthia J. Devine

You are correct with respect to our total revenue growth this quarter was huge given that we had our distribution sales growth did outpace our system wide sales growth, but we really highlighted a few things that were significant this quarter, but I can't comment on whether those same things will exist in the future. The primary one being commodity cost of coffee, I mean, our hope is that coffee doesn't stay at that high point and therefore comes down, but we've gone through this several times with respect to the commodity cost. As commodity pricing increases our warehouse sales go up, our cost of sales go up and because we work of a penny profit it does impact our margins. But there's nothing to suggest that we have shift in our business more towards distribution in the future than we've had in the past, but you are going to, from time-to-time you're going to see either prices going up or going down, depending on what's happening in underlying commodity cost and that's something what we look at, from that perspective is, providing the value to our franchisees that we do and continuing to grow the overall operating income, rather than focusing our margins when you're dealing with a commodity-based business like that.

Steven Kron – Goldman Sachs

All right, that's helpful. Thank you.

Operator

Thank you. Our next question comes from the line of Peter Sklar – CIBC World Markets. Please proceed with their question.

Peter Sklar – CIBC World Markets

Good morning. I was particularly interested in any comments you could provide on how the stores that you acquired in Manhattan and brought into the Tim Hortons system, the re-badging from the Dunkin' Donuts to the Tim Hortons, how those stores are performing, very curious as to how there was change in the product offering and how you are seeing the revenue track at the Tim Hortons brand versus the previous brand?

Donald B. Schroeder

Okay. We are very pleased with what's happened with respect to the stores we opened in New York as our storeowner, who is operating all 12 units there in Manhattan, and we are very proud of our U.S. team, I mean, we took over those sites on a Friday night at 6 P.M. They were Dunkin' Donuts at 6 P.M. on Friday and at 6 A.M. Monday morning they were all converted to Tim Hortons, offering our full product line on Monday morning to the customers, so there was no disruption of service for all those regular customers, going to those sites. And we've had very positive response from the customers since that time. We are still going through a period of transition as we educate the staff that were former Duncan staff to the Tim Hortons way of doing business that we are working through that. The staff is very positive and excited now to be part of the Tim Hortons system. So again, we are pleased, the store operator is pleased, and I can say that we are very happy with the media attention that those stores provided to us in our U.S. market.

Peter Sklar – CIBC World Markets

And is there any change in the product offering as a result of your brand?

Donald B. Schroeder

There was an expanded product offering because of what we offer, a breakfast compared to what Duncan offers. So, the customers there now have a greater selection of product and certainly they, the typical great quality coffee, and other goods that we offer at all our locations.

Peter Sklar – CIBC World Markets

Okay, thank you

Operator

Thank you. Our next question comes from the line of [Stephen Lee]. Please proceed with their question

Donald B. Schroeder

Hi, Winston.

Unidentified Analyst

Was that me?

Operator

Yes, your line is open.

Unidentified Analyst

I just wanted to know if Cold Stone, although a significant contributor to the U.S. comp, was that a significant contributor to the operating income in the US.

Cynthia J. Devine

It positively impacted the operating income in the U.S. definitely as it is helping those stores get to a higher average unit volume level and helping a lot of those stores come off of release and also you know benefiting us, but as we said the improvement in our U.S. business is a combination of several factors and that was one of them.

Unidentified Analyst

Okay. And as you look at Cold Stone in Canada, do you know, do you have, sort of a target that you can speak to for 2010 or is it very, very much still just early days to be able to speak about that, just some sense of it?

Donald B. Schroeder

We are in the midst of doing a series of meetings across the countries. Our regular fall regional meetings with our storeowners, we will be discussing the opportunity with them in our desire to expand the test, but again it will be done in conjunction and after discussion with our storeowners.

Scott Bonikowsky

Well let me follow our consistent path as well, Winston I'm talking about 2010 early in the spring.

Unidentified Analyst

Okay. And I just want to ask you guys about, what you thought about HST next year, I think that's going to be in the back half of the year in some provinces and what your feeling is about THI in terms of past experiences when you've had sort of that kind of value added tax increase and what has been done, I guess was that done through sales of any?

Donald B. Schroeder

There is no question, we are genuinely concerned about the impact on our stores and certainly our customers as a result of the HST, if you look at Ontario in particular there is a four dollar food exemption, currently in place and under the situation as it now stands that would disappear at the beginning of July next year, that would translate on average to about a 4.5% price increase to our customer with zero benefit to our store owners. So we are talking with the government, putting submissions forward to them in terms of the concern over the impact that it would have on those consumers who the government is targeting in terms of when they are talking about minimum wage increases and so on that those people would negatively impacted if that $4 exemption is removed. You go to British Columbia the situation would be even more dramatic since there is no tax on food there at the present time. And the concern generally is that we need a level playing field with respect to taxation on food for food purchase in a grocery store would be tax exempt and food purchased at your local Tim Hortons or other QSR location would be subjected to tax. So, all of those things are concerned to us, to our storeowners and certainly for their customers. So we'll continue to make representations to the appropriate authorities.

Unidentified Analyst

Thanks, I appreciate the point sir.

Operator

And thank you for your question. Continuing on, our next question comes from the line Michael Van Aelst. Please proceed with your question.

Michael Van Aelst – TD Newcrest

Most of the questions have been answered but just want to clarify a few things. First of all on the price increases that you are taking, I know you said that – that it's offset some of the higher labor cost and coffee cost, things like that but are you also passing on some of the higher bakery cost that you had said earlier in the year, you where absorbing some of those costs as a joint-venture?

Donald B. Schroeder

When we talk about price increases, those are the price increases that our storeowners are taking at store level and as we have indicated before we were on an ongoing basis with our storeowners. We would review with them their P&L on a line-to-line basis trying to identify where the cost pressures are and so on. And as I said we are very proud in terms of how the storeowners have responded given the ongoing pressures that they've had for almost two years to be able to avoid taking price. Ontario has taken it, but if you look at Quebec they haven't touched coffee pricing there since 2006. So, again they have been very responsible.

If you look at the other regions that will be taking price in the November, they haven't touched coffee in almost two years, so its really a review of the total package of goods that they have and their input cost and how do we go about managing it in a way that as a last resort that they will increase prices to their customers.

Michael Van Aelst – TD Newcrest

But, is there any of the price increase just then passing through, higher bakery cost?

Cynthia J. Devine

It's not related to bakery cost increases.

Michael Van Aelst – TD Newcrest

Okay. All right and just on the G&A expense I think without the extra charges you're still up around 7% or is that just a balancing out of what happened in Q2 when it was kind of flat or was there something else going on there?

Cynthia J. Devine

No, it's been the most part timing. You'll see it fluctuate quarter-to -quarter. One thing we did have, we had a major systems implementation in the RP system in the quarter and there was some additional cost related to training of our employees and what not for the new system. That’s a little bit of it, but you're going to see G&A costs fluctuate on a quarter-to-quarter basis depending on spending.

Michael Van Aelst – TD Newcrest

Okay. And the franchise convention or is that – has that been done already this year?

Cynthia J. Devine

Sir, it's not a convention but you're right. We do have ongoing regional meeting. Those are – have not been completed fully yet. There's some of them that have taken place, that they'll continue to takes place through fourth quarter.

Donald B. Schroeder

The big annual convention was an expense from before. That doesn't happen every year, it's usually on an infrequent basis?

Michael Van Aelst – TD Newcrest

Okay there was none indulged this year. Thank you

Operator

Thank you, sir. Continuing on, our next question comes from the line [Keith Howard]. Please proceed with your question.

Keith Howlett – Desjardins Securities

Yes, just wondering if you could indicate what you expect the tax rate to be on a go forward basis?

Cynthia J. Devine

Yeah, sure Keith, with respect to as we outlined with project Fosters or our public company restructure sorry, with respect to tax rate in 2010 we expect that it would be about 32% if there are no discreet tax items because we can't forecast discreet tax item And then in future years beyond that in 2011 and 2012 we talked about the tax rate. Although we can't give you a specific rate that our tax is going to be that they would be approximately 6% better in 2011 and 8% better in 2012 than they otherwise would have been had we not restructured as a Canadian public company.

Keith Howlett – Desjardins Securities

Great, and just on the master or the exclusive development rates with Cold Stone Creamery, have you sort of purchased the rights, outright or will you paying royalties on an ongoing basis?

Donald B. Schroeder

Yeah at this point I would just say that we have acquired the exclusive right to develop Cold Stone in Canada.

Keith Howlett – Desjardins Securities

Okay thanks.

Operator

And thank you, we now have a followup from the line of Mr. Jim Durran. Please proceed with your question.

Jim Durran – National Bank Financial

I was wondering if you can just give us an update on the new Coffee Roasting Facility. Where it is at in terms of ramp up?

Donald B. Schroeder

The new roasting facility in Hamilton is the construction is complete, all the equipment has been installed. They are currently in the process of testing all of the equipment, including the roasters and it will be up, we expect that it will be up and in full production by the end of November.

Jim Durran – National Bank Financial

Okay. And Cynthia, just on the ERP system installation, is there still additional training cost et cetera to impact future quarters?

Cynthia J. Devine

No doubt there will continue to be some training cost in ongoing stabilization cost that will exist as we get through a cycle of bringing the system on stream.

Jim Durran – National Bank Financial

Great thank you.

Operator

And thank you. (Operator Instructions) And we appear to have a question from the line of I believe its [Frank Gifford]. Please proceed with your question.

Unidentified Analyst

Yeah I am calling to find out whether or not you are finding there is a difference in U.S. traction by region?

Cynthia J. Devine

We were pretty pleased with our results across most of the regions in the U.S., if not all of the regions in the U.S. The momentum is great and there aren't any significant differences by region other than what we typically see

Unidentified Analyst

Are you finding now that there is a greater pool of qualified potential franchisees because of the economic downturn?

Donald B. Schroeder

Yes, I mean historically that has always happened when the downturn in the nearly 1990s. We had an influx of some very good and qualified people that have been displaced who wanted to take greater control of their lives and we are seeing the same thing happen during this economic crisis.

Unidentified Analyst

All right, thank you.

Operator

And thank you. We'll now return the conference back to the speakers for your concluding remarks. Thank you.

Donald B. Schroeder

Thanks operator. Just thank you again for joining us for our call this morning. We appreciate that as always and if you have any additional questions are topics that you didn’t get to or you like to address still, please feel free to give me a call, you can reach me at 905-339-6186, or alternatively by email at investor_relation@timhortons.com. And have a great day.

Operator

Thank you sir. Ladies and gentlemen that does conclude the conference call for today. We thank you all for your participation and ask that you please disconnect. Thank you once again. Have a great weak-end.

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Source: Tim Hortons Inc. Q3 2009 Earnings Call Transcript
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