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Tim Hortons Inc. (THI)
Q2 2007 Earnings Call
August 3, 2007 8:00 AM ET

Executives

Rachel Douglas - Director of Public Affairs
Paul D. House - Chairman, Chief Executive Officer and President
Cynthia J. Devine - Chief Financial Officer, Principal Accounting Officer and Executive Vice President of Finance

Analysts

Irene Nattel - RBC Capital Markets
Steven Kron - Goldman Sachs
Jim Durran - National Bank Financial
David Hartley - BMO Capital Markets
Adina Bloom - TD Newcrest
Turan Quettawala - Scotia Capital
Joe Buckley - Bear Stearns
Glenn (inaudible) - City Investment Research
Winston Lee - Credit Suisse
Richard Piticco - CIBC World Markets
Rachel Rothman - Merrill Lynch

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Q2 2007 Tim Hortons Earnings Conference Call. During the presentation, all participants will be able to listen on remote. Afterwards we will conduct a question and answer session. At that time, if you have a question please press the “one” followed by the “four” on the telephone. If at any time during the conference you need to reach an operator, please press “star” “zero.”

As a reminder, this conference is being recorder, Friday, August the third, 2007. And it is now my pleasure to turn the conference over to Rachel Douglas, Director of Public Affairs. Please proceed.

Rachel Douglas - Director of Public Affairs

Good morning, everyone. And thanks for joining Tim Hortons second quarter financial results conference call. On the call today will be Paul House, Chairman and CEO of Tim Hortons, followed by our Executive Vice President and Chief Financial Officer, Cynthia Devine.

This call will last approximately 45 minutes. Paul will provide some general comments on the business over the quarter, followed by Cynthia, who will provide more detail on the financial results. After their remarks we will open the call for questions.

During the Q&A session, we ask that you limit yourself to one question and one follow-up, in order to allow everyone who wants to ask a question the opportunity to do so. After your question you’re welcome to get back in the queue for any other questions you may have.

I’d like to refer you to the Safe Harbor statement attached to the press release issued today and I’d like to remind everyone that certain information that we discuss today regarding future performance, such as financial expectations, goals, plans and developments, is forward-looking. Various factors could affect the company’s results and cause those results to differ materially from those expressed from our forward-looking statement.

Some of those factors are set forth in the Safe Harbor statement that is attached to the earnings released, and others are contained in our public security filings, including our prospectus, and our 2006 annual report on Form 10K, filed March 9, 2007. You may access the full text of our Safe Harbor statement and our Form 10K annual report on our website at www.timhortons.com under the “investor” tab.

All Tim Hortons results are presented in accordance with US GAAP and reported in Canadian dollars. In the event we reference non-GAAP. financial information that we have not already reconciled in the press release issued earlier today, we will post a reconciliation to the most directly comparable GAAP financial measure on our website as mandated by regulation G.

I will now turn the call over the Paul House. Paul?

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

Thanks, Rachel. Good morning.

On the call today I’m going to provide business highlights for the quarter. Cynthia will provide you with details on our second quarter financial results.

Our same-store sales momentum continued in the second quarter, with Canada delivering a healthy 6.5% same-store sales growth, and the US growing by 3.8%. Pricing accounted for approximately 1% of our same-store sales growth in the quarter for both Canada and the United States.

In the first quarter, US growth was 4%, which was primarily pricing. In the second quarter we delivered 3.8% growth, with only 1% of pricing in that number.

As you may recall, we were rolling over strong quarters last year, with 2006 second quarter Canadian and US growth at 6.1% and 8.4%, respectively. In addition you will hear from Cynthia about a significant improvement in US operating results over the first quarter of this year.

We were pleased that the US business contributed positively to our consolidated operating results. We continue to execute our plan of developing our brand in selected US markets.

Our same-store sales growth momentum in both Canada and the US was driven by our promotional calendar, product innovation, store-level operations, and, as mentioned, some price increases.

During the quarter, we promoted the Triple-Chocolate Donut, Ice Cap Supreme, and our Chicken Salad and Egg Salad Wrap sandwiches. In the US, we had a soft launch of our new iced coffee beverage in late June, and we had a sampling day across the system in July and began media.

We added six new restaurants in the US and 12 in Canada in the quarter. We are on track for our previously announced 2007 new store opening targets of 120 to 140 in Canada, and 60 to 80 in the United States.

Our Guelph distribution center continues to deliver on the transition plan for three channel delivery in Ontario. Three channel delivery is dry, refrigerated, and frozen products all on the same truck. We have been pleased to see that the ongoing transition is yielding positive operating income contribution. We currently expect this transition will be completed later this quarter.

Turning to more recent initiatives, the implementation of the electronic payment in Canada is also proceeding as expected, with approximately one thousand restaurant locations now accepting MasterCard. We continue to deliver our commitment of enhancing customer convenience, as we are on track to have all participating stores in Canada accepting electronic payment by late 2007. In the US our stores also accept electronic payment.

As you have heard before, we are working on implementation of a cash card program for the US and Canada and we are targeting a fall 2007 launch. We are excited about the prospect of our Tim Card. Our cards will be reloadable, a feature that enhances flexibility and convenience for our consumers.

The implementation of our automated Tim Card program is another way we will be promoting our brand every day while also satisfying our customer demand.

With respect to driving shareholder value, we are pleased to announce the declaration of our fifth consecutive $0.07 quarterly dividend. We delivered additional value to our shareholders over the quarter by continuing our previously announced $200 million share repurchase program. At the end of the second quarter we had completed approximately 77% of this program. Cynthia will give you additional details of total value returned under this program today.

Other highlights of the quarter included our annual Camp Day event. You are all familiar with the Tim Hortons Children’s Foundation, and Camp Day illustrates the commitment of our franchisees to give back to the communities in which they operate. On Camp Day, our franchisees and company stores donated 100% of coffee sales across our system to the Foundation. This year’s Camp Day raised $8.3 million dollars from coffee sales and other fundraising events. This amount is a new record, exceeding last year’s amount by over $1 million. These substantial proceeds will help send over 12,000 kids to camp throughout the year at one of the Foundation’s six camps. Five of the camps are in Canada and one is located in the US in Campbellsville, Kentucky.

I want to conclude by mentioning our very successful franchisee convention held last week in Quebec City. The company has hosted conventions for our franchisees for many years, with the last one being in 2000. We bring together our franchisees to discuss relevant topics, trends, and initiatives for the company as well as the industry.

This concludes my remarks, so let me now turn it over to Cynthia. Cynthia?

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

Thank you Paul, and good morning. As a reminder, all of our results are stated in Canadian dollars in accordance with US GAAP.

So let me start with the top line. Revenues in the quarter were strong, at $465.3 million up 14.4% compared to $406.8 million in the second quarter of 2006. As Paul noted, same-store sales growth grew 6.5% in Canada, and 3.8% in the US. Though our US sales growth was softer than our expectations, the US operating income has really shown significant improvement compared to the first quarter of 2007, and I’ll discuss this in more detail in a few moments.

So leading the growth in revenues were our sales revenues, and they were up $44.5 million versus 2006. A majority of this increase related to warehouse sales, which were up 19.6%, or $42.8 million versus prior year. The warehouse sales growth, which really exceeded our system-wide sales growth of 10.9% was driven primarily by the expansion of our frozen and refrigerated distribution business through the Guelph facility.

The distribution sales represented about 56.2% of our total revenues, while a year ago they were 53.8% of our total relatives. So we anticipated this shift in our business mix in connection with our three-channel delivery roll out. This business shift mix has had some effect on our margins, which I will discuss further in a few moments.

Rent royalty relatives grew 10.5% compared to the same period last year; this is in line with our system-wide sales growth for the second quarter. Our franchise fees increased 4.1% in the second quarter, in 2006, to $17.1 million despite, as Paul mentioned, a lower number of new store openings. The increase was the result of a higher number of re-sales and store renovations in the second quarter of 2007 over the second quarter of 2006.

Our operating income in the second quarter was $106.3 million compared to $98.5 million for the same period in 2006. This represents a growth of 8%. As anticipated, operating income growth was lower than our revenue growth, primarily as a result in the change of business mix, with distribution contributing a higher portion of our revenue growth, as mentioned earlier. So this has been expected in connection with the continued roll out of refrigerated and frozen distribution capabilities. And as we previously disclosed, distribution operating margins are generally lower than other areas of our franchising business, but they remain a critical element of our overall strategy and they do contribute positively to our operating income.

Net income was $67.2 million compared to $76.3 million last year. This was down 11.9% primarily due to a significantly lower tax rate in 2006 relating to certain tax benefits that did not recur in 2007. The affective tax rate in the second quarter was 33.8% compared to 19.8% in Q2 of 2006. The reported EPS was $0.36 compared to $0.39 in the second quarter of 2006, and the EPS was negatively impacted by the year over year increase in our tax rate. This was partially offset by a 2.1% decrease in our share count. This decrease was the result of our share repurchase program that commenced in the fourth quarter of 2006. The diluted weighted average shares outstanding in the second quarter were 189.3 million compared to 193.3 million in the second quarter last year. At the quarter end the company had 188.4 million shares outstanding.

Let me take you through the some of the income statement cost and expense items in a bit more detail. Our cost of sales was $269.8 million compared to $229.3 million in Q2 last year. That line in our discussion of warehouse sales, this 17.7% increase was higher than our system-wide sales growth primarily as a result of the higher cost of product associated with the expansion of our distribution business.

Operating expenses increased 14.5% to $50.1 million compared to $43.8 million in the second quarter of 2006. This line item really consists primarily of our rent expense and other property related cost. This increase in operating expenses was higher than our system-wide sales percentage growth, in part due to a higher number of properties being leased and subleased, and we had costs associated with research and development in the area of new store design.

General and administrative expenses were $30.8 million, up 12.1% compared to prior year expense of $27.5 million. This increase was primarily as a result of higher restrictive stock units or RSU expenses, and higher public company costs. The company granted RSUs to officers and certain employees in May of 2007. The 2006 grant was made in August last year.

As we previously discussed, the RSU expense is higher in the quarter of the grant, due to the requirement to immediately expense grants to retirement eligible employees. The expense in the quarter was approximately $4 million. We anticipate that Q3 and Q4 expense amounts to be about half of that amount.

In addition to the higher stock-based compensation expenses in the second quarter, we continued to experience higher public company costs related to such costs as professional fees in 2007 compared to 2006. We had lower shared service fees from Wendy’s in 2007, offsetting higher salaries and other costs that we are now incurring directly as a standalone public company in 2007.

As a percentage of revenue, generally administrative expenses decreased from 6.8% in the second quarter of 2006 to 6.6% in the second quarter of 2007. This shows the continued traction we are getting as we add required resources and costs at a slower pace in our revenue growth.

Equity income increased 1% compared to second quarter of 2006. As we previously disclosed we did not expect that our equity income would necessarily grow at the same rate as the rest of our business.

Then interest expense in the second quarter was $4.8 million, compared to net interest expense of $3.3 million in the same period last year. The higher net interest expense was primarily the result of lower interest income due to lower cash balances in the second quarter of 2007, compared to 2006.

The US segment income of $100,000 was down $400,000 compared to $500,000 in the second quarter of 2006, but as Paul mentioned improved considerable over our first quarter 2007 loss. While the year over year income is slightly lower, we had a $4.2 million improvement in our US operating income compared to first quarter.

As we have previously discussed, we expect that our US operating results may continue to show some volatility, between quarters, and on a year over year basis as we continue in our US growth strategy for establishing our brand in these developing markets.

We are pleased with our progress as we had improvements across most areas of our business over the first quarter of 2007.

Moving to the balance sheet, cash on hand was $98.6 million compared to $176.1 million at year end. The lower cash balance is primarily related to our year-to-date share repurchases of $90 million and dividend payments of $26.6 million.

On a year-to-date basis in 2007, we’ve spent $70.4 million in capital expenditures, with $31.8 million in the quarter. Capital expenditures are primarily related to new-store development and renovations of existing stores. Depreciation and amortization was $21.4 million, in Q2 2007, compared to $17.7 million in Q2 2006.

During the quarter we repurchased 1.3 million shares at an average cost of $34.45. We have now compared $155 million of the previously announced $200 million share repurchase program. At the end of the second quarter 2007, we had approximately $372 million in term debt and capital leases on our balance sheets.

We continue to believe that the strength of our balance sheet provides the company with a great deal of opportunity and flexibility for future growth in our business. As we have said before we remain committed to look for ways to utilize the strength of our balance sheet to provide ongoing shareholder value.

In conclusion, we are currently tracking ahead of where we thought we would be at the midpoint of the year from an operating income perspective. Based on what we know today, we expect to meet or exceed our operating income target of 10% growth in 2007.

So that concludes my remarks. I’d now ask the operator to open the line for questions.

Question-and-Answer Session

Operator

[operator instructions]

Our first question comes from the line of Irene Nattel from RBC Capital Markets. Please proceed.

Irene Nattel - RBC Capital Markets

Thank you and good morning.

In terms of the improvement sequentially quarter over quarter in the US, you had noted at the Q1 conference call that part of that was coffee roasters, part of it was increased investments in the franchised network. Can you give us an idea of on a sequential basis how those two items trended, please.

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

Irene. I’m not going to give any specifics around it, but as I said we had improvements across every line item of our US business, so we were very pleased not only with the progress we made not only in coffee roasting, but in all - in franchising, in all items of our US business. So it really was a multiple contribution from each area.

Irene Nattel - RBC Capital Markets

And if we look through the balance of the year, I know you said it was going to be somewhat volatile, but clearly the pickup in real growth quarter over quarter has to be something that should be, that should bode well for the ongoing progress in the US?

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

Yeah, we continue to feel good about our US business and as I think we said, we know that sometimes as you make investments in these new markets, you’re gonna have some volatility in your earnings. But, you know, we are feeling very good about the progress we’re making.

Irene Nattel - RBC Capital Markets

That’s great, thank you Cynthia.

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

Thanks Irene.

Operator

Our next question from the line of Stephen Akron from Goldman Sachs. Please proceed.

Steven Kron - Goldman Sachs

Great, thanks. Hi, guys.

A couple of cost questions for you. First, I guess, if you look at cost of sales is controlled relatively well considering the environment and given your vertical integration, can you maybe Cynthia just talk about how you’re, I guess, the philosophy on passing through rising costs, you know, onto, you know, franchisees.

And then, included in that, just talk about your decision to keep only 1% price in the system in the current environment. I think you had maybe four points of price in the US last quarter.

And then I have a follow-up.

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

OK. With respect to the cost of sales, remember that’s primarily, you know, cost associated with our warehouse business. And you’re right, as we have fluctuations in underlying costs in commodity type things we pass on, you know, both upsides and downsides through to the store owners.

But we look at is as a whole portfolio, so what’s happening in coffee may be different than what’s happening in other areas of it. So yes, that is correct, that typically it’s a pass through in terms of the warehousing business.

With respect to the pricing question, Stephen, yeah, we had pricing in the US that we took in April of 2006, and so we lapsed over that so we had very little pricing in the US business beyond April of 2007. We just had a little bit in our Ohio market. So, you know, what we’ve done in Canada from a pricing standpoint, you probably know in July we took a little bit of pricing in Ontario and in some of our Atlantic regions.

Steven Kron - Goldman Sachs

OK. And then on the G&A leverage, Cynthia, if you back the restricted grants this quarter, I think in dollars terms G&A would have been down on a year over year basis despite the incremental costs associated with being a public company. So, I guess where are you - first of all, am I correct in my math here, and secondly where are you finding the cost efficiencies.

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

You know, let me check your math first, I hadn’t exactly looked at it that way. We probably would have been roughly - we would have been up a little bit. The year over year change we had some RSU expenses last year in the second quarter even though we didn't have as much as we had in the third quarter of last year.

But from a G&A perspective, I think a piece of it is the shared service charges as I noted that we were being charged from Wendy’s. We feel we’ve done a pretty good job at adding resources where we need them.

As I talk about from time to time we’re still going to continue to add resources, as we go on our systems, which we hope to do in the fourth quarter of 2007. Those types of things, where we will start to see some more costs. But I think the company has always had a fair amount of discipline around G&A spending and hope that those trends will continue.

Steven Kron - Goldman Sachs

OK, thanks a lot.

Operator

Our next question comes from the line of Jim Durran from National Bank Financial.

Jim Durran - National Bank Financial

Just a couple of follow-ups, first of all on the price increases. Can you give us some idea as to what percent increase you did take on an aggregate basis in Ontario and Atlantic Canada?

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

Sure. In Ontario it was just slightly below 2%, and in the Atlantic it was just slightly above 3%. In that area.

Jim Durran - National Bank Financial

And the 2% Ontario is excluding coffee?

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

That’s correct.

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

That’s correct.

Jim Durran - National Bank Financial

Is there any expectations of having to take coffee up some time this year?

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

No.

Jim Durran - National Bank Financial

Thanks for that answer!

On your IT systems, you just mentioned that you’re going to be switching your systems over in Q4. You know, experience with IT systems switchovers is not good in the public domain. Can you give us some indication as to what your timetable is and how that might affect your year-end result reporting?

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

Sorry, I just want to clarify one other thing. We did have some pricing in Manitoba as well, slightly above 2%. So I just wanted to add that to it.

Jim, with respect to your question on the system, yeah, any time you bring a system up in the fourth quarter it’s not without risk, but we have, you know, we’ve put in a lot of controls, we understand the risks, you know, we’ve been working with Deloitte to make sure we have adequate controls. At this time we’re on track to bring up our system.

And remember, it’s not an entire ERP system. It is, it’s a general ledger, is really, a general ledger and then we had to take Tim’s US was sharing a fixed asset package with Wendy’s. So, it’s not a complete ERP system and I think that’s sometimes a misconception that’s out there, it’s a general ledger package.

Jim Durran - National Bank Financial

Last question, then I’ll turn it over to somebody else. In the US, how did you find the pricing environment during the quarter compared to Q1?

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

You mean from a cost point of view, Jim?

Jim Durran - National Bank Financial

Competitive pricing standpoint.

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

Oh, competitive pricing? Well, as you know Starbucks just announced a price increase, and other than that I think it’s been relatively stable.

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

And it really varies by market. You see different things going on. When you go to Ohio you see McDonald’s doing different things versus what they’re doing in Detroit and different areas. So it really depends on what’s going on in each market.

Jim Durran - National Bank Financial

Thank you, I’ll come back later.

Operator

Our next question comes from the line David Hartley from BMO Capital Markets. Please proceed.

David Hartley - BMO Capital Markets

Good morning and thanks for taking the call. I just want to ask a bit about your business about your comment about the balance sheet. If there’s something more we should read into that, or if you plan to detail your plans for perhaps using your balance sheet for further expansion or share buybacks, or dividend, what have you?

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

No, that’s a pretty consistent comment that I’ve made quarter to quarter. We feel that our balance sheet is in very good position. We are continuing to execute on our $200 million share repurchase program and will, you know, as we get into post-Q3 we’ll look at what phase two looks like if anything in terms of share repurchases.

But overall it’s just a comment that we feel very good about it, we have a lot of flexibility on our balance sheet and we can continue to look for ways to add value for our shareholders.

David Hartley - BMO Capital Markets

Now is there a, I believe there may be a restriction still in terms of the agreement with Wendy’s that prevents you from buying back more than you have in the past in terms of your share buyback. Can you explain that a little bit to me if I’m onto this right thing here?

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

Sure. There were certain restrictions with respect to the 355 ruling, but that’s not really what’s driving our decisions right now in terms of share repurchase. But you’re absolutely right ,there are some restrictions. But those are, we still would be well below those restrictions in terms of what we’ve executed from a share repurchase standpoint.

David Hartley - BMO Capital Markets

And when do those restrictions fall off exactly?

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

There’s no – you know what, it’s interesting, with the 355 ruling, there’s no, it’s not an exact science, there’s not a date that says, OK, you can go crazy right now. It’s more of a, how does it feel relative to how long you’ve been out there. People talk about 18 to 24 months, that kind of time frame.

David Hartley - BMO Capital Markets

OK, that’s good. And in the US, you talked a bit about the competitive landscape. Are you, can you talk a little bit about your expansion and where you’ve been focused in the quarter in terms of opening your stores there?

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

Well, we’re basically doing an expansion in the markets that we’re already established in, and that’s where we plan to stay for the near term. We are going to open some stores later this year up in the Lansing market area, in Michigan, so that’ll be a new market for us this year. But the rest of our expansion is basically focused in the markets of Buffalo, Rochester, Maine and in Detroit area and so forth.

David Hartley - BMO Capital Markets

And in terms of securing franchisees, could you give us an idea of what you’re seeing? Has there been a new influx of franchisees lately, or has it been pretty much the same type of pipeline that you’ve had in the past?

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

Well, you know, all of our new stores that we’re opening we’re opening with franchisees. Some of them are the existing franchisees, and some of them are with brand new franchises.

David Hartley - BMO Capital Markets

OK, and last question. Just on the old Bess Eaton stores, could you talk a bit about their contribution nowadays, is it trending positively there in terms of the sale and could you talk a bit about the profitability, if it’s possible, in those stores?

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

No, we don’t break out individually what we’re doing in each market. But we’re pleased with the performance of our US business in the second quarter.

David Hartley - BMO Capital Markets

OK, thank you.

Operator

Our next question comes from the line of Adina Bloom from TD Newcrest. Please proceed.

Adina Bloom - TD Newcrest

Good morning. I realize that the master (inaudible) only rolled out in about a thousand stores in Canada, but wondering how the take up is so far and kind of what you’re seeing from your experience so far there?

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

It’s really too early. We’re just in the process of rolling out and so forth, so, we’ll get a better fix into the end of the year and the first quarter next year.

Adina Bloom - TD Newcrest

OK. Wondering if you can talk a little bit more about the competitive landscape in the US. Obviously last quarter you talked a lot about what you saw as competition from McDonald’s and Dunkin’ and whatnot. Wondering if, what’s kind of what Q2 looked like from that perspective?

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

Well I’m sorry to report they haven’t closed any stores in the market that we’re in. They’re still all there and alive and some of them are discounting and doing things that they do in the marketplace, and as you know we don’t do that. But as you can tell from the results of our second quarter we feel that we’re getting momentum in our US business.

Adina Bloom - TD Newcrest

All right, thanks very much.

Operator

Our next question comes from the line of Turan Quettawala, from Scotia Capital. Please proceed.

Turan Quettawala - Scotia Capital

Yes, good morning. Just a quick question on, I guess I noticed some new store design costs. I’m just wondering what state of development that’s in right now and, you know, when can we expect to see a roll out, if at all?

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

No, I mean, the new store design costs, we’ve been looking at ways to, to fit our stores into smaller land pieces and whatnot, due to control real estate costs given escalating construction costs and real estate costs. This is an ongoing thing, but it happened to be a project that we had and we’ve used a lot of it now in new stores that we’re putting up. So it was just taking care of some of the expenses associated with that.

Turan Quettawala - Scotia Capital

I see. So there is no new store, new branding or anything?

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

No, no. This is taking our existing store and trying to make sure it fits into urban design in areas where you don’t have the ability to have a lot of land, to make sure that the drive through functions properly, and that the restaurant is, the size is probably a little bit more compact but still delivers on the customer experience.

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

And our design is always evolving. I mean as it has for 40-some odd years and will continue to do so. From time to time, we construct stores and look at the designs of them in a warehouse environment and study the flow and so forth within the operation. So we’ve just concluded one of those studies.

Turan Quettawala - Scotia Capital

Great, thank you. And I guess on the US side, just on the (inaudible) store sales growth, you had approximately 3% volume growth, which is a lot better than a lot of your costs in the US. Just wondering if you could share with us, at least qualitatively, how much of a variance there was within different regions.

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

No. Again, we don’t disclose by region what our sales growth is. As I stated earlier, we’re pleased with the momentum our US business is gaining.

Turan Quettawala - Scotia Capital

Great, thank you very much., I thought I’d try.

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

Good try!

Operator

Our next question comes from the line of Joe Buckley from Bear Stearns. Please proceed.

Joe Buckley - Bear Stearns

Thank you. Couple of questions. Talking about pricing that you mentioned in the various Canadian markets. Is the Canadian market different from the US market in terms of the franchisee’s pricing versus your pricing? Were those comments meant to be system-wide comments?

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

I’m not sure, Joe, what you’re asking. Sorry.

Joe Buckley - Bear Stearns

Can you guys basically tell the franchisees to raise prices 2%, or, or . . . or do they price independently?

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

We set maximum selling prices, so, and they can price below that, and we follow a similar model throughout system in Canada and the US today.

Joe Buckley - Bear Stearns

OK. Those numbers you shared with us, I mean, that’s a few company stores in Canada, I’m assuming those were numbers for the system?

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

Those were numbers for the system, system numbers, yes.

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

Absolutely right. But it is, it’s based on setting a maximum selling price, we typically know what the blended average increase is going to be for all those restaurants. But again it’s an estimate and I think we’ve always talked about it as being an estimate based on the mix of products that we have.

Joe Buckley - Bear Stearns

OK. And then, on the distribution side, in an inflationary environment for food costs, how does that play out? Does it end up being a higher revenue number because you’re passing it through, but maybe a lower margin because the mark-up is more fixed as opposed to moving as a percent of sales?

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

Exactly right, Joe. We get, we work on fixed margins in a lot of cases, especially coffee. And we’ve had some cost pressures but we do some long term buying and we’ve done some very good positional buying, so we’ve had some cost pressures but through our distribution system we’ve really not had any of any major nature.

They’ve been external. I mean, we get, in Canada we get dairy price increases every year because of the way the industry is regulated. In the United States as you know it varies by areas dramatically. But from a supply-side point of view, we feel cost pressures but they’re not, they’re not severely impacting our business at this point in time.

Joe Buckley - Bear Stearns

OK. And given the US business, and recording reasonable same-store sales growth but below your expectations, does that play an impact on your expansion plans for the US?

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

No. We’re still giving the guidance that with 60 to 80 new stores, and I say we’re pleased with the momentum we’re making and we’re going to stay true to what we’ve said earlier, that we’re going to stay in the regions that we’ve got some concentration and we’re going to build those areas out, and we’re going to continue to expand the Canadian business by 120 to 140 new stores. So the strategy that we’ve laid out two years ago still is in place and we’re very content with where we are today.

Joe Buckley - Bear Stearns

Are you still talking 500 for the US by I think the end of ’08?

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

Well, we’re online with our guidance for this year, and you know, we’ve got 18 months before we get there, Joe. But again, we’re going to look for good prudent growth, and we’ve got a lot of sites that we’re working on for next year as we speak. So it’s early to predict a head but we’re feeling positive about where we are today.

Joe Buckley - Bear Stearns

OK, thank you.

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

Thank you, Joe.

Operator

Our next question comes from the line of Glenn (inaudible) from City Investment Research. Please proceed.

Glenn (inaudible) - City Investment Research

Thanks. Cynthia just first, the RSU grants in the third and fourth quarter of 2006, do you happen to know what those were?

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

We’ll show that in the quarter. But they were in Q3 it was significantly higher than it was for the balance of the year. And then it was much lower in the fourth quarter again because of the expensing. But you’ll see some of that detail in the Q.

Glenn (inaudible) - City Investment Research

OK. And then in terms of the US growth plan, Paul you mentioned that you’re going to stay primarily focused in the regions where you already have a presence. I guess the Bess Eaton stores are perhaps an issue unto themselves given the strength of Dunkin’ Donuts in that market. But if you could maybe comment on some of the challenges you might face as you try to get out of the markets where you already have a meaningful presence?

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

No different than any other new market. We’re looking at expanding in markets that are adjacent to markets that we’ve already established in. You know, as we’re moving in Michigan, we’re going to Lansing. As you well know we’ve been in Rochester, you know, we’ll migrate into Syracuse in due course, and that’s the way we plan to continue to expand the company: With steady, responsible growth as we go forward.

Glenn (inaudible) - City Investment Research

OK. And then, just lastly, the cash card roll out, is that something that has to be phased similar to the roll out of the MasterCard program, or is this something that can be done more rapidly?

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

It can be done more rapidly. I guess in plain English we’re building the highway with the credit, and then it’s very easy to add additional cards on it if you like. And so, now the cash card will come relatively quickly once we complete the credit card application within our units.

Glenn (inaudible) - City Investment Research

Thank you.

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

Thank you.

Operator

Our next question comes from the line of Winston Lee from Credit Suisse. Please proceed.

Winston Lee - Credit Suisse

Thanks. Just looking at the US loss to income position this quarter, wondered how much of that was related to, I guess, we had some weather issues last quarter and it seemed like your traffic was positive whereas last quarter it was flat. When you talk about the improvement in the US business, how much of this is kind of related to store increases or new stores. Because we didn't have very much in the quarter. Versus one-time issues like weather versus real fundamental improvements in the business that you’re seeing.

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

One of the things – again, we’re not going to provide real specifics around each line item of our US P&L. But you’re absolutely right, and it’s not as much, weather was one of the factors in the first quarter. But as we’ve talked about before, when you have the number of new stores that we’ve brought on in the fourth quarter, in the first quarter of 2007 that’s traditionally from an average-unit volume standpoint, that’s traditionally one of our slowest times.

So those stores needed a little bit of help in the first quarter from a relief standpoint. As you move to the second quarter you have those average unit volumes coming up, so we were able to provide less relief to those franchisees. So that’s a big part of it. But that’s a bit of the seasonability of the business. But it was, as I said to Irene earlier on, it was really every line item of the P&L really helped contribute to the improvement.

Winston Lee - Credit Suisse

When I think about that 500 target for the end of ’08, you know, that’s a 47% increase from the current US store count level. Are we expecting to see a large second-half increase in US store counts for ‘07, and if that’s so, what do you think that’s going to do for the contribution from the US?

Cynthia J. Devine - Chief Financial Officer, Principal Accounting Officer and \Executive Vice President of Finance

Well, again, I mean, you know, our guidance is 60 to 80 stores, so we always have a stronger finish to our store openings in the back half of the year than we do in the first half of the year. So, yes, you will definitely see more openings in the back half of the year in our US business.

But again, your question is a good one in terms of, as you had, you know, big bulks of new stores, you’re going to affect some of your business, in terms of you’re now in a market so it does have a little bit of an impact on those other stores in that market from a growth standpoint.

So, and that’s why we talk about having some volatility between quarters and between years – that’s precisely the reason.

Winston Lee - Credit Suisse

And as you look at your operating income growth guidance and saying that you now can meet or exceed that, what’s caused the, I guess, your upside in that? Is it the US business or is it the Canadian business? I wonder if you can give us some color on that?

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

I think it would be, given our same store sales growth in Canada were 4 – 5% and we’re above that, it’s clearly coming from our Canadian same-store sales momentum.

Winston Lee - Credit Suisse

OK, great, thanks.

Operator

[reminding instructions]

Our next question comes from the line of Richard Piticco from CIBC World Markets.

Richard Piticco - CIBC World Markets

Good morning. Most of my questions have been asked, but just two really quick easy ones for you.

First on the product innovation front. You’ve obviously done two new pretty heavy hitting product innovations, in my opinion, with the specialty coffee program in Canada and the iced coffee in the US. The latter one being more recent. But can you give us some indication of how that’s trending in line with your expectations?

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

Well we’re pleased with the iced coffee. The specialty coffee in Canada we’re really just in test with that, in two or three markets, so it’s early to tell with that. But the iced coffee roll out in the United States, we’re very pleased with the results that have come out of that.

Richard Piticco - CIBC World Markets

And Paul, on the specialty coffee in Canada, can you give any kind of indication of when that might be a national roll out?

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

No, it’s premature to talk about that. We’re just, went into a couple more tests and we’re adding some additional variations to it. I guess I could say that we don’t expect to see it into 2008. We’re going to be working and testing it through the next few months, and that’s our plan with it. It’s a major step for us to go into the specialty coffee business and we want to be sure when we step in there that we do it correctly.

Richard Piticco - CIBC World Markets

Great. And then just finally, on the price increases in Canada, in Ontario the food price some particular commodities, if I’ve done my math correctly, you know, previously under a dollar, now above a dollar – is that taking certain quantities above that dollar do anything in terms of volume in your opinion?

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

No, I don’t think so. We deal in pennies, so tax has a bigger impact than . . . you know, there’s a lot of factors that affect what it costs the consumer in the end. But, you know, we’ve been very prudent about price increases to our consumer. We’ve built a great level of trust with our consumer. And I think they understand that when we put something through we absolutely have to, and we do it out of necessity and we generally don’t get a push back from our consumers when we do it that way.

And we don’t have to discount to apologize for putting prices up.

Richard Piticco - CIBC World Markets

Perfect. Thanks a lot.

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

Thanks, Richard.

Operator

Our next question comes from the line of Rachel Rothman from Merrill Lynch. Please proceed.

Rachel Rothman - Merrill Lynch

Hey, guys.

On the reloadable card and the MasterCard program? When other chains at least in the US have launched these programs they’ve seen a pretty big uptick in traffic, and I would guess that you guys being high purchase frequency, low ticket, that it would be able to help in terms of speed at the drive through, et cetera.

Are you running tests in the stores, and maybe can you talk about what some of the experiences that you’ve seen or what the potential to drive traffic or incremental visits?

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

We don’t disclose that, from a competitive point of view, but obviously the cash card will increase the speed of service. We’ve found that in our testing as we went into this program, and you know, we feel very good about it.

I think, you know, as the cash card, it’s going to take a period of time for the consumer to get used to it. It’ll probably take a 24 month period before it reaches its peak performance as far as saturating – not saturating, but getting into the marketplace as consumers—

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

For consumers to understand it.

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

Understand it and be aware of it. Because of the repetition of so many customers that come to us frequently, we see the cash card as a great addition to our operating mode.

Rachel Rothman - Merrill Lynch

For those of us who aren’t in Canada, can you just give us a little bit of color on whether or not it’s offered by many of your competitors and whether or not there’s the same holiday gift-giving of . . .

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

Yeah, the cash cards are quite common in the Canadian marketplace, as they are in the US.

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

The other thing, we have a tremendous gift certificate business that we’ve had for years and years. And so, and that, we do a very large volume of gift certificates in the fourth quarter around gift-giving time, if you will. So, but they are, cash, reloadable cash and gift cards are pretty common in the Canadian market.

Rachel Rothman - Merrill Lynch

Perfect. And then just a quick one on Cap-Ex, I may have missed it. Can you just talk a little bit about what your Cap-Ex was, where you are in the context of the year. And then I know this comment was made about a greater name of leased sites. Is this just about what was available this quarter, or is that a shift in your strategy at all?

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

No, it’s just what’s available. There’s no definite change. At the beginning of the year, we try to figure out what our mix of stores are gonna be, whether they’re going to be owned or leased, and sometimes it changes throughout the period.

But our Cap-Ex on a year-to-date basis as I said was about $70 million and then in the quarter was about $31.8 million. I don't know –

Rachel Rothman - Merrill Lynch

Perfect, thank you so much.

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

I don't know if I can expand any further than that.

Rachel Rothman - Merrill Lynch

I think I just missed it.

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

OK, that’s OK, Rachel. Take care.

Operator

Our next-question is a follow-up question coming from the line of Irene Nattel of RBC Capital Markets.

Irene Nattel - RBC Capital Markets

Thanks. Cynthia, could you give us the depreciation costs for the quarter?

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

I must speak too quickly. I’m sorry about that. The depreciation for the quarter was $21.4 million, and that’s versus $17.7 million a year ago.

Irene Nattel - RBC Capital Markets

That’s great.

And Cynthia, in your prepared remarks you noted that warehouse sales as a percentage of total sales was 56.2%. Can you give us an idea of where you would expect that number to be once you reach your 85% target?

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

There’s some real background noise in that, but I think I caught the question., I’m probably not going to go out and say what it would be as a percentage, but I think as we talked about with the roll out of frozen, it is going to level out when we get it fully implemented, and then as the business continues to grow it will remain as a fairly fixed percentage of our revenues.

Actually, I shouldn't even say that because as you know the warehouse sales, they’re going to fluctuate, depending on what’s going in with coffee prices and other commodity prices, you’re going to have ups and downs, but as a result of the frozen roll out, once we get to a steady pace, you’re not going to see a big change from that perspective.

That’s what it really was this quarter, that was the biggest change that occurred in terms of business mix shift, was getting more frozen revenues in there. But please remember the other point, because it is important that warehouse revenues can go up and down depending what’s going on with underlying commodities.

Irene Nattel - RBC Capital Markets

Absolutely. So let me ask the question a different way, Cynthia. What proportion of the restaurants in Ontario were you delivering frozen to in the quarter?

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

What percentage? You know, we’re very close to getting to full roll out. So, we’re on track, Irene. Ahead of track, actually. We’ll finish – originally we had said late 2007, now we’re saying we’re going to finish that roll out in Q3. We feel very good about the progress that that team has made.

Irene Nattel - RBC Capital Markets

OK, that’s great, thanks Cynthia.

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

Thanks Irene.

Operator

Our next question is a follow-up question coming from the line of Jim Durran from National Bank Financial.

Jim Durran - National Bank Financial

Just wondering on the new-store growth front. Are we going to have the same degree of Q4 back load that we had last year in terms of new store openings?

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

Yeah, that’s pretty traditional. We’re hoping that there will be a larger number in the third quarter, but there’ll still be a heavy load in the fourth quarter. I’ve been here for 22 years, and we’ve always opened a ton of stores in the fourth quarter. And I think it’s pretty well, everybody in the industry does that, it’s the nature of the business and the construction industry.

Jim Durran - National Bank Financial

On your credit card roll out – and I understand you may not be able to answer this question for me – but can you give us some idea based on your experience in the US and Alberta what the difference is on a percentage basis, or index or something, on your average credit card transaction value versus your total cash transaction value?

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

No, I mean – other than, you know, it’s a higher number, that’s all that we’re going to disclose.

Jim Durran - National Bank Financial

And is the transaction time of a credit card equal or faster than a cash transaction.

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

Faster, with no verification or signature. It is not your, we have debit in Western Canada, and it’s slower than cash.

Jim Durran - National Bank Financial

OK. Last question, just where are we in terms of the credit card roll-out as a percent of total stores or total store count at this point?

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

As I said, we have over a thousand stores rolled out currently and we’re on with our guidance that we gave that we expect to have our Tim’s card into the system late this year, so we’ve gotta get credit cards finished first. And we’re on schedule with that, so we’re very comfortable with where we are.

We’re going to be marketing our Tim’s card around the Christmas season this year.

Jim Durran - National Bank Financial

Last question. For the franchisee, is the credit card transaction a margin investment, or is it a better margin than the cash transaction?

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

You have to compare two things. Because obviously there’s the transaction costs associated with using a credit card, but the speed of service, the benefit you get out of that, and you know and obviously as you’ve heard, that average check size is another thing that has happened in the industry, when people move to this type of payments, so we think there’s benefit there.

Jim Durran - National Bank Financial

So – equal or better?

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

We believe it’s better.

Jim Durran - National Bank Financial

OK. And that’s excluding any capital costs for putting the system in?

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

Again, that’s something that we’ve worked out with the franchisees and MasterCard and so we feel good about the program that we have in the stores.

Jim Durran - National Bank Financial

Thanks, Cynthia.

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

Operator, this will be the last question.

Operator

Thank you, ladies and gentlemen. Our last question comes from the line David Hartley from BMO Capital Markets, please proceed.

David Hartley - BMO Capital Markets

Hi. Just furthermore on the cash card. Could you talk a little bit about what type of cash card it’ll be? RFID, Magstripe Smart Card? And whether or not – I’ve asked this question before – whether or not there’ll be a loyalty program built into that any time soon?

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

As Paul mentioned, we’ve built the highway now. We’re going to be out with Magstripe as the first, but we have the capability to go RFID. Right now you can go in the store and you can use MasterCard RFID . I do that personally.

But that capability exists, and we will be with that at some point, but originally the roll out is going to be Magstripe. Loyalty, all those things, the possibilities are endless for this. It’s, the highway has been built and now we have to learn to use it.

David Hartley - BMO Capital Markets

OK. And in terms of having other credit card, like Visa, that can be used on the system – when will you accept Visa, or when is the opportunity to accept other players in that market, and can you use the same types of terminals to accept those other players?

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

We’re putting the Tim’s Card in and we’ve got MasterCard in and we’re very content with where we are at this point in time, and that may be as far as we go. The future will play itself out.

David Hartley - BMO Capital Markets

OK, thank you.

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

Thanks, everyone.

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

Operator, we’re complete with the call.

Operator

Thank you very much, ladies and gentlemen. That does conclude our conference call for today and we ask that you please disconnect your line, and have a great weekend.

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Source: Tim Hortons Q2 2007 Earnings Call Transcript
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