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Tim Hortons Inc. (NYSE:THI)

Q2 2008 Earnings Call

August 7, 2008 2:30 pm ET

Executives

Scott Bonikowsky - Vice President Investor Relations

Donald B. Schroeder - President, Chief Executive Officer, Director

Cynthia J. Devine - Chief Financial Officer, Executive Vice President

Analysts

Irene Nattel - RBC Capital Markets

Steven Kron - Goldman Sachs

Turan Quettawala - Scotia Capital

David Hartley - BMO Capital Markets

Jim Durran - National Bank Financial

Adina Bloom - TD Newcrest

Rachael Rothman - Merrill Lynch

Winston Lee - Credit Suisse

John Ivankoe - J.P. Morgan

Operator

Ladies and gentlemen, thank you for standing by and welcome to the 2008 second quarter Tim Hortons earnings conference call. (Operator Instructions) It is now my pleasure to turn the conference over to Scott Bonikowsky, Vice President of Investor Relations at Tim Hortons. Please proceed.

Scott Bonikowsky

Thanks and good afternoon, everyone. Thanks for joining us for our second quarter 2008 conference call. We released our second quarter results earlier today. If you’ve not had the opportunity yet to review this material, you can access the information on our newly relaunched investor relations section of our website at timhortons.com and by clicking on the events and presentations tab.

We have prepared a presentation to support today’s discussion. You can also access this and other material associated with our call on the website in the same section, and it will be available to you for a period of one year.

Joining me on the call this afternoon for remarks are Don Schroeder, our President and CEO; and Cynthia Devine, our Chief Financial Officer. And after the remarks, we’d be pleased to take questions, for which our Executive Chairman, Paul House, will also be available and joining us for the call as well.

Before we begin today, I would like to remind everyone on the call that we may have forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which includes discussions about future performance based on current expectations and information. Various risks and uncertainties could cause our company’s results to differ materially from those expressed in our forward-looking statements, which speak only as of the date and time made. More detailed information about these risks and uncertainties is contained within the Safe Harbor statement included in the earnings release issued and additional risk factors are also described in our public securities filings and our 2007 annual report on Form 10-K, also available on our website under the regulatory filings tab, and we’d encourage you to read that.

All Tim Hortons results are presented in accordance with U.S. GAAP and reported in Canadian dollars, unless otherwise noted. In the event we reference non-GAAP financial information that we have not already reconciled in the earnings release and today’s slide presentation, we will post a reconciliation to the most directly comparable GAAP financial measure on our website, as required by Regulation G.

And with that, it’s now my pleasure to turn the call over to Don Schroeder, our President and CEO. Don.

Donald B. Schroeder

Thanks, Scott and hello, everyone. Thanks for joining us today. Tim Hortons has a proven business model that has stood the test of time throughout our 44 year history. Our second quarter results reflect the strength of our business model in what can only be described as a difficult and challenging macroeconomic environment. We were very pleased with both our top line growth and earnings performance in these circumstances.

Consumers today face daunting challenges, stemming from economic weakness, compounded by high gas and food prices and greater uncertainty about the future. At the same time, restaurant companies are facing volatile commodity prices and increasing labor costs, creating additional pressures within the food service industry.

While we have seen some challenges in Canada, those macroeconomic challenges are deeper and more embedded in the U.S. I would point out that the Canadian segment accounts for 92% of our revenues.

On slide five, you will see that in this environment, we delivered solid same-store sales growth in both the Canadian and U.S. businesses. In Canada, same-store sales were up 5.7%, lapping growth of 6.6%. In the U.S., same-store sales were up 3.1%, lapping growth of 3.8%.

On slide 6, we have listed several sales catalysts which contributed to the second quarter performance. The largest contributor and first item I will discuss is pricing. During the quarter, pricing contributed significantly to our growth in both markets, supported by organic growth.

Our differentiation with our customers as a destination for great quality food at a reasonable price supports our ability to take price when necessary. Generally, a measure taken to help offset restaurant level cost pressures. The timing of Easter also benefited sales this quarter, contributing about 0.5% to Canadian same-store sales and less than 0.4% to U.S. same-store sales.

We were also pleased in this quarter with continued system-wide sales growth, which includes all sales from company-operated and franchised restaurants.

In the U.S. business, our system-wide sales grew by just over 30% over a two-year period, reflecting continued growth of our brand through the expansion of our restaurant base in the U.S. markets where we operate.

Positive same-store sales growth and unit expansion in both markets contributed to an increase in operating income of 10% in the second quarter and earnings per share growth of more than 14%.

If you would turn to page seven in the slide presentation, you will get a sense of the active menu and promotional program we had in the second quarter. Our growth came, as always, from several catalysts in the quarter, including pricing, store level operations, menu innovation, and promotions.

During the quarter, we promoted whole-grain raspberry muffins, green tea, a Chocolate Brownie Iced Capp Supreme, homestyle hashbrowns, strawberry blossom donuts, and in the U.S. only, French Vanilla Iced Coffee. We also promoted our popular maple themed lineup, including the Maple Crunch Donut, Maple Pecan Danish, and Maple Shortbread Cookie.

Late at the end of the first quarter, we also introduced a slow roast beef sandwich, a promotion which was designed to fill a gap in our lunch day part for customers seeking a hardy, hot sandwich. This sandwich leveraged our equipment platform which delivers the hot breakfast sandwich.

Contrary to what some recent reports speculated, the slow roast beef sandwich boosted overall lunch sales and experienced significant consumer trial during our promotional period, so we expect to be back in the market with the slow roast beef product again in the months ahead.

The slow roast beef sandwich represents an evolution of our lunch menu and as such, we had significant learnings, so we will push continued refinement, such as product formulation and operational efficiencies.

Our lunch program will continue to evolve with new menu offerings and choice for customers, and we see good growth potential during this day part.

I would like to spend a minute on one of our programs that I am most proud of, and that is our annual Tim Hortons Camp Day. Turning to slide eight, you can see the infrastructure we have in place to support our vision of helping economically disadvantaged children from the communities in which we operate. Our storeowners donate their entire coffee sales proceeds on Camp Day towards sending children to the Tim Hortons Children’s Foundation camps in Canada and the U.S. We raised a record $9 million on Camp Day that will be used to send literally thousands of economically disadvantaged children to our camps for an opportunity of a lifetime. Our goal is to help these children build leadership and social skills and to develop their self esteem.

Above all, we are working to create an environment where they can have fun and develop lasting memories. So I am very proud of our storeowners, store staff, and our customers for raising a record amount on this year’s Camp Day.

Turning to store development and slide nine in the presentation, you will see that execution of our store expansion strategies continued in the quarter and contributed to our system-wide sales growth. We opened 23 restaurants in Canada in the second quarter and 45 year-to-date. In the U.S., we opened eight restaurants and a total of 11 year-to-date.

As part of our strategy to build out adjacent markets, we are expanding our presence in Lansing, Michigan, which we entered last year, and we are also aggressively entering the market of Syracuse, New York in the next few months, with a total of six new restaurants planned between now and November.

As we have mentioned on several occasions, our real estate development activities, like most restaurant companies, are typically back-end loaded and this will be the case in 2008 as well.

2008 represents our most ambitious store development agenda in several years, with a target of approximately 210 to 250 projects planned, including 120 to 140 restaurants in Canada and 90 to 110 projects in the U.S., potentially including a number of self-serve kiosks but as always, we will only open sites in a disciplined manner in locations that we believe will be successful over the long-term.

Our international growth in Ireland and the U.K. also continues. We now have 213 licensed sites primarily under the Tim Hortons name.

Our international platform provides a high quality bean-to-cup coffee offering and a focused assortment of pastry and baked goods products. While our international business is not a material contributor to revenues or earnings at this time, we do believe international development represents a positive potential avenue of future growth for the Tim Hortons brand.

David Clanachan, Chief Operations Officer for the U.S. and International, continues to be focused on the development of our international growth strategy.

The final topic I will speak to before I turn it over to Cynthia is the TimCard. If you turn to slide 11, you will see some metrics associated with the TimCard. We have now completed our U.S. TimCard rollout. We continue to gain traction with the TimCard and are pleased with what we see.

We had 1.4 million card activations in the quarter and about $1 million reloads, building on our earlier launch success. We saw a spike in activations, particularly around gift giving periods, such as the end of school as gifts for teachers and with Mother’s and Father’s Day, which are patterns we expected to see.

Our next major milestone with the TimCard is integration into our point-of-sale system, which is scheduled to begin in the third quarter. POS integration will allow us to increase speed of service so that transactions are faster than cash, which is a key benefit of the TimCard.

We’ve identified over 2,000 restaurants in our system for this integration and we will follow that with TimCard implementation at non-traditional stores, likely to begin rolling out in the fourth quarter.

To sum up, I would say that we continue to face some difficult macro headwinds, as does the rest of the industry. We are pleased with our performance in the current environment. Based on our performance to date, we continue to be on track to meet our earnings target of 10% operating income growth excluding the $3.1 million restructuring charge we discussed on our last call.

Our customer offering, brand strength, and loyalty in Canada, coupled with our quality products at reasonable prices positions us well. However, we will continue to closely monitor the macroeconomic situation which continues to be challenging, and with that, I will turn it over to Cynthia.

Cynthia J. Devine

Thanks, Don and good afternoon, everyone. We delivered strong top line growth and we were pleased with our earnings performance in the second quarter, particularly in light of some of the factors at play in the economy.

I will provide some perspective on our financial performance and the underlying trends, and then we’ll open it up for questions. I will start with revenues and you can see more detailed information on revenues on slide 14. Revenues rose approximately 10% in the second quarter to about $511 million. Sales, being the largest component of revenues, consisting primarily of our warehouse sales, were up about 9% to approximately $336 million.

We continued our focus on reducing the number of company-operated restaurants in the quarter by transitioning more stores primarily to our operator model. We reduced the number of corporate stores by 22 compared to the second quarter of 2007. Having fewer corporate stores was more than offset by a higher number of stores consolidated under FIN-46R.

Our rent and royalties in the second quarter grew close to 10% to about $154 million, which was consistent with our system-wide sales growth. Franchise fees were up 24% in the second quarter compared to last year due to a higher number of units sold and a shift in mix towards standard restaurants versus non-standard restaurants in the second quarter of 2007.

The benefit of higher units sold and the mix of restaurant types was partially offset by lower deferred revenues recognized from our U.S. franchise incentive program.

Turning to the cost side of the business, this is detailed on slide 15 of the presentation. I’ll walk you through the dynamics of the second quarter cost structure. We were able to constrain costs fairly well in the quarter, keeping in mind the continued system growth that we experienced, in addition to the restructuring charge that we absorbed in the second quarter.

While franchise fee revenues were up significantly, so were associated franchise fee costs which rose close to 17%. The growth in franchise fee cost was due mostly to a higher number of units sold compared to last year and a higher number of renovations and replacement stores, increased franchise support costs and expenses we incurred to establish a franchisee’s business also contributed to higher franchise fee costs.

Cost of sales growth was slightly below our warehouse sales growth and reflects the completion of the refrigerated/frozen product distribution at the Guelph distribution center, which was not fully operational in Q2 of 2007.

Operating expenses in the second quarter were up 9% over the same period last year, due primarily to increased property costs related to a greater number of system restaurants versus a year ago and higher variable rent on existing properties.

G&A expenses increased just over 17% compared to the second quarter of 2007. I would remind you though that this number includes the $3.1 million management restructuring charge that we announced in parallel with our first quarter results and excluding this charge, our G&A expenses were up approximately 7% as a result of the continued growth that we’ve experienced in the business.

Our original management restructuring charge estimate was $3.8 million with $1.5 million in annual savings. Having completed the restructuring implementation, the amount recorded ended up being $3.1 million with approximately $1 million in annualized savings that will be realized as the transition [inaudible].

Our equity income was up a little over 8% compared to the second quarter of 2007. Improvements in both our two joint ventures and a gain in one of our smaller joint ventures contributed to this increase in equity income.

Turning to earnings, which can be found on page 17 of the presentation, second quarter operating income rose 10% to $117 million. Excluding the restructuring charge I mentioned, adjusted operating income was up 13% year over year. Adjusted operating income is a non-GAAP measure, so please see the disclosure in either the news release and the reconciliation to U.S. GAAP operating income provided on page 21 of the slide presentation.

Several growth catalysts contributed to the higher operating income, including our same-store sales growth, our unit expansion, higher franchise fee income, and equity income, along with higher revenue contributions from the distribution center.

Franchise fee income is a variable factor and was much higher in the second quarter compared to our 2008 first quarter, primarily due to timing of store openings and certain resales.

Net interest expense of $4.9 million in the quarter, compared to $4.8 million in Q2 of 2007.

Second quarter net income grew close to 12% to approximately $75 million. This compares to $67 million in the same quarter last year. The effective tax rate in the quarter was 33.2%, and that was slightly lower than the rate of 33.8% in Q2 of 2007. Our EPS was $0.41 per share, compared to $0.36 per share in the second quarter of last year, and that was up 14.5%.

In addition to the earnings drivers I described previously, our EPS growth rate this quarter also benefited from the repurchase of approximately 1.5 million shares as part of our $200 million share repurchase program, resulting in a 2.6% reduction in weighted average shares outstanding on a year-over-year basis.

On a segmented basis, Don already discussed the sales performance and the sales climate, so I will focus primarily on the financial performance. If you wish to follow along in the presentation, this information can be found on slide 17.

Before I speak to the specific segment financial performance, I do want to add some color regarding pricing impact on the same-store sales for the balance of the year. Pricing implemented in Ontario, in Atlantic Canada and Manitoba in July of 2007 contributed about 1.6% to our Q2 same-store sales results, and that pricing rolls off for the remainder of 2008. As a result of the pricing implemented this year, there was approximately 3.2% pricing in the third and fourth quarters in Canada versus a year ago and about 3% in our U.S. business.

Focusing for a moment now on the Canadian segment, it had operating income growth of approximately 13%, rising to $130 million. Segment margins in Canada were higher, reflecting increased leverage from top line growth and the benefit of the completed rollout of refrigerated and frozen distribution at the Guelph distribution center. Margins also benefited from increased franchise fee income and from higher system-wide sales growth.

In the U.S. segment, we had a small operating loss of $200,000 in the second quarter. Increased system-wide sales growth contributed to higher rents and royalties, but this was offset by increased franchisee release. U.S. segment margins were also impacted by the timing of gains on the sales of restaurants versus a year ago and higher support costs.

I will now turn to the balance sheet items, which can be found on slide 18. We continue to view the financial strength and flexibility of our balance sheet as a positive defining characteristic of Tim Hortons within the restaurant sector. Our financial flexibility provides us with the ability to selectively target investments and growth opportunities that make sense for our business.

For example, today, earlier today we announced that we will be constructing a coffee roasting and green coffee blending operation in Southern Ontario as part of our vertical integration strategy.

Consistent with this strategy, a new roasting facility will provide system benefits important to our store owners and to the company. When fully operational, this facility, coupled with our existing roasting operation in Rochester, New York, will provide about three-quarters of our system needs. Equally important, our green coffee blending capability will help us protect the quality, integrity, and supply of our proprietary coffee blend from tree to cup at a competitive rate for our store owners and provide for a reasonable return on our investment.

We continue to selectively invest in growth opportunities for our business and believe our financial position is a key enabler of future growth.

Turning to cash, we ended the quarter with $72 million of cash and cash equivalents on hand. This number excludes the restricted cash, which represents cash flow from our TimCard program. Restricted cash was about $19 million at the end of the quarter.

We spent approximately $49 million during the quarter to purchase 1.5 million shares as part of the share repurchase program. Capital expenditures in the quarter totaled $34 million and $66 million year-to-date, primarily oriented to store development and renovation activities. Depreciation and amortization for the quarter was $22.3 million and $44 million on a year-to-date basis.

To wrap up, I would like to spend a moment discussing our outlook for the remainder of the year. Don mentioned earlier that based on our performance to this point in the year, we are currently on track to meet our operating income target excluding the impact of restructuring. Let me remind you what our 2008 targets, announced in February 2008 are comprised of. Our target for operating income is 10% growth excluding the $3.1 million restructuring charge. Our target for same-store sales growth in Canada is 4% to 6% and in the U.S., is 2% to 4%. Our store development target in Canada is 120 to 140 restaurants, and in the U.S., it is 90 to 110 restaurants, potentially including some self-serve kiosk locations. Our targeted tax rate is 33% to 35% and our planned capital expenditures are $200 million to $250 million.

Several factors underlay our ability to meet these targets. These factors include our performance to this point in the year compared to our plans, our menu, promotional and operational initiatives, and pricing, including the increases put into the market earlier this year.

Offsetting factors include continued macroeconomic weakness, pressures on consumers and related competitive activity in the sector to drive traffic, along with the timing of real estate projects.

Commodities are an important part of the sector dynamics. I also know commodity volatility is of great interest to many of you on the call. The industry has seen sharp cost increases in many commodities like coffee, wheat, and cooking oil. Increased volatility has been the order of the day, although we are seeing recent signs of some slight pull-back in key commodities like coffee and wheat versus their recent highs.

Although we are one of the most franchised QSR chains in North America, and thus not directly affected by commodity swings which impact restaurant level economics, the success of our store owners is critical to our success. We are heavily focused on store level margins and work actively with our store owners to manage those pressures.

To that end, we are currently bought out in coffee through the end of January of next year and our positions in other key commodities like wheat, sugar, and cooking oil are for the most part also covered for the remainder of 2008.

There have been some downward movements in key commodities of late but if costs remain at current levels into 2009, we would need to take additional mitigating actions.

We have a 17-year track record of positive same-store sales growth and that includes several cycles of economic weakness. We’ve seen similar cycles before and have performed relatively well. What is perhaps unique in the current scenario is the continued inflationary pressures, particularly with record highs for gasoline.

We believe we are relatively well-positioned in this environment because of our business models and our customer offering, which stands for value in the minds of our consumers. With that, I will turn it back over to Scott.

Scott Bonikowsky

Thanks, Cynthia. I understand that we lost the connection with some of you for about a minute or so. During that time, Cynthia was highlighting some of the factors affecting revenues and costs, so we’ll work to get the transcript posted as soon as we can to make sure that you get access to that. If there are any questions in the meantime, feel free to follow-up with me after the call.

So with that, we will begin our Q&A session now. I would also mention to you that we will be filing our 10-Q. It will be available to you tomorrow, which is earlier than often you will see from us, and I know that will excite many of you, so do look for the 10-Q. It will be filed tomorrow.

So with that, we will begin Q&A and I’ll remind you that Paul House, our Executive Chairman, is with us as well. We request you stay to the limit of one question with one follow-up so that everybody on the call has a chance to ask a question and has an opportunity. After your question, you are welcome to get back into the queue for any other questions you might have.

So with that, I will turn it back over to you, Operator, to start the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Irene Nattel from RBC Capital Markets.

Irene Nattel - RBC Capital Markets

Thanks and good afternoon, everyone. When we look at the same-store sales trend in Q2, certainly a combination of price and the shift in the timing of Easter account for a fair amount of it but that nevertheless means that underlying -- the underlying business was still relatively solid, which is in sharp contrast to a lot of other operators out there. So I was wondering if you could give us just a little bit more color on what you are seeing in terms of consumer demand, whether you are seeing any shifts in traffic, whether you are seeing any shifts in mix, day part, anything like that.

Donald B. Schroeder

I don’t think there’s any question that there is a lot of pressure on traffic within the restaurants, given the high price of gasoline and so on, and the limited amount of discretionary dollars available to many of our customers. But as Cynthia said, we’ve seen cycles like this before. We’ve weathered the storm relatively well and to a certain extent, I think we benefit from people trading down from casual dining and coming into our restaurant. With the continued pressure, I don’t think there’s any question that a lot of our customers who would visit us normally seven or eight times a week might only be coming seven times a week or six times a week, but hopefully we are making up the shortfall with those customers trading down from other establishments.

Irene Nattel - RBC Capital Markets

Have you seen any shift let’s say between breakfast and lunch, where you’ve got smaller ticket at breakfast, bigger ticket at lunch, or even within those segments more -- I guess more price consciousness or really Tim’s is just so well-entrenched for most of your customers that you are not seeing those kinds of changes?

Donald B. Schroeder

I don’t think we’ve seen any real traffic pattern changes like that at all.

Irene Nattel - RBC Capital Markets

Okay, that’s great. I’ll leave it to that and I’ll get back in the queue.

Operator

Your next question comes from the line of Steven Kron from Goldman Sachs. Please proceed.

Steven Kron - Goldman Sachs

A question on the U.S. business. I recognize that this is on a quarter-to-quarter basis, fairly seasonal. Historically I think over the last few years, the second quarter has been one of the better quarters from a profitability standpoint. The slight loss in this quarter is a little bit down from the income from the prior year, which was down from greater income from the year before that. All the while, the comps remain in that 4% to 5% range, and I would think given that you’ve reduced company ownership I think on a year-over-year basis by around 33% or like 17 units, I would have expected given that it’s a greater franchise mix, has typically higher margin, I would have expected a little bit better from a profitability standpoint. You mentioned franchisee relief -- I mean, how much is that? Is that really the big offset here and how should we expect that to trend going forward?

Cynthia J. Devine

It is really the big offset because we’ve added a lot of new restaurants to the system and as we said before, and as you move stores over from corporate stores to franchise, or to operator models, we’re going to help them out and help them be successful, and so we are doing that through relief, so it is a factor. We also talked about the timing of certain gains on sales of restaurant in prior years that we didn’t have similar gains this year, so those are probably two of the main factors as we invest in this market for future growth.

Steven Kron - Goldman Sachs

Do you find that on a store-by-store basis, you are contributing more to the franchisees today than maybe you did last year at this time because of the environment or because of the demand out there?

Cynthia J. Devine

Not on a store-by-store basis, but we have a greater number of stores in the system and we are probably helping more stores.

Steven Kron - Goldman Sachs

Okay, and you would anticipate that that’s going to continue as the system grows?

Cynthia J. Devine

Well, the game plan is actually to increase AUVs and help those franchisees get stronger so that you can reduce the amount of relief to them, so that’s the game plan. But it typically with the brand, it’s not dissimilar to trends that we saw in the early days in Canada. You want to help store owners so that they can be successful, so as you go into new markets, we always anticipate that we will help them in the early days so that they can be successful and we can be successful in the long run.

Donald B. Schroeder

Relief has always been part of the way Tim Hortons has grown. In every new market, relief has been there and we have relief in various parts of Canada, in all parts of the chain. So this is not something new. The U.S. is a developing market and so we will follow that pattern as we have done historically.

Steven Kron - Goldman Sachs

That’s helpful. If I could just slip one more in there -- Cynthia, just looking at the cost of sales line. You had nice year-over-year basis point improvement. You don’t see that too much in restaurants these days as a percentage of restaurant sales. I guess the question is given the inflationary environment, I was -- you guys tend to pass along the cost to your franchisees more on a penny profit basis as opposed to a percentage basis and I would have thought in a rising environment, that line might have seen some pressure. Is there anything notable that we should look at as it relates to that line?

Cynthia J. Devine

No, that’s a good question. Some of the things obviously because we are fully ramped up at the Guelph distribution and in the prior year period, we weren’t, so we expected to see some improvements there. We’ve also -- I think the Guelph distribution center in particular, and distribution across the company have taken on a lot of initiatives to try to improve efficiencies and we’ve done that to try to offset some of the increase in fuel costs and various cost increases that we are facing, so that was a contributing factor as well in the quarter.

The second part of it is that some of the rising commodity costs, we haven’t seen as much in the second quarter and so we may -- your point is a good one -- as you go out into the year, if you have rising commodity costs, as we’ve talked about before, the penny profit ends up making your percentage margin come down but hopefully the overall profitability is what we are more focused on. But we just haven’t seen as much of that in the first half of the year in our results.

Steven Kron - Goldman Sachs

Okay. Thank you very much.

Operator

Your next question comes from the line of Turan Quettawala. Please proceed.

Turan Quettawala - Scotia Capital

Good afternoon. I guess first off on the U.S. stores, in terms of -- you haven’t obviously given any guidance yet on ’09. Just wondering, is there any reason to believe that you would slow down the development, or maybe increase it?

Donald B. Schroeder

We set an annual target each year for Canada and for the U.S., and again it’s just a target. Our philosophy is that we will not open stores unless we believe long-term that it’s beneficial for the system. So whether it’s this year or next year, we will always act responsibly in terms of the growth of the system.

Cynthia J. Devine

And we are just in the process of heading into our annual budgeting program and so we will be looking at those targets and making sure that they make sense for the markets that we are in and be ready to communicate those early in ’09.

Turan Quettawala - Scotia Capital

Great, thanks, and I guess, if I may just ask one more in terms of the gains that you spoke about, Cynthia, on the U.S. business, is it possible to quantify those?

Cynthia J. Devine

The gains? Which gains, Turan?

Turan Quettawala - Scotia Capital

I guess you mentioned that there were some gains in the last few years in the U.S. business that were helping the profitability there.

Cynthia J. Devine

It was really just timing of gains that we recognized in the second quarter. I probably wouldn’t break those out separately within our segment operating income. It’s not something that we’ve previously done.

You know, for the overall company, not significant but when you are looking at such a small P&L for our U.S. business, we felt it was worthwhile to call it out.

Turan Quettawala - Scotia Capital

Sure, great. Thank you very much.

Operator

Your next question comes from the line of David Hartley with BMO Capital Markets.

David Hartley - BMO Capital Markets

Good afternoon. On the operating expense line, if I back out depreciation, I think we get growth somewhere in the order of 13%. And I’m just wondering if you could quantify what is propping that growth? I know it’s only a $32 million item then all of a sudden but could you break it down? And I have a follow-up question.

Cynthia J. Devine

Operating expenses excluding depreciation?

David Hartley - BMO Capital Markets

Yes.

Cynthia J. Devine

You know, again it’s probably ongoing increases to property costs as we’ve added new restaurants into the system. As well, we have variable rent contracts that also attract increased rent as our same-store sales go up, so those would probably be some of the key factors.

David Hartley - BMO Capital Markets

What about things like gasoline prices and support? Is there any of the support relief in there as well?

Cynthia J. Devine

No, operating expenses is primarily property related costs, depreciation, rent expense, those types of items. Gasoline costs associated with our distribution business would mainly go through cost of sales.

David Hartley - BMO Capital Markets

Okay, and is it possible there’s some lumpiness then in here that we won’t -- like, maybe a higher growth percentage, 13% this quarter but maybe it’s going to come off in subsequent quarters? Could you talk to that? And could you also talk just to the lumpiness of some of your costs going out for the rest of the year? I’m just trying to get a sense of whether or not you are going to be more consistent in terms of your operating earnings growth in the following two quarters relative to what you showed in Q1 and Q2.

Cynthia J. Devine

With respect to the operating expenses, we look at it all-in, and we felt we were pretty consistent with respect to our operating expenses when you compare that to our overall growth in rents and royalties. But you will always find in any business there’s lumpiness associated with expenses that you have to recognize in a certain period that you can’t smooth out, so I can’t make any promises that there won’t be lumpiness going forward, but in my mind I felt like we were pretty online with our growth in revenues and pretty consistent with our top line growth and our development, really, in new restaurants.

David Hartley - BMO Capital Markets

Thank you.

Operator

Your next question comes from the line of Jim Durran from National Bank Financial. Please proceed.

Jim Durran - National Bank Financial

Going back to the top line, it certainly looks like your volume growth, both in Canada and the United States, has slowed quite significantly when we pull out the price increase contribution to your comp store sales number. Is that mostly traffic or what might be going on there with the consumer that’s causing that to happen?

Donald B. Schroeder

Well, there is no question there is pressure on traffic, as I said before, with the high cost of gasoline and the limited number of discretionary dollars available to customers. They have choices to make, so it will continue to put pressure on traffic in all the restaurants. The good news is we continue to have a product offering that reinforces always the price value proposition that we are famous for and customers looking for value will continue to come to Tim Hortons.

Jim Durran - National Bank Financial

And you are not concerned that part of that is a result of the price increases you put in place?

Donald B. Schroeder

Well, there’s no question that price played a big part in our increases for the gains in the second quarter, and they will be there for the balance of this year. As Cynthia said, it’s over 3% in both Canada and the U.S.

Jim Durran - National Bank Financial

Just on systems, I know you were in the process of looking at a systems upgrade in the company. Can you tell us where you are at on that project?

Cynthia J. Devine

Sorry, can you repeat the question? We couldn’t hear you. There was a little static.

Scott Bonikowsky

Are you referring to the SAP implementation, Jim?

Jim Durran - National Bank Financial

Yes, thanks, Scott.

Cynthia J. Devine

Sorry?

Scott Bonikowsky

An update on SAP.

Cynthia J. Devine

On the system implementation? You know, as we talked about last year, we had the general ledger was put into place in the fourth quarter and now the remainder of the system will not be coming up live until probably mid-2009, so there’s really not a lot to update on it other than we are progressing through and feel we’re in a relatively good position.

The one thing of note is we did during the quarter, and it’s noted in the Q, that we did put in a fixed asset as part of the system implementation. We had a small implementation of a fixed asset repository that did come into play in the second quarter but the bulk of the system will be up and running in ’09.

Jim Durran - National Bank Financial

Great. Thank you.

Operator

Your next question comes from the line of Adina Bloom with TD Newcrest.

Adina Bloom - TD Newcrest

Good afternoon. I’m wondering if there’s any new menu items you can talk about for the back half of the year that you are particularly excited about.

Donald B. Schroeder

In terms of -- yeah, we’ve got a good program scheduled for the back half of the year, again emphasizing just the price value proposition, trying to provide good quality products to our customers that will also satisfy that issue that I referred to a few minutes ago in terms of the limited number of discretionary dollars in their pockets, so getting them good quality products at a good price.

Scott Bonikowsky

I think for competitive reasons, Adina, we probably wouldn’t go much beyond that.

Adina Bloom - TD Newcrest

Okay. And also, just to clarify, are there any additional price increases on the horizon?

Cynthia J. Devine

We don’t typically talk about price increases unless they are implemented in a particular market.

Adina Bloom - TD Newcrest

Okay. Thank you.

Operator

Your next question comes from the line of Rachael Rothman with Merrill Lynch. Please proceed.

Rachael Rothman - Merrill Lynch

Good afternoon. Could you talk a little bit about the new coffee roasting facility and how that will potentially impact your P&L, both -- maybe which line items we would see it in and is it more of a cost containment initiative or a revenue opportunity? And how will it net out through the financial statements? And then I guess if you could, some timing.

Cynthia J. Devine

Well, I’ll start with the end, which was the timing is in ’09, so it’s not going to be completed in ’08.

With respect to the P&L, you’d likely see the impact of that through warehouse and cost of sales, although a lot of it is going to be eliminated as previously, the coffee is already going through our warehouse business, so you will see it through those two line items primarily.

With respect to why we are doing it, it is really to provide overall system-wide benefits to maintain the quality, the integrity, and the profile and proprietary nature of the most significant product that goes through our stores, which is coffee. And so we felt that it was very critical to the ongoing success of the business to control the green blending operation as well as the roasting facility.

Rachael Rothman - Merrill Lynch

So should we be modeling in some incremental profit or revenue or is it mostly just going to offset each other?

Cynthia J. Devine

Well, as we talked about, we are making approximately a $30 million investment and we would expect a reasonable return on that investment over time, so that’s really -- in terms of any specificity around the profitability, that’s all we’d be talking about. But it really was more designed as system-wide benefits.

Donald B. Schroeder

One of the big benefits there is the facility will include a coffee blending facility, which means that we will be able to blend all the green coffee at our facility and then deliver that pre-blended coffee to our third-party roasters, so again with an idea of really controlling the proprietary nature of the blend and raising the bar in terms of consistency and quality the coffee that will be available to our customers.

Rachael Rothman - Merrill Lynch

Great. Thank you so much.

Operator

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

Winston Lee - Credit Suisse

Thank you. I want to get a feel for the slow roast beef sandwich, if it was a significant contributor to his quarter for Canada and for the U.S. as well.

Donald B. Schroeder

The roast beef sandwich during that promotional period did drive activity in sales at the stores. Again, as I said earlier, there was some significant learning from the promotion itself and we expect to bring it back to the market in the months ahead. There were some good learnings. It’s a new product. It’s an expansion of our lunch menu and going into the hot sandwich offering, so again we got some good learnings from our store owners and we will use that learning to further enhance the program when it’s brought back again later.

Winston Lee - Credit Suisse

Sorry, does that mean that it was a significant contributor to the comp or that it wasn’t?

Cynthia J. Devine

We typically don’t break out individual products and what they do to comps because it’s always a combination of various things but we believe it was part of the success of our second quarter results.

Donald B. Schroeder

Yeah, for sure. During the promotion, we are very satisfied that it accomplished what we had hoped to do during that period, and driving new trial at lunchtime.

Winston Lee - Credit Suisse

And in terms of the learnings, perhaps are you able to share with us what you’ve learned and what will change coming forward when you relaunch it?

Donald B. Schroeder

Not really but again, in terms of the operational efficiencies that we expect to gain going forward in terms of packaging of the product and so on, all with a view to improving the overall bottom line effect for our store owners.

Winston Lee - Credit Suisse

And just one last question on specialty coffee -- is that something that’s being considered in the next year?

Donald B. Schroeder

We’ve been testing the specialty coffee for some time and I think you can expect to see it in another market before the end of the year.

Winston Lee - Credit Suisse

Great. Thank you.

Operator

Your next question comes from the line of John Ivankoe from J.P. Morgan. Please proceed.

John Ivankoe - J.P. Morgan

The question might be for you, Cynthia -- on the COGS line, looking at it either as a percentage of system-wide sales or in revenue, you showed the first leverage in the second quarter in ’08 for some time and I know there are some issues with lapping the [inaudible] three channel distribution but I didn’t think we’d get benefit of that until the third quarter. So I guess what I want to understand is why you think COGS slipped into leverage in the second quarter and whether that’s a trend that we should now expect to continue for some time, or at least the next four quarters?

Cynthia J. Devine

Well, from the Guelph distribution center, we actually expect to continue to get leverage, you know, as you are lapping a period when it wasn’t fully operational the year before. So it actually -- when you get to the third quarter is when it should be a steady state that you are no longer talking about it as a year-over-year difference. But your comment is correct in terms of this is probably the first time that we’ve shown some leverage on it and it goes back to maybe the comments that I spoke to about with respect to Steve Kron’s question, which was really along the lines of our distribution division has really been working on a number of efficiency initiatives to try to drive some of the costs out of the system as well, and specifically in Guelph to try to really get some of those efficiencies from the facility that we hope to get and really help offset some pretty significant rises that we’ve had in gasoline costs that we have not passed on to our store owners.

So those types of initiatives have been underway and have helped us, but again as I also mentioned previously, you have to be careful with comparing cost of sales to sales and being able to predict that going forward because if you do have rises in commodity costs, such as coffee, your margins will be impacted by that because the penny profit will remain fairly consistent but your green, your underlying green coffee costs have gone up. So that’s why we stay away from predicting what we will see in terms of the overall margin from that part of our business.

But we are pleased with the performance that we’ve had from the facility now. We think that we will continue to look for opportunities to leverage some efficiencies.

John Ivankoe - J.P. Morgan

Thank you. That’s fine, Cynthia. I understand. I’ll follow-up with you later on that.

Scott Bonikowsky

Operator, I think we have time for a couple more calls.

Operator

The next question is a follow-up question from Irene Nattel. Please proceed.

Irene Nattel - RBC Capital Markets

Thanks. A couple, if I may; Cynthia, following up on that last question, presumably one of the objectives of the new distribution center was to be able to send more to each restaurant at each time and so limit the number of actual trips. And with gasoline prices rising, that should be helpful, should it not?

Cynthia J. Devine

Absolutely. I mean, that’s one of the benefits as well. This disruption at store level -- to have three trucks a week going to the store, unloading is much disruptive at store level than having two, so that’s part of it. But before the other two trucks were going from a third party operator versus coming from us.

Irene Nattel - RBC Capital Markets

Right but presumably, someone had to absorb the cost of that. But anyways, just one question if I may -- you know, it’s never easy to expand into new geographies against a backdrop of a slow consumer spending environment. I guess, Don, in your opening remarks, you mentioned Lansing, you talked about Syracuse -- could you just give us a little bit -- again, a little bit of color on what it’s like trying to establish yourself in these markets right now?

Donald B. Schroeder

Well, there is no question going into new markets in the present environment is very difficult, and that’s why I say when we set the objectives and the targets, we try to make sure that we do it responsibly. If it required that we change the timing of the openings and so on, then we would do that. But we are very happy with what’s happened in Lansing. We know that in order to get the proper impact and the level of convenience that produces good traffic in the stores, we need to open more stores. So that’s why we are going into Lansing. We’re on track for doing that.

Syracuse, opening up six restaurants is part of our plan. When we go into a new adjacent market like that, that there’s a certain minimum number of stores that we have to open. We’ve got all those sites located and as I indicated, they should be open by November. But it is challenging and we will work very closely with the operations team and the operators to make sure that they have the best opportunity for success.

Irene Nattel - RBC Capital Markets

And as you go into these new markets, are you offering any kinds of special promotions?

Donald B. Schroeder

The marketing group normally focus on what do we have to do around the openings in terms of what we need to do to get trail in the restaurants in the early stages, so there’s unique marketing opportunities and platforms for that.

Cynthia J. Devine

We are also adjusting in terms of our -- you know, how we go into markets too. We’re looking at trying to put some smaller stores in and adjusting to the economic climate, so that we are trying to get some cost out of it so that it’s a better store from a franchisee perspective to operate as you go into new markets during challenging times, and it’s more efficient from a capital standpoint.

So we’re doing things a little bit differently as well to reflect some of those challenges as they are going into new markets.

Irene Nattel - RBC Capital Markets

That’s great. Thank you.

Operator

Our last question comes from the line of David Hartley with BMO Capital Markets. Please proceed.

David Hartley - BMO Capital Markets

Thanks for the metrics on the TimCard. I was just wondering if you could give us a little bit more color there. We had quite a swing I guess from Q4 when really it all got launched into Q1, now into Q2. There’s I guess just a slight increase, or maybe a million dollars roughly increase in the number of dollars that you have restricted on your balance sheet. Do you have any programs planned to increase the visibility of the TimCard or rally it around more events or holidays, these kinds of things? And what should we expect in terms of the kind of growth that maybe you would expect in terms of that restricted cash balance on that balance sheet?

Cynthia J. Devine

Well, in terms of the restricted cash balance, I think it is behaving exactly as we would have anticipated. We knew that the holiday season, you are going to get the bulk of it and the fact that it leveled off and leveled off at around first at $18 million and now has risen up to $19 million, those are the people that are now -- those are the people that are reusing it. Now you have a bit of a steady state and so I think in many ways, David, it’s doing what we expect it to do, and as Don mentioned in his opening comments, we were very pleased with what we saw at the end of -- in the second quarter really around Father’s Day and Mother’s Day and end of school. It’s doing things that we expected it to do from a gift-giving idea and absolutely we feel with the TimCard property, we have still lots of opportunity to continue to look at programs that are going to focus on the TimCard and around holiday occasion and different gift-giving occasions. So we feel there’s a lot of opportunity with respect to the TimCard.

Donald B. Schroeder

Remember, David, as well that the point of sale integration is a key piece to deliver on the speed of service.

David Hartley - BMO Capital Markets

I would agree and are you going to be increasing the MasterCard point -- like, would that help MasterCard as well, that integration? Will you be integrating that as well into the registers?

Cynthia J. Devine

So that you don’t have to double key? Once the keypad is integrated into the register, it will accommodate --

David Hartley - BMO Capital Markets

It will work for both, okay. And just back to that, the penetration of use, is there some kind of metric we can get our head around in terms of the number of transactions you have in the store and the number of transactions one of these cards is being used for?

Cynthia J. Devine

No, there really isn’t anything in terms of those kind of metrics that we have to give you at this point. But again, we feel very good about it, about the success of it and feel there’s a lot of potential going forward. We had a gift certificate program before. Our hope is to be out of the gift certificate business. This is just a much more efficient way to drive transactions through gift giving and then have the ongoing customer that’s coming in every day to the store that’s using it to really get the speed of service benefit, and that’s our hope in the balance of the year.

David Hartley - BMO Capital Markets

Okay, and just last but not least, when you look at the transactions, is there any way that you internally can measure whether or not there’s been up-sales due to the waving around of this card? I mean, if someone was coming in for a coffee, are they adding that Timbit simply because they are suing that card? What are you seeing there?

Donald B. Schroeder

Again, our real focus with the TimCard was on speed of service, which is very important in terms of driving sales at the store, and we are very pleased with that in terms of where we are at with that. I would say is it increasing the average spend? Probably not. I don’t think there is anything to suggest that at this point but in terms of the convenience for our customer, the number of reloads and so on, at a time like this, it’s just showing -- yes, it goes a long way in terms of building loyalty to the store.

David Hartley - BMO Capital Markets

Okay, and the sales I guess of TimCard downloads, if you will, or TimCards with money on it for gift-giving purchases, I guess is there some kind of metric or some kind of indication you can give us on the time it takes to kind of unload that card, if you will, so there’s a delayed reaction in terms of what you can book for sales? Because I don’t believe you book the load-ups as sales, right? They get deferred into sales later on when they get unloaded. Is that correct?

Cynthia J. Devine

When they get spent, yes. That’s correct.

David Hartley - BMO Capital Markets

Thank you. So is there a way you -- is there a timeframe that you are seeing in average spending of that balance?

Cynthia J. Devine

It really varies and you have two types of things going on. You have the everyday user, the people that are automatically reloading their card on their credit cards, as soon as it gets to a low balance that are just using it every day as their every day way to pay for it. And then you have gift giving times where it’s a different occasion.

So it’s really hard to say specifically what is going on. Again, one of the goals that we have is registering the card, right? You need to get a lot of people to register so you can gather some of that data, and so that’s one of the initiatives we have underway as well.

I think what we can say is that we’re pleased with it and we think there is a lot of opportunity to continue to expand what we do with the TimCard.

David Hartley - BMO Capital Markets

Thank you.

Scott Bonikowsky

With that, we will close out the Q&A portion of the call. I do appreciate everybody joining us for our second quarter earnings conference call. If you have any additional questions or topics that you wish to address, please feel free to contact me. The number is 905-339-6186, or alternatively by e-mail at investor_relations@timhortons.com. Thanks very much.

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.

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Source: Tim Hortons Q2 2008 Earnings Call Transcript
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