May 8 (Bloomberg) -- Tim Hortons Inc. investors are betting Highfields Capital Management LP will spark an extended rally as the hedge fund demands higher payouts and an end to a struggling U.S. expansion at Canada’s largest coffee and doughnuts chain.
Shares of the Oakville, Ontario-based company have risen 4.7 percent to C$57.13 since Boston-based Highfields said May 1 it had increased its stake to 4 percent and met with the company to recommend using debt to fund “capital return” and halting a push into the U.S. The stock had been the third-worst performing among 16 global restaurant companies on a one-year basis through April, according to data compiled by Bloomberg.
“Even if they only get half of what they’re proposing done, the change that would drive in terms of how they think about the business and how they manage the business would be pretty material,” Kenric Tyghe, an analyst with Raymond James Securities said by phone from Toronto yesterday.
While Tim Hortons, founded by a National Hockey League player of the same name in 1964, says it sells eight out of 10 cups of coffee in Canada from 3,436 restaurants, the brand has been slow to catch on in the U.S. Operating profit last year was C$182,000 ($181,180) per store in Canada compared with C$20,000 per store in the U.S., Derek Dley, an analyst at Canaccord Genuity Corp. said in an e-mail yesterday.
Tim Hortons, which reported first-quarter revenue and net income below analysts’ estimates today, said on its earnings call that it was committed to the U.S. market, sees potential to add debt to its balance sheet and rejected the idea of transferring its real estate to a real estate income trust. The company also said it has more bias toward share buybacks than special dividends.
The company reported revenue rose 1.4 percent to C$731.5 million, compared with the average estimate of C$748.9 million. Net income fell 2.9 percent to C$86.2 million, or 56 cents a share, compared with estimates of 61 cents.
The dropped 2.6 percent to C$57.13 in Toronto today after the earnings report, which included the first drop in Canadian same store sales since the company went public in 2006, according to data compiled by Bloomberg. The stock has risen 79 percent in the five years through yesterday, compared with a 13 percent drop in the broad Standard & Poor’s/TSX Composite index.
Tim Hortons today appointed Marc Caira, 59, a former executive with Nestle SA as its new president and chief executive officer. Paul House had been acting CEO since May 2011.
“We are committed to the United States market and continue to believe it holds great potential for us,” House said on the earnings call. Growth patterns are no different than in the early days of development markets in Canada, he said.
By increasing leverage and cutting back or stopping investment in its U.S. business, Tim Hortons’ shares could approach or exceed C$100 within 12 to 18 months, Highfields said in a letter to Tim Hortons’ management. Earnings growth “would be achieved by reducing the equity base through capital return as opposed to investing capital into the U.S. at sub-par returns,” said the letter, which Highfields provided to Bloomberg.
Molly Morse, a Highfields spokeswoman, declined to comment further. Highfields, founded in 1998, manages $11 billion and does not make performance figures public, Morse said.
Cynthia Devine, chief financial officer at Tim Hortons, rejected Highfields’ suggestion that the company establish a REIT as the company leases some of its sites and some income would not qualify.
“There may be greater value creation potential in adding leverage,” given the historically low interest-rate environment, Devine said on the call. “This additional debt can be used for several purposes including potential share repurchases and other uses of capital.”
Tim Hortons should emulate rivals Dunkin’ Brands Group Inc. and Domino’s Pizza Inc. by taking advantage of record low borrowing rates to drive growth, said Highfields in the letter.
The company’s ratio of net debt to earnings before interest, taxes, depreciation and amortization, or EBITDA, is 0.56 times, below the average 1.1 times of its restaurant peers, according to data compiled by Bloomberg. Dunkin’ Brands and Domino’s have the highest ratios at 5.1 times and 4.7 times respectively.
“We do not see any structural reason why THI couldn’t increase its debt leverage and return the cash back to shareholders, if it chose to do so,” Michael Kelter, an analyst at Goldman Sachs, wrote in a research note to clients May 1, referring to Tim Hortons by its stock ticker symbol.
Kelter estimates if the company took on C$1 billion of debt and increased its leverage to three times EBITDA including restructuring or rent costs, it could fund a C$6.50 special dividend or buy back up to 12 percent of shares. If Tim Hortons increased its ratio of adjusted net debt to four times earnings with C$2 billion of debt it could fund a special dividend of $13 a share or buy back up to 23 percent of the stock, the note said.
Taking on that kind of debt would be a risk the company can ill afford amid headwinds in Canada as consumers carry record debt, said Stephen Groff, who helps run $6 billion as a portfolio manager at Cambridge Global Asset Management, a unit of CI Investments Inc. The ratio of Canadian household debt to disposable income rose to a record 165 percent in the first quarter from 164.7 percent in the previous period.
“What’s good for the company in the short term isn’t necessarily the best in the long term,” Groff, whose company owns Tim Hortons’ shares, said in an interview May 6. He said he favors sticking with management’s current strategy of trying to expand the business rather than taking on debt.
“Average sales per store appears destined for lower levels than that experienced in Canada, perhaps dictated by a more competitive environment in the U.S.,’ David Hartley, an analyst with Credit Suisse, said in a note April 24.
Hartley estimates closing the U.S. business would generate C$3.34 per share. He declined to be comment further.
‘‘Adding five times leverage to your balance sheet can be very risky,’’ said Dley. ‘‘While it may lead to short-term earnings accretion, investors that have been with Tim Hortons since the IPO essentially are likely not going to want to go that route.’’
The company will hold its annual shareholders’ meeting tomorrow.
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