Tim Hortons’ (THI) CEO Marc Caira on Q2 2014 Results – Earnings Call Transcript

With all of these initiatives now in place, we have begun to see an increase in our combo penetration rates, particularly at breakfast.

Other innovations in the second quarter included Frozen Green Tea, made with real green tea; our new Greek Yogurt Parfaits; and our smoothies, now being made with standard Greek yogurt. These items also deliver enhanced product benefits that our guests are looking for.

We also introduced the OREO Iced Capp Supreme Pineapple Mango Smoothies, Ultimate Cinnamon Buns, and a line of strawberry baked goods.

Menu innovation was a key element of our strong sales results in the quarter, and they will continue to be a major focus for us. We know we still have significant opportunities ahead of us. For example in the U.S., we continue to grow the breakfast daypart, which is great. It’s what we are known for in that market. And now we are focusing on extending that momentum into other dayparts, such as lunch. This is a key priority for our U.S. team as identified in our strategic plan, where one of the key strategic priorities is to grow our AUVs by extending our success beyond breakfast.

There are a number of other important developments that I would like to highlight. We’ve recently begun our first large-scale pilot of Dark Roast coffee in our restaurants across the province of Québec. Innovation is an important part of our overall coffee leadership strategy. We believe a new blend, like Dark Roast, is a good start in expanding our appeal to the full spectrum of coffee drinkers.

Also, on the topic of coffee leadership, as previously announced, we have begun selling our Single Serve coffee platforms through the retail grocery channel. Our products will soon be available at most of the major grocery sellers in Canada. With the grocery segment representing approximately 40% of the Single Serve market, it is important for us to be in that channel.

On the technology side, our key accomplishment in the second quarter was the launch of new mobile payment capabilities. We now have barcode scanners in our restaurants across North America allowing our guests to pay by scanning their smartphones. We are one of the first in our industry to support payment on all 4 of the major mobile platforms: Android, iOS, Windows and BlackBerry. Our mobile payment platform is designed to improve speed of service and enhance guest experience.

Subsequent to the quarter together with our partners CIBC and Visa, we launched the Double Double co-branded Visa card Canada-wide. It is very early days but the launch generated a lot of media attention, and we are seeing significant consumer interests in this innovation in the card loyalty space. As a reminder, the Double Double is a 2-in-1 payment card. Every purchase on the Visa earns 1% Tim Cash that can be redeemed using the same card in our restaurants. The card features first of its kind technology in Canada. This is another example of how we plan to embrace new technologies in a way that will resonate and build loyalty with our guests, while at the same time, allowing us to better leverage and aggregate consumer insights. These insights will help us as we implement other aspects of our strategic plan.

This morning, we announced that we have recently signed another development agreement in the U.S. The latest one is for 25 locations around the New York City and New Jersey DMAs. That takes up the 6 development agreements totaling approximately 135 locations, all of which are helping us to expand our footprint in a capital-efficient manner.

The last update I will provide is on our international plan. We said in February that we would continue to work on our international strategy throughout 2014. We have completed the first phase of that work, and identified a short list of markets we believe are most suitable for Tim Hortons. In the next phase, we are determining the appropriate size and scale of international growth and developing tailored strategies for market entries in 2015 and beyond.

Before I conclude, I will say a few words about a major franchisee convention we hosted last month in Toronto. The event was attended by our restaurant owners and key suppliers. The convention helped celebrate our 50th anniversary, so it was a very special occasion and it was also a great opportunity for our key stakeholders to spend time together, share ideas and achieve alignment on our strategic roadmap. I was very pleased with the owners’ response to the new ideas, new technologies and strategies we showcased for them. There was a lot of excitement and enthusiasm about the opportunities for us to grow our collective business. That is very important to me because we need our restaurant owners to be fully committed as we embark on the next phase of our growth. We understand that they must be engaged in the restaurants and be dedicated to deliver the ultimate in guest experience through flawless execution.

I will now ask Cynthia to provide more details on our financial performance in the second quarter. Cynthia?

Cynthia Jane Devine – Chief Financial Officer and Principal Accounting Officer

Thanks, Marc, and good afternoon, everyone. The key to our solid results in the second quarter was a strong sales performance at our restaurants. Systemwide sales grew by 6.5% on a constant currency basis. That breaks down to 5.8% in Canada and 12.3% in the U.S. Systemwide sales growth is driven by the impact of new restaurant development and by same-store sales growth. Canada same-store sales growth of 2.6% was driven by an increase in average check, resulting from favorable product mix and pricing. Average check benefited from increased sales in both the lunch and breakfast dayparts. This growth in Canada was partially offset by lower same-store transactions, although we continue to grow systemwide transactions through the addition of new restaurants.

Turning to the U.S. Our strong same-store sales growth rate of 5.9% was supported by gains in average check resulting from favorable product mix and pricing. Cold beverage sales were an important contributor. And in terms of dayparts, breakfast was the biggest contributor to the growth.

In this morning’s disclosure materials, we provided an update on our 2014 target for U.S. same-store sales growth. February, we communicated a target range of 2% to 4% for the year. Q2 year-to-date, we are at 3.9% with solid sales momentum heading into the second half of 2014. On that basis, we now believe that we will be at the high end or slightly above that range.

Moving to our overall results. Systemwide sales growth was the primary driver of the increase in the 2 largest component of our total revenues. The distribution sales were up by 9.2% in the quarter, while rents and royalties increased 7.5%. We show these and other revenue line items on Slide 15 of today’s presentation. You will see on that slide that franchise fee revenue grew at a faster rate due to an increase in renovations and new restaurant development, namely in our Canadian market. Those same activities caused franchise fee cost to increase at a similar rate. We show this on the next slide along with other expense items.

The 7.8% increase in cost of sales was driven once again by systemwide sales growth. Operating expenses increased by 9.6% as a result of higher depreciation and rent expense driven by the addition of new restaurants and then renovations to our existing restaurants. We expect these same factors to lead to further increases in operating expenses through the remainder of 2014. We had a 5.8% increase in G&A expense as we lapped the period when we still had unfilled vacancies in the organization following last year’s reorganization. Higher professional fees related to the execution of our strategic plan also contributed to the increase.

As we show on Slide 17, operating income increased by a solid 8.9% to $192.4 million. On the same slide, you will see that net income attributable to THI was flat compared to Q2 of last year. The reason we didn’t see growth in net income is partly tied to the recapitalization we completed over the past year. So to summarize, we issued $900 million of new debt, and we repurchased over $1 billion of our shares since August of 2013. So our interest expense has more than doubled as a result of this new debt. In Q2, with the first period in which of the interest on that entire amount of debt, was reflected for the full quarter.

Our effective tax rate increased from 26.1% in the second quarter of 2013 to 28.3% in Q2 of 2014. But for the most part, this is due to a favorable tax impact last year as a result of the change in our reserve balance. The recapitalization and, specifically, the new debt also caused an increase in our effective tax rate for the quarter. As we’ve explained in the past, our cross-border corporate structure constrains our ability to recognize the full-tax benefit that one might expect from additional interest costs related to our new debt.

Despite these increases in interest and income taxes, the recapitalization as expected was clearly accretive to our earnings per share. Our repurchase of over 18 million shares in the past year helped us achieved EPS growth of 13.6% to $0.92 a share in the second quarter. We have also provided an update to our target for full year EPS. We believe that our 2014 EPS will be at the high end or slightly above our previous targeted range of $3.17 to $3.27 per share.

At this point, I’d like to turn to our performance of our operating segments for the second quarter, which are summarized on Slide 19. Operating income in the Canadian segment increased by 8.1% to $188.9 million. Systemwide sales growth resulted in higher rents and royalties income, as well as the higher allocation of supply chain income. Increased franchise fee income also contributed to our Canadian operating income growth.

In the U.S. segment, we’ve been very encouraged by the overall strengthening and progression in our business. This is a result of some very focused initiatives our team has been working on, and it has led to solid improvements in operating income and cash flow contribution. Gross operating income was $9.3 million, an increase of $6.7 million over last year. That’s a good result for us and, in fact, the highest quarterly operating income we have reported for the U.S. segment. The biggest factor in the increase in operating income was systemwide sales growth, which resulted in higher rents and royalty income. Part of the rents and royalties story is that we’ve been able to significantly reduce the amount of release that we provide to some of our developing restaurants. Releases declined for a few reasons, but more significantly because of the strong sales performance. Release also declined due to specific operational improvement initiative, including certain restaurant closings during the overnight hours, which increased operating margins. And finally, we noted lower release due to the closure late in 2013 of a small group of underperforming restaurants in noncore markets.

Systemwide sales growth also led to a higher allocation of the supply chain income in the U.S. segment. And our U.S. operating income benefited from favorable lease termination settlements, as well as foreign currency translation. Additionally, we’ve been working to improve our business model and reduce the capital intensity in the U.S. I believe we are starting to see the positive results of that new approach.

I will conclude by saying that we are pleased with the progress we saw this quarter in a number of important areas of our business. The competitive environment remains intense, but we believe we have a solid strategic plan in place to address the challenges and position our company for long-term success.

So with that, I’d like to turn the call back over to Scott.

Scott Bonikowsky – Senior Vice President of Corporate, Public & Government Affairs

Great. Thanks, Cynthia. We’re now ready for the Q&A portion of the call. [Operator Instructions] And operator, with that, well, please proceed with the first question.

Question-and-Answer Session

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