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U.S. hedge fund asks Tim Hortons to raise debt levels, buy back shares

TORONTO – Tim Hortons Inc. (TSX:THI) management is under another round of pressure to boost its stock price, this time from significant shareholder Scout Capital Management, which has published an open letter demanding changes.

Scout’s demands, contained in a letter to the company’s board of directors, calls on the operator of the iconic coffee and doughnut chain to revamp its U.S. expansion plans and to raise debt levels to buy back shares.

Tuesday’s letter came after unsuccessful attempts by Scout to meet directly with the board of directors to discuss its views, the New York-based hedge fund said.

Scout, which announced last week that it had increase its stake in the company to 5.5 per cent, praised Tims as a “wonderful business” with an iconic brand and unparalleled customer loyalty in Canada, but said its returns to shareholders could be dramatically improved.

The fund said it believed the company’s free cash flow could be doubled to $4.50 per share by 2015, which should result in the stock’s price rising to the range of $90 to $112.

Tim Hortons shares closed at $56.29 on the Toronto Stock Exchange on Tuesday, up $1.74 or just over three per cent.

Scout Capital is the second large shareholder to push for changes at Tim Hortons this year after another U.S. investment firm, Highfields Capital Management, pushed its own demands on Tims a couple of months ago.

“Tim Hortons is a very stable franchising business which enjoys predictable cash flow streams,” Scout Capital said in its letter.

“This is exactly the type of business that can and should operate comfortably with a higher degree of financial leverage than the company has chosen in the past, and than it seems to be hinting at for the future.”

Tim Hortons’ four largest publicly-traded, highly-franchised restaurant peers — Domino’s Pizza, Dunkin’ Brands, Burger King, and DineEquity — all have substantially higher leverage ratios, it said.

The fund also urged Tim Hortons to curtail the use of its cash flow to fund real estate investment or new store purchases in the U.S., saying chains should only expand within “the constraints of a capital allocation discipline that has been sorely lacking.”

The last suggestion was that Tim Hortons bring its executive compensation framework more in line with a plan for long-term shareholder value and align management incentives with value creation targets.

“We believe the existing approach to executive compensation has partly contributed to the company’s underperformance, and we were disappointed that the board chose not to change these poor practices with the hiring of a new CEO,” the letter said.

“The company’s consistent and long-standing underperformance should long ago have been a wake-up call to Tim Hortons’ board and management. We believe that there is a lot more the company could have done, and should be doing, to address its record of relative underperformance and realize its full potential.”

Tim Hortons, in a short statement of response to the letter, said “we welcome constructive dialogue with our shareholders and are committed to continuing our ongoing discussions with them and our ongoing focus on maximizing shareholder value.”

In April, Highfields Capital asked Tims back in April to borrow $3.4 billion to buy back more than a third of its stock, create a real estate trust for its real estate assets and spin off or sell its distribution business.

Tim Hortons owns about 20 per cent of its more than 3,400 restaurant locations and kiosks, though most are leased. It also owns its corporate headquarters and distribution centres.

The company has faced stiff competition from coffee chains like Starbucks and fast food restaurants like McDonald’s and reported weaker quarterly results last month. Marc Caira, a longtime senior executive at Nestle, will take over from interim CEO Paul House next week.