A U.S. hedge fund that's been pressuring Tim Hortons behind the scenes to change its business model went public with its demands Tuesday, including buying back more of its own shares, and hitting the brakes on expensive U.S. expansion plans.
In recent weeks, Scout Capital Management LLC, which has offices in New York and Palo Alto, Calif., has been buying up shares in the iconic Canadian coffee and doughnut chain, in an effort to get more of a say in the company and gain an audience with management to voice their ideas for how the company can improve its returns for shareholders.
Scout now owns $458 million worth of Tim Hortons shares, good enough to hold seven per cent of the company. The hedge fund has been lobbying Tim Hortons management to listen to its ideas, but after being repeatedly rebuffed, the fund went public on Tuesday with a letter addressed to the company's management, and filed with the SEC, that lays out what Scout has in mind.
"We invested in Tim Hortons, because we believe it is a wonderful business with an iconic brand and unparalleled customer loyalty in Canada — and because we believe the company’s returns to shareholders can be dramatically improved," the letter reads.
Broadly, Scout wants Tims to do two things: spend money to buy back the company's shares (that would improve the earnings per share of remaining stock, which tends to push the stock price higher) and rethink its current strategy of trying to expand more in the U.S. where it doesn't enjoy a competitive advantage.
'We are proposing a few simple and long overdue changes'—Scout Capital's letter to Tim Hortons
Scout calls the first part of their plan "optimize capital structure to fund enhanced and ongoing share buyback program" but essentially, what they want the company to do is to spend money to buy back as much as 23 per cent of the outstanding shares, which would make the remaining shares that much more profitable.
"With an appropriate capital structure and more judicious allocation of capital spending, we believe Tim Hortons can double free cash flow per share to $4.50 per share by 2015," Scout said.
Underperforming stock price
Based on how Tim Hortons peers are treated in the market, a cash flow like that "should result in a stock price of $90-$112," the fund claims. That's roughly 65-105 per cent higher than where Tims shares were trading before Scout went public.
Tim Hortons shares rose as much as 4.5 per cent to $56.99 in midday Toronto trading Tuesday before settling at $56.29 by the close of markets.
"To be clear: this strategy is not a one-time boost for short-term investors, but rather is the optimal long-term capital allocation policy that would significantly enhance shareholder value over the next decade," Scout's letter reads.
Although Tim Hortons enjoys almost unparalleled brand loyalty in Canada and has a steady streak of improving profits, that hasn't translated to huge gains in the stock price. Scout says Tim Hortons has underperformed its peer group by as much as 114 per cent over the past five years, in terms of the stock price.
"By all rights, the company’s brand positioning should have led to superior shareholder returns and performance over time," Scout said. "Unfortunately, this has not been the case."
The second plank of Scout's plan is to rethink the company's plans for the U.S. market. Tim Hortons has spent $600 million in the past decade trying to improve its foothold in the competitive U.S. market.
"We urge you to curtail the use of the company’s cash flow to fund real estate investment or new store capex in the U.S," Scout said. "We would like to see Tim Hortons grow in the U.S. and elsewhere, but only within the constraints of a capital allocation discipline that has been sorely lacking."
Rather than waste money on a U. S. expansion that's seen mixed results, Scout wants Tim Hortons to focus on its strengths in the Canadian marketplace.
Change management compensation
A final plank of Scout's plan calls for the company to formally adopt certain metrics that keep the focus on returns for shareholders, things like earnings-per-share, and stock price targets that would keep management accountable to shareholders.
Scout also alleges that the way Tim Hortons currently pays its management team is part of the problem.
"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 reads.
"We strongly urge the board to promptly bring Tim Hortons’ executive compensation framework more in line with the creation of long-term shareholder value."
Tims is the latest Canadian company to become a target of activist U.S. hedge funds seeking to maximize shareholder return. In recent years, fertilizer company Agrium, telecom companyTelus and most notably, railroad operator Canadian Pacific have had very public fights with activist U.S. hedge funds over the direction of those companies
"We believe Tim Hortons has an incredible opportunity ahead to substantially improve its prospects of maximizing long-term shareholder value," Scout says. "We are proposing a few simple and long overdue changes that are widely deployed at well-run companies and in many cases, have been working well for your direct peers."