Amidst the buzz of Popeye’s eye-popping 34% comp growth from the chicken sandwich, the dark side of Restaurant Brand’s earnings was a negative 4.6% comp at Tim Hortons stores in Canada. This is about as ugly as it gets and a very sad story at that, given Tim Horton’s unique place in Canadian culture. With 80% market share in coffee servings at one point, Tim Hortons was the dominant coffee company in Canada and is a part of the daily routine for many Canadians.
A primer on the fast food business
Fast-food franchising overall is a very attractive business: the company gets paid a steady stream of royalties (about 4.5% of sales by Tim Hortons) simply for the right to use the brand name. All capital, labour, and marketing expenditures are funded by the franchisees who benefit from the brand recognition. For a major brand like Tim Hortons, there is no shortage of capital and potential franchisees waiting to open new stores, so all the management of the company has to do is protect the brand name of the company and ensure that franchisees are doing a good job.
Given the high-margin and stable stream of fees with essentially no capital needs, fast-food franchising stocks employ significant amounts of debt to reduce their cost of capital where possible. Growth from new stores or comparable store sales allows more borrowing capacity to further enhance shareholder returns. Unfortunately, this happy state of affairs can lead to a misalignment of incentives between the franchisor and franchisee: franchisors have an incentive to pursue growth at all costs, since the costs are all borne by the franchisees. Ultimately, history has shown that these situations tend to end poorly, and good franchisors understand that the health of their franchisees is the key to long-term success.
The coffee industry in Canada
Although investors tend to lump all fast-food businesses together, the coffee industry is unique in that, unlike burgers or fried chicken, coffee is a daily purchase for drinkers. Coffee is something that is consumed to “get you going” and is also a relatively commoditized product: it’s not too difficult to make and although most people have their preferred brands, most aren’t willing to travel too far to buy a cup.
Given the above, there are two criteria for being a successful mass coffee chain and, under Restaurant Brands, Tim Horton’s management has failed on both, reflecting a lack of understanding about the key drivers of the business.
- Store density and unit economics are critical
Coffee shops serve two purposes: 1) being a place to get a quick/cheap/decent cup of coffee, and 2) a hangout place (can we grab coffee to chat to learn about your job experience?). For both reasons, the raw store count and density are extremely important. A coffee chain’s market share and sales are largely tied to the # of stores you have and how close you can be to the customer. Being ten steps closer to an office building can be the difference in being the go-to coffee shop or not. This is not correspondingly true for burgers, fried chicken, and Mexican food. As an example, the intersection where Baskin Wealth Management’s office is located has 4 Starbucks, 2 Tim Hortons, and 5 more smaller coffee chains all in less than 1 km.
A large part of what made Tim Hortons so dominant is its sheer scale and store density. Today, there are just over 4,000 Tim Hortons in Canada or just under 1 per 10,000 Canadians. In comparison, there is 1 Starbucks per 21,000 people in the US.
Tim Horton’s massive store count gives it widespread brand recognition and makes it the default coffee store for many people. It might not be the best coffee, but it is acceptable, and that’s good enough for many people if you’re on your way to work.
Since the coffee chain with the most stores should simply by default gain a large market share, stores should be designed as economically efficient as possible to maximize franchisee returns Increasing store density will inevitably result in cannibalization of nearby stores, so store opening costs should be as low as possible so that franchisees will still make healthy returns on lower unit volume sales. This might involve creatively designing new formats to meet the consumers in every possible place.
For Tim Hortons, this is especially important given the competitive landscape. Starbucks owns and operates the bulk of its stores, so doesn’t need to worry about cannibalizing itself. As long as new units exceed a basic return threshold, it can simply keep opening new stores. More importantly, owning the stores gives Starbucks the nimbleness to test and pull products quickly if the customer response is poor. McDonalds doesn’t live and breathe off the coffee transaction since franchisees also sell burgers, fries, ice cream, and so on. It can afford to (and occasionally does) give away free coffee in order to sell more Egg McMuffins or Big Macs.
Under Restaurant Brands, Tim Hortons instead aimed to gain share in under-penetrated categories such as dinner and lunch, espresso and nitro-based drinks, kids meals and, in doing so, had reportedly raised supply chain prices on franchisees. Tim Hortons also launched a new innovative based “super-urban” format which is exactly the opposite of what Tim Hortons should be doing to grow density. All of this does nothing to improve Tim Hortons’s competitive positioning, brand image or improve franchisee returns.
2) Convenience is more important than the product (as long as it’s good enough)
Tim Hortons will never be able to make a better green-tea latte than Starbucks, nor create a better burger than McDonalds, given the global R&D capabilities of both. As much as a company would like to be everything to everyone, there are finite resources and the focus for a company like Tim Hortons should be on convenience and technology rather than food innovation. Things like mobile or digital ordering, new store formats and a loyalty program should take precedence over new menu options since the goal should to get people in the door. As discussed above, food can be sold to compliment the coffee, but only if they do not increase operational complexity (long-lines) or hamper franchisee returns.
This should also reflect the marketing approach: a focus on convenience and branding (which creates longer-lasting consumer goodwill) as opposed to product-focused ads particularly for limited time offers which provides a limited return beyond the availability of that product. Canadians already know what Tim Hortons is: the key is to continually reinforce what people already love about Tim Hortons.
Tim Hortons management under Restaurant Brands, in an effort to grow Tim Hortons internationally, pursued the entirely wrong strategy. Tim Hortons mostly spent their time launching new products such as steak wraps, Beyond Meat burgers, French-toast sandwiches, egg-bites, and so on in an effort to create products that would resonate in other countries. According to management, Tim Hortons launched 60 limited time offers[i] in 2019. There seems to have been minimal market research conducted in terms of whether Canadians actually wanted these products (hence pulling the Beyond Meat burgers after about 6 months).
This is a clear example of the misalignment of incentives discussed above. It is essentially riskless for Restaurant Brands to pursue international growth for Tim Hortons since it 1) has minimal brand recognition outside of Canada and 2) has no skin in the game. If it fails, some master franchisee in Taiwan or Saudi Arabia loses their investment with no permanent damage to the brand in Canada. If it succeeds, it provides a new stream of royalties. The problem is that Tim Hortons actually changed the core Canadian business to make it more suitable for international markets:
It’s difficult to articulate what a disaster this has been: they increased store operational complexity and used up valuable marketing resources, both in-store and for the ad fund. Even worse, the products are not incremental: most people who go to Tim Hortons for breakfast or lunch are doing so largely because of the convenience factor and the coffee as opposed to the quality of the food. As such, a new sandwich would merely replace the sale of another lunch item, and it is surprising that same-store sales were essentially flat over the last year despite the 60 limited time offers.
Lastly, these came at the expense of critical technology and loyalty investments. Tim Hortons did not launch a loyalty program until 2019, 6 years after McDonalds launched McCafe Rewards, nor did it launch an app or mobile ordering until 2018. Things like a good mobile app and digital ordering kiosks are valuable investments in reducing lineups (convenience matters) and driving up sales (would you like a donut with that?) and should have been day-one priorities.
Where did it all go wrong?
Without passing any judgement on the 3G cost-cutting model, I believe a key contributor to the problem was that the management team was not Canadian. Prior to the recent management team changes, none of the top management at Tim Hortons were Canadians and most of them were former Burger King alumni.
For most companies this would not matter, but only people who have grown up and lived in Canada would truly appreciate the cultural heritage and impact that Tim Hortons has on Canada. A Canadian management team would never have cut local community sponsorships from the advertising pool or launched chicken nuggets on the menu. This isn’t only coming from me; it is obvious to consumers as well.
The other part is from a poor response to smart and aggressive competition. A decade ago, McDonald’s McCafe did not even exist in Canada, yet is today ranked the favourite coffee of Canada.
McDonald’s Canada has clearly designed their breakfast and coffee strategy to attack at the core of Tim Hortons: giving away free coffee (later $1 coffee) during Tim Horton’s Roll up the Rim promotion, creating a loyalty program that is attached to the coffee cup, and launching bagels during the Tim Hortons franchisee dispute. Given Tim Hortons’s feeble response, it is not surprising that Canada was the first place for McDonalds to open standalone McCafe stores, and the first place for Starbucks to open pick-up only stores.
Where does Tim Hortons go from here?
This brings us to the Q4 results where Restaurant Brands announced a -4.6% comp for Tim Hortons in Canada, attributing 3% of the drop to the loyalty program and 1% to soft lunch sales. The swipe-card loyalty program launched in March 2019 basically mimics McDonalds’ program of one free coffee for every seven purchase without any user data, and the -3% comp implies that the loyalty program drove no incremental traffic or product attachment. Tim Hortons has since stopped giving out the swipe card with new sign-ups needing to go through the mobile app.
This comes as Tim Hortons’s president Alex Macedo is replaced with Axel Schwan, who was the former Chief Marketing Officer of Burger King and, in response to the continued poor results, announced a new plan to “reignite growth in Canada by focusing on its fundamentals and founding values”. There are three aspects to the plan:
- Elevating the quality of core categories: Improve the quality of coffee and breakfast food.
- Innovate for growth in core categories: Introduce premium products in existing core products such as Dream Donuts, and a better Iced Coffee.
- Invest to modernize the brand: Invest in digital initiatives such as digital menu boards and the loyalty program.
The plan at face value is certainly an improvement and is what Tim Hortons should have been doing from the beginning. The problem is that no one (franchisees, investors, the media, consumers) trusts management’s ability to execute today:
That franchisees are even considering whether the loyalty program is a good idea should tell you about the level of trust between them and management, and the sudden transition away from the swipe card doesn’t help. A franchise business that loses the trust of franchisees is in for a tough slog as they will resist changes and be unwilling to invest in new equipment, upgrades, products, overall making it tougher for management to implement its strategy.
The reality is, that as much as a new management team and investors would like a quick fix, it will take time and a series of small positive steps to rebuild franchisee trust and brand value among consumers. The turnaround will be tough: competitors are smart with structurally different business models, so Tim Hortons will need to leverage every ounce of advantage that it has in its installed base and Canadian brand heritage
The flip side is that Tim Horton’s massive installed base and brand legacy gives it time to transition. Franchisees and consumers all want Tim Hortons to succeed, and recent hires of Canadians as the CMO, CFO, and Head of Sponsorships are all positives in the right direction for Tim Hortons to hopefully regain its place as Canada’s favourite coffee.
[i] Limited Time Offerings are temporary seasonal or promotional products such as Christmas Donuts