By Euan Rocha and Solarina Ho
TORONTO (Reuters) - Scout Capital Management, a U.S. hedge fund, said on Tuesday it is urging Canadian coffee and doughnut chain Tim Hortons to increase its debt levels in order to fund a share buyback, measures that Scout say should help drive up Tim Horton's share price by as much as 100 percent from current levels.
The demands to Tim Hortons' board by New York-based Scout Capital are similar those put forward by rival U.S. hedge fund Highfields Capital earlier this year.
In a letter to the board on Tuesday, Scout, which has a 5.5 percent stake in the company, said the measures would allow Tims - as the company's patrons affectionately call it - to dramatically improve shareholder returns.
"I think certainly there is room for Tim Hortons to take on more leverage," said R.J. Hottovy, an analyst at Morningstar. "For a name like Tim Hortons, which does have a pretty robust revenue stream in terms of franchisee rents and royalties, I think that does make a lot of sense."
Scout Capital said it believed Tims could double its free cash flow to C$4.50 per share by 2015 and push its stock price into the C$90 to C$112 range. The shares closed up 3.2 percent to C$56.29 on the Toronto Stock Exchange.
Scout urged the company to increase its debt to a "moderate level" of three times earnings before interest, taxes, depreciation and amortization, saying this would allow the company to buy back roughly 23 percent of its outstanding shares.
The proposal is much more conservative than the one put forward by Highfields, which has a 4 percent stake in Tims. According to documents viewed by Reuters, Highfields suggested Tims raise its debt to roughly five times EBITDA and buy back some 37 percent of its shares.
Tim Hortons has indicated that it will likely raise its debt levels and buy back shares, but nowhere near the extent that Highfields is seeking.
"We are a very healthy company and we want to stay a very healthy company," interim head Paul House told Reuters after the company's annual shareholders meeting in Toronto last month.
The emergence of two large investors, which combined own close to 10 percent of Tims' shares, is however, likely to put more pressure on the company to act at least on some of the suggested changes.
Big decisions on acceptable debt levels, buybacks and the other proposals put forward by the two hedge funds are, however, going to likely come only after Nestle veteran Marc Caira takes over as Tims chief executive next week.
Scout, like Highfields, has urged Tims to curtail the use of its cash flow for real estate investments or new store openings in the United States.
"If new stores make sense and unit economics are good, well-capitalized franchisees will be happy to invest their own capital," said Scout, in a letter filed with regulators.
Scout, unlike Highfields, has not suggested that Tims spin out its real estate holdings into a real estate investment trust, an idea that Tims has panned since it only owns about 20 percent of its real estate footprint.
Scout also said it wants to see Tims' management compensation structure tied more to per share metrics like free cash flow per share or earnings per share, as it argues Tims' existing approach to executive compensation is responsible for the company's underperformance versus its peers.
Scout, which invests in businesses that are "misunderstood and incorrectly valued by the markets," disclosed its stake in Tim Hortons last week and said it was pushing the company to make changes.
Founded in 1999, the fund has been a mostly a passive investor to date, though last month it said it was also taking an activist role at DineEquity Inc , owner of Applebee's and IHOP restaurants.
"We believe Tim Hortons' Canadian franchisee system is among the strongest and most passionate in North America," Scout said in the letter to Tims' board. "With relative market share in Canada of nearly three times the nearest competitor, there are few businesses on the planet like Tim Hortons."
However, Scout said Tims' shareholder returns and performance have lagged those of its peers. The fund said it would like to present its case directly to Tims' board, but the company has not yet responded to its request.
"We welcome constructive dialogue with our shareholders and are committed to continuing our ongoing discussions with them," said a spokeswoman for Tims, who declined to provide any further detail on the matter.
(Reporting by Euan Rocha and Solarina Ho; Editing by Janet Guttsman, Lisa Von Ahn and Leslie Adler)