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A Tim Hortons in Toronto. (Fred Lum/The Globe and Mail)
A Tim Hortons in Toronto. (Fred Lum/The Globe and Mail)

Can Tim Hortons fight off McDonald's attack? Add to ...

After closing for several weeks, a Tim Hortons restaurant in north Toronto reopened this month with a new look: A sleek flat-screen television is now mounted on a stone wall above a gas fireplace, while customers slide onto benches to sip their lattes at tables overlooking an enlarged kitchen area.

McDonald’s is also giving its Canadian restaurants a facelift – with flat-screen televisions, gas fireplaces, long communal tables and armchairs where patrons can linger over their McCafé brews.

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The makeovers seem similar, but there’s a big difference to the eateries’ rush to draw more customers and get them to spend more: Today, McDonald’s Canada has remodelled about 70 per cent of its 1,400-plus restaurants in Canada and will have three-quarters of them completed by the end of this year, says the domestic chain’s chief executive officer John Betts.

By contrast, Tim Hortons Inc. will have close to 10 per cent of its roughly 3,300 restaurants refurbished at the end of 2013, a spokesman says. At that rate, the job still won’t be done by the end of the decade.

A market share battle is brewing in the fast-food sector, with Tim Hortons confronting an unprecedented challenge to its decades-long reign as Canada’s coffee-and-doughnut icon.

In their glory days, Tim Hortons’ franchisees were guaranteed success and hearty profits. As Judge George Strathy of Ontario Superior Court said last year in tossing out an attempted class-action suit by franchisees: “Under the Tim Hortons system, the franchisees are given the licence to sell Tim Hortons trademarked coffee – a brand that is about as iconic as there is in Canada.”

But now its coffee business, as a foundation of Tim Hortons’ strength, is under attack.

As the Oakville, Ont-based chain faces a hesitant consumer and fiercer competition, it is grappling with some franchisees who are becoming restless about the cost of upgrading their stores, as well as an ever-expanding menu of low-margin food items, making them more reliant than ever on higher-margin coffee for their bottom line.

And the toughest challenge of all comes from global juggernaut McDonald’s Corp. of Oak Brook, Ill. The chain is gunning for Tim Hortons coffee business, touting an updated McCafé store ambiance, improved drinks and free week-long promotions. The efforts are forcing rivals to shave prices as well, bruising their profits, but the initiatives are showing signs of bolstering the burger purveyor’s position in the coffee sweepstakes: McDonald’s Canadian share of the roughly $3.3-billion out-of-home coffee market has more than doubled to 10.3 per cent in just four years, according to its data.

The coffee fight comes at a time of sluggish growth over all in the restaurant industry, with the number of restaurants having jumped by more than 12 per cent to 72,000-plus in the past five years, but customer traffic having perked up only by between 1 and 2 per cent, says market researcher NPD.

“Coffee wars are alive and well in Canada and it’s just going to continue,” said Robert Carter, executive director of food services at NPD.

McDonald’s is gaining market share, but so far Tim Hortons is holding its own, with the venerable Canadian chain continuing to command an industry-leading 77 per cent of the coffee segment, NPD figures show.

But that mounting pressure from rivals, and a soft economy, are forcing Tim Hortons to shake up the competitive formula that has churned out profits for decades. “We are working hard to adapt to current market conditions,” Paul House, chief executive officer at Tim Hortons, told analysts on Thursday.

Part of that adaptation is a reshuffling of its corporate ranks, with dozens of its 2,000 corporate staff departing. But according to company spokesman Scott Bonikowsky, “the number of people in new roles and people we are bringing into the organization bringing new capabilities exceeds those who left.” The chain is still looking for a permanent CEO after the previous one left unexpectedly 21 months ago and Mr. House temporarily stepped back into the role.

It is decentralizing and streamlining functions to prepare for international growth and broader menu offerings (although Tim Hortons has struggled to make its mark in the U.S., where it has about 620 stores). Boston Consulting Group is helping in the overhaul, sources said.

In the process, Tim Hortons may be on its way to transitioning from being a high-growth company to one that returns excess cash to shareholders. The company’s shares have softened about 14 per cent from a peak of nearly $58 last spring, reflecting worries about sluggish same-store sales growth and rising competition.

Tim Hortons‘ future could be one of slower growth, with a focus on returning cash to shareholders rather than one of expansion, Peter Sklar, retail analyst at BMO Nesbitt Burns, wrote in a research note this week. “This transition period will likely cause a substantial recycling of the stock, limiting the potential for meaningful stock price appreciation until this process has been completed.”

Tim Hortons has to contend not only with the uncertainty created by the corporate office shakeup and a prolonged search for a new CEO, but also with its franchisees’ concerns over pinched profits. “There is a lot of discontent in the system,” said Ron Joyce, co-founder of Tim Hortons who left the company 12 years ago but still has friends and relatives among the franchisees. “For the profitability of the store owners, it’s not nearly as profitable as it was when I was there.”

(The discontent has spilled over into the courts as Mr. Joyce’s cousin, Arch Jollymore and his wife Anne – he is a former senior Tim Hortons executive and both are long-time franchisees in Burlington, Ont. – wage a so-far unsuccessful fight through two levels of court to launch a $2-billion class-action lawsuit against Tim Hortons over its decision in in the early 2000s to introduce its “Always Fresh” flash-freezing baking, rather than baking from scratch. The Jollymores, who this month sought leave to appeal at the Supreme Court of Canada, argue that the company is unfairly ringing up profits at the expense of franchisees.)

Coffee-serving restaurants are racing to entice customers – and keep them lingering and spending – with lucrative specialty brews, free Wifi and discounting in an increasingly crowded field.

The reason for the jockeying for customers is evident: Coffee is the single top item that is being purchased in restaurants, NPD says. As a result, restaurateurs from McDonald’s to Subway and Starbucks Canada are beefing up their breakfast menus to lure more people to their cafés. About 60 per cent of customers who purchase coffee buy another menu item as well, McDonald’s research has found.

Fast-food players feel the pressure to steal business from rivals in the morning because restaurant traffic gains at that time of day are outpacing those at eateries over all, NDP data show: Fast-food morning traffic grew 3 per cent in the year to the end of November, while total traffic rose by just 2 per cent.

Tim Hortons, which has suffered traffic declines in the past four quarters at outlets open a year or more – a key retail barometer – is beefing up its lunchtime menu to counter McDonald’s attack on coffee and morning meals.

“What we did five years ago is put together a concerted effort to improve our focus on coffee,” said Mr. Betts at McDonald’s, holding up his medium-sized morning cup of 2 per cent latte. “In Canada, if you don’t play in this game, you’re not playing.”

McDonald’s has “rewritten the rules in the last number of years,” Mr. Carter of NPD added. “The menu innovation is just off the charts. They’re going hard after the morning meals.”

It’s pouring $1-billion into refurbishing its Canadian restaurants, adding its McCafé coffee menu to stores and updating their look. Tim Hortons is following suit, stepping up its renovation efforts this year by doubling the number of stores being remodelled to 300, chief financial officer Cynthia Devine said.

Tim Hortons also plans to open 160 to 180 new restaurants, boosting its capital spending to between $250-million and $300-million, up from less than $200-million in 2012.

But franchisees have to be prodded to make their own investment because their contracts only require renovations every 10 years. The company usually is responsible for building costs while franchisees take on equipment-related expenses. “That’s still going to take some time to work renovations through the entire system.,” Ms. Devine said. In the meantime, Tim Hortons is enhancing its drive-throughs, such as double lanes, to reduce lineups and prevent impatient customers from fleeing to rivals.

However necessary, the changes – particularly the expense for franchisees – are creating tension within the Tim Hortons chain. Said one franchisee, who asked not to be named: “There’s a lot of stress in the company.” One franchisee who left the company recently pointed to shrinking profit margins: “Stuff like this percolates when people are not making as much as they used to.”

Mr. House told analysts this week that the company does a lot for its store owners. “We do contribute,” he said. “We do it as a good partner ... We do a lot more than most franchisors do with their franchise communities. We will continue in that type of relationship.”

But the tensions with some franchisees underscore the divisions between Mr. Joyce and Mr. House, who succeeded the former as CEO until 2008, when he was replaced by another long-time Tim Hortons executive, Don Schroeder. But in May, 2011, Mr. Schroeder left suddenly, prompting an external search for a new CEO. Mr. House said on Thursday that the search for an external candidate by Tim Hortons’ board of directors is proceeding well, and a decision could be reached by early summer.

Tim Hortons is pleased with its performance in a tough environment and “the market share that we’ve been able to retain and how we are building our lunch business as a share of our business,” Mr. House said in November.

Last fall, Tim Hortons introduced Tassimo, the single-serve coffee that is taking the industry by storm, although some analysts feel Tim Hortons is late to the game. “Some people might say we’re a little late coming to the market,” Mr. House said on Thursday. “It was intentional. We wanted to come to the market with more than one platform,” which it plans to introduce this year.

To ease what some would consider an enviable problem – long lineups – Tim Hortons sees lots of opportunities to add more stores in Canada, resulting in some cannibalization of existing franchisees’ business, Mr. House said. It’s moving to more dual drive-throughs, which McDonald’s is also doing – finding that they increase service efficiency at its chain by about 40 per cent, a spokeswoman said.

But rivals aren’t standing still. Starbucks, with about 1,200 cafés in Canada, is set to open 150 in 2013, many of them within outlets of popular U.S. discounter Target Corp., which starts its highly-anticipated store rollout next month. Starbucks has got a boost from its new Blonde Roast, which is a milder brew that many compare to Tim Hortons’ coffee.

Cliff Burrows, president of the Americas at Seattle-based Starbucks, said in December that competition in Canada is comprised largely of Tim Hortons “pretty much in a head-to-head with McDonald’s. ... In some ways we have to make sure we double down on our strengths, focusing and winning through innovation.”

Starbucks Canada is betting heavily on its Blonde Roast, which already accounts for about 20 per cent of its brewed coffee sales, it said. The brew is important to the chain because 60 per cent of Canadians prefer a lighter roast coffee, its research found. Subway, for its part, has launched Starbucks-owned Seattle Best Coffee, along with breakfast fare.

Mr. House said all players are feeling the economic pinch, which contributed to Tim Hortons’ slowing same-store sales growth – up 2.8 per cent in Canada in 2012, below the 4 per cent lift a year earlier and also below the company’s target of a 3 to 5 per cent rise. “Subway – everybody – is trying to crowd into the coffee category, so the competition has intensified from many positions, and given that the economic conditions aren’t great, everybody is trying to find some share from somebody else,” he said last November.

For food services consultant Doug Fisher, Tim Hortons faces a threat not to its survival – “I don’t think this is the end of Tim Hortons” – but to its status as Canada’s unchallenged king of coffee. With its core business being squeezed by the likes of McDonald’s, Tim Hortons needs a new recipe if it wants to continue on a growth trajectory, says Mr. Fisher (who provided expert testimony to the franchisees suing Tim Hortons).

“They certainly need some refreshment within the organization.”

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