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Trouble in the kitchen at Tim Hortons Add to ...

All is well with Tim Hortons' coffee, but the chain faces a major problem with its crullers and Timbits.

Tim Hortons surprised analysts on Thursday by announcing its joint venture partner in its baking operations - Swiss food conglomerate Aryzta AG - invoked what's known as a shot-gun provision that allows one side to buy out the other.

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While these negotations are expected to be friendly, Tim Hortons must now decide between spending a large and unexpected amount of money to take full control of its kitchen, or seeing Aryzta take full control of a key operation at the fast food chain.

"We consider the uncertainties surrounding this announcement to be a negative development," said BMO Nesbitt Burns analyst Peter Sklar. "While Tim Hortons has supply rights for seven years in the event that it is required to sell its JV interest, pre-baked goods are a critical element of the company's strategy, and we believe that investors would not look favourably upon the loss of control."

Tim Hortons gave no guidance on the value of the baking joint venture, and the company does not break out revenues from baked goods, versus beverages and other products. But the company did say it plans to build its capital base by selling up to $250-million of bonds in coming months, the first debenture issue from the iconic chain.

"It would likely require a considerable premium for Tim Hortons to buy out its partner's interest, given that it was the partner who invoked the shot-gun provision," said BMO Nesbitt Burns' Mr. Sklar.

Operationally, Tim Hortons has never been doing better. Consider the headwinds facing this company in the past quarter:

- The chain's major competitor is giving away Tim Hortons' single best-selling product, for free.

- Tim Horton's central strategy is expansion in U.S. cities such as New York, a concept that has never, ever worked out well when attempted by Canadian retailing peers.

McDonald's handed out free coffee, across Canada, for two weeks of the past quarter. Customers still lined up for Tim Hortons - same-store sales at the chain were up 5.2 per cent in Canada. The loyalty exceeded expectations - the consensus forecast from analysts was a 3.5 per cent rise.

In the U.S. market, a graveyard for Canadian retailers over the past three decades, Tim Hortons saw same-store sales rise 3 per cent. Again, that was better than consensus expectations of a 2.3 per cent rise. UBS Securities analyst Vishal Shreedhar went through the numbers and said in a report on Friday: "U.S. same store sales growth remains strong and continues to outpace the industry."

Tim Hortons enjoys a following that consumer products companies can only dream of, as Mr. Shreedhar said -- the chain "has a dominant brand/market share, which provides insulation against competitive activity."

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