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CRUSHED

A photo illustration of a Second Cup takeout cup on the ground in Toronto.

A photo illustration of a Second Cup takeout cup on the ground in Toronto.

Fred Lum/The Globe and Mail

Second Cup was once king of upscale coffee in Canada, but giant rivals have reduced the company to a bit player in the market it pioneered. Now it's pinning its hopes on a café makeover to win back customers – and reverse the tide of declining sales, recurring losses and disgruntled franchisees. How a once-mighty chain found itself in the fight of its life.

As a 26-year veteran of Second Cup Ltd., Bob Riche had an insider's view of the coffee pioneer's triumphs and tribulations.

The former Second Cup executive became its single largest franchisee, profiting as the company blazed the trail in Canada with upscale cafes and fancy brews, eventually dominating its field with nearly 400 stores across the country at its peak.

But bigger rivals soon declared war. Food-service giants Starbucks Corp., Tim Hortons Inc. and McDonald's Corp. opened thousands of restaurants and snared away customers and sales from Second Cup.

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By the end of 2014, Mr. Riche and his wife Debbie, with 18 franchised cafes between them, mostly in Toronto, went into bankruptcy, owing creditors $2.8-million, according to court documents. At least five other Second Cup franchisees have also gone bankrupt or succumbed to other insolvency proceedings over the past few years, documents show, while dozens of others have abandoned their shops or were forced to leave, unable to keep afloat.

"I didn't have a location where there wasn't four or five Starbucks surrounding me," Mr. Riche said in an interview. "It was a never-ending battle."

A Starbucks location in downtown Toronto, with Second Cup seen across the street.

A Starbucks location in downtown Toronto, with Second Cup seen across the street.

Fred Lum/The Globe and Mail

Today, Second Cup is in the fight of its life, suffering losses, a dwindling stock price and a shrinking store count and market share. Under new leadership since early 2014, Second Cup is working to win back customers with a chic upmarket café redesign, fresh menu offerings, and a search for new franchisees who would be ready to invest potentially hundreds of thousands of dollars in its turnaround effort.

As Second Cup tries to catch up, it is grappling with losing some of its top franchisees amid messy legal battles involving some former and current operators who say they can't afford costly renovations and high rents.

At the same time, Second Cup faces an urgent deadline. A $5.99-million debt facility is due on Jan. 1 and "based on expected cash flows from operations, the company will not generate sufficient funds from operations to repay the debt," the company said in a filing last month.

As a result, Second Cup said it is seeking alternative debt financing, the issuing of equity, or "other strategic alternatives," which is often code for selling a company.

In a bid to revive the chain, Michael Bregman, owner of Second Cup in its heyday of the 1990s, returned as chairman at the end of 2013 after having left more than a decade earlier. His investment firm, Tailwind Capital Inc., bought a 5-per-cent stake in the chain while a board-of-directors shakeup led to a number of his allies, including Alton McEwen, a former chief executive officer of Second Cup, being appointed as board members.

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In early 2014, the chain named as CEO Alix Box, a former executive at Starbucks and, more recently, luxury fashion retailer Holt Renfrew & Co. After introducing a sleek new café prototype in downtown Toronto, she set out a three-year business plan to reinvigorate Second Cup. But she's already a year behind in reaching her goals, she said in an interview.

"It's taking a little bit longer than I'd like, for sure," she said. "But we're still focused on revitalization of the network. … We have ambitious goals. … When you go through change like this, I think we can agree, not everyone is going to embrace it, and some didn't want to embrace the changes, and many did."

Some former and current franchisees say the company expects them to pay too much for the new "café-of-the-future" prototype. Some have also complained that Second Cup negotiated overly high lease rates for them and didn't disclose enough information about the company's problems before they signed on. These and other issues are the subject of a number of the legal disputes.

Mr. Bregman insists Second Cup can solve its issues and has the means to execute a comeback. "The company has the capacity to see its way through this strategic plan," he said in an interview.

"This company was not in good shape. It is immensely better today than it was two years ago. But it's not where it needs to be. There's a lot more work to do."

The number of legal spats with franchisees and delinquent royalty fee payments has declined from two years ago, Mr. Bregman said. (Second Cup doesn't disclose those figures.) And its balance sheet is stronger than two years ago, with less debt, he said.

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Second Cup has been in retreat for years. Its café network fell to 310 stores at the end of last year, while system-wide sales dropped to $175-million in 2015 from $182.8-million in 2014 and $191-million in 2013. The company has posted persistent losses, including a loss of $441,000 in the second quarter as same-store sales slipped 1.3 per cent.

Second Cup's stock price has also taken a beating. It has fallen more than 30 per cent this year, closing at $2.37 on the Toronto Stock Exchange on Friday.

Lou Brzezinski, a partner at law firm Blaney McMurtry who handles insolvency cases, said Second Cup's latest financial statements underline its problems, even though its debt has been reduced from a couple of years ago.

"The bankruptcy of franchisees in the number that they occurred in the last several years would cause concern to any franchise network," Mr. Brzezinski said.

As a reflection of a festering dissatisfaction among some franchisees, a former operator recently set up a Facebook page called "Canadian Franchisee Nightmare Association." In posting Second Cup's second-quarter results, it warned, in capital letters "do not buy a Second Cup franchise!!"

Kathy Wilkes, who launched the Facebook page and is also locked in legal battles with Second Cup over her former Hamilton café and her $60,000 of debts, said in an interview that the company is failing to support franchisees. Her complaints caused Ian Roher, a lawyer for Second Cup, to post on the Facebook page a warning "against engaging in further defamatory or otherwise actionable conduct."

Against this tense backdrop, Ms. Box is determined to revive Second Cup. She said the company is seeking franchisee feedback more than ever while lowering their fees.

"We said right from the beginning that this turnaround is ambitious," Ms. Box said. "This wasn't just a few little tweaks. We're fundamentally turning around a ship that had lost its way."

McDonald's Canada CEO John Betts, right, at a Toronto location in 2014.

McDonald’s Canada CEO John Betts, right, at a Toronto location in 2014.

Kevin Van Paasen/The Globe and Mail

What went wrong

For years, Second Cup was the go-to premium coffee chain in Canada. But Starbucks, Tim Hortons and McDonald's had their own big plans in the 2000s. Starbucks blanketed the country with highly concentrated locations; Tim Hortons also expanded its store base along with a broader menu; and McDonald's began to focus increasingly on coffee, touting a premium brew.

"I knew that we could do amazing things with coffee here," John Betts, CEO of McDonald's Canada since 2008, said in a recent interview. He had overseen the strategy at the U.S. parent and was intent on bringing it to this country, along with heavy promotions and free coffee.

Starbucks, which launched its first café outside its U.S. home base in Vancouver in 1987, had a North American mantra in the late 1990s to hit 2,000 cafés by the year 2000 – "2,000 by 2000" – from 1,400, said Roly Morris, a former Starbucks executive. By the early 2000s, Starbucks signalled its rising focus on the Canadian market by naming its first president here rather than running the operations from south of the border, he said. "The infrastructure was put in place to pave the way for growth."

Today, with estimated annual sales of more than $1-billion in Canada, "Starbucks continues to experience strong growth," Rossann Williams, president of Starbucks Canada, said in an e-mail. While the Seattle-based company doesn't break out its Canadian results, same-store sales in its key international business, led by Canada, Britain and Australia, rose 2.6 per cent in its latest quarter, the U.S. parent reported.

Tim Hortons, for its part, saw sales at stores open a year or more rise 2.3 per cent in its second quarter.

Freshly brewed Tim Hortons coffee at an Oakville, Ont., location in 2013.

Freshly brewed Tim Hortons coffee at an Oakville, Ont., location in 2013.

Chris Young/The Canadian Press

Second Cup, meanwhile, has lagged. According to market researcher NPD Group, the chain's share of Canada's coffee-chain traffic has fallen to just 0.5 per cent with its 300 or so stores.

It's now far behind its three big rivals in Canada: Starbucks has 1,378 cafés, Tim Hortons runs 3,692 coffee shops and McDonald's has 1,439 restaurants (most of them with a McCafé counter).

Jean-Pierre Lacroix, president of retail consultancy Shakatani Lacroix, which counted Second Cup as a past client, said its franchise structure is part of its problem: The quality of operators is inconsistent. And with its declining performance, Second Cup struggles to attract top talent to run its cafés while Tim Hortons gets the pick of the candidates, he said. Starbucks, in contrast, has more control over its operations because most of its cafés are company-owned.

In 2004, Second Cup was converted to an income trust, whose business model concentrates on returning profits to unitholders rather than using the money to expand a business. As rivals rushed to add more cafés, Second Cup was a sleepy player, Mr. Lacroix said. Starbucks had the allure of being a foreign player and, years later, became an early developer of popular mobile payment options, Mr. Lacroix said.

The sheer size of Second Cup's powerful competitors and their many locations is tough to compete with. "Coffee, to a certain degree, is convenience-driven," he said. "You're not going to go an extra four blocks to go to a Second Cup if you're walking by four Starbucks."

The fast-food business is also driven by new menu offerings, and Second Cup fell behind on that front as well, said NPD Group executive director Robert Carter. It didn't sell as many high-margin, blended coffees as Starbucks or come up with as many new menu items, he said.

Now Second Cup has a hard time getting franchisees to invest in the new prototype, Mr. Carter said. The remodelling of the flagship in downtown Toronto cost about $1-million, although subsequent remakes are less than $500,000, Ms. Box said. "A lot of franchisees have just walked away," Mr. Lacroix said.

Kathy Wilkes, a former Second Cup franchisee, is an outspoken critic of the company. She stands in front of a KFC location where her Second Cup once stood in Hamilton, Ont.

Kathy Wilkes, a former Second Cup franchisee, is an outspoken critic of the company. She stands in front of a KFC location where her Second Cup once stood in Hamilton, Ont.

Peter Power for The Globe and Mail

Franchisee problems

The outspoken Ms. Wilkes had launched her café in the Hamilton suburb of Stoney Creek in early 2013 and left almost two years later, awash in more than $165,000 of red ink and unable to find a buyer, according to court documents.

Second Cup had terminated her franchise agreement and taken over her café after she racked up almost $92,000 in unpaid rent, royalties and other fees, the company said in a filing.

She sued the company for failing to disclose accurate information to her about the chain, failing to support her by negotiating rent breaks and failing to relocate her café at no cost to her, the documents say. Second Cup rejected her allegations and countersued, accusing Ms. Wilkes of spreading false or defamatory information, filings say. She tried to mobilize other franchisees to launch a class-action lawsuit against the company, but it never got off the ground.

Others, who didn't want their names used, said they couldn't afford the $300,000 to $500,000 to renovate (although Ms. Box said in some cases the amount is lower), and didn't renew their franchise agreements. "It felt more like starting over than reinvesting in a business," said one franchisee who left this year.

Jack Ahmed, a Second Cup franchisee in Montreal for 21 years who operated as many as 15 cafés, faced a different situation. In 2011, he and Second Cup agreed to relocate one of his cafés in the coming years but by 2014, under new leadership, the company expected him to pay between $800,000 and $1-million – up to double his budget – to renovate the new site, he said. He balked at paying the higher amount and the company sued him for breaching his franchise agreement.

Last year, when the leases of two others of his cafés came up for renewal, Second Cup refused to renew them because of the pending litigation, his court documents said. He still has one café but its lease runs out early next year and he doesn't expect Second Cup will renew it. "At this point in time, I do not believe in the future of Second Cup," he said in an interview.

Long-time franchisees Mr. Riche and his wife had a thriving business until the recession hit in 2008 and competition stiffened, he said. By 2014, "we had no money for the new café concept" remodelling, Mr. Riche said. Their franchise business went into bankruptcy and they took jobs at Second Cup's head office, although they have since left. "Second Cup is stuck between three monsters – McDonald's, Tim Hortons and Starbucks," he said.

CEO Ms. Box said that when she arrived at the company in 2014, "it was a very messy situation" with financially challenged franchisees. Among them were Mr. Riche and his wife who "had built up large debt which we inherited … There was really no way out for them."

Second Cup CEO Alix Box at a redesigned location in 2014.

Second Cup CEO Alix Box at a redesigned location in 2014.

Fred Lum/The Globe and Mail

Second Cup has taken steps to help franchisees. The company two years ago cut staff and costs at head office, taking the savings to reduce franchisees' royalty fees to 7.5 per cent of their revenue from 9 per cent previously, while lowering their marketing fees to 2 per cent from 3 per cent. Currently, less than 3 per cent of franchisees are behind in their royalty payments, Mr. Bregman said.

In the meantime, Second Cup is looking for franchisees to run its 29 corporate cafés, down from a peak of 47 last year. Its strategy is to return to an "asset light" model of converting corporate stores to franchises, thus shifting costs to franchisees. Second Cup's second-quarter loss wouldn't have been so large if it had had fewer corporate cafés, Ms. Box noted.

She said the company's latest franchisee survey shows optimism for the future and a feeling that "coffee central," as she renamed head office, "is on the right track."

"In this business, you've got to have enthused and engaged owners that embrace change," Ms. Box said. "If people don't want to do that, then it is best for them to leave because not everyone does embrace the change."

As for the cost of remodelling, Mr. Bregman said it isn't more expensive than past renovations or new store constructions. Ms. Box said the tab is less than $500,000, although she did not provide specific amounts. "We take a very customized approach to each renovation so it's not possible to provide you a range. They all vary."

So far, Second Cup has launched 14 cafés with the prototype redesign modelled on the one at King Street West and John Street in downtown Toronto. It enjoyed a 48-per-cent sales lift in its first year and is "cash flow profitable," she said.

The interior of a redesigned Second Cup location in downtown Toronto in 2014.

The interior of a redesigned Second Cup location in downtown Toronto in 2014.

Fred Lum/The Globe and Mail

Already, Ms. Box is making changes to the prototype that can reduce renovation costs. The once highly touted "slow bar" and high-tech Steampunk coffee brewing machine are no longer features in all the renovations, she said. But the chain is introducing new coffee blends (Batch49) and FroCho frozen hot chocolate flavours, such as salted caramel, as well as new breakfast offerings, such as a $4.25 egg white, pesto and Swiss cheese sandwich on naan bread, now in about half of its cafés. More than 20 per cent of its sales are tied to its rewards program, which it launched in April of 2015.

Despite the competitive forces against Second Cup, the company will tap the resilience that has kept it in business since 1975 as it seeks a turnaround. It is reducing the slide in its same-store sales. In the last quarter of 2015, it posted its first increase in that metric in 14 quarters and its first quarterly profit since 2012. It still has some prime sites, and some of them still attract crowds.

"This is hard work," Ms. Box said. "It's a great challenge. We're in this for the long game. We think we're doing all the right things. We would love it to happen faster. But we're not discouraged."

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