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Hedge fund faces challenge in Tim Hortons shakeup bid

By Euan Rocha and Jessica Toonkel

TORONTO/NEW YORK (Reuters) - Highfields Capital, a U.S. hedge fund agitating for change at Tim Hortons Inc, may have a hard time convincing institutional investors that the chain that says it sells eight out of every 10 cups of coffee in Canada needs a wake-up call.

The Boston-based activist investor, with an about 4 percent stake in the company, wants Tim Hortons to boost shareholder returns by taking on new debt to buy back its stock.

It is also pushing Tim Hortons to scale back its U.S. expansion and focus more closely on its thriving Canadian business. The fund, which also outlined a second tier list of demands, wants Tims to spin off or sell its distribution business, create a real estate investment trust to house its property assets and bring in new directors with more financial experience.

On Wednesday, Highfields confirmed an earlier exclusive Reuters report about the proposals, and said it currently owns 6.1 million shares of Tim Hortons. The fund said the company is studying its proposals and it looks forward to continuing a dialogue with Tim Hortons.

But the proposals may not be so easy to sell to long-term investors, according to some money managers and investors.

"This business ain't broke and needs no fixin'," said Barry Schwartz, a portfolio manager at Baskin Financial, which owns roughly 130,000 shares in Tim Hortons, according to Thomson Reuters data.

"The company is shareholder-friendly and has rewarded long-term investors with rising dividends and share buybacks, plus the stock performance since the IPO has been terrific," he said.

The shares have more than doubled in value since an IPO in March 2006, when Wendy's Co spun off Tim Hortons.

The proposals from Highfields represent the latest attempt by a U.S. hedge fund to shake up a Canadian company.

Last year, Bill Ackman's Pershing Square won big change at Canadian Pacific Railway after a bitter public battle. Earlier this year, fertilizer company Agrium Inc fended off an attempt by its biggest shareholder, U.S. hedge fund Jana Partners LLC, to break up the company and defeated Jana's slate in a hard fought proxy battle.

SIMILAR DEMANDS

Highfields has made demands that are similar to those put forth by Jana in its fight at Agrium. The fund wanted Agrium to spin off or sell its retail arm and add people with more experience in retail to its board.

But David Baskin, the head of Baskin Financial, sees big differences between the situation facing Highfields and Ackman's successful proxy fight at CP Rail, which resulted in a sweep for his slate.

"Canadian Pacific had a tired board with weak management, chronic underperformance and restive shareholders," he said. "None of that applies to Tim Hortons, which I think is still widely liked by institutional holders."

Tim Hortons' stock has rose about 60 percent over the last five years, while the Toronto Stock Exchange's S&P/TSX composite index has fallen roughly 13 percent over the period.

That said, shares of some of Tim Hortons' U.S.-based rivals have outpaced the Canadian chain.

McDonald's Corp shares have climbed about 70 percent over the same period, while Starbucks Corp has nearly quadrupled in value.

"Tims' performance has been somewhere between good and very good, given economic conditions in a hyper-competitive sector. So I would guess it will be hard for these guys to get traction but maybe the stock will respond anyway," Baskin said.

The shares closed up 4 percent at $56.32 on the New York Stock Exchange on Wednesday, while Tims' Toronto-listed shares rose by a similar margin to C$56.77.

TOUGH LANDSCAPE

Despite its growth and strong performance, analysts concede that the Canadian coffee chain faces strong headwinds.

Analysts have questioned whether the brand - which arguably trails only hockey and the maple leaf as a symbol of Canada - can continue to grow at home.

Tim Hortons - with some 3,400 company-owned and franchised stores in Canada - has virtually saturated the market. At the same time, U.S. rivals such as McDonald's and Starbucks have also stepped up their presence north of the border, limiting Tim's organic growth potential.

"We don't view either player as an immediate threat to Tim Hortons' scale and strong brand perception," said R.J. Hottovy an analyst at Morningstar. "But we believe competition will become increasingly fierce in the decade to come, leading to more aggressive price wars."

Highfields may have some success in building a case for spinning off Tim Hortons' real estate assets into a new publicly traded REIT - a path that other players have taken. Canada's top food retailer, Loblaw Cos, said earlier on Wednesday that it plans to complete the initial public offering of its REIT in early July.

"Canada is a more conducive market than the U.S. right now, when it comes to REIT conversions," said Hottovy, noting that a company spinning off the assets can still maintain a controlling interest in a REIT in Canada.

Tim Hortons in the past has panned the REIT idea, as it owns only 20 percent of its retail real estate assets. The company declined to comment beyond saying it remains focused on creating shareholder value.

"(We) always welcome constructive dialogue with our shareholders. We don't comment on specific conversations," said Tim Hortons spokesman Scott Bonikowsky.

BUYBACK PLAN

Highfields also faces a tough task convincing long-term investors that a debt-funded share buyback is a sound plan.

John Goldsmith, deputy head of equities at Montrusco Bolton, a firm that owns nearly 260,000 Tim Hortons shares, questions whether the strategy makes sense over the long term, even though low interest rates have made it more attractive for activists to push companies to take on cheap debt to fund buybacks.

"This might temporarily add value per share mathematically, the question is does this create sustainable value add or simply a one-time pop?" he said.

RBC Capital Markets analyst Irene Nattel said layering on $3.4 billion in debt to fund a buyback might add to earnings. But it puts Tim's investment-grade rating at risk, potentially raising borrowing costs and moderating any earnings per share gains for the company.

Tim Hortons is being advised by Citigroup Inc and RBC Capital Markets - both banks declined to comment.

(Additional reporting by Solarina Ho and Allison Martell; Editing by Frank McGurty, Bernard Orr)

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