Second Cup: Going Back For A Second Cup

MTY Group should acquire the financially strapped Second Cup and re-establish the iconic coffee company’s brand identity

Not long ago, Second Cup Coffee Company (Second Cup) was considered the king of upscale coffee in Canada. The company has grown from its humble beginnings as a kiosk in 1975 to operating more than 300 Cafés across Canada at its peak. However, over the last 10 years, the premium coffee industry had undergone significant disruption from specialty Cafés and new international players, whose brands offered elite, specialized consumer experiences. This has gradually phased Second Cup out of the Canadian coffee market. This has significantly decreased the appeal of Second Cup’s premium coffee value proposition and has hindered their growth prospects. In fact, revenues have dropped 10 per cent over the last 10 years.

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The introduction of CEO Alix Box in February 2014, a former Starbucks executive, also did little to spur growth of its retail coffee business. With competitors such as Tim Hortons, Starbucks, and McDonald’s all occupying unique niches within the Canadian market, the once up-scale Second Cup has seen its efforts to entice customers fall short, reflected by a stock price that has dropped 70 per cent since Box’s arrival.

Limited Financial Capabilities

On January 1, 2017, the company’s existing credit facility of $6-million matured and Second Cup was forced to generate funds from other sources to comply with the required bank covenants and debt obligations. Serruya Private Equity emerged as the only lender to offer Second Cup $8-million in cash to keep the business afloat at an alarmingly high interest rate of 10 per cent. Six million dollars of these funds were used to pay down the outstanding credit facility, with the remaining going towards general corporate purposes. Consequently, the company’s inability to generate sufficient cash flows from operations, due to declining foot traffic in stores, has put the business at risk of insolvency. Second Cup’s reliance on financial maneuvering to stay afloat shows that Second Cup’s ability to grow sustainably is limited. However, these financial problems are symptoms of a deeper issue, one wherein disincentivized customers have resulted in the closing of 20 stores over the past year. Ultimately, Second Cup’s lack of financial flexibility limits its ability to undergo a company-wide rebranding effort.

Franchising Difficulties

Capitalizing on Second Cup’s Growth Potential

Second Cup’s position is not all bad news for investors; in fact, it presents a fantastic opportunity for Second Cup to put up a ‘for sale’ sign on its front yard. To do this, Second Cup can leverage its primary asset: the prime locations of its under-utilized stores. These assets will present a unique value proposition to vendors who are seeking high foot traffic locations. Although Second Cup’s current financial constraints prevent them from properly capitalizing upon or further investing in these stores, a larger firm with greater financial resources will be able to take advantage of these currently under-utilized stores.

In 2014, Second Cup initiated a store renovation project aimed at redeveloping its premium brand identity. During this time, the company made the decision to launch 14 Cafés that incorporated Second Cup’s new prototype redesign model, including a location in downtown Toronto’s entertainment district. These redesigned stores, dubbed “Cafés of the future,” feature an on-tap dairy bar, murals by local artists, a central baking case, and a more dynamic seating arrangement; all in an effort to provide its consumers with an artisanal experience. The effects of this project have been overwhelmingly positive, with the downtown Toronto location turning cash flow positive. As well, same-store-sales increased by 48 per cent during the project’s first year and the location became profitable. Though this trial run demonstrates a clear opportunity for growth and brand equity development, Second Cup’s current financial struggles pose a hurdle. Given Second Cup’s lack of access to financing, rolling out the required capital investment of $500,000 capital investment for each location to even more stores would prove difficult. With a source of capital infusion, Second Cup would be able to pursue this strategy of redefining itself within the marketplace and reclaim its position as a company that provides an exceptional coffee experience.

Furthermore, in the food retailing space, establishing partnerships is a key factor in boosting top-line growth, as it provides businesses with the ability to diversify revenue streams with minimal capital investment. In 1996, Second Cup was able to capitalize upon its premium quality and Canadian heritage in order to sign a contract with aviation giant Air Canada. Although this is a potential avenue for future growth, external companies may now be wary of partnering with Second Cup given its lack of marketability due to its diminished reputation. However, if Second Cup were to be acquired by an stable parent company, they would have the financial strength to rebrand and successfully reclaim strong partnerships in the future.

Second Cup Graphic 2 - Important Facts

Searching for the Ideal Partner

If Second Cup sells its business to a large Canadian quick service restaurant operator, the company could gain resources such as portfolio company synergies, easy access to capital, and management experience in the food and beverage industry. Given the necessity of these benefits as a result of Second Cup’s precarious financial position, MTY Food Group (MTY) should be approached as a potential acquirer.

MTY is a publicly traded franchisor of numerous quick service restaurants with 48 different brand names. The company has a history of acquiring troubled companies, and Second Cup fits the criteria given its current financial concerns.

MTY’s new $325-million credit facilities provide them with the flexibility to pursue additional acquisitions. Specifically, the company has been looking to acquire companies based in Canada, with CEO Stanley Ma hinting that the company was looking to grow its presence in the coffee retail space. Supporting Ma’s comments are the fact that MTY already owns Country Style, Café Van Houtte, and Café Dépôt. Therefore, Second Cup clearly fits the bill and its potential for a turnaround makes it an attractive target for MTY.

MTY Group can help Second Cup revitalize its value proposition of providing an upscale coffee experience by deploying the required capital to finance the renovation of several underperforming stores. The significant spike in sales, as a result of these changes within existing stores, is a testament to the brewing potential hidden within Second Cup. From a financial standpoint, each individual remake would require approximately $500,000 in capital, and given that much of the operations will remain the same, the associated operating costs will not materially change. In addition, given that MTY’s portfolio companies have several food retail locations across Canada, the company can look to establish partnerships between its existing companies that serve complementary products (i.e. Croissant Plus) to improve Second Cup’s same-store sales. This process is similar to the partnership Second Cup engaged in with Air Canada.

Second Cup Graphic 3

Serruya Private Equity’s relationship with Second Cup and MTY could be the darkhorse that revitalizes Second Cup’s business strategy. On top of the eight million dollar credit facility it has issued to Second Cup, the Serruya family also divested one of their portfolio companies through a sale to MTY in July 2016. Second Cup can leverage Serruya’s relationship with MTY in order to sell their business and provide their largest investor with an opportunity to seek financial gain from their investment.

Moving Forward

Second Cup’s struggle to win over customers in the Canadian retail coffee market has resulted in the closure of over 53 stores since Q3 2014 and a $25.7-million write down of Second Cup’s trademarks. The company has failed to keep up with the premium Café experience the Canadian market is currently demanding, and has faced financial difficulties. By changing the company’s ownership, Second Cup can ensure that they have the required resources to move forward. In particular, an acquisition by MTY would enable Second Cup to benefit from its acquirer’s vast experience in company turnarounds. With a precarious financial situation preventing the company from enacting compelling business strategy, Second Cup’s future is clear: if they do not act fast, they may find themselves serving their last cup.