Saturday, 10 November 2012

Tim Hortons - Investment Analysis

Tim Horton's is one of Canada's most admired companies, and is frequented by fiercely loyal customers.  Indeed, 40% of the restaurant icon's customers visit the company at least 4 times per week.  All of these rushed early morning, lazy afternoon, and last-minute evening visits add up: the company has a 41% market share in the Canadian quick service restaurant industry, a striking figure, given the hyper-competitive competitive landscape.  In the coffee space, the proportion is radically high: Tim Hortons accounts for nearly 80% of the coffee sold in similar stores. 
As enthusiastic as that group of fanatics is, however, there's one cohort that Tim Hortons has made even happier: its shareholders.  With operating margins approaching 20%, return on invested capital even higher, and same stores sales over the past decade increasing at over 5% per annum, the company's financial metrics are as mouthwatering as its famous coffee.  There can hardly be a better example for Peter Lynch's "buy-what-you-know" investing mantra.

Scale provides the company with one of its most important competitive advantages: advertising.  The strength of the company's annual advertising blitz, however, applies much more to the Canadian market than it does south of the border.  After all, a national television spot in Canada is ultimately spread across over 3000 locations, with very little waste, since almost all Canadians live close to a Tim Hortons location.  This does not apply in the US.  Not only are there only 700 locations, they are heavily concentrated in just a few states.  That means the company will have to rely mostly on local and regional marketing, where it’s more difficult to take advantage of its hefty resources.
A persistent - and valid - concern among investors is the company's capacity to grow outside the Canadian market.  Management believes that it can expand to 4000 locations north of the 49th, but that will only allow for a few more years of significant unit growth.  To maintain double digit sales increases, Tim Hortons will have to successfully expand in the US and elsewhere.  This is far from assured.  McDonalds thrives around the globe; Gap Inc. flourishes largely only in North America.  There's no reliable formula to predict which concepts will "translate" in another market and which will fail.  Historically, many American brands have succeeded in Canada, but the reverse has rarely been true. 

Offering investors hope are two facts: the company has a larger footprint in the US - around 700 stores - than it did in Canada after the first 20 years of operating in each respective market.  What's more, US same stores sales growth has been an impressive 5.8% per year over the past decade, marginally ahead of its Canadian performance.  Success, though, has only come in certain markets - in the Northeast and Midwest, mostly in New York, Ohio and Michigan - and it’s not clear how deeply the US can be penetrated.  Moreover, sales per US store runs at about half the rate of a Canadian location.  However, by focusing on creating a "critical mass" in successful American markets, the company strives to capitalize on economies of scale in areas such as advertising. 

The company's business model at least mitigates some of the uncertainty of expansion outside of Canada, generating low-risk, high returns to shareholders.  The bulk of its revenues are generated from distribution (sales to store owners), and rent and royalties charged to franchisees, who operate 99% of the company's locations.  Though over the long-term the corporate office can only thrive if operators flourish, a notable amount of risk is borne by the store owners.

Given the company's high market share, long history of above average same store sale growth, there may be a risk that "comps" will be less appetizing in the future.  However, a company posting "average" same store sales growth is one that growing exactly in line with nominal GDP (real GDP plus inflation).  By that measure, Tim Hortons' growth has only been modestly above average over the past decade.  And, given that the average cheque is just $3.00-3.75, there remains ample room to pull on that "lever" to increase sales.  In addition, the company is in the process of increasing the capacity of its drive-thrus at many locations; for many on-the-go consumers, a few extra seconds can make the difference between grabbing something on the way to work or not.

Management is especially important in hyper-competitive industries such as retailing and food service, and there are legitimate questions about the future CEO.  Currently, Paul House is serving as the interim Chief Executive, and until a permanent replacement is tapped, shareholders will be left wondering what comes next.  Despite what appears to be a deep bench of talent, the Board has decided to hire from the outside.  It is generally agreed that the food service industry is not overflowing with top-tier talent, though the quality and power of the Tim Hortons franchise may mean that the company is able to recruit one of the best.
In the all-important area of capital allocation, management has done a decent job.  From 2009 to Q2 2012, the company generated around $1.6 billion in operating cash flows.  Nearly $600 million was reinvested in the business, which, considering Tim Hortons' high return on invested capital, was money well spent.  Close to $350 million was returned to shareholders via dividend.  The dividend has increased at a clip of around 25% per year for the past 5 years, and currently yields just shy of 2%.  (The company has a long-term goal of distributing 30-35% of prior year normalized net income as a dividend).  Over $1 billion was spent repurchasing shares.  In general, it's debatable whether the company has created value with its buyback program in recent years.  The price paid, after all, has tended to be around 20 times earnings (at the time of purchase), which is not exactly bargain-bin shopping.

At today's price, the stock probably offers little margin of safety.  At around 17.5x 2012 earnings (EPS is expected to be around $2.70), shares are discounting fairly high growth for a number of years into the future.  If the company's growth were to slow significantly - which could happen, given that the US expansion has been spotty, having modest success in a few states, and none at all in others - there is a risk of a "one-two" punch: a combination of P/E multiple compression, plus only modest EPS growth.  While Tim Hortons remains a superb franchise, investors may be wise to hold out for a more attractive share price.   

There's ongoing commentary on Tim Hortons: a 2012 Third Quarter Update

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