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
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.
Conclusion
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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