Today I look at Tim Hortons restaurant chain as a possible investment idea. Tim Hortons (THI) overview (from Google Finance):
Tim Hortons Inc. is quick-service restaurant chain in Canada. Tim Hortons restaurants operate in a variety of formats. A standard Tim Hortons restaurant is a freestanding building, ranging in size from 1,400 to 3,090 square feet with a drive-thru window. As of December 31, 2006, franchisees operated 96.9% of Tim Hortons systemwide restaurants. In addition, the Company has warehouse and distribution operations, which supply Tim Hortons Canadian restaurants with paper and dry goods, and for certain restaurants in Ontario, frozen baked goods and some refrigerated products. It also has non-standard restaurants designed to fit anywhere, consisting of kiosks in offices, hospitals, colleges, airports,
gas station convenience stores, and drive-thru only units on smaller pieces of
- Business Model: THI operates a franchise model earning close to 15% royalties on franchisees store sales, in addition it charges rents to franchisees as it develops and owns franchisees' stores. The company has about 97% of its stores franchised. However the percentage diverge from Canada to the US; the US has much lower franchise rate than Canada at 85% only compared to 99% in Canada. Also the US revenue per store and profitability is much lower than the average Canadian store.
- Product Offering: THI's sales is dominated of coffee to the tune of 40% of its sales. However in the last couple of years it started to expand its offering and menu. It has introduced several new products and expanded into the breakfast area. THI offers a quality healthy alternative to fast food and value offering to cash strapped consumer.
- Food inflation and higher milk cost for its backed goods and coffee present strong challenges to its revenue growth. THI is very sensitive to raising prices dramatically as its sales can get affected. The company's cost of sales have risen from 54.3% to 56.76% in its latest fiscal year and up to 58% in its latest quarter.
- THI has saturated Canada with its stores as the demand for its products is phenomenal. The exception of few growth opportunities in western Canada as number of outlets per-capita is behind that of Ontario and eastern Canada.
- Indeed the number of outlets in the US is very small compared with Canadian numbers. However the growth in US outlets is triple that of Canadian growth rates. US growth rate in new outlets is averaging 19% annually over the last 6 years, while the Canadian figure is 3.5%. But you got to realize that the US growth rate is coming from a smaller base and it will be hard to maintain going forward.
- Coffee wars in the states is in full swing with McDonald's competing against Starbucks and Dunkin Donuts so THI would be hard pressed to find its footing in such an environment against more established and big opponents. However, management approach to expansion is measured and disciplined as they go slowly and in adjacent states to areas where they have some clout and brand name recognition.
- The site location although sited by management as a core competency for the company due to the extensive analysis and research done however, the closed sites to new sites ratio is high. For the year to date ending July 2007 the ratio stood at 36%, and a similar % registered for 2006.
- Management ability to manage the company and support franchisees is phenomenal. Their quality checks is second to none. Store owners that I talked to complain about quality inspections and regular check ups from THI management as being tough and detailed. This is a very strong indication to the management commitment to support the THI's brand.
- THI's strongest competitive advantage is its brand name and strong, even religious, customer preference to its coffee and breakfast menu. The brand is iconic in magnitude and size. THI has one of the strongest brand names in Canada. Line ups for coffee are a notoriously long in the morning.
- THI has over 2,700 stores in Canada and a large concentration in Ontario, Quebec and eastern Canada gives the chain large economies of scales compared to its competitors. THI advertising and marketing per store is much smaller than McDonald's Canada and its other peers.THI competitive advantages helped the chain fend expansion plans of Dunkin Donuts in Quebec and played a major factor in establishing Tim's outlets all over Canada.
- However these advantages are local to Canada and do not extend beyond its borders. The brand is virtually non existent in the US except for northern and eastern states in the US. THI has a small presence in Buffalo and Michigan but beyond this it has anemic brand recognition and customer base.
- THI does not enjoy any economies of scale in the US. THI would sustain significant losses in any price war with its rivals over customers evident of its earlier attempt to expand in the northeast against a more established Dunkin Donuts, which lead to a disastrous write off for THI. Since then they reined their expansion plans. Due to its limited number of outlets in the US the cost of customer acquisition, marketing and advertising is extremely higher than their competition like McDonald's and Dunkin where they can amortize these cost among a significantly higher number of outlets. So in case of an advertising blitz to compete against each other THI will be the loser amongst the three as others can withstand expenditure without affecting their margins while THI would see huge losses. For comparison sake, Dunkin has more than 5,000 outlets in the US and McDonald's has more than 15,000 around the world and more than 8,000 in the US, while THI has only 345 stores in the US.
- In summary, a very competitive environment and lack of strong competitive advantage in the US makes THI's expansion plans in the US a very tough undertaking and have a low probability of success.
- My valuation puts the company's intrinsic value from $28-$34 per share. Currently it is trading at premium at the $37 level. To download my valuation analysis spreadsheet click here.
- The run up in price is due to investor appetite for consumer staples stock in a difficult environment. In addition most investors are buying the US growth story, which as I outlined earlier is not high probability scenario and it is the big hole in any investment thesis for THI business. Moreover, the higher input costs will constrain profitability and put margins under pressure going forward. For these factors I think the stock is overpriced to offer me any returns for the long run.
Sources: THI Financial Statements, Google Finance, Dunkin Donuts Fact Sheet, McDonald's Annual report