January 13, 2008

Is Tim Hortons Yummy?

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 Economics:

  • 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.

Competitive Advantage:

  • 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


MG said...

Good analysis.

When I look at THI as a possible investment there are more negatives than postives there.

1. The stock is wildly expensive.
2. Their customer service is going downhill and fast.
3. U.S. same store sales have failed to impress, and I don't fell confident that they can succeed there they way they will need to.
4. The stock might make a better income trust due to it's limited growth in Canada and stable cash flow.
5. The brand in Canada is top tier, probably the best brand in Canada. This does not cross borders though.

Sami said...

Hi MG,

exactly my thoughts. Everyone rushed to own it when it was spun off. Although I liked some elements of the business: the brand, customer loyalty and the free cash flow, I did not like the US expansion plans and the price. They will never make any major US foot print. They better hold their market share in Canada, increase dividends, look for some brand licensing opportunities in Canada and just forget about going head to head with US food companies.

Glad to have some one from Canada to have the same opinion as I am, Otherwise it is very lonely opinion among Canadian:)

4u2nv71 said...

I guess I will be the contrarian on this blog. Tim's is a Canadian icon, as much, or moreso than SBUX in the US, but for different reasons.

Before I go on with my anecdotal opinion, I need to divuldge I don't own any THI right now, but plan on getting into some soon.

More importantly, I lived in Western New York (Buffalo and Rochester) for the first 25 years of my life, and *before* there was a single Tim's in Buffalo.

Ok, why I think Tim's is a good buy:

1) Their customer base crosses economic and social boundaries, moreso than SBUX or MCD. You can see it in the lines every morning.

2) They have *alot* of room to grow into the US, even limiting to the cold weather (northern) states.

3) They are picking up steam in their lunch menu - which is diverse, fairly healthy (or healthier than MCD), and inexpesive. They have a lunch menu that is all of these: simple, diverse, alternative, broad appeal, healthy. Sound like a contradiction of terms? Look at their menu for lunch sandwiches and soups.

So why did SBUX used to be such a Wall Street darling, but has lost its lustre esp in the last year or two? Opportunity to move into new markets...

Tim's has alot of opportunity in the US, but yet still in Canada. As the Canadian economy and population grows, so do their suburbs and with every burb comes multiple Tims.

Now back to Buffalo. Mayby Buffalo is an exception and not the rule. Buffalonians regularly travelled to Canada for entertainment and business prior to Tims moving into the US, so there was already a name and product branding. This was, in other words, perhaps the easiest market for Tims to move into the US.

Move outside of the border cities, and business is slow. The store in Erie, PA I used to visit frequently was usually dead. I havem't been there in over two years, as my business doesn't take me to Erie anymore, so if anyone knows that store please speak up.

*If* they can build brand recognition in a community, they dominate. If they don't - we will see. I think time is a factor Tims can afford to build that recognition in US markets - I think saturating a market is a good plan for them, but the payoff won't come for years.

But once a Tims customer is hooked, they are hardcore hooked, more than SBUX or MCD.

My summary:

1) Fanatical loyalty from their customer base, once established.
2) Broad customer base.
3) Lots of room to grow into new markets (and snowball effect in the US possible).
4) Broadening product base that is inline with modern consumer demand (not health food, but healthier, yet cheaper than competition).

I am ready to put my money where my mouth is, but not a huge investment. If the dividend were increased, doubled, then this would be a no-brainer for a long term investment. As it stands, I think it is a no-brainer for small, long-term position.

The downside risk is minimal, the upside is significant. I believe THI will outperform the S&P500 over the next 2-3 years by several %, and while minimal, does have a yield.

THI on 1/24/08 at 34.95/share with a 7 cent quarterly dividend.

Sami said...

Thanks 4u2nv71 for the comment.

I do not disagree with you on the brand of Tim and its operations in canada; it is absolutely top notch. And I have said in my post that Tim's management is very diligent in supporting its brand.

However where it breaks down for me is the US expansion. They will have some stores in the US but not any thing that can replicate their success in Canada. Simply:
1. Competition is more fierce in US
2. TIM lack size to go head to head with Dunkin and Macdonald's and if they do it, it is very costly and have low probability of success.
3. new stores opening in Canada will cannibalize each other as i have talked to several store owners and the one complain is too many Tim locations opening around them and they see their revenue decrease as soon another one pops up.
4. valuation is way to high for TIM current free cash flow and assets.

Off course they can beat the odds and grow in the US but that does not offer assurance to the safety of my investment in the business. Investing in TIM shares at these levels have a risk reward ratio that is not favorable to me.

However I still line up every morning to get my timmy.

Btw: I do not think you can compare Starbux client's to Tim's and Macdonalds. The demographics are a bit different