— Charlie Munger
In the late summer of 2005, my wife and I enjoyed the best vacation of our lives. We flew to Toronto to visit our daughter and one of her good friends. They had performed extensive planning prior to the trip and they surprised us with a wonderful list of experiences which we will always remember fondly.
We attended the Peach Festival at Niagara-on-the-Lake as well as witnessing the Falls. During that time a tight-rope walker was navigating hundreds of yards of free space between two high rise hotels.
A few days later we spent a few days in a state-of-the-art cabin on scenic Lake Muskoka, courtesy of our daughter's boss. Her boss distinguished himself as an outstanding businessman by bringing a successful hot Yoga business to the Danforth district of Toronto as well as a number of other areas. By the way, if you ever visit Toronto, make sure you spend some time in the Danforth. It is a fascinating cultural experience which is thoroughly enjoyable.
As an aside, I took an hour-long hot yoga class and lived to tell about it, although I never strayed far away from the fan. My continual grunts and groans were probably distracting to the rest of the class. To the best of understanding the idea of hot yoga is akin to boiling spaghetti noodles; try and bend a dry noodle and its breaks but if you boil the noodle it is pliable. Veteran hot yoga students resemble "noodle people" in flexibility and most of them appeared to be extremely healthy and well-adjusted (Bill Gross is a perfect example). Although I hold no future as a "noodle man," I can certainly appreciate the benefits of yoga — but I think I will stick to my elliptical, thank you.
Tim Horton's (THI)
Before I break into the chorus of "Oh Canada," allow me to get to the point of the article, which is Tim Horton's (THI). Tim Horton's is an outstanding business, a company which I never appreciated until I journeyed to Canada. I was amazed as we drove about one Sunday; I witnessed dozens of vehicles waiting patiently at the Horton drive-through lanes. Every time I visited a store during my stay, business was always brisk; on weekends the in-store lines were excessively long. I sampled the coffee and bakery items and they were quite good, although I was unable to account for their extreme popularity.
When I got back to the house we were visiting, I looked up Tim Horton's and found that the company was 85% owned by Wendy's (WEN). Wendy's was in the process of spinning off THI. At that time, Nelson Peltz, an activist shareholder, felt that the embedded value of Horton's was not reflected in the price per share of Wendy's. I considered buying Wendy's stock at the time; however, after reviewing the financials I strongly underestimated the value of the spin-off. In other words, I severely underestimated the stand-alone market cap of Horton's following their IPO — so what else is new?
Six years later the current market capitalization of THI is approximately $8 billion; while the market capitalization of Wendy's, which has since merged with Arby's, is approximately $2 billion. As the old saying goes, Peltz spotted "a diamond in a billy goat's rear end." I spotted the diamond as well after witnessing the Tim Horton's phenomena first hand; however, I mistakenly assessed the value of the diamond to be that of cubic zirconium.
What Makes Tim Horton's a Great Business
Tim Horton's is a phenomenal business in Canada, although the U.S. operations have never achieved the same results. According to Wikipeda: "The chain accounted for 22.6% of all fast food industry revenues in Canada in 2005." Tim Hortons commands 76% of the Canadian market for baked goods (based on the number of customers served) and holds 62% of the Canadian coffee market (compared to Starbucks, in the number two position, at 7%).
Those numbers are staggering and they point to the extreme competitive advantage which THI holds in Canada. Horton's Canadian operations hold three characteristics which define all great businesses:
1) Near-universal appeal for their products
2) Steady residual business with reasonable pricing power
3) Consistency of product without regard to location
Similar to Panera's (PNRA) in the U.S., and Apple (AAPL) worldwide, their products appeal to all walks of Canadian society. Similar to Berkshire-owned See's Candy, their products generate ongoing residual business which is largely unaffected by reasonable price increases. Finally, similar to McDonald's (MCD), a patron can enter any Horton's store and receive exactly the same quality of product and service.
Great Businesses Are not Always Great Buys
As Warren Buffett has pointed out on numerous occasions, it is not sufficient to merely identify and buy into a great business — one needs to pay attention to price which one pays. Joel Greenblatt's Magic Formula contains the same message. Specifically, the earnings yield of a company is equally important to its return on invested capital. At some point, most great businesses become overvalued despite their enduring competitive advantage and steady rate of growth.
If one purchases a stock during a period of excessive optimism when the stock is trading a premium multiple, invariably the investor will suffer through a long period of underperformance despite the steady profits of the company. In other words, an investor needs to be careful not to pay a dollar and a half for a business which is worth a dollar despite the fact that the business is outstanding and holds a durable competitive advantage.
Tim Horton's Valuation
At first glance, THI appears to be reasonably priced for a premium business based upon a trailing EV/EBIT valuation. In 2010, the company made approximately $872 million in operating income; the enterprise value for THI is currently around $8.4 billion. That translates to about 9.6 times EV/EBIT. However, upon further examination that trailing figure is overstated due to a one time sale of Maidstone Bakeries which amounted to around $361 million in pretax profit. If we back out the one-time gain,THI is trading at a hefty multiple of nearly 16.5x EV/EBIT.
While the EV/EBIT earnings multiple for THI may appear reasonable when compared to Starbucks (SBUX) and roughly comparable to the multiple for Panera (PNRA), it appears to be too high to provide investors with a sufficient margin of safety. Horton's holds a great franchise; however, the time to buy the company was during the period of excessive pessimism during the financial crisis of 2008, not now as the stock is approaching an all-time high.
1) Tim Horton's is an outstanding business which holds an enduring moat in the Canadian fast food sector.
2) Businesses which hold durable competitive advantages and strong brands offer investors a potentially outstanding investment. However, an investor must always pay close attention to the price he pays for a stock.
3) The best time to buy outstanding businesses is during periods of excessive pessimism.
4) Great businesses are exemplified by certain characteristics including: universal appeal, consistent residual customer purchases, and consistency of product and service.
5) Buying great businesses at bloated prices frequently results in significant market under performance.