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A Canadian Quick-Service Restaurant on the Fast Track

February 13, 2014 | About:
Patricio Kehoe

Patricio Kehoe

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Investment guru Joel Greenblatt (Trades, Portfolio) recently bought 5800 shares of Tim Hortons Inc. (THI) and Jim Simons (Trades, Portfolio) added 65% shares to his stock portfolio, due to the company’s strong financial results in 2013. Despite fierce competition in an industry with low switching costs, this quick-service restaurant has maintained its position as Canada’s largest chain, earning CAD 6.1 billion through 2013’s system sales. Its dominant brand, cohesive franchisee system and highly scalable business model has awarded the firm with a narrow economic moat, making it a solid contender for profitable long-term investments.

A Solid Business Model

Tim Hortons operates through an integral franchisee model, which reaches 99% of its 3,500 locations in Canada and 850 units in the Northeast and Midwest of the U.S. The company offers its customers a wide variety of premium-blend coffee, as well as other beverages and baked goods. However, the vertically integrated supply-chain business, which distributes beverage and food products to franchisees, is one of the firm’s most reliable revenue sources, in addition to royalty and rent payments. This multiple revenue stream has contributed to the company’s high returns on capital of 37.2%, and beneficial shareholder return strategy with 1.93% dividend yield and a 4.80 share buyback rate.

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Despite a high level of maturity in Canada’s quick-service market, Tim Hortons’ expansion into less penetrated regions of the country will continue to define the firm’s brand strength. In fact, the company is currently Canada’s leading QSR chain, with 30% of the CAD20 billion industry sales and 900 more restaurants than the runner-up Subway (2,600 units). In comparison, McDonald’s Corp. (MCD) and Starbucks Corp. (SBUX) merely own 1,400 and 1,200 restaurant units each. Furthermore, the firm’s expansion pace (150 new stores in Canada and 70 franchises in the U.S. in 2013) puts the potential locations at 4,800 in Canada and 1,600 in the U.S. for fiscal 2022. As for expansion overseas, Tim Hortons recently entered into a master license agreement with Apparel Group, via which it will be opening 120 locations in Dubai over the next five years.

Valuation and Competition

Although market rivals are looking to expand north into the Canadian quick-service restaurant market, I believe the firm will be able to maintain growth through price and product differentiation. Furthermore, Tim Hortons' position as one the most popular brands in Canada provides it with access to prime retail real estate, bargaining power over suppliers, and large advertising scale. The result has been positive so far, with a 19% operating margin that will gradually move towards the 24% mark for 2017, as operations develop larger scale in North America. The 16.5% EPS growth, along with $3.1 billion in revenue, growing at a 17.3% annual rate, place this firm well above the industry’s average.

The 33.9% returns on equity should also be enticing for investors, given the steadily growing trend of this metric over the past five years (2008 marked 26.9% growth). Furthermore, with the company’s stock currently trading at a price discount of 11% relative to the industry average of 23.60x, this might be the best time to initiate a long-term investment in Tim Hortons. Also, the positive EBITDA growth levels of 12.3% are bound to experience a boost in future years, due to improvements in the company’s restaurant productivity (via menu innovations and reimaged locations in Canada). Therefore, I feel bullish about this quick-service restaurant operator’s future profitability.

Disclosure: Patricio Kehoe holds no position in any stocks mentioned.

About the author:

Patricio Kehoe
A fundamental analyst at Lone Tree Analytics

Rating: 4.6/5 (5 votes)

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