valuebeacon

One Large Double-Double, a Dozen Timbits and a Case Study in Restaurant Valuation

In Investment ideas on July 29, 2010 at 4:03 pm

Not many restaurant chains can boast a location in war-torn Kandahar, Afghanistan. Tim Hortons can. The iconic coffee and donuts purveyor is so vital to the daily routine of a Canadian soldier that the army asked the company to open an outlet for troops stationed there.

Tim Hortons (TSX:THI) retails coffee, baked goods (donuts, pastries, muffins, bagels), sandwiches, soups and other products in cities across Canada and in parts of the U.S. The company has grown from just shy of 2000 stores at the start of this decade to 3578 at the end of 2009.

The company was started in 1964 by NHL hockey player Tim Horton. It wasn’t an immediate success. The company struggled in the beginning until Ron Joyce, the Ray Kroc of donuts, came along. The two became partners and with Joyce’s natural abilities, the business turned around. New locations were opened and Joyce then began franchising the concept. It grew by leaps and bounds stretching from coast to coast. The company was acquired in 1996 by Wendy’s International and then spun off in an initial public offering (IPO) in 2006.

Tim Hortons is held out as a shining example of a Canadian success story. The company boasts a market share of over 40% of all quick service restaurant (QSR) visits in Canada and more than 40% of its customers visit four or more times per week. Ownership of a franchise location in Canada is well known to be a cash cow like no other. And as any morning visit can evidence, the line-ups are always long.

The company has also been a very strong performer financially. Revenue has increased from $1.5b in 2005 to $2.2b in 2009. Earnings have grown from $191m to $296m over the same period. Returns on shareholder equity have been consistently around a whopping 25%. And dividends have increased three times since the IPO to $0.52 per share in 2010.

Despite this, however, the Company’s stock price has languished since its IPO day close price of $33.10 on March 24, 2006, more than four years ago. At time of writing, the shares currently trade around $35. And, due to buybacks, there are less shares now than there were in 2006. So, are the shares a good value? Is this a good time to buy? Let’s take a closer look.

The method that I like to use in valuing a business is the discounted cash flow method. As I have explained in earlier posts, I estimate the owner earning in the future and then discount them back to today’s value. Owner earnings are defined as cash flow from operations less capital expenditures.

The key to any valuation are the assumptions used. I use pretty conservative assumptions. I have assumed a discount rate of 12% – that’s the rate I would like to earn on this investment. I also made my own assumptions of new store openings. The most important assumption in the case of Tim Hortons is how many stores they will open and what annual increases one can expect in same store sales. It seems to me that the company’s home market in Canada is pretty much saturated. The big question on everyone’s mind is how successful the Company will be in its expansion into the United States.

All the evidence and rationale I have looked at tells me that the chain is unlikely to have much success there. Here are the reasons:

  • The U.S. market is a lot more competitive with not only the usual names such as McDonalds and Starbucks but also other competitors including Dunkin Donuts, Panera Bread, Peets Coffee, Einstein Bros. Bagels and many more. Consumers there have many more choices and don’t have a history with Tim Hortons.
  • In the seven years of data available on operating income in the U.S. market, operating profit has been breakeven at best.
  • Tim Hortons’ nostalgic Canadiana branding is no benefit and possibly a turnoff in the US market.

Based on that rationale, I have assumed new store growth for 2010-2020 of only 1000 stores in Canada only, starting with 200 stores in 2010 and dropping each year due to saturation. I also assumed modest increases in same store sales (SSS) falling to a rate in line with inflation.

Admittedly, my model is crude and doesn’t incorporate all of the inputs that could be used. I also give no weight to the introduction of Cold Stone Creamery ice-cream concept into the stores which is in test stages now.

Regardless, based on my conservative valuation (email me for the full spreadsheet), I calculate an intrinsic value of $14.66 per share. This is less than half of the current share price. It’s too bad, I would have liked to add this stock to my portfolio.

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