Today I am going to talk about a very interesting investment. The returns from Tim Hortons Inc. (THI) will not come over the next 3 years or less like most investments would. Instead I think this company will return 20% per year over the next 10 years or so. You may not think that's a lot but keep in mind that Buffett has "only" averaged 22% per year for more than 50 years so this is nothing to sneeze at. What's really interesting about this company is that it is a safe bet. There are no problems with this business at all at this time. In fact, we can only say good things. Let us start with the financial statements.
As always we start with the balance sheet. Here you may note that the current assets is not double current liabilities. That is a small problem but they have cash and net receivables that can more than cover their current liabilities. I don't always like to use inventory because we don't actually know how long it will take to convert it to cash but in this case we can assume it'll be fast because historically THI has done a good job with inventory. But even ignoring that they have enough to cover debts. Furthermore, the total assets are twice total liabilities. Some of you may be concerned that the debt is increasing over the last 2 years (especially the long term debt), but profits have gone up. Interestingly the debt has gone up 26% whereas profits have gone up 30% or so. So they have just been financing some profits with debt. I would give the balanche sheet a B+. I can't give it an A because of the current liabilities being too close to current assets, but it is somewhat justifiable in this case.
Now let us go to the income statement. Remember how I said I hate retail businesses? This is in a way retail. It retails food and drinks. However, the margins are not low. With the niche THI has discovered they get margins of 12%-13%. Not bad eh? In the last 3 years SBUX has gotten anywhere between 9%-16%. So while some of their margins were higher, THI was more consistent. Thus we can expect this level of profits in the long term. I am not saying SBUX was bad in terms of margins, just less predictable. This is probably due to the recession thus causing margins to dip for expensive SBUX as opposed to cheap THI. But it has come back and THI margins have not gotten lower so we should expect it in the long term to be 12%-13%. I like higher margins but for retail this is solid. In case you were wondering I look for 15% or higher profit margins typically. Also the nonrecurring charges are negligible for THI. So I would give the income statement an A-.
Now we look at the cash flow statement. Here you will notice that the free cash flow is lower than profits. Typically this is a problem. Not in this case. First of all you will notice that the free cash flow is not increasing in the last few years. Year ended 2009 FCF was $268 million, year ended 2010 FCF was $390 million, and year ended 2011 FCF was $206 million. This gives you an average FCF of $288 million. However, remember that THI is growing a lot and much of the capital expenditures is due to expansion. As a result, we cannot say it is bad that they're spending their money to expand, especially with the margins they are getting. Also in the last 4 reported quarters FCF was $371 million. So P/FCF is anywhere between 26.4 and 20.5. But with P/E at 20, which in this case may be more accurate than P/FCF, we have to consider that you are getting returns of 5%. Sounds bad doesn't it? Not if you pay attention to the next few paragraphs. In conclusion I rate the cash flow statement a B-.
So now we must do the qualitative analysis. As you must have noticed you are only expected to get returns of 5% if there is no growth. But I expect plenty of growth. The reason is that while THI is very prevalent in Canada they are also expanding to the US which is a market ten times bigger. And I would not believe they would be successful growing there, unless they had already been there and done that, which they have. Their growth in the US is outstanding. Furthmore, they are refusing to give franchises to anyone who does not already own a THI franchise. This helps because you have experienced people handling the business who have been successful before (otherwise they would not have the money for another franchise) so you can expect them to duplicate their success. This also makes sure they don't grow too fast, because when companies grow too fast they cannot get the right people to implement that growth (Good to Great, Jim Collins). People may worry about competition from Dunkin Donuts, but I've been to those stores. Sadly, they are not as good at this as THI. Their stores are typically dead (as in very few customers) whereas THI is almost always packed. So regarding growth strategy this is outstanding. As for competitors, they would have to build their own stores which would take a while, and as Peter Lynch points out in One Up on Wall Street these businesses can grow by 20% per year for 10 years. That would give you a compounded return of 20% annually for 10 years. This is typical and as for looking at the ceiling on this business just look at SBUX profits and sales. They are at $1.4 billion in profits for now and they have far more stores so it's not unlikely that THI gets to the same profits as they have one fourth of the number of stores as SBUX. Thus the growth strategy is solid and I give it an A+.
Now we come back to the old dilemma of where's the niche? Remember this is still a bad industry (retail). I gave you the niche for HPQ in that they make cost effective laptops. What is the niche market for THI? The answer is the low end coffee shop frequenters. Lots of people meet over coffee at SBUX, but it's expensive. As money is always tight the less wealthy among us, and even the wealthy who are thrifty would come to THI over SBUX. SBUX has their own niche of wealthy clients and a brand name they've built over many decades, but THI has separate niche allowing them to compete. I think this niche market is larger than the one captured by SBUX so THI can grow quite well.
In conclusion I expect this business to grow at around 20% per year for 10 years. You may say that after that time the P/E will fall so our returns won't be as high. I respectfully disagree. Look at SBUX P/E ratio. It's 30. Even if THI maintains it's 20 it would give you 20% returns, while the market typically averages 10% per year. So that is what you can expect from THI. As always if you disagree or would like to add something please do so in the comments below. Thank you.
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