Fast-Food Fight in the Great White North

11/30/2011 10:09 am EST


John Heinzl

Reporter and Columnist,

America’s most iconic brand is establishing a beachhead by going after Canadian hearts and minds where they’re the weakest: junior hockey, writes John Heinzl, reporter and columnist for Globe Investor.

To mark the start of their outdoor hockey season, both of my kids proudly wore their house league jerseys to school the other day.

That by itself wasn’t remarkable. What was remarkable, at least to their financial reporter dad, were the names of their sponsors. My six-year-old daughter’s team is sponsored by Tim Hortons (THI), a longtime minor hockey supporter, but my nine-year-old son’s shirt bears a logo I hadn’t seen at our local rink before: Tims’ arch-rival McDonald’s (MCD).

McDonald’s? Yup. To make the most of this branding opportunity in Tims’ own backyard, the fast-food giant also supplied McDonald’s water bottles and winter hats to all the kids, and plied the parents with coupons for free McDonald’s coffee and Egg McMuffins—part of an ambitious foray into minor hockey sponsorship that covers 1,200 teams across Canada.

That McDonald’s is skating into minor hockey in such a big way is more than a symbolic move. It underscores how determined the US chain—which is rolling out McCafés to virtually all of its 1,400 Canadian stores—is to grab market share from Canada’s coffee and doughnut leader. It’s also a warning to Tim Hortons investors: Keep your head up.

"McDonald’s is going to keep coming," Kenric Tyghe, an analyst at Raymond James, told me. "McDonald’s and its McCafés represent a material threat to the heart of Tim Hortons’ coffee business."

To be sure, Tims is a formidable competitor. Its 3,225 restaurants in Canada (it has another 645 in the United States) keep customers coming back, thanks to an ever-evolving menu and ubiquitous advertising.

As Canada’s largest restaurant chain, it generates plenty of free cash flow, to the delight of investors who have benefited from dividend increases in each of the past four years. The 1.3% yield won’t make you rich overnight, but the dividend will almost certainly keep growing—Bloomberg is predicting an 18% increase in February.

Problem is, Tims’ shares have had a huge run, and the frothy valuation is starting to concern some analysts at a time when McDonald’s is taking direct aim at Tims’ coffee and breakfast business, using some of the same marketing tools that put Tims on the map.

[For the record, Tims has had some success the other way around, taking a few pips of market share from Mickey D’s in the US, so this isn’t exactly a tale of unprovoked hostile takeover—Editor.]

Partly because it’s a nice, comfortable story in uncertain economic times, Tim stock has soared nearly 70% in the past two years, supported by a large share buyback. Based on 2012 estimates, Tims’ forward price-to-earnings multiple has climbed to about 19—similar to Starbucks (SBUX), but higher than McDonald’s forward P/E of about 16.5.

Is Tims’ premium valuation warranted? Not everyone thinks so. Analysts note that, although its Canadian same-store sales rose 4.7% in the third quarter, the gains were driven partly by price increases, while the number of same-store transactions actually slipped. (Same-store numbers exclude the impact of store openings or closings.)

"The decline in same-store transaction growth in Canada demonstrates our view that Tim Hortons is facing a slowing growth profile in its core Canadian market, and we believe the shares are fully valued at current levels," Canaccord Genuity analyst Candice Williams said in a November 11 note. She rates the stock a "hold" with a target of $46—about 10% below Tuesday’s closing price of $51.01.

Tyghe, who has an identical $46 target, said the drop in transactions reflects a combination of a weak economy and Tims’ market-share losses in the brewed coffee segment. He also observed that Tims’ recent launch of espresso-based beverages has met with unflattering reviews, including a Toronto Life tester who compared the cappuccino to a "double-double with foam on it."

"They are, in our opinion, late to market…which we believe will make for relatively tough sledding," Tyghe said in a note.

Tims spokeswoman Alexandra Cygal put a different spin on the launch, saying the company has received "very positive feedback from guests." She added that Tims accounts for about eight out of every ten cups of coffee sold by quick-service restaurants in Canada and "that hasn’t changed," despite McDonald’s efforts.

For its part, McDonald’s said its brewed coffee business has doubled in the past two years in Canada, with about 10% of its volume this year consisting of coffee giveaways.

Excluding such freebies, McDonald’s sales of breakfast food and beverages have grown by double digits in each of the past three years, spokesman Louis Payette said. As for Mickey D’s own espresso beverages, he said the customer response has been "just fantastic."

Disclosure: I’m a McDonald’s shareholder. I’m also big fan of Tim Hortons as a company. But after watching my kids go out the door in their hockey jerseys, I think I’ll wait for Tims’ shares to cool off before I take a sip.

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