The Mickey D’s and Dunkin Donuts of Canada

12/26/2011 10:30 am EST

Focus: GLOBAL

Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

A cup of coffee, friends, and solid comfort food are universal, and this Canadian food franchise is a gem, writes Gordon Pape of The Canada Report.

We’re adding a new name to our Super Stocks list: Tim Hortons (THI).

We began this series last summer with the idea of choosing one leading Canadian company from the key sectors of the economy. Those selected to date are Enbridge (ENB) and CN Rail (CNI). Tim Hortons is the nominee for the consumer-discretionary category. Here’s the background.

The Business
Tim Hortons is the iconic Canadian fast food franchise. Ever since the company opened its first doughnut and coffee shop in Hamilton ON in 1964, it has been a favorite drop-in place for people.

Almost all Canadians have been in a Tim Hortons restaurant at least once—many have been there dozens or even hundreds of times.

Why? A combination of good coffee, freshly baked doughnuts and cookies, friendly service, low prices, and great marketing. It has proven to be an unbeatable formula.

The company was named for NHL hall-of-famer Tim Horton, who was one of the founders. He played for the Toronto Maple Leafs, New York Rangers, and Buffalo Sabres until his death in 1974.

The chain operated exclusively in Canada for 20 years, then opened its first US store in Tonawanda, NY (near Buffalo) in 1984. Its coffee-bean roasting plant is based in Rochester, NY.

Only old-timers remember that the original stores offered only two products: coffee and doughnuts. But as the years passed, a variety of new items appeared, ranging from apple fritters to freshly baked pies.

In the 1980s, the company took the big step of tackling the lunch market with such products as chili, soup, bagels, sandwiches, and wraps. This expanded the appeal of the stores and increased revenue dramatically.

In 1995, Tim Hortons was taken over by Wendy’s International and a great Canadian name passed into Yankee hands. However, just over a decade later, it was spun off as a separate company in September 2006, and subsequently moved its head office back to Canada.

Today, Tim Hortons is the fourth-largest publicly traded fast food restaurant chain in North America, and the largest in Canada. It operates a total of 3,871 outlets, with 3,225 in Canada and 645 in the US, and is in the process of expanding into the Persian Gulf region. [The opening of the company’s Dubai store was so mobbed that staff had to turn people away at the door—Editor.]

The Security
The common shares of Tim Hortons trade on the New York Stock Exchange under the symbol THI. We originally recommended the company in The Canada Report in July 2009 at $24.85.

NEXT: Why We Like It

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Why We Like It
After a brief hiccup last year when the CEO departed under unusual circumstances, Tim Hortons is back on track and is showing strong growth. The expansion into the US has hit a few rough spots, but on the whole it appears to be working well, despite fierce competition from several other fast food franchises ranging from Country Style to McDonalds (MCD).

Third-quarter same-store sales were up 6.3% over last year in the US, a very good performance, especially in difficult economic times. (In Canada, the gain was 4.7%.)

The US growth is contributing to the company’s bottom line, with operating income of $2.9 million in the US segment in the third quarter, compared to a $17.5 million loss in the same period last year (figures in Canadian dollars).

The company is actively buying back its shares, and had 7.9% fewer fully diluted shares outstanding in the third quarter compared to the same period last year. It still has $64 million available for more buybacks between now and the expiration of the current program next March.

Financial Highlights
Tim Hortons reported third-quarter revenue of $726.9 million, compared to $670.5 million in the prior year, an increase of 8.4%. Net income rose 40.4%, to $103.6 million (65 cents a share, fully diluted), compared to $73.8 million (42 cents a share) last year. The balance sheet is sound, with a very comfortable debt-to-equity ratio of 0.38 as of the end of the 2010 fiscal year.

Risks
The company is not recession-proof, but is close to it. Historically, low-cost fast food operations fare better than most hospitality companies during an economic downturn, because they are more affordable to people on limited budgets.

Distribution Policy
The stock pays a quarterly dividend of 17 cents a share (68 cents a year) to yield 1.3% at the current price. We expect a dividend increase in 2012.

Tax Implications
For US investors, dividends qualify for the lowest rate. However, there is a 15% withholding tax which can be recovered through the foreign tax credit.

Who It’s For
This is a core stock for long-term investors who are interested in capital gains plus modest but growing cash flow. The risk level is moderate.

Buy below $50. [Right now, the stock is trading above $48 and creeping upward—Editor.]

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