A dream fulfilled ...
 Tim Horton's (NYSE:THI) is one company whose IPO I've awaited for a long, long time. I suppose it might be described as the Starbucks of Canada, but more addictive, if you can believe it. I have not had a Tim Horton's doughnut for nearly 10 years, but I can taste it like it was yesterday. Roughly half of all Canadians visit Tim's an average of four times a week or more, and you'd better believe that I wish I was one of them. Even our own Philip Durell of Inside Value fame expresses a love for their tasty treats.

The company is one of the strongest (voted best-managed by Canadian Business in 2004 and 2005) and most cherished brands in Canada. The chain has about 2,600-plus restaurants across Canada, about half located in Ontario, and 292 in the U.S., primarily located in the cities of Columbus, Detroit, and Buffalo. The company mostly sells coffee and doughnuts but has expanded the menu over the years to encompass changing consumer tastes by offering bagels, soups, and sandwiches. It's no slouch in the growth department, having compounded its sales by 16.5%, profits by 17%, and same-store sales by 7% annually over the last ten years.

Tim's was founded by the former Leafs hockey player Tim Horton in 1964, and posted 2005 annual sales of roughly $1.5 billion and net income of $191 million. Net income was affected by a $53 million asset impairment charge, as the company wrote down the value of some recently acquired and underperforming stores in New England. Its restaurants are 97% franchised, which makes for strong operating cash flow, $378 million in 2005. However, capital expenditures ate up a lot of that cash (as is usual with restaurant chains); they were $218 million in 2005, up about 10% from 2004. These numbers reflect Tim's extensive expansion in recent years, having added more than 100 stores in Canada and more than 30 in the U.S. each year for the past three years.

And check this out: It has an lock on the Canadian fast food wallet -- 23% of the fast food market based on dollars (McDonald's (NYSE:MCD) is second with 18%) -- and 76% of the coffee and doughnuts crowd, based on traffic. When's the last time you saw Mickey D's second in anything? McDonald's does stack up well when comparing operating profits, net profits, and cash flow margins, since they are virtually identical to Tim's at 20%, 13%, and a slightly lower operating cash flow margin at 21%. However, Tim's wins out with its return on equity, soundly crushing McDonald's 17% with 36% in 2005.

It's not just the doughnuts ...
Tim's has several additional competitive advantages that will keep it on top of the Canadian doughnut market for some time to come.

  • A "we fit anywhere" strategy for placing restaurants. Standard restaurants are from 1,400 to 3,000 square feet, with about 70% having drive-thru service. However, about 25% of restaurants are non-standard, located in office towers, airports, hospitals, and colleges, among others. These types of locations range from 150 to 900 square feet but offer a way for the company to further penetrate regions where space might not be otherwise available.

  • Extensive penetration into the Canadian market, with more than 2,600 restaurants, and plans to expand long-term to 3,500 to 4,000 restaurants in Canada. On the positive side, this offers an avenue for significant growth and allows the company to complete their stranglehold (so to speak) on the Canadian fast food dollar.

  • Almost ridiculous brand strength and loyalty.

  • "Flavor of the Month" promotions, where for a limited time, Tim's offers new doughnut flavors such as spiced pumpkin or triple berry to drive repeat traffic. I realize that Starbucks does the same with coffee, but this seems like an underutilized method in the fast food industry, probably because of the logistics of managing the promotion across a large store base.

The downside
Their lack of penetration in the U.S. market is not really surprising, given that the brand is relatively unknown outside of Canada. But it's a bit disheartening to see that the chain only plans on expanding to about 500 Tim's in the U.S. by 2008. Not only does this mean that I won't be eating Timbits anytime soon, but it is leaving a rather large market opportunity underdeveloped in order to focus on what may be diminishing returns in Canada.

By my estimation, there is one Tim Horton's for every 12,200 residents in Canada, and the company's expansion plans put the company at a one to 7,900 ratio. Even Starbucks, with their massive expansion over the past few years, has reached only a one-to-36,000 penetration rate in the U.S. And while the company may prove a good investment in the meantime, this rate of Canadian expansion has the potential, eight to twelve years down the road, to hurt same-stores sales growth and margins. It could even eventually lower company growth, since the newer locations may cannibalize the existing ones. This would occur as saturation kicks in at the company's current growth rate of a little more than 100 stores a year.

Oh, how I long for a Timbit ...
However, investors are paying a premium price for a premium brand. Tim's is trading at a P/E of 28, and about 15 times operating cash flow (both on a trailing-12-months basis). McDonald's, long the blue chip of the restaurant sector, trades at a P/E of 17, and price-to-OCF of 11, and Dunkin' Donuts was also acquired at an enterprise value-to-cash flow of 13. While I love the company dearly, I find it difficult to state that the shares are priced at anything but fairly valued, and an investor today would do best to wait on the sidelines for a dip in the price and a good buying opportunity. Since the company is such a powerhouse, I would be happy with a relatively small margin of safety, but would look to buy shares in the $20-$22 range. This opportunity may arise when Wendy's potentially unloads the rest of their stake in Tim's at the end of 2006.

Valuation aside, Tim's does look like a great company, and one that investors should keep their eye on for a potential buying opportunity. Strong brand name recognition, excellent management, and impressive growth offer a compelling combination for Canadian and U.S. investors looking for some international diversification. Of course, while we're waiting for shares to hit our buy point, can someone mail down some Timbits for me?

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Fool contributor Stephen Ellis is a long time devotee of donuts, and believes Tim's has the best in the world. He welcomes feedback. He does not own shares of any companies mentioned in the article. The Motley Fool has a tasty disclosure policy .