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Tim Hortons (THI) is the largest restaurant chain in Canada offering fast foods, including coffee, donuts, muffins, and bagels. The company currently operates 3,100 stores in Canada through a franchising model. THI also has presence in the US market, with 600 restaurants, primarily in the Northeast and Midwest regions. Since THI targets the low-end coffee market, its shares bear the nature of a defensive investment.

The stock has returned 14% over the past 12 months, despite overall equity market weakness. The current price of $51.89 is not far down from its 52-week high of $58.47. THI initiated its first dividend in August 2006 and currently has a dividend yield of 1.6%. At this level, I believe the stock is a solid dividend play, with an attractive valuation and dividend increase potential based on the reasons discussed below:

  • THI is undervalued. The table below shows a relative analysis for THI's most comparable companies including Starbucks (NASDAQ:SBUX), Dunkin's Brands (NASDAQ:DNKN), and McDonald's (NYSE:MCD). Compared to the group averages, although THI underperforms in many of the growth and margin measures, the company has higher net income margin and ROE. As such, a small valuation discount should be warranted. To justify the current price level at $51.89, a valuation discount of 23% needs to be factored in the model (see below). However, such a substantial discount appears to be overblown, given THI's comparable top-line growth prospect, better bottom-line profitability, as well as its dominant market position in Canada. But on a different perspective, the current market discount does offer investors a fair margin of safety. Assuming a more realistic valuation discount of 10%, the model yields a fair stock value of $60.58, implying a 17% upside.

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  • THI has a solid balance sheet. The firm is less leveraged relative to its peer group as reflected by its lower debt to capitalization ratio of 30.3%. This helps THI to maintain a very healthy interest coverage ratio at 18.8x. Its current ratio of 1.3x is in line with the peer average.
  • THI has a proven record of raising dividends. According to the chart below, dividend per share has been in an upward trend since it was first initiated in August 2006.

  • THI has a solid capacity to continue raising dividends and buy back shares down the road. According to the analysis below (the assumptions are highlighted), the ratio of FCF per share to EPS has historically been ranging from 55.0% to 80.9%. Dividend payout ratio has increased from 19.6% in FY2007 to 30.6% in FY2011, and dividend to FCF ratio has risen from 24.2% to 55.6% over the same period. Assuming the EPS to grow at the consensus estimates over the current and next fiscal years, FCF to EPS ratio to stay at a 5-year historical level of 70.0%, and payout ratio to be the same at 30.6%, I estimate the dividend per share to be $0.78 and $0.84 in FY2012 and FY2013, respectively, and dividend yields to be same as the current level. With these assumptions, dividend paid will only represent 43.7% of the total FCF over the projected period, suggesting ample room for either a dividend raise or continued share buyback.

I have just established a position for THI at around $52. In the light of an attractive valuation, a solid balance sheet, and a sustainable dividend yield, I would advise investors to do the same.

Dividend charts is sourced from CapitalIQ, data tables are created by author, and financial data is sourced from company 10-Q, 10-K, press release, Yahoo Finance, YCharts, Wall Street Journal, Thomson One, Bloomberg and Morningstar.

Disclosure: I am long THI.

Source: Why Tim Hortons Is A Solid Dividend Play