Double Double

In Canada, the phrase “double double” is instantly associated with donut-and-coffee chain Tim Hortons Inc. (TSX: THI, Frodays Close $52.81). The chain, whose ubiquitous stores, counters, and outlets seem to be on every corner, just reported fourth-quarter results, with net income of $0.65 per share. That was down considerably from the $2.19 per share reported a year ago, which was boosted by a one-time gain from the sale of an interest in a bakery supplier. Excluding that gain and impairment costs, net income rose 26% year over year. Sales were also up, as revenues rose 21% from the previous year, as sales at stores open for more than 13 months rose in both Canada and the US.

The company said it plans to open up to another 290 stores this year across Canada and the US. It already claims to sell eight of every ten cups of coffee in Canada. It’ll soon be impossible to avoid Tim’s. The company also announced a share buyback program of up to $200 million. Share price surged to a new 52-week high as investors gobbled up the news, doubtless fuelled by an extra-large cup of coffee, double-cream, double-sugar of course.

When a stock hits an all time high it is reasonable to step back and re-evaluate. For example, what will drive future growth? If the company is already selling 8 out of every 10 cups of coffee in Canada, that looks like a saturated market. Which means that Canadian growth will primarily be tied to population expansion. Assuming the company can maintain their dominant foothold.

The company could expand margins. But to do that they would have to keep a tight control on costs while at the same time raising prices for their coffee. That is not a likely scenario for two reasons; 1) the price that someone will pay for a cup of coffee is elastic and tied to fickle consumer preferences and 2) cost containment is a challenge given that producers work in very different economic environments.

The company could also expand internationally as it is doing in the US. But that strategy has had limited success. Wendy’s tried and failed to wedge THI into the consciousness of the American consumer. What’s left from that experiment are a limited number of franchises that are close to Canadian border towns and probably survive because they attract Canadians travelling south or in the US on shopping excursions.

What we have then is a successful Canadian company holding a dominant position in a loyal but limited market which probably dampens future growth. I suspect THI management sees it much the same way as evidenced by their share buyback program and a reasonable dividend yield. Certainly Canadian option traders see it this way, as the implied volatility on THI options is in the lowest quartile of all Canadian options.

The bottom line is that THI is an excellent company with an excellent history. The future while positive will be marginal at best which makes this a stock play for longer term investors who are will to exchange upside potential for limited downside risk.

All of which makes THI an excellent candidate for a longer term covered call strategy. For example, buying THI at $52.81 and writing the THI October 54 calls at $2.45. THI options are not liquid so this is a position if established, will likely be held to expiration.

On that basis, the eight month return if exercised is 6.89%, the return if unchanged is 4.86% and the downside breakeven is $50.36. These returns do not include any dividends received over the holding period.