1.Summarize the company, its current financial health and overall capital structure. Tim Hortons is a leader of QSR (quick service restaurants) in Canada and fourth in North America. The company has 3,148 restaurant in Canada and 602 in USA, 194 locations in the Republic of Ireland, 81self-serve kiosks in the United Kingdom and temporary location in Kandahar, Afghanistan. THI restaurants represents by standard restaurants, small full-service restaurants and self-serve kiosks.
Business model: THI charges restaurant owners a Franchise fee of 4.5% of their gross sales. Rental income results from an 8.5% charge on restaurant sales. In addition, owners have to pay for advertising funds. Another way to manage Tim Hortons restaurant is operator agreement (not typical franchise) – 20% of gross sale.
I have chosen these competitors for Tim Hortons: McDonald’s Corp., Yum! Brands , The Wendy’s Comp, Starbucks Corporation. The company’s Net Income is CAD 627 million for the Last Twelve Months however this number is impacted by the Maidstone Bakeries sale. NI for the past 5 years has been between CAD 259 and CAD 296 million. Tim Hortons’ Interest Coverage ratio (EBIT/Interest Expense) has been increasing from 11 to 24 between 2006 and 2009 and then settled at around 18. This means that THI has in EBIT 18 times its Interest Expense. The LTM number is close to the industry ratio. The company’s Return on Assets has been increasing since 2006 by almost 1% every year and now is at 15.3%. The industry ratio has been more flat with the exception of the last year when ROA jumped from 11% to 14%.
THI’s Return on Equity is higher than the industry however players such as Yum! Brands have a higher ratio. Total Liabilities to Total Assets is 45% which means that for every dollar of assets, THI has 45 cents in liabilities. The industry sits at a 5 year geometric mean of 53% as for THI’s average, it is 42%. Average Total Debt to Equity is 36% for THI as for the industry it is 59% which puts THI’s capital structure in a better position relative to the industry. 2. Comment on its working capital position and ability to support current operating and immediate business needs. By examining the below ratios we can have an idea of how Tim Hortons’ has been operating its working capital for the past 5 years as well as a relative comparison to its
peers in the industry.
Tim Hortons geometric mean of Current Ratio for the last 5 years is 1.47 which is 36% higher than the industry average (also geomean). However, I should note that the Current Ratio in 2010 was 2.05 and due to the cash factor in the numerator, this ratio was overstated when compared to other years due to the sale of Maidstone Bakeries.
The Quick Ratio average for THI in the past 5 years is 0.94, also well above the 0.69 industry average. Nonetheless, the Maidstone joint venture sale had its impact over that ratio in 2010. Average day’s sales outstanding: Looking at the 5 year average for THI, the company needs 23 days to collect its Accounts Receivables. The industry average is at 10 days which is more efficient in turning A/Rs into collected funds. This aspect of Working Capital is important for conducting the day-to-day operations of the company. Average day’s Inventory Outstanding: This ratio gives us an estimate of how long products are staying in inventory before they turn into sales.
THI has an average of 12 days for the past 5 years, with 20 days for 2011 LTM compared to 7 days at the industry average level (including Starbucks) and 5 days of industry average without Starbucks. I assume that the average day’s inventory for Starbuck is so high (56 days) due to the shelf life of its products that are mainly concentrated in the coffee/sugar products as compared to a wider perishable food items in the whole industry, including Tim Hortons, but mostly represented by Yum! Brands and McDonald’s whose average is 3 to 4 days. Generally, Tim Hortons menu represents a middle ground in the industry, balancing between “food” and “coffee” products. Nonetheless, a higher average day’s inventory outstanding would put a big question mark on THI’s slogan: Always fresh!
Average day’s Payable Outstanding: This ratio tells us how efficient THI is in paying it’s current portion of liabilities. With 26 days Tim Horton is experiencing a downward (ameliorating) trend since 2006. Today THI is able to pay off its Accounts Payables faster than the years before; this average is 20% lower than the industry. With an Average Cash Conversion Cycle of 10 days (2007 to 2011) THI is able to pay for the materials purchased from suppliers, sell them and then collect cash on the retail level within a period of 10 days. The operating cycle of THI is 36 days as for the industry average its 21 days. Overall the liquidity of
the company is very stable, THI working capital is healthy and the company is able to support its short term business needs in an efficient manner. 3. Comment on its effective or ineffective use of debt.
Tim Hortons debt can be classified into the following categories: Senior Unsecured notes trading at a market value 327 million with face-value of 300 million and a coupon of 4.2%. Moreover, a revolver with a ceiling of CAD 250 million. Tim Hortons has a large number of capital leases. 2,176 stores, out of 3750, are leased by THI (and subleased to restaurant owners). Generally the lease period is 10 to 20 years with an obligation to cover expenses such as insurance, taxes, maintenance etc.
Moreover, those leases cannot be cancelled even in the case where the store is not profitable and closed. Having capital leases on its balance sheet, THI is increasing its Debt ratios and at the same time increasing its risk exposure. Overall the Long Term Debt account is low With 0.30 D/E ratio, THI has a low debt to equity ratio as compared to the whole industry’s ratio of 0.67. When looking at the weight of debt from a WACC perspective, we notice that the weight of debt is at 4%. This figure is reached by calculating the market value of debt as of July 1st,2011. At the same time THI has a 23% weight of debt in its capital structure when looking at the weight from a book value perspective. Also, taking into consideration that debt is tax deductable, I believe that THI could be taking further advantage by increasing the weight of debt.
4. State the current rating of the firm’s debt and state whether you feel it is justified or not? THI’s current rating is A (low) by Dominion Bond Rating Service. I believe that this rating is fair especially that the stock is still relatively new on the market and this bond issue is the first. THI, in the eyes of rating agencies, would have to prove itself as a bond issuer before it gets a better bond rating. I believe that with the current new global expansion, the company will face some volatility with respect to the risks of the new ventures and the probability of success. However, I believe that in future with a sustainable growth THI would receive higher rating for their bonds.
5. Comment on the company’s sensitivity to rising interest rates: THI’s bond prospectus indicates at what price the bond can be redeemed. Having this option in the prospectus shows that THI can manoeuvre their bonds according to interest rates by redeeming the bonds when interest rates in the market are lower than the 4.2% coupon. Also, THI’s sensitivity to interest rate changes has been hedged and accounted for by the bond contract with the investors when rates are downward trending. In the case of increasing rates, the company is well-off paying the low 4.2% coupon but this will not go forever since the maturity date on the bond is in 2017. The company also has a bank revolver of CAD 250 million which acts like an overdraft facility for the company with banks. The interest rate on the revolver is LIBOR + 1%.
THI’s sensitivity in that case is directly related to LIBOR. With rising interest rates THI would be paying a higher interest on the portion of borrowed money from the revolver. Another hedging strategy used by THI is interest swap whereby the company has fixed a portion of the variable rate at a rate of 5.04%. In that case increasing rates will have a less impact on the company payments. Keeping in mind that the company has a low Debt to Equity ratio, therefore higher interest rates will not make a huge impact on the overall situation of the company.
6. How does the company’s capital structure compare to its overall industry? To analyze the capital structure of Tim Hortons, we will use Debt/Equty ratio. Tim Hortons’ has a downgraded rate of this ratio from 0.39 to 0.30 within 5 years of its public life, this means that THI has consistently decreased its debt portion and/or increased equity in its capital structure. Compared to the industry, THI’s D/E ratio is quite low, the industry geomen is 0.66. We could notice that Yum!
Brands has been more aggressive in financing its growth with debt and this fact creates additional interest expense that generally could lead to volatility in Earnings per Share ratio. However, if we compare EPS for THI and Yum! Brands, they are almost the same. It means that Yum! Brands, despite of its debt, is able to generate growth in shareholder wealth. Also, I would like to note that extra debt is an instrument that can generate more earnings then the operation without such financing. Further advantageous, debt is Tax deductible.
Overall, it could be beneficial for THI to increase its D/E ratio and be at a closer rate to the one of the average industry. 7. Calculate its operating leverage, financial leverage and total leverage. Degree of Operating leverage – is a measure of operating risks that shows the sensitivity of operating income to changes in sales. Businesses with small sales changes but leading to high profits have high leverage and the opposite is also true.
In addition, a low operating leverage means that the
company has a lower proportion of fixed cost and a higher portion of variable cost vice versa for firms with high leverage. Degree of Financial leverage – is the sensitivity of net income to changes in operating income. Also it can determine the sensitivity of earnings per share. Degree of Total leverage – is a combination of both leverage measures. This ratio is a measure of effects from financial and operation decision, also used to find optimal level of financial and operational leverage. For Tim Hortons I chose data of changes in 2009 and 2008 years, because 2010 data is not reflective due to ¬ Maidstone Bakeries sale that generated a Net Income in 2010 of 624 million while in 2009 and 2008 these figures were 296 million and 284 million respectively.
It means for every 1% change in Sales, operating income will change by 0.64%. So, if Sales increase by 10%, Operating Income will increase by 6.4% (0.64*10%=6.4%). It means for every 1% change in operating income, Net income will change by 0.68%. Thus, if Operating income increase by 10%, Net Income will increase by 6.8% (0.68*10%=6.8%). It means for every 1% change in Sales, Net Income will change by 0.44%. Therefore, if Sales increase by 10%, Net Income will increase by 4.4%. Lets compa Tim Hortons leverage with the industry, below there is a table that demonstrates figures of some competitors. From this table we can determine that Tim Hortons’ Operating Income is more sensitive to changes in Sales then its competitors, while its EPS is less sensitive from a DFL perspective.
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