For an Investment in Coffee and Donuts, Head North?

Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When Americans think of coffee and donuts, Dunkin' Brands (NASDAQ: DNKN) and Krispy Kreme Doughnuts (NYSE: KKD) typically come to mind. But for Canadians, the first think they think of is Tim Hortons (NYSE: THI). Tim Hortons is the largest quick-service restaurant chain in Canada and has achieved iconic-brand status among Canadians. The chain serves always-fresh coffee, baked goods and home-style lunches. At the end of the first quarter of this year, Tim Hortons had 4,288 total locations, with 3,453 in Canada and 808 in the U.S.

Recent events

Tim Hortons released second-quarter numbers this month. Earnings per share increased 17%, and adjusted operating income grew 10.7%. Same-store sales grew 1.5% in Canada and 1.4% in the U.S. Total revenue increased 1.9% to $800.1 million.

The company also announced that it approved a $900 million share-repurchase program. Tim Hortons plans to use its strong balance sheet to borrow the money for the repurchase program. Tim Hortons will then have approximately $1.4 billion in debt. Even though its cash balance is only $88 million, the company has an enterprise value of $9.4 billion. Last year, operating cash flow was $612 million and free cash flow was $306 million. The added debt load will not change the company's credit rating.

I think when a company uses its balance sheet to take advantage of favorable interest rates and return money to shareholders, it is doing right by shareholders. Over the next 12 months, the company will be in the market repurchasing about $1 billion in shares, or about 10% of its outstanding shares.

Going forward

All eyes will be on new CEO Marc Caira as he takes over from Paul House, who will become Chairman. Marc Caira will be just the fourth CEO in the company's history. Prior to becoming CEO, he was an Executive at Nestle in its food and beverage operations, overseeing 10,000 employees in more than 100 countries.

His first order of business will be increasing Tim Hortons presence in the U.S. I see plenty of room for the company to grow in the U.S. beyond its 808 locations, especially if the company can increase brand awareness and get Americans to love its locations as much as Canadians do. It is certainly doable considering how similar the U.S. and Canadian markets are. On the company's earnings call, Caira said

I consider the U.S. to be an important part of our growth strategy. I very much see the U.S. market as a must-win market for us. Based on the dynamics of the market and the footprint we already have created, I believe the U.S. represents an opportunity for significant long-term earnings growth for us.

The other segment for growth is in the single-serve coffee market. According to Tim Hortons vice president Mike Meilleur

Single-serve coffee is the fastest-growing segment of at home coffee and it continues to grow every year. Offering our premium blend coffee in a single-serve cup allows our guests to enjoy their Tim Hortons coffee in the comforts of home, as well as introduce new fans to the brand.

Competition

The parent of Dunkin' Donuts is Dunkin' Brands. At the end of June, the company had approximately 10,600 Dunkin' Donuts locations and approximately 7,000 Baskin-Robbins locations. Krispy Kreme is a much smaller brand with approximately 97 company stores, 142 domestic franchise locations, and 509 international franchise locations.

Dunkin' Brands is looking to grow via menu innovations and continued restaurant expansion. In terms of menu innovations, the company is not only adding breakfast items but also lunch items to attract the afternoon crowd. This is when business is typically the slowest. The company has added chicken and tuna salad wraps, chicken sandwiches, a pretzel-roll bakery sandwich, a turkey sausage breakfast sandwich under 400 calories, and cold and frozen beverages. The menu innovations are helping, as same-store sales rose 4% in the second quarter.

In terms of expansion, Dunkin' Brands is focused on the U.S. The company, over the long term, is looking to add another 3,000 stores east of the Mississippi and 5,000 locations west of the Mississippi. California is particularly exciting, where the first Dunkin' Donuts location will open in Southern California in 2015. This year alone, the company expects to add 330 to 360 net new Dunkin' Donuts locations.

Krispy Kreme is primarily known for its donuts and less for its coffee and beverages. The company has been working to change that view and is offering customers deals on coffee and beverages with different doughnut combinations. So far it's working, as same-store sales rose over 11% in the first quarter for the 18th consecutive quarter of increased sales at company stores.

The other avenue for Krispy Kreme's growth is expansion. The company hopes to almost double its store count in the U.S. to over 400 locations by January 2017. By that time, Krispy Kreme also hopes to have about 900 international shops. Currently, there are 360 shops in the international pipeline and the company is working on expansion opportunities in Europe and Central and South America.

Foolish assessment

In comparing the three companies, Tim Hortons looks to be the most undervalued. It has a forward P/E of 17 and an enterprise value/EBITDA of 12. Dunkin' Brands has a forward P/E of 24 and an enterprise value/EBITDA of 18. Krispy Kreme has the highest valuation with a forward P/E of 29 and an enterprise value/EBITDA of 25. With the reputation that Tim Hortons has in Canada and the potential for growth in the U.S., investors should head north and go with Tim Hortons for coffee and donuts.

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Mark Yagalla has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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