3 Reasons to Sell Tim Horton Inc. (USA)’s (THI)

Last week, Iain Butler at the Motley Fool Canadawrote a great piece on   recent financial results. But while Iain maintains a fairly neutral outlook on the Canadian icon, I’m decidedly more negative. Tim Horton Inc. (USA) (NYSE:THI)‘s should be sold due to increased competition, limited growth opportunities and expensive valuation.

Competition

The Canadian coffee wars are heating up.

is set for a big expansion campaign with plans to open 150 new locations in 2013. The company is gaining market share with the release of its lighter ‘blonde’ roast. The new product launch is attracting new customers who dislike Starbucks (NASDAQ:SBUX)’ traditional darker blends. Recent financial results have been positive. Starbucks’ Canadian revenue grew 7% in 2012 to $971 million and operating margins increased 20 basis points to 15.3%.

McDonald’s Corporation (NYSE:MCD) is also challenging Tim Horton’s dominance. Since 2008, the company has doubled its market share and now accounts for 10.3% of coffee sales in Canada. McDonalds’ is using its McCafe beverages as a loss leader and has invested $1 billion refurbishing its 1,400 locations. While Canada doesn’t move the needle for McDonald’s operating results (Canadian sales accounted for less than 5% of total revenues in 2011), the company’s enormous size is pressuring smaller players.

With the company challenged by competitors on several fronts, Tim Horton Inc. (USA) (NYSE:THI) gross margins have been steadily eroded. It’s awfully hard to raise prices when your competitors are giving away beverages for free.

Tim Horton’s won’t be a casualty the coffee war but the company will likely earn itself a Purple Heart.

Saturation

Tim’s is running out of expansion room. The company operates 3,400 Canadian locations with management estimating there’s room for an additional 600 stores in Quebec and Western Canada. However, given the company opened 74 new restaurants during the previous quarter, it may hit that target quickly.

There are also persistent doubts about the company’s U.S. expansion. There’s no evidence to suggest that the iconic Canadian brand has translated to American consumers. Without strong brand loyalty, Tim’s is just another coffee shop in a crowded U.S. market.

Valuation

Despite declining profitability and limited growth prospects, Timmies is one of the most expensive stocks in the coffee space when valued on a PEG basis.

This is troubling because Tim’sisn’t the top name in the industry. As I have written previously, Starbucks is the best of breed coffee retailer with lots of growth runway internationally. Management has been very successful with product line expansions and exploiting new channels.  Yes, the stock trades at a premium high-teen forward multiple, but it’s deserved given the company’s 20% projected earnings growth rate.