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Wendy’s International, Inc. $62 – New York symbol WEN

WENDY’S INTERNATIONAL, INC. $62 (New York symbol WEN; WSSF Rating: Above average) is the third-largest hamburger chain in the world, behind McDonald’s and Burger King. In 1995, it acquired coffee and donut chain TIM HORTONS INC. $27 (New York symbol THI; WSSF Rating: Extra risk).

Tim Hortons is Canada’s largest fast-food chain, with 2,597 outlets. This includes 681 smaller restaurants in non-traditional locations such as gas station convenience stores, universities, hospitals and office buildings.

Tim Hortons now has about 23% of the Canadian fast-food market (compared to 18% for McDonald’s). It also has 76% of the coffee and baked goods segment. It plans to expand by at least 1,000 new locations in the next few years.

The company also operates 288 restaurants in the United States, mostly in urban areas near the Canadian border, particularly Buffalo and Detroit.

In 2004, it acquired 42 donut outlets in New England. However, these stores failed to live up to expectations due to strong competition from more established stores. Consequently, Tim Hortons wrote down the value of this investment in 2005 by $22.3 million (the company reports in Canadian dollars; $1 Cdn. = $0.85 U.S.). Tim Hortons still plans to expand its U.S. operations to 500 stores by the end of 2008.

The writedown helped cut Tim Hortons’ 2005 profit to $1.19 a share (total $191.1 million) from $1.28 a share ($205.1 million) in 2004. Revenue grew 10.4%, to $1.48 billion from $1.34 billion. Same-store sales rose 5.2% in Canada, and 7% in the U.S.

Healthier foods help drive Tim’s sales

Like its parent Wendy’s, Tim Hortons has spurred its sales with healthier foods, such as fresh sandwiches and home-style soups. That helped it attract customers who might otherwise avoid its traditional donuts and cakes. Tim Hortons now plans to capture a larger share of the fast-growing breakfast market with new egg-based menu items. Innovative customer contests have also helped drive its growth.

The recent share issue raised around $726.1 million U.S. for Tim Hortons. The company will use most of that to pay back loans from Wendy’s. Its long-term debt now stands at $588 million (Canadian), or a high 95% of stockholders’ equity.

Tim Hortons stock gained 30% on its first day of trading. Much of that came from heavy demand from Canadian investors, who consider Tim Hortons a national icon. The stock now trades for 26.7 times its 2005 earnings, and 3.4 times its revenue of $9.27 a share (Canadian). It also trades at a high 15.4 times its 2005 cash flow of $2.06 a share (Canadian). Tim Hortons aims to pay out 20% of its net income in dividends, starting in the third quarter of 2006. That implies an annual rate of about $0.25 (Canadian) a share, and a yield of 0.8%.

Remaining operations still appealing

We’ve long recommended Wendy’s for the hidden value of Tim Hortons. Right now, the market capitalization (current share price times the number of shares outstanding) is $5.1 billion for Tim Hortons, and $7.2 billion for Wendy’s. If you factor out Wendy’s 83% stake in Tim Hortons, that implies the remaining hamburger and other businesses (often called “the stub”) are worth about $3.0 billion, or $26 per Wendy’s share.

Wendy’s earned $1.92 a share (including unusual items) in 2005, but the stub supplied just 29% or $0.56 of that. That implies a p/e of 46.4. The stub also supplied 69% of Wendy’s total sales of $32.38 a share, or $22.25. That implies the stub trades at 1.2 times sales. The stub also accounted for 55% of Wendy’s 2005 cash flow of $3.80 a share. So, the stub trades at 12.4 times its implied cash flow of $2.09 a share.

Tim Hortons’ stock could fall once the initial euphoria fades. It could also come under pressure after Wendy’s completes its spin-off, and more shares come onto the market. However, its strong brand and high market share enhance its long-term prospects.

Spin-off part of larger plan

As for Wendy’s, the spin-off will let it focus on its hamburger business, which has lost ground to other chains that have copied many of its successful concepts. Its smaller size could also turn it into an attractive takeover target for one of its main rivals. The company will also continue to enhance its value by selling or closing its struggling casual dining restaurants, and selling more company-owned outlets to franchisees.

Wendy’s is a buy. Tim Hortons is also a buy, but only for aggressive investors.

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