A Boston Real Estate Empire at a Discount – New England Realty Associates, LP: NEN

New England Realty Associates, LP is an NYSE-listed real estate partnership that trades at a 30%+ discount to a conservative estimate of asset value. “NERA” is lead by Boston real estate magnate Harold Brown. The partnership has produced exceptional returns for its partners since inception. Though the market has begun to wake up to NERA’s substantial value in recent years, the partnership remains undervalued due to its small size, limited liquidity and confusing structure.

New England Realty Associates, LP (ticker NEN) was founded in 1977 and currently owns 24 properties in and around Boston, Massachusetts. Of these properties, 17 are residential buildings, 4 are mixed use, 3 are commercial buildings and 1 property is comprised of individual units within a condo complex. as of June 30, the partnership owned 2,412 apartment units, 19 condo units and 108,043 square feet of leasable commercial space. Additionally, the company owns partial interests in another 9 properties, a mix of apartments, commercial space and a parking lot.

NERA’s properties are located in central Boston and in surrounding affluent suburbs. The partnership got its start in Allston, and four of the properties are located there.


I’ve done some poking around on various apartment rental sites, and NERA seems to target young professionals and students to fill its rentals, many of which are located in busy settings near universities. Rents seem on par with the local market, and NERA (via Hamilton Company, which manages its properties) gets good reviews as a landlord. (This may be a recent development. There is no shortage of older articles criticizing the company’s property management practices.) NERA’s properties boast occupancy rates near 100%.

Like many realty partnerships, NERA’s ownership structure is made up of multiple classes of units. NERA has two classes of limited partnership interests, Class A and Class B, plus General Partnership Units. Class A units have an 80% ownership interest, Class B unitholders own 19%, and the General Partner owns 1%. None of these units are publicly-traded. What is publicly-traded are depositary receipts that are the equivalent of 1/30th of one Class A Unit. Class A units themselves are not tradable, but may be converted into depositary receipts at a 30-to-1 ratio at any time, then traded. Because of the odd depositary receipt structure, many financial data providers do not accurately report NERA’s market capitalization or units outstanding. This lack of good data contributes to NERA’s mis-valuation.

NERA has a long history of profitable operations. The company does not always report a GAAP profit, but does produce consistent and growing funds from operations. As I’ve mentioned many times before, GAAP net income is a terrible metric for evaluating real estate companies. Non-economic expenses like depreciation and accounting for partial interests obscure actual profitability. What matters is distributable cash flows, and NERA excels at creating these. Here’s a look at the partnership’s historical results. Results are in millions and are taken from the partnership’s annual reports, without any adjustment for restatements or amendments.


NERA’s annual funds from operations have more than doubled since 2008, while gross rents rose 39%. That’s a nice result. But the truly impressive achievement is NERA’s tax efficiency. From 2008 to 2014, the partnership recorded a sum of just $5.0 million in continuing net income for its partners. Yet it produced $77.4 million in funds from operations, a very close proxy for distributable cash flow. What’s clear is that NERA’s management understands the “secret sauce” of real estate investing: leverage and depreciation. Reasonable leverage allows a partnership to control a large asset base while the associated interest expense creates a tax shield. So long as the cap rate on the assets acquired is below the cost of the associated debt, positive cash flow results. The second part of the equation is to continually add new properties to the roster, bringing in fresh depreciable assets to further shelter cash flows from taxation. Because high quality real estate tends to appreciate over time, this depreciation is merely a “phantom” expense and a valuable tax shield.

On a trailing basis, NERA produced nearly $16 million in funds from operations. This figure will almost certainly increase as rents rise and as the company continues to pay down debt. Also, the company just closed on the purchase of another rental complex, the 94 unit Captain Parker Arms in Lexington, Massachusetts. The purchase price was $31.5 million, 79% of which the company funded using its Keybank line of credit. The partnership has also begun converting the parking lot it owns into a 49,000 square foot, 48 unit apartment building. Both of these projects will contribute substantial cash in years to come.

There’s one other area where NERA excels: buying back its units. Since inception, NERA has repurchased a full 30% of its issued units. In the last twelve months, the company reduced its fully-diluted units outstanding by 1.9%, and is set to continue buying back units. In March, the board of directors approved an expansion of the unit repurchase program sufficient to repurchase an additional 13.2% of outstanding units within five years.

But what is NERA worth? The answer to the question depends on determining the proper multiple of net operating income for Boston-area apartment properties. While NERA also holds some commercial properties and condos, the vast majority of its assets are invested in apartment assets. Unsurprisingly, the average cap rate for class A Boston apartment assets is extremely low. The Boston real estate market has long been one of the tightest in the country, and cap rates reflect this. Recent transactions have been done at cap rates as low as 4%! More typical transactions have crossed in the 5% range. For anyone interested, there are a number of market reports available via a little Googling. Here’s one.

For conservatism’s sake, I’ll use a cap rate of 6%/16.7x net operating income to estimate the value of NERA’s properties. The chart below lays out the value of NERA’s fully owned properties and its stake in equity-accounted projects, net of debt.


It’s very easy to get to value of over $255 million for NERA’s properties and investments, net of debt. Using market valuations for the Boston metro yields an even higher value. The chart below shows the values of New England Realty Associates, LP depositary receipts at various cap rates.


At a 6.0% cap rate, NERA depositary receipts are worth just over $70, 48% higher than the current trading price. This value does not include the increased cash flow from the newly-acquired apartment complex, or the value to be created by developing the parking lot into a residential property. If we assign even modest value to those new assets and nudge the cap rate down just slightly, the fair value of NERA’s depositary units approaches twice the current trading price. At NERA’s current trading price, I think it’s fair to say the market is valuing the company’s holdings at a cap rate of around 7.5%, well above market cap rates.

NERA’s valuation is compelling, but potential investors must be aware of a few potential risks. First, NERA’s two largest unitholders, Harold and Ronald Brown, are quite elderly. These men together own over 40% of NERA’s units. In the not distant future, NERA may face succession challenges. NERA also holds many highly appreciated properties, and unitholders may find themselves with an large tax bill should the partnership ever be wound down for any reason. And finally, because NERA is a pass-through entity, unitholders must be sure to handle the associated tax complexity carefully, including paying state taxes to Massachusetts.

For those unconcerned by these risks, NERA could be a great way to create a portfolio of quality Boston properties at a cap rate unheard of on the ground.

Alluvial Capital Management, LLC does not hold shares of New England Realty Associates, LP for client accounts. Alluvial may buy or sell shares of New England Realty Associates, LP at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

The Fight for Warrnambool – WCB:ASX

Before I get into this post, I’m happy to say I’ll be a panelist at The Microcap Conference, a new conference taking place in Philadelphia on November 5. It will be a great opportunity to hear from some promising small companies, meet with company management, and network with other analysts and investors. Anyone interested can find more information at microcapconf.com.

Fair warning: my subject today is so thinly-traded that building a meaningful position is next to impossible. So, I present the situation mainly as a profile in corporate gamesmanship, of multiple competitors sparring to achieve complete control over a valuable asset. The asset in question is a real mouthful: Warrnambool Cheese and Butter Factory Company Holdings Limited.


“WCB” is Australia’s oldest dairy company, founded in 1888. From the very beginning, WCB was export-oriented, first sending a shipment of butter to London in 1893. The company grew by leaps and bounds in the 20th century, overcoming a disastrous fire in 1929 and forming many joint ventures and licensing agreements with major world cheese and dairy brands. Over time, the company’s footprint increased to encompass many different categories of dairy products, as well as many supply chain inputs. The company listed on the ASX in 2004.

Dairy prices can be volatile and WCB’s results are not immune, but on average the company has been profitable. Here are annual results from the company’s listing in 2004 to fiscal 2014.


Like I said. Hardly consistent, but generally profitable and moving in the right direction. Over this stretch, WCB caught the eye of other Australian dairy businesses looking to expand. WCB’s international distribution and valuable partnerships were enticing for other operators looking to achieve higher margins through increased scale and improve their market share.

The first company to propose an outright acquisition of Warrnambool was Murray Goulburn, an Australian dairy co-op. Murray Goulburn approached WCB in late 2009 but was rebuffed. The WCB board viewed the proposal as opportunistic, and to a degree it was. WCB suffered heavily amidst the global financial crisis, and 2009’s results were very poor. Though Murray Goulburn would raise its offer multiple times, they were repeatedly turned down and ultimately withdrew their offer in June, 2010. Still, they began a creeping takeover of WCB, announcing they had purchased nearly 5% of WCB’s shares in early 2010. Through continued purchases, Murray Goulburn increased its stake in WCB to just under 10% by late 2010. WCB, for its part, brought in another competitor as a substantial shareholder. Through a rights offering, Bega Cheese purchased a 15% interest in WCB.

The games would continue, with various competitors quietly building their stakes in WCB. By mid 2013, Murray Goulburn had built its ownership to 16% of WCB, and Bega held 17%. Bega was the next to attempt to acquire WCB, offering the equivalent of $5.78 in cash and Bega Cheese stock. Again, WCB’s board recommended against the offer. Finally, after nearly a year of warring press releases and attempts to rally shareholders for or against the deal, Warrnambool found itself a savior in a white knight: Saputo, Inc. The large Canadian dairy company stepped in with a superior offer of $7.00 per share, payable in cash.

However, Bega Cheese and the Murray Goulburn Co-Op were far from done. Murray Goulburn returned with a bid of $7.50 per share, while Bega Cheese maintained that its offer was superior in that it allowed WCB shareholders continued participation in an Australian dairy company. Saputo fired back with an improved offer of $8.00. Meanwhile, a previously unknown player crept in and began accumulating WCB shares in earnest. On October 29, 2013, Lion Dairy went on a massive buying spree and bought up 9.99% of WCB’s shares outstanding. Lion Dairy is a subsidiary of Japanese beverage giant Kirin Holdings. Lion Dairy had long had a partnership relationship with WCB, and now had a substantial financial investment as well.

On and on it went, with the three bidders increasing their bids in turn. Murray Goulburn’s offer would eventually reach $9.50 per share. Meanwhile, Saputo took matters into its own hands and began buying WCB shares aggressively. In the end, it was Saputo that won out. Bega Cheese capitulated and sold its holdings to Saputo and Murray Goulburn did the same. Through its various open market purchases and the takeover offer, Saputo managed to increase its ownership of WCB to 87.92%.

That might be the end of the story, were it not for Lion Dairy. One of Saputo’s explicit goals in offering to purchase WCB was to obtain a shareholding of over 90%. Saputo even offered an additional 20 cents per share if its offer succeeded in achieving 90% ownership. Why is the 90% threshold a big deal? Well, under Australian corporate law, a purchaser can force remaining shareholders to sell if the purchaser can achieve 90% ownership. Lion Dairy’s stake is now just over 10%, and it represents a blocking interest than prevents Saputo from taking full ownership of WCB. It also prevents Saputo from delisting WCB from the Australian stock exchange, forcing them to continue paying additional listing and auditors fees.

In essence, what Lion Dairy now possesses is a valuable intangible asset via its ability to prevent Saputo from fully achieving its goals. If Saputo wants to achieve complete ownership of Warrnambool, it will likely have to pay Lion Dairy (and all remaining minority shareholders) a premium for the remaining shares. The companies are not exactly adversarial at this point (witness the recent transaction where Lion Dairy sold an entire division to WCB) but Lion Dairy and Kirin Holdings are certainly aware of the strength of their position. Saputo cannot force a merger, nor can it delist WCB, nor can it directly dividend cash back to Saputo without sending 10% of it to Lion Dairy.

Perhaps Saputo will play a waiting game. If a recession rolls around, Lion may become more willing to sell its blocking interest to Saputo at a lower price. On the other hand, Lion Dairy’s asking price may only increase if WCB does well under Saputo’s ownership. Warrnambool Cheese and Butter recently traded at just under Saputo’s acquisition price. Anybody interested in aligning with Lion Dairy and taking part in the next round of corporate soap operatics might enjoy owning a few shares just for the entertainment value, with upside if WCB’s operations perform well. But purchase carefully. Warrnambool’s stock may be one of the world’s most closely-held listed companies, with a free float of less than $6 million on a market capitalization of $522 million.

Alluvial Capital Management, LLC does not hold shares of Warrnambool Cheese and Butter Factory Company Holdings Limited for client accounts. Alluvial may buy or sell shares of Warrnambool Cheese and Butter Factory Company Holdings Limited at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.


What’s New With Retail Holdings NV? – RHDGF

Long-time readers may remember previous posts on Retail Holdings NV. “ReHo” is one of my longest-held and sadly, most stubbornly lackluster performers. Still, I remain convinced that Retail Holdings’ collection of profitable and growing Asian businesses and large discount to NAV will eventually result in substantial appreciation. ReHo recently published its first half 2015 results. Let’s take a look at how they did, and how the company’s earnings and NAV have developed.

Reho’s semi-annual report (available here) reveals a few major changes in the company’s assets and operations. First, Singer Thailand is no longer a Singer Asia subsidiary. In June, Singer Asia sold its 40% stake in Singer Thailand for $44.8 million. In CEO Stephen Goodman’s words,

“The sale reflects the unique circumstances of Singer Thailand: the Company only had a 40% stake compared to the very much larger, majority stakes in the Company’s other operations, and Singer Thailand employs a very different, direct selling business model, as compared to the retail and wholesale business models employed elsewhere.”

Mr. Goodman went on to say there are no plans for any immediate disposition of the company’s remaining subsidiaries, and the use of the proceeds of the Singer Thailand sale is yet to be determined.

The second major revelation is a large writedown in the value of the SVP notes that ReHo holds. These notes have been distressed for a long while and have undergone multiple restructurings. In June, SVP failed to make a full cash interest payment on the notes, and Retail Holdings moved to classify the notes as impaired, writing down their value from $25.9 million to $13 million. This large impairment necessarily took a toll on ReHo’s reported EPS for the half year. I must admit that the degree of the writedown surprised me. I had long valued the notes at less than par, but declaring the notes impaired by a full 50% indicates a great deal more financial difficulty at SVP than I had expected.

Operational results were good. ReHo’s consolidated revenues rose 14.3% year over year in US dollar terms. Retail Holdings’ two largest subsidiaries (via Singer Asia) are Singer Sri Lanka and Singer Bangladesh, and their fortunes moved in opposite directions. Revenues at the Sri Lanka company soared 26% with pre-tax income up 66%. The Bangladesh division struggled with the country’s continued political and economic instability, and revenues declined 7.6%, dashing earnings. Nonetheless, Singer Bangladesh remained profitable. Singer India also turned in a profit, while Singer Pakistan and the newly-established Singer Cambodia lost money.

ReHo’s reported first half EPS was $1.13 compared to $0.73 a year ago, but the figures are hardly comparable due to the SVP notes impairment and the gain on the Singer Thailand sale.

There are two ways to evaluate Retail Holdings NV’s worth: via its assets and via its earnings power. These are, of course, just the two sides of one coin. Still, a separate look at each is useful. Evaluating Retail Holdings from an asset perspective is easy. Retail Holdings owns 54.1% of Singer Asia, which in turn owns five business units in Asia, four of which are traded on local stock exchanges. Additionally, both Retail Holdings and Singer Asia hold unencumbered cash at the company level and Retail Holdings holds high yield bonds, the SVP notes. Neither Retail Holdings nor Singer Asia has any company-level debt.

Here’s a look at ReHo’s current NAV breakdown.




At a current mid-point of $18.63 or so, ReHo shares trade at a 38% discount to NAV. No surprise. This discount has persisted for years in various degrees. Now let’s take a look at the underlying earnings of Retail Holdings’ subsidiaries. The chart below presents trailing twelve months results for the various Singer entities, divided between the profitable and unprofitable segments.


By buying one share of Retail Holdings, you’re purchasing $1.22 in attributable earnings from Singer Asia’s profitable subsidiaries. The losses of the Pakistani and Cambodian subsidiaries can be ignored because they are separate legal entities that Singer Asia is not obligated to support. After backing out the value of the enterprise’s corporate cash, the SVP notes, and the stock market value of the loss-making Pakistani subsidiary, you’re paying a very reasonable multiple for these fast-growing and profitable businesses, Singer Sri Lanka in particular.

As if there weren’t enough tedious explanations in this post already, here’s the breakdown of the components of Retail Holdings’ share price.


Just to emphasize, Retail Holdings’ share price implies a 9.3x earnings multiple on profitable subsidiaries growing at well over 10% annually with no slowdown in sight. The Sri Lankan subsidiary in particular is attractive. The Sri Lankan economy is one of the world’s fastest-growing following the end of the decades long civil war in 2009.

With all that said, one question remains: why? Specifically, why does Retail Holdings NV trade at 62% of NAV and under 10x the earnings of its fast-growing subsidiaries? I don’t think the answer is difficult to find. ReHo’s corporate configuration could hardly be more awkward. What sensible company would be headquartered in a Caribbean tax shelter, operate solely in South-East Asia, and have its stock traded only in the US? On top of that, Retail Holdings’ stock is highly illiquid and the company is not an SEC filer. The cherry on top is repeated broken promises by management to IPO Singer Asia, only to see the IPO process abandoned each time.

I do have some small amount of sympathy for management. It seems that each time the company begins preparing the Asian operations for an IPO, some market or political crisis erupts that torpedoes the IPO market. But the fact remains that Retail Holdings NV is not likely to achieve its full value until an IPO is achieved.

If all Retail Holdings had going for it was the hope of a future convergence to NAV via an IPO of its Asian operations, I would not be interested. There are hundreds of holding companies that trade at a discount to NAV, and many times these discounts persist for decades. But in Retail Holdings’ case, the NAV is growing rapidly and will continue to grow as the Asian subsidiaries grow revenues at 10-15% annually. It doesn’t take long for serious value creation to result at those rates of growth. 9.3x earnings is a silly valuation for companies on this trajectory.

For that reason, I am happy to hold Retail Holdings for as long as its subsidiaries’ values continue to build. The Singer brand remains exceedingly strong, especially in the company’s primary Sri Lanka market. In the mean time, ReHo will continue to pay out most of its free cash flow in annual distributions, with the possibility of special distributions from asset sales, like Singer Thailand.

Alluvial Capital Management, LLC holds shares of Retail Holdings NV for client accounts. Alluvial may buy or sell shares of Retail Holdings NV at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Undervalued Quality – Nathan’s Famous Inc.

Where did the summer go? After quite a long break from the blog, I’m back to talk about the newest stock I’ve been purchasing for Alluvial’s clients: Nathan’s Famous Inc.


Nathan’s will be a familiar name for any New York natives (which I am not, but I know many blog readers are.) Founded in 1916, the company has never deviated from its business of selling hot dogs made with its proprietary blend of spices. These days, the company focuses on franchising and branding revenues. There are around 300 franchised Nathan’s Famous locations around the world, and five company-owned locations. Nathan’s branded hot dogs and other foods can be purchased at many supermarkets and wholesale clubs, and the company sponsors the annual hot dog eating contest at their flagship restaurant on Coney Island.

I’ll go into detail below, but the crux of my thesis rests on a simple assertion: Nathan’s is a premium business, therefore it should command a premium valuation. Nathan’s trades at a very pedestrian valuation. Therefore, Nathan’s is undervalued and is an attractive investment. Just what qualities a “good business” possesses has been explored at length by better investors than I, and I won’t waste words on that topic. Instead, I’ll illustrate the ways in which Nathan’s business characteristics demonstrate its quality.


Nathan’s has a strong history of growth, and there is more to come. Over the last ten fiscal years, Nathan’s revenues grew at 11.5% annually. Nathan’s trailing revenues surpassed $100 million for the first time in the most recent quarter. There is no reason to expect this growth to halt any time soon. At $100 million in revenue, Nathan’s is still a tiny, tiny player and will not run into issues of market saturation for many years. Furthermore, in 2014 the company signed a new product licensing agreement with the world’s largest pork processor, Smithfield. The agreement replaces a previous licensing agreement and provides hugely improved economics for Nathan’s. The new agreement more than doubles the gross sales royalty Nathan’s receives for Nathan’s branded products and features high and increasing minimum annual royalty payments.

Then again, any company can grow. All it requires is a willingness to commit capital, whether through internal investments or external acquisitions. Growth in itself is not inherently good if it requires excessive additional capital. What makes Nathan’s special is its ability to create sustained growth with minimal capital commitment.

Pricing Power/Brand Value

From fiscal 2010 through fiscal 2015, Nathan’s experienced torrid growth and an associated increase in operating income. Revenues rose 95%, from $50.9 million to $99.1 million. Operating income rose more, jumping 135% to $20.0 million from $8.5 million. And what did Nathan’s have to invest to grow operating income by $11.5 million in five years? Very little. Assuming operating cash of 2% of revenues, invested capital increased by just $2.3 million over the stretch.

When a business is able to produce significant profit growth without a corresponding increase in its capital base, it indicates pricing power. Now, investors must distinguish between illusory pricing power that is the result of cyclicality, such as the increased earnings that commodities producers can show when demand growth outstrips supply growth, and authentic pricing power that is the result of brand strength. Seeing as the demand for summertime comfort food remains relatively stable from year to year, it is highly unlikely that Nathan’s results are attributable to some hot dog super-cycle. Rather, Nathan’s strong brand and popular products allow it to command price increases year after year and to achieve better terms on licensing agreements as they come up for renewal.

Operating Leverage and Margin Expansion

Quality businesses find ways to do more with a dollar as they grow, and Nathan’s is no exception. The growing revenue base allows the company to spread its fixed costs over a large base, and the ongoing move into licensing revenues over restaurants sales has resulted in high and higher contributions to the bottom line. Compared to other revenue sources, royalty streams have nearly no associated costs. As a result, Nathan’s operating margins have surpassed 20% and are set to continue their increase. Compared to just five years ago, nearly an additional nickel of every dollar of sales falls to operating income.

Free Cash Flow 

Quality businesses produce copious and consistent free cash flow. Some may reinvest the majority of it into the business in order to further drive growth (above and beyond that which is naturally created by pricing power) but many return most or all cash flow to shareholders. Nathan’s is one of these. In the ten years ended in fiscal 2015, Nathan’s produced total free cash flow of $55 million. Of that $55 million, Nathan’s spent $49.6 million to repurchase shares. How many companies can devote 90% of free cash flow to share buybacks and still triple revenues over the same period? Better yet, the majority of the share repurchases were done in 2008 and 2009, when Nathan’s shares traded at depressed levels. With little need to innovate and minimal capital needs for expansion, Nathan’s appears set to continue returning nearly all cash flow to shareholders in a tax-efficient manner.


I think I’ve made a case for Nathan’s as a “premium” business. There’s more I could talk about, like the company’s astronomical returns on capital and its highly incentivized insiders, but let’s move on to valuation. What is the proper price for an “average” business? It depends on a number of things like interest rates, capital structure, industry growth rates, and margins. But in general, I think the average publicly-traded business is worth at least 10x operating income, assuming a normal economic growth outlook. I usually think I’m getting a good deal if I can pay 8x or less. Premium businesses, on the other hand, can and should command a premium valuation. I don’t hesitate to pay 12, 14, or even 15 times operating income for a business that can truly produce excellent growth with modest investment, while increasing its margins at the same time. I find that the market systematically undervalues these rare companies.

The market currently values Nathan’s at just a hair over 10x adjusted trailing operating income. Before getting further into that, let’s take a look at how the market values Nathan’s competitors. I’ve ranked the chart by historical revenue growth. The calculations are my own.


I don’t mean to say that all these business are directly comparable to Nathan’s. In fact, most are traditional restaurant operators, not licensors. Rather, I provide this chart simply to point out that despite superior growth, margins, and asset utilization, Nathan’s valuation is the lowest I can find among American restaurant companies. Of the companies included in the chart, DineEquity is the most similar to Nathan’s. Despite actually shrinking by 14.3% annually and becoming more asset-intensive along the way, DineEquity trades at a 39% valuation premium to Nathan’s.

So why does Nathan’s trade at this large discount to its peers, most of which are distinctly less attractive from a business perspective? I believe the biggest reason is the large leveraged dividend recap that Nathan’s just did. In March, Nathan’s took on $135 million in senior secured debt at 10%, due in 2020. Nathan’s used the proceeds of the debt offering to pay a $25 per share dividend. Since the dividend was paid out, Nathan’s shares have fallen 36%. Post-transaction, Nathan’s finds itself with very high headline leverage, and also set to see its net income drop substantially year-over-year, neither of which most investors like to see. The $135 million in debt will reduce annual net income by almost $1.80, and now the company appears to have EBIT/cash interest expense coverage of just 1.5x.

To a casual observer, Nathan’s may now appear leveraged to the hilt, with deeply impaired earnings power. However, things are not  as they seem. Despite its large debt load, Nathan’s has $60 million in cash and securities on its balance sheet. The company also has well over $200 million in guaranteed cash flows it will receive between now and 2032, and will probably receive a great deal more. The licensing agreement with Smithfield specifies minimum annual royalties of $10 million in the first year of the contract, growing to $17 million by the last year. Simply put, Nathan’s risk of encountering financial difficulties due to its leverage is practically zero.

I also expect Nathan’s earnings power to be restored in short order. Powered by the new licensing agreement, I expect the company’s growth to continue with an associated gradual increase in operating margins. Earnings rise quickly as leveraged firms grow. Nathan’s interest expense, while high, is fixed, and incremental earnings will flow to equity owners.

So what do I think Nathan’s is worth? It’s hard to say, exactly, because much depends on how successful the company is in increasing its royalty revenues, and how much of that $60 million sitting on the balance sheet is used to repurchase stock. But I do expect Nathan’s to continue to grow its operating income at a double digit rate, and that will quickly result in an increased business value. Sooner or later the market will realize the dividend recap hasn’t permanently crushed Nathan’s earnings power. I expect substantial appreciation from Nathan’s Famous shares in the coming years.

Alluvial Capital Management, LLC holds shares of Nathan’s Famous, Inc. for client accounts. Alluvial may buy or sell shares of Nathan’s Famous, Inc. at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.