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.

Nathans-Logo

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.

Growth

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.

Valuation

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.

Capture

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.

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15 Responses to Undervalued Quality – Nathan’s Famous Inc.

  1. Nelson says:

    You had me excited right until the special dividend transaction. Am I missing something, or is it as boneheaded as I think it is? And the interest rate is terrible.

    • otcadventures says:

      Not so boneheaded, I don’t think. It was a very tax efficient means of returning capital. Only $10 of the dividend was taxable, the rest was a return of capital. Sure, the 10% coupon looks very high, but again, it’s not all as it seems. Nathan’s pays very high taxes (41%!) because of its New York location. So the debt only costs 5.9% after tax. And the debt leaves Nathan’s with plenty of firepower for share repurchases. Excess cash and securities is a whopping 40% of market cap, and I expect most of that to be returned to shareholders over time.

      • Anon says:

        The trailing yield was about 6.9% before the recap, so at 5.9% after tax I think it is a value-add transaction. Would have to look at transaction costs to be sure. Still it makes you wonder why the couldn’t get a better rate. I mean, even the Greek government can get 9% now.

        • Anon says:

          On second thought, with the corresponding increase in cost of equity (justified or not) they are worse off. Like you mentioned we will have to see if they can support the stock prices with buybacks.

        • otcadventures says:

          It is weird that the rate was so high, but then again, the headline leverage is huge. The debt issue was around 5.7x trailing EBITDA, and for many investors that kind of ratio says RISKY, details be bothered. Nevermind the contracted revenue or gigantic cash reserves.

  2. Nat Stewart says:

    The fact that the special dividend was perceived as “completely boneheaded” might prove to be part of it’s genius. Watch buyback activity over the next 2-3 quarters and we will get a good clue.

  3. William Knecht says:

    Why should the equity have a lower yield than the bonds? They issued the bonds at a slight discount so the yield is actually higher than 10%.

    • otcadventures says:

      In the long term, properly-priced equity should yield more than company bonds, it’s true. But the “yield” of equity can grow. Company bonds will never increase their coupon, but a growing company’s equity yield can grow at double digit rates for years on end if the company has growth potential and is properly managed. That is what I am counting on with Nathan’s: a rapidly increasing equity yield that results from rapid growth.

  4. Don says:

    Dave,
    A bit off topic, but in regards to Cross-Harbour holdings, what do you think of the HK$116mm Yacht owned by the company and the convoluted holding structure?
    Regards,
    Don

    • otcadventures says:

      Well, I wish they didn’t own it. But then again, I don’t invest in Hong Kong for the superior corporate governance, and the multiple at which I value firms like these reflects that.

  5. Eridon says:

    This article is fascinating. Is great to see you come back with a truly exceptional idea.

  6. Len Rosenthal says:

    One thing that was not mentioned is whether the bond indenture for the bonds restricts share repurchases. I have not checked this, so I don’t know if these restrictions exist. Any comments.

    • otcadventures says:

      I should have mentioned that in the blog post. Under the indenture, Nathan’s may repurchase a maximum of $28.5 million in stock, equal to about 850,000 shares, or 19% of the outstanding stock. This is equal to about one third of the shares not owned by management or GAMCO.

  7. pietje says:

    Interesting idea. I wonder why they borrowed $130m, seems a bit much. They now have ~ $30m in excess cash that they can’t use for buybacks due to the indenture.

  8. budi says:

    Hi interesting post. Just one question on their financials.

    I see that revenue has grown well over the years, and like you pointed out, net profit margin has been expanding as well. However, gross profit margin has actually declined from around 48% in 2005 to around 37% in 2015.

    How do I interpret that? Intuitively, for a business with strong pricing power, an increase in cost of materials should be passed through to end clients, indicating a stable gross profit margin. In this case, it appears that the increase in cost of raw materials is partly absorbed by the company (and partly passed through), and the increase in net profit margin is more attributable to the savings in opex ( revenue tripled in the past 3 years, whereas opex increased only by around 50% or so), which means an improvement in business efficiency, as opposed to strong pricing power.

    What’s your thought?

    Thanks

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