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http://otcadventures.com/?p=1636

Undervalued Quality – Nathan’s Famous Inc.

by otcadventures

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.

 

otcadventures | September 4, 2015 at 2:08 pm | Categories: Uncategorized | URL: http://wp.me/p1wO4P-qo

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Jesus they've done well. Going back to the 90's, it doesn't look like they did that well (stock price, not the financials, i'm being lazy) so maybe this is tied to the success of their hotdog eating contest?

 

edit: Apparently, they consider the hot dog eating contest to be their most important brand advertising. So, apparently its been a gold mine.

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Arguing the equity is undervalued basically concedes that management made a mistake issuing the senior notes at such a high rate. Why else should the equity trade at a lower yield than the debt? They issued the notes at a small discount, so the yield is actually higher than 10%.

 

Does anyone know if that bond trades and if so at what price?

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Arguing the equity is undervalued basically concedes that management made a mistake issuing the senior notes at such a high rate. Why else should the equity trade at a lower yield than the debt? They issued the notes at a small discount, so the yield is actually higher than 10%.

 

Does anyone know if that bond trades and if so at what price?

1. So the rate is high,

2. They raised debt to pay a divi of which Howard Lorber the largest shareholder/insider was a major beneficiary, and now

3. Howard Lorber sold almost 20% of his stake.

4. The lead independent director is also selling.

 

Granted Lorber is 66, but he is increasing his stakes in other companies.

I think something is up.

 

P.S. I don't think that bond trades.

 

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ISIN is US632347AA83, don't know where could you trade it though or what the current price is. Anyone got a clue why they issued the debt to pay that dividend?

Ah, thanks for that.

$135m 10% 2020 bond issued 3/15. Issued at 100. Early call 9/17

Coupon x2

Current price/yield 105.87/8.4%

Has Collateral cover

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Arguing the equity is undervalued basically concedes that management made a mistake issuing the senior notes at such a high rate. Why else should the equity trade at a lower yield than the debt? They issued the notes at a small discount, so the yield is actually higher than 10%.

 

Does anyone know if that bond trades and if so at what price?

1. So the rate is high,

2. They raised debt to pay a divi of which Howard Lorber the largest shareholder/insider was a major beneficiary, and now

3. Howard Lorber sold almost 20% of his stake.

4. The lead independent director is also selling.

 

Granted Lorber is 66, but he is increasing his stakes in other companies.

I think something is up.

 

P.S. I don't think that bond trades.

 

I see Steel Partners also sold out. The above was probably their idea all along.

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I don't like the levered recap either but in its defense, there are substantial tax advantages. Something like 60% of the dividend was not taxable to share holders  and was paid for essentially by future earnings  that have been locked in.  Given that, I am not sure that it matters quite as much that the rate on the debt is high.  They were probably pretty motivated to get it done.

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A first look at the 10-k Shows that most of the money is made on the royalties. The franchise is at best marginal or break even. Overall this reminds me of see's Candy were the business franchise is only powerful in it regional niche, expansion outside of it's region is unproductive method of capital allocation. Growing SG&A being covered up by more profitable contracts with sub par management and sub par capital allocation.  At current price the stock is trading at fair to 20 to 30% discount with reinvestment risk and management risk. I am uncertain if brand can maintain its share of mind and doesn't  get watered down over time since more money is coming from royalties than the main operating business.

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