Subject: Nathan's Famous Inc. (NATH)
Share Price: $16.50
Intrinsic Value: $22
Buy Below: $17
Business Description and Background:
Nathan’s Famous began as a nickel hot dog stand in Coney Island in 1916 and has become a much-loved New York institution now available throughout the United States and overseas.
Through innovative points-of-distribution strategies, Nathan’s products are marketed within its restaurant system and throughout a broad spectrum of other food-service and retail environments. Our Branded Product Program provides for the sale of Nathan’s signature products in over 7,700 food-service locations nationwide. Nathan’s products are also featured in over 7,000 supermarkets and club stores throughout the United States and are being marketed on television by QVC .
NATH is a tiny company that owns one of the most well-known consumer staple brands in the Northeast, and is the #1 selling premium hot dog in the U.S.. NATH is flush with cash, trading at low valuations, and management is buying back shares. We believe this is a recipe for success and feel the shares warrant a premium to its current price.
For a number of years NATH has been undergoing a transformation from a restaurant franchising business to a multi-national licensing company. It has divested a number of underperforming businesses, such as Kenny Rogers Roasters in 2009 and Miami Subs in 2007, and has focused efforts on growing its brand by leveraging off the tremendous success of its July 4th International Hot Dog Eating Contest, which now receives national TV coverage on outlets including ESPN.
Product-licensing revenue overtook restaurant operations in 2009 and looks poised to continue its strong pace of growth over the coming years. Yet NATH is still classified as a restaurant in many databases, and is often compared to other lower-margin restaurant companies. Once it becomes clear that NATH operates in the high-margin, consumer staples/services industry, NATH shares should be re-valued to the upside.
The hot dog business may not be flashy, but the durability of the industry has been stellar. During the worst economic recession since the Great Depression, NATH's sales increased by over 4%, with increases in all its divisions (branded products, licensing, and restaurant franchising).
Nathan's Famous' brand, scale, and size in the hot dog market enable it to have a wide economic moat. NATH is highly profitable, with gross margins averaging +40% over the past four years. Pre-tax return on invested capital (ROIC) has averaged about 17 percent. So for every dollar NATH reinvests in itself, it earns about 17 cents ... not bad for a mature business in a sleepy industry. It's quite astonishing that such a high-profile brand and profitable company is only covered by one sell-side analyst. Their loss, our gain.
NATH has been able to increase revenue and free-cash-flow (FCF) by 8% and 13% annualized respectively over the past five years. Sales-per-employee has increased 6% annualized over this same timeframe, which coincides with NATH's business changing from a lower-margin restaurant business to a higher-margin licensee business. This shows management's long-term objectives for the business are playing out nicely.
NATH has pricing power due to its strong brand. In 2005 and in 2008, NATH was able to pass off increased beef prices to consumers in the form of price increases. NATH experienced increased revenue growth and margins in both of those years.
NATH's fortress-like balance sheet ($35mm in cash, $0mm in debt) gives management plenty of flexibility to get creative in increasing shareholder value. Management has been buying back shares at what we believe are attractive valuations, which should add to shareholder value over time. The share count has been reduced from 6.5mm to 5.7mm diluted shares over the past three years. NATH has ample cash to continue to repurchase shares or possibly pay a dividend. We would prefer management stick with shares repurchases since the shares are inexpensive.
Management and Stewardship:
NATH is managed by Eric Gatoff, CEO and Wayne Norbitz, president and COO. Gatoff became CEO of NATH in 2007, having been VP and corporate counsel from October 2003. Prior to his work with NATH, he was a partner at Grubman, Indursky & Schindler, P.C., a law firm specializing in intellectual property, media, and entertainment law. Norbitz has been president since 1989 and has worked in various capacities at NATH since 1975. Together they own approximately 3.5% of shares outstanding.
Both seem capable of running NATH for the benefit of shareholders. Even the acquisition of Kenny Rogers was a fortuitous one. It was purchased out of bankruptcy and the brand was leveraged to introduce chicken sandwiches. Kenny Rogers was later sold at a profit.
NATH just received a ruling in the pending litigation between it and its licensee, SMG, Inc.; subsequently, we are estimating that $4.5mm in cash will be paid out over the next year. Nathan’s has been engaged in litigation with SMG regarding the license agreement between them. The main issue in the case is whether Nathan’s is entitled to terminate the license agreement early. On December 17, 2010, the Court ruled that Nathan’s is not entitled to do so. The license agreement is scheduled to terminate on March 1, 2014. We should assume that after 2014, NATH will be able to enter into a more favorable agreement with SMG or another potential licensee. Here is how the capital structure looks after deducting cash from the legal proceedings:
Net Cash ($34.4)
Market Cap ($91.0)
Enterprise Value ($56.7)
NATH shares are inexpensive on a Trailing-Twelve-Month (TTM) basis when adjusted for cash on the balance sheet and non-cash expenses.
P/E (TTM) 24.9x
P/S (TTM) 1.7x
P/FCF (TTM) 15.4x
EV/FCF, ex int (TTM) 9.6x
EV/FCF, ex int (YO) 9.6x
On a normalized FCF basis using $5mm, NATH shares have an FCF yield of 8.7% when cash is deducted. Take into account a 2% annualized deduction of shares through repurchases and a single digit FCF growth rate, and one can see how an investment in NATH can easily earn a low-teens rate of return over the next couple of years.
Sales for NATH could reach $67mm and $78mm in five and 10 years, respectively, up from $54mm over the past 12 months. With a p/s multiple of 1.7, we believe the market-cap of NATH could be around $114 in five years and $140 in 10, using a 1.9 p/s ratio. We think it is reasonable to expect NATH to command a higher p/s multiple as it recognizes its potential as a high-margin business.
Based on our discounted cash flow analysis, NATH shares are worth $21, or 31% more than NATH's current share price.
YEAR LOW MIDDLE HIGH
1 2.0% 3.0% 4.0%
2 3.0% 4.0% 5.0%
3 3.0% 4.0% 5.0%
4 3.0% 4.0% 5.0%
5 2.0% 3.0% 4.0%
6 1.0% 2.0% 3.0%
7 1.0% 1.5% 2.0%
8 0.8% 1.0% 1.3%
11.0% 11.0% 11.0%
-1.6% -2.0% -2.6%
Total per share:
$19.11 $20.99 $23.65
Multiple to YO FCF:
18.4x 20.2x 22.8x
Price % of IV:
0.8x 0.8x 0.7x
19% 31% 48%
19% 31% 48%
Overall we think shares of NATH are easily worth $22, a substantial premium to today's current market price of $16.
To achieve our targeted upside of 30%, we would recommend purchasing the shares at, or below, $17.
Variant View and Risks:
NATH is in a highly competitive market where competitors could lower costs, drive down prices, and lower profits for NATH.
NATH is highly exposed to beef prices. Nearly 90% of NATH's food costs consist of beef. It is unclear if NATH will be able to pass along costs to customers in the event of a large price increase.
NATH is exposed to one large supplier of product; the loss of a key supplier may impair management's ability to execute its objectives.
NATH's management team may not use the company's cash in the most shareholder-friendly way.
Sources: Company website, sec.gov, company filings, Yahoo! Finance, Morningstar.com, data provided by EDGAR Online’s I-Metrix Professional, XBRL-enabled application.
Disclosure: I am long NATH.