In 2007, Nathan's Famous Hot Dogs (NASDAQ:NATH) began using its cash flow that had been growing at a rate of 11% annually to begin a significant stock buyback program. Over the past seven years, the change in share count has been significant: The company had 6.18 million shares outstanding in 2007, bought back their stock throughout the recession to take the shares outstanding to 5.08 million by 2010, and further reducing the share count to the point that there are now only 4.50 million shares outstanding (in other words, 27% of the shares that existed in 2007 no longer exist today).
What is most impressive about Nathan's buyback is this: The balance sheet looks excellent, with the implication being that Nathan's didn't just load up on debt to reduce its share count. The company has no debt on its books, no leases outstanding (either capitalized or uncapitalized), no pension liability, and no preferred stock. The company simply has 57.6 million in total assets, and 8.5 million in current liabilities, for current assets in the $49 million-$50 million range. Since initiating the buyback program from its free cash flow, Nathan's has returned 19.99% annually so that a $10,000 investment in 2007 would now be worth $37,160 today.
The company's earnings and sales have grown at a significant pace over the past five years, with sales increasing by 15.5% annually and earnings growing by 12.5% annually. The impetus for Nathan's profit growth has been the blend of (1) using free cash flow from its buyback program to remove stock and increase earnings per share, mixed with (2) new royalty arrangements that allow Nathan's to charge around 10% instead of slightly under 5% as part of its distributorship arrangements.
The hard question for prospective investors is determining the appropriate price to buy for Nathan's stock. In 2006-2008, the P/E ratio hovered between 16.6 and 21.8. In 2009 through 2011, the company's valuation shifted between 14.6x and 16.4x profits. The P/E ratio increased to 19x profits in 2012, before spiking towards 36x profits in 2013. Today, Nathan's valuation sits at 28x profits.
Although the valuation placed on the stock has significantly increased, so too have the company's fundamentals. For most of the early part of the 2000s, Nathan's was not buying back much stock, and was not growing profits at a 10% clip despite not paying out a dividend and keeping all of its cash profits to be reinvested into future growth opportunities. The Nathan's company of today that charges twice as high distributorship rates is achieving 14% returns on capital (compared to its historical average of 11%), and has retired a significant amount of stock, which boosts earnings per share in a way that did not exist before 2007.
Going forward, I would look for expected growth in the 15% range over the course of 2015 as its new agreement with John Morrell & Company takes full effect in the earnings figures. The normalized quarterly earnings that take into account the new distribution agreements actually improved 21.9% in the quarterly figures reported on August 5th, and the reason why I would expect earnings per share growth to drift from 21% towards 15% is because that would fully reflect the sales growth per share in conjunction with the new licensing agreement.
For those reasons, it's hard to say that the stock is significantly overvalued, because the business performance has improved so significantly that the stock deserves a higher valuation. It's not as simple as saying "Oh, the stock will come down to the 15x-20x earnings valuation range, like it did for most of the early part of the 2000s" because the company is fundamentally better than it used to be. Organic profits are growing faster, and there's a significant buyback program that exists now that wasn't in place over eight years ago (and the low valuation during the first couple years of the buyback program seem to represent a lag in the investor community in catching on to what Nathan's was doing). The 28x earnings price tag looks high at the superficial level when compared to historical norms, but you need to reflect significant improvements in the company's business operations into your analysis.
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