Description

Overview –

Despite a run up on the heels of a recent Barron’s article, Nathan’s Famous still trades at a healthy discount to intrinsic value, which I peg at somewhere around $90/share and growing.  At today’s price, investors are still paying below fair value for the company’s product licensing business, which comprises an exclusive 18-year license for Smithfield Foods to manufacture and distribute Nathan’s Famous products throughout the U.S. retail channel (supermarkets, groceries, club stores), and getting everything else –

1) Branded Product Program – provides hot-dog products to other restaurant chains, movie theaters, sports stadiums, casinos, airports, gas stations, etc. ($58m in sales, $10m in EBITDA)

2) Franchise restaurant operations (279 units, $75m in sales and $3.3m in traditional royalties)

3) Company-owned restaurants (5 units, $15m in sales, >$3m EBIT)

– for free.

While no obvious catalyst is on the horizon to close the value gap, as of today (9/15/17), Nathan’s is be able to refinance its unusually high-cost debt (fixed at 10%) at a decreased premium.  Refinancing at 5%, for example, would add an incremental $1.00/share to earnings (for context, LTM eps was $1.62).

NATH has been written up twice on VIC (in 2010 by finn520 and 2015 by zbeex).  Both write-ups provide good background on the company.  Over the past ten years, Nathan’s has quietly transformed itself from a restaurant operator with minimal franchising into a national consumer-product company and successful franchisor with a triple-digit ROIC.  Nathan’s license and franchise royalties make up roughly 25% of total sales, but over 70% of segment level EBITDA.

With no sell-side coverage and a sub-$300m market cap with an even smaller float (33% of shares owned by insiders), the reasons for mispricing are clear.

Business Model –

Branded Product Program –

Nathan’s Branded Product Program (BPP) segment sells hot-dogs directly to foodservice operators at a variety of venues (national restaurant chains, movie theater chains, casino hotels, convenience store chains, and sports arenas, etc.).  Production of these hot-dogs is outsourced and the foodservice operators are granted a limited use of the Nathan’s Famous trademark, as well as Nathan’s point of purchase materials.  This segment represents 58% of total sales.

Company-owned restaurants –

Nathan’s operates five company-owned units, including the iconic, original Coney Island restaurant opened over 100 years ago.  These five restaurants make up 15% of sales.

Franchised restaurants –

Nathan’s franchise system includes 279 restaurants operating in 19 states and 12 foreign countries.  Franchisees pay Nathan’s a standard $30k one-time franchise fee, 5.5% of restaurant sales, and commit to spending up to 2% of sales on advertising.  While the overall number of franchised units has not grown over the past three years, I believe that is more a function of other growth opportunities that management has given priority to.  With only 200 franchised units in the U.S. (over half of which are in NY/NJ), I believe there is ample room for expansion.  I note that Nathan’s did see growth in the net number of franchised units fiscal 2017 and 10 additional units opened during Q1 of fiscal 2018.  Franchise royalties represent 5% of total sales.

Product License –

In March 2014, Nathan’s signed a new license agreement with a subsidiary of Smithfield Foods.  This agreement granted Smithfield the exclusive right to manufacture, market, and distribute hot-dog products under the Nathan's Famous name.  The agreement is in effect for 18 years and Smithfield is obligated to pay Nathan's an exceptionally high 10.8% of annual sales in royalties (typical industry royalty rates are mid-single digits).  Such a high royalty rate underscores the perceived strength of the Nathan's Famous brand, as well as its underpenetration in the grocery channel.

This segment, which accounts for only 21% of total sales but 77% of operating profit, has become the crown jewel of Nathan's and I believe is worth more than the current market cap today.  The agreement with Smithfield solidified NATH's transition to a national consumer product company, with the risk and funding requirements associated with such an endeavor borne entirely by Smithfield.

This model, which requires minimal capital outlay from Nathan’s to grow, has combined with the growth of Nathan's franchise business to create an exceptionally high ROIC profile for the company:

Management / Capital Allocation -

Howard Lorber (of Vector Group / Douglas Elliman fame) is the chairman of the board.  10 years ago he installed Eric Gatoff as CEO, and the two embarked on a plan to capitalize on the untapped brand equity of the Nathan's Famous brand by shifting to a more capital light business model.  Over the past 10 years, management has successfully made the pivot, massively increased the ROIC profile of the business, and returned a significant amount of capital to shareholders by paying a $25 special dividend and repurchasing a third of the company’s shares.

Even Lorber's penchant for excessive compensation seems to have been held somewhat in check here.  He pays himself a flat $600k/year and there are no excessive option grants to speak of.

2015 Dividend Recap / Refinancing Opportunity –

In 2015 management raised $135m to do a dividend recap.  The market reacted negatively to the deal because of the unusually high interest rate attached to the debt (10%).  Management was expecting a much lower rate and did not want to pull the deal at the last minute, as much of the dividend was being treated as a return of capital and therefore not taxable (insiders own 33% of the company).  The bonds quickly began trading at a premium and have done so ever since, as far as I know.

As of today (9/15/17), Nathan’s is able to refinance this expensive debt at a decreased premium.  Even a marginal reduction in the interest rate has a material impact on EPS:

Valuation -

I think a sum-of-the-parts makes the most sense given the different growth / margin profiles of each part of the business.

BPP

BOBE is a good comp for this business.  After the sale of the Bob Evans Restaurants business to Golden Gate earlier this year, BOBE’s entire business now involves the distribution of Bob Evans branded pork sausage and other frozen foods items to the grocery channel.  Note that BOBE’s projected topline growth of >20% in 2018 reflects a sizeable acquisition they closed a few months ago.  Organic topline growth is actually low-single-digits.  Nathan’s BPP business grew 9.2% y/y in the most recent quarter.  BOBE trades at 14x forward EBITDA, but I apply a 15% discount to this multiple to account for Nathan’s illiquidity and for the sake of conservatism.

Franchised restaurants

Pure-play franchisors like QSR and DPZ trade around between 15-20x EBITDA, but these larger companies have saturated much of their addressable market and lack the expansion opportunities in front of Nathan's.  As a result, I ascribe the low end of this multiple range to Nathan’s franchised restaurants business.

Company-owned restaurants

These generate $3m in EBITDA and represent a small piece of the overall value.  I’m not sure what the appropriate multiple is for five company-owned restaurants, but 7x does not feel overly generous.  All five restaurants are located in the NY area and have been around for a long time.

License products

At EBITDA flow through of 99+% and expected continued growth, a DPZ multiple seems reasonable.  Again, the license products segment is a growing royalty stream backed by a strong distribution partner with national scale, a broad distribution platform, and deep retail relationships.  This partnership is locked in through 2032 and the growth generated over the next 15 years requires no incremental capital from Nathan’s.  Still, I apply a 20% discount to reflect illiquidity and the fact that the Nathan’s Famous brand is still unknown in many parts of the country.

Putting it all together:

On a FCF basis, Nathan’s trades at a mid-single digit yield pro forma for a 5% debt refinancing.  I acknowledge this does not look cheap, but I believe it is justified given the quality of the business.

Nathan’s Famous ultimately belongs inside a larger CPG company, and I expect that is Lorber’s endgame.  The recent Hillshire and Applegate transactions support a value of close to $100/share for Nathan’s should management decide to explore a sale.

In the meantime, Nathan’s will continue to generate fantastic returns on invested capital and either deploy cash into additional high-ROIC opportunities or return it to shareholders.  What's nice about companies like this is that with such a high ROIC and savvy capital allocators at the helm, it is very hard to lose money over time unless you massively overpay.

Risks -

- Nathan's is exposed to fluctuations in the cost of beef, which can have an outsized impact on margins, as seen in Q1 2018, when blizzards in the Midwest tightened meat supplies.  Beef prices have declined since the highs in May and June.

- As with all food companies, a product recall is always a risk factor.  Smithfield had to recall 200,000 lbs of hot-dogs earlier this year, but no illnesses or injuries were reported and I do not believe the value of the Nathan’s Famous brand was impaired in any way.

- Health trends are clearly moving away from processed meats.

Disclaimer: The views expressed in this note are only the opinion of the author.  This report is not a recommendation to purchase or sell any securities mentioned.  The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein.  Readers should conduct their own verification of any information or analyses contained in this report.  The author undertakes no obligation to update this report based on any future events or information.

Catalyst

- Refinancing of expensive debt

- Margin boost off of declining beef prices

- Continued growth of licensing / franchise segments

- Additional return of capital to shareholders

- Eventual sale to larger CPG company