Nathan’s Famous – 45% Upside To Fair Value
|July 16, 2015||Posted by Nat Stewart under Uncategorized||
- Massive, expensive dividend recap (10% interest rate, 33% of prior market cap) has left investors confused and highly pessimistic.
- A high quality, high return on invested capital (78% pre-tax) licensing and franchising business disguised as a simple hot dog maker and restaurant.
- Today’s price fully discounts the next five years’ worth of net (after tax) interest payments relative to the price prior to the dividend recapitalization or the company’s fair value.
- 45% upside to fair value, 14% upside to conservative value, and 90% upside in a takeover situation.
Nathan’s Famous is a high quality licensing and franchising business disguised as a simple hot dog manufacturer and restaurant operator. All are encouraged to visit the company’s investor site here and view the summary and recent annual report (The CEO’s annual letter is well done, in my opinion).
The Company’s share price has recently taken a hit do to confusion surrounding a large, high cost (10% interest rate) dividend recapitalization that occurred earlier this year. This event has left investors in a seriously negative state of mind.
Recent article headlines at Seeking Alpha include the following:
-Nathan’s Famous shareholders are about to get barbecued
-Nathan’s Famous: It’s officially time to get out fast
-Nathan’s Famous: A sell from both a corporate finance and common sense perspective
-Why you should avoid Nathan’s Famous
-Nathan’s Famous’ shares getting pricy
These authors should be credited and congratulated for their prescient calls – the stock has declined substantially since these articles were written.
A high return on invested capital business
Nathan’s Famous is a business in the mold of Warren Buffett’s famous See’s Candy investment. The key feature of See’s Candy that made it unusually valuable was its high return on invested capital. This quality allowed the business to not only maintain its assets and fund growth, but also pay a massive amount in dividends to Berkshire Hathaway in the years since it was acquired.
By this measure, Nathan’s Famous is exceptional. My calculations (which conservatively adds back in accumulated depreciation, among other adjustments) suggest that the business earns a 78% pre-tax return on invested capital, or about a 50% return after tax.
Note, the $135M in debt resulting from the special dividend did not impact the capital invested in the business, as it was either paid out to shareholders or added to cash on hand.
The key to this high return on investment is the substantial economic goodwill associated with the Nathan’s Famous brand – an asset that has been building over the company’s storied 99 year history. Indeed, when I began researching this company, I was surprised by the number of people I discussed it with who have a deep emotional connection to the brand do to visiting the restaurants and eating the hotdogs as a child. One investor even suggested to me that if run properly, the franchise business alone should have billion dollar potential.
In the case of Nathan’s Famous, we have a way to quantify a portion of this “economic goodwill” fairly directly. This is because a substantial portion of the company’s economic profit derives from its licensing business with John Morrell Food Group, a division of Smithfield Foods. Nathan’s Famous earns a 10.8% royalty on the sale of the Nathan’s Famous products that John Morrell Food Group distributes, with a minimum payment of $10M per year. This minimum value escalates over the next 18 years, the term of the agreement.
Last year, Nathan’s Famous earned $14.37M as a result of this deal (which was initiated in 2014). As the royalty payment is a fixed percent of sales, it is nearly 100% contribution margin, and as such is extremely valuable.
Capitalizing this revenue stream at a 15X multiple puts the value of this one business segment at close to $220M. Indeed, intangible assets (vs. the mere 1.3M of intangible assets listed on the balance sheet) is truly the key to understanding this company’s value.
Prior to the dividend recapitalization, the stock had been doing very well. The new licensing deal with John Morrell Food group increased the royalty rate while expanding potential distribution channels. Largely as a result of this new agreement, licensing royalties jumped from $8,513 in 2014 to $18,011 in 2015, or up 112%, while operating income increased to $19,958 vs. $10,921, a gain of 83%.
While I believe that both the product licensing and franchising businesses contain latent, untapped growth potential, I am going to keep my valuation case linear and straight-forward in order to add a measure of conservatism. I will be using fiscal year 2015 (ended March 29th) numbers and will not attempt to extrapolate or estimate future results.
Valuation: Franchise and licensing business:
Total Royalty Revenue: 18M
Franchise Revenue: 5.6M
Overhead: (70% of total) 8.5M
The Multiple is based on a peer group that includes Popeye’s, Dunkin Brands, and Papa Johns. The average of this group is 19.5, so I believe that my 15X multiple adds a significant measure of conservatism and is reasonable.
Valuation: Restaurant Business
Overhead (30% of total) 3.66M
Summing these two values gives us a total business value of $281M.
Next, let’s break out the equity value
-Enterprise Value: 281M
-Debt: – 135M
-Cash: + 51M
-Securities: + 7
-Net Debt: 77M
-Fair value Equity: 204M
-Implied Price: 44.35 (4,604,410 shares):
-Current Price: 30.50
-Appreciation to fair value: 45%
Conservative case: Equity value less the next 5 years of undiscounted total net interest payments
-Fair value Equity: 204M
-Next five years (net) interest payments: – $43.875M
-Fair value of Equity – interest payments: $161M
-Implied Price: 35 (4,604,410 shares):
-Current Price: 30.5
-Conservative Appreciation to fair value: 14%
Note – total overhead is 12.2M. I assigned 70% of this value to the licensing business and capitalized it at that business’s multiple, and 30% to the restaurant capitalized at that business’s multiple.
Conservative Case: Using the market price prior to the dividend recap as a reference point
-Price prior to dividend recap: 73.5
-Next five years of net (factoring in the tax shield effect) interest payments per share: -9.53
-Adjusted price: 38.97
-Current price 30.5
-Appreciation to adjusted price: 28%
Potential acquisition value is far higher
I believe that this company has substantial excess overhead that could be removed if it was acquired by a larger company. Using the same framework as above, if 50% of the overhead applied to the licensing/franchise business could be taken out, the enterprise value of that segment would jump to over 300M, which would imply a $58 share price, or 90% upside relative to the current price (base case scenario). This demonstrates that the high margin royalty/franchise business creates a great deal of optionality in an acquisition situation.
Why did the company finance such a large special dividend given the high cost?
I believe that this is the question that most concerns investors. Effectively, they pulled forward and distributed the value of the new John Morrell and Co. licensing agreement. While unusual for a public company, this type of tactic is standard practice in the private equity industry.
The problem is that the cost (A 10% interest rate) seems to have been very high, particularly relative to interest rates seen on other public-market recapitalization deals (where the motive is often to take advantage of low interest rates).
If “pulling forward cash” was the company’s only motive, why did they leave so much cash and securities on the balance sheet? Consider, had they used 50M of their excess cash and securities instead of 50M in debt, pre-tax income would be (going forward) $5M higher per year.
I see two potential options
First, the note buyers seem to have received a very good deal. Some investors have expressed to me that they are concerned that the deal was structured to benefit the note buyers at the common shareholder’s expense. This is troubling, as the company’s executives and board of directors should be working for the benefit of equity owners. I attempted to contact the company in order to better understand their logic, but was not able to get through.
This the lack of clarity has left me somewhat concerned about the company’s corporate governance standards.
Second, and more favorably, the pending drop in net income and the higher debt load have led to the company’s shares becoming significantly undervalued. With $58M in cash and securities on hand (vs. a market cap of only 140M), they are now in a very good position to buy back a significant amount stock.
The company is no stranger to buybacks. From the recent annual report:
Since the commencement of the Company’s stock buyback program in September 2001 through March 29, 2015, Nathan’s has purchased a total of 4,647,687 shares of common stock at a cost of approximately $56,800,000 under all of its stock repurchase programs and the modified dutch tender offer, which includes the shares purchased during the fiscal year ended March 29, 2015.
The company currently has 251,000 shares remaining to be repurchased on its current plan – It will be something worth tracking at the next quarterly report.
With 32% of the stock owned by insiders as of the last proxy statement and 20% owned by long time investor, former CEO, and Executive Chairman of the Board Howard Lorber, I find it very unlikely that the dividend recapitalization will prove to be at the long term expense of equity owners.
The fear that resulted from the dividend recapitalization has provided us with an opportunity to pick up a high quality “See’s Candy” business at a significant discount. I see 45% upside to fair value.