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Hot Dog, it's Nathan's Famous
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By pencils2
July 18, 2007

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Pencils Fund Purchase: Nathan's Famous (NATH)

Purchase Price: $18.92
Purchase Date: 7/12/07
Commission: $6.95

Business

Nathan's Famous operates and franchises fast food units featuring Nathan's Famous brand all-beef frankfurters, crinkle-cut French-fried potatoes and a variety of other menu offerings. Nathan's began as a hot dog stand in Coney Island in 1916. International master franchise agreements have recently placed Nathan's in Israel and Egypt. Nathan's Branded-Product Program has grown to over 1,400 points of sale. This highly-popular program enables independent foodservice operators to sell Nathan's products with no up-front franchise fees or ongoing royalties at venues such as airports, B&I accounts, hotels, sports arenas, convention centers, colleges, and convenience stores. Nathan's has acquired Kenny Rogers Roasters and Miami Subs (which they recently sold; more on this later), and also owns the rights to co-brand Arthur Treacher's Fish & Chips.

Nathan's combined restaurant system consists of 357 franchised or licensed units and six company-owned units. These stores are located in 22 states and 11 foreign countries. So they actually haven't penetrated the U.S. a whole lot, there is a lot of room for expansion. The Branded-Product program has expanded to 41 states, Washington D.C., and 17 foreign countries. My guess would be that this is a much cheaper way to penetrate new markets, and it also builds up a customer base and is a good way to tell where interest is. Nathan's management has a strategy and is expanding the company quickly but they're actually expanding margins in the process.

Financials

Nathan's has gone unnoticed by Wall Street even while producing strong cash flow, sporting a very healthy balance sheet, and having a good reputation has a brand. For those of you who don't know what Nathan's is - that giant Independence Day hot dog eating contest (with that crazy Japanese dude) is a Nathan's Famous contest with Nathan's hot dogs. There is a lot of business potential with this brand, but the stock is still very cheap even after finally being noticed by some Wall Street folk. But there are still no analysts following the stock. Many executives on the board of directors have been with Nathan's since the 1990's, some have been with the company for 25-30 years. There is a lot of experience here, and they have done a fine job running and expanding the business. Look at how the balance sheet improved in the five quarters leading up to this past September:

          2006-09-24  2006-06-25  2006-03-26  2005-12-25  2005-09-25
Cash         25.14       20.38       19.89       21.22       21.36   
Debt          0.00        0.04        0.04        0.73        0.78 


That is terrific management of cash and debt, it's not something you see often in micro-cap businesses (Nathan's currently has a market cap of $112.6 million). Nathan's has produced cash flow production, margins, pretty much the whole operation has improved for the past few years. Management has done a tremendous job making this an efficient operation, and Wall Street isn't even close to fully noticing it yet. For the past few quarters, I've been taking notes on the results.

2Q 2007 - Reported on November 6, 2006

** Revenue increased 12.6% to $13,124,000, compared to $11,653,000 the previous year
** Branded Product Program sales increased 16.0% to $9,937,000 during the 26 weeks (two quarters) ended September 24, 2006, compared to $8,563,000 the previous year.

** Net income was $1,844,000 or $0.30 per share, compared to $3,108,000 or $0.48 per share from the previous year
** Earnings from continuing operations increased by 14.1% to $1,582,000 or $0.26 per share, compared to $1,387,000 or $0.21 per share the previous year

** Cash flow from operating activities stands at $3.69 million, business fueling growth, non-reliant on the bank. This is up from $0.52 million produced in 1Q 2007
** Cash from investing activities stands at -$4.21 million (from higher investments in equipment), up from -$0.13 million in 1Q 2007

** Cash stands at $25.14 million ($4.258 per share)
** 0 debt

Full release
http://tinyurl.com/2jjlud

3Q 2007 - Reported on February 7, 2007

** Revenue up 11.3% to $10,554,000 from $9,479,000 in 3Q 2006
** Branded Product Program saw sales increase 12.0% to $4,783,000 from $4,269,000 in 3Q 2006
** Revenues from Nathan's other operating profit centers, including company-owned restaurants, restaurant franchising, retail licensing, and sales to its television marketer, increased 12.4% $611,000

** Net income up 37.8% to $1,061,000 ($0.17 per share) from $770,000 ($0.12 per share) in 3Q 2006
** Diluted shares outstanding 6,401,000 from 6,565,000 in 3Q 2006
** This is the 15th consecutive quarter in which Nathan's has posted an increase in quarterly profits YOY

** Nathan's products now distributed in 49 states, D.C., and 13 foreign countries

** Currently operate 361 franchise restaurants and six company-owned units

Full release:
http://tinyurl.com/36nuku

Notes:

Definitely an impressive quarter for Nathan's, net income and sales are strongly growing. It's good to see that the company bought back some shares to keep dilution down, hopefully they can keep it up (that's one of the kickers with Nathan's -- most of the executives hold stock largely through stock options).

4Q 2007 - Reported on June 22, 2007

Net income for the fifty-two weeks ended March 25, 2007 was $5,543,000 or $0.87 per diluted share as compared to $5,677,000 or $0.87 per diluted share for the fifty-two weeks ended March 26, 2006.

Nathan's realized gains of $400,000 and $2,919,000, during the 2007 and 2006 periods, respectively, from the sale of a previously owned vacant parcel of land and adjacent leasehold interest. The effects of these gains, net of tax, were $239,000 or $0.04 per diluted share, during the fifty-two weeks ended March 25, 2007 and $1,785,000 or $0.27 per diluted share, respectively, during the fifty-two weeks ended March 26, 2006.

Earnings from continuing operations increased by 34.2% to $5,208,000 or $0.82 per diluted share for the fifty-two weeks ended March 25, 2007 as compared to $3,881,000 or $0.59 per diluted share for the fifty-two weeks ended March 26, 2006. Total revenue from continuing operations increased by 10.9% to $45,730,000 during the fifty-two weeks ended March 25, 2007 as compared to $41,249,000 during the fifty-two weeks ended March 26, 2006.

Net income for the thirteen weeks ended March 25, 2007 was $1,242,000 or $0.19 per diluted share as compared to $630,000 or $0.10 per diluted share for the thirteen weeks ended March 26, 2006.

Earnings from continuing operations increased by 111.0% to $1,226,000 or $0.19 per diluted share for the thirteen weeks ended March 25, 2007 as compared to $581,000 or $0.09 per diluted share for the thirteen weeks ended March 26, 2006. Total revenue from continuing operations increased by 12.2% to $9,868,000 during the thirteen weeks ended March 25, 2007 as compared to $8,794,000 during the thirteen weeks ended March 26, 2006.


** Currently have $29.72 million in cash
** No debt
** Profit margin 12.42%
** Diluted share count 6,430,000

Full release
http://tinyurl.com/27r29r

On 6/8/07, Nathan's announced they were selling their Miami Subs subsidiary for $3,250,000. $850,000 will be paid now, the remaining $2,400,000 is payable over the next four years.

WESTBURY, N.Y.--(BUSINESS WIRE)--June 8, 2007--Nathan's Famous, Inc., announced today the sale of its subsidiary, Miami Subs Corporation to Miami Subs Capital Partners I, Inc., an investment entity led by Bruce Galloway and Gary Herman. The purchase price was $3,250,000, consisting of $850,000 in cash and the buyer's secured promissory note in the amount of $2,400,000 payable over a four-year term.
http://tinyurl.com/2gpu36

Personally, I think this is a smart move and will benefit the company over the long run. You get some extra cash, but now Nathan's can put more focus on the actual Nathan's brand and not worry about two other subsidiaries. Expanding one brand is hard enough, so I think this will benefit shareholders over the long run. I'm curious to know if this was the reason or one of the reasons for selling Miami Subs, or if it was for something completely different. Is Kenny Rogers Roasters also on the market? In today's buyout paradise, I wouldn't be surprised. Anyway, I like this move and think it will help the company and give management an easier time.

Here is a revenue breakdown for the past three quarters (actually the most recent one is missing, the 4Q 10-Q hasn't been filed yet).

                                  1Q 07         2Q 07         3Q 07
                                 --------      --------      -------- 
Sales                            $9,162        10,229         7,695   
Franchise fees and royalties      1,677         1,756         1,781
License royalties                 1,176           907           844
Interest income                     132           150           180
Investment and other income          97            82            54
----------------------         ---------     --------      --------
Total                            12,244        13,124        10,554 


This info is all from the company's 10-Q filings. Here is the breakdown from the past five fiscal years, although it isn't quite as detailed as the 10-Qs. Each fiscal year ends in late March.

                            2003      2004      2005      2006      2007
                           ------    ------    ------    ------    ------ 
Sales                      22,908    19,664    23,296    29,785    33,425
Franchise fees/royalties    5,977     6,280     6,766     6,785     7,160
License royalties, 
investment/other income     3,164     3,729     4,137     4,679     5,145
----------------------     ------    ------    ------    ------    ------
Total                      32,049    29,673    34,199    41,249    45,730 


Nathan's three main revenue streams are sales from the Branded-Product Program, franchise royalties and fees, and licensing fees. Nathan's only has six company-owned units, the majority of their restaurants are licensed or franchised. This is a less expensive way to expand, but the benefits probably aren't quite as great in the long run. Looking at the 10-K, you can see that restaurant operating expenses have decreased from $4.96 million in fiscal 2003 to $3.19 million in fiscal 2007. As I suspected, this is because they went from having 12 company-owned units in fiscal 2003 to 6 in fiscal 2007. In fiscal 2000 the company owned 32 units. It seems management has gone the route to expand restaurants through franchisees and focus on the Branded-Product Program for the bulk of sales. This increases efficiency within the company (keeps management's primary focus on the B-P Program) as well as margins (lower expenses but still strong sales growth). This switch, from what I can tell, is what has turned the company around. Some companies (like Chipotle) do fine owning all of their units, but some do much better going the franchising route. Going with franchising and focusing on the B-P Program has increased efficiency and turned this into a very profitable and strong cash producing business.

As for future expansion, my guess would be that they will continue franchising restaurants and saturate more of the U.S. market. The B-P Program still has a lot of potential, because it is a relatively new operation. Here are a couple quotes from the 2007 10-K on this operation.

Our revenues are generated primarily from selling products under Nathan's Branded Product Program, and in our Company-owned restaurants.

Over the past six years, we have focused on expanding our Nathan's Branded Product Program; developing our restaurant franchise system by continuing to open new franchised restaurants; expanding our Nathan's branded retail licensing programs; operating our existing Company-owned restaurants; and developing an international franchising program.

http://tinyurl.com/3b7mb4

Valuation

Let's run some future value calculations. Currently the EPS is $0.87. I think Nathan's will easily be able to grow 20% annually for the next three years and sport a P/E of 25. Today the P/E stands at 20.25, and that's with no analysts following the company, very little Wall Street coverage on this fine business. So, I think there is some P/E expansion left, I mean, Nathan's has been reporting amazing earnings growth quarter after quarter. They deserve a P/E higher than 20. If Nathan's can grow the EPS at 20% annually for the next three years and the P/E expands to 25:

.87 * (1.2^3) * 25 = 37.58

A price of $37.58 in three years if that were to happen. And I think these are pretty darn conservative estimates. Nathan's still has a lot of states to expand to with restaurants, and the Branded-Product Program still has a lot of room to run. If Nathan's were to grow earnings at 25% annually for the next three years and have a P/E of 25:

.87 * (1.25^3) * 25 = 42.48

That is not bad at all for three years. I think this is a business that can keep expanding for many years, I would definitely hold for a longer period of time. The main risk that I see that could potentially dampen Nathan's market is the fast growth of organic, natural, and healthier food. Hot dogs aren't your healthiest product, and the organic market is growing at 15%-20%. Currently, organics make up only approximately 2% of the U.S. food market. If organic food does keep up growth over a 10-15 year period of time, it could shrink the market for hot dogs and put pressure on Nathan's. I have my doubts that organics will continue to grow like it is, but there is a trend toward healthier food that Nathan's may need to adjust to. This management team has experience and I'm sure they'll act when they need to. I don't think this healthy food trend will make much of an impact on Nathan's in the immediate future (3-5 years), so I still see an excellent opportunity here. Nathan's has received very good ratings for their hot dogs, so people aren't going to give them up too easily in my opinion.

Now let's do some calculations for five years out. My everything-goes-wrong estimate is 12% annual earnings growth with a P/E of 15:

.87 * (1.12^5) * 15 = $23.00

My most expected estimate is 19% annual earnings growth with a P/E of 24:

.87 * (1.19^5) * 24 = 49.83

And my praise-the-lord-everything-goes-right estimate is annual earnings growth of 26% with a P/E of 28:

.87 * (1.26^5) * 28 = 77.36

Conclusion

I see a lot of potential with Nathan's as an investment. I've always been waiting for a lower price, but I just don't see a lot of downside with the stock. If you subtract Nathan's large cash position from its market cap, the stock is trading at 9.4 times cash flow. McDonald's trades at more than 15 times cash flow. The stock is simply too cheap considering how strong earnings and cash flow growth has been. Plus, the future potential left for the company is still quite large in all of its segments, at least for the next 3-5 years. I should have invested in Nathan's months ago; but even with the stock's strong performance recently, I think we've got a strong market beater here and look forward to following the company's progress.

Best,

David K


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