As Nathan's Famous (NASDAQ:NATH) turns 100 years young in 2016, you would probably think that its earnings growth power has matured and there isn't much excitement ahead. However, a deeper look underneath the surface and some simple calculations reveal a food company that is about to flex its muscle with a giant, yet sustainable earnings jump. How could this be?
Starting out with the bun
On June 13, Nathan's reported full-year results for the fiscal year ending March 30, 2014. Excluding a one-time insurance gain, revenue increased 12% to $80.2 million. Adjusted net income slipped 11.3% to $6.6 million or $1.43 per diluted share. This mostly happened because a drought in the Midwest caused a spike in beef prices that the company was unable to pass on to its customers.
Nathan's expects to continue its expansion of restaurants and retail distribution through franchisees and other development agreements.
As fellow Fool contributor Adem Tahiri points out, 33,000 supermarkets and clubhouse locations sell Nathan's products across forty-five states, and it doesn't seem like growth will come from anywhere aside from the new franchised restaurant units popping up.
While I agree with the opportunity he sees in the non-retail business, I respectively disagree about the opportunity -- and the actually contracted guarantee -- on the food retail front and believe the Street is missing this as well.
Adding the delicious meat
For starters, while 33,000 sounds like a big number, there are actually hundreds of thousands of U.S. retail food establishments in the United States once you include convenience stores and all sorts of other places beyond supermarkets that could potentially sell hot dogs and other Nathan's products.
But let's forget even that for now. The company already has plenty of opportunity in its current 33,000 points of sale.
For years, Nathan's had an agreement with a company called "SMG Inc" under which it was the company's exclusive manufacturer and distributor of products for which it paid Nathan's a 4.5% royalty for using the brand. I happen to love royalty agreements because, all things being equal, the company just receives checks from them while incurring little or no cost.
Squeezing on some ketchup and mustard
This means that each dollar of royalty tends to mean a dollar in pre-tax income. Or more specifically and perhaps more accurately, each dollar increase in royalty is a dollar increase in pre-tax income. SMG has now been replaced with a company called John Morrell & Co. in a deal that requires a minimum $10 million royalty for the first year and goes up from there.
John Morrell & Co has already been the company's distributor for its foodservice accounts for eight years. It obviously knows a thing or two, and is likely passionate about, Nathan's products. Now John Morrell & Co is replacing SMG and paying a 10.8% royalty compared to a 4.5% royalty under SMG.
The difference between 10.8% and 4.5% might not sound like much, but 10.8% is actually 140% higher than 4.5%. More specifically, over the last 12 months SMG paid $5.3 million in royalties to Nathan's. This means if John Morrell & Co merely matches that performance on sales and volume, it will pay $12.7 million in royalties instead of $5.3 million for an increase of $7.4 million.
Adding some sauerkraut that is anything but sour
Using the 38.6% tax rate of Nathan's in its most recent fiscal year, that's an increase in net income of $4.5 million or an over 68% increase. But it doesn't stop there.
Eric Gatoff, CEO of Nathan's, stated in a press release, "It will allow our very successful retail licensing program to finally achieve a truly national sales, marketing and distribution footprint." Obviously he and John Morrell & Co intend to increase the number of locations and sales (and therefore royalties) under the new agreement.
Considering that Nathan's and SMG have locked horns on legal matters over the last few years, SMG's passion was probably less than full so you should reasonably expect John Morrell to do better. John Morrell Group plans full-scale marketing efforts both in-store and outside which include new sponsorships, hot dog eating contests, and all sorts of other events that will start this summer.
Throwing in a side of delicious, crispy fries
The group plans to have mobile sampling vehicles do a nationwide tour with stops at hundreds of places as well as brand new social media efforts. It probably doesn't hurt that the warmer spring and summer BBQ months are seasonally better for Nathan's.
The first full quarter under the new agreement will be the first fiscal quarter ending in June and Nathan's should report results for the quarter in early August. That should show the first big, sustainable jump in insurance-gain-excluded earnings and perhaps begin a long trend of high and rising earnings.
Would I be crazy to suggest that the new deal will jump licensing sales well above $12.7 million annually? For the first two weeks, Nathan's Famous recognized $548,000 in royalties for an annual pace of over $13 million even with the prior SMG inventory still being worked off.
Let's just use the $12.7 million as a reasonable minimum estimate for now. I'll spare you the math, but Nathan's will realize after-tax net income of $2.27 per diluted share with all things being equal (and no growth) in terms of the rest of the business. That seems more than possible.
Washing it all down
Nathan's has traded with a P/E of between 25 and 35 over the last few years and even right around 20 during the terrible 2008 recession (which as a bonus didn't seem to affect the company at all as even low budgets apparently have room for hot dogs). Using $2.27 in earnings per share, that P/E range of between 25 and 35, and assuming that the execution goes well, Nathan's could fetch between $56 and $79 per share at this time next year (after a full year under Morrell) and could be even higher if the marketing efforts pay off.
With a current share price of $54 per share, that leaves a lot of potential opportunity with the additional wild card that if beef prices return to more normal levels or if Nathan's can pass that cost on to its consumers then that would add between $0.40 and $0.50 per share in pre-tax net income. And if Morrell has its way, the brand itself will see renewed rejuvenation for many years to come well beyond these numbers.