After spending my early years in New York, I know a little about Nathan's Famous (NASDAQ:NATH). Born in 1916, the company is looked upon fondly by older New Yorkers, such as my Dad, who equate the hot dog maker with spending summers riding the Coney Island Cyclone. If only Nathan's could pack its locations with nostalgic New Yorkers.

Alas, it can't. A check of the last 10 years shows Nathan's peaked in fiscal 2001 at $47 million in sales. At the time, however, net income was substantially lower, at $1.6 million, than in 1999, its best year at $2.7 million. Nathan's troubles came to a head in 2003 when sales dropped by more than $10 million from the prior year, resulting in a loss of $14 million.

Fast-forward to yesterday's fiscal 2005 second-quarter earnings report, which contained some good news. Total revenue for the quarter was up 16% from last year, while net income was 27% higher over the same period. Nathan's 10-Q, delightfully filed on earnings day, also shows structural free cash flow up by more than 8% over the same six months last year.

All that made me wonder whether Nathan's, trading at $6.40 per share as of this writing, is one of those undervalued penny stocks I recently wrote about. So I ran the numbers using a thumbnail valuation borrowed from the experts at Motley Fool Hidden Gems:

Metric 2005 (estimated) 2004
Revenue $38.3 $30.7
Earnings $4.1 $1.9
Enterprise value $24.6 $20.9
Structural free cash flow $4.1 $3.8
All numbers in millions. Fiscal 2005 enterprise value equals the number reported at Yahoo! Finance. 2004 enterprise value was calculated using Nathan's share price as of March 29. All other figures taken either from Morningstar or Securities and Exchange Commission filings.

Taking the current enterprise value and dividing it by the estimated 2005 structural free cash flow yields a result of 6. That means Nathan's trades for six times its expected cash flow. But cash flow growth is humming along at 8%. Divide the cash flow multiplier (6) by the growth rate (8), and you get what's called an EV-to-FCF-to-FCF growth rate of 0.75. (Fellow Fool Rich Smith wrote a great article discussing this concept in detail.)

A result below 1.0 suggests upside. In this case, Nathan's could be undervalued by close to 25%. But this is hardly a rigorous analysis, and there are a number of reasons to be concerned about the company.

First, Nathan's has no track record for consistently growing earnings or cash flow. Second, the restaurant and foodservice business is tremendously competitive. Third, the business has several unrelated chains under its umbrella a la Darden Restaurants (NYSE:DRI), CKE Restaurants (NYSE:CKR), and Brinker International (NYSE:EAT), but without the same scale. And, finally, there have been no changes in the executive suite over the past 10 years, yet shareholder equity has declined. Sorry, that's not exactly the taste I'm looking for.

For related Foolishness:

  • Nathan's may be stuck in purgatory, but some penny stocks are from heaven.
  • Fellow Fool Rick Munarriz relayed some of Nathan's troubles here.
  • Small restaurants sometimes make for delicious stocks.

Do you frequent the bargain bins at your local department store? Do you brake for garage sales? Are leftovers your cuisine of choice? Yes? Then we've got good news. Philip Durell can show you how to shop for bargain stocks on the way to outsized returns for your portfolio in hisMotley Fool Inside Valuenewsletter. A free, 30-day trial is yours for the asking.

Fool contributor Tim Beyers likes his hot dogs burned and crispy and his steak medium and juicy. He doesn't own shares in any company mentioned. To get a peek at what Tim is invested in, go to his Fool profile, which is here.