2023-09-07 03:40:40 ET
Summary
- Nathan's strong brand has allowed the company to maintain strong earnings power with little capital invested into the business.
- The value of the company depends on the growth of the high value royalty stream from its Product Licensing segment.
- If this segment grows, company earnings will grow with it. I estimate that Nathan's stock is undervalued by 30% even with little growth.
Nathan’s Famous, Inc. ( NATH ) gets its value from its brand. This is typical of many great businesses as brand strength creates pricing power and makes accretive growth much easier. One good example of this that Buffett often mentions is See’s Candies. See’s has been able to grow greatly over time without requiring much capital to do so, which points to the company's ability to sustainably generate very high returns on invested capital.
These sustainably high returns have been possible due to See’s strong brand. Customer’s enjoy the feeling of giving and receiving See’s Candies around the holidays and the company’s moat comes from the fact that this same feeling can’t be replicated with other brands. Customers then come back to See's every year for the holidays and they are willing to pay up for the product.
An ideal scenario for Nathan’s would be similar to that of See’s Candies. If it’s brand is truly strong, it will be able to grow for a long period of time without needing much additional capital invested into the company. Ever since the company shifted to focus more on generating revenue from high margin royalties, they have managed to accomplish this relatively well. However if the company is unable to grow, then the stock essentially becomes a bond yielding whatever the free cash flow yield is at the time of the investor’s purchase. Depending on the investor’s individual hurdle rate, this could be a bad outcome.
Most of Nathan’s potential earnings growth would likely come from Nathan’s Product Licensing segment. This segment houses its contracts with food processing companies in which those companies use Nathan’s brand and likeness to sell frozen food products. The largest deal is with Smithfield Foods, a privately owned pork processor and processed foods manufacturer that generated around $18 billion in revenue in 2022 . Smithfield Foods accounted for $28.7 million of the $33.8 million in revenue for this segment in 2022. As this revenue is a royalty payment from Smithfield Foods it flows almost entirely from Nathan’s revenue line to its operating income line which leads to it accounting for the majority of Nathan’s operating income.
I believe that Nathan’s brand strength creates potential for solid growth in its Product Licensing segment via Smithfield Foods. However even with minimal growth, I estimate that Nathan’s stock is undervalued by about 30%. With this in mind I am initiating coverage with a buy rating and a price target of $94.
Business Overview
Nathan’s has a long history with humble beginnings as a single hot dog stand at Coney Island in the early 1900s. Today, Nathan’s is much different and operates 3 business segments: Branded Products, Product Licensing and Restaurant Operations.
The Branded Products segment encompasses sales of Nathan’s branded products to foodservice distributors and operators that resell the products to other foodservice operators. The operators purchasing these Nathan’s branded products could be restaurants, or other foodservice operators in venues such as stadiums, movie theaters, amusement parks etc. This segment accounts for the majority of revenue but has low and recently declining margins.
The Product Licensing segment that I mentioned above, houses the contracts in which Nathan’s receives a royalty payment when certain food manufacturers sell Nathan’s branded products. While this represents a smaller portion of total revenue than does the Branded Products segment, this revenue flows almost completely to the operating income line and makes up the majority of the company’s operating income.
The Restaurant Operations segment encompasses all of the domestic and international Nathan’s branded company owned restaurants, franchised units, and virtual kitchens. This segment represents the smallest portion of revenue of the three and also has the lowest margins, making it the least important segment with regard to the company’s value.
Past Financial Results
Nathan's earnings have been volatile over the past few years but have grown well.
Nathan's Financials FY2019-FY2023 (Nathan's 2023 Annual Report)
One of the first things I do when I research a business after studying its financials is check its returns on invested capital. This information provides valuable insights into the company’s moat that the financial statements do not directly reveal. Nathan’s ROIC over the last decade is incredibly high, but it is also a bit misleading.
Nathan's ROIC (Created by Author)
It’s misleading because Nathan’s has invested very little into the business so the current and future earnings are based on past investments and the strength of the brand. Additionally, there are few opportunities to make investments. If Nathan’s had many opportunities to make investments that generated 70%+ returns, the stock would be trading at a much higher multiple of earnings than it currently is.
At the same time, this is why future earnings growth would be very valuable. With so few investment opportunities, all of the additional earnings generated by the business would go directly to investors. This is the same reason why See’s Candies has been such a great investment.
The key to this additional growth lies in its deals with companies such as Smithfield Foods in its Product Licensing segment. If revenue from this segment becomes a larger percentage of total revenue while revenue and margins from the other segments remain flat, Nathan’s will prove to be a very valuable business.
Since FY2018, Product Licensing revenue has grown from 22% of total revenue to 26% of revenue. Despite this relatively slow growth, it was 41.4% of revenue in FY2021 as restaurants shut down due to the pandemic. This helped the company stay strongly profitable as many other food service businesses struggled. In general, this segment diversification creates more resiliency in the business.
Also since FY2018, revenue from the Branded Products segment has remained at 60% of total revenue, although margins have dropped from 15% to 11%. This decline in the segment’s margin can be attributed to increasing input and labor costs that have not been entirely offset by price. These factors have contributed to a lower operating margin for the entire business since that time.
These two segments are the most important for the business and if both are able to grow while the Branded Products segment is able to increase margins, the stock should do quite well. However, at its current valuation, this doesn’t need to happen case for it to be undervalued.
Price Target
As I mentioned above, if earnings don’t grow from here, Nathan’s equity can almost be thought of as a bond due to its non-existent capital intensity. However with some modest growth, the stock looks undervalued.
The following are the assumptions in my model:
Revenue growth is 8.83% percent in FY2024 and gradually declines to 2% in FY2028. Nathan’s operating margin in 24.3% in FY2024 and 24% through FY2028. Interest expense is equal to 4.22% of revenue in FY2024 and declines to be 1% of revenue in FY2028 as the company pays down its remaining debt. The company’s tax rate is 22% from FY2024-FY2028. D&A and capital expenditures are equal to 1% of revenue from FY2024-FY2028. The company’s weighted average cost of capital is 12% and its terminal growth rate is 2%.
All of these assumptions lead to an intrinsic value estimate of $94.
Nathan's DCF (Created by Author) Nathan's DCF Continued (Created by Author)
I believe these assumptions are reasonable mainly due to past trends in the company’s margins and growth, my beliefs of the strength of the company’s brand, and Nathan’s contract with Smithfield that extends through 2032.
This price target is also about 17x my FY2024 EPS estimate of $5.56, which seems reasonable given the stock’s average multiple from the past decade and my expectations of growth in its high value royalty streams from Smithfield and other food processing companies.
Risks
The primary risks of an investment in Nathan’s are a misevaluation of the brand’s strength, economic weakness that would lead to consumers trading down to more private label brands, and its contract with Smithfield not renewing in 2032.
It is difficult to evaluate the strength of the brand but the company’s high earnings power with little invested capital indicate that it is high. This is a reflection of a brand that is quite well-known and trusted. This in no way guarantees what customers will think in the future, but I would not bet against a brand that has shown solid strength for as long as it has.
Ideally, the strength of the brand would lead to relative pricing power during a recession but it is likely that consumers would trade down if economic conditions worsened. Investors should be attentive to economic data, but recent estimates indicate that the economy could see growth in the second half of the year and into 2024. For example, the Atlanta Fed’s GDPNow forecast is calling for 5.6% real GDP growth in Q3.
Atlanta Fed GDPNow Estimate (Atlanta Fed)
This is only an estimate, but shows that some data indicates continued economic strength going forward.
Finally, the company’s relationship with Smithfield Foods seems to be strong although it is difficult to judge for company outsiders. If this contract were not renewed after 2032, terminal value growth expectations would take a hit. Additionally, the contract could be renewed but with better terms for Smithfield which would also hurt terminal value growth expectations.
Final Thoughts
Nathan’s brand strength has led to strong earnings power despite the company’s small asset base. It is this brand strength that guides the assumptions that lead to my $94 price target and buy rating. I am assigning this buy rating despite declining margins in its Branded Products segment as I believe this decline will be more than offset by growth in the high value royalty stream from its Product Licensing segment.
For further details see:
Nathan's Famous: High Value Growth Driven By A Strong Brand