Nathan's Improves, but Downside Remains Prevalent

Warren Buffett loves the idea of buying commodities and selling brands. Nathan's Famous , while technically not a commodity business, produces its own products and licenses out its famous name for lucrative royalties. The result is a restaurant business with smoothed-out long-term earnings due to consistent royalty payments. The company recently negotiated a new royalty deal with John Morrell & Co. -- worth a bare minimum of $10 million this year and more in the coming years. Healthy sales at the restaurants and other business segments are keeping both the top and bottom lines on an upward trend. The tough question facing investors is whether the company can fulfill the expectations baked into the richly valued stock price.

Hot-diggity
With the aforementioned licensing deal in place -- worth a guaranteed $10 million and likely more, according to management -- Nathan's has a bonus on top of its capital-light business model. Its stores are almost entirely franchise locations (a structure that aids gross margins), and its handful of company-owned stores are recovering fast from Superstorm Sandy.

Nathan's iconic flagship restaurant is back on line as of May 2013. The seven-figure-grossing store had been substantially damaged during Sandy and this past year was closed for eight weeks for continued repairs and renovations. Still, in its comparable operating weeks, the Coney Island Nathan's saw nearly 17% higher sales than in the year-ago 30-week period.

In the just-ended quarter, the company posted a 4.3% gain in adjusted EPS -- up one penny to $0.24 per share. The top line grew more impressively at 23.3%.

The quarter outperformed analyst expectations, but Nathan's wasn't concluding a banner year. Franchise revenues were flat year over year, which is especially tepid in light of the fact that the company added 26 new franchised locations around the world. Also weak for the full year was the company's gross profit -- down 20% due to higher beef costs. Management intends to level the playing field by raising prices, but could not guarantee this would mitigate the effects of heightened costs.

Better times ahead?
Nathan's new licensing agreement is a substantial improvement over its former one with SMG (in the just-ended year, SMG licensing revenue was less than $6 million). With sustained franchised location growth in the coming years, investors can reasonably expect to see sales figures rise comfortably, though the troubling cost environment will likely keep pressure on margins.

At a glance, the company looks richly valued for a fast-food business -- trading at a trailing EV/EBITDA of more than 15 times. Investors should note, though, that franchise fast-food businesses, with the exception of McDonald's, are holding relatively high valuations and nearly all are enjoying brisk growth. Burger King Worldwide, for instance, trades at almost 18 times trailing EV/EBITDA. It is possible that the sector at large is a bit overvalued. Recent market pariah McDonald's trades at less than 11 times EV/EBITDA. While it is certainly experiencing a blip in its otherwise steady growth, the company's long-term remains compelling; Nathan's easily has the potential to grow faster than McDonald's due to the size difference between the two companies. Still, it's hard to imagine the significant pricing premium is worthwhile.

Nathan's has recovered fast from the tragic Superstorm Sandy. The company also is in a much better position on its licensing front -- more than doubling its royalty percentage of sales. Still, the market has given the company and some of its peers big shoes to fill. With a lack of downside protection, Nathan's isn't a buy today.

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The article Nathan's Improves, but Downside Remains Prevalent originally appeared on Fool.com.

Michael Lewis has no position in any stocks mentioned. The Motley Fool recommends Burger King Worldwide and McDonald's. The Motley Fool owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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