Nathan’s Famous, Inc. — Form 10-Q Summary
Reporting period: Thirteen weeks (second quarter) and twenty-six weeks ended September 25, 2016, compared with the periods ended September 27, 2015. The interim statements are unaudited. Amounts below are in millions of dollars unless stated otherwise.
Business context
Nathan’s generates revenue from branded foodservice product sales, licensing royalties, company-operated restaurants, franchising and related fees. At quarter-end it reported five company-operated restaurants and a franchise system spanning domestic and international markets. The filing gives different franchise counts: the overview reports 271 franchised units, while MD&A reports 266 operating franchised outlets; the difference is not explained in the filing text.
Financial performance
| Metric | 13 weeks 2016 | 13 weeks 2015 | 26 weeks 2016 | 26 weeks 2015 |
|---|---|---|---|---|
| Total revenue | $28.013 | $30.619 | $57.429 | $61.273 |
| Operating income | $8.031 | $8.426 | $16.855 | $16.042 |
| Net income | $2.507 | $2.847 | $6.057 | $5.157 |
| Diluted EPS | $0.60 | $0.64 | $1.44 | $1.14 |
| Adjusted EBITDA | $8.610 | $9.006 | $17.976 | $17.257 |
- Second-quarter revenue fell 8.5%; first-half revenue fell 6.3%. Sales declined 8.7% and 7.9%, respectively. Licensing royalties were $4.788 million for the quarter and $11.612 million for the half-year; franchise fees and royalties were $1.334 million and $2.664 million.
- Gross profit was $6.402 million in the quarter, or 29.2% of sales, versus $6.313 million, or 26.3%. For the half-year, gross profit was $12.206 million, or 28.3%, versus $11.098 million, or 23.7%. Lower beef costs and lower restaurant incentive compensation supported margin improvement.
- Quarterly operating income decreased 4.7%, while first-half operating income increased 5.1%. Quarterly net income declined 11.9%; first-half net income rose 17.5%. First-half effective tax rate was 36.9%, versus 40.9%, including a $621,000 discrete stock-compensation tax benefit from early adoption of accounting guidance. The company says the benefit is excluded from its full-year tax-rate estimate.
- First-half operating cash flow was $7.561 million, compared with $8.630 million. Capital spending was $0.606 million; financing used $2.058 million, including $1.272 million for share repurchases and $0.705 million of withholding taxes on share-based compensation. Cash increased $4.897 million to $55.125 million.
- At September 25, cash was $55.125 million, current assets $65.184 million and current liabilities $10.259 million; reported net working capital was $54.925 million. Stockholders’ deficit was $67.866 million.
- Debt consisted of $135 million principal amount of 10% senior secured notes due in 2020, with a $130.877 million carrying value net of discounts and issuance costs. The notes have no scheduled principal amortization before maturity. The company reported covenant compliance. Annual cash interest is approximately $13.5 million.
Material changes and management commentary
- Lower average selling prices, reflecting the company’s cost-based pricing as beef costs fell, reduced branded product sales; higher product volume partly offset the price effect. First-half branded product sales were down 6.3%, while average selling prices fell about 9.2% and volume increased 3.1%.
- Company-operated restaurant sales declined 12.3% in the quarter and 10.8% for the half-year, primarily because unfavorable summer weather, and April–May weather, affected the Coney Island locations. Management noted that 2015 Coney Island sales were record-high.
- License royalties declined in the quarter amid competitor pricing pressure and the absence of a September 2015 promotion; first-half royalties were down modestly. Comparable domestic franchise sales also declined.
- Management expects the fiscal year ending March 25, 2017 effective tax rate to be approximately 42%–44%, excluding the stock-compensation tax benefit and possible changes in uncertain tax positions. This is an estimate, not earnings guidance; the filing provides no revenue or EPS forecast.
- Management believes cash and operating cash flow should fund operations, debt service and potential repurchases for at least twelve months. It expects continued investment in restaurants and branded programs and may continue buybacks, subject to debt restrictions; no future repurchases are assured.
Risks, contingencies and unusual items
- Beef and other food costs are volatile. The company said beef prices were favorable in the period, but a 10% change in food and paper costs would have changed first-half cost of sales by approximately $2.698 million. Passing future cost increases through to customers may not be possible.
- New York State minimum-wage increases, healthcare costs, labor availability, weather, utilities and distribution costs may pressure margins. Management warned that wage increases could significantly affect the company and its franchisees.
- The business is seasonal, and interim results may not indicate full-year results. The company depends on John Morrell & Co. as its principal hot-dog supplier and identifies supply, consumer demand, franchise growth, food safety and debt service among its risks.
- The IRS was reviewing the company’s federal tax return for April 2014–March 2015. Unrecognized tax benefits were $223,000, with $221,000 of accrued interest and penalties; management considers its reserve adequate. Ordinary-course litigation was disclosed, with management not expecting a material adverse outcome, while noting litigation uncertainty.
- The notes impose restrictions on additional debt, dividends, repurchases, investments and other actions. Contractual obligations include $135 million of principal due in the 3–5 year period and $13.546 million of operating lease payments before sublease income.
- The company early adopted share-based payment accounting guidance, recording the $621,000 excess tax benefit in income tax expense and operating cash flows. Management cautioned that this treatment may increase effective-tax-rate volatility.
Most important facts for investors to verify
- Whether the lower selling prices and weaker comparable restaurant sales are offset by volume growth and improved gross margins over subsequent periods.
- The franchise-unit count and definition: the filing reports 271 units in its overview but 266 operating outlets in MD&A.
- The sustainability of first-half earnings growth given the $621,000 discrete tax benefit and management’s 42%–44% full-year tax-rate estimate.
- Ability to service and refinance the $135 million, 10% notes due in 2020 while funding operations, investment and any buybacks.
- Exposure to beef-cost reversals, New York wage increases, weather effects at Coney Island and the outcome of the ongoing IRS review.