Summary

• HNH is undervalued at a price of $37, the true value is at least $56.
• Some accounting peculiarities cloud the true earnings power of HNH.
• The stock repurchase program is a possible catalyst; simultaneously it’s an insurance against downside risks.

Handy & Harman Ltd. (NASDAQ:HNH ) is a diversified manufacturer of engineered niche industrial products. The company has five different business segments: joining materials, tubing, building materials, electronic materials (Arlon), and cutting and blade products (Kasco). This structure with five business segments means the analysis of the company is a little bit more intricate in comparison to other companies of comparable size. That’s probably one reason why HNH is undervalued.

But there are additional reasons why HNH is neglected or outright disliked:

1. HNH doesn’t pay a dividend

2. The average volume of traded shares is quite low

3. The stock price performance over the last six month was quite impressive, so some people think the stock has reached its fair value

4. HNH is controlled by a hedge fund

Reason number 1 and 2 are not important from a fundamental standpoint. Number 3 could be. The stock price appreciated nearly 70% over the last six months. But the P/E is still only about 14, so HNH doesn’t look expensive. Of course, 14 doesn’t look cheap either. I’ll explain below why the P/E is misleading and HNH is at least 50% undervalued.

Another possible drawback is the fact that HNH is controlled by Steel Partners Holdings (NYSE:SPLP ), a hedge fund company founded by CEO Warren Lichtenstein. Steel Partners is a global holding company that controls and invests in multiple businesses. One of the controlled companies is HNH, of which Steel Partners holds about 65 percent. Mr. Lichtenstein is Chairman and CEO of both Steel Partners and HNH and has connections to other companies, too. That’s why some business took place that you wouldn’t see if HNH was truly independent.

When you read the SEC-filings, you find that HNH entered into a Management Services Agreement with an affiliate company of Steel Partners. That costs HNH $11m per year, a substantial amount for a company that had $42m in earnings in 2013 and $33m in FCF. So is Steel Partners taking money out of HNH? On the contrary, the deal is an advantageous arrangement for the company. HNH transferred to Steel Partners approximately 37 employees, so they are no longer on the payroll. And Steel Partners is quite experienced in providing legal, tax, accounting, marketing and other similar services. So the deal is not really a drawback as you could think at a first glance. It’s true that Mr. Lichtenstein has a controlling interest in HNH, but that’s actually a plus as this constellation reduces principal-agent-problems for other investors.

Another unusual move was a big investment in ModusLink three years ago, and for that HNH holds now well over 10 percent. ModusLink provides supply chain and logistics services aimed at improving clients’ revenue, cost, sustainability and customer experience objectives, but had negative earnings for the last five years. One of the major shareholders of ModusLink is Steel Partners with roughly 25%, and HNH was used as some kind of agent for Steel Partners. The book value of the investment fluctuates quite a lot and affects the earnings of HNH, depending on the share price of ModusLink. That’s not something an investor in HNH particularly likes. It’s also the main reason why you have to correct the income and cash flow statements when you want to know the true earnings power of HNH.

Impressive stock price performance and convincing fundamentals

One key driver for the stock price performance of nearly 70% in six months was the stock repurchase program that HNH announced in the first quarter of 2014. By now HNH has spent roughly half of the $13m allocated to the buyback program. In addition to that share buyback HNH published a tender offer last summer. They announced to purchase for cash up to $60m in value of its common stock at a price of $26.00 per share. So it’s understandable that the stock price rose a lot.

However, the stock price didn’t rise only because of the buyback program. The fundamentals were increasing over the last years. When you look at revenues you see that HNH recovered very well after the crash. And the niches where the company competes make it very likely that the revenue will rise over the next years. In addition, when you look at the overall margins, you see that they improved nicely during the last 10 years: gross margin 10 years ago was under 18%, now it is roughly 28%. Operating margin was negative in 2004, improved to 0.675% in 2005 and almost continuously went up to around 8% in 2014. The margin improvement showed up in the cash flows, too. FCF per share for 2012 and 2013 was $2.88 and $2.49.

So when the shares traded between $18 and $22 in the first quarter of the year, HNH was very cheap. The question is whether they are still cheap at a share price of $37. The short answer is, yes, they are. Of course, when you look only at the earnings per share from the latest quarterly report the figures don’t seem very impressive. The nine-month-earnings were $1.76 and when you extrapolate you get earnings of about $2.35 for the whole year. With a normal P/E of 15 that would bring the value to $35, less than the actual price.

But the $1.76 were calculated with a weighted-average number of common shares outstanding of 12.9m. Now there are only 10.8m shares outstanding because of the buyback program and the tender offer. When you calculate the per share earnings with this figure, you get earnings per share for nine months in the amount of $2.09. When you extrapolate that you get earnings of about $2.79 for the whole year. Take a P/E ratio of 15 and you get a value of $41.85. Not bad, but certainly not a big deal either. But there’s more.

I mentioned above that the investment in ModusLink distorts the income and cash flow statements of HNH. When you add back the book-loss of $7.8m resulting from the declining share price of ModusLink, you get the figure that reveals the true earnings power of HNH. The 10-Q says that net income was $22.6m, but the true earnings were $30.4m for nine month. So with 10.8m outstanding shares that results in earnings per share of $2.81. And when you extrapolate that you get earnings of $3.75 for the whole year. If you apply a P/E of 15 you get a value of $56.30, and that is quite a decent margin of safety.

And that’s not even all. Remember the share repurchase program? There are still $7m unused. Quite possible that HNH buys back some shares as long as they are rather inexpensive. So HNH has some very favorable characteristics. The fundamentals are strong, the revenue should rise over the next years while the margins should stay at the actual rates. There is a possible catalyst in the form of another round of share buybacks, and simultaneously the unused amount of the buyback program is an insurance against downside risks. I think the stock price reaches the fair value over the next two years, so when you buy HNH at $37 that gives you a nice yield of 25% per year.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.