I like to explore situations with regardsto dealmaking as they often have the potential to alter the investment case in a significant way.
Handy & Harman (HNH) might be just such a case as it announced its intention to acquire SL Industries. While deals often look good on paper, I'm not very upbeat on the prospects of HNH in the wake of this deal as the leverage position will be far too high in my opinion.
Handy's Business And History
HNH is in essence quite an interesting business. The company focuses on niche industrial products while it serves a diverse customer base. The company is active in five segments, after adding a performance materials business last year. Other segments include joining materials, tubing, building materials and Kasco.
This diversification and steady growth has served investors well. Since the company went public at the end of 2008, HNH has grown its sales by roughly $100 million toward $650 million. While this looks good, take into account that HNH has made some deals over this time period while the economy has seen a recovery as well of course. The major deal which allowed HNH to grow to this revenue base is the $100 million acquisition of JPS Industries. This deal was announced last year and adds some $160 million in sales per annum.
The real achievement has been seen in terms of operating margins which have risen to a stable range of 6-8% in recent years. This improved margin profile, growing revenues and upbeat financial markets have acted as positive drivers for the shares. Shares of HNH have risen from levels around $10 at the time of the IPO toward highs in the $40s last year, only to fall back to the mid-twenties at the current moment.
Worries about the industrial sector in the US and organic sales declines have been fueling concerns after the multi-year momentum run which ended in 2015. Another concern is the fact that operating margins are reasonably low, if you take into account the debt taken on by the business. Excluding one-time gains, net earnings amounted to just $17 million last year.
The company ended 2015 with a net debt load of $75 million which is pretty much equivalent to 1 times EBITDA. While this looks reasonable, the real issue is that the business has pension related liabilities totaling a whopping $265 million. If you include this liability, leverage would come in at 4.3 times EBITDA.
With 11.4 million shares outstanding, and those shares trading at $25 per share, equity is valued at $285 million. Including net debt, the business is valued at $360 million which is equivalent to little over 0.5 times sales and 4.5 times EBITDA. Based on the dismal earnings, shares trade at 17 times earnings. Again, this calculation does not include the very sizable pension related liabilities.
Looking To Acquire SL Industries
Despite the questionable state of the balance sheet, if you fully count pension related liabilities as debt, HNH is looking to acquire publicly listed SL Industries (SLI). HNH is willing to acquire the business for $40 per share in cash, equivalent to an equity valuation of roughly $160 million. With no significant net debt position, or pension liabilities, the purchase price pretty closely resembles the enterprise valuation.
This particular deal will add some $200 million in sales for a sales multiple of 0.8 times. This marks a premium compared to HNH's sales multiple (again excluding pension-related liabilities) as this can be explained by the solid operating margins of 9%. On a standalone basis, SLI posted $11 million in earnings which translates into a 15 times earnings multiple. This number does not take into account potential synergies nor does it take into account the financing costs related to this deal.
Caution Is Warranted
The combination of dealmaking, through the purchase of JPS and now through the purchase of SLI, raises some concerns amidst the surging debt load. Another worrying sign is the outlook for 2016 which has been released before the purchase of SLI, as this outlook is very wide.
On the fourth quarter earnings release, HNH guided for annual sales of $666 million to $813 million for 2016, which is an incredibly wide range after sales totaled $650 million in 2015. The wide discrepancy is not really caused by uncertainty surrounding the closure of past deals, yet it really seems to relate to the underlying business. Adjusted EBITDA is projected to come in at $86 million to $105 million. Given that the JPS deal closed late into 2015, and adds $160 million in sales, the sales outlook is not really encouraging.
This outlook excludes the impact of LSI which adds some $200 million in sales and $22 million in EBITDA. At the midpoint of the range, HNH is anticipated to report sales of nearly $950 million and adjusted EBITDA of nearly $120 million. These are of course pro-forma numbers as the deal will not close immediately.
With sales approaching a billion, the equity valuation of $285 million seems optically low. This is the result of the debt load. If you simply take into account the "regular" bank net debt load of $250 million, leverage is somewhat reasonable. If you include the pension-related liabilities, debt levels exceed half a billion, translating into a >4 leverage ratio.
It is this leverage and the huge gap between net earnings and the adjusted EBITDA numbers which warrant real caution, as HNH might be getting in over its head.
Final Thoughts - Avoid
HNH is a diversified industrial player which trades at market-equivalent earnings multiples. Such a story, combined with solid margins and willingness to engage in M&A activity, looks pretty interesting.
There are some real troubles however and that relates largely to the dismal state of the finances, with this headwind primarily resulting from the pension liabilities. These liabilities result in a sizable cash contribution which will have to be made in the coming years. In the annual report, HNH says that it anticipates to pay $30-$40 million per year into these plans for each year between 2017 and 2020.
These payments, high leverage, lack of dividends and concerns with regard to the viability of the business in a downturn cast a shadow on the stock. This is certainly the case as the history has been "full" with transactions and restructuring, not creating imminent value.
You get the point, HNH has a real pension related issue and is willing to leverage up the balance sheet by engaging in acquisitions, being a willing payer of acquisition premiums in the process. These red flags make it easy to avoid this player, even if upside reveals itself in case the economy unexpectedly grows at a rapid pace.
You are probably better off paying up for a quality industrial names, rather than pursuing this company, with a somewhat cheaper earnings multiple.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.