Background

We discovered Hardinge, an Elmira, NY machine tools manufacturer, as a result of Romi's hostile tender offer in early 2010. Romi (ROMI3 BZ) is a large Brazilian machine tools manufacturer with a market cap of about $500mm. On February 4^th, 2010 Romi made an $8 unsolicited offer to buy Hardinge, which they subsequently changed to a hostile tender offer. Romi raised its offer to $10 on May 10^th but eventually dropped the offer after several extensions on July 15^th, 2010, despite receiving 49% of the shares tendered into the offer. The offer was very well-timed from Romi's perspective: Hardinge was in the midst of its lowest revenue quarter in almost 7 years and the company was poised to report its 7^th consecutive quarter of operating losses. Romi was in effect looking to steal the company at the bottom of the cycle, valuing the enterprise under $100mm, or equal to about 45% of trailing sales that were the lowest they had been in six years, and 26% of peak sales in 2007-8. Despite the obvious disadvantage of attempting to sway investors in a foreign country in a foreign language, Romi played the public relations game much more skillfully than did Hardinge, and the whole affair made Hardinge management appear very shareholder unfriendly. They instituted a poison pill that has subsequently expired and they refused to negotiate with Romi or allow them to perform in depth due diligence. At the time of Romi's first offer, the HDNG was at $5.48, and had been as low as $2.79, so $8 looked pretty good, and $10 even better, given desultory state of Hardinge's sales and no end in site to operating losses. However, HDNG stock had almost hit $40 in 2007 and from management's perspective, should sales and margins ever rebound, accepting the $10 would have been akin to giving the company away. As a result of management's poor communication, 49% of shares were tendered, and 43% of the votes counted at the annual meeting in May voted against re-electing the chairman and CEO to the board. The good that came out of the experience  from our perspective was at least fourfold: 1) management became more willing to discuss their outlook for the company's future, citing a return to 30% gross margins as their expectation; 2) management created an informative investor slide presentation (http://www.hardingeus.com/usr/pdf/Investor%20Relations/Hardinge_Investor%20Presentation_45.pdf); 3) management was even more eager to cut costs and return the company to profitability, and finally 4) as investors in Hardinge we learned a very valuable piece of information about the company's value: a knowledgeable third party was willing to buy Hardinge for $10/share at the trough of the business cycle without doing in depth due diligence. This information is very valuable as it limits our theoretical downside with this investment.

Subsequent to Romi's withdrawal of their tender offer in July, the stock fell from $10 to the high $7s throughout the summer and fall. This was despite Hardinge's return to positive EBITDA in the June quarter for the first time in eight quarters and YoY revenue growth for the first quarter in the last seven. The stock rallied sharply in recent weeks based on a strong 4^th quarter where they reported $5mm in EBITDA, grew sales 45% YoY, and grew orders 63% YoY. Despite the nearly +50% move in the stock price since this earnings announcement, we believe over the next 1-2 years that HDNG could at least double in price.

Investment Highlights

The thesis is pretty simple:

1)      If HDNG can return to historical margins and historical multiples there is enormous upside to the stock. There don't appear to be structural reasons to explain why this cannot happen.

2)      HDNG has significantly reduced its fixed costs, which should facilitate this return to prior average operating margins once sales return to higher levels in 2011 and 2012.

3)      Downside should be limited-we know that a knowledgeable third party was willing to pay $10/share prior to the recent signs of improved orders and sales, without performing detailed due diligence.

4)      Attractive industry characteristics: fragmented customer base, diversified group of end customers, barriers to entry and switching costs, and a very strong growth outlook driven by continued strength in China and a rebound in Europe and the United States.

Business Description

From the 10-K:

Hardinge Inc. (the "Company") is a machine tool manufacturer, which designs and manufactures computer-numerically controlled (CNC) cutting lathes, machining centers, grinding machines, collets, chucks, index fixtures and other industrial products. Sales are to customers in North America, Europe, and 'Asia and Other.' A substantial portion of our sales are to small and medium-sized independent job shops, which in turn sell machined parts to their industrial customers. Industries directly and indirectly served by the Company include: aerospace, automotive, construction equipment, defense, energy, farm equipment, medical equipment, recreational equipment, telecommunications, and transportation. Approximately 77% of 2010 sales were outside of North America.

Non-machine sales, which include collets, accessories, repair parts, and service revenue, have typically accounted for approximately 26% of overall sales and are an important part of our business, especially in the U.S. where Hardinge has an installed base of thousands of machines. Sales of these products do not vary on a year-to-year basis as significantly as capital goods, but demand does typically track the direction of the related machine metrics.

Profitability

In $ millions

Discounting has had a bigger impact on margins than negative operating leverage due to lower capacity utilization; according to the 10-K, gross profit in 2009 fell $11.9mm due to discounting, in some cases below cost, and $4.6mm due to lower capacity utilization in the US and Taiwan. Today pricing has stabilized but is still at levels below those before the global recession. It appears therefore that an improvement in pricing is key to a return to 30% gross margins. Here is what the CEO said on the last conference call (2/17/11) regarding pricing:

"I think there is still very competitive pricing markets. Our gross margins still are not back up although they have improved, they are not back up to the level that they were before the whole collapse and most of that gets down to pricing. I mean, right now everyone is pricing, everyone is hungry for orders. I think it's typical of coming out of a recession like we did, initially people want to get their factories working and get back to work and then eventually as the recovery matures, we would expect to get back to more normal pricing. But this industry it does not have particularly good pricing discipline and so it will take some time to get back to those normal times."

Historically there doesn't appear to be any predictable seasonality with respect to changes in gross margin, so I don't think we can learn anything from the fact that gross margin fell sequentially in the 4^th quarter 0.8%. This most likely is a result of the mix of orders rather than an indication of a weakening of the pricing environment.

Industry Overview and Competition

In 2008 the global machine tools industry was $66B and no single competitor had more than a 5% market share. In other words it is a very large and very fragmented industry. It is a global industry, with machine tools manufactured in many countries around the world. Each market however is different, with different players, selling models and pricing characteristics.

Positive industry characteristics

Switching costs: customers are loyal to controls, which are the computer systems that control the machines. As a result it is difficult to gain new customers if you don't have machines with the controls they are used to using. At the same time, this creates barriers to entry and customer stickiness as customers will order from the same manufacturer for decades.

Customer fragmentation: Hardinge's end users are primarily "job shops" which are generally small, privately owned single-factory companies employing anywhere from about 10 to as many as 200 workers. These shops are generally suppliers to Tier 1 OEMs in the construction, automotive, aerospace, medical instruments, and communications industries, and they are located in close proximity to their customers. As a result of this fragmentation-the company has thousands of customers globally-historically no single customer comprises a large percentage of Hardinge's sales, and therefore no customer has undue influence over pricing or Hardinge's ability to grow. This situation changed somewhat in 2010 as HDNG received $35mm, or 13.6% of revenues from Foxconn, a supplier to Apple (HDNG machines make the Macbook shell). Such a large order relative to total sales was an aberration, unlikely to be repeated, and compares to 2009 when the largest customer accounted for 6.8% of sales, and 2008 and 2007 when no single customer accounted for more than 5% of sales.

Hardinge competes with different competitors in different markets based on the types of machines primarily sold in the different geographies. The lowest end milling or lathe product (except for the manual $13k product) is priced in the $50-70k range and the most complex is $300k for the milling or turning product. Grinding machines are more expensive, and can range from $100k to $1.5mm on the high end. For the higher end grinding machines Hardinge makes a few hundred every year, while they manufacture and sell thousands of the lower end products. Higher precision machines can last 20-30 years while milling products can last 10-15 years. The typical reason to buy a new machine prior to its wearing out is to increase capacity or to upgrade the precision characteristics or other features that have been incorporated in newer machines over the years.

The following is a description of the competitors in Hardinge's different markets modified from the 2009 10-K:

--High precision, multi-tasking turning and milling equipment, competition comes primarily from: Mori-Seiki, Mazak, Nakamura Tome, and Okuma, which are based in Japan, and DMG, which is based in Germany. DMG and Mori-Seiki have a 5% cross shareholding.

--More standard turning and milling equipment comes to some degree from those companies as well as Hyundai-Kia and Doosan, which are based in South Korea, and Haas Automation which is based in the U.S. (large privately held, all manufacturing in the US), as well as several smaller Taiwanese and Korean companies.

--Our cylindrical grinding machines compete primarily with two Swiss companies, Studer (part of Schleifring Group), and Voumard, and Toyoda and Shigiya, which are based in Japan.

--Hauser jig grinding machines compete primarily with Moore, which is based in the U.S., and some Japanese suppliers.

--accessories products compete with many smaller companies.

One potential impediment to a return to historical margins would be if new entrants were undercutting the established players on price. However, this is not the case as the traditional players in the US and Europe as the same ones from the mid-2000s and if anything there has been a retrenchment from certain products which should benefit Hardinge. In China there are new entrants, but the market is growing so quickly that it is accommodating the pace of expanded capacity. Hardinge is expanding its capacity in both Switzerland and China, and while it is difficult to determine the exact increase in capacity, it is significant, and should accommodate growth for at least the next 5 years. While gross margins in China are lower than the company-wide average, operating margins are higher as labor costs there are much lower than they are in Switzerland and in the US.

Recent machine tools industry results

The Association of Manufacturing Technology (AMT) is the primary industry group for U.S. machine tool manufacturers. Machine tool consumption is reported annually by Gardner Publications in the Metalworking Insiders Report.

In 2009, industry-wide orders for metal-cutting machine tools reported by the AMT declined 60.4% versus 2008. The 2009 decrease was primarily related to the sharp decline in world-wide order activity brought on by the global economic conditions. In 2008 orders decreased by 0.3% over 2007.

World machine tool consumption data (domestic production plus imports, less exports) as reported by the Metalworking Insiders Report, an annual report on machine-tool output and consumption, shows a decrease in consumption of 33% in 2009 due to the worldwide economic conditions. This report indicates that consumption in China, the world's largest market, remained stable over the course of 2009 versus 2008, and increased by 11% in 2008 versus 2007. Consumption in Germany, the world's second largest market, decreased by 41% in 2009 versus 2008 as measured in local currencies, and increased 25% in 2008 compared to 2007. In the United Kingdom, machine tool consumption measured in pound sterling decreased by 40% in 2009 versus 2008 and increased by 16% in 2008 versus 2007. Machine tool consumption in the U.S. decreased by 51% in 2009 versus 2008 and increased by 15% in 2008 compared to 2007.

HDNG grew sales 20% in 2010 and this was in line with industry forecasts for global industry growth.

Current business climate and near-term forecast

Conditions are improving in the US and Europe, with increased capacity utilization and improved pricing for machine tools, both of which will help margin expansion. Industry growth forecasts call for 20% global growth, based on the October forecast from an industry group, and management's expectation is that this forecast could increase in April. Management expects the company to grow in line with its markets.

Here is an excerpt from the 2009 10-K:

Other closely followed U.S. market indicators are tracked to determine activity levels in U.S. manufacturing plants that might purchase our products. One such measurement is the PMI (formerly called the Purchasing Manager's Index), as reported by the Institute for Supply Management. Another measurement is capacity utilization of U.S. manufacturing plants, as reported by the Federal Reserve Board. Similar information regarding machine tool consumption in foreign countries is published in various trade journals.

The PMI reached 61.4 for February, the highest reading since May 2004. The new orders component hit 68.4, which is the highest reading since January 2004. It appears as if US manufacturing is as strong as it has been in years and as a result Hardinge should benefit from increasing new orders.

The other indicator mentioned in the above paragraph is US capacity utilization, which reached 76.2 in December, as measured by the Federal Reserve, which was the highest reading since September 2008 although still far below the peak of 81.7 in April 2007. Underutilized capacity might still be a drag on margins in 2011, but it will be less of a drag than it was in 2009 when national capacity utilization averaged 70% and in 2010 when it averaged 74.3%.

The Oxford Economics Group, which provides industry forecasts to the AMT, predicted the following for 2011 as of October 2010: growth in machine tool consumption of 17% in Asia, 22% in Europe, 36% in the US, and overall worldwide sales growth of 20%. Oxford will release an updated forecast in April 2011. Using the mix of 4^th quarter orders and Oxford's forecast for 2011, if HDNG grows sales in line with the industry, sales will grow 23% in 2011. Using a more historical mix of sales, in which Europe and the US constituted a larger percentage of sales, HDNG sales could grow even faster.

Recent cost cutting initiatives and other changes

Over the past year Hardinge cut $10mm from cost of goods fixed cost base, mostly in the United States. They also cut $20mm from SG&A fixed cost base. It is hard to say by what percentage this reduced the company's fixed costs, but the reduction is significant, particularly in the United States. COGS + SG&A in 2010 was about $260mm, and assuming fixed costs are no more than 50% of total expenses, the reduction was at least a 20-25% cut. A majority of these costs were taken out of the United States where Hardinge historically had a sales force to sell complex, more expensive machines. In February 2010 the company changed its US business model from a mixed distributor/direct model with about 50% of sales going through each channel, to a nearly 100% distributor model. The company replaced 20 small distributors and 50 direct sales and service people with 5 large, well-capitalized distributors: Gosiger (WA, OR, CA, NV), Hartwig (Mountain West, Midwest), the Morris Group (Southeast, Northeast), Hegman (ND, SD, MN) and Arizona CNC (AZ). According to the CFO, Hardinge never really recovered from the downturn after September 11, 2001, and operating losses followed in the United States every year since that time. When the new CEO re-joined the company in 2008 they decided that they could not grow their way to profitability in the US, and they committed to being profitable here, so they began planning for the switch to an entirely distributor-based model. When a large competitor exited certain competitive product lines, Hardinge was able to engage these new distributors, who had been prevented from selling their machines due to the large competitors' requirements. Since Hardinge made the switch to these new distributors on February 1, 2010 they have devoted a lot of time to training and educating the sales people. The cost cutting and 100% distributor model has significantly lowered the company's breakeven point in the US and should position them to generate profit here even at the currently reduced level of sales. The new distributors should also improve overall US sales as they can introduce Hardinge products to new customers.

Hidden Assets

As of 12/31/09 HDNG had US NOLs of $52.2mm, State NOLs of $100.9mm, and foreign NOLs of $26.6mm. Most of the foreign NOLs are in the UK and Germany where HDNG has distribution businesses. As a result of these NOLs the company has only been paying taxes in Switzerland, Taiwan and China, and will not pay taxes in the US in the foreseeable future should they become profitable here. Notably, $150mm of domestic NOLs is quite a large amount for a company with a current market cap of $150mm, and this asset could make HDNG an attractive takeover candidate at a significant premium to the current price should these NOLs be usable to an potential acquirer.

Management

The main point here is that management is experienced, fairly compensated, and incentivized to maximize cash flow.

Bonuses are determined by two metrics: 2011 performance goals under the Plan include a threshold, target and maximum for the Company's (a) EBITDA and (b) managed working capital (expressed as a percentage of annualized sales). Both of these metrics encourage maximization of cash flow.

In the April 2010 investor presentation referenced earlier you'll notice that most of the senior management has at least 20 years of experience in the machine tools industry. Current CEO Richard Simons began his career at Hardinge in 1983, worked his way up to CFO in 1999, left in 2005 presumably when it appeared he wouldn't become CEO, and then returned as COO in March 2008, subsequently becoming President and CEO in late May 2008. He earns a base salary of $375,000, and is eligible for a bonus of a maximum of $393,750 if both EBITDA and working capital goals are achieved. Simons owns 74,644 shares currently worth $970,000, as well as an additional 33,000 options and 57,000 unvested shares.

Ed Gaio, CFO, joined in March 2008, has a base salary of $235,000 and is eligible for a maximum bonus of $176,250. Gaio owns 23,800 shares worth $309,000, as well as 13,000 options and 15,000 unvested shares.

The point is that they guys are not multi-millionaires like many corporate officers, but rather experienced working class guys, who are paid reasonable wages for their labor, and are working hard to create value for shareholders. They are incentivized to maximize profitability and cash flow.

All management and board members combined own 3.5%, worth about $5.5mm, which is not that much, but enough to matter based on their likely net worths.

Why is the stock mispriced?

1)      Microcap and illiquid--$150mm market cap and prior to the February 17^th earnings announcement which significantly increased trading volume, ADV was 35k/day, which is about 0.3% of S/O, and about $455,000 in dollar volume at the current price. This small size and illiquidity makes it difficult for many larger managers to build a sizeable position or to make a meaningful impact on their portfolio and therefore they ignore these companies. Despite its size and illiquidity, however, many of the top 15 shareholders are among the best known mutual fund managers. This indicates that there is buyside institutional awareness and demand for the stock.

2)      No sellside coverage-without sellside analysts as guides many institutional investors never become aware of this company.

3)      Does not look cheap on current earnings-Operating income has been negative for 3 consecutive years. Continued sales growth and margin expansion is required for this investment to work. Not all investors rely on forward projections: some are not aware of the company's past margins and some choose not to make the leap of faith that they will reach those margins again in the near future.

4)      No near-term catalysts-this investment will take one to two years to play out and there are no near-term catalysts to drive the stock price higher. This type of investment is not interesting to many near-term catalyst-oriented investors.

Balance Sheet

$31mm cash

$0.6mm short-term debt

$2.8mm long-term debt

$28mm Net Cash

Valuation

Relative valuation: There are a number of publicly traded machine tools manufacturers globally, including Hurco (HURC), Mori Seiki (6141 JP), Okuma (6103 JP), JTEKT (6473 JP), Doosan (042670 KS), and Romi (ROMI3 BZ). Few have been profitable recently so it is difficult to gauge current earnings multiples. Here is some data on these publicly traded peers:

n.b. EV/Sales is taken over the entire business cycle during the past 7-10 years or however long the company has financial reports if shorter, while EV/EBIT is calculated only for the profitable period in the late 2000s; Operating Margin is calculated over the entire cycle.

Direct comparisons are not entirely fair as many of these companies have slightly different business models. For example, Okuma is known for its controls, and Hurco also includes proprietary software and hardware with its machines, whereas Hardinge purchases other manufacturers' controls off-the-shelf and incorporates them into its machines. As the controls have higher profit margins, this difference explains some of the lower than average margins that Hardinge has had over the years.

One interesting data point is that while HDNG historical margins are below average, and therefore we wouldn't argue that HDNG ought to trade at peers' EV/Sales multiple, four out of the six peers are currently trading well above their own historical average EV/Sales multiple. Were HDNG to rise to 1.26x its historical sales multiple the stock would be about $20. It appears that 11x trailing EBIT is a standard multiple during profitable times for the group.

Absolute valuation: Here is one potential scenario for the next 2 years:

It appears that the market is discounting some improvement in gross margin but certainly not a return to 30% in the near future.

24-month return forecasts and estimated probabilities:

Base case: $22, +65%. Gross margins only increase halfway from the last quarter's result (24%) to the historical average of 30% and land at 27% in 2012. Sales grow according to industry forecasts at 23% in 2011 and 16% in 2012. EV/EBIT is the historical peer group median of 11.3. p=45%

Upside: $41, +210%. The global economy continues to strengthen and in particular US and European manufacturing recover, pushing overall sales growth to >20% in both 2011 and 2012. Gross margin recovers fully to 30% in 2012, and the market gives HDNG a premium multiple, albeit in line with its historical average during profitable years, of 13.5 trailing EV/EBIT. p=35%.

Downside: $8, -40%. In this scenario the global economy reenters recession and HDNG fails to reestablish consistent profitability. As a result of their $20mm expansion in Switzerland and China they have less liquidity and struggle to generate enough cash to operate. The $8 target is derived from Romi's initial low-ball bid in February 2010. In a recession the stock has fallen and could again fall far below $8; however, given the value of Hardinge's brands and global assets, we don't believe the eventual recovery would be below $8, even in a liquidation scenario. p=20%.

Expected Value = $26, +100%

Base / Downside: 1.8x

Upside / Downside: 5.6x

Risks

--Higher mix of Taiwan/China sales depress gross margin and the shift to a 100% distributor model in US from 50/50 prevents company from achieving prior 30% gross margins. While this is not a business risk it is a risk to the thesis and would significantly decrease the investment's upside and therefore decrease the reward/risk ratio.

--Global economic growth stalls due to any number of factors, at the moment surging oil prices seems to be the most likely cause. In a worst case scenario, customers stop orders just as HDNG is expanding in China and Switzerland and the company faces a liquidity crisis. Although at the moment a liquidity crisis seems unlikely given their $31mm of cash and only $3mm of debt. They plan to finance $8mm of the $20mm in incremental CapEx and use $12mm of their balance sheet cash to fund the rest. Under most scenarios they should have no trouble financing this expansion. However, if we experience another financial crisis they will turn net income negative again, and given their lack of recent profitability external debt financing would likely be difficult. And HDNG has a leaner operation now with lower DSI and DSO than at the beginning of the 2008 crisis, which makes squeezing cash out of working capital more difficult.

--The US and foreign pension plans are underfunded-by $20mm as of 12/31/09--and HDNG is required to contribute cash to them every year until they are fully funded. Contributions to the pension plans the last three years were $9.8mm (2008), $4.4mm (2009) and $2.9mm (2010e). If global equity and debt indexes plummet the plans will become more underfunded and required contributions will increase.

Conclusion

Upside to downside is greater than 3 to 1, which is our threshold for making an investment. Upside appears achievable over a 1-2 year time frame. Cost reduction efforts will help offset any continued pricing pressure and allow HDNG to return to historical operating margins once pricing improves and sales return to higher levels. One set of investors ignores this stock and another is underestimating the likelihood of a return to previously stable margins; this creates enormous upside potential for HDNG stock if we are right. Downside is limited by external validation of intrinsic value.

Oxford revised industry growth forecast in April

Quarterly earnings in May, August and November