Friday, January 23, 2015

Not a fan of Horsehead Holding

I've been meaning to write a bearish article about Horesehead Holding (ZINC) for a while. Unfortunately the stock is down 11% over the past couple of days and trades at its 52-week low, so this post is less timely than I'd hoped it would be.

I have no idea how the stock will perform over the next few months. It may bounce back from its recent sell-off. I'm skeptical of the company's long-term prospects, though, and think it has underappreciated risks.


The bull case

Steelmakers use zinc to galvanize many kinds of steel, and the galvanization process generates zinc dust as a byproduct. ZINC has a unique business model: it removes this dust from steel mills, processes it into usable zinc, and then sells it back to steelmakers for the next round of galvanization. The company recently built a new refinery that it expects to increase its capacity and lower its operating costs once it's fully operational.

At the risk of oversimplifying the bull case for ZINC, I'll boil it down to three arguments:

• ZINC will be a low-cost producer after the new refinery scales up.
• The fundamentals for zinc-- the metal, not the company-- are good.
• ZINC has two high-quality niche divisions that complement its main business.

There's a writeup on Value Investors Club recommending the stock. It's well-written and mentions all of the things that I consider major risks, although obviously I disagree about their likelihood.


My bearish counterpoints

• ZINC's historical cash flow is negative. That's a result of its building the new refinery, which has experienced operational delays and necessitated three dilutive securities offerings, but its historical returns were unimpressive even before that. As of now, the bull case for ZINC rests on projections of how much it will earn once the refinery reaches capacity, but the company's track record gives reasons for skepticism.

• ZINC borrowed a lot of money to build the refinery, so while this will lower the company's operating costs, it will simultaneously raise its financing costs. I don't think this was a good trade: if operating costs make a refiner unprofitable, the refinery can be idled. If financing costs make it unprofitable, the interest payments can't be put on standby. ZINC's predecessor company went bankrupt in 2002, during the last commodities bust.

• Zinc prices are above their historical norm. The VIC writeup uses the average zinc price from 2004-14 in its projections, but the commodity bubble started around 2004, so the past decade isn't representative of normal zinc prices. They were much lower, on average, during the 1990s. In 1995, a typical year, they were around 65-70 cents per pound in today's prices compared to 96c right now. In 2001-02, zinc got down to 35c, or 45c in today's prices. By comparison, the VIC writeup suggests 60c as ZINC's cash-flow breakeven point after debt service.

• The writeup states that the new refinery will make ZINC "a global low cost producer," but I don't think that's the case. The writeup suggests that ZINC's EBITDA breakeven will be 42c per pound, but many zinc mines have lower cash costs. A few have negative cash costs after byproducts. ZINC does have lower transportation costs, however, since its facilities are situated near it customers' facilities, whereas the U.S. has to import most of the mined zinc that it consumes.

• Several large zinc mines will close over the next few years, and many investors expect this to result in higher prices. I'm skeptical because the mine closures have been anticipated for a while, so I think the market has had time to price them in.

Ed Seykota's Market Wizards interview describes a similar scenario early in his career: the US Treasury was about to finish selling down its silver holdings, and Seykota went long silver futures because he expected the price to rise once the Treasury was done. Instead the price fell, giving him "a very stunning education about the way markets discount news."

• Most zinc-bearing mines are polymetallic: they might produce gold, silver and zinc together, or copper, zinc and molybdenum, or zinc and lead, or some other combination of metals.  Zinc is a byproduct for many of these mines, so the zinc price has relatively little influence over their production decisions. This limits the market's ability to adjust supply when zinc prices fall and can lead to protracted gluts.

A couple of mines that Teck Resources owns, Red Dog and Antamina, illustrate this. Red Dog is one of the world's three largest zinc mines. Antamina produces copper, zinc, and molybdenum, and its copper output is worth five times as much as its zinc output. Although zinc is a fairly minor byproduct for Antamina, it produced almost half as much as Red Dog in 2013.

• ZINC's niche divisions, Zochem and INMETCO, may produce good long-term returns on invested capital, but they're cyclical. ZINC bought INMETCO for a song in 2009 in part because the Global Financal Crisis had temporarily destroyed its earnings.

• ZINC reminds me of Fortress Paper, a one-time value favorite that's down 95% over the past few years. Like Fortress, ZINC has a couple of niche divisions that are hidden gems. Like Fortress, ZINC is responding to a promising market opportunity by bringing new capacity online. And like Fortress, ZINC has borrowed a lot of money, done a dilutive stock offering, and experienced operational problems while developing that capacity.

• Many value investors are interested in ZINC because Mohnish Pabrai is the company's largest shareholder. Pabrai has good long-term returns, but he's also had his share of losing investments, so I hope that investors aren't outsourcing their due diligence to him.

5 comments:

  1. Hi James. Curious if you have the same take on Horsehead currently. The stock is down 50% since January as they continue to struggle to ramp up capacity at Mooresboro.

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  2. Hi James. (Re-posting to be notified of follow-up comments). Curious if you have the same take on Horsehead currently. The stock is down 50% since January as they continue to struggle to ramp up capacity at Mooresboro. Thanks, Walter

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    1. Hi Walter,

      I think the company is in a worse position than before the decline-- Back then, the could issue new stock to finance delays and cost overruns at the new plant. With the stock in the single digits, any future stock issuance will be much tougher to pull off. In my opinion, this is a rare case where a falling stock price actually erodes the margin of safety.

      I didn't anticipate that the plant would have more problems, and I have no idea when they'll finally get it to work. Further delays wouldn't surprise me considering their track record, but I really don't know. Sorry I can't offer a more definite opinion.

      I'm still long-term bearish on the stock for the reasons in the post-- I think it's a mediocre business, there's commodity price risk, there's risk related to the debt load, etc.

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  3. Hi James,

    Thanks for the reply. Did you or are you short the stock? Execution risk on the ramp-up of Mooresboro remains in play as management cannot forecast when full capacity utilization will be achieved. So the question is whether/how soon they'll begin realizing the projected $90-100M upside in annual EBITDA from operating near or at full capacity and how that will impact cash flow and the ability to service the debt load. We'll see!

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    1. I was short for a while but covered in June, right before the stock started to crash-- pretty awful timing on my part.

      I agree with your assessment re: execution risk, etc.

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