Zinc Producer Horsehead Appears Very Undervalued

Horsehead Holding Corp. (ZINC) is a producer of zinc and zinc-based products, with production and recycling operations at six facilities in five states. The company along with its predecessors has been operating in the Zinc industry for over 150 years.

Horsehead is currently trading for $145 million with $123 million in cash on the balance sheet and no debt. Book value currently stands at $358 million. The net current asset value is $150 million.

The company filed for bankruptcy in 2002 due to record low zinc prices, production inefficiencies, high operational costs, and legacy environmental costs associated with prior owners. Sun Capital purchased the company out of bankruptcy and the company went public in 2007 at $18 per share.

Horsehead is the largest refiner of zinc oxide and prime western (PW) zinc metal in North America. The Company is the largest recycler of electric arc furnace (EAF) dust, a hazardous waste produced by the steel mini-mill manufacturing process.

Horsehead operates five hazardous waste recycling facilities for the recovery of zinc from electric arc furnace (EAF) dust and other zinc feedstocks. The five recycling facilities recycle the EAF dust into a zinc intermediate called CZO, which is shipped to their Monaca, Pennsylvania, facility for further processing into zinc metal and zinc oxide. The company’s processing capacity is 565,000 tons of feedstocks which will be processed into 150,000 tons of finished products. They own all of their facilities. Its products are used in a variety of applications, including in the galvanizing of fabricated steel products and as components in rubber tires, alkaline batteries, paint, chemicals and pharmaceuticals. The Company also owns and operates on its premises a 110 megawatt coal-fired power plant that provides it with a source of electricity and allows the Company to sell approximately one-fifth of its capacity on the open market.

EAF Dust Recycling

The company is the largest recycler of EAF dust, a hazardous material produced in the steel mini mill process. For every ton of steel produced in the mills 30-40 pounds of EAF dust is generated as a byproduct. This dust contains about 20% zinc. About one million tons of EAF dust is produced in the U.S. every year. The full capacity of their seven kilns plus the flame reactor in Beaumont is 565,000 tons of zinc feedstocks and they are looking to expand that further.

The EAF dust collection market started in 1988 when EPA classified EAF dust as a hazardous waste. Horsehead’s predecessor company, New Jersey Zinc, was among the 55-60 different technologies that were developed to address the regulatory issue. However, none succeeded on commercial basis, except very few ones such as Horsehead’s. Horsehead’s ability to recycle EAF dust and use it as a feedstock for its Monaca smelter gives them a competitive advantage over traditional producers of zinc. The company has a lower breakeven point because instead of paying for its raw materials or mining for zinc, it receives a service fee from the steel mini mills to recycle their EAF dust. Acquiring their raw material at a negative cost gives Horsehead a competitive advantage over their competitors. Horsehead has the only zinc smelter in North America that can produce zinc metal and zinc oxide using 100% recycled zinc feedstocks. In addition their recycling process has been designated by the EPA as a “Best Demonstrated Available Technology” for the processing of EAF dust. In addition, EAF dust recycling operations provide them with a reliable, cost-effective source of recycled zinc without relying on third-party sellers

Horsehead gets about 50% of its EAF dust from Nucor steel. Many of their facilities are situated near Nucor’s plants. Most of Horsehead’s suppliers of EAF dust have been with them since the business started in the 80’s. The company recycles EAF dust for 7 of the 10 largest EAF producers.

Currently, 60% of their feedstocks come from EAF dust. There are significant new opportunities for Horsehead to increase the amount of its feed stocks that come from EAF dust. Since the EAF dust is acquired at negative cost, every increase in the use of EAF dust lowers their overall costs and increases margins. Currently about 1/3 of EAF dust production in the U.S. is deposited in landfills. The steel mini mill share of U.S. steel market has doubled over last 10 years and is expected to increase to 70% of the market by 2017 up from less than 60% today. The steel mini mill market is expected to continue to grow 2-3% a year with new projects under construction currently. Horsehead has many opportunities to increase the portion of their feedstocks that come from EAF dust.

Horsehead management has continually stated that they are looking to increase their EAF processing capabilities. In January of 08 they placed a second kiln into production at their Rockwood, Tennessee facility. This kiln will add 90,000 -100,000 tons to Horsehead’s feedstock capacity per year resulting in approximately 14,500 tons of additional finished zinc product. A new recycling facility is currently under construction in Barnwell, South Carolina near a Nucor Steel facility. The new facility will be able to process 160,000 tons of feedstocks per year and is expected to be complete in the latter half of 09. Management expects production of zinc will increase to 175,000 tons from around 150,000 tons per year currently due to these new projects.

Competitors

Horsehead is the only proven recycler of EAF dust and has no direct competitors. The competition comes from domestic recyclers of zinc secondary’s and miners. U.S. Zinc is a recycler of zinc secondary’s with the ability to produce 75,000 tons of zinc oxide per year. But, U.S. Zinc lacks the integrated processing and smelting capabilities that Horsehead has. The high price of zinc in recent years has attracted attention to the industry. Zinc Ox is currently constructing a plant in Ohio with output of 90,000 tons of zinc metal from dust sourced from a company called Envirosafe and Turkey. In addition, Steel Dust Recycling is currently constructing a plant to recycle EAF dust in Alabama and The Heritage Group has announced its intention to build an EAF dust processing facility in Arkansas. All of these facilities are years away from startup but could pose a risk to Horsehead.

Horsehead competes with landfills for EAF dust. But steel mills have many reasons to go to Horsehead instead. The mills that the company purchases its EAF dust from benefit from less exposure to potential environmental liabilities arising from disposing the hazardous dust in a land fill.

Over 75% of the zinc used in the U.S. is imported. Horsehead benefits from its close proximity to end users and lower costs of transportation verse foreign producers.

Operations

Horsehead sells its finished products based on a slight premium to the prior month London Metals Exchange (LME) price for zinc. The LME price dipped just below 50 cents per pound in 2003 and rose to a high of just of over $2 per pound in December of 2006. But since then the price has fallen to just below 60 cents per pound. The company has been working to reduce costs and their cash flow breakeven level is currently around 50 cents. In 2006 the company made $54.5 million which includes a $16 million management fee to Sun Capital. Excluding this fee, the company made $65 million in 2006 and $90.7 million in 2007. Net income for 2008 fell to $39.4 million due to the decline in the price of zinc and a decline in shipments, offset by a large gain due to hedging.

The future LME price of zinc will be affected by idled or closed zinc mining and smelting capacity growth in steel consumption and falling inventories. The current inventories of zinc have risen from the all time lows of a few years ago but are still well below historical average. Inventories have begun to fall as zinc mines and smelter capacity has been removed due to the low price of zinc. In 07, 11.3 million tons of zinc was consumed worldwide. This is expected to increase by 4-5% a year to 13.6 million in 2012. Meanwhile the supply of zinc is likely to be tight, when the economy improves. Brunswick, the world’s fourth largest zinc mine owned by Xstrata, produced 2% of the world’s zinc last year, is expected to be depleted by the end of 2010. It is likely that a decrease in capacity and curtailed capacity additions will cause the price of zinc to rise from the current historically low levels. Also, any stimulus such as the U.S.’s and China’s that includes infrastructure spending will increase demand for zinc.

In the 4th quarter cash provided by operations was $65.5 million. This includes $64 million in cash received from puts on the price of zinc which were sold in the 4th quarter. Sales of finished product were at an average zinc contained price of $.79 in the quarter. When the price of zinc declines the company is also affected by a lag in cost because the feed stocks going through the income statement were purchased back when prices were higher. When prices for zinc stabilize, costs will decrease further. Management expects that cash from operations will be negative for the first half of 09. But, cost cutting measures and an increase in the use of EAF dust instead of other feed stocks have pushed the breakeven point down to around $.50 per pound. Horsehead made $70 million on put options in 08 and they currently have puts for 90,000 tons of zinc at $.5 per pound through 09 to protect them if prices fall further.

Because of the large decline in the price of zinc the company has taken many actions to reduce costs and conserve cash. During the 4th quarter the company has: reduced output at the Monaca facility, suspended production of zinc oxide made from higher cost feed sources, took at extended outage at the recycling operations over the holidays, implemented a reduction in workforce, renegotiated feed prices and cut smelter output by 17%.

Untapped Value in Iron Byproduct

Horsehead’s operations produce about 350,000 tons of iron rich material that they sell into the aggregate market each year. This iron rich material contains about 175,000 tons of iron that the company believes they could sell for much more than they are getting currently. The company sells this material for about $1 per ton. The company believes they could sell the iron portion for $50- $75 per ton. The company successfully tested higher value applications for the iron rich material in the fourth quarter and expects to place its first order during the first quarter of 2009. The value of this byproduct could be worth $9-$13 million per year.

Undervalued

The company is the largest recycler of EAF dust in the world with no direct competitors. Horsehead's ability to recycle EAF dust gives them a competitive advantage over traditional miners and smelters of zinc. Horsehead is working to increase the portion of their feedstocks that are EAF dust and increase processing capacity. Horsehead also benefits from its close proximity to end users in the U.S. In addition, Horsehead has the potential to make a lot of money on the iron byproduct produced from their operations.

Horsehead's stock has collapsed due to the decline in the price of Zinc. But, with their competitive advantages and large cash hoard, Horsehead can survive the recession. Horsehead is currently trading for $145 million with $123 million in cash on the balance sheet and no debt. Book value currently stands at $358 million and net current asset value is $150 million. The company made $65 million in 2006, $90.7 million in 2007 and $39.4 million in 2008. I believe Horsehead is very undervalued.