Horsehead: Strong And Sustainable Moat; 50+% Upside Driven By Transformative New Facility

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By KL Investment Partners :

Source, unless stated otherwise: 10-K ( click here ) and 10-Q ( click here ).

About the company

Horsehead Holding Corporation (( HHC )) ( ZINC ) is the largest producer of zinc in the United States and the leading manufacturer of value-added zinc products, including zinc oxide and zinc powder. HHC has three sources of revenue: zinc products and services (~78% of revenue), nickel products and services (~22% of sales) and electric arc furnace (EAF) dust recycling fees (~10% of revenues).

HHC has a unique business model that focuses almost entirely on producing zinc from recycled sources, which is distinct from mining companies. HHC is an integrated producer and is the world's largest producer of zinc from recycled sources. It has no direct competitor that recycles similar secondary materials into finished zinc products in North America.

HHC was formed in 2003, but its predecessor companies, the New Jersey Zinc Company and St. Joe Resources Company, each having been in the zinc production business, date back to the mid-1800's.

Strong sustainable competitive advantage

Low cost producer

  • Once operational and fully ramped, HHC's new plant should permanently reduce cash breakeven point from its already industry leading level of ~$0.65/lb. to $0.40-$0.45/lb. This compares to ~0.80/lb. for low-cost zinc miners. This would make ZINC one of the lowest cost producers of zinc products in the world. (source: sell side report)
  • HHC's significantly lower cost is due to its ability to convert recycled zinc into finished products. Other zinc producers rely primarily on zinc concentrates.

Freight and reliability advantage over foreign competitors

  • ~76% of zinc metal consumed in the United States is imported. HHC enjoys a domestic freight and reliability advantage over foreign competitors with respect to US customers. This advantage is in addition to its industry leading production cost advantage.

No direct competitor in North America

  • HHC is an integrated producer and is the only smelter in North America with the proven ability to refine zinc metal using 100% recycled zinc feedstocks.

Strategically located recycling facilities and dominant market share of its raw material in North America

  • HHC's four company-owned EAF dust recycling facilities are strategically located near major EAF operators, reducing transportation costs and enhancing its ability to compete effectively with other means of EAF dust disposal.
  • HHC recycles EAF dust for nine of North America's ten largest carbon steel EAF operators and North America's four largest stainless steel producers. HHC recycles more than half of all EAF dust generated in the United States.
  • HHC's EAF dust recycling plants generate service fees from steel mills and supply recycled zinc to its own smelters (that can convert it to zinc products) and to third party zinc smelters.

Economies of scale and leading market position

  • HHC is the largest producer of zinc in the United States based on capacity and is the world's largest producer of zinc from recycled sources. It is also a leading recycler of nickel-bearing waste material generated by the stainless and specialty steel industry and a leading recycler of nickel-bearing batteries.
  • HHC is the largest North American recycler of EAF dust and it recycles more than half of all EAF dust generated in the United States.

Contracted EAF dust sources and very few other buyers in a position to compete for EAF dust

  • Several of its EAF dust customers have long-term contracts to provide it with their EAF dust
  • EAF dust, its primary raw material, is a hazardous waste by-product of the steel industry. The steel industry is primarily focused on disposing of EAF dust while avoiding any environmental pollution related issues. HHC's recycling and conversion of this EAF dust reduces a steel mini-mill's exposure to environmental liabilities which may arise when the EAF dust is sent to a landfill. HHC competes for EAF dust management contracts primarily with one another domestic recycler of EAF dust and to a lesser extent with landfill operators.

Strong, long-standing relationships with a diverse customer base

  • HHC sells zinc oxide to over 200 producers of tire and rubber products, chemicals, paints, plastics and pharmaceuticals. It has supplied zinc oxide to nine of its current ten largest zinc oxide customers for over ten years.
  • In addition, it provides environmental services to over 200 customers that generate nickel-containing waste products such as filter cake, spent pickle liquor, grinding swarf and mill scale.

New facility in Mooresboro will dramatically reduce its production cost and give it access to a market that is 8x bigger (and has higher margins) than the market it can currently target.

In September of 2011, HHC announced that it would build a new zinc facility in Mooresboro, North Carolina. Production started in May 2014 . The new zinc facility utilizes ZINCEXTM solvent extraction technology coupled with state-of-the-art electro-winning and casting capabilities. It will convert Waelz oxide ("WOX") produced from EAF dust recycling and other recycled materials into zinc and will eliminate the need to calcine a portion of its WOX prior to its use. The facility is capable of production in excess of 155,000 tons of zinc metal per year once fully operational. The facility is designed to be capable of producing up to 175,000 tons of zinc metal per year without significant additional investment.

Cost reduction

  • Once operational and fully ramped, HHC's new plant should permanently reduce cash breakeven point from its already industry leading level of ~$0.65/lb. to $0.40-$0.45/lb. This compares to ~0.80/lb. for low-cost zinc miners. This would make ZINC one of the lowest cost producers of zinc products in the world. HHC's significantly lower cost is due to its ability to convert recycled zinc into finished products. Other zinc producers rely primarily on zinc concentrates. (source: sell side report).
  • The new facility will reduce HHC's manufacturing conversion costs due to lower energy cost, higher labor productivity, reduced operating maintenance costs and lower operating costs in its EAF dust recycling plants resulting from the elimination of the need to calcine a portion of its WOX prior to its use.
  • Additional benefits not reflected in current company estimates may be realized once the new facility is fully operational. These additional benefits include reduced maintenance capital spending and reduced state income taxes as a result of credits that HHC believes it will qualify for. Under its hedging program, HHC has purchased put options at an average annual cost of $9.1 million for the last six years; however, as a low cost producer at its new zinc facility, HHC expects its hedging costs to be substantially lower, as its risk of negative cash flow at lower zinc prices will be substantially less. Further, HHC believes the state-of-the-art capabilities at the new facility will allow it to recover value from metals such as silver and lead contained in EAF dust.

Increases sales volume and price

  • The new zinc facility will enable HHC to convert WOX and other recycled materials into special high grade (( SHG )) zinc and other grades that sell at a premium to the prime western (( PW )) grade that its other facilities produce. SHG sells for $50-$60/ton over PW metal. The SHG market size (1.2 million tons) is 8x the PW market (151K tons).

Products, Services and Customers

Zinc metal: Most of the zinc metal HHC produces (PW grade) is purchased by galvanizers and brass producers, who use zinc metal to provide a protective coating to a myriad of fabricated products. HHC is the leading supplier of zinc metal to the after-fabrication hot-dip segment of the North American galvanizing industry. It sells zinc metal to a broad group of approximately 90 hot-dip galvanizers. In many cases, these customers are also suppliers of secondary materials, including zinc remnants of steel galvanizing processes, to HHC. The new zinc facility will allow HHC to expand into new markets, including selling to continuous galvanizers operated by the steel mills, which include some of its EAF dust customers, die casters and LME warehouses.

Zinc oxide: HHC sells over 50 different grades of zinc oxide to over 200 different customers under contract as well as on a spot basis, principally to manufacturers of tire and rubber products, lubricating oils, chemicals, paints, ceramics, plastics and pharmaceuticals.

EAF dust recycling services: HHC typically enters into multi-year service contracts with steel mini-mills to recycle their EAF dust. It provides EAF dust recycling services to over 50 steel producing facilities.

WOX: HHC sells a portion of the WOX generated at its EAF dust recycling facilities to other zinc smelters.

Zinc Powder: HHC's zinc powder is sold for use in a variety of chemical, metallurgical and battery applications as well as for use in corrosion-resistant coating applications.

Nickel recycling: HHC provides recycling services to its customers under fee arrangements.

Nickel alloy: HHC sells its remelt alloy product, produced from waste accepted as an environmental service, back to the stainless steel industry.

Operations

HHC has six facilities in four states in the US and one in Canada

  • Zinc Recycling: (1) Palmerton, PA - produces WOX, Calcine and Zinc Powder (2) Calumet, Illinois - produces WOX (3) Rockwood, Tennessee - produces WOX (4) Barnwell, SC - produces WOX.
  • Zinc Production: (1) New facility in Mooresboro, NC replaced facility in Monaca, PA - new facility produces Zinc Oxide, Zinc from WOX (2) Zochem facility in Brampton, Ontario Canada - produces Zinc Oxide from SHZ Zinc metal.
  • Nickel recycling: INMETCO facility in Ellwood City, PA - produces Nickel-chromium-iron alloy.

HHC operates four hazardous waste recycling facilities to create WOX (55%-65% zinc) from EAF dust. The facilities are strategically located near sources of EAF dust production. The output of the recycling facilities is WOX and iron-rich material that is sold as aggregate in asphalt and as an iron source in cement. Other components of EAF dust are converted to non-hazardous materials.

Prior to the May 2014 shut down of the Monaca, PA facility and full ramp up of capacity at its new Mooresboro facility (expected in six months), the majority of the WOX generated was shipped to one of its four recycling facilities, which is also a refining facility (Palmerton, PA) where WOX is converted to zinc calcine (65-70% zinc). This zinc calcine was then shipped to its (now shut down) smelting facility in Monaca, PA, where it was converted to zinc metal and value-added zinc products (zinc oxide etc) and to other zinc refineries around the world.

The new zinc facility in Mooresboro utilizes ZINCEX solvent extraction technology coupled with state-of-the-art electro-winning and casting capabilities. The new zinc facility will convert WOX produced from EAF dust recycling (at its zinc recycling facilities) and other recycled materials into zinc and will eliminate the need to calcine WOX prior to its use.

The company also produces Zinc from zinc metal at its Zochem facility in Brampton Ontario, Canada.

Its nickel facility is the largest recycler of nickel-bearing hazardous waste in North America. It sources raw material from a variety of metal-bearing waste materials, generated primarily by the specialty steel industry. The facility's main product is a nickel-chromium-iron remelt alloy ingot that is used as a feedstock to produce stainless and specialty steels. The facility also recycles Ni-Cd batteries and alkaline batteries.

Zinc

Zinc is a natural component of the earth's crust and an inherent part of our environment. Zinc is present not only in rock and soil, but also in air, water and the biosphere. Plants, animals and humans contain zinc. Zinc ore deposits are widely spread throughout the world. Zinc ores are extracted in more than 50 countries. China, Australia, Peru, Europe and Canada are the biggest zinc mining countries. Zinc is normally associated with lead and other metals including copper, gold and silver.

At present, approximately 75% of the zinc consumed worldwide originates from mined ores and 25% from recycled or secondary zinc. The level of recycling is increasing each year, in step with progress in the technology of zinc production and zinc recycling.

About 12 million tons of zinc is produced annually worldwide. ~58% is used for galvanizing to protect steel from corrosion, ~14% goes into the production of zinc base alloys mainly to supply the die casting industry and ~10% to produce brass and bronze. Significant amounts are also utilized in rolled zinc applications including roofing, gutters and down-pipes. The remainder is consumed in compounds such as zinc oxide and zinc sulfate.

The nominal price of zinc has averaged $0.68/lb. for the last ~25 years, with a low of $0.33/lb in 2002 and a high of $2.09/lb. in 2006. On an inflation adjusted basis, the preceding average, minimum and maximum prices will be higher. The current price is $1.04/lb. Many analysts are arguing that zinc prices are likely to rise due to declining zinc production, which is a result of long-term underinvestment in the sector. The valuation section below does not incorporate any increase in zinc prices in the upside.

Largest Holders

Mohnish Pabrai's hedge fund Dalal Street LLC (12.5%), RS Investment Management (9.2%), BlackRock (6.2%), Vanguard Group (5.9%), Dimensional Fund Advisors (5.6%).

Valuation: 53+% upside

Relevant data:

  • Current stock price: $17.65
  • Number of shares (including to be issued to the convertible debt holders): 57.57 million
  • Net debt (excluding convertible debt): $205 million
  • Current zinc price: $1.04/lb.

Assumptions:

  • Ebitda prior to full ramp up of the new facility and zinc at current zinc prices = ~$65 million.
  • New facility will deliver $90 million to $110 million in incremental annual adjusted Ebitda (based on management guidance).
  • Additional benefit from reduced cost of hedging, maintenance cap-ex, cash taxes = $13 million.
  • Comps (due to lack of direct comps, companies in the following industries have been used: mining, smelting, specialty metals, recyclers): Nucor Corp ( NUE ), Allegheny Tech (ATI), Harsco Corp (HSC), Teck Resources (TCK), US Ecology Inc (ECOL), Schnitzer Steel (SCHN), Sims Metal Management (SMSMY), Metalico (MEA).
  • Median EV/Ebitda of comps: 9.87x (this is higher than the valuation of large mining companies due to the significant and sustainable cost advantage that HHC enjoys)

Computation:

  • Revised Ebitda = $178 million.
  • EV/Ebitda = 9.87x.
  • Target EV = $1,757.
  • Target market capitalization = $1,552.
  • Target price per share: $26.96/ share

There is further upside if the company is able to materially increase sales by tapping new markets or improve margins via SHG sales or if zinc prices increase like some expect.

Risks

Commodity price risk: The metals industry is highly cyclical. Fluctuations in the availability of zinc and nickel and in levels of customer demand have historically been severe, and future changes and/or fluctuations could cause HHC to experience lower sales volumes, which would negatively impact HHC's profit margins due to high fixed costs. In 2002, record-low zinc prices, production inefficiencies, high operational costs and legacy environmental costs associated with prior owners/operators of HHC's facilities caused HHC to file for Chapter 11 bankruptcy protection. This risk is partly mitigated since the new facility further improves the cost advantage enjoyed by HHC.

High debt: The company raised significant debt to fund the new facility in Mooresboro.

New facility risk: Some aspects of the technology in the new zinc facility have not been tested in exactly the same manner on a production scale or the equipment in the new zinc facility may not be operated in exactly the same manner as the other production environments.

Conclusion

Horsehead is a company with a very strong and sustainable competitive advantage, enabling it to have production costs significantly lower than competitors. Its new facility further strengthens its cost advantage and enables it to increase sales volume and sales price via giving it access to new markets (8x bigger than its current market) where price-per-unit is higher. 53+% upside.

Disclosure: The author is long ZINC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: KL Investment Partners may change or exit its position (buy or sell shares) without updating this article and without informing the Seeking Alpha community. KL's articles, blogs and comments are not an offer to sell or a solicitation of offers to buy any securities. Securities of the Fund are offered to selected investors only by means of a complete offering memorandum and related subscription materials. There is the possibility of loss and all investment involves risk including the loss of principal.

See also Praxair's (PX) Q2 2014 Results - Earnings Call Transcript on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: HHC , ZINC , SHG , PW , NUE

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