Last price: $17
Market Cap: $854 million
Horsehead Holdings (ZINC) is at an inflection point as they shift production to new zinc recycling facility that will lower their cash breakeven price of producing zinc, making them one of the world's lowest cost producers. Horsehead's use of recycled electric arc furnace (EAF) dust feedstock sourced from the steel industry gives them an enduring and sustainable competitive advantage. Once the new facility is complete, Horsehead's cash breakeven cost of producing zinc will be below the lowest price zinc has traded for in the past 10 years and the second lowest cost of production of any zinc producer in the world. Unlike their competitors, the cost advantage will grow over time because as the price of zinc rises, their cost of goods sold remains stable whereas their competitors generally have costs that are linked to revenue. Horsehead currently trades at FY '15 FCF yield of 14%. Horsehead is worth at least $22 valuing them at FCF yield of 10% and potentially much more if zinc prices increase, which I view as very likely. In addition, the replacement value of their assets has been estimated at over $1.5 billion or twice today's market cap. Furthermore, the recycling fees Horsehead charges create a base of stable recurring cash flow of over $85 million per year regardless of the level of zinc prices. The market appears to be valuing this company as a traditional metals/ mining firm when this is not going to be the case once the new facility opens. Commodity companies can have massive moats if they have a sustainable low cost advantage, which Horsehead will have. Furthermore, Horsehead has long term contracts with steel mini mills to recycle about 70% of the dust produced in North America that date back to the 1980's, when the industry began. These contracts and long standing relationships as well as geographic advantages stemming from placing their plants in close proximity to their customers is the reason that competitors have not moved into North American market and aren't likely to in the future. Investing at today's price is also a free option on future increases in the price of zinc. Although this is not an element of my valuation, I believe due to market factors, increases in zinc prices going forward are likely and this creates massive upside to earnings. If zinc prices reach $1.30/ pound, Horsehead would be worth $35/ share valuing the company at 10x FCF. Further upside comes from a likely increase in steel industry utilization which would increase the amount of dust sent to Horsehead. Finally, super investor Mohnish Pabrai has been buying a significant amount of stock in recent weeks at the current price.
Horsehead Holdings is trading for $14 and is worth in excess of $25 and potentially a lot more. In the 1980's, Horsehead was one of the first companies to develop a method to recycle a hazardous waste produced from steel mini mills called electric arc furnace (EAF) dust. Horsehead is paid to take on the dust from steel mini mills such as Nucor (their largest customer) and it's cheaper for steel companies to pay Horsehead to recycle the dust rather than deposit the hazardous dust in landfills. The relationships they have with the steel mini mills date back to the 80's and the revenue they receive from taking on the dust provides a stable base of cash flow that is independent of the price of zinc.
Horsehead has 3 segments:
· EAF dust fees - Horsehead obtains its raw material from steel mini mills and receives a fee for taking on the hazardous dust. In 2012, Horsehead received $43 million in EAF dust fees. These fees are independent of zinc prices.
· Zinc Recycling - Horsehead recycles zinc waste into zinc oxide and prime western grade zinc. This represented 79% of revenue in 2012.
· Nickel recycling - Nickel based waste is recycled by their subsidiary Immetco, which was acquired in 2009. This segment represents 13% of sales and a portion of this revenue is recurring fees charged for recycling. $22.5 million of revenue in this segment comes from fees charged to suppliers of nickel waste and is independent of nickel prices.
Horsehead's business is at an inflection point as they are about to transfer operations to a new $490 million facility that is 90%+ complete at this point. The new facility in Rutherford County, North Carolina replaces their Monaca Pennsylvania facility that is 80 years old. Once the new facility opens (Q1 2014) and fully ramps up by the end of Q2 2014, Horsehead's zinc cash break even will be reduced from the mid $.70's/ pound to the low $.40's/ pound and management estimates EBITDA will increase by an incremental $90-$110 million, independent of the price of zinc. There are four primary ways that the cash breakeven will fall and EBITDA will improve: 1) The new plant will produce a higher grade of zinc. The difference in premium between prime western (Horseheads current zinc grade) and special high grade zinc, which will be produced at the new facility, is $.05/ pound. This is the smallest contributing factor. 2) Lead and silver will be extracted in the new plant and this accounts for $18-$22 million of the increase. 3) The new technology takes a step out of the zinc smelting process, reducing costs. 4) Finally, the new facility will be more cost efficient and boost revenue. A more efficient process will save on manpower (250 employees will be needed, half of the previous facility), power consumption will be reduced (the new plant eliminates the use of metallurgical coke, saving $26 million) and other cost savings and an increase revenue due to an increase in the recovery rate from 92% to 98%. The builder and developer of the new facility, Tecnicas Reunidas, has built 3 similar facilities in the past successfully.
Significant and sustainable competitive advantages
Horsehead operates in a closed loop, they receive the EAF dust from the steel producers and once processed, sell the finished zinc back to them. They have long term contracts in place with these firms as well as facilities situated in close proximity to the steel companies. This makes it nearly impossible for another company to move in and take market share from them. Since the 1980's, no other zinc recycler has taken meaningful market share in the United States. Once the new facility is up and running, Horsehead will be among the lowest cost producers of zinc in the world. At this point Horsehead will have a sustainable and enduring competitive advantage. At a cash break even in the low $.40's/ pound there is only one major producer below them on the cost curve, the Skorpion Zinc Mine in Namibia owned by Vendanta Resources. Since 2004, zinc has traded for a low of $.50/ pound in 2009 and a high of $2/ pound in 2006. When the new facility is complete, Hosehead's cash breakeven price will be below the lowest trading price of zinc over the past 10 years. Horsehead is the bottom 25% of the cost curve, companies in the 25-50% quartile have costs above $.60-$.70/ pound, the 50-75% quartile of production has costs above $.70-$.80/ pound and the highest cost, 75-100% quartile has costs above $.90/ pound. Horsehead has an enormous competitive advantage being the lowest cost producer in the world. In a scenario where zinc prices collapse, Horsehead is protected by having the lowest cost of production on the cost curve. When prices decline far below the industry average cost of production, the highest cost mines shut production and prices will eventually rationalize.
Zinc supply/ demand dynamics
It's important to understand the supply/ demand in the zinc market when investing in Horshead. Although my thesis on Horsehead doesn't require an increase in zinc prices, the EBITDA delta to a $.10 change in zinc prices is $30 million. In the past 5 years, depressed zinc prices have disincentivized investment in new mining. In the next few years, significant zinc mining capacity will be taken out of production, including a few of the worlds largest mines. The Lisheen Mine in Ireland is the worlds 5th largest mine and is closing next year. In 2016, the worlds 3rd largest mine, Century Mine, in Australia will be closed. There are few large projects planned to take their place largely because they require higher zinc prices to justify development. According to Glencore Xstrata, 2 million tons of supply is needed by 2016. "There is a real shortage of quality projects in the pipeline which are anywhere near ready for production." A lot of the zinc mines that were built in the 1970's are nearing exhaustion. According to FMZ, 1.7 million tons (12.5% of the worlds zinc production in 2012) will be taken out of the market by 2016. Today inventories are near all time highs, this could easily reverse as new supply doesn't keep up with demand. Zinc is mainly used in the automobile, housing and construction markets, all of which have significant tailwinds that will lead to continued improvement. In addition, a push by China to begin galvanizing a significant portion of steel (China currently galvanize 4% of steel vs. 18% in the US), all will lead to future increases in demand.
Unlike their competitors, Horsehead has a growing cost advantage because as zinc prices go up their cost of goods sold remains stable. For traditional mining companies, cost of goods sold increases in lockstep with increases in revenue from higher zinc prices. Furthermore, the new plant allows for an eventual increase in production from the current 140,000 tons to 175,000 tons with no increase in capex. As production increases, certain costs stay unchanged, which results in a falling cost per pound and a growing cost advantage to peers over time. The thesis on Horsehead doesn't require higher zinc prices but it appears likely that prices will increase going forward. If zinc prices were to rise to level more in line with historical average, lets say $1.30/ pound, this would increase EBITDA $111 million above my estimate. Investors are receiving a free option on future zinc price increases when buying Horsehead at today's price.
Increasing use of EAF dust feedstock
Furthermore, Horsehead's earnings would increase significantly if they are able to move from the current level of 80% EAF dust feedstock to 100%. 20% of feedstock comes from non EAF sources today such as galvanized shimming that Horsehead has to pay for. Every ton of steel produced generates 30-40 pounds of EAF dust, so as steel industry utilization continues to improve from the mid 70% level it's at today driven by improvements in the construction and automobile sectors, Horsehead will likely return to 100% EAF dust feedstock. Since they are paid to take on EAF dust, when this occurs, operating earnings will increase by at least $10 million.
Horsehead is trading for $854 million and by FY '15 will be earning between $110-$123 million/ year in unlevered FCF with no change in zinc prices. Horsehead is not a traditional zinc producer and is one of the lowest cost producers in the world, with long term relationships with customers and geographic advantages. They are at an inflection point as they begin to transition production to their new facility. Commodity companies can have huge competitive advantages if they are the lowest cost producer. In addition, the fees Horsehead charges to take on the EAF dust and nickel provide a base of sustainable cash flow of $85 million/ year regardless of zinc prices. The replacement value of their assets is more than $1.5 billion or double the current market cap. At a more appropriate 10% FCF yield they are worth $22/ share. However, this doesn't account for any increase in the current price of zinc. Investing in Horsehead today provides a free option on future increases in zinc prices. Based on the last 10 years of zinc prices if zinc prices return to the middle range of $1.30/ pound EBITDA would rise to $266 million and FCF would be $190 million. At a 10% FCF yield Horsehead is worth $35/ share under this scenario and that optionality is free at the current price. Finally, super investor Mohnish Pabrai has been buying a significant amount of Horsehead stock at the current price.