Handicapping Horsehead Holding Stock

| About: Horsehead Holding (ZINCQ)

Summary

The formation of the equity committee suggests that as an investor of the stock at current levels, you’re more likely to break even than lose money.

The judge does not seem to agree with the bankruptcy plan as proposed.

While there’s a risk that you may lose all of your capital, the risk-reward payoff looks attractive.

Horsehead Holding (OTCPK:ZINCQ) is the largest producer of zinc in the United States. Unlike traditional mining companies, however, Horsehead manufactures zinc by recycling zinc containing waste from other industries such as steel manufacturers. Thus, Horsehead is considered a low cost producer of zinc. Horsehead, however, has filed for bankruptcy. I strongly advise you to read the excellent Seeking Alpha article by Christopher Collins to understand the circumstances under which Horsehead Holding has had to file for bankruptcy. He also raises questions regarding extremely important issues such as shareholder rights, fiduciary duty by management towards shareholders, etc., that I believe every shareholder should be aware of.

In this article, however, I'll try to handicap the odds of winning by buying Horsehead's stock at current prices, which could result in three outcomes.

First: The stockholders get wiped out and end up with nothing. In this scenario, the investor would experience total loss of capital. However - thanks to Guy Spier and Phil Town's heroic efforts - the bankruptcy judge has approved an equity committee stating, "Something doesn't smell right to the court." This means that the equity committee gets to represent the rights of the shareholders and increases the potential that the shareholders end up with something. While I think the first scenario is unlikely, it is certainly possible. I'll place the odds at 20%.

Second: There is a potential that the equity committee is able to convince the court that Horsehead Holding is worth a lot more than what the management and creditors are claiming it is worth - which is about $350M. Please refer to the article by Christopher Collins - and I agree with Christopher that Horsehead Holding is worth close to $1B. The rationale for the valuation is that the company has two subsidiaries that generate $30M in annual cash flow, with 8 times multiple, we arrive at $240M in valuation for the subsidiaries. The state of the art Mooresboro facility is expected to generate $120M in annual EBITDA in about two years with $80M in additional investment. At 8 times multiple, the Mooresboro facility would be worth $960M in two years. Discounting back the $960M to today's at 10% discount rate would imply $720M in valuation for the facility. After reducing $80M in investment needed to ramp up the facility implies a valuation of $640M for the facility. Thus, Horsehead's enterprise value is worth $880M. I've used EBITDA multiple of 8 taking average of Environmental and Waste Services (EBITDA multiple of 10) and Metals and Mining (EBITDA multiple of 6) from the list provided by renowned NYU Prof. Damodaran.

For the purposes of this article, let's assume that the court agrees that the company is worth $750M. In this scenario, after accounting for debt ($400M) and debtor-in-possession financing ($90M), it would leave the shareholders with $260M (about 35% of the company). Since the equity is currently trading at $15M, it would imply a 17x return - assuming all of the debt get swapped for equity and the market cap for the company trades at $750M post restructuring. I may be really off here, but I'll place the odds of this scenario unfolding at 20%.

Third: Due to the approval of the equity committee, it is likely that the creditors will want to offer the equity holders a small concession just to keep the shareholders quiet - some call it offering "nuisance value." To me, this is a very likely scenario. Assuming the shareholders end up with 3% of the company, and assuming a valuation of Horsehead at $500M (assuming EBITDA multiple of 4), we arrive at equity worth about $15M. Incidentally, the equity is currently trading at about $15M. As for the odds, I'll place it at 60%.

To summarize, there's a good chance that you'll break even with this investment. While there's also a small chance that you'll lose all of your money, you could also make a windfall. With these potential odds and payout, I certainly like the risk/reward and I am comfortable allocating a small portion of my portfolio on this stock. Before you get excited, let me remind you again that your investment may go to zero if the first scenario plays out. I, however, get some confidence in the fact that from the report published by the equity committee, which is available in the bankruptcy docket, Horsehead was offered decent price for its subsidiaries towards the end of 2015.

I also get comfort from the fact that zinc prices have increased substantially over the past year and the outlook looks extremely positive. Finally, the US has imposed tariffs on Chinese steels, implying that US steel manufacturers should be producing more steel and thus more recycling waste for Horsehead to produce zinc with. Since Horsehead sells zinc and zinc based compounds, these facts would suggest that Horsehead is worth a lot more than it was worth 6 months ago.

Disclosure: I am/we are long ZINCQ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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