To put it bluntly, something doesn't smell right to the court. I don't know what happened. I don't know if there was inappropriate behavior." - Judge Sontchi at the Equity Committee hearing on May 2nd.
On May 2nd, the Court appointed an Equity Committee for the Horsehead (OTCPK:ZINCQ) bankruptcy case, which gives shareholders (via the Equity Committee) access to certain Company documents and details leading up to the filing. On May 27th, the Equity Committee filed an Objection to the Disclosure Statements of the Company's Joint Plan of Reorganization and followed it up with a letter to Judge Sontchi.
The Objection details seven material issues with the Disclosure Statements and I encourage readers to review the entire Objection. The most notable finding in the Objection was that Horsehead received offers for a portion of their assets (excluding the $550 million Mooresboro facility) for substantially more than the value ascribed in the Disclosure Statement to all of their assets ("Disclosure Statement Valuation"). In my view, (1) pre-petition offers for the Company excluding Mooresboro, (2) a conservative valuation of Mooresboro based on Management's pre-petition statements, and (3) rising zinc prices support a valuation of Horsehead in excess of $1 billion and discredit the Disclosure Statement Valuation ($255 million - $305 million). In this article, I will review these three valuation considerations discussed in the Objection, which I have supplemented with my own research. I have also included my thoughts on the Company's recently filed financial audit and a recap of the events to date to shed light on Judge Sontchi's suspicion that "Something doesn't smell right" with the Company's story.
Valuation Consideration #1: Pre-Petition Offers
Pg. 5, Paragraph 10: The Disclosure Statement Omits Critical Valuation Information, Including Recent Offers to Purchase the Debtors' Assets, and Contains Materially Misleading Information.
"The Disclosure Statement severely understates the value of the Debtors' assets. The most obvious proof is its failure to mention that in December 2015, the Debtors were in receipt of offers to buy a portion of their assets for substantially more than the value ascribed in the Disclosure Statement to all of their assets. These offers - which did not even include the Mooresboro plant, the crown jewel of the Debtors' operations, or a fifth recycling plant - are for substantially more than the value put on the entirety of the Debtors' assets in the Disclosure Statement ($255 million to $305 million)."
The receipt of these pre-petition offers confirms the significant value of Horsehead's subsidiaries (Zochem and Inmetco) and recycling facilities and raises the question: Why were these subsidiaries not sold to keep the Company out of bankruptcy? The exact offer amounts were not released to the public, but were reported by the Equity Committee as "far in excess" of the Disclosure Statement Valuation, so I will assume $350 million, which is likely conservative given that these buyers would pay more for these assets now with the significant recovery in zinc prices. With that solid data point for the valuation of the Company excluding Mooresboro, I will turn to some thoughts on the valuation of the Mooresboro plant.
Valuation Consideration #2: Management's Pre-Petition Statements on Mooresboro
Pg. 7, Paragraphs 14-17: The Disclosure Statement Omits Essential Information and Contains Misleading Statements Regarding the Value of the Mooresboro Plant.
"The Disclosure Statement's assessment of Mooresboro paints a dire picture, one entirely at odds with the company's pre-petition prognostications… The Disclosure Statement inaccurately characterizes the value of Mooresboro in at least four ways: (1) by increasing the estimated cost of repairs; (2) by increasing the anticipated time the repairs will take; (3) by dramatically decreasing the expected profits the plant will provide; and (4) by using, but not disclosing, deflated prices for zinc even though the price of zinc has increased."
The Objection explains these inaccuracies in detail, which I have summarized in the chart below with additions from my own research. The Objection also includes a detailed list of pre-petition statements directly from Management regarding key assumptions to the value of the Mooresboro plant. I've included a selection of these statements mentioned in the Objection and added several others below the chart.
These statements are primarily from the Q3'15 earnings call in November - only a few months before the Disclosure Statements were filed. In my opinion, these new assumptions are being used to distort the true value of Mooresboro. If Mooresboro makes $100 million in 2 years (as Management stated only months ago) and requires $100 million in capital, a conservative valuation is $500 million (close to cost) with the potential to be worth multiples of that if zinc prices reach $1.875 as Wood Mackenzie predicts. Others may argue that the Mooresboro issues are as severe as Management indicates, but the rapid change of the assumptions and other questionable events (not acting on pre-petition offers) make me believe otherwise. Even if it takes the time and capital that Management now estimates, there is enough value to put the equity in the money with an option of exponentially higher zinc prices.
Management's Pre-Petition Statements on Mooresboro:
- "I have the full confidence that we're going to be able to get this plant up to design capacity… These are just fundamentals or problems that exist that all metallurgical operations, hydro or power metallurgical operations that with engineering focus and operations focus can be resolved." - Greg Belland, Horsehead Senior Vice President
- "We think that the pilot plant the way it's configured right now would allow us to run in the mid-200 ton per day level may be a bit higher, maybe approaching 300. So say 60% of nameplate capacity and may be a little bit higher than that." - Jim Hensler, Horsehead CEO
- "Yes, sure, Jim. Yes, totally we can hit 60% we've been able to demonstrate that over the last week here that the current pilot plant facility can run reliably" - Greg Belland
- "We believe we will begin to approach that in 2016 (100% capacity). We believe we have our arms around the issues we've been able to identify so far and have a plan to address those - Ali Alavi, Horsehead Senior Vice President - Corporate & Environmental Affairs (Oct.-15 Pittsburgh Post-Gazette Interview)
- "We've got an extremely valuable attractive security package when we've got four EAF dust recycling plants out there plus the INMETCO facility in Zochem and in the Mooresboro plant. So there is a tremendous amount of fixed assets out there from a security standpoint." - Jim Hensler
- "Yes, we're still bullish on the medium to long-term story on zinc, and we think that there is a supply deficit looming and we think that we'll see that at some point in time, in the short-term, that the price of commodities is getting buffeted by lot of factors." - Jim Hensler
Valuation Consideration # 3 - Zinc Prices and Conclusion
Many of the Company and Creditor's arguments on value are based on a deflated price of zinc, which dipped to $0.65 in January of 2016 and triggered the technical default that allowed the Creditors to force the Company into bankruptcy. The price of zinc has increased nearly 50% to ~$0.95 and metals expert Wood Mackenzie predicts that zinc prices will reach $3,750 per ton or $1.875 per pound by 2018. It is important to note that Wood Mackenzie is the same expert consulting firm that the Company referenced in its own Investment Presentation in September 2015.
"Smelter output will not keep pace with demand this year or next. Two years of refined deficits provide fundamental support which will be amplified by the activities of investors to propel the price to a cyclical high of $3,750/t in 2018." - Wood Mackenzie (May 2016)
The estimated value of the Company excluding Mooresboro based on pre-petition offers ($350 million) plus a conservative valuation of Mooresboro ($500 million) puts the total value of the Company at $850 million with a strong probability that the value will be closer to $1 billion - $2 billion when zinc prices rise. These factors support the shareholders case that the equity has significant value and discredit the Disclosure Statement Valuation.
Recently Filed 2015 Financial Audit
“’F.A.S.B’” … ‘Financial Accounts Still Bogus’” - Charlie Munger
Horsehead recently filed audited financial statements for 2015 that include a $528 million write-down of the entire value of the Mooresboro facility (Pg. 16). The audit addresses the bankruptcy in Note AA on the last page of the audit as a "Subsequent Event". The write-down was based on the Company's bond and equity trading prices and the income approach was not considered (see note below). In addition, the audit assumes that the deferred tax assets (hundreds of millions) are also worthless.
Audit note - The income approach was not considered an appropriate fair value measurement due to the absence of reliable forecast data as the facility was idled indefinitely in early 2016 as a result of uncertainty around timing of future capital inflows necessary to make required capital improvements to generate positive cash flows stemming from the Chapter 11 proceedings as well as uncertainty around recovery timing of commodity prices.
As Charlie Munger suggests, accounting standards are open to a lot of interpretation and I view the audit as an aggressive interpretation of those standards that greatly distorts the true value of Horsehead and hope the Court will not give it merit. I ask readers to take into account the following questions in determining if this audit reflects the true value of Horsehead:
- How can the audit assume Mooresboro is worthless given Management's statements listed above from only a few months ago and (ii) the Company's own projections in the Disclosure Statements of $57mm of profit?
- Is uncertainty of future capital inflows to fix an extremely valuable stand-alone asset grounds for assuming that asset is worthless?
- Is a 2-paragraph note on pg. 16 of an audit an adequate explanation for a ~60% reduction in asset value within a few months?
- Should a financial audit that is released to public investors include a note about pre-petition offers for a portion of the assets that were "far in excess" of $300 million? Note that the audit was signed off on May 31st, days after the information from the Equity Committee regarding these offers was made public.
- Is there a strong chance that the Company will realize profits once Mooresboro ramps up and zinc prices recover (as they already have) and the Company is able to use the deferred tax assets that have been assumed worthless?
- Why did the Company change auditors during the bankruptcy? Audit costs savings is not a logical justification given the huge bills for legal and financial consultants as part of the restructuring and the importance of the audit itself.
Recap of Events to Date and Conclusion
The bankruptcy process is complex and Horsehead has been a unique case, but as Judge Sontchi said in Court on May 2nd, "Something doesn't smell right" about the Company's reorganization plan. To recap:
- A $550 million plant, which was touted only months ago by the Company as extremely valuable and capable of generating ~$100 million+ in profit is suddenly deemed worthless.
- The Company received offers for a portion of their assets (excluding the $550 million Mooresboro facility) for substantially more than the Disclosure Statement Valuation of all of their assets, but chose not to sell the subsidiaries and pursue bankruptcy instead, calling into question whether the Company upheld their fiduciary duties to shareholders.
- Management was extremely bullish on zinc prices on the Q3'15 earnings call and in an investor presentation, but decreased their assumptions (and likely lowered in the Disclosure Statements) while zinc prices have recovered nearly 50% since the filing and the same consultants they cited in their materials predicts that they will reach $1.875 by 2018.
- Huge fees have been paid to auditors, consultants, financial advisors and their conclusions all line up with the Creditors/Company's story that the Company has suddenly declined by 60% in value.
This story doesn't add up to me as a long-time shareholder of Horsehead. From my perspective, a large hedge fund has forced a productive company into bankruptcy, resulting in the loss of employment and a delay in the development of a productive plant in a rural area. Thousands of individual shareholders (view hundreds of their letters to the Court), primarily consisting of retirees and hardworking citizens (teachers, engineers, small business owners) stand to lose their investments, while a hedge fund and management team stand to get rich with stock options at a depressed value. I don't believe this is an intended outcome in the U.S. financial system and ask the SEC, who's stated mission statement is to protect investors, and the Court to take these facts raised by the Objection into account in the Horsehead case.
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. I have no business relationship with any company whose stock is mentioned in this article.
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