Horsehead Holding: Compelling Idea with Large Potential

| About: Horsehead Holding (ZINCQ)

Horsehead (ZINC) produces zinc metal and zinc oxide from recycled metal. The company and its predecessors have been around for a long time but emerged in a new restructured form via an IPO priced at around $18 one year ago. After a brief excursion to the mid-20's, the stock has mostly drifted lower since then. Most recently, after second quarter earnings, it got slammed particularly hard to its current level of just under $8. This looks like a severe overreaction based on my understanding of the company. To be sure, I am not a metals analyst, but a generalist. So this analysis will take a look at the financials and try to put some context on the share price.

The main reason for the lower stock price is lower prices for zinc, traded on the LME. While inventories on the LME are low, there seems to be ample supply. And the price of zinc stayed low for most of the 1990's, around 50 to 60 cents/lb, before soaring to over $2.00 in 2006. With the U.S. in recessionary conditions and lots of discussion that global economies are also headed for recession, it is easy to see the sudden emergence of gloom for all commodities.

(Aside: it is remarkable how quickly sentiment changes in the markets. Four months ago, investors [read: hedge funds] believed commodities were bulletproof, insulated by insatiable demand from the BRIC's. Now commodities have become a negative momentum trade. Similarly, in early 2007, optimism was rampant about the durability of U. S. economic growth, but by mid year when credit markets began to unravel, psychology changed dramatically. Thus, in our analysis of stocks, we need to be aware of the macro environment, but remembering that cycles are inevitable. And investor moods are magnified by the volatility of cyclical swings. For cyclical stocks, this means focusing on reasonable estimates of future earnings power, and furthermore, buying the shares when earnings are depressed.)

In Q2, Horsehead actually beat the Street estimate, but then investors discovered a good bit of the earnings came from mark to market on hedges the company established to lock in about 60% of this years production at $1.00 per pound. As usual, the Street fails to reward profitable hedging, but punishes hedge losses or unhedged exposures. Regardless, it is clear that ZINC did the right thing by hedging.

That said, not all of the decline in ZINC's share price is unwarranted. It appears that expectations for earning power in 2008-09 have eroded severely, from well over $2/shr to about $1 for this year and basically flat for '09. In other words, no improvement in current zinc metal pricing. That may well be the case, if global growth contracts more and economies stay down for all of 2009, which is clearly possible. But by 2010, we should see recovery based on the elements of monetary stimulus, fairly low interest rates and by then, some pent up demand.

In an investor presentation earlier this year, Horsehead management estimated the following levels of earning power for the 2010 timeframe. With LME zinc metal around $1.00/lb, EPS power was projected in a range of $1.65 – 1.85. It is important to realize this range is after completion of current capital spending projects. However, zinc nearby futures are currently just under 76 cents/lb, which would be problematic for the company should the level persist, since its hedge for over half of production is in place for 2009, at 90 cents/lb, but 2010 is open.

Based on other information from the company including the Q2-08 conference call and the investor presentation, I have attempted a very rough stab at worst case/ recovery case earnings for 2009 – 10. Management pegged Q2-08 normal EPS at about 20 cents, adjusting for the hedges and certain other items. For 2009, if LME zinc stays around 75 cents earnings could be maybe as low at $0.35, including hedged production as well as some minor interest expense from a shortfall in cash flow (see below). That sounds pretty grim, but for a highly cyclical business, to stay in the black assuming very depressed markets is a great victory. For example, Weyerhaeuser (NYSE:WY), which I wrote about a couple of months ago in this space, is currently running at an annualized loss of $4 per share on continuing ops basis in the first half of 2008.

Looking out to 2010, I come up with earnings power potential of $2.20 – 2.30 per share, based on the following assumptions:

  1. LME zinc recovers to Q2-08 average level.
  2. Current capital spending programs are completed on time, and work efficiently. In particular, the zinc dust recycling plant currently under build in South Carolina is a very important project in terms of incremental earnings.
  3. $35mm in cost reduction projects underway are accomplished by no later than end of '09 (management is actually targeting mid-year).
  4. While somewhat speculative, there is an intriguing wild card in the potential sale of iron residuals to steel mills. This material is currently sold for minimal amounts owing to impurities. However, Horsehead is working on processes to upgrade the material into furnace grade iron, either for blast furnaces or better yet, for electric furnaces.

The reader is encouraged to be careful with the apparent precision of this earnings estimate: this company has huge operating leverage to zinc pricing, so earnings can and probably will be materially different from this back of the envelope guesstimate.

Finances: Horsehead has a big jump in planned CAPX next year. There may be a modest shortfall in cash flow unless zinc prices recover. The current balance sheet shows $69mm in cash equivalents and minimal debt, while a $60mm revolving credit is available for any shortfall. Thus, financial risk is modest at the current time.

As another aside, many years ago I invested in a steel company specializing in stainless steel. The company had some very good assets, but it also was loaded with debt. Ultimately the debt did the company in and from that I learned to avoid cyclicals which have more than modest debt. It is a simple formula. Operating leverage = OK if you buy at the bottom of the cycle. Operating leverage plus financial leverage is a recipe for disaster. I have little doubt Horsehead management knows this, since the company itself came out of bankruptcy a few years ago.

Cash earnings and free cash flow: Adjusting for non-cash marks to market on the derivative hedges, I calculate that cash earnings for the first half of 2008 fell about 85% to $7.9mm while cash flow was down about 78% to $11.1mm. Free cash flow, net of working capital changes and CAPX I calculate swung negative to around -$6.7mm vs. a positive $34.4mm last year. Liquidation of inventories was helpful in '08 to the tune of $10.6mm. Looking out to our earnings guess for 2010 shows that ZINC should be generating lots of free cash flow, by my estimate about $44mm. CAPX declines sharply in 2010, so cash will be available for other uses. The revolving credit agreement has restrictions on paying dividends but this agreement expires in 2010 and presumably could be renegotiated more favorably if the company is doing well (and the current credit crunch eases up!) Management has also expressed interest in acquisitions. Obviously we would like to see some cash returned to shareholders at some point in time, via either a dividend or repurchase of shares, depending on the price at the time.

Insiders sold some stock in May at the $15 level. These were option exercises at very low prices in the $1 to $2 range, but nicely timed on the disposition. More recent options were priced at $13 so they are not "easy money" at this point.

Valuation: The stock is selling at essentially book value. Book is pretty clean, but to be conservative we could haircut the derivatives asset since that is marked to market at the end of each quarter. But the derivatives have an offset and that is while the mark will be negative if LME zinc rises in price, Horsehead earnings will also rise in that scenario, which will be additive to book value. Current book is $7.66 per share. I don't necessarily like book as a value metric unless the company earns a decent return. In the case of ZINC, I calculated the annualized ROE on reported earnings at 18.6% for H-1 2008, and the pretax return on capital at 30.2%. In other words, even with earnings on the down slope, and with no balance sheet leverage, ZINC is a very profitable company. Thus, on the upside the stock should be able to sell at say 2.5 to 3X book, or $20 to 24.

In that price range, the P/E multiple would be roughly 10X. Whether it can see higher depends on whether investors see those earnings as peak or a step to a higher level. If the latter, then the stock could sell at a better P/E. Lastly, if the take the guess of $44 mm in free cash flow for 2010E and capitalize it at a 7% yield, we get just under $18 per share as a conservative estimate of upside potential.

Overall, ZINC looks to be a pretty good cyclical reward/risk. The assets are domestic and unencumbered by debt. The company produces a vital product and is a low cost producer. The primary risk is zinc prices continue down and stay down for an extended period of time. I am not qualified to make any judgments about supply/demand for zinc or its marginal cost of production or a reasonable estimate of future zinc prices. However, at this valuation, Horsehead shares incorporate a pretty dire outlook for the next 18 months, while anticipating no recovery.

Disclosure: Long ZINC.

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