Why I Bought More Of Horsehead Holding After The 15% Drop

Horsehead Holding Corp (ZINC, Financial) is the largest zinc producer in the United States and a leading maker of zinc value-added products like zinc oxide and zinc powder. Globally Horsehead holding is the largest producer of zinc from recycled sources. Horsehead has just finished building a solvent extraction/electro winning production facility which is central to this investment idea. Horsehead was formed only 12 years ago but its predecessor companies, New Jersey Zinc Company and the St. Joe resources company, have been in zinc production since the 1800s. On 7-6-2015 the stock fell 20% without any news. After checking for news updates, I decided this created an attractive entry point but was unable to get shares at the absolute bottom of the day as the stock bounced back a little. Given the fundamentals it looks to be an excellent entry point to me and I've taken the opportunity to lower my cost base.

Financial strength

The company carries about $500 million in debt. The company racked up that much debt to pay for the new facility and is now experiencing difficulties getting the facility to full capacity. I have been bullish for quite a while on this company, but my patience is being tested in that regard. However, it is a given that start-up problems are within the realm of possibilities with a new facility. My valuation model shows an estimated FCF of $74 million once the facility is up and running at full capacity. Originally I thought that was going to be realized mid 2015, but that now turns out to be a pipe dream. Meanwhile, the company is losing money as it is forced to continue to run below 60% capacity. If it can get the plant up and running, the $500 million should be serviceable easily enough but if it is unable to execute on that or it takes too long, the debt becomes a problem. There is a real liquidity risk as the majority of the company's debt is due in 2017.

Management

James M. Hensler, chairman of the board and CEO, bought 5,000 shares on 5/12/2015. He owns a fair bit of shares but less than I would like to see. The entire team is getting a fair bit of criticism over the recent failure to get the new plant going. That is fair enough as it is rather disappointing. Management has also been fairly ineffective growing tangible book value or achieving adequate RoA over the past 10 years. It is hard to make this investment thesis on the basis of great management. At the same time it should be kept in mind that it takes a lot of time to invest in a new plant, move operations and this throws the entire company into disarray. Once the plant is finally up and running it is possible the CEO’s performance record improves very quickly.

Valuation

Based on management guidance of EBITDA once the plant is up and running and 10 year historical figures of the company’s finances my model for normalized FCF at 100% capacity looks like this:

Originally, I expected the company to reach this point about a year sooner. The company also issued equity. Presumably to deal with liquidity concerns until the plant gets going. Even with that new equity the upside profile has much improved because the share price declined sharply. This has spurred me to add some shares to my holdings. Today the ultimate FCF per share I’m buying is lower than it was last year but the upside is larger because I’m paying so much less per share.

Risks

A worst case scenario would be where the company being unable to get the plant to full capacity before 2017 when the company has a large tranche of its debt maturing, while Zinc prices plummet. In these negative scenarios the company will be forced to issue additional equity and there is no guarantee the market will be willing to absorb it.

Limiting risk is the company’s high tangible book value which includes a new built plant. It is at $8,3 per share which is close to the company’s share price. Admittedly the tangible book value would need to be discounted if management can’t get the plant to operate but it does help to put a floor under the stock price. The company has hedged Zinc prices by the way but you can only hedge prices so far out. Ultimately, the company is still affected by long term high or low Zinc prices. Management is mainly hedging because it is producing so far under maximum capacity. At higher capacities and in a better liquidity situation they are likely to hedge out commodity risks to a lesser extent.

Outlook

Expect the problems with the plant to continue. Depending on management communications about the ramp up, the stock will trade up or down. There may be lawsuits against the plant designers and/or contractors. The company will need to refinance its debt which comes due in 2017 and progress at the plant will determine the conditions the company will get. This is an ugly situation that will test your patience. However, patience is what sets the value investor apart from next quarters earnings chaser. Ultimately, this could result in me owning a piece of a company that dominates the U.S. Zinc market for the next few decades with a sustainable competitive advantage. Building an additional plant in the far future is likely to be executed far smoother. That is what I am signing up for. If I need to exert some patience, so be it. I am not alone in liking it as famous guru's Guy Spier and Mohnish Pabrai (Trades, Portfolio) have sizeable positions in the stock.