Description

ZINC is uniquely positioned to benefit if zinc price stays strong for longer (say, above $1/lb for the next 2-3 years) thanks to its low cost position with 55-60% of feedstock from electric arc furnace (EAF) dust and the rest from zinc scrap. Even with $1/lb zinc price, the company could earn up to $1.25-1.50/shr earnings by 2009. And free cashflow associated with such earnings could be at least $1.50/shr. With $3/shr cash sitting on balance sheet by 2009, the stock should be worth at least $18 or 10x '09 FCF @ $1/lb zinc price, excluding cash. On the other hand, if zinc price happens to be stronger, ZINC’s earnings could move up dramatically. The industry forecasts actually put '09 zinc market back into deficit again. If that happens, given the significant leverage to zinc price, the stock could go up to $30, assuming 12x P/'09 EPS est. of $2.50+/shr with zinc price at $1.25-1.30/lb.

a.      ZINC appears to be more “aggressive” (the word was from CEO) securing new EAF dust collection contracts with key customers (NUE being 50%). In exchange, ZINC will reduce the collection fee it receives from steel mills. Although the CEO assures me that the reduction will not be more than 1c/lb (out of 4c/lb base), for an investor who is not aware of this could be something negative (more discussion later on why I believe 1c/lb cut is very conservative). A 1c/lb cut in collection fee across the all customer base will reduce its earnings by 20c/shr – not meaningful if that’s all.

b.      The contract with NUE, the biggest EAF dust customer for Horsehead, will not expire until 2009. However, the management clearly indicated that they want to get the renegotiation done quickly and they actually expect the new contract will kick in by 2008. If this occurs, depending on the sentiment in the market, such news could be interpreted as a negative since ZINC will never disclose how much discount they give up on collection fee and there could be concern that the other customers might demand same kind of fee cut.

 

Business description 

 

The company operates five EAF dust processing (recycling) plants around the country. These plants are strategically located close to major mini-mill production areas and nobody else today has such national footprint.

 

If you compare ZINC’s facilities' location with Nucor’s major plants, you'll find two maps match quite well – this is not a concidence. Nucor is almost 50% of total EAF dust supply to Horsehead. Horsehead does business with all the major mini-mills in the States.

 

The company runs one major smelting facility in Monaca, PA, where its headquarters are located. The major products are Prime Western (PW) zinc metal (40+% of total sales) and Zinc Oxide (35+% of total sales). Horsehead has dominant market share in the US for these two products: for PW, its market share is more than 60% (for PW after-fab, just 58%; for PW brass, over 70%); and for Zinc Oxide, its market share is almost 1/3 of total US market.   

 

At Monaca, PA site, Horsehead also runs a coal-fired 110MW power plant. 60-70% power generated is for self-use and the rest 30-40% is sold to the grid. It receives $6-7mm revenue per year and probably earns $2-3mm profit.

 

There is also a zinc powder plant in Monaca, PA, but that property is owned by Mitsui, which used to have a JV with Horsehead. Horsehead still supplies zinc slabs to this plant and the supply contract will expire by 2011 – theoretically, Horsehead will have an upper end by 2011 if they want to buy this plant since nobody else can supply Mitsui.

 

The company treats the five EAF dust processing plants as cost centers, and operating managers get compensated to lower cost of recycling EAF dust, plus sharing the profitability in the downstream operation. As a result, P&L only resides in the Monaca, PA plant, which is the only major smelting facility Horsehead has.

 

Horesehead uses EAF dust, a zinc-bearing hazardous waste generated by mini-mills, as 55-60% of its feedstock, which costs ZINC only 13c/lb; the remaining feedstock source from scrap costs ZINC 70% of LME price.  

 

The operation, though complex in technical detail, appears to be easily run on daily basis. I got that impression by observing CEO/CFO’s schedule – when I requested the meeting in mid-October, their sectary gave me more than five dates to select from Oct. 31 to Nov. 20. They also scheduled a group investor visit (arranged by Friedman Billings) on Nov. 8^th, just one day before their earnings release. CEO actually admitted to me personally that it’s an easy business – as long as they can maintain safety and productivity. I guess the cost advantage is so enormous that at today’s high zinc price level, everything else is really irrelevant – thinking about labor, energy, etc., all the things that bother other CEOs today.

 

So what does the CEO do to justify his pay? He appears to be laser-focused on securing more EAF dust supply at acceptable terms (i.e. getting paid collection fee) and on a long term contractual basis. This strategy, if successful, will enable Horsehead to take advantage of its low-cost position to grab more market share in the downstream market.

 

This job is actually not easy, particularly given the rising competition. But I’m glad to hear from him personally saying he will be “aggressive” to go after incremental EAF dust volume – more about this later.

 

 

Market situation review

 

PW zinc metal mainly goes to infrastructure projects, which have been strong. Zinc oxide goes to rubber (tire), pharm as well as chemical and paints, but tire industry holds the key. Tire market is largely stable given replacement demand exceeding OEM demand by 4:1. So the market condition for end products looks good, according to the management.

 

Also, with 70% of US zinc currently imported, Horsehead’s products have cost advantage via lower shipping costs; the recent weak dollars further enhance such advantage. In other words, zinc demand is largely driven by factors outside the US, mainly by global infrastructure spending, which is booming these days thanks to 1) petrodollar spending in the middle east and Russia as well as South America; 2) fixed-asset investment driven growth model adopted by China (infrastructure building now is moving from Tier 1 cities, like Shanghai, Beijing. etc., to Tier 2 (province capitals), Tier 3 (major industrial cities in the heartland) or even Tier 4 cities (thousands of counties, towns, etc).

 

Zinc oxide is sold at a premium to the LME benchmark price but with 2-month lag. Zinc metal is priced at par with LME benchmark on real time basis.

 

In terms of EAF dust collection, its volume is correlated with mini-mill steel production level. The decline in steel production for US steel mills started in 3Q06 but in the recent quarters production level has been flattish. Nevertheless, it was still 10% down YoY, with weakness mainly from auto steel. Steel inventory continues to decline, which could lead to a rebound in steel production activity. Seasonality-wise, 4Q/1Q are typically strong for steel production. In the meantime, Horsehead is more aggressive picking up new customers. So sequentially, dust collection volume should go up in 4Q07. This is confirmed by the CEO in the latest meeting with investors in New York when they attended FBR conference last week.

 

Horsehead’s dust inventory is currently at only 1 month’ supply level – a comfortable level but lower than typically 2-month. But the management assured me that this is only short term situation, which was caused by some blending bottlenecking in its recycling facilities as well as some railcar turnaround issues.

 

EAF dust collection – key to Horsehead’s business success

 

Market total size is roughly 1mm tons, of which landfills account for 350k. The market is expected to grow by another 100K tons over the next 12-19 months, based on announced mini-mill expansions in the US. Since landfills don’t remove environmental liability, dust recyclers like ZINC are preferred. As a result, the total addressable market for ZINC to go after further is 450K tons (350k existing landfills + 100k added by new steel mills). The announced capacity expansion by mini-mills include:

 

                                    Location                       Timing              Capacity (mm tons)

1. SeverCorr                Columbus, MS 2H07               1.65

2. Nucor/Birmingham    Memphis, TN               1Q08               0.85

3. Essar/Minnesota       Duluth, MN                  2009                2.76

4. ThyssenKrupp          Mobile, AL                  2010                4.96

5. Wheeling Pittsburg    (restart of idled capacity)

 

The rule of thumb is roughly 30-40 lbs of dust is generated per ton of steel produced. The dust, on average, contains 20% zinc.

 

Today, Horsehead is one of the two major US market players with 500,000 tons capacity. The other one is Zinc National (140,000 tons capacity), which is located in Mexico and mainly do business in the Southern US (constrained by transportation).

 

The whole EAF dust collection market really started in August ’88 when EPA classified EAF dust as a hazardous waste (actual industry practice of recycling EAF dust started in ’84, though). ZINC’s predecessor company, New Jersey Zinc, was among the 55-60 different technologies that were developed to address the regulatory issue. However, none succeeded on commercial basis, except very few ones such as ZINC (obviously, during 80s, the total EAF dust recycling industry was still very small). As a matter of fact, its technology is designated by the EPA as “Best Demonstrated Available Technology”.

 

Given the high zinc price level today (over $1/lb) and enormous return from its EAF dust collection business, it’s not surprising to see more competition.

 

My meeting with CEO/CFO of ZINC led to my belief that the magnitude of competitive influence, however, will be limited. In other words, EAF dust collection business will transit from a near-monopoly business to an above-average business over the next two years. This business alone should contribute 60-70c/shr earnings and there is literally no cost/capex associated with it, so it’s all free cash. At 8% yield, the dust collection business could be worth anywhere btw. $7.50-8.50 per share.

 

The new competitors mainly include

 

A.     Steel Dust Recycling, LLC (SDR)

 

This company is expected to have 150,000 tons capacity by 2H08. It’s located in Millport, Alabama, which is about 300 mile away from Horsehead’s Rockwood, TN recycling plant. This company is actually started by ex-Horsehead employees (believe there are three senior level people involved, two of which were hired away recently but the other one had worked for different companies before jumping to SDR).

 

The challenge facing SDR is, instead of being an integrated producer, it only processes EAF dust into CZO, an intermediate material (@ 50% LME benchmark) that needs to be further processed to produce zinc downstream products. There are just not many smelters that can use recycle-based oxide in large quantity. Other than Horsehead itself, there is only one another smelter (NYSTAR), which can only take 3-5% of its total capacity. Horsehead believes SDR will have to export CZO. However, Europe is an already saturated market and Asia is competitive, too. Moreover, zinc concentrate supply will rise, further reducing demand for oxide, a less desirable feedstock if compared to concentrate.

 

SDR already signed dust supply contract from SeverCorr, which would provide SDR 50,000 tons of EAF dust a year – only 1/3 of its designed capacity.

 

For Horsehead, zinc price at 80c/lb still give IRR above 20-25% level. For SDR, it appears they need at least $1.00/lb to get to the same return. So if zinc price goes lower, SDR project will easily become uneconomic.

 

B.     ZincOX Resources plc

 

This company recently acquired Big River Zinc Corporation so they already own a smelter, though a small one. They plan to produce zinc metal from both concentrates and recycled EAF dust, which is sourced from Envirosafe (a landfill company) and Turkey. The estimated capacity that uses EAF dust is about 90,000 tons. However, the project now seems to be delayed to 2009/2010.

 

C.     PIZO Operating Co.

Nucor Corp. and The Heritage Group recently announced plans to invest $29 million in PIZO Operating Co., which will operate its plant east of Blytheville, Ark. The plant will convert 50,000 tons of dust a year - from nearby Nucor Steel Arkansas and Nucor-Yamato plants - into crude zinc oxide (CZO), pig iron and slag. A groundbreaking will be held in early 2008 and the plant is expected to be complete and operational by the end of next year. The unique thing about PIZO is the technology is based on the PIZO process, to which Nucor owns the rights in North America. The process is a one-step continuous process to process EAF dust into CZO, pig iron and slag.

This new plant, if started, is 350 miles away from Horsehead’s Rockwood, TN plant.

A + B +C = 200,000 tons by y/e ’08; 290,000 by 2009/2010

It appears ZINC will have to lose some existing contracts to some of these new players, particularly for its Rockwood, TN plant since that plant faces competition from both SDR and PIZO. However, I expect ZINC to win more new businesses from landfills and new steel mills since there are still 450,000 tons’ incremental opportunities. Horsehead’s own two-phase expansion plans include 80,000 tons in each phase, totaling 160,000 tons by 2009. As a result, the market will turn from being tight today to being balanced by 2009.

 

There are three reasons to believe the actual impact on Horsehead will be limited before 2010:

 

1)      Landfills break even at collection fee of 2.5c/lb, therefore the lowest level fee can go would be 2.5c/lb vs. today’s 4c/lb. As long as the market is not oversupplied, which I don’t foresee before 2010 given the above analysis, it’s not unreasonable to assume 3c/lb as the fee level in 2008/2009. Actually, the VP of sales from Horsehead believes 3.5c/lb seems more realistic based on the current negotiation;

 

2)      CEO said he will be aggressive in the next few months to secure more long term contracts. I feel he has fully analyzed the competitive landscape and understands he only has one chance in 2008 to lock in some big long term EAF dust supply commitment before competition heats up by 2009/2010. The reality is, in 2008 there is still no competition until the very latter half of the year when SDR capacity is up running. So this is a rare window opportunity – before 2008, Horsehead wouldn’t have this opportunity, either, since it’s operatign at full capacity.

 

Nucor is the most important supplier of EAF dust as it accounts almost half of total supply today. Nucor’s contract will not expire until 2009. However, Horsehead is taking pre-emptive actions to negotiate with Nucor right now, aiming to replace the current contract with a new long term contract that can start in 2008. No doubt Horesehead will have to give a bit more discount but the strategic benefit will be significant if Nucor can agree to a new contract. CEO told me they would have a formal meeting with Nucor last Friday and he appeared to be confident that an agreement will be reached by y/e '07 - if that's true, it'd be great positive for the stock.

 

3)      All these new capacities have not been built yet, not to mention the reliability of their service. Remember in the 80s, there were more than 50 technologies developed to comply with EPA regulation but very few succeeded. Actually Nucor itself tried in 1990s but also failed. For the moment, Horsehead doesn’t want to speculate on other people’s failure but running these EAF dust recycling plants on commercial scale is not an easy job at all.

 

The real risk, though quite small, is these new entrants might not understand the business well enough to price their service right, say pricing collection fee below 2.5c/lb or even 2c/lb. I’d put probability of this occurrence at less than 5% but it’s still a risk. I think the probability might get higher in 2009 or 2010 when competition is getting more intensified. That’s why it’s important for Horsehead to secure long term supply commitment as soon as possible.

Catalyst

1) higher zinc price - not sth. my thesis is based upon, butin the short term, it's what influences the trading range for the stock;
2) announcement of a full-scale new EAF dust supply contract with Nucor, the largest EAF dust supplier, before the year end of 2008;
3) a take-out canddidate - $30 is a fair price in my opinion.