Description

Integrated zinc and lead producer. 1st post-bankruptcy IPO in Australia. During bankruptcy process, company’s worst assets were closed or sold. Virtually all debt was exchanged for equity (the rest has been paid down since emergence). Entire mgt team replaced. New mgt team spent last two years cutting costs. Stock trading at 3x ebitda, 9x ebitda-capex, and, with $1.8 billion NOL, won’t pay taxes for years. Peers trade at 50%-100% premiums to ZFX. Board undergoing strategic review---management’s recommendation is to return cash to stockholders—we expect news on this in February 2005. Potential takeout candidate.

Background

Zinifex, an Austrlian based zinc and lead producer, is the successor corporation to Pasminco Ltd. Pasminco had gone into administration (ie Australia’s version of bankruptcy) in 2001 due to excess leverage, a bad currency hedge, poor management and weak commodity prices. Pursuant to the administration process, Zinifex acquired portions of the restructured Pasminco and emerged from administration as a new company in April 2004.

In short, ZFX has better assets, better management, and a better balance sheet than Pasminco. Specifically, Pasminco’s five worst assets were sold or closed; virtually all of Pasminco’s debt was converted into equity; Pasminco’s entire senior management team was replaced; a new board was put in place; and new management spent its two years in Administration cutting costs, improving processes and systems, growing production and increasing the mix of higher margin, value added products.

The investment thesis for Zinifex is as follows:

• The stock is hated by the Aussies, who have long memories of getting burned by Pasminco. Their feelings are augmented by the lack of experience with post-bankruptcy equities in the Australian market---as we understand it, ZFX is first public company to go into Australia’s administration process and emerge as a publicly traded company

• New CEO Greig Gailey has track record of fixing a business and selling it, having sold Fletcher Challenge Energy to Shell. Importantly, Mr. Gailey is not a “metals guy” and is outspoken in his reluctance to pour more money into the metals business. His stated preference is to return capital to shareholders (see below)

• We believe that management has sandbagged on cost side---in its first quarter as a public company (the quarter ending June 2004), ZFX generated ebitda of $127 million vs expectations of $103 based on then current commodity and currency prices. We are forecasting f’05 ebitda of $450 million and net income of $150 million vs consensus net income expectations of $130 million.

• Zinifex’s Board is currently undergoing a strategic review that it will complete in calendar q1 ’05. The Board has said that any investments will be measured against returning cash to shareholders, which, as mentioned above, is the CEO’s stated preference. Assuming a 40% debt to capital ratio (including provisions of $245 million as part of net debt), ZFX would be able to return over $300 million or 25% of its current market cap to shareholders. At these debt levels, net debt (plus provisions)/ebitda would still be at a manageable 1.3x. We expect an announcement from them on the capital return in February 2005.

• Cheap, absolute. ZFX has 500 mil shares outstanding. The stock has run a bit recently and trades at $2.38. Thus, market cap = $1.2 billion. There is no net debt. EV/ebitda is a little over 3x. EV/(ebitda-capex) is 9x. Importantly, they have $1.8 billion in tax credits (see discussion below) and thus will not pay cash taxes for a long time. Moreover, these are not peak numbers—zinc and the A$ are at normalized levels (though admittedly, lead prices are at peak, but lead is less material to results than zinc). Lastly, while in administration, the assets now controlled by ZFX were cash positive at the trough in 2002-03 when USD zinc prices fell to under $800/metric tonne.

• Trading well below replacement cost. Pasminco spent $1.3 billion in the late 1990s building the company’s Century Mine alone. ZFX’s portfolio includes Century, plus one other mine and three smelting plants.

• Cheap, relative. ZFX trades at huge discount to publicly traded peers and to private market value. Comparable companies (e.g. Teck Cominco, Boliden, Noranda, Xstrata, etc.) trade at average 7x ebitda and 11x ebitda-capex. We would not be surprised to see ZFX taken out given its focus as an integrated lead and zinc producer, its ownership of world’s 2nd largest zinc mine (Century), it’s proximity to China and management’s willingness to sell.

• $1.8 billion NOL. NOL is transferable, though mgt expects tax authorities to challenge a portion of the NOL, given the cleansing of the balance sheet achieved in administration. Nevertheless, management has risked weighted the tax credits at $1.1 billion.

• ASX 100 inclusion. Currently, ZFX is not in the Australian Stock Exchange 100 index (cap-weighted index of 100 most highly capitalized companies). However, based on current market caps, ZFX is currently the 98th largest company by market cap in Australia. The ASX reviews the weightings every April. We don’t think this is hugely meaningful, in terms of dollars directly indexed, but don’t discount it entirely due to the effect of closet-indexing.

Catalyst

Catalysts
Feb 2005 capital review---potential for huge capital return
Beating earnings expectations due to better than expected cost performance
Takeout??? Bite sized acquisition for someone wanting to acquire one of world’s leading zinc and lead producers, in close proximity to china;

Risks
--Macro. Severe global economic slowdown that reduces metal demand and metal prices
--Operational problems
--Resource renewal. Some of their properties are getting long in the tooth; there is thus, some pressure on ZFX to explore in an effort to extend their resource base.
--Australian government’s legal challenge on ZFX’s NOL. Management stated that it expects the government to contest its NOL, but ZFX has analyzed its position thoroughly (via Monte Carlo risk analysis) and is confident the majority of the NOL will pass legal scrutiny. They have placed risk weighted value of NOL at $1.1 billion.