Blogvesting

I re-established my position in ZINC on Friday, at a cost of $7.62 per share. I had previously written about this company, and had in fact been stopped out of a position in this stock. However, I still feel that the valuation of this stock is very compelling, and decided to take the plunge during a dive in the stock price.

For more discussion on ZINC, I refer you to this article, as well as to the investor letter filed by Cobalt Capital Management, a new 5% shareholder in Horsehead. Making any kind of earnings projections with Horsehead requires assuming a zinc price, which makes it a rather academic exercise unless you can accurately predict zinc commodity price (which I cannot). Rather, I will point out several important structural factors in the zinc market which are favorable to Horsehead :

1. The US imports 75% of the zinc it uses. Domestic zinc producers enjoy a freight and reliability advantage over foreign producers, and should gain in market share. That is, the US zinc market is under-supplied by local producers.
2. EAF dust is a low-cost feedstock for zinc production (in fact, its a negative cost feedstock, because Horsehead gets paid to take EAF dust off the hands of steel mini mill operators), and is preferable to using other zinc scraps as feedstock. Horsehead already processes more than half of all EAF dust generated in the US, has strong relationships with many steel mill operators going back many years, and has plans to further increase its share of the EAF recycling market.
3. EAF dust production is set to grow as steel producers shift to the mini mill format. Mini mills have an operational advantage over integrated steel mills because they can be started and stopped easily, which make them more adaptable to fluctuating steel prices.

Of course, there are also risks involved. Zinc demand in the US may be depressed for a long time due to the downturn in housing and auto production. Horsehead is currently the only EAF recycler in the US, but several smaller competitors are trying to enter the market, and steel producers are likely to support these competitors just to make sure that they are not locked into a single recycler. To head off this possibility, Horsehead is planning to build two more kilns in South Carolina. The main competitors for EAF dust are landfills, and Horsehead’s strategy to gain EAF dust market share is to situate new kilns in close proximity to steel mini mills, and thus gain a freight advantage over landfills, which tend to be situated in the middle of nowhere due to environmental and geographical factors.

In the near future, Horsehead will spend close to $90 million to set up two new kilns in South Carolina, which would probably make them cash flow negative in the near term (assuming that zinc prices do not recover). However, Horsehead has $68 million in cash, no net debt, and a $60 million credit facility, which should be more than enough to tide them over the next two years. In addition, Horsehead is taking steps to reduce expenses y $35 million, and has just idled one if its smelters. Every month, the company receives a cash payment from the favorable settlement of its hedges, as well as cash from operations. I believe that Horsehead is extremely unlikely to run into financial difficulties in the near future. Even with a further drop in zinc prices, Horsehead can always suspend its kiln building plans, or negotiate a higher EAF recycling fee.

From 7-1-08 to 7-15-08, short interest in ZINC jumped from 1 million shares (historically its long-term average short ratio), to over 3 million shares by 7-15-08, no doubt a bet on declining commodity prices by short sellers. The bulk of those shares is likely to have been shorted at around $10. I believe that the recent strong support at $7 is due to short covering, which is probably almost complete by now. As we enter the final stretch of the year, tax loss selling by small investors may push the share price further downwards, while several hedge funds have taken long positions at these depressed prices. All these factors, combined with ZINC’s small capitalization, makes this a highly volatile stock. Therefore, I’ve decided to widen my stops on this position and hold this for the long term, and perhaps increase my position if zinc prices hold steady and ZINC stock price sinks further.