“No wise pilot, no matter how great his talent and experience, fails to use his checklist.” –Charlie Munger
Horsehead has received a lot of coverage through these letters over the last few quarters and the good news is that the bleeding has finally stopped. Horsehead remains a valuable business, yet, for two years it has been a destructive force within our portfolio. Several times, as prices declined, Horsehead has been rebalanced upward to approximately 8% of the portfolio. This is often wise because each purchase decreases the average price and increases our percentage ownership of the business. However, at today’s prices, Horsehead stands at 0.5% of the portfolio. There are two leading possibilities moving forward: either the twelve-cent stock declines to zero; or, a strong bid or restructuring for Horsehead provides a 20% or more gain for our entire portfolio.
Horsehead is a leading North American producer of zinc and related products, and a recycler of electric arc furnace dust. Horsehead is not a mining company. Instead, they recycle scrap metals and other hazardous and nonhazardous material. Its end products are used in a variety of applications, including chemicals, pharmaceuticals and galvanized fabricated steel products. Inmetco and Zochem are two Horesehead subsidiaries that recycle metals-bearing waste. Horsehead is developing a state-ofthe-art plant in Mooresboro, NC that will secure their position as the largest and lowest cost producer of zinc in North America.
Horsehead was responsible for significant declines in 2015 and 2016 yet price swings are of no concern when the business fundamentals are solid. Horsehead’s year end SEC 10K report filed March 1, 2016, describe Horsehead concluding 2015 as a solvent business with $970 million in total assets and only $435 million in total debt. In February, a KPMG report declared Horsehead’s value at $1.1 billion. With 58 million shares outstanding, simple division shows $19 in per-share value. Yet, in January, under pressure from a group of predatory lenders, the firm unexpectedly filed for chapter 11 bankruptcy protection with the state of Delaware. Despite the firm being worth $1 billion or more, the stock price collapsed to twelve cents, and the market cap fell below $8 million.
With Mooresboro running at full capacity, between $150 million and $200 million in EBITDA is expected annually, increasing Horsehead’s value to between $1.5 and $2 billion. For several years we have been building our position with an average cost per share of approximately $7 while obtaining .35% ownership of the company. At a full $1-$2 billion valuation, this represents between $3.5 and $7 million for our portfolio.
Through 2015, management continued to share positive and arguably deceptive public statements with shareholders regarding the firm’s financial well-being. At a dinner I had with Chief Financial Officer, Robert Scherich, in September 2015, he assured me that zinc price exposure was hedged, engineering tasks at Mooresboro were manageable, and most importantly, any future funding requirements would be met through a secondary stock offering. Furthermore, on the November 9th, 2015, earnings call, Scherich concluded his prepared remarks stating:
Given our current liquidity, and expected cash flow from operations, at current commodity prices we believe that we have adequate liquidity and availability of capital resources including the ATM program to support the business for the next 12 months.
Despite these reassurances, in January (only two months following this statement), Horsehead skipped a $1.8 million coupon payment on a minor $30 million line of credit. I contacted Ali Alavi, Senior Vice President of Corporate Affairs who informed me in writing that “payment within the grace period causes no issues.”
To the contrary, this technical default on a $30 million line of credit allowed a highly intelligent and secretive group of predatory lenders to freeze lines of credit and force Horsehead to file for Chapter 11 bankruptcy protection. Although the value of the firm remains, the lenders are causing mass destruction in an attempt to award themselves this business. Mooresboro has been idled, 200 employees have lost their jobs, and shares have declined from $6 in October 2015 to $0.12 today.
The chapter 11 proceedings are moving toward a 363 Sale2 involving the auction of business entities. The coordinated ad-hoc debt holders are able to bid the face value of their debt (purchased at a discount) of approximately $300 million without any further cash outlay. To prevent this outcome, it is imperative that this story is publicized and a bidder comes to the table to offer a fair price for the business.
At current zinc prices, Horsehead will soon be earning $150 million to $200 million pre-tax every year. However, if zinc prices spike (as they did in 2007), earnings will be far greater. That computes to nearly $3.50 in EBITDA annually for each share of stock currently selling for pennies. Awarding Horsehead to the ad-hoc lenders who bought debt tranches for approximately $200 million is unconscionable. A bid of $500 million will only cover the current liability, while a reasonable bid of $1 billion or more will allow $500 million to be divided among the 58 million shares outstanding. This outcome suggests $8 could be paid for each share.
We have filed a joinder to the motions by Guy Spier of Aquamarine Capital and by advisor Phil Town requesting the appointment of an equity committee with the bankruptcy court in Delaware. As owners of Horsehead, we deserve a seat at the negotiating table. I will be present along with others at the May 2 court hearing in Delaware to represent our collective support. If you have a personal equity position, I strongly urge you to file a joinder to the motion and, if possible, join us in person next month.
The debtholders in the Horsehead case have done significant damage and are operating on the fringe of legal boundary. Their intention is to use the regulatory system to award themselves this valuable entity. Our intention is to stop them by raising awareness, and to design a restructuring plan or find a strategic buyer who will pay a fair price for the business. For reference, our joinder has been reproduced on page 5 of this letter.
Howard Marks often quips that “experience is what you got when you didn’t get what you wanted.” Horsehead has been the most painful investing experience since the inception of this fund. In Atul Gawande’s book, The Checklist Manifesto: How to Get Things Right, he describes how the use of clear and concise checklists by professionals, ranging from surgeons to pilots, have averted immeasurable errors. We also use checklists. Consequently, several items will be added to our checklists based on this experience, so similar mistakes can be avoided in the future. These items are:
- Does the potential investment exhibit cyclical characteristics in a commodity based environment? Cyclical firms relying on commodity prices can experience price swings far beyond any rational expectation. In commodities, black swan events are common. Margin of safety evaluated with a decline in commodity price, delays in production, or challenges with market liquidity is not enough. All three events can and do happen simultaneously.
- Does the potential investment have unusually high leverage or increasing debt with limited control over the price of their end product? Business leverage has been the killer of many great businesses and in the commodity space, stated assets may not be adequate collateral against debt.
- Is the potential investment reliant upon the success of a single new product, plant, or process? Reliance on the completion of a single facility is dangerous. Horsehead had five other profitable facilities including two profitable subsidiaries, Imetco and Zochem. The cost overruns and delays, while anticipated, kept production down while their capital expenditures and debt grew. A business that solely relies on a single new operating facility or product has the potential to destroy the value of the existing components of its business.
- Are any business expectations based on statements or opinions from management that may be biased or overly optimistic in their reporting? Speaking with management is highly debated among professional money managers. Some suggest that it is a fiduciary responsibility to speak with management. Others claim that business leaders have developed a refined capability to inspire others to facilitate their corporate accent. This characteristic may harm an investor wishing to limit their biases. Rarely are business executives meaningfully deceptive. However, they may harbor financial and psychological biases supporting the praise for their business. It is rare to find a corporate leader who does not believe in their product or service.
- Has the fund cost averaged with this position before? Cost averaging is a useful tool although it consumes capital within a portfolio as a target investment is rebuilt to the desired percentage allocation. A final mistake with Horsehead was continuing to cost average and rebalance to roughly 8% of our portfolio as the price declined. Our firm policy has been updated to allow for exactly one opportunity to cost average after the position has been established. This will protect us against repeatedly cost averaging into a mistake; it will assist in reducing damage derived from biases like commitment and consistency; and it will force increased patience and greater margins of safety before executing with our single bullet. To some market participants, falling market prices create fear. However, to a value investor, it is exciting to see wonderful businesses get cheaper. Those fortunate to become greedy when the markets becomes fearful must still moderate their greed. The expected normal distribution of outcomes may have fat tails. Black swan events are common.
Joinder to the Motions of Guy Spier and of Phil Town Requesting The Appointment of an Equity Committee
Justice Christopher Sontchi,
David D. Bird
Clerk of the Court
United States Bankruptcy Court of the District of Delaware
824 Market St. N
Wilmington, DE 19801
Re: Horsehead Holdings Corp. et. al.
Joinder to the Motion of Guy Spier for the Entry of an Order Appointing an Equity Committee
Dear Justice Sontchi,
I am writing to express my support of the motions by Guy Spier and by Phil Town, requesting an equity committee in the case of Horsehead Holdings. Additionally, I would like to add the following supporting statements.
I am the manager of Peterson Capital Management, a long-term, value-based hedge fund that closely follows the teachings of Warren Buffett and Charlie Munger. Unlike many hedge funds, we are not traders. Instead, we are long-term shareholders of businesses and our performance is tied closely to the level of value created by the firms within our portfolio. By operating in this way, we are not at odds with the firms in our portfolio. Rather, the fund, our partners, and the businesses we are invested in all share a common interest: success.
One firm that we felt was poised for success, and displayed significant value was Horsehead Holdings. As we analyzed the fundamentals of the company, we saw (as others had, too) that there was a gap between Horsehead’s market price and the intrinsic value of the business. This made it an attractive investment, and consequently Horsehead became a significant holding in our fund. Since 2014, for more than two years now, my fund has been consistently invested in Horsehead. Through our equity and two bullish positions in cash-secured short put and long call options, we hold exposure to more than 217,000 equity shares of the company, which represents nearly .35% of the business.
Our internal models value Horsehead (conservatively) above $1 billion, with potential to reach $2 billion or higher. (These calculations are supported by KPMG estimates.) Thus, our position represents a potential value in Horsehead that ranges from $3.5 million to $7 million. And yet, today, we risk a complete loss due to the unfathomable actions taken by the group of ad-hoc debt holders who are forcing this solvent business to lay off workers, and make active plants idle. Ultimately, these debt holders are stripping the assets of Horsehead and awarding those assets to themselves.
We entered our position based on the sound premise of business fundamentals as shown in their audited GAAP financials. Given the accuracy of these statements, it is clear: Horsehead is a solvent business with great value to its surrounding community, employees, and customers. And, as the largest and lowest cost zinc recycler in North America, Horsehead is also valuable for the environment and nation as a whole. Much of the supporting documentation found in the motion presented by Guy Spier and Phil Town corroborate these findings, including the KPMG private valuation and statements by members of the management at Horsehead.
Your Honor, I respectfully request that you thoroughly examine the documentation provided and grant an equity committee to ensure we have proper representation in the upcoming proceedings.
The above commentary is excerpted from the 1Q16 quarterly letter of Peterson Capital Management, LLC.
The performance data presented represents that of Peterson Investment Fund I, LP.
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