Jason Knapp
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Jason Knapp in Special Situation Investing News,

The Hottest Commodity on the Planet and a Special Situation in One Investment

Oil - POW!, Corn - ZAP!, Gold - BLAP!  The prices for most major commodities have been taking it on the chin lately.  One surprising less talked about commodity has held up surprisingly well during this rout...zinc. A strong 8% rally in the price of the metal over the past three weeks has caused its price to go positive for the year.  While the prices of most commodities are down over the past year, zinc prices are actually up 7.5%.  Why is that the case?  Because some of the most important zinc mines in the world are being shut down. Analysts at Morgan Stanley have estimated that by the year 2017 over 1.2 million metric tons of mined zinc will be taken off-line by miners.  To put that number in perspective, that's more zinc than the entire United States uses each year.

People have been talking about the zinc supply situation for well over a year now, but pricing in the market is only just starting to bear out this theory.  While it's great that many smart people believe that zinc prices are headed higher, as someone who hates investing directly in volatile commodities that in itself would not be enough to get me interested in investing in it.  Lucky for me, there is a company that is in the midst of a special situation that will benefit tremendously if zinc prices do indeed rally and do pretty well even if they don't.

Enter the Horsehead Holdings (ZINC).

Not only does this company have a sweet name and cool logo, but it should end up being a profitable investment.  Horsehead is a zinc producer, but it is not a miner. It actually produces the commodity by recycling electric-arc furnace (EAF) dust. This dust is a waste byproduct created during the process of manufacturing steel. Get this, not only does Horsehead not have to mine for the zinc that it produces...it actually gets paid by steel manufacturers to take away the waste dust. Talk about a good position to be in. The problem with Horsehead is that it has traditionally been nearly twice as expensive to produce zinc at its facilities by recycling EAF dust than to dig it out of the ground at quality mines.  Here's where the special situation comes in. ZINC has been building a new, super efficient recycling plant. 

I have mentioned in the past that I love it when companies bring new, expensive products or facilities on line.  Doing so makes their financials look terrible during the build out process and amazing when the fantastic new facility comes online.  It's even better when the company that is building a new facility inevitably runs into issues getting the new plant up and running.  Such events usually cause companies' stocks to sell off at precisely the time that one should be buying.  I swooped in and scooped up some shares of Horsehead Holdings when it had some issues ramping up its new recycling facility both recently and in late 2014.

So how much is ZINC's stock worth?  This is where I and many of the snootier people aka "analysts" of the world differ.  As the old adage goes, I'd rather be generally right than specifically wrong.  I believe that Horsehead's stock is worth...more than the $12.90 it currently trades for.  I have seen specific estimates that when ZINC's new facility is up and running it will produce $100 million in free cash flow and that a reasonable multiple to that would be 12x.  Were that to materialize the stock would be a double from here.  I tend to be more conservative in my valuation of stocks than most people, but I still see tremendous upsize in ZINC.

Now you must fight the bear!

Any good investment thesis always contains a bear case for why an idea might not work out as planned.  I see two potential problems with an investment in ZINC today.

First and probably most obvious is a complete collapse in the price of zinc.  A company that sells zinc is going to have a tough time making money if zinc prices fall significantly. When I initially bought into ZINC with real money, the company's commodity exposure was the main thing that gave me pause.

Before investing in Horsehead, I did some research on zinc pricing, what influences it and where we were at with them in a historical context. Naturally, it's always better to invest in a company that deals with commodities at the bottom of the pricing cycle than the top. Zinc prices were reasonably high then (several months ago), substantially higher than they were at the post-Great Recession (TM) low and they appeared to be approaching recent highs, achieved twice several years ago.

In fact, the price of zinc at the time of my purchase of Horsehead several months ago was substantially higher than the price for the metal was at any point between 1989 and 2004.

Zinc demand is global. One of its main uses is in the production of steel. Obviously recessions are bad for steel production. The economies of most countries outside of the United States, i.e. the Euro Zone, Russia, Japan, China, etc. are all in pretty rough shape.  I'm particularly concerned about a massive slowdown in China. When investing in Horsehead, the question is whether there is enough U.S. demand for zinc to keep prices elevated or would a an even deeper global economic slowdown have a significant negative impact upon the commodity's price?

Here's a chart that shows zinc prices over the past several years. As you can see, despite all that's happened to the economies of most countries in Europe and Asia zinc prices are still fairly solid. Let's hope they stay that way.

https://ycharts.com/indicators/zinc_lme_settlement_price

The main factor that eased my concerns about weak demand hurting zinc prices is that my research lead me to believe that the higher zinc pricing that we have experienced in recent times is more supply-driven than demand-driven, again as I mentioned previously in large part the result of aging mines. An investment in Horsehead at this level is a bet that the decline zinc demand caused by slowing global economies will be more than offset by a drop in supply of the metal as older mines become less productive and that the company's new facility will enable it to be significantly more profitable in the future.

The second thing that I can think of that would cause problems with the investment case for ZINC is that the company's management just stinks.  If ZINC continues to have problems bringing its new plant on-line the issues could become very costly.  From my research, it looks like Horsehead has a quality management team and this is an industry that they are familiar with.  It's not like a chemical company trying to expand into a completely different industry like oil-by-rail, see the painful story that is Canexus (CXUSF). 

ZINC's management team seems to be on the right track and to have enough expertise to do this right. If they are able to bring the new facility completely on-line and zinc prices hold steady this should be a good investment.  If the new facility comes on-line and zinc prices increase, as many analysts believe they will, Horsehead's stock should soar.  My concerns about commodity price exposure and past investments in companies that even have indirect exposure to such uncontrollable variables will cause me to limit my position size in ZINC, but it definitely has a place in my portfolio.