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Mohnish Pabrai and the Horsehead Holdings Catastrophe
Last Friday shares in Horsehead Holdings Corp crashed by more than 91% after a judge approved the company’s Chapter 11 bankruptcy restructuring, bringing an end to months of uncertainty for the business and shareholders.
Horsehead filed for Chapter 11 protection in February, listing $421 million in secured and unsecured debt obligations and ever since the filing the producer of zinc and nickel products has faced a barrage of criticism and accusations of foul play from its shareholders. Shareholders now claim that Horsehead is lowballing the value of its assets to let creditors gain control of the company at a bargain price.
According to Gretchen Morgenson of The New York Times, at the beginning of 2016 Horsehead was valuing its assets at around $1 billion, six months after this valuation the company was estimating the value of its assets to be around $300 million — even for a commodity company this drop in value a staggering. As explained in the article and the company published in the New York Times at the end of August:
“Horsehead’s valuation history certainly seems odd. Its audited financial statements for the September 2015 quarter show assets worth $1 billion. An unaudited report from early February valued the assets at roughly the same. A KPMG report commissioned by Horsehead shareholders values the company at over $1.1 billion.”
“But in a July filing with the court, Horsehead’s financial adviser said the company’s assets were worth an estimated $280 million to $375 million. The main reason for the decline? The company’s decision to write down to almost zero the new zinc plant in Mooresboro it built for $550 million.”
The problems with Horsehead’s Mooresboro mine are well known and even equity holders seem to agree that the assets are not worth much (as explained below)
Back in 2011 Horsehead decided to transition zinc production from its 80-year old smelter to using a different chemical process to produce zinc. The new plant was expected to cost about $350 million and increase EBITDA by as much as $110 million making the company one of the lowest cost zinc producers on the planet. Unfortunately, the company completely failed to manage this project effectively. Costs spiralled to $500 million and after 18 months of operation, the plant could only manage 25% capacity. The final death blow for the company came when it announced that the new smelter needed another $100 million to cover losses while the plant ramped up to full production.
Mohnish Pabrai and the Horsehead Holdings catastrophe
Mohnish Pabrai’s Pabrai Funds are one of the largest investors in Horsehead’s equity and until the beginning of this year, the position had generated impressive returns for Pabrai’s investors. As I wrote earlier this year:
“Horsehead Holdings was originally acquired by the funds back in 2008 as a traditional Benjamin Graham investment. At first, the stock produced a great return of the fund appreciating by over 400% in less than 13 months. And after conducting further due diligence on the company, Pabrai became impressed with Horsehead’s management and continued to hold the company even after its impressive gains.”
The Pabrai Funds acquired over 4.9% of Horsehead’s outstanding shares and the company’s troubles have cost Pabrai’s investors years of positive returns. According to the Pabrai Investment Funds’ Q2 first half letter to investors a copy of which was reviewed by ValueWalk, Pabrai’s leading fund is down 17.7% for the first half of 2016. Last year, the fund returned -30% for investors as Horsehead’s troubles started to play out.
Horsehead Holdings – Pabrai on mistakes
Pabrai ends off the Horsehead Holdings section stating:
Was the Horsehead investment a mistake? Well, the original bet was not a mistake. The mistake was buying over 4.9% of the shares outstanding. In the last 16+ years at Pabrai Funds, we have bought over 5% or even over 10% of a few public companies. In no cases have we ever ended up with a winner. It is a small data set, but there are obvious reasons why going over 4.9% is dumb. Buying over 10% makes us subject to a variety of insider disclosure rules. Going over 5% requires us to make a 13G filing. All these Form 4 and 13G filings not only add cost and administrative time, but they also make it hard to increase or decrease position size.
If we owned less than 4.9% of Horsehead, it is almost certain we would have done tax loss selling in 2015 at significantly higher prices – and decided not to buy it back based on all the updated current facts. We are going to endeavor to never ever go over 4.9% anymore on any stock in the US. Been there. Done that. Got the T-shirt.One can make mistakes in investing and end up with a profit (e.g. Chesapeake). Or you can lose money and the bet would still have been the right one to make. If the odds of tails in a coin toss is 75% and pays 1:1, it is a very worthwhile bet to make, even though there is a 25% chance you lose the bet. We are going to lose some, even when we are ultra-vigilant and prudent. It is the nature of the game. With Horsehead, just 6 months ago, things looked benign. zinc prices were decent and the best information management had was that they had sufficient runway to get the new plant to 100% capacity and be generating nearly $200 million a year or more in EBITDA.
But we ended up with a trifecta of low probability events in unison. They ran into very significant ramp-up difficulties on a proven process, at the same time zinc prices collapsed to levels not seen since the financial crisis. Nickel prices have collapsed to a multi-decade low. All of these decreased profitability and increased the need for cash at the very same time that their liquidity was becoming quite stressed. Looking back at all the available information, I would still have made the investment (though we’d have maxed out at $35 million invested).
It is hard to predict where we end up with Horsehead, but the prospects are not good. They do have a wide range of assets whose value exceeds the company’s liabilities, but if there is a restructuring, assets like INMETCO and Zochem may be sold at fire-sale prices and restructuring costs themselves may be significant. In addition, it is unknown when the new plant will be profitable or when zinc prices may recover. The good news is that we have taken nearly all of the pain. There are no plans to add to our position. Even with a 100% loss on Horsehead, Pabrai Funds has plenty of other great irons in the fire and we expect to do quite well in the years ahead.
These Horsehead Holdings losses have cost investors years of returns. For example, $100,000 invested in Pabrai’s leading fund at inception on July 1, 1999 was worth $800,000 by June 2014. According to the Q2 results, the value of such an investment has now dropped to $522,000 a loss of 35%, but Mohnish urges investors to focus on the long term.
Horsehead Holdings isn’t Pabrai’s only losing position. He writes in the Q2 letter that the leading fund’s two largest positions Fiat Chrysler and GM Warrants were valued at $290 million at the beginning of the year and on June 30 were changing hands at less than $204 million.
If the performance of these assets had remained flat throughout the first half, performance would have been in line with the indices Pabrai writes.
This article was originally published in ValueWalk.
Photo: Keith Allison