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ZINC > SEC Filings for ZINC > Form 10-Q on 9-Nov-2012All Recent SEC Filings

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Form 10-Q for HORSEHEAD HOLDING CORP


9-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

General

This discussion should be read in conjunction with the Notes to Consolidated Financial Statements included herein and the Notes to Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2011, which was filed with the SEC on March 9, 2012.

Overview

Our Business

We are a leading U.S. producer of zinc and zinc oxide, a leading recycler of electric arc furnace dust and a leading recycler of nickel-bearing wastes and nickel-cadmium batteries in North America. Our products are used in a wide variety of applications, including in the galvanizing of fabricated steel products and as components in rubber tires, alkaline batteries, paint, chemicals, pharmaceuticals and as a remelt alloy in the production of stainless steel. We believe we are the largest refiner of zinc oxide and Prime Western ("PW") zinc metal in North America. We believe we are also the largest North American recycler of EAF dust, a hazardous waste produced by the carbon steel mini-mill manufacturing process. Through our INMETCO operations, we believe we are also a leading recycler of EAF dust and other nickel-bearing waste generated by specialty steel producers and a leading recycler of nickel-cadmium batteries in North America. We, together with our predecessors, have been operating in the zinc industry for more than 150 years and in the nickel-bearing waste industry for more than 30 years. We operate as two business segments, zinc products and services and nickel product and services.

While we vary our raw material inputs, or feedstocks, based on cost and availability, we generally produce our zinc products at our Monaca, Pennsylvania facility, and our nickel-based products, at our INMETCO facility, using nearly 100% recycled materials, including zinc recovered from our four EAF dust recycling operations located in four states. We believe our ability to convert recycled zinc into finished products results in lower feed costs than for smelters that rely primarily on zinc concentrates. We also produce zinc oxide at our Brampton, Ontario, Canada facility and utilize special high grade zinc metal as raw material feedstock. Our four EAF dust recycling facilities also generate service fee revenue from steel mini-mills by providing a convenient and safe means for recycling their EAF dust. INMETCO provides recycling services, some of which is on a tolling basis, from a single production facility in Ellwood City, Pennsylvania.

Strategic Investments and Acquisitions

During the fourth quarter of 2011, we began construction on a new zinc facility located in Rutherford County, North Carolina, which we anticipate will be capable of production in excess of 150,000 tons of zinc metal per year, including Special High Grade ("SHG") zinc, Continuous Galvanizing Grade zinc as well as PW zinc and will also enable us to potentially recover other marketable metals from EAF dust. The new facility will significantly reduce our manufacturing conversion costs due to the lower energy usage, higher labor productivity and lower maintenance needs associated with the new technology to be employed at the facility. The plant design will rely upon sustainable manufacturing practices to produce zinc solely from recycled materials and use significantly less fossil fuel than our current smelter. The new zinc facility will convert Waelz oxide and other recycled materials into SHG zinc and other grades that sell at a premium to the PW grade that we currently offer. This will allow us to expand into new markets, including selling to continuous galvanizers operated by steel mills, which include some of our EAF dust customers, die casters and LME warehouses, while continuing to serve customers in our existing markets. In addition, we believe the process will allow us to recover value from new metals such as silver and lead as well as the copper contained in EAF dust. We have incurred approximately $137 million of these expenditures as of September 30, 2012. We had originally estimated total capital expenditures for the construction of the new zinc facility to be approximately $375 million, however, as we have advanced the detailed engineering on this project, we have decided to expand the scope of the project to provide for lower long-term operating costs by upgrading the materials of construction, enhancing the recovery of by-products such as lead and silver and upgrading effluent and storm water management. The net effect of these changes and our being able to quantify more precisely certain other projected costs is an increase in the total capital investment of approximately $40 million or about 10% of the total project cost. In addition to the approximately $20 million under the Credit Agreement we recently secured, we also have $ 44.2 million of availability under our Credit Facility and have plans to increase the availability under the Credit Facility by an additional $30 million during the fourth quarter of 2012.

To fund the initial stages of construction, we issued $100.0 million in principal amount of Convertible Notes on July 27, 2011 in a private placement. We received proceeds of $100.0 million and recognized approximately $3.5 million in


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issuance costs in connection with the offering. On September 28, 2011, we entered into our $60.0 million Revolving Credit Agreement (as amended "the ABL Facility" to support our liquidity needs during construction and to allow for the availability of previously restricted cash. We were able to release $18.7 million of restricted cash which was replaced with $17.8 million in letters of credit under the Revolving Credit Agreement. On July 26, 2012, we issued $175.0 million of Senior Secured Notes on July 26, 2012, in a private placement. We received proceeds of $171.8 million and recognized approximately $7.4 million in issuance costs in connection with the offering. In addition, on August 28, 2012, we announced that we entered into a Credit Agreement with a Spanish bank to provide for the financing of up to Euros 14.6 million (approximately $20.3 million USD) for purchases under certain contracts for equipment and related products and services for the new zinc facility and for payment of approximately $1.0 million for the insurance premium on this loan. We intend to use the net proceeds of approximately $164.5 million from the Senior Secured Notes offering, $44.2 million of availability under the Revolving Credit Agreement, $20.3 million of availability under the Credit Agreement, together with cash on hand, to complete the construction of the new zinc facility and for general corporate purposes, including working capital needs, investment in other business initiatives, other capital expenditures and acquisitions. In addition, we are in the process of adding two additional credit facilities which would provide additional availability of $30.0 million.

On November 1, 2011, we acquired all of the outstanding shares of Zochem, a zinc oxide producer located in Brampton, Ontario Canada, from HudBay for a cash purchase price of $15.1 million. The acquisition broadened the Company's geographic reach, provided added operational flexibility and diversified our customers and markets for zinc oxide. We recently announced that we have decided to move forward with plans to expand capacity at the Zochem facility in anticipation of the idling of the zinc oxide refinery at the Monaca, Pennsylvania location. The expansion project, which will increase the total zinc oxide production capacity at Zochem to 72,000 tons per year, should be completed by mid-2013 prior to the closure of the Monaca smelter.

On March 15, 2012, we announced that we had entered into an option agreement with Shell, which if exercised by Shell, would require us to vacate our facility in Monaca by April 30, 2014. In the event that Shell does not exercise its option to purchase our Monaca facility, we still intend to shut down the smelting operations when the new zinc facility becomes operational and potentially the refinery operations when the expanded capacity at Zochem becomes operational. We may, however, continue to operate various other non-smelting assets that include production of zinc oxide from our Larvik furnaces at the Monaca facility.

Economic Conditions and Outlook

EAF dust receipt levels for the first three quarters of 2012 were significantly higher than during the same periods in 2011 due primarily to entering into additional contracts. A downward trend, however, in US raw steel output during the third quarter of 2012 reduced third quarter EAF dust receipt levels below the first two quarters of 2012, although they still remained higher than the 2011 quarterly receipts levels. We operated all nine of our Waelz kilns through the first nine months of 2012 but have idled one of these kilns early in the fourth quarter as a result of the decrease in steel production. Oxide shipments have been steady at both oxide production facilities, reflecting some increase in market share and some strengthening of underlying market demand. Third quarter 2012 oxide shipments at the Monaca, Pennsylvania facility, although higher than third quarter 2011 shipments, decreased from the first two quarters of 2012 shipments. Demand for zinc metal for the first two quarters of 2012 outpaced 2011 quarterly shipments, however, third quarter 2012 zinc metal shipments decreased from the previous quarters. We anticipate demand for our zinc products to remain steady for the remainder of 2012 and plan to continue to operate our full complement of zinc smelting furnaces. LME zinc and nickel prices, although significantly lower than the first nine months of 2011, have remained relatively stable since the end of 2011.

Our zinc smelting facility and our recycling plants operated at close to full capacity during the first nine months of 2012.

Factors Affecting Our Operating Results

Market Price for Zinc and Nickel. Since we generate the substantial majority of our net sales from the sale of zinc and nickel-based products, our operating results depend heavily on the prevailing market price for zinc and nickel. Our principal raw materials are zinc extracted from recycled EAF dust, for which we receive revenue from the carbon steel mini-mill companies, and other zinc-bearing secondary materials ("purchased feedstock" or "purchased feed") we purchase from


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third parties. Costs to acquire and recycle EAF dust, which, during the first nine months of 2012, comprised approximately 79% of our raw materials at our Monaca, Pennsylvania facility, were not impacted significantly by fluctuations in the market price of zinc on the LME. However, the cost for the remaining portion of our raw materials is directly impacted by changes in the market price of zinc. Our Zochem facility relies entirely on purchased feedstock that is dependent on the LME zinc price. The price of our finished products is impacted directly by changes in the market price of zinc and nickel, which can result in rapid and significant changes in our monthly revenues. Zinc prices experienced a period of general decline between 2000 and 2003, primarily due to increased exports from China and declines in global zinc consumption. During 2004, however, zinc prices began to recover, primarily due to increases in global zinc demand, including in China and to declines in global production due to closed or permanently idled zinc mining and smelting capacity. Monthly average zinc prices rose throughout 2005 and 2006, then began a steady decline through 2008, which was particularly sharp in the fourth quarter of 2008. Monthly average zinc prices began to gradually strengthen in 2009 and continued to strengthen throughout 2010 and the first half of 2011. During the second half of 2011, however, the monthly average zinc prices began a steady decline, that continued through the end of 2011 and then stabilized during the nine months ended September 30, 2012.

Average monthly, daily and yearly LME zinc prices for the years 2004 through 2011 and the nine months ended September 30, 2012 were as follows:

                                                                                                                                Nine months ended
                                                                                                                                  September 30,
LME Zinc Prices                         2004       2005       2006       2007       2008       2009       2010       2011             2012
Monthly Average
High                                   $ 0.54     $ 0.83     $ 2.00     $ 1.74     $ 1.14     $ 1.08     $ 1.10     $ 1.12     $              0.93
Low                                    $ 0.44     $ 0.54     $ 0.95     $ 1.07     $ 0.50     $ 0.50     $ 0.79     $ 0.84     $              0.82
Daily High                             $ 0.58     $ 0.86     $ 2.08     $ 1.93     $ 1.28     $ 1.17     $ 1.20     $ 1.15     $              0.99
Daily Low                              $ 0.43     $ 0.53     $ 0.87     $ 1.00     $ 0.47     $ 0.48     $ 0.72     $ 0.79     $              0.80
Average per year                       $ 0.48     $ 0.63     $ 1.48     $ 1.47     $ 0.85     $ 0.75     $ 0.98     $ 0.99     $              0.88

In 2010, we purchased 2011 put options as a financial hedge for approximately 99,000 tons of zinc for 2011, having a strike price of $0.65 per pound, to mitigate the effects of decreases in the LME average zinc price. The purchases represented approximately 70% of our expected zinc production for 2011. We also sold 2011 put options for approximately 35,000 tons of zinc having a strike price of $0.55 per pound. The cost of the options purchased was $3.0 million and the proceeds from the options sold was $0.2 million. These options expired during 2011 with no settlement amounts due to us and no settlement amounts due from us.

At December 31, 2011, we had zinc put options with an $0.85 per pound strike price outstanding, which covered approximately 160,000 tons of zinc production, representing approximately 75% of the expected shipments for the period from January 2012 through June 2013. These put options were put in place to provide protection to operating cash flow in the event that zinc prices decline below that level during the construction of the new zinc facility. In June 2011, we entered into hedge arrangements in which we bought put options with a strike price of $0.85 per pound, sold call options with a strike price of $1.20 per pound and bought call options with a strike price of $1.81 per pound. The value of these bought and sold positions resulted in a zero cash outlay. The hedges reduced our exposure to future declines in zinc prices below $0.85 per pound. We would not, however, have been able to participate in increased zinc prices beyond $1.20 per pound until the zinc price reached $1.81 per pound. The $1.81 per pound call options were bought in order to cap the potential collateral requirements surrounding these hedge arrangements. During the fourth quarter of 2011, with forward zinc prices lower than when the program was implemented, we bought back the $1.20 per pound sold call option positions at a cost of $15.7 million and realized a gain of $13.4 million. The repurchase of these $1.20 per pound call options effectively eliminated both the risk of a potential cash collateral requirement and the limitation to our profitability, in the event that zinc prices increased above the $1.20 per pound during that period.

The zinc put options with an $0.85 per pound strike price and the zinc call options with a $1.81 per pound strike price continue to be held at September 30, 2012. The value of the zinc call options with a $1.81 per pound strike price was negligible at both December 31, 2011 and September 30, 2012.

The put options settle monthly on an average LME pricing basis. The average LME monthly zinc price for June, July and August was lower than the strike price for the contract and we received $0.8 million in cash from settlement of these contracts. The monthly average LME zinc price for the remaining months, during the nine months ended September 30, 2012, was above the strike prices for the contracts and they consequently expired with no settlement payment due to us. Since the average monthly LME zinc price was lower than $1.81 per pound, we did not exercise any call options during the nine months ended September 30, 2012.


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During the third quarter of 2012, we purchased zinc put options, for the third quarter of 2013, with an $0.85 per pound strike price, which covered approximately 16,500 tons of zinc production, at a cost of $1.6 million. We purchased additional $0.85 per pound strike price zinc put options, for the third quarter of 2013, at a cost of $0.9 million during October 2012 covering an additional 10,000 tons of zinc production. The total zinc put options, for the third quarter of 2013, represent approximately 75% of the expected shipments for the period from July 2013 through September 2013. These put options were put in place to provide protection to operating cash flow in the event that zinc prices decline below that level during the completion of construction of the new zinc facility.

For 2010, LME average nickel prices ranged from $8.36 per pound to $11.81 per pound and averaged $9.89 per pound. For 2011, LME average nickel pries ranged from $7.68 per pound to $13.17 per pound and averaged $10.36 per pound. For the nine months ended September 30, 2011, LME nickel prices ranged from $8.13 per pound to $13.17 per pound and averaged $11.04 per pound. For the nine months ended September 30, 2012, LME average nickel prices ranged from $6.89 per pound to $9.90 per pound and averaged $8.04 per pound.

Demand for Zinc and Nickel-Based Products. We generate revenue from the sale of zinc metal, zinc oxide, zinc- and copper-based powders and nickel-based products and services, as well as from the collection and recycling of EAF dust. Demand for our products increased from the fourth quarter of 2011 as our smelting facility and recycling plants operated at near- capacity during the nine months ended September 30, 2012, reflecting some increase in market share and some strengthening of underlying market demand. Our zinc equivalent of production of zinc products for the first nine months of 2012, which included Zochem, increased to an annual rate of 173,000 tons from 140,000 tons for 2011.

Weekly steel industry capacity utilization continued the general upward trend from 2010 through the second quarter of 2012, thereby increasing the amount of EAF dust generated and the demand for our EAF dust recycling services. In addition, EAF dust receipts increased due in part to additional contracts we entered into during the latter part of 2011 that took effect during the first quarter of 2012. During the third quarter of 2012, weekly steel industry capacity began to decline and thus reduced the amount of EAF dust generated and demand for our EAF dust recycling services. Third quarter receipts, although higher than 2011 quarterly receipts, were lower than the first and second 2012 quarterly receipts.

The table below illustrates historical production and sales volumes and revenues for zinc products, EAF dust and nickel-based products:

                                             Shipments/EAF Dust Receipts                               Revenue/Ton
                                       Nine Months Ended           Year Ended           Nine Months Ended            Year Ended
                                         September 30,            December 31,            September 30,             December 31,
                                       2012           2011       2011       2010         2012         2011        2011        2010
                                                (Tons, in thousands)                                (In U.S. dollars)
Product:
Zinc Products (1)                          143          110         152       137     $    1,875     $ 2,105     $ 2,024     $ 1,976
EAF Dust                                   476          401         528       532     $       69     $    68     $    69     $    74
Nickel-based products                       22           21          28        27     $    1,737     $ 1,945     $ 1,930     $ 1,768

(1) Includes Zochem since November 1, 2011

Cost of Sales (excluding depreciation and amortization). Our cost of producing zinc and nickel products consists principally of purchased feedstock, energy, maintenance and labor costs. During the first nine months of 2012, our zinc related purchased feedstock costs at our Monaca, Pennsylvania facility comprised approximately 14% of our production costs compared to 19% for the first nine months of 2011. Purchased-feedstock-related costs are driven by the percentage of purchased feed used in the feed mix, the average LME zinc price and the price paid for the purchased feed expressed as a percentage of the LME average zinc price. Purchased feedstock sells at a discount to the LME price of zinc. The decrease in the percentage of purchased feedstock related costs at our Monaca facility reflects our efforts to increase the use of EAF dust-based feedstock at that site. Purchased feedstock costs at our Zochem facility, which comprised approximately 88% of production costs, consisted entirely of SHG zinc metal purchased primarily from one supplier. The price of these metal blocks is based on the LME zinc price.


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The remaining 86% of our production costs at our Monaca, Pennsylvania facility and 12% of our production costs at our Zochem facility during the first nine months of 2012 were conversion-related. A portion of our conversion costs do not change proportionally with changes in production volume. Consequently, as volume changes a portion of our conversion cost per ton changes inversely. Other components of cost of sales include transportation costs, as well as other manufacturing expenses. The main factors that influence our cost of sales as a percentage of net sales are fluctuations in zinc and nickel prices, production and shipment volumes, efficiencies, energy costs and our ability to implement cost control measures aimed at improving productivity.

We value the majority of our inventories using the weighted average actual cost method. Under this method, the cost of our purchased feedstock generally takes three to four months to flow through our cost of sales. In an environment of declining LME average zinc and nickel prices, our inventory cost can exceed the market value of our finished goods. Lower-of-cost-or-market ("LCM") adjustments can result. The Company recorded an LCM adjustment of $1.2 million during the second quarter of 2012 and an additional LCM adjustment of $0.2 million in the third quarter of 2012. An LCM adjustment of $0.8 million was recorded during the third quarter of September 30, 2011. Total LCM adjustments were $1.4 million for the nine months ended September 30, 2012 and $0.8 million for the twelve months ended December 31, 2011. Zochem values its inventory using the first in-first out method and therefore the majority of the cost of our purchased feedstock generally flows through costs of sales during the same month it is purchased.

Selling, General and Administrative Expenses. Our selling, general and administrative expenses consist of all sales and marketing expenditures, as well as administrative overhead costs, such as salary and benefit costs for sales personnel and administrative staff, expenses related to the use and maintenance of administrative offices, costs associated with acquisitions, other administrative expenses, including expenses relating to logistics and information systems and legal and accounting expense, and other selling expenses, including travel costs. Salary and benefit costs historically have comprised the largest single component of our selling, general and administrative expenses. Selling, general and administrative expenses as a percent of net sales historically have been impacted by changes in salary and benefit costs, as well as by changes in selling prices.

Refinery incident at our Monaca, Pennsylvania facility on July 22, 2010

On July 22, 2010, a refinery incident occurred at our Monaca, Pennsylvania zinc oxide refining facility. The zinc refinery was shut down for repairs and an investigation and assessment of the damage. Each of the ten columns used to produce zinc oxide and refined zinc metal in the refining facility was redesigned and rebuilt. Production resumed in the fourth quarter of 2010.

We pursued recovery of the cost of repairs, lost profit and other losses from our zinc oxide and refined metal, subject to customary deductibles, under our business interruption and property insurance. We submitted a claim totaling $33,831 and reached a final settlement in the amount of $29,614 in the first quarter of 2011. As of December 31, 2011, the entire insurance recoveries of $29,614 had been received in cash. See Footnote U-Monaca, Pennsylvania Accident Insurance Recovery in our Consolidated Financial Statements.

Trends Affecting Our Business

Our operating results are and will be influenced by a variety of factors, including:

LME price of zinc and nickel;

changes in cost of energy and fuels;

gain and loss of customers;

pricing pressures from competitors, including new entrants into the EAF dust or nickel-bearing waste recycling markets;

production levels in the domestic steel industry;

increases and decreases in the use of zinc and nickel-based products;


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expansions into new products and expansion of our capacity, which requires us to incur costs prior to generating revenues;

expenditures required to comply with environmental and other operational regulations;

access to credit by our customers; and

our operational efficiency improvement programs.

We have experienced fluctuations in our sales and operating profits in recent years due to fluctuations in zinc, energy and fuel prices. Historically, zinc prices have been extremely volatile, and we expect that volatility to continue. Changes in zinc pricing have impacted our sales revenue since the prices of the products we sell are based primarily on LME zinc prices, and they have impacted our costs of production, since the prices of some of our feedstocks are based on LME zinc prices. Therefore, since a large portion of our sales and a portion of our costs are affected by the LME zinc price, we expect that changing zinc prices will continue to impact our operations and financial results in the future and any significant drop in zinc prices will negatively impact our results of operations. We employ various hedging instruments in an attempt to reduce the impact of decreases in the selling prices of a portion of our expected production.

Energy is one of our most significant costs. Our processes rely on electricity, coke and natural gas to operate. Our freight operations depend heavily on the availability of diesel fuel. Energy prices, particularly for coke and diesel fuel, have been volatile in recent years and currently exceed long-term historical averages. These fluctuations impact our manufacturing costs and contribute to earnings volatility. In September 2011, we entered into a new power purchase agreement to supply our electrical power needs at our Monaca, Pennsylvania facility at rates lower than the cost at which we are currently able to produce power on-site, which led to our decision to idle our Monaca, Pennsylvania power plant in September 2011. The power plant was idled and is . . .

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