Summary of HORSEHEAD HOLDING CORP

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, 2007, which was filed with the SEC on March 31, 2008.
Overview
Our History
We are a leading U.S. producer of specialty zinc and zinc-based products. 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 and pharmaceuticals. We believe that 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 electric arc furnace ("EAF") dust, a hazardous waste produced by the steel mini-mill manufacturing process. We, together with our predecessors, have been operating in the zinc industry for more than 150 years.
While we vary our raw material inputs, or feedstocks, based on cost and availability, we generally produce our zinc products using nearly 100% recycled zinc, including zinc recovered from our EAF dust recycling operations. We believe that our ability to convert recycled zinc into finished products results in lower feed costs than for smelters that rely primarily on zinc concentrates. 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.
Factors Affecting Our Operating Results Market Price for Zinc. Since we generate the substantial majority of our net sales from the sale of zinc and zinc-based products, our operating results depend greatly on the prevailing market price for zinc. Our principal raw materials are zinc extracted from recycled EAF dust, for which we receive revenue from the steel mini-mill companies, and other zinc-bearing secondary materials that we purchase from third parties. Costs to acquire and recycle EAF dust, which, during the first six months of 2008, comprised approximately 60% of our raw materials, are not directly impacted 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. The price of our finished products is also impacted directly by changes in the market price of zinc, which can result in rapid and significant changes in our monthly revenues. Zinc prices experienced a period of general decline between 2000 and 2004, 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. Zinc prices rose throughout 2005 and 2006 to a historical high of $2.08 per pound on December 5, 2006 and have since fallen to $0.82 per pound as of July 28, 2008.
Demand for Zinc-Based Products. We generate revenue from the sale of zinc metal, zinc oxide and zinc- and copper-based powders, as well as from the collection and recycling of EAF dust. For the periods covered in this discussion and analysis, North American consumption of PW zinc metal (the grade of zinc metal in which we specialize) and zinc oxide (the value-added zinc-based product from which we have generated the most net sales on an historical basis) has increased. Because of the need to perform additional maintenance on key equipment that was deferred due to our predecessor's financial difficulties, we have not been able to produce at capacity to take full advantage of this consumption increase. Production of zinc at our Monaca facility declined, primarily due to this delayed maintenance on equipment, from approximately 170,000 tons in 2000 to approximately 139,000 tons per year in 2005 and 2006 and approximately 140,000 in 2007. Production for the twelve months ended June 30, 2008 was approximately 150,000 tons. To meet demand we purchased and resold metal to our customers. We began to reduce these purchases in 2006 and further in 2007. We purchased no metal in the first six months of 2008. We expect to continue to perform additional maintenance to this equipment for the foreseeable future. The table below illustrates historical sales volumes and revenues for the zinc products and EAF dust.

Table of Contents

                                      Volumes                        U.S. Sales/Unit
                              2007       2006      2005       2007        2006        2005
                                (Tons, in thousands)               (In whole dollars)
           Product:
           Zinc Products       153        158       165     $ 3,104     $ 2,750     $ 1,284
           EAF Dust            458        504       498     $    99     $   101     $    94

Cost of Sales (excluding depreciation). Our cost of producing zinc products consists principally of purchased feedstock, energy, maintenance and labor costs. In the first six months of 2008, approximately 35% of our production costs were purchased-feedstock-related and approximately 65% were conversion-related. 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 prices, production and shipment volumes, efficiencies, energy costs and our ability to implement cost control measures aimed at improving productivity. We purchase a majority of our purchased feedstock at a discount to the LME price of zinc. 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, 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 sales volumes. Trends Affecting Our Business
Our operating results are and will be influenced by a variety of factors, including:
• LME price of zinc;

• changes in cost of energy and fuels;

• gain and loss of customers;

• pricing pressures from competitors;

• new entrants into the EAF dust recycling market;

• decline in use of zinc products;

• 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; and

• our operational efficiency improvement programs.

We have experienced fluctuations in our sales and operating profits in recent years due to fluctuations in zinc prices. Historically, zinc prices have been extremely volatile, and we expect that volatility to continue. For example, the LME price of zinc rose from $0.58 per pound on December 31, 2004 to $2.08 per pound on December 5, 2006 and has since fallen to $0.82 per pound as of July 28, 2008. 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 many of our feedstocks are based on LME zinc prices. Therefore, since a large portion of our sales and a portion of our expenses 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 to protect us from the volatility in zinc prices.

Table of Contents

Energy is one of our most significant costs. Our processes rely on electricity, coke and natural gas in order to operate. Our freight operations depend heavily on the availability of diesel fuel, and our Monaca power plant uses coal to generate electricity for our operations in that facility. Energy prices, particularly for electricity, natural gas, coal, coke and diesel fuel, have been volatile in recent years and currently exceed historical averages. These fluctuations impact our manufacturing costs and contribute to earnings volatility.
Changes in zinc prices have also made it attractive for new competitors to enter the EAF dust recycling market to compete for dust generated by existing EAF producers as well as anticipated new EAF capacity. This could have an adverse impact on our price realization from EAF dust recycling.
Since 2004, our management has been focused on opportunities to improve our results of operations by improving operational efficiencies. We have reduced our manufacturing costs by increasing our usage of low-cost feedstock, reducing our energy consumption, streamlining our organizational structure and implementing process improvement initiatives based on "Six Sigma," a methodology for eliminating production defects, and we intend to continue to focus on these and similar initiatives in the future. We believe that our ability to capitalize on these and other efficiency improvements will help us to improve our margins. Our management is also focused on increasing our EAF dust recycling capabilities, in order to capture opportunities created by the expansion in the EAF dust recycling market that we anticipate. We have begun additional capacity expansion projects, including the addition of smelter capacity.
Our zinc products compete with other materials in many of their applications, and in some cases our customers may shift to new processes or products. For example, our zinc is used by steel fabricators in the hot dip galvanizing process, in which steel is coated with zinc in order to protect it from corrosion. Demand for our zinc as a galvanizing material may shift depending on how customers view the respective merits of hot dip galvanizing and paint. Our ability to anticipate shifts in product usage and to produce new products to meet our current and future customers' needs will significantly impact our operating results. We also face intense competition from regional, national and global providers of zinc based products, and the growth of any of those competitors could reduce our market share and negatively impact our operating results.
Finally, our business is subject to a wide variety of environmental and other regulations, and our operations expose us to a wide variety of potential liabilities. Our total cost of environmental compliance at any time depends on a variety of regulatory, technical and factual issues, some of which cannot be anticipated. Changes in regulations and/or our failure to comply with existing regulations can result in significant capital expenditure requirements or penalties.
Summary of Critical Accounting Policies and Estimates The Company's Consolidated Financial Statements and the notes thereto for the fiscal year ended December 31, 2007 included in the Company's Annual Report on Form 10-K, which was filed with the SEC on March 31, 2008, contain a summary of significant accounting policies followed by the Company in the preparation of its consolidated financial statements. These policies were also followed in preparing the consolidated financial statements as of June 30, 2008 and for the three and six months ended June 30, 2008 and 2007. Certain of these accounting policies are described below.
Inventories
Inventories, which consist primarily of zinc bearing materials, zinc products and supplies and spare parts, are valued at the lower of cost or market using a moving average cost method. Raw materials are purchased, as well as produced from the processing of EAF dust. Supplies and spare parts inventory used in the production process are purchased. Work-in-process and finished goods inventories are valued based on the costs of raw materials plus applicable conversion costs, including depreciation and overhead costs relating to associated process facilities.
Zinc is traded as a commodity on the LME and, accordingly, product inventories are subject to price fluctuations. When reviewing inventory for the lower of cost or market, we consider decreases in the LME zinc price subsequent to the end of the period.
Financial Instruments
The following methods are used to estimate the fair value of our financial instruments.
Cash and cash equivalents, accounts receivable, notes payable due within one year, accounts payable and accrued expenses approximate their fair value due to the short-term nature of these instruments.

Table of Contents

We enter into certain financial swap and financial option instruments that are carried at fair value in accordance with Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"). We measure fair value in accordance with SFAS No. 157, Fair Value Measurements ("SFAS 157"). We recognize changes in fair value within the consolidated statements of income as they occur.
We do not purchase, hold or sell derivative financial instruments unless we have an existing asset or obligation or anticipate a future activity that is likely to occur and will result in exposing us to market risk. We use various strategies to manage our market risk, including the use of derivative instruments to limit, offset or reduce such risk. Derivative financial instruments are used to manage well-defined commodity price risks from our primary business activity. The fair values of derivative instruments are based on valuations provided by third parties.
We are exposed to credit loss in cases where counter-parties with which we have entered into derivative transactions are unable to pay us when they owe us funds as a result of agreements with them. To minimize the risk of such losses, we use highly rated counter-parties that meet certain requirements. We currently do not anticipate that any of our counter-parties will default on their obligations to us.
Recently Issued Accounting Pronouncements In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133 ("SFAS 161"). SFAS 161 requires enhanced disclosures about an entity's derivative and hedging activities. The enhanced disclosures address how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations, and how derivative instruments and related hedged items affect an entity's financial position, financial performance and cash flows. SFAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008. The Company is currently evaluating the impact of its adoption of SFAS 161. Results of Operations
The following table sets forth the percentages of sales that certain items of operating data constitute for the periods indicated.

                                                      Three months ended June 30,                Six months ended June 30,
                                                      2008                  2007                 2008                 2007
Net sales                                                 100.0 %               100.0 %             100.0 %              100.0 %
Cost of sales (excluding depreciation)                     76.7                  69.2                78.7                 67.4
Depreciation                                                2.3                   1.7                 2.4                  1.7
Selling, general and administrative expenses                3.9                   3.2                 3.6                  2.7

Income from operations                                     17.1                  25.9                15.3                 28.2
Interest expense                                            0.3                   2.1                 0.3                  1.9
Interest and other income                                   0.3                   0.5                 0.5                  0.2

Income before income taxes                                 17.1                  24.3                15.5                 26.5
Income tax provision                                        6.5                   8.8                 5.8                  9.7

Net income                                                 10.6 %                15.5 %               9.7 %               16.8 %

A significant portion of our zinc product shipments are priced based on prior months' LME average zinc price. Consequently, changes in the LME average zinc price are not fully realized until subsequent periods. The LME average zinc prices are listed in the table below:

                                   2006                             2007                                 2008
                           Fiscal quarter ended              Fiscal quarter ended                Fiscal quarter ended
Average LME zinc price         December 31           March 31      June 30     December 31      March 31        June 30

Quarter                     $           1.91         $   1.57      $ 1.66      $     1.19      $    1.10        $ 0.96
Year-to-date                $           1.49         $   1.57      $ 1.61      $     1.47      $    1.10        $ 1.03

Table of Contents

Three Months Ended June 30, 2008 Compared with Three Months Ended June 30, 2007
Net sales. Net sales decreased $14.1 million, or 9.7%, to $130.5 million for the three months ended June 30, 2008 compared to $144.6 million for the three months ended June 30, 2007. The decrease was a result of a $49.9 million decrease in price realization, due primarily to a lower average LME zinc price for the second quarter of fiscal 2008 versus the second quarter of fiscal 2007 and a $0.5 million decrease in co-product and miscellaneous sales. Partially offsetting our decreases in net sales was a sales volume increase of $18.3 million reflecting increases in shipments in our zinc metal and zinc oxide product lines and increases of EAF dust receipts. The average premium to the LME on zinc products sold for the second quarter of fiscal 2008 versus the second quarter of fiscal 2007 remained unchanged for zinc metal but improved for zinc oxide. Zinc product shipments were 43,114 tons for the three months ended June 30, 2008, or 38,866 tons on a zinc contained basis, compared to 38,427 tons, or 34,284 tons on a zinc contained basis, for the three months ended June 30, 2007. The average sales price realization for zinc products on a zinc contained basis was $1.18 per pound for the three months ended June 30, 2008, compared to $1.84 per pound for the three months ended June 30, 2007.
Our hedging positions partially mitigated the fluctuations in our revenues caused by the changing LME prices. We received cash and increased our revenues by $1.4 million and $1.5 million for the three months ended June 30, 2008 and June 30, 2007, respectively, from the settlement of our various hedging positions. The settlements are components of the change in net sales relating to changes in price realization and volume. For the three months ended June 30, 2008, our revenues were further increased by a favorable non-cash mark to market adjustment of $16.7 million on our open hedge positions. For the three months ended June 30, 2007, we decreased our revenues by an unfavorable non-cash mark to market adjustment of $1.3 million on our open hedge positions.
Net sales of zinc metal decreased $16.0 million, or 26.1%, to $45.4 million for the three months ended June 30, 2008, compared to $61.4 million for the three months ended June 30, 2007. The decrease was attributable primarily to a $30.6 million decrease in price realization partially offset by a $14.5 million increase in sales volume. The decrease in price realization was attributable to a lower average LME zinc price for the second quarter of fiscal 2008 versus the second quarter of fiscal 2007.
Net sales of zinc oxide decreased $18.0 million, or 28.2%, to $45.8 million for the three months ended June 30, 2008, compared to $63.8 million for the three months ended June 30, 2007. The decrease was attributable to a $19.6 million decrease in price realization due primarily to lower average LME zinc prices for second quarter of 2008 versus the second quarter of 2007, partially offset by the lag effect of pricing a majority of our zinc oxide shipments on prior months' average LME zinc prices. The average LME zinc prices were $1.10 per pound for the three months ended March 31, 2008 and $0.96 per pound for the three months ended June 30, 2008 compared to $1.57 per pound for the three months ended March 31, 2007 and $1.66 per pound for the three months ended June 30, 2007. We realized a premium to the LME on sales of zinc oxide in the second quarter of fiscal 2008 versus a discount to the LME in the second quarter of fiscal 2007, both reflecting the lag effect and the movements of the average LME zinc prices from the immediately preceding quarters. The decreases were partially offset by a $1.6 million increase in sales volume.
Net sales of zinc and copper-based powder decreased $0.2 million, or 5.0%, to $3.8 million for the three months ended June 30, 2008, compared to $4.0 million for the three months ended June 30, 2007. This increase was attributable primarily to a decrease in shipment volumes partially offset by an increase in prices in our copper-based powders.
Net sales from EAF dust recycling increased $2.6 million, or 23.2%, to $13.8 million for the three months ended June 30, 2008, compared to $11.2 million for the three months ended June 30, 2007. Increased volumes caused net sales to increase by $2.8 million. A 1% decrease in price realization on EAF dust recycling fees for the three months ended June 30, 2008 compared to the three months ended June 30, 2007 resulted in a decrease in net sales of $0.2 million. Net sales from EAF dust receipts for the three months ended June 30, 2008 were based upon 144,614 tons versus 115,653 tons for the three months ended June 30, 2007.
Cost of sales (excluding depreciation). Cost of sales was $100.1 million for the three months ended June 30, 2008 and June 30, 2007. As a percentage of net sales, cost of sales was 76.7% for the three months ended June 30, 2008, compared to 69.2% for the three months ended June 30, 2007. The change in percentage reflects the net effect of changes in the average LME zinc prices on our net sales and cost of sales. Changes in the average LME zinc price are restricted to the purchased feed component of our cost of sales; therefore any changes in the average LME zinc price have a smaller effect on our cost of sales than on our net sales. Inventories are carried at weighted average actual cost. Consequently, current quarter cost of sales flowing from inventory includes some of the higher costs incurred in the prior months to acquire our purchased feeds.

Table of Contents

The cost of products sold decreased $2.5 million, or 2.6%, to $96.3 million for the three months ended June 30, 2008, compared to $98.8 million for the three months ended June 30, 2007. The decrease was primarily a result of a $14.6 million decrease in the cost of produced metal, oxide and powders shipped in the three months ended June 30, 2008 compared to the three months ended June 30, 2007 and a $4.6 million decrease in cost of brokered metal shipped. These decreases were partially offset by a $12.6 million increase in shipment volume and a $3.3 million increase in our recycling and other costs. The cost decrease was caused largely by a decline in the cost of purchased feeds which reflects the net effect of the 42.3% decline in the LME average zinc price from the three months ended June 30, 2007 partially offset by an increase in the percentage of the purchased feeds used in the feed mix.
The cost of EAF dust services increased $2.6 million, or 195%, to $3.9 million for the three months ended June 30, 2008, compared to $1.3 million for the three months ended June 30, 2007. The increase was the result of a $2.2 million increase in the cost of the services provided reflecting primarily an increase in fuel and other transportation costs and a $0.3 million increase in volume of EAF dust received.
Depreciation. Depreciation expense increased $0.5 million, or 23.7%, to $2.9 million for the three months ended June 30, 2008 compared to $2.4 million for the three months ended June 30, 2007. The increase reflects the increased capital expenditures during the twelve months ended June 30, 2008, most notably the kiln expansion project at our Rockwood, Tennessee facility which was completed and placed into service in early January 2008.
Selling, general and administrative expenses. Selling, general and administrative expenses increased $0.5 million to $5.1 million for the three months ended June 30, 2008, compared to $4.6 million for the three months ended June 30, 2007. The increase reflects primarily costs associated with our public company status, namely increased legal and audit expenses, and public company filing fees not incurred in the three months ended June 30, 2007. Non-cash compensation expense included in selling, general and administrative expenses was $0.5 million and $0.3 million for the three months ended June 30, 2008 and June 30, 2007, respectively.
Interest expense. Interest expense decreased $2.6 million to $0.4 million for the three months ended June 30, 2008, compared to $3.0 million for the three months ended June 30, 2007. The decrease is attributable primarily to lower debt levels in 2008. Substantially all of our debt was repaid in the second and third quarters of fiscal 2007 in conjunction with the private placement of shares of our common stock in April 2007 and the initial public offering of our common stock in August 2007.
Interest and other income decreased $0.2 million for the three months ended June 30, 2008. The decrease was attributable primarily to a $0.3 million decrease in interest earned on excess cash during the quarter.
Income tax provision. Our income tax provision was $8.5 million for the three months ended June 30, 2008, compared to $12.8 million for the three months ended June 30, 2007. Our effective tax rates were 38.1% for the three months ended June 30, 2008 and 36.5% for the three months ended June 30, 2007.
Net income. For the reasons stated above, our net income decreased to $13.9 million for the three months ended June 30, 2008, compared to $22.4 million for the three months ended June 30, 2007.
Six Months Ended June 30, 2008 Compared with Six Months Ended June 30, 2007 Net sales. Net sales decreased $47.5 million, or 16.2%, to $244.9 million for the six months ended June 30, 2008 compared to $292.4 million from the six months ended June 30, 2007. The decrease was a result of a $94.9 million decrease in price realization, due primarily to a lower average LME zinc price for the first six months of fiscal 2008 versus the first six months of fiscal 2007. Partially offsetting our decreases in net sales was a sales volume . . .