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The Case For Why Freeport McMoRan Is Almost Criminally Undervalued

Summary

  • Freeport-McMoRan is an undervalued company due to past operational decisions and commodity price pressure.
  • The outlook for the company is solid because it has taken great care with the balance sheet and is now throwing off significant levels of cash.
  • Its three main commodities all have bullish cases, which I will walk through.
  • I reached out to the VP of Investor Relations and discussed the current company operations, along with his view on the future.

I love value investments as they provide investors with less expensive exposure to markets and reduce overall investment risk. Being that I also love the direction the resource markets are likely headed, I was enamored with the potential value that a large copper company is providing to the market.

Photo Credit

Freeport McMoRan (FCX) is a copper, molybdenum, gold, and silver producer based out of Phoenix, AZ. The company has as diverse portfolio of assets across three major continents as shown.

Source: Freeport McMoRan

Freeport primarily mines copper, but they have substantial assets in the gold and molybdenum space as well. Those are nice offsets to the copper price as molybdenum prices have been rising and there is a bull market case developing for gold.

However, copper prices have been depressed for a number of years.

Source: Macro Trends

Despite the decline in price, the demand for copper continues to grow, largely due to expected increases in emerging market demand.

Source: Science Direct

So what gives with the copper market? Well some trade war stuff you may have heard about is rearing its ugly head and affecting the markets of base metals.

While this affects sentiment towards certain base metals markets, the reality is that worldwide demand for copper and most other base metals used in economic development is still expected to increase which is causing supply deficits.

Per John Gross, publisher of the Copper Journal:

“We are running a parallel in the market today to that period in time,” Gross said. “We have been in a deficit, and the forecast for 2019 is for a further deficit. At some point, the price is going to respond to that.”

Recognizing the importance of US and China relations, Robin Bhar, metals analyst with Societe Generale:

projected that copper will rise to $6,800 a tonne, or $3.08 a pound, in six months. He listed a 12-month outlook of $7,100, or $3.22.“We would expect a gradual rise in price,” Bhar said, suggesting that price dips will be buying opportunities in a market that will be in a supply deficit. “A lot will depend on ongoing negotiations between China and the U.S.”

At some point, the fundamentals have to triumph over the sentiment in the markets. As Stuart Burns of MetalMiner notes:

But while investors’ short-term positions are the stuff of expectation, longer-term prices are moved by supply and demand.

In the meantime, the situation presents investors with a fairly rare arbitrage play between actual demand and the pessimism of the market over the future of the metal price.

Enter Freeport McMoRan, which is ready to fulfill the deficits with additional production. I discussed the state of the company with David Joint, VP Investor Relations this Thursday to get a clear picture of where the company stands and what they are projecting for 2019. I will analyze the company and include some of his insights into company operations.

Grasberg Project in Indonesia

The company is currently about to transition to deep mining at Grasberg in Indonesia, and therefore expects 2019 to have reduced overall copper sales until that transition is completed.

Source: Freeport McMoRan

For safety reasons, the company cannot mine at surface and at depth simultaneously, so the copper sales are expected to fall off to 3.3 billion pounds for 2019, but recovery fully to 3.9 billion pounds by 2020 through 2022 after the block cave infrastructure is completed.

Here is where the company is in the development of the Grasberg block cave mine. They expect to start mining this portion of the project in the first half of 2019.

Source: Freeport McMoRan

While the Indonesian Grasberg project makes up 29% of copper reserves and 25% of overall mineralized assets for the company, Freeport is also well diversified with projects around the world.

South America and the States

As you can see in the graphic, Freeport has substantial copper and molybdenum assets in the US which is a friendly mining district. The assets exist primarily in New Mexico and Arizona.

Source: Freeport McMoRan

The South American Assets Cerro Verde and El Abra are shown below.

Source: Freeport McMoRan

75% of the overall mineralized material for Freeport exists on these two continents.

Source: Freeport McMoRan

The unit net cash costs are positive for all of the company’s projects, when the by product credits for the moly, silver, and gold are applied. Even if we were to take out the Indonesian project, Freeport McMoRan still has great cost fundamentals even with the current low copper price which I don’t see staying this low for very long.

Commodity Price Leverage & Outlook

Considering all mining projects, every 10 cent rise in the price of copper results in $325 million increase in EBITDA and $245 million increase in operating cash flow. Freeport’s strength is the leverage to the copper price, however the changes in byproduct prices also provide leveraged returns for investors.

According to David, for every $50 change in the price of gold, the company realizes an additional $40 million EBITDA and $20 million in operating cash flow. For molybdenum, for which the company is also a leading provider, every $1 change in price has an $80 million impact on EBITDA and $75 million impact on operating cash flow.

Prices for molybdenum have risen substantially in the last year, though the price is still nowhere near historic norms.

Source: Trading Economics

And industrial demand, which uses moly for making strong metals such as stainless steel, steel and cast iron as well as in nickel and other super alloys, is strong. One common use for moly is tubular parts, such as what is used in shale gas drilling projects.

“We’re seeing a pick up in tubular goods used in the North American shale gas market,” said David Merriman, a senior analyst at metals consultancy Roskill. “There’s a strong correlation between moly demand and active drill counts.”

The increased demand for moly should continue to raise the price, as the industry was suffering from supply destruction brought on by the rapid decreases in price in the middle of this decade. I have highlighted this price destruction in the graphic below from Metalry.

Source: Metalry

CRU Group’s George Heppel spoke to Reuter’s regarding moly supply rebuilding:

“The trend over the next 5 years is one of very low supply growth from by-product sources. In the early-2020s, we will need to see primary mines reopened to keep the market balanced,” he noted.

So I have provided you multiple analysts predict stronger demand for copper and molybdenum, and I have provided an article with my own rationale on why gold prices are likely to increase as well.

Financial Positioning

The company has done a great deal of work in the last few years fixing the balance sheet. They divested their oil and gas assets and paid down net debt from $20 billion to now $6.6 billion. Net debt is defined as debt minus consolidated cash. The last twelve months leverage ratio is a paltry 0.8x. This has led to the reinstatement of a dividend for shareholders.

Source: Freeport McMoRan

Here are some valuation measures from Yahoo Finance.

Source: Yahoo Finance

This is not a stock that has an expensive P/E ratio or Enterprise Value/EBITDA in a market that is saturated with expensive stocks. This is exactly what I am looking for in an undervalued stock pick where I expect the trend in the business fundamentals to affect market sentiment to the upside, and provide higher than market returns moving forward.

Reserve Replacement Value

The enterprise value is substantially under what Freeport calculates as the reserve replacement value. Meaning, if the market needed to replace Freeport’s reserves and production, it would cost between $8 – $10 per pound copper to develop the new greenfield capacity, assuming it can be found to do so.

Source: Freeport McMoRan

This is largely because Freeport is the second largest copper producer, which also means that it is not possible for other companies to quickly ramp up enough brownfield capacity to make up for Freeport’s assets.

Source: Freeport McMoran

Large copper discoveries do not grow on trees, as most major assets and production have been found decades ago as shown in the following chart.

Source: Freeport McMoRan

Long term Freeport will be integral to meeting increased demands for copper, molybdenum, and even gold. Therefore, the long term trend in share price for Freeport is then bullish.

Risks of This Company

The main risk people see for the company is the recent change in ownership structure for the Grasberg mine in Indonesia. This is not an insignificant change; however, it does appear most of the details have been worked out with the government and the state owned entity (aka SOE) that will own 51% of the project. Here is the current status of that change.

Source: Freeport McMoRan

Per discussion with David, the agreement allows Freeport to keep operational management of the mine in exchange for the SOE, PT Inalum, to acquire 51% of the mine by buying out Rio Tinto and purchasing additional shares from Freeport.

Basically, the Indonesian government wanted their own state owned company to profit from the resource found within its borders. I am honestly surprised these types of deals have not happened more often around the world.

While Freeport’s share ownership decreased, overall the company still has a major stake in the success of the project and any revenues stemming from it.

Source: Freeport McMoRan

While the Indonesian government has changed policy with regards to this mine, it is also in the best interests of both PT Inalum and Freeport to work together for the success of the mine. The revenues from Grasberg are crucial to the country as well as the current government which has already marketed the project as a success.

A failure to complete the deal on Grasberg would likely have had both economic and political consequences for Indonesian officials with a key election coming up in April of 2019. That is why today, Freeport announced the consummation of the deal with the Indonesian government.

Other risks mainly include things like free cash flow and price of the underlying commodities. Freeport has good cash flow now and I have already established that I think their three main products are setup for more price appreciation.

Source: Freeport McMoRan

The company also makes healthy operating and profit margins, even with the depressed commodity prices.

Source: Yahoo Finance

Here is the debt maturity schedule for the company, with the most significant portions coming due in 2022 – 2023.

Source: Freeport McMoRan

To be fair, Freeport does have a higher debt to equity ratio than industry average. Given good cash flows and upside in commodities prices, this number should continue to normalize over the next 3-4 years for the company.

Source: Guru Focus

Additional Upside in the Americas

Lastly, I wanted to take a moment to discuss the Lone Star project in Arizona.

Source: Freeport McMoran

While the project is not a game changer, it does significantly add to the expected reserves for the company in a very friendly mining district. When David and I discussed the project, the real value seems to be getting through the oxides into the sulfide part of the project where the intercepts are very healthy. The mine could have up to a 20 year life and add up to 60 billion pounds of copper to production over that time frame.

Summary

There is an overhang on Freeport McMoRan’s stock price due to past mistakes with oil and gas, heavy debts, and uncertainty at the Grasberg mine project. Those concerns have largely been addressed, and right now the main issue is the macro versus micro view on the commodity markets.

Given the trade war and some uncertainty over growth in China, the macro story suggests a shrinking demand for copper. However, I would like to point out that despite these concerns, the prices of copper, moly, and gold are all holding below their longer term values given current global demand. Even with a recession, the prices of all three products would likely still have to rise to avoid costly supply destruction as available inventories are being used up.

I expect the micro story on strong fundamentals of the underlying assets to eventually push the share price up through the current level and into a more fairly valued territory. I won’t comment on a specific price target because we have several moving parts that are working themselves out, but it would not surprise me to see significant share price appreciation for this stock in the next couple of years.

I will be initiating coverage on the company for 2019 and will bring you news on significant updates as they occur. I will also maintain my relationship with company management for your benefit.