Freeport-McMoran: Dead Money Until Copper Prices Recover

Beware to those who ignore historical market cylicality. I made two late-cycle investments in stocks heavily associated with copper and am paying for it now. While I hardly bought in at the top, being early doesn’t feel much different from being wrong. Unlike my previous blow-up with American Capital (ACAS), I do not believe the future prospects for Freeport McMoran Copper & Gold (FCX) or Northgate Minerals (NXG) are permanently impaired. With enough patience, metals prices will recover and hopefully, share prices with them.

Before delving into the companies, I’d like to bring this quote to readers’ attentions. From NXG’s Q3 release regarding the copper market situation, it is especially pertinent to Freeport’s current dilemma:

… certain higher-cost copper mines in the United States and other areas of the world that will be forced to close if the current price environment persists, which should reduce near-term copper supply. In addition to these expected closures of producing mines, most, if not all, expansion and greenfield copper projects have been delayed or cancelled as a result of credit market conditions and the falling copper price.

Freeport McMoran Copper & Gold held an investor update conference call on 12/3/2008 and announced drastic actions in response to rapidly deteriorating metals prices:

• Suspending the dividend, saving $755M per annum.
• Reducing 2009 capex from $2.3B to $1.1B, deferring several key expansion projects such as the Climax moly mine and El Abra sulfide expansion.
• Lowering net production output by 5% in 2009, 11% in 2010. The reduced capacity resides in higher cost regions like North America.
• Assuming $1.75 cu, $750 au & $10 moly, FCX estimates $2B in cash flow before working capital and ~$1.25B OCF.
• At those same prices, management is estimating 2009 net unit cash costs @ $0.89/lb cu.
• Conceding that perhaps all $6B in goodwill from the 2007 Phelps Dodge acquisition could be written off in Q4 if prices remain near current levels. This would be a noncash charge with no bearing on any debt covenants or cash flow.

I did expect Freeport to cut the dividend but not entirely do away with it altogether. While certainly not a pleasant day for shareholders, management demonstrated responsibility and assertiveness in the face of difficult circumstances. They are also earlier than some of their peers, who I expect to follow Freeport’s lead in taking decisive action.

At today’s prices ($1.50 cu, $775 au, $8 moly), FCX would generate 2009 cash flow of $1.2B ($455M after working capital) and negative $645M FCF after $1.1B projected capex. While it has suspended common share dividends, the preferred dividend runs over $200M per annum. Even though management warned against annualizing certain run rates, we’re looking at $850M cash burn just from capex and preferred payouts.

It is unclear to me whether FCX is obligated to continue paying minority interest dividends, which ran $714M through the first 9 months of 2008. From a scan of the 10K, it seems the minority interests stem from operations in South America and Indonesia. If FCX is required to pay out minority interest dividends, Q4 should provide a good basis for a 2009 run rate estimate. Also note 2009 production is expected to mirror 2008 totals with the notable exception of Indonesian gold production, which is expected to double (and whose price is holding up well relative to other metals). The net takeaway is that minority interest payouts may not reduce at the same rate as revenue and cash flow. I will try to get clarification from IR and will post updates in the comments of my blog post.

FCX senior notes are yielding 10-15% in the secondary market so issuing new debt could be rough. The company does have $1.2B cash on hand (as of Q3 2008) and $1.5B bank credit facility with favorable terms. They have no significant debt maturing until 2011 ($118M), 2014 ($340M) & 2015 ($2.5B). With nearly $3B in liquidity, the company seems to be OK for the next year or two but if this recession lingers or intensifies, more hard decisions lay ahead.

Bold action notwithstanding, the company finds itself in a tough position. Management stated they have room to cut further if prices fell even more but I would say, as of now, management has little safety net left. For example, US unit net cash cost is expected to average $1.86/lb cu in 2009 while current prices hover around $1.50. As noted at the top of the post, FCX may have to consider closing US mines.

The global economic situation shows little sign of letting up and without improvement there, prices for copper and moly (90% of FCX revenue) are unlikely to recover. That said, the long-term supply/demand outlook seems favorable. If the planet is going to support 6B people, we’re going to need a 21st century infrastructure build-out, and the world’s two largest copper consumers have telegraphed major stimulus packages forthcoming. One look at the chart below reveals that copper supplies have hardly kept up even during the boom period and rationalizing supply should provide price support eventually.

With Freeport’s solid assets and prudent management, it doesn’t make any sense to sell now; I have a rough NAV of $50 per share assuming prices lower than today ($1 cu, $600 au, $5 moly). Of course, spreadsheet assumptions don’t translate into real returns and with the dividend now suspended, these shares are probably dead money for the foreseeable future. At a share price of $18, it’s too late to sell and assuming FCX can stay solvent and ride out this storm, the stock could rebound down the road.

Performance Management:

• FCX has little control over metals prices so must focus on operations and hope for the best.
• Hit production and unit cash cost guidance:
  • 4.1B lbs cu, 2.2M oz au, 70M lbs moly
  • $0.89/lb cu assuming $750 au & $10 moly
• Keep capex under control ($1.1B est 2009) or possibly reduce even further.
• Lower energy and materials prices should help with operating costs.
• Hold the line on Tenke, government stake situation.
• Take further action if conditions worsen.

Disclosure: Long FCX and NXG.

Comments

[CT Programmer:]

I just tripled my stake in FCX today. I'll re-evaluate it in 5 years. I have a hunch I'll have made quite a bit of money.

2008 Dec 05 09:53 AM

[anarchist:]

I sold some puts at a $20 strike and looks like I probably will get assigned 100 shares but if I do I will buy another hundred at what ever the current price is on expiration day-doubt it will be above $16. Like CT Programmer I think FCX will survive and prosper in the future.

2008 Dec 05 10:36 AM

[JasonC:]

On minority interest, I may be wrong but I believe much of that is their royalty payments to the host governments, which structure their deals with FCX as joint ventures. Basically it lets them set a separate tax rate or royalty scheme for each individual producer. I'd expect the payments to them to decline in line with revenue but not faster. Your mileage may vary, check my assumption, etc.

I also like FCX long term but I have not jumped in just yet. Normally I avoid trying to call bottoms as impossible, and just want to call levels instead. But FCX doesn't yet meet my criteria for its level, compared to my other materials companies. Of course it is already cheap by bubbles standards, but I see cheaper around it in today's market.

My materials buy list and strategy is to go for large players in profitable materials, waiting until they are selling at a fraction of sales. My target has been about 1/4 of sales and many great companies have hit that line - MT in steel, DOW in chemicals, AA in aluminum. FCX is my copper buy list item in that group, with the smaller speciality ATI (titanium) rounding it out. You can buy this group today at a trailing PE around 3. It is probably still early, I always seem to be with these cyclicals.

My overall depression strategy is to take positions in smashed corporate bonds and spend the interest on common stock, to gradually accumulate and average in to the latter, on a time scale of years not weeks or months. I only recommend positions around 1% each in the materials stocks above, at this time. And for FCX, you could wait a little - it is around 0.4 times sales rather than 0.25 times sales.

On man's opinion. BTW, thanks to the original poster for the useful and honest article...

2008 Dec 05 11:46 AM

[optionsgirl:]

Very good article and excellent commentary from readers, too. I started nibbling at $15.99 and will continue to do so, as it falls. Another hedging strategy again your $50. per share position: sell calls.

2008 Dec 05 12:21 PM

[Rich in Bpt.:]

We are going to see $.90 a lb. cu.,before we see $2.00 a lb. cu. FCX is going below $10.00 a common share.

2008 Dec 05 12:26 PM

[NOWHEREMAN:]

I hope so Rich. I missed it on the way up. I would like to pick it up at lower levels than when I first missed it.

Any thoughts on PCU and AAUK?

2008 Dec 05 01:16 PM

[ritr54:]

I am kind of surprised FCX didn't make a play for Lundin Mining (LMC)who is their partner in Tenke; also NXG is a steal at these price levels with their low cost reserves in copper and gold!!

2008 Dec 05 01:46 PM

[NOWHEREMAN:]

I think .89 is supposed to be breakeven on FCX.

2008 Dec 05 02:19 PM

[Russ Winter:]

The FCX cv pf M yields 20% and the payout looks well covered, Not bad for "waiting".

2008 Dec 05 02:47 PM

[SouthShore:]

First Davy, decent write up. Thanks. Will look for any comments from FCX investor relations that you post.

Regarding the preferreds: The convertible preferred mentioned above isn't as attractive as I thought at first glance. As long as FCX common moves down, then the payout from the FCXpM convertible preferreds is more like a return of capital with the preferred share price not rebounding. Upon conversion you won't have a dividend to look forward too, either. Thus, unless you can buy the convertible at a large discount to its conversion including cumulative dividends, then you are just buying the common. Probably better is the FCXGL preferreds that can't be redeemed unless the common shares trade above $69.14/sh. I would like to hear thoughts on this PK. They are cumulative and perpetual.

Also, if Copper returns to historic levels below $1/lb and stays there, can anyone be confident that FCX is viable long term? Again, the more models the better here. I put FCX under $10/sh as a guess if this happens.

Cheers,

2008 Dec 05 03:44 PM

[Pipo:]

Freeport McMoran CEO gave an interview explaning the situation of its industry.

Very good interview.

ceotalk.blogspot.com/2...

2008 Dec 05 05:22 PM

[Russ Winter:]

Actually the conversion when FCX is below 61.25 is 1.6327 shares. Thus the premium or parity of the cv pfd is very small right now: 1.6327 x 16.80 FCX= 27.42, with FCXpfM trading about 32.50. Thus the pfM will get a direct play on the stock while paying a huge yield. In my opinion buying the stock over the pfM would be almost criminally negligent right now.
www.quantumonline.com/...


On Dec 05 03:44 PM SouthShore wrote:

> First Davy, decent write up. Thanks. Will look for any comments
> from FCX investor relations that you post.
>
> Regarding the preferreds: The convertible preferred mentioned above
> isn't as attractive as I thought at first glance. As long as FCX
> common moves down, then the payout from the FCXpM convertible preferreds
> is more like a return of capital with the preferred share price not
> rebounding. Upon conversion you won't have a dividend to look forward
> too, either. Thus, unless you can buy the convertible at a large
> discount to its conversion including cumulative dividends, then you
> are just buying the common. Probably better is the FCXGL preferreds
> that can't be redeemed unless the common shares trade above $69.14/sh.
> I would like to hear thoughts on this PK. They are cumulative and
> perpetual.
>
> Also, if Copper returns to historic levels below $1/lb and stays
> there, can anyone be confident that FCX is viable long term? Again,
> the more models the better here. I put FCX under $10/sh as a guess
> if this happens.
>
> Cheers,

2008 Dec 06 06:22 AM

[curious cat:]

at these low levels, freeport is going to be bought out. i expect them to get a friendly high bid before the end of this month. the buyer will want to close this deal before the new anti-merger democrats come into office. i bought some calls to take advantage of a quick move. don't expect it to fall from here, even if no one buys them out, though. they have been beaten sensless by hedge fund forced selling. investors are already seeing great long term value. loved this article.

2008 Dec 06 02:59 PM

[DHS:]

TGB should be added to this short list.

2008 Dec 06 03:25 PM

[Fighting Yoda:]

All commodities are going down a lot more - not just industrial commodities like Copper, Al, Steel but also Corn, Oil, Nat-gas, fertilizers, etc - all have gone down 50 -80% already from recent highs. The historical lows are even lower - we already have a $25 call for oil, copper below a $ entirely feasible even by end of year.

Takeovers may happen - China etc may make a move. But Chinese takeovers will likely not be feasible in the global political environment -especially at these low prices. BHP-RTP takeover has failed, XSTRATA takeover failed.

Overall market is going much lower, stay defensive, even shorting the market at very rip is still a good idea.

2008 Dec 06 03:36 PM

[resolved:]

There has not been a shortage of copper since about mid 2005, the price surge was a creation of investment banks, hedge funds and other related speculators. There has been an accumulation of unsold inventories between 1 and 2m tons which have not been in the world statistics. Freeport did not hedge sell forward but they did hedge buy forward to cover sales to customers who wanted a fixed price instead of the monthly average price. The question now becomes how much was fixed forward and covered on the commodity market (through a swap) and is that customer going to honor a contract which is so far from current prices. If the contract is not honored it would mean that Freeport could now have exchange commodity losses to contend with. Does anyone have any idea what tonnage may have been fixed? The answer could be significant.

2008 Dec 06 10:49 PM

[Cole Bene':]

Copper prices are being forced down (DEAL) to try to stop theft 1.6 B this year and the market should see it as a construction material. Go to your local metal recycler and watch the copper flow.

[e-mail]

2008 Dec 07 12:07 AM

[Cole Bene':]

Almost forgot buy silver bullion. Some people are paying as much as 40% more than the market price to get the hard stuff. Play these right prices and soon a lot of money can be made.

BROKERS what do you think ?.

[e-mail]

2008 Dec 07 12:13 AM

[NOWHEREMAN:]

Do not get caught in the frenzy, the same people who bought and stored copper are probably in that game as well.

Go to garage sales, pawn shops, estate sales or similar, look for those old acrylic sealed timepieces which used silver coins as hour designators. I have a couple, still sealed. Even Pawn shops may misprice them.

The problem that the Hunts encountered in their attempt to corner the Silver market was the influx of silver from silverware accumulated over generations. Prices have not gotten to the level where similar activity can take place.

However, a deep recession can get people to sell things of value which they would not otherwise sell. Hence, the inclusion of Pawn Shops for your Silver needs.

IMHO

2008 Dec 07 05:29 AM

[kappaquint:]

I agree with most comments. Especially the ones stating that FCX is still a solid company making the changes that are called for, but I agree even more strongly with the idea that the common share still has a ways to fall. Several factors weigh in on my thought.

1. This stock is one of the most common stocks in large mutual funds and hedge funds (holding massive positions) -- and I am willing to bet some of these knee-jerk money managers will make a decision to sell, or their computers will force-sell due to leverage and hedging.

2. There are still a sizeable portion of shareholders that were in this stock for the dividend and I am willing to bet a large portion of them still have to sell.

I admit this stock is attractive at... lets say $15/share. Although I do think it is relatively likely that before the new year we will see this stock dip $10-12 range in intraday trading, and if we are lucky maybe even below that. If it does I am a buyer at both levels and then turning off my screen for 5 years to wake up with sizeable gains.

--recently shorted fcx, planning long position. no current position of any sort

2008 Dec 07 05:14 PM

[DollarTalkNet:]

I echo the surprise of the author at the complete cessation of the dividend. I've written about this stock and fully expected a dividend cut, but the cancellation honestly seems like an overreaction.

2008 Dec 07 10:13 PM

[Socialism c...:]

How now, brown cow!?! I was long and tripled my position last week...taking nice gains today! Be careful of proclaiming from the rooftop that a stock is dead, or trying to know a timeframe for its recovery. Just watch the surrounding news and data...and move on it!

2008 Dec 08 02:16 PM