Freeport-McMoRan Copper (FCX), the world’s largest copper miner, is set to release its Q4 earnings on January 22. The majority of the company’s revenues are derived from copper which is extremely sensitive to cyclical industries like construction and industrial machinery manufacturing. These industries, in turn, are heavily influenced by the macroeconomic sentiment and outlook. Macroeconomic factors remained largely unchanged in the fourth quarter, so not much upside in revenues is expected.
The biggest focus of investors would be the status update on Freeport’s pending mergers with McMoRan Exploration and Plains Exploration and Production. These are oil and gas companies which were recently acquired by Freeport but the deals are expected to be concluded sometime in Q2 2013.
The three companies’ boards are interconnected in a convoluted manner which has resulted in the deal receiving a lot of flak. McMoRan Chairman Moffett could collect $73 million cash for his shares while Plains Chief Executive Jim Flores stands to get $65.4 million for his. Flores could also receive a change-in-control payout of as much as $150 million. These apparent conflicts of interests have made investors question whether the deals have been made more for personal reasons than commercial.
Effect Of Macroeconomic Factors
Global macroeconomic conditions remained challenging this quarter. The U.S. struggled to avoid the fiscal cliff while problems in the Euro zone continued to fester. There was finally some good news from China as infrastructure spending by the government began to show effect. Iron ore prices have risen considerably over the last month alone, presumably due to restocking by Chinese companies in anticipation of future requirement. However, the data for copper prices on the London Metal Exchange (LME) for the last quarter doesn’t show a similar positive trend.
The reason for this could be the Chinese stimulus being spent not on the construction of real estate, but rather highways, dams etc. Copper is used extensively in residential construction, especially in areas such as pipes for plumbing, heating and ventilating, as well as building wire and sheet metal facings. However, it is not needed in large quantities for other construction projects.
Going by the copper price data on the LME, the average realized price of copper for Freeport is likely to be lower this quarter as compared to the previous quarter’s realized price of $3.64 per pound. Volumes sold are not likely to be higher than the previous quarter so we don’t expect much revenue growth.
Re-entering The Energy Business
The big story this quarter, however, was Freeport’s renewed foray into the energy business. Freeport had exited its energy business in 1994 by spinning off McMoran Exploration as a separate company.
Freeport will pay $6.9 billion in cash and stock for Plains, and a net $2.1 billion for McMoRan, in which both it and Plains already hold a 36% stake. The deal will be financed using $5.5 billion in senior unsecured notes and $4 billion in term loans. The additional debt is expected to take Freeport’s total debt to a staggering $20 billion. It would come to approximately $16 billion net of cash. To put these figures in perspective, the combined company may generate an EBITDA of about $12 billion and operating cash flows of $9 billion in 2013. Of this, 74% is expected to be contributed by mining activities and 26% by oil and gas. Freeport’s reported EBITDA for the past 12 months was $6.88 billion.
If the oil and gas production gets delayed or mining revenues are less than expected, it may hamper Freeport’s ability to generate adequate cash flows to service its debt comfortably.
There has been concern for some time about growth opportunities in the copper mining business. Easy to tap reserves are very difficult to come by these days, especially in countries like Chile which has been the largest producer of copper for long. Rich reserves are increasingly being found in remote locations like Mongolia. Taking the inorganic growth route also isn’t very feasible as there are fewer deal targets after almost a decade of mega-mergers. Mining assets are essentially depleting in nature and need to be replaced over a period of 10-20 years to ensure future growth. The declining grade of copper ore, a simultaneous increase in costs and political problems are other major problems facing Freeport.
The oil and gas upstream business can give potentially much higher returns than copper mining. It is to be noted that both Plains and McMoRan Exploration’s have excellent assets in the U.S. These deals will give Freeport access to shale formations in Texas and Louisiana that produce both oil and gas, as well as offshore oil and gas production facilities in the Gulf of Mexico. The McMoRan Exploration portfolio is expected to provide a large, long-term and low cost source of natural gas production. McMoRan has been developing expertise in drilling at extreme depths below sea level in the shallow waters of the gulf. Although commercial success has eluded it thus far, the potential is estimated to be huge. Naysayers counter that oil revenues dominate the revenue mix from acquired assets so any upside resulting from high natural gas prices in future will be limited.
Investors would like the company management to answer questions on how they plan to service Freeport’s massive debt if there is a downturn in the price of copper or the economy in general. Failure to address concerns surrounding these deals could see the stock price of Freeport sliding further. It had dipped by nearly 16% when the deal was first announced in December last year.
We have a Trefis price estimate for Freeport McMoRan Copper of $42 which will be revised after the fourth quarter’s earnings results.