Freeport-McMoRan Copper & Gold Inc. (FCX) explores and mines mineral resources, primarily copper, gold, and molybdenum. Recently, the company has made moves to enter the energy market by acquiring Plains Exploration & Production Company (PXP) and McMoRan Exploration Company (MMR) for $20 billion combined, which gives it access to high quality U.S. oil and natural gas reserves. This move is significant as the latest projections from the International Energy Agency suggest that the U.S. will overtake Saudi Arabia as the world's leading oil producer by 2017 and will become a net exporter of oil by 2030. Clearly, the company -- like so many others in the energy sector -- is jostling to carve out its market in the ever-growing domestic oil production in the U.S.
Therefore, it is logical to review Freeport-McMoRan in terms of current valuation, as well as the potential future improvements in its top and bottom lines with these acquisitions.
The Current Valuation
At the time of writing this, FCX traded at $34.51/share, which values the company at $32.75 billion in the market. With $3.13 in trailing 12 months (ttm) earnings per share, the P/E ratio is 11.03. This compares favorably to Southern Copper (SO), another major copper producer that is valued at 17.44 times earnings. However, the companies differ in key metrics like profitability and efficiency, so a vanilla P/E comparison is not always appropriate.
One quick check I do when looking at the current operations and its profitability of an asset-heavy company is to compare the earnings yield of the stock to the returns the company is generating on its equity. For FCX, the ROE (ttm) is 20.11%. The shares are also priced at 1.95x tangible book value, so investors should get 20.11/1.95 = 10.31% return on the equity they hold per share. However, the earnings yield of the stock is 9.1% (inverse of P/E ratio) -- therefore the shares appear to be fairly valued to mildly overvalued. Here, I am using ROE as a proxy for expected growth rate since the growth projections are generally unreliable. The return on equity is a measure of how well the company uses its assets and capital, and gives us a better understanding of the management effectiveness at growing the company from its current base. This way you can also simplify analysis in industries where revenues and earnings are bought and sold more frequently in terms of mergers and acquisitions, as you would generally expect the management to make transactions that are in line with their internal hurdle rate.
This is not perfect, of course, but unless something else stands out causing me to go much deeper into the financials, it is a good proxy for valuation. It also does not account for any future price increases in the underlying commodities, which could potentially improve the margins and returns.
Give me a 15%-20% discount to the current share price and I will be interested in buying the stock today, all other things being equal (but they are not, as we will find out). However, investor optimism can be justified in situations where the assets themselves can be expected to be revalued higher. That's either because the current book valuations are below the market, or as is more likely the case for FCX, commodity prices for copper, gold, and now oil/gas are expected to increase at better than the rate of inflation -- making their productive assets more valuable.
The Energy Acquisitions and Future for Shareholders
FCX is acquiring the following two companies in the energy sector:
- Plains Exploration and Production Company, for a total cost of $6.9 billion. This values the company at 2.1x book value and buys an operation returning 5.91% on equity. It is clearly overpaying.
- McMoran Exploration Company for a total valuation of $3.4 billion ($2.1 billion in cash net of 36% it already owns). This values the company at 3.85x book value. MMR is currently unprofitable, having lost money in three of the last three fiscal years and three of the last fourfiscal quarters. Also, PXP and FCX jointly owned 36% of MMR prior to the acquisition, with MMR sharing some board members and executives with FCX.
The company is also assuming $10.6 billion in debt as part of the acquisition. In short, the company is overpaying for the acquisitions. It is likely that this consolidation will result in more efficient management and better utilization of assets, but it is not clear how much benefit it will produce for the shareholders. One of the strategic advantage is securing a long-term, low-cost supply of natural gas for its mining operations. The company does expect the acquisitions to self-fund using the cash flows.
After the acquisitions are closed, the company expects oil and gas to be 26% of its EBITDA. This is a significant amount, and the short-term dynamics of the oil prices may be favorable. Global demand growth of 30%-40% is expected by 2035. However, U.S. production is expected to grow 23% by 2014 and will accelerate. Even with production growth in the rest of the world staying moderate, it is likely that we may see oil prices declining before the decade is out. There is a small window for the combined company to generate growing excess cash flows to compensate for the excess valuation. The company also estimates the demand for Copper growing at 60% by 2025, which should help.
If this was not enough, FCX will also issue 91 million new shares to close the PXP acquisition, sometime in Q2 2013. This is a little less than 10% of the current shares outstanding and will dilute the existing shareholders. The additional $10.6 billion in assumed debt, at say 1% rate of interest will cost the company an additional $100 million in cash for interest payments, plus any principal payments they make. This is not enough to cause undue concern for a company that expects to generate $12 billion in EBITDA and $9 billion in combined cash flows, and FCX is likely to de-lever quickly similar to the way it did with its Phelps-Dodge acquisition.
In short, the stock today does not offer compelling value, and I am not confident that the foray in the energy sector is going to be a game changer for FCX. It might, of course, make other moves in the future, but that is investing based on speculation. I expect the stock will become cheaper between now and Q2 2013, at which point it might be a good time to re-evaluate. For now, I will stay neutral on the stock.