By Ahmed Istiaq
Freeport-McMoRan Copper & Gold (FCX) is among the leading basic material producers around the world. In fact, it is the world's largest publicly traded copper company based on revenues. Established in 1987, the Phoenix, Arizona,-headquartered company has grown into a diversified mining giant. Freeport-McMoRan has interests in several mines spread around the world. While copper and gold are the primary products, Freeport-McMoRan also explores and extracts several other materials including silver and cobalt. Thanks to the Henderson underground and Climax open-pit mines, FCX is also the largest producer of molybdenum.
Recently, FCX announced a definitive agreement to acquire Plains Exploration & Production Company (PXP) and McMoRan Exploration (MMR). The planned merger will take place in the second quarter of 2013. While the shareholders of PXP and MMR enjoyed the premium price offering, shareholders of Freeport McMoRan were highly disappointed. FCX lost almost 20% and fell below $30 after the deal announcement. The stock is experiencing a slow bounce thanks to better-than-expected earnings, but it is still trading way below its fair value.
As of the time of writing, Freeport-McMoRan stock was trading at $35.67 with a 52-week range of $30.27 - $44. The company has a market cap of $33.9 billion. Trailing twelve month P/E ratio is 11.2, and forward P/E ratio is 7.5. P/B, P/S, and P/CF ratios stand at 2.0, 1.9, and 10.4, respectively. Operating margin is 32.6% and net profit margin is 16.6%. The company has only minor debt issues. Debt/equity ratio of 0.2 is well below the market average. Freeport-McMoRan pays nifty dividends. Trailing yield is 3.54%.
Freeport-McMoRan has a 3-star rating from Morningstar. Out of five analysts covering the company, 4 have buy, and 1 has a hold rating. Wall Street has a diverse opinion about the company's future, but the average five-year annualized growth forecast estimate is 5%. Given the company's past growth rate of 7.5%, this is a pretty achievable target.
What is the fair value of Freeport-McMoRan given the forecast estimates? We can estimate Freeport-McMoRan's fair value using the discounted earnings plus equity model as follows.
Discounted Earnings Plus Equity Model
This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value
V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.
E0 = EPS = ($3.19 + $4.76) / 2 = $3.98
Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 5%. Book value per share is $18.49. The rest is as follows:
Fair Value Estimator
Fair Value Range
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Freeport-McMoRan is between $48 and $67 per share. At a price of $35, Freeport-McMoRan is trading at a significant discount. The stock has at least 35% upside potential to reach its fair value.
While there are several companies in the copper business, Southern Copper (SCCO) is probably the closest competitor of Freeport-McMoRan. Both stocks have performed well this year so far. Since January, Southern Copper returned about 6.3% and FCX returned about 5.3%. However, Freeport-McMoRan's annual return is deep in the red territory compared with Southern Copper. The two stocks diverged in different directions particularly after the announcement of Freeport's merger deal. FCX disappointed its shareholders with an annual return of -20%, whereas Southern Cooper shareholders enjoyed an annual return of about 30%.
Freeport McMoRan has a cheaper valuation, as its stock is trading at a relatively lower P/E ratio. FCX also has a relatively lower debt/equity ratio. However, this is likely to change as the company needs financing to complete the merger deal. FCX will obviously have the benefits of larger post-merger production scale, but this will come with a cost. Not only did it have to offer substantial premium to MMR and Plains Exploration, but it will also have to assume outstanding debts.
So, if you want to stay on the safe side of the copper market, Southern Copper could be a better choice. It also offers a trailing yield of 9.8%, thanks to a special cash dividend of $2.75. Apparently, Southern Copper prefers to share its earnings with shareholders instead of paying premium acquisition prices. Based on an EPS growth estimate of 8.7%, Southern Copper has a fair value range of $36 - $42. At a price of $40, it is fairly priced based on my fair value estimates.
Freeport-McMoRan has been a nifty dividend payer. While the dividends are erratic, the company managed to boost dividends by 100% in the last 5 years. The recent increase moved the quarterly dividend to 31.25 cents from 25 cents. I expect the company to keep increasing its dividends as the global economic recovery keeps its pace.
Southern Copper is also a great dividend stock. While the projected yield without a special dividend is only 2.4%, the company has the potential to pay special dividends, if the recovery in copper prices keeps its pace.
Based on the historical valuation metrics, Freeport-McMoRan is trading at a deep discount. The trailing P/B ratio of 2.0 is significantly lower than the 5-year average P/B ratio of 3.7. Compared with the market's forward P/E ratio of 15.6, FCX is significantly undervalued. The stock looks like a deep bargain as it is trading with low valuation multiples.
The market has obviously overreacted to the recent merger announcement. The deal, which is valued at $20 billion, will create a gigantic company that can effectively utilize the returns from economies of scale. Surely, the premium offered to McMoRan and Plains Exploration will be a big financial issue for shareholders. FCX will pay about $6.8 billion in cash and the rest will be paid in terms of common stock. The dilution of shares will also create an additional pressure on the stock once the deal is closed.
However, the above impacts are likely to be offset by long-term gains. Most analysts also agree with me. In agreement to what my model suggests, their target price of $40 suggests significant upside potential. UBS recently issued a buy rating with a target price of $39. Note that the stock is highly cyclical. Similar to other commodity producers, Freeport-McMoRan's future growth is determined by its primary commodity output. If copper prices collapse due to lower demand, then its stock might also suffer.