Shares of Freeport McMoRan (FCX) have been hit hard, first by Wall Street's sour outlook on its proposed merger with Plains Exploration & Production (PXP) and McMoRan Exploration (MMR), and then by the recent plunge in commodity prices. A closer look at the benefits of the deal and the company's valuation relative to peers suggests that this underappreciated miner may be ready to rebound.
Becoming a safer, more diversified company
Freeport McMoRan is one of the world's largest copper producers with major assets in gold and molybdenum as well. The $27 billion miner sees 79% of its sales from copper, 10% from gold, and 7% from molybdenum.
A strong exposure to copper was a great driver of earnings during the housing boom as the shares increased ten-fold in the five years to October 2007. Residential construction accounts for approximately a quarter of the copper demand in the United States. As the housing bubble burst, so did the fortunes of the copper miners.
Lately, the slowdown in China has offset the rebound in U.S. residential construction to drive copper prices lower. China is responsible for 40% of the world demand in the metal and a disappointing first quarter GDP report last week is responsible for much of the commodities slide of late.
Still, global demand for copper is seen at 3.7% higher this year with Chinese demand 6% higher than last year. The jump in housing starts, from 780,000 in 2012 to an annualized pace of 1.04 million in March should help support stronger demand for copper here in the United States.
In December, the company announced a definitive merger agreement to acquire Plains Exploration & Production for $6.9 billion in cash and 91 million shares of stock and McMoRan Exploration for $3.4 billion in cash. The deal, valued at $20 billion including the assumption of debt, is likely to close this quarter. The street did not take the announcement well and set the shares back 16% when the deal was announced on December 5th.
The bears point to the amount of debt the company will need to take on for the transaction and the hit to earnings if commodity prices weaken further. Others wonder if the company can perform as well across the energy complex as it has in copper and gold. The new company is expected to receive 76% of EBITDA from mining and the remaining 24% from oil and gas.
I am more positive on the deal. Management points to the fact that the merger will add new growth to its portfolio and complement aggressive plans to boost copper sales by 5 billion pounds a year by 2015. The deal offers a near-term upside in the oil assets while giving the company exposure to the developing natural gas boom that will take a few more years to fully realize. Overall, the deal diversifies the company's revenue into the faster growing energy space and smoothes cyclicality in earnings.
I think the street underappreciates the benefit of a more diversified revenue stream and the ability it will give the company to increase dividend payouts regularly. We have seen how investors are pricing a premium on stable dividend-payers and I don't think it is long until Freeport McMoRan gains on a stronger dividend outlook.
Unloved but an opportunity in value
The real impetus for a quick recovery is in the company's relative valuation to peers. The shares trade for just 9.2 times trailing earnings, a 24% discount to peers in the industry and the 12.1 times average price multiple.
In fact, the company's closest competitors, Southern Copper (SCCO) and BHP Billiton (BHP), trade at significantly higher price multiples. Southern Copper trades for 14.2 times trailing earnings while BHP Billiton trades at almost twice as expensive at 17.9 times trailing earnings.
This is despite a stronger cash position and comparable profitability at Freeport McMoRan. The company reported $9.6 billion of cash and cash equivalents at the end of the first quarter almost three times the $3.3 billion in current liabilities, and almost enough to completely cover its $10.1 billion in total debt. By comparison, Southern Copper has only $2.6 billion in cash to $4.2 billion in debt and BHP Billiton is holding just $5.3 billion in cash against $35.5 billion in debt. Granted, Freeport McMoRan will be taking on more debt for its merger transaction but its liquidity position should still be relatively good compared to peers. That level of liquidity, along with more stabilized revenue from energy products, could help the company big time if metal prices continue to languish.
While Southern Copper is the leader in profitability with a return-on-equity of 44%, Freeport McMoRan's ROE of 18.5% is well above the 14.6% earned by BHP Billiton. The company's operating margin of 29.9% shows a strong commitment by management to control costs and the net margin of 21.1% is well above the 17.4% industry average.
The company is clearly the better value with a stronger cash position and comparable profitability though its shares continue to underperform its peers. While the street may not like the proposed deal and the entire sector may continue to feel the weight of lower commodity prices, I don't think it will be too long until sentiment in the shares begins to turn.
While I think the shares could go higher, even a rebound to the industry average price multiple of 12.1 times would bring the stock to around $37.50 per share.