The recent shift in commodity prices has raised some very serious questions about the performance of mining companies. Specifically in the near term as the dip in prices can affect the profit margins. With regards to copper, concerns about the Chinese economy have put future copper demand in doubt. As China is the biggest consumer of copper, the 40% reduction in demand from this region has convinced many analysts to reconsider their stances about mining companies. Freeport-McMoRan (FCX) has lost 13.5% of its value following the decrease in gold prices. Citigroup's revision of its recommendation to sell also played a part in the recent decline.
How to Tackle Commodity Risk of Copper and Gold?
In light of these recent events and considerations, Freeport has adapted a strategy of product portfolio expansion. The company is fairly diversified with respect to regional risks as it operates in North America, South America, Indonesia and Africa. The variety of products has remained limited mainly to copper and gold. However, recently, the company has decided to pursue strategic acquisitions in order to attain exposure to other products. Two such acquisitions have already been confirmed.
It has been announced that Freeport will acquire Plains, Exploration & Production Company (PXP) for approximately $6.9 billion and McMoran Exploration Co. (MMR) for $3.4 billion. As a result of these acquisitions, the company will expand its operations in the oil and gas sector. By introducing commodities with stronger price appreciation, the company is expected to adapt a stronger position. Consequently, according to company estimates, the long run earnings of the company may improve by approximately 50%.
Concerns Regarding Chinese Economy
A rising concern proposed by bearish analysts is regarding the slowdown across emerging markets. China is most relevant as it is the dominant demand region for Freeport. The expected growth in the Chinese economy is 5%, which is well below the growth demonstrated by the Chinese economy in the previous years. In my opinion, these concerns have been largely overstated. It is true that Chinese economy is slowing down as compared to previous periods, but it is following a natural economic cycle as it enters into the next phase of economic growth - we cannot expect the Chinese economy to grow at hyper-growth phase forever.
However, the base of the Chinese economy is much larger now, and the demand for Copper will remain strong despite recent dip. Furthermore, company's new acquisitions limit the scope of such risks. The new investments are more concentrated in the North American markets. With the improvement in housing and automotive sectors, these markets are expected to demonstrate a commendable performance supporting the growth prospects of Freeport.
Valuation: What Should Investors Look for?
Freeport is currently trading at a P/E of 9.59 as compared to the industry average of 15.13. The first quarter results of 2013 show that the company's profitability has been affected by a slowdown in revenues, despite the improvement in copper production from Africa and Indonesia. With the new direction of product diversification, this slowdown becomes less relevant. Despite the clear advantage over its competitors, the company is currently trading at a lower price. This undervaluation projects a potential for improvement in stock price. Moreover, the company has managed to remain consistent with respect to dividends. FCX currently offers a dividend yield of 4.25%.
The mining industry and economic growth are directly related and slowdown in any one of these two will have a severe impact on the other. We will see substantial increase in demand for copper as the global economy recovers. At the moment, Europe is showing no signs of growth, and European debt crisis is weighing heavily on the global economy. As a result, we are not seeing a substantial recovery in the economic conditions. However, over the next two-three years, there will be a considerable recovery in the global economy, which will propel the mining industry.
Also, in the process of pursuing the acquisitions, the company has taken up a considerable amount of financial risk, which may decrease the financial flexibility of the company. However, there are various examples in which such debt-based acquisitions have performed very smoothly. Freeport-McMoRan offers attractive dividend yield to income investors as well as solid growth opportunity - the investors can collect dividends while they wait for the economic recovery to gather pace.