It has been a brutal few years for shareholders of Freeport-McMoRan (FCX). After reaching a post-recession peak of $60.04 on December 31st, 2010, FCX fell more than 50% to its July 2013 low of $27.34 before rebounding slightly. In the same period, the S&P 500 rose 30%. The company has faced a multitude of headwinds, including several of its own making. Despite these setbacks, I believe that the FCX is one of the most severely underpriced stocks in a market where many equities have become distinctly overvalued.
Freeport is one of the world's premier producers of copper and gold, with minor production of molybdenum and cobalt. In addition, following a merger with Plains Exploration in May 2013, FCX has become a modest player in global oil production. In 2012, FCX derived 82% of revenues from copper production, 10% from gold production, and 7% from molybdenum production, while in 2013 the revenue mix is likely to be 67% from copper, 8% from gold, 6% from molybdenum, and 19% from oil and gas.
The year 2013 was marked by an extraordinary confluence of adverse events that negatively impacted the price. Gold had its worst quarterly price decline in decades. The Chinese economy had an aberrant decrease in its growth rate due to artificial tightening in the money supply by the Chinese government, resulting in a 20% decline in realized copper prices. Investors reacted negatively to the merger with Plains Exploration (largely due to accusations that Freeport's management had incestuous relationships with Plains and was self-dealing). A mining accident on May 14th, killing 28 workers, temporarily cut copper production by 125 million pounds and gold production by 125,000 ounces for the second quarter, reducing earnings by approximately $250-$300 million. Finally, mining at Freeport's marquee property, the Grasberg mine, has been unusually unprofitable due to necessary mining from less-valuable portions of the ore body.
It is impossible to accurately price FCX without understanding some of the basic parameters at the Grasberg mine, the details of which are published in the scientific literature (Journal of Geochemical Exploration 50: 143-178, 1994). Grasberg is one of the world's most valuable deposits of copper and gold. The second-richest copper deposit ever found but discovered only in 1988, Grasberg has numerous features that are of key relevance to investors. Geologically speaking, Grasberg is a new formation--a mere 3 million years old. Consisting of several concentric cylinder-shaped intrusions of metal-bearing rock into pre-existing limestone matrix, Grasberg contains high concentrations of copper ore, primarily in the form of chalcopyrite veins. The ore concentration is not uniform throughout the formation, being around 3% in the center and dropping to 0.25%-0.5% on the periphery. Grasberg is an open pit mine centered on the highest concentration of ore-bearing rock. To deepen the mine into the region of highest concentration, however, the "shoulders" of the mine have to be dug before the center. As a result, Freeport is obliged to extract low-grade material from the sides of the deposit through 2013 before hitting the main bonanza in 2014-2015. Diagrams of Freeport's Grasberg development plan can be found in their 2Q conference call presentation, pp. 35-42.
There are several other key features of Grasberg. First, the ore is primarily copper sulfides, which are chemically easy to refine. The mine is at high altitude with the lip of the mine at 4000 meters in an area of high rainfall, allowing Freeport to cheaply pipe concentrated ore as a slurry to the coast for refinement and transport. The relative geological youth of the mineral deposit has prevented erosion from degrading the ore body or depositing any significant sedimentary overburden. Finally, the ore concentrations and underground locations have been exceptionally well mapped by core sampling, allowing us to take Freeport's claims of proven and probable reserves at face value. In 2014, copper production is expected to increase to 1.1 billion pounds and gold production is expected to reach 1.7 million ounces at Grasberg alone, yielding profits from that single mine of around $2.8 billion in the coming year. Reserves at Grasberg are estimated at 31 billion pounds of copper and 30.9 million ounces of gold.
Yet Grasberg is not Freeport's only major asset. Freeport estimates its reserves at 39 billion pounds of copper in North America, 39 billion pounds of copper in South America, 8 billion pounds of copper in Africa, 1 million ounces of gold outside New Guinea, 3.4 billion pounds of molybdenum, and 172 million barrels of oil equivalent in politically stable areas. As at Grasberg, Freeport supports its assertions of global reserves with detailed core sampling and seismic data, best publicly documented for the Cerro Verde and Morenci projects. By my read, the geological data is both believable and convincing. The future profits to be obtained from all of Freeport's current properties total around $200 billion prior to discounting for the 30-year lifetimes of these assets.
Freeport's overall market capitalization is $31.8 billion for a PE of 10.9 times last year's earnings. Looking forward, however, Freeport is trading at only 11.4 times the annual profits to be gained from the mining activities just at Grasberg. Essentially, the profits from the American oil-and-gas assets at Plains Exploration, the molybdenum at the Climax mine in Colorado, the copper at the Morenci mine in Arizona, the copper at Cerro Verde in Peru, and the copper and cobalt at the Tenke Fungurume mine in the Democratic Republic of Congo are all thrown in for free. Moreover, with a dividend of 4.1%, investors are paid generously to wait until Grasberg can ramp up to full production at the richest portions of the deposit in 2015-2016.
To be sure, there is a huge difference between metal in the ground and money in the pocket. Political strain in Indonesia is a constant threat to Freeport's development of the Grasberg mine, particularly in the context of Freeport's environmental damage, occasional insensitivity to local people, governmental temptations to extract higher mineral royalties, and the recent mining accident. Mining in troubled parts of the globe is inherently risky. Commodity markets, especially in copper and gold, have been volatile over the past several years. Because of these political and economic issues, Freeport's assets are priced at an unusually large risk discount.
Nevertheless, Freeport's track record of superb management, enthusiastic return of money to shareholders in the form of regular and frequent special dividends, global diversification, and expansion into oil and gas at a serendipitous moment of increasing political instability in the Middle East all lend credence to the thesis that Freeport is profoundly undervalued. Using Freeport's reasonable estimates of 2014 production at 4.5 billion pounds of copper, 2.8 million ounces of gold, 95 million pounds of molybdenum, and 57 million barrels of oil equivalent, I estimate 2014 profits to be around $6 billion after taxes and minority interest. Moreover, Freeport's access to cheap open-pit mining through the very best portions of the Grasberg mine in the next few years suggest that Freeport will be entering a period of cheaper extraction and long-term increased profitability. The company would be inexpensive at $45 and is an absolute steal at less than $31.