Freeport-McMoRan - Strong Execution, But Premium Valuation And Leverage Remains A Concern

Oct.23.13 | About: Freeport-McMoRan Inc. (FCX)

Shares of Freeport-McMoRan Copper & Gold (NYSE:FCX), or Freeport in the remaining of this article, saw a nice boost on Tuesday after the mining and oil company released its third quarter earnings.

The company saw solid production and production efficiency being masked out by poor pricing to some extent. I remain cautious given the high leverage employed and the reasonably high valuation.

Third Quarter Results

Freeport generated third quarter revenues of $6.16 billion, up 39.6% on the year before. Revenues comfortably beat consensus estimates at $5.7 billion.

Operating income advanced by 21.0% to $1.71 billion as net earnings fell by 0.4% to $821 million. Note that following dilution over the past year and higher financing costs, earnings per share fell by 7 cents to $0.79 per diluted share.

Still, earnings comfortably beat consensus estimates of $0.62 per share.

Chairman James Moffett commented on the performance over the past quarter, "Our third quarter results reflect strong operating performance from our global mining business together with an impressive and significant contribution from our recently acquired oil and gas operations."

Looking Into The Results..

Freeport reported strong copper results as sales rose by 12.9% to 1.04 billion pounds. A $0.36 drop in average prices to $3.28 per pound was only partially offset by an $0.18 drop production costs to $1.85 per pound.

Gold sales roughly increased by some 50% to 305,000 ounces. Unfortunately for Freeport, prices fell by some 23% to $1.329 per ounce.

Sales of molybdenum rose by roughly 10% to 23 million pounds, while the acquired oil activities produced some 179,000 barrels of oil-equivalent per day.

..And Looking Ahead

Freeport sees steady sales into the final quarter. This includes sales of 1.1 billion pounds of copper, 390,000 ounces of gold, 21 million pounds of molybdenum and roughly 175,000 barrels of oil-equivalent per day. Note that the company didn't provide a financial outlook in terms of revenues or earnings in its press release.


Freeport ended the third quarter with $2.22 billion in cash and equivalents. Total debt stood at $21.12 billion, for a debt position of $18.9 billion.

Revenues for the first nine months of the year came in at $15.04 billion, up 11.4% on the year before. Net earnings fell to $1.95 billion, or $1.96 per share in the meantime. At this pace annual revenues are seen around $21 billion as earnings could come in around $2.8 billion.

Factoring in gains of 4%, with shares exchanging hands around $36.50 per share, the market values Freeport at $38 billion. This values operations of the firm around 1.8 times annual revenues and 13-14 times annual earnings.

Freeport currently pays a quarterly dividend of $0.3125 for an annual dividend yield of 3.4%. On top of this, shareholders received a special dividend of $1.00 per share over the summer.

Some Historical Perspective

Shares of Freeport have historically seen very large moves. Shares traded around $20 per share in 2005 to set a peak around $60 during the summer of 2007, only to end that year around $10 per share.

From there onwards, shares recovered to highs of $60 again by the end of 2010 to slowly lose ground again. Shares touched upon lows of $27 during this summer, but have seen a steady recovery to current levels around $36-$37 per share.

Between 2009 and 2012, Freeport has seen solid revenue growth. Freeport reported a cumulative 19% increase in annual revenues to $17.9 billion. Earnings rose modestly to $3.04 billion after earnings peaked around $4.5 billion in 2011.

Investment Thesis

Freeport is still working hard to reduce the significant debt incurred following two large deals, announced in December of last year. Just last week, Freeport announced that it will redeem all of its 11.875% senior notes with $299.2 million principal outstanding, due in 2014, to save on interest costs. These incremental steps to deleverage should accrue to earnings going forwards.

In general the market is quite happy with the results as solid production growth and cost control compensated for poor prices, notably of copper and gold. In that respect, the acquisition of oil assets last year brought some diversification although it resulted in a high leverage position for the firm. Freeport continues to cut on capital spending while it is also looking to divest assets and partner through joint-ventures.

Total debt stood around $21 billion at the end of the quarter, for a net debt position of around $19 billion. Freeport continues to be committed to reduce its debt load to $12 billion in the coming three years.

Back in December of 2012, when Freeport announced the two oil acquisitions, I last took a look at the company's prospects. At the time shares plunged some 16%, with shares trading in their low thirties after the announced acquisitions had little strategic rationale.

Freeport acquired Plains Exploration and Production for $6.9 billion and McMoRan Exploration for another $3.4 billion. Including the assumption of debt, the two deals cost about $20 billion combined. Also notice that Freeport paid steep premiums of 39% and 74% for the equity in the two firms, respectively.

This was for acquisitions with low operational synergies. The main reason was the "strategic rationale" to diversify Freeport's operations and reduce the dependency on a key group of commodities and geographical areas.

I furthermore noted that there were some key red flags, including the fact that not all companies being involved were 100% independent before the deal, with McMoRan being spun off from Freeport two decades ago. Additionally, executives were holding roles at both companies, as well as holding significant equity stakes in the acquired businesses.

Given the continued pressure on gold, copper and molybdenum prices, Freeport has a better argument today in its decision to acquire these assets. Realized oil revenues for the quarter were $1.33 billion as cash operating margins of $1.06 billion are very high. Note that so far this year, these assets have only been incorporated into Freeport's results for four months time.

As such, revenues into 2014 could come in around $25 billion assuming today's run rate, as earnings total $3 billion with further accretion potential as Freeport is deleveraging, notably through divestitures and the retirement of expensive debt. Factoring all of this in, and multiples could come down to 1.5 times revenues and 12-13 times earnings. While the more stable oil operations deserve a premium multiple compared to mining activities, the overall valuation is still quite steep, as Freeport still has a lot of work to do in fixing the balance sheet.

So overall, Freeport had a nice quarter in terms of production growth and costs, while poor sales prices have hidden the true extent of the strong quarter. So it is understandable why investors are pleased with the report, as it does show promising signs for the short to the medium term. At the same time, the price tag of the deals executed last year are still quite steep. The combined oil assets are expected to run revenues just north of $5 billion at the moment.

I remain on the sidelines on the back of a premium valuation. Freeport is still very much focused on mining and employs quite some leverage.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.