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Freeport-McMoRan (NYSE:FCX), the world's second largest copper producer, was a pure-play metals company until last fiscal year. In a bid to diversify away from its metals business, the company announced plans to re-enter the oil and gas business and went on to acquire Plains Exploration & Production (NYSE:PXP) and McMoRan Exploration (NYSE:MMR). Freeport completed the acquisition of both these companies by June 2013. As a result, the company's third-quarter revenue grew almost 40%, quarter over quarter.

Freeport's diversification decision was received negatively by investors at first, causing its stock price to fall 16% on December 5, 2012. However, the company's decision to diversify from its metals business seems to be a masterstroke. Metal prices, in general, have remained under pressure this year. The price of copper on the London Metal Exchange, or LME, has declined 11.6% since the beginning of 2013. During this period, gold prices also declined almost 25.7%.

Even though the commodity prices declined considerably, Freeport's stock witnessed a decline of just 2.6% year-to-date. This has lot to do with the fact that Freeport is no longer just a metal producing company. The company derived 19% of its third quarter revenue from the oil and gas business. In the past one year, the price of brent crude oil increased 4.25%, and the price of natural gas increased 13.62%, thus providing the company with some protection from the rapidly declining copper and gold prices.

On the contrary, companies that focus entirely on the production of metals, such as Southern Copper (NYSE:SCCO) and Newmont Mining (NYSE:NEM), are feeling the heat from diminishing metal prices. The stocks of both Southern Copper and Newmont have fallen around 36% and 51% respectively since the beginning of 2013.

(click to enlarge)

The reason behind the decline in stock price is that both Southern Copper and Newmont derive the majority of their revenue from the production of a single metal. In the first nine months of 2013, Southern Copper generated around 78% of its total revenue from the sale of copper. During the same period, Newmont generated 92.5% of its total revenue from the sale of gold. In the case of Freeport, the largest contribution to total revenue came from copper sales at 64.8%. Understandably, Southern Copper and Newmont are more exposed to commodity price volatility compared to Freeport. With diversification, Freeport reduced its sensitivity to commodity prices, thereby limiting its overall risk.

Further, the company estimates to incur $1.5 billion in capital expenditures, or capex, for its oil and gas business this year. Out of this projected $1.5 billion capex, the company has already incurred $0.9 billion as of the end of the third quarter, leaving an estimate of $0.6 billion to be incurred in the fourth quarter.

Ever since the company incurred capex on its oil and gas segment in June 2013, the segment has generated a total of $1.34 billion in cash flow from operations, or CFO, indicating operational efficiency with a CFO to capex ratio of 1.49. Going forward, Freeport plans to allocate an increased amount of capex to the oil and gas business, as seen below.

(click to enlarge)

Assuming the company maintains the same level of efficiency and with a projected $2.7 billion of capex for oil and gas next year, I expect it to generate around $4 billion in CFO from its oil and gas segment in fiscal year 2014. This will certainly help the company pay off its debt, which it raised to acquire the oil and gas business.

Freeport raised an additional debt of $10.5 billion this year in order to fund the acquisition of the oil and gas business. In addition, the company has almost $7.1 billion of total debt on its balance sheet after acquiring both the companies. This contributed largely to the increase in company's debt from $3.52 billion at year-end 2012 to $21.1 billion at the end of the third quarter. The company incurs a weighted average interest rate of 4.4% as seen below:

Type of debt

Amount

Weighted average interest rate

Acquisition-related debt

$10.5 billion

3.1%

Assumed debt of acquired companies

$7.1 billion

7.0%

Freeport's previously existing debt

$3.5 billion

3.5%

Total debt and weighted average interest rate

$21.1 billion

4.4%

From above, it can be seen that the assumed debt of the acquired companies has a weighted average interest rate of 7%, which is considerably higher than that of Freeport's acquisition related debt and previously existing debt. At the current weighted average interest rate, the company faces an annual interest expense of $928 million, of which $497 million is related to the higher interest assumed debt. Going forward, the company plans to bring its debt down to $12 billion in the next three years. The company plans to either reduce or refinance its higher interest debt, thereby reducing the interest expense. However, debt repayments remain dependent on the company's ability to generate substantial cash flows.

Historically, the company has consistently performed well in terms of cash flow generation. Also, the company's operating cash flow-to-debt ratio has increased in four out of the five previous years, helping the company reduce its debt from $7.35 billion in 2008 to $3.52 billion in 2012.

Parameter

2008

2009

2010

2011

2012

Operating

cash flow

(in $ billions)

3.37

4.39

6.27

6.62

3.77

Total debt at the end of fiscal

(in $ billions)

7.35

6.34

4.75

3.53

3.52

Operating cash flow-to-debt ratio

0.46

0.69

1.32

1.87

1.07

For the nine months ended in September 2013, the company has already generated operating cash flows worth $3.74 billion. Further, the company expects to generate around $6 billion in cash from operating activities in fiscal year 2013. With the addition of the oil and gas business in the company's portfolio, I anticipate Freeport will generate good cash flows in the coming quarters, thus helping it to meet its debt obligations comfortably.

Conclusion

Freeport has been able to counter the declining copper and gold prices by diversifying into the oil and gas business. Although the acquisition of the oil and gas business has made the company highly leveraged, I expect Freeport to satisfy its debt obligations considering its cash flow history and future prospects.

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.