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Investors in Freeport-McMoRan (FCX) are welcoming a bullish research report from analysts at Nomura which see further upside from current levels. This is especially true when deleveraging and a recovery in commodity prices drive the potential for shares to show meaningful upside.

While I acknowledge the potential for this bullish scenario, the high operating and financial leverage leaves the company still vulnerable to the state of the world economy.

I remain on the sidelines with a cautious positive stance.

Nomura Remains Bullish

Analysts at Japanese Nomura Securities reiterated a "Buy" rating on the firm, while raising the price target by $7 per share towards $45. The new price target suggests shares have some 30% upside from current levels.

Analyst Curt Woodworth cites several catalysts and growth drivers ahead. Equity value potential of $55-$60 per share is possible by 2017 depending on the opportunities for master limited partnerships, as well as future copper prices.

All of this will impact the pace of deleveraging between 2015 and 2017. A more positive view on the core operations could accelerate the net debt reduction pace, leaving more certainty and upside left for shareholders.

Valuation

Towards the end of October, Freeport released its third quarter results. The company ended the quarter with $2.2 billion in cash and equivalents, while operating with $21.1 billion in debt. This leaves a high net debt position of $18.9 billion, a substantial amount.

Revenues for the first nine months of 2013 came in at $15.0 billion, up 11.4% compared to a year earlier. Earnings came in just shy of $2.0 billion. Full year revenues are seen around $21 billion as earnings could come in around $2.8 billion.

With shares trading around $34.50 per share, the market values Freeport at $35.7 billion. This values equity in the firm at 1.7 times expected annual revenues and 12-13 times annual earnings.

Freeport pays a quarterly dividend of $0.3125 per share, providing its investors with an annual yield of 3.6%.

Some Historical Perspective

Long term investors in Freeport have seen their ups and downs. In sympathy with the wider sector, shares quadrupled from $15 in 2004 to $60 by 2008, to end that year around $10 per share.

Shares have regained their lost ground and rose to highs of $60 by 2010. So far this year, shares of Freeport are trading flat, although they trade far above their lows of $26 in the summer of this year.

Between 2009 and 2013, Freeport is expected to increase its annual revenues by a cumulative 40% to $21 billion. The company posted large profits between $2.5 and $4.5 billion in recent years. Shareholders have seen roughly 10% dilution over the past year on the back of the acquisitions, as announced late last year.

Investment Thesis

Investors are still busy dealing with last year's surprise acquisitions of Plains Exploration & Production as well as McMoRan Exploration, both spin-offs of the company a long time ago. The announcement of these deal triggered a nearly 20% sell-off in the company's shares. Combined, Freeport acquired roughly $20 billion in assets a huge premium in a deal with many red flags. On top of the high premiums and potential conflict of interests, I was very skeptic about the deals back in 2012.

On top of these relative expensive deals, which added significantly to the debt position, investors were suffering from the shock of a tunnel collapse near the company's crucial Grasberg operations, interrupting shipments for 6 weeks.

While these headwinds put significant pressure on the company's shares, triggering a 35% sell-off between December of 2012 and summer of this year, shares have largely recovered, trading in their mid-thirties. The reason for this is solid operational performance, with solid cash flows allowing for debt reduction, appealing dividends and capital expenditures, all at once.

On top of that, the valuation is not excessive given the not so great circumstances for a miner to be in at the moment. While miners always face higher operating leverage and in this case financial leverage as well, the future share price performance largely depends on the state of the global economy and key commodities.

Yet besides these cycles, Freeport has high quality assets, notably in its reserve base. Copper reserves are equivalent to 30-40 years of current production, with current prices being far above cash production costs, resulting in good potential for cash flows. The acquired oil assets give the company diversification to more stable commodities, as well as more stable operating conditions with production fields being located in the US.

Back in October, following the third quarter earnings release, I last took a look at Freeport's prospects. I noted that the company is executing well, yet the premium valuation and leverage remains a concern. At the time, Freeport announced to redeem nearly $300 million in debt, carrying high rates of 11.875% per annum.

I noted that the market is happy with production growth and cost control, which compensates for poor commodity pricing, notably in copper and gold. The acquired oil assets bring diversification, with oil prices still trading at historically high levels. On top of operational cash flows, divestitures and joint-ventures should allow for a quick deleverage path. Freeport has committed itself to reduce its debt load to $12 billion in the coming three years.

With revenues on track to reach $25 billion in 2014, earnings could come in around $3-$3.5 billion, making the current valuation reasonably appealing. Also note that the more stable oil operations deserve premium multiples compared to mining activities, as the company continues to work to fix the balance sheet.

While the long term prospects are solid, especially if commodity prices can recover, Freeport's destiny still relies to a great extent on commodity pricing given the huge operating and financial leverage. I remain cautiously optimistic, but I can see why Nomura turns bullish.

Source: Freeport-McMoRan - Deleveraging And Recovery Leaves Potential To Unlock Further Upside