Over the weekend, Indonesia diluted its metal export ban in a way that is extremely beneficial to Freeport-McMoRan (NYSE:FCX) (report on the ban available here). When first proposed, it appeared that Indonesia would ban the export of all mined products, which would have had a major impact on FCX as its Grasberg mine has one of the largest copper reserves in the entire world. In fact, this mine accounts for about 26.5% of the company's copper reserves.
In other words, if Freeport were banned from exporting copper out of Indonesia, its future cash flow potential would be significantly impaired. Fortunately for investors, that is no longer an immediate concern as the export ban is focused narrowly on nickel and bauxite with copper exempted. However, the country says it will only grant a reprieve to the other exports like copper until 2017. At this point, the country threatens to apply the ban to all mineral exports.
How should investors react to this news? First, I would suggest that an export ban is unlikely to be implemented in 2017. The Indonesian government already backed down once, and it did so for a reason. While the country wants to protect its resources, an export ban would shoot its economy in the foot. Freeport Indonesia employees directly over 11,000 people, and the vast majority would lose their jobs under a ban. Copper exports could total over $3.3 billion this year from Freeport alone. Indonesia backed down because it recognized its citizens would suffer as copper exporting provides a significant lift to the economy. This will also be true in 2017, which makes government action then unlikely.
Further, it is critical for Freeport's health today that is continues to export copper from Indonesia, and the issue is somewhat less pressing in 2017. The company recently diversified into oil exploration, by purchasing two firms with 30 years of reserves. These acquisitions significantly increased the firm's debt load to $21 billion from $3.5 billion. Simply put, now is not the time for FCX to have roughly one-quarter of its copper production taken off line, especially if the company is going to cut its debt burden as originally planned to $12-$14 billion within three years.
Assuming no export ban, I expected Freeport to generate roughly $20-23 billion in operating cash flow over three years. Cutting debt by $9 billion as planned would leave $11-$14 billion in cash flow. Assuming mild increases, FCX should pay a total of $4 billion in dividends over three years, leaving it with $7-$10 billion for capital-expenditures. At this pace, FCX would be able to grow copper production by 2-3% annually while oil would grow 3-5%. Simply put, Freeport needs to generate this level of cash to pay down debt, pay the dividend, and make necessary investments in the business.
If Indonesia banned exports, FCX would lose about $4 billion in copper operating cash flows over three years, which would mean FCX could not pay down debt as much as hoped or invest to grow the business. Now is precisely the wrong time for FCX to take a cash flow hit. There would certainly be no solvency issue as FCX faces $930 million in annual interest due to a low average weighted interest rate of 4.4x. As a consequence, there is a robust cash flow coverage ratio of 7-7.5x.
While solvency was never in question due to FCX's global footprint, the company's capital plan could have been threatened, and it is integral to cut debt over time to a more normal level to guard against a depressed pricing environment should there be another severe recession. Given the cyclicality of mining, carrying over $20 billion of debt for a prolonged period is financially unwise, but an Indonesian export ban would have made this outcome more likely.
So where do investors go from here? We have taken this so-called black swan event off the table, and we can value Freeport on a normalized cash flow and earnings basis. Over the long run, I am a major believer in the copper story as the emerging world will need to make major infrastructure investments to foster growth. At the same time, much of the developed world needs to make serious infrastructure investments after years of neglect. In fact, McKinsey estimates the world will have to spend $57 trillion on infrastructure in coming years. With this in mind, there are two ways to value Freeport: net asset value and earnings per share.
On the first count, FCX has 116 billion pounds of proven and probable copper reserves with annual production of 3.65 billion pounds, 32.5 million ounces of gold with 1 million ounces of annual production, and 688 million barrels of oil equivalents. This reserve base gives FCX the capacity to maintain current production levels for thirty years. Moreover, as prices rise over time due to inflation and their scarcity, reserves that are considered uneconomical do become recoverable, suggesting actual production potential is in excess of current reserves. With net copper cash cost of $1.46 a pound compared to realized prices of $3.30, the company has significant cash flow potential. Assuming a constant cash margin of $1.84 and no additional discoveries, its reserves have a total value of $185 billion. With its current depletion rate and a discount rate of 10%, its reserves have a present value of $54.38.
Second, on an earnings per share basis, I find the following value. In 2014, I am expecting FCX to grow production by 2-3% and get end prices of $3.25/lb for copper, $,1150-1,200 for gold, and $80-$82.50 per barrel of oil equivalent, which should result in EPS of roughly $3.50. At 13-15x earnings, FCX should trade at between $45 and $52 per share.
Therefore, FCX is worth around $50, which suggests around 38.5% upside from current levels. Now that an Indonesian export ban is off the table, investors don't have to worry about a worst case scenario, which would have threatened the company's capital plan. Instead, investors can focus on the value of Freeport's operations, and when doing this, it is clear significant upside remains.