Shares of Freeport-McMoRan (NYSE:FCX) were trading down 2% Wednesday morning as investors digested an earnings report that largely missed expectations (press release available here). FCX reported earnings of $0.68 on revenue of $5.885 billion while investors were looking for $0.80 on $6.4 billion. If you exclude one-time charges and changes due to the market value of oil hedges, earnings would have been $0.84. Over the past six months, shares have rallied 23.5%, so FCX needed to report strong numbers to keep pushing the stock higher. Instead, many investors have decided to take profits on this number. While I understand that reaction to the headline number, the internal numbers were not that bad and suggest the bull thesis is intact.
First, FCX continues to grow production while maintaining cost discipline, which will be extremely accretive when metal prices rebound. Copper production was up 17% to 1.14 billion pounds while gold production doubled to 514,000 ounces thanks to mining in higher-grade ore. It should be noted that FCX's gold production come as a byproduct of its copper mining and that the firm focuses primarily on copper, not gold, mining. Oil production of 16.6 million BOE (barrels of oil equivalents) remains in-line with its performance since FCX completed its acquisitions of oil exploration firms this summer.
Now while production was up across the board, net income was down nearly 5% year over year. Lower end market prices was a major reason for this. Copper prices were $3.31 per pound down from $3.60 last year while gold prices were $1,220, down 25% year over year. Much of FCX's oil production is hedged, and prices remain robust at $73.58. As a commodity firm, FCX is not going to thrive if end prices are low. In the long run, I expect metal prices to resume their upward trajectory due to strong demand from developing countries, infrastructure needs in the developed world, and ever-shrinking supply, which is why I remain optimistic about Freeport's long-term prospects.
In the meantime, Freeport continues to cut cost to maintain profitability in this environment and is among the low cost producers. Oil production continues to be extremely low cost with cash production costs of $17.63 per barrel. As a consequence, Freeport's oil operations continue to be self-sustaining with an operating cash margin of $929 million far exceeding capital expenditures of $523 million. In 2014, oil operations should continue to be free cash flow positive as cash costs should stay below $20, and the subsidiary may be able to pay a small dividend to the parent to pay down some debt.
Copper costs were fantastic thanks to strong by-product production with gold output doubling. As a consequence, cash cost per pound was $1.16, which was down dramatically from last year's $1.54. Thanks to lower cash costs, FCX is maintaining strong profitability despite lower end prices. Now, cash costs were helped by strong by-product production, which cannot be that strong over a full year. As a consequence, management is guiding to copper cash cost of $1.45, which would represent a year over year decline of $0.04. FCX is operating its mine with strong efficiencies and is focusing on higher-grade regions, which is why the company has been able to handle the downturn better than other commodity companies.
Thanks to these efforts, cash flow is still exceptionally strong. Operating cash flow totaled $2.337 billion compared to last year's $1.265 billion. Factoring out oil and gas acquisitions, cash flow from mining operations was up $140 million or 11%. Freeport has also focused on cutting capital expenditures so cash can be used to pay down debt, and in the quarter, cap-ex was $1.66 billion. As a consequence, the firm generated free cash flow of $660 million in the quarter. With strong capital discipline in 2014, annual free cash flow should be substantially higher in 2014. Freeport guided to $7 billion in cap-ex, and it should generate over $9 billion in operating cash flow. Free cash flow will be at least $2 billion.
After acquiring the oil firms, debt grew dramatically at FCX, which is why free cash flow is so critical. At the end of the quarter, FCX has $2 billion in cash and $20.7 billion in total debt. Over three years, FCX hopes to pay that total down to the $12 billion range. With production growing and cap-ex needs declining after 2014, this goal is achievable so long as commodity prices stay at current levels. If commodity prices recover thanks to stronger end demand, FCX will generate excess cash to return to shareholders.
After going through this quarter, it is clear the company actually performed well in a difficult environment, and I remain constructive on the stock. This year FCX should grow copper production by 2-4%. I expect average realized prices of at least $3.25/lb for copper, $1,220 for gold, and $78-$80.50 per barrel of oil equivalent. With declining cash costs at FCX's mining operations, EPS should be at $3.45-$3.55, which gives the stock a 10x forward multiple. Operating cash flow should continue to grow to about $9-9.5 billion, leaving $2.5 billion in free cash flow. I expect a constant quarterly dividend of $0.3125, which would leave about $1-1.25 billion in cash to pay down debt. I continue to believe Freeport should trade at least 13x earnings or $45. On this weakness, I would consider buying more FCX.