Freeport-McMoRan Copper & Gold (FCX), the largest publicly listed copper miner, reported better than expected 4Q13 results. The company reported adjusted EPS of $0.84, better than the sell-side estimates of $0.80. The company not only reported higher than expected results, the 2016 guidance for copper and oil & gas production also exceeded expectations, which suggests that the long-term growth story is intact.
Despite of the impressive results, the uncertainty surrounding the company's Indonesian operations continues to be an overhang. However, it is important to note here that this risk is nothing new for Freeport. FCX has been trading with the Indonesian risk factor for a long time now. As Jefferies analyst, Peter Ward, recently wrote in his report, "We don't ever recall a time when investors were very comfortable with Indonesia risk."
Contract of Work Protects Freeport
While shipments of some processed minerals such as copper concentrate is allowed, from January 12, Jakarta banned exports of all unprocessed mineral ores including nickel and bauxite as part of a drive to promote the development of a refining industry. Following the ban, FCX is yet resume concentrate shipments from Indonesia as it awaits administrative permits. Although the explicit protections in FCX's Contract of Work should protect the company from any new mining rules, the ban has halted shipments by Freeport from Indonesia.
The company is in discussion with the Indonesian government to resolve issues related to the export duties and remains confident that it will reach an agreement soon. An agreement would be positive for FCX's share price as the market continues to apply a lower multiple given the near-term risk to 2014 shipments. Freeport's CEO, Richard Adkerson, recently met the Indonesian Industry Minister M.S. Hidayat to discuss the issue.
"We are committed to be a positive partner with the government of Indonesia," Adkerson told reporters in Jakarta. "The export duty was announced just over two weeks ago, and so the purpose of my trip here is to have discussions with the minister, with other ministers, as it creates an issue that needs to be resolved."
Freeport needs "to be permitted to continue its operations in a normal fashion with no export restriction or duties so that we can continue to provide employment for the 30,000 workers that we have in our operations in Papua," said Adkerson. "We're going to do this in the right way, there are issues between regulation and our contracts."
Indonesia Has More To Lose Than Freeport
Although the Indonesian risk factor continues to be an overhang, investors need to keep in mind that, 1) FCX is no longer one asset company and 2) if FCX decides to partially or completely shut down its Grasberg operations, we believe Indonesia has more to lose than Freeport. Particularly, the second point is precisely the reason why the Grasberg issue will be solved with much smaller impact to FCX than what the market is anticipating.
It is important to note here that FCX has significant bargaining power and a long history of resolving complicated Indonesian issues with meaningfully less impact than what the FCX haters would suggest. Freeport Indonesia operates under a Contract of Work with the Indonesian government that governs FCX's rights and obligations relating to taxes, exchange controls, royalties, repatriation and other matters, and was concluded pursuant to the 1967 Foreign Capital Investment Law. Any disputes regarding the provisions of the Contract of Work are subject to international arbitration. There have been no disputes requiring arbitration during the 40+ years FCX has operated in Indonesia.
Freeport Indonesia employs more than 30,000 employees and generates significant tax revenues for Indonesia. FCX currently pays a 35% corporate tax rate, a 10% withholding tax, a 3.5% copper royalty and a 1% gold royalty. Freeport is not only an important local employer but also an important source of tax revenue for the Indonesian government. If the negotiations fail and FCX decides to close down or scale back the Grasberg operations, the Indonesian government could lose significantly more future tax revenues than it stands to gain from implementing new concentrate export taxes. In addition, it could also result in major labor disruptions, which historically have been very messy in Indonesia. We are of the opinion that the Indonesian government would like to avoid both these situations and a compromise would be reached between Freeport and the government of Indonesia.
Future of Foreign Direct Investment In Indonesia at Stake
Other than FCX, Newmont (NEM) is another important U.S. miner affected by the new rules. Although both these companies are in talks with the government, NEM said it was considering other remedies including "possible legal action". Both FCX and NEM employ thousands of people at their Indonesian mines and contribute well over $1 billion a year in taxes and royalties to the Indonesian government. Both these companies initially got permission to export their partially processed copper concentrate until 2017 but the financial ministry later announced that companies would have to pay a progressive export tax that will start at 25% and rise to 60% by 2017.
Both these companies are in talks with the government of Indonesia and a resolution would also play an important role in deciding the future of foreign direct investments in Indonesia. If the negotiations fail and FCX shuts down its Grasberg operations or Indonesia no longer remains an economically viable option for mining companies, many other big mining companies might also avoid future investments in Indonesia, again a situation which the Indonesian government would like to avoid as it would deliver a significant blow to the Indonesian economy.
More Flexible Company
FCX is also a much more flexible company now than it used to be before the 2012 and 2007 acquisitions. The company acquired Phelps Dodge in 2007 and PXP/MMR in 2012. These acquisitions have provided FCX with more flexibility in terms of how and where it deploys its future capital. Before the acquisitions, Freeport used to be a highly levered single mining company. That is no longer the case. Grasberg's total output now represents approximately a quarter of company's total copper production. In addition, this percentage is expected to decline further in coming years as Grasberg volumes are expected to decline beginning in 2017, while elsewhere volumes are expected to increase. This flexibility has provided FCX with more bargaining power. This does not mean that Grasberg is no longer important; it is just not as significant as it used to be. Therefore, as mentioned earlier, keeping Grasberg in operation and resolving the issue is more in the interest of Indonesia than Freeport.
FCX also has a number of other capital allocation opportunities including accelerating the funding for the energy-related growth potential following the PXP acquisition and funding other copper projects out of Indonesia. It could also reduce its debt. If the new export taxes and processing requirements make economies associated with continuing to operate and invest in Indonesia excessively strained for FCX, it would not be unrealistic of Freeport to delay or cancel the expansion plans at Grasberg. The company could redeploy that capital elsewhere. Any such scenario would prove to be an even more significant blow to the Indonesian economy compared to the potential benefits associated with higher export taxes and increased domestic copper smelting capacity.
It is also important to note here that although Grasberg is an important EBITDA contributor for Freeport and a meaningful drop in copper shipments out of Indonesia would result in a direct hit to FCX's profitability, it would also significantly reduce global copper supply as Grasberg is one of the world's largest copper mines. Any significant long-term reductions in output from Grasberg should translate into higher copper prices over time, which in turn would boost FCX's profitability.
We have a buy rating on FCX. We have long been saying that Freeport-McMoRan after its controversial decision to acquire Plains Exploration & Production Company (PXP), shale and gulf oil player, and McMoRan Exploration Co. (MMR), a deep sea drilling company, has emerged one of the most underappreciated and undervalued stock in the North American mining sector. The company is looking at a multi-year volume driven growth largely outside of Indonesia. Freeport's strong pipeline of growth projects will provide the company with significant capacity in coming years. Moreover, since they are all brownfield projects, they have relatively low capital costs and risk.
The Indonesian export ban of copper concentrate is the single biggest overhang that could keep FCX shares range-bound in the near-term but the long-term story remains strong. Freeport's Contract of Work protects the company from any new mining rules and the company is in talks with the Indonesian government to resolve the issue. The Contract of Work can only be modified by mutual agreement between Freeport and the government of Indonesia. We are of the opinion that an amicable resolution would be reached soon, as mentioned earlier Indonesia also stand to lose significantly if FCX decides to curtail operations at Grasberg, the world's second largest copper mine. FCX remains confident that an agreement would soon be reached and shares should be rewarded whenever that happens.
FCX's attractive valuations and forward annual dividend yield of 3.8% also make a compelling case for investment in this Phoenix, Arizona based company. Freeport shares have further upside potential from current levels, as the company executes on its deleveraging goals, production growth plan, and value-enhancing MLP opportunities in the energy and copper businesses.