Freeport-McMoRan (NYSE:FCX) has started off 2014 on the wrong foot with shares down 13.6% so far. After an up and down 2013, many investors were hoping for a better start to the year. Unfortunately, concerns about sagging growth in emerging economies have weighed on shares as China and others are major consumers of copper. Second, Freeport's largest mine is in Indonesia, and there have been political problems in the country. It appears like these problems are beginning to dissipate, which could help shares regain their footing and slowly return to a more appropriate valuation of $47-$53.
(Chart from Google Finance)
At the beginning of this year, Indonesia was going to ban the export of copper and other metals. This was sold domestically in an effort to keep critical resources within the country. However, exporting metals is a key driver of economic activity in Indonesia. An export ban would cause major problems for Freeport as over 25% of its global copper reserves are at its Grasberg mine in Indonesia (all financial data can be found in its most recent 10-K). An export ban would have seriously impaired Freeport's cash flow generation. However, Indonesia decided not to enforce an export ban because its economy is heavily dependent on mineral exports.
While the country wants to protect its resources, an export ban would shoot its economy in the foot. Freeport Indonesia employs directly over 12,000 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.
As a consequence, Indonesia decided to implement an export tax. In the current year, the tax would total 25% and would get progressively steeper to 60% by the end of 2016. While this is obviously better than a ban, it is certainly a hefty tax. Unsurprisingly, FCX has markedly cut its production at Grasberg; in its 10-K, it disclosed a 50% decrease in production since January. Freeport would rather wait out the situation than pay a hefty tax on its exports. In fact, it would consider declaring a force majeure at Grasberg to suspend production if Indonesia does not resolve this export issue.
Fearing the ramifications of lower exports, the Indonesian government is backtracking again. The government will now allow companies to export without facing any taxes so long as they build smelters to process the copper domestically. FCX already has plans to build a smelter, which should be fully operational within three years. If all goes according to plan, it will be allowed to resume exporting normally as long as it continues to build the smelter and starts to use it when it is completed.
In other words, we are finally reaching a conclusion to the Indonesian drama, and it appears to be a very favorable outcome for Freeport. In the past two months, the policy has gone from a ban to a tax to no tax. This could not be better for FCX shareholders as the company can ramp production at Grasberg back up and generate its potential cash flow. This is critical as the company aims to cut $7-9 billion in debt over the next three years from the current $21 billion level.
With the ban seemingly in the rear view mirror, FCX should generate $20-$23 billion in operating cash flow (I anticipate 2-3% copper production growth and 3-5% oil production growth). With $4 billion in dividends and $7-$10 billion in cap-ex requirements, FCX will be able to pay down $9 billion in debt. In other words, FCX needs to be fully operational to meet its debt reduction targets, so a favorable resolution in Indonesia is critical for the stock to move higher. A total ban in Indonesia would have cut about $4 billion in cash flow over three years. It should be noted that while FCX carries a high debt load, there is no near term solvency risk. 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.
With Indonesia concerns fading, we can value FCX on the fundamentals. 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.
Using a present value of reserves methodology, FCX is worth $53-$56. In 2014, I expect FCX to earn $3.50, so at 13-15x earnings, it is worth $45-$52. At current prices, FCX is extremely cheap and offers a fantastic 3.8% yield. I would be a buyer here and look for strong returns over the next three years.
Disclosure: I am long FCX. 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.