Freeport-McMoRan: A Few Identifiable Catalysts Are To Lift Valuation

Mar.24.14 | About: Freeport-McMoRan Inc. (FCX)

Summary

FCX shares trade at a notable discount to average peer valuation despite the company's better growth and profitability profile.

It is believed that the current valuation has priced in major negatives including the Indonesian export tax issue and weak copper price.

Valuation upside is expected to be driven by management's commitment to cut debt, solid growth from O&G business, and potential recovery in copper price.

The share price of Freeport-McMoRan (NYSE:FCX) has declined by 14% year to date, compared to a 1% return for S&P 500 Index. In my view, the price pullback has created a compelling buying opportunity as I believe the shares are oversold at ~$32 and the company is poised for multiple upside opportunities, presenting a very attractive risk-reward bet for investors.

At ~$32, FCX shares trade at 5.1x 2015 consensus EBITDA estimate and 10.2x 2015 consensus EPS estimate, representing discounts of 5% and 19%, respectively, to averages from its copper mining peers. The notable valuation discounts exist despite the facts that 1) FCX's consensus long-term earnings growth estimate of 28% is considerably above peer average at just 9%; 2) the company's trailing capital return metrics (i.e. returns on equity and common equity) also exceed peer averages; and 3) FCX offers a 3.9% dividend yield which is more than twice of peer average at 1.8%. Factoring in the long-term earnings growth potential, FCX trades at just 0.4x PEG, compared to the peers' average PEG at 0.9x (see chart below).

(click to enlarge)Click to enlarge

My view is that further downside from FCX's current valuation would be limited as the current share price appears to have baked in a most-likely outcome from the Indonesian export tax issue and the market's exaggerated concern on copper pricing. For the tax issue, based on the details provided by management, I expect the most-likely outcome would be that FCX will construct a smelter with a local partner in return for tax exemption on the export. The issue is likely to remain unresolved over a near term as the Indonesian president election will take place in July 2014. Prior to the final result, it is expected that FCX would scale back its operations (i.e. the company is currently selling 50% of production at 100% operating costs) and reduce headcounts. On the macro front, the copper price has fallen notably since early this year due to the market's concern that a wave of default from Chinese companies may weigh on the country's demand for copper. Again, I believe all these developments have been baked in the current stock valuation given its notable discount to the peers' average level in spite of FCX's better growth and profitability profile.

Looking forward, I expect a meaningful price upside to be driven by the following factors:

  1. Management has announced a plan to reduce the company's net debt from the current level at $18.7B to about $12.0B by 2016, which I believe would drive material appreciation of shareholder value. The funds that will be used for debt repayment are expected to generate from asset monetization. Given that FCX has a few steady-state assets which primarily require maintenance capital expenditure, the company should generate sufficient proceeds as these assets are believed to be attractive to many upstream MLPs. I expect the Indonesia issue may result in some interruption on the deleveraging plan as the possible result to build a smelter would cost approximately $2.3B. Given that FCX's operating cash flow is mostly used to fund dividend payment, the additional cost would need to be funded by the proceeds from asset monetization, which would then delay the progress of deleveraging. Nevertheless, I have performed an analysis to roughly quantify the impact from debt reduction on shareholder value and concluded that its positive impact remains material even if the net debt balance only drops to $15B instead of management's plan at $12B. Based on the conservative assumptions (e.g. trailing EV/EBITDA multiple was assumed to decrease from the current 6.8x to 5.5x by 2016 and 5% to 10% haircut was applied to the current consensus estimated EBITDA from 2014 to 2016), equity value would rise by ~60% by 2016 without any debt reduction and this upside would increase to 74% if net debt balance drops to $15B by 2016.(click to enlarge)Click to enlarge
  2. FCX's O&G segment is expected to experience good growth over the next few years given that a lot of projects remain in early exploration stage. In the near term, production will primarily come from deep-water exploration projects such as Lucius. In late 2014 and beyond, exploration drilling results from projects such as Tara would provide visibility of future production trajectory.
  3. In terms of copper price, management has reiterated their view that the price will be well supported by strong demand/supply fundamentals over a long term. They believe that the recent price weakness was largely due to investors' negative sentiment on copper financing issue in China and not owing to material change in near-term physical supply or demand fundamentals. Given that FCX's current valuation has baked in a bearish pricing prospect, an improvement down the road would be likely a positive surprise.

In summary, FCX is believed to offer a significant value at the current level as most of negatives are factored in while the company is poised to benefit from a few identifiable upside drivers. Hence, a buy rating is warranted.

All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.

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.