An Analysis on Freeport-McMoRan's Bid for Phelps Dodge

I have conducted an analysis on Freeport-McMoRan's (FCX) bid for Phelps Dodge (PD):

* FCX has bid $25.9b cash and share offer for Phelps Dodge. FCX will offer $88/ps in cash and 0.67 of an FCX share, valuing Phelps Dodge at $126.46/ps, a 33% premium to its Nov. 17 closing price.

* The $18b cash portion equates to 70% of the total consideration, and the share ratio requires Freeport to issue 137m shares, giving Phelps Dodge shareholders a 38% ownership. Freeport intends to debt finance the cash portion, increasing its total debt to $17.6b.

* The combined company would be the largest public copper company, producing 3.7b copper, 1.8m oz gold and 69m lbs molybdenum per year from a reserve base of 75b lbs copper, 41m oz gold and 1.9b lbs molybdenum. Combined revenues at Sept. 30 are $16.6b, with EBITDA of $7.0b and operating cash flow of $5.5b.

* There is a break fee of $750m payable to FCX by Phelps Dodge and $375m payable to Phelps Dodge by Freeport in the event the transaction does not go forward

FCX's main drivers for this deal are: increased copper exposure, geographic diversification [reducing political risk] and Phelps’ underground expertise. No operational cost synergies have been mentioned so far, but Freeport expects to capture technical synergies.

1) Greater copper exposure- The deal positions FCX to benefit from the tight copper market. Based on a forecast 25% growth in production over the next three years to 4.6b lbs/year and record copper prices, the FCX expects to generate strong revenues.

With gold becoming a smaller revenue factor in the combined company [10% vs 32% on a standalone basis], Freeport indicated it is considering splitting the copper and gold revenue streams.

2) Geographical diversification- FCX currently has one operating mine, Grasberg, in Indonesia, a country that does not have an investment grade rating. The combined company will have significant geographical diversification with Phelps Dodge’s 14 mines and development projects.

About 60% of production will come from investment grade countries, including 42% from North America and 23% from South America, with Indonesia reduced to 35%. On the reserve side, 34% are located in NA, 17% in South America and 49% in Indonesia.

3) Strong cash flow- FCX expects the transaction to be accretive to earnings and cash flow despite the use of purchase accounting. As of the last reporting date for FCX, proforma revenues were $16.6b, with EBITDA of $7.0b and operating cash flows of $5.5b.

For 06, EBITDA is estimated at approximately $7.0b and operating cash flow at $6.5b. Excess cash flow will be used primarily to reduce the $17.6b combined debt position with two thirds of the debt estimated to be paid down by the end of 2009.

These are not all of the synergies, but the ones which I could make out from my due diligence. You will notice PD's stock trading below the offer price; that's because there are rumors that BHP Billiton Limited (BHP) will make a bid for FCX. Hence there is a an arbitrage opportunity for PD shares, if you can handle the risk and volatility.

You can play this two ways: 1) Buy call options in PD & FCX. I won't be surprised if they are trading at a premium, or derivatives if you're an institutional trader 2) Buy both FCX and PD's stock, because one will hit. Which one? Not sure but place equal dollar amounts and make sure its part of your speculative portfolio.

FCX 1-yr chart

PD 1-yr chart