Freeport-McMoRan Tackles Balance Sheet Risk

| About: Freeport-McMoRan Inc. (FCX)

Summary

Last year, Freeport diversified into oil and gas; while this decision has been profitable, it has left Freeport with $21 billion in debt.

Freeport aims to reduce this total to $12 billion by the end of 2016, which will require $3 billion in asset sales.

Freeport's sale of Eagle Ford properties will generate $2.5 billion in net proceeds, putting the company on track to hit its target.

With falling leverage and strong reserves, FCX should hit $40 this year.

Last year, Freeport-McMoRan (NYSE:FCX) diversified into the energy space, which has since proven to be a profitable decision. In the last quarter, the company produced a surprisingly strong 16.1 million barrels of oil (all financial and operating data available here). Its energy assets generated $946 million of operating cash and $366 million of free cash flow. This acquisition has helped to lessen Freeport's reliance on copper, though copper does remain the primary source of revenue and profits for the firm. Still, adding a business line that is within FCX's core commodity competency will help the firm weather pricing pressure in copper, should the Chinese economy decelerate more quickly than anticipated.

While the oil subsidiary is definitely adding value to Freeport, it was a costly acquisition that forced the company to significantly increase its debt position, which now stands at $20.85 billion. This debt is the primary risk to Freeport's operations. The company has tremendous assets with 116 billion pounds of copper reserves and 688 million barrels of oil equivalents. With industry leading cash costs, these reserves have significant value for shareholders as FCX increases its mining operations in Indonesia where a resolution to the export tax should be reached shortly and North America.

The long-term picture is very strong as the global economy continues to grow and both developed and emerging economies will need significant amounts of copper and oil to foster growth and develop better infrastructure. As we know though, commodity prices can be very volatile, and a cyclical company like FCX should not continue to carry so much debt on its balance sheet. Now within three years, the company has committed to cut its debt position to roughly $12 billion. This is an aggressive target that is just barely attainable. In 2014, FCX is on track to deliver $7.7 billion of operating cash flow and spend $7 billion on cap-ex. In 2015 and 2016, we should see continued increases in operating cash flow while cap-ex needs will shrink.

Over 2014-2016, it is reasonable to expect FCX to generate $24-25 billion of operating cash flow while the dividend will cost $4 billion and cap-ex could be roughly $14 billion. This leaves only $6 billion for debt repayment. To meet its goal of reducing debt to a more sustainable levels, FCX will need to sell at least $3 billion in assets. On Wednesday, FCX did just that. It announced a deal to sell its position in the Eagle Ford Shale for $3.1 billion or $2.5 billion net of taxes (release available here).

This deal sells about 45,000 acres to Encana (NYSE:ECA) and is in line with valuations from similar assets. FCX aims to focus its oil assets on the Gulf of Mexico region where it can deliver higher cash margins. These acres accounted for about 69 million barrels of oil equivalents, or 10% of Freeport's total oil reserves. FCX's oil acquisitions cost $20 billion in cash, stock, and assumed debt, so a $3.1 billion valuation is an attractive one.

FCX will use about half of the proceeds to immediately repay debt while the remaining cash will go towards cap-ex needs in the Gulf of Mexico. That means that over the balance of the year about $1 billion less of operating cash flow is needed to fund cap-ex and can instead be directed towards debt reduction. As mentioned above, FCX needs to generate about $3 billion in asset sales to reach its debt reduction target, assuming operations continue to perform as anticipated. This deal provides $2.5 billion of that sum. FCX hopes to sell about $4 billion in energy assets, and this deal moves FCX over 75% of the way towards this goal. Selling another non-core oil field will fulfill the company's asset sales plan.

The biggest risk for FCX investors is the highly indebted balance sheet. The Eagle Ford deal helps to mitigate some of this risk, and the $12 billion in debt by 2016 goal suddenly seems much more attainable. With one more asset sale, FCX's operations should provide enough cash to meet the target. With the debt less of a concern, investors can focus on FCX' fantastic low-cost reserves and $3.40 in earnings power. I expect shares to move past $40 this year and would be a buyer of FCX as it takes steps to restore the balance sheet.

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.