- Freeport had a busy week as it reported decent quarterly earnings and struck a deal to export from Indonesia again.
- While the Indonesia ban slowed down production, cash costs continue to be extremely low, still high cap-ex spending will make it difficult to meet its debt-reduction targets.
- FCX will now be able to export from Indonesia but will have to build a smelter, though long-term uncertainties are still be negotiated.
- At 11x earnings, FCX is very cheap, and I would be a buyer here.
Last week was one of the busiest and most consequential for Freeport-McMoRan (NYSE:FCX) in some time as the company reported insightful quarterly earnings and may have finally put its problems in Indonesia to rest. All in all while results are imperfect and some questions about its Grasberg mine linger, this week was a net positive for the company. During the week, shares did fall by about 1%, though I imagine some sold on the relatively positive news to book some profits as shares have soared 17% in the past six months. Nonetheless, I continue to believe the stock is materially undervalued and would either stay long or be a buyer at current levels.
First, let's look at the quarterly numbers (all financial and operating data is available here). The company earned $0.46 on revenue of $5.5 billion. While earnings missed by $0.03, revenue beat by $280 million. Results continued to be impacted by the concentrate ban in Indonesia, which seriously limited FCX's copper sales, fortunately that headwind appears to be abating (more on that below). Copper sales of 968 million pounds missed the prior guidance of 1.1 billion pounds. This miss was entirely because Freeport had expected to resolve its Indonesia problems in the second quarter.
Most importantly, Freeport continues to have best-in-class cash costs, which will keep the company profitable in just about any pricing environment. Copper cash costs were $1.72 and improved by $0.13 year over year. Copper prices have been impacted by a delevering in China as copper had been used as a source of financing in the banking system. The government has cracked down on this process, temporarily cutting copper demand. Realized prices were down $0.01 year over year. Given a relatively solid world economy and increasing infrastructure needs in developing and even developed economies, I do believe copper has decent long-term fundamentals and prices should gradually rise.
FCX's oil unit continues to perform solidly thanks to cash costs of $19.57 per barrel of oil equivalents. With a refocusing on the Gulf of Mexico and movement towards liquids rather than gas, I expect cash costs to rise towards $25 over the next twelve months, which is still a healthy discount to the $100 crude oil trades for. As a consequence, the unit had a strong cash margin of $929 million, though cap-ex of $903 million consumed pretty much all of this cash.
FCX's cash flow is critical because it wants to cut its debt burden to $12 billion by the end of 2016, which is looking like an increasingly aggressive target. At the end of the quarter, FCX carried $18.8 billion in net debt. For 2014, FCX also cut its operating cash flow estimate due to Indonesia and raised its cap-ex guidance. These revisions cut its previous free cash flow estimate by $1.5 billion, and FCX will burn $800 million of cash this year. In an effort to meet this target, FCX will consider another $5 billion in asset sales. Assuming it does this, I do think the company can meet this target, but it will be very tight.
Finally on Friday, FCX announced it reached a deal to resume exports in Indonesia (press release available here). It signed a memorandum of understanding that was essentially a grand compromise. FCX will build a smelter to process copper, which it had previously resisted. This could cost $2.5 billion. While the smelter is being built, FCX will pay a discounted tax of 7.5%, and it also agreed to increase copper royalty payments by 0.5% and gold by 2.75%.
Two overhangs remain and will be negotiated on over the next 6 months. Indonesia wants to increase its ownership in the Grasberg mine to 30% from 10% now, and there will be tough negotiations to agree on a fair price. At the same time, FCX wants to agree to a contract extension. Its license to operate Grasberg ends in 2021 with two 10-year extensions that would extend its ownership until 2041. Indonesia accounts for over 30% of FCX's reserves, so losing this mine in 2021 would be a devastating blow to FCX's long-term growth. Given the parties' ability to strike a deal on the export ban, I expect them to reach a deal over these two issues. In the end, FCX may accept a slightly below market price for 20% of its operations to lock in the 20-year extension, which would remove that last major uncertainty surrounding shares.
As you can see, this was quite a busy week. FCX continues to perform well with fantastic cash costs. Still, meeting the debt target will be difficult and will require further asset sales, which management plans on doing. The company was also able to strike a near-term deal in Indonesia, and I expect longer-term issues to be resolved before the end of the year. Once Grasberg is running at capacity, FCX has earnings power of at least $3.50. At 11x earnings, FCX is extremely cheap and a great play on global growth. I would be a buyer at current levels and expect shares to move past $40 before the end of the year.