Freeport McMoran: More Upside Than Downside

| About: Freeport-McMoRan Inc. (FCX)

I write primarily to organize and document my own thoughts. I respect and enjoy the craft of writing - and I also like to write thought pieces to amuse friends or anyone who cares to look at this blog.

My day job frequently entails writing investment memoranda regarding performance and strategy, as well as the occasional research report. I don't generally blog about stocks, but today I am going to break with tradition.

Freeport McMoran (NYSE:FCX) has become very cheap and oversold. That is not to say that the stock, currently $56, will not see $50 before it sees $60. I have been around markets long enough to learn the cardinal rule: markets can remain irrational longer than you can remain solvent. But the stock is approaching an attractive entry point. To be fair, I do offer this disclosure: I am long the stock and have been - happily so - for several months.

Freeport reported earnings three weeks ago that exceeded consensus estimates, and by most every metric heralded the company's best year. However the market found the results disappointing as production forecasts came down, particularly after a forecast offered in November that was higher.


FCX has shown a .66 daily correlation to front-month CBOE copper over the past year, which varies, of course, by periodicity. However the relationship of front month copper to FCX has not maintained its stationarity. This likely has to do with Freeport's recent earnings report; more on that below. It is also indicative of a strong metals trade by many different investors. The correlation of FCX to copper has been appreciably lower, or inverse,( -0.39) during 2006 when FCX stock did appreciate by 13% on a total return basis; the company has been very focussed on returning cash to shareholders.



We do not use technical signals as a means of selection, but we do pay attention to them in regards to likely, or forecast, short-term price movements. The stock recently breached its 50-day moving average, which is widely regarded as an inflection point.


Copper demand has grown 20% over the past five years, whereas demand in China has tripled. China now consumes 25% of the world's copper and has been the marginal copper buyer for the past three years. A point that is seemingly overlooked is that Chinese demand for copper may well slow, but Chinese copper intensity is still very low on a per-capita basis in comparison to most G8 economies. Copper demand in China, however sporadic, is a secular story - and there are other sources of demand. Many people are now expecting India to enter a new infrastructure growth phase.

Other themes are at work as well. The "Monetization of Metals" has moved to aluminium and copper. In October 2010 three new metals ETFs were announced that will likely begin trading in 2011. Every billion invested in a copper ETF would represent 0.8% of incremental copper demand. In December of last year it was reported that one investor, perhaps acting as an agent for others, held a dominant position in copper on the LME.

Lastly, the copper market is entering deficit for the first time in a few years. This will play a role in copper pricing. Forward curves have moved up on a parallel basis for months and now, as before, exhibit normal backwardation. Copper was only up 13% in 2010, and while it is certainly conceivable that copper may not increase much or at all in value in 2011, it is very hard to conceive of a significant pullback in copper at this point. Metals have become increasingly speculative, but have yet to attain anything like the degree of frothiness that has impacted the oil markets in recent years. And copper has attained its moniker "Dr Copper" for good reason; the metal's price is strongly correlated to economic activity. Most purchasing manager indices, as well as ISM indices here, remain positive - suggesting worldwide growth in 2011.


Freeport's earnings, as previously indicated, were not well received. The company reported a record year and added significantly to its copper reserve base while marginally reducing its production forecast and increasing cash-cost forecast to $1.10, both due to sequencing issues and subsequent lower recoverable grades at its Grasberg mine. The stock has sold off 6% since reporting earnings. Fair enough - on any given day in the markets a security's price might react to any number of things. However the company is forecasting a substantial increase in cash flow from operations, and consensus analyst estimates are for FCX to grow EPS by 28%. Freeport, valued at 9.5x prospective annual earnings, or 4.5x EV/EBITDA, is extremely cheap on this basis. Moreover, Freeport remains very cheap relative to its peers, though some of them are currently forecast to achieve greater net income growth in 2011.

FCX relative

Freeport also added substantially to its reserve base, and not on the basis of copper revaluation alone.

In comparison to any industrial or service company, of course, many of these companies are exceedingly cheap. But that is an element of commodity-based investing, and peak multiples do tend to compress. Regardless, Freeport returned nearly $1 billion to equity investors last year in the form of dividends, and paid off $1.7B in debt. Despite an increasing capital budget the company has the wherewithal to return plenty of cash to investors given a stable - and likely - price deck in copper.

We value FCX at $70 on a dcf basis utilizing $4/pound of copper; this forecast is subject to change given significant changes - downward or upward - in the price of copper and gold. If one applies a 7.0 times EV/EBITDA to the stock, its average over the past 7 years, the stock ends up at roughly $75. Downside on the stock is likely in the $40s, implying a 4 EV/EBITDA multiple should copper come in to $3.50 a pound.

Lastly, I note debt-to-equity ratios in this industry have come down across the board. Freeport may not be the most likely acquisition candidate should it cheapen, but there will likely be more consolidation in this space given balance sheet repair and stable commodity prices.

Disclosure: I am long FCX.

Additional disclosure: We periodically use options to hedge positions around earnings announcements.

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