Freeport-McMoRan (FCX) is a good operating company saddled by inappropriate amounts of debt (ca. $20bn, 6x 2015 EBITDA) as well as a pronounced bear market for copper and oil.
Its situation has worsened to the point that its survival is no longer guaranteed unless remedial actions are taken. Initial steps by management (no dividend and aggressive CAPEX cuts) were sensible but insufficient. Absent a significant rebound in commodity prices, debt reduction is the only viable way forward to ensure survival.
The recent Q4 earnings call has marked the first time where FCX's management has publicly shown a full appreciation of the direness of the situation and their full commitment to address it. FCX has established a concrete debt reduction target ($5-10bn) and, crucially, has put every asset and business of the company up for sale in order to achieve it.
The success or failure of this disposal plan has such bearing on the value of the company that, in our view, FCX can no longer be analyzed as a traditional stock and instead must be regarded as a "special situation" investment opportunity.
This article examines whether this special situation (the company deleveraging) is achievable, how it is likely to be implemented and, most importantly, how it is possible to profit from it.
It also shows that even if one is to assume the success of the disposal plan, buying FCX stock is unlikely to be a winning strategy and investors will have to resort to alternative strategies to stack the odds in their favor.
Finally, this article shows the best way to play the FCX story over the next 6-12 months, with estimated returns of 32-56% over that time frame and a relatively limited downside.
2. Is the debt reduction target realistic?
During its Q4 earnings call, FCX's management disclosed that debt reduction via asset disposals has become a priority for the firm, with a stated reduction target of $5-10bn (25-50% of the total outstanding debt of $20.4bn).
As per their current loan covenants, FCX has to use at least 50% of any disposal proceeds to repay their existing $4.7bn term loan. However, management was emphatic that they expect to use 100% of disposal proceeds to reduce debt (which can include senior unsecured bonds).
The company has also already started conversations with a number of potential acquirers and JV partners in respect of a number of assets of the company, and expects to be in a position to make a specific announcement on asset disposals in 2016 H1.
Assessing the prospects of this deleveraging is fundamental to understand whether FCX has any chance of survival. Our central investment thesis is that this is indeed a realistic target for the following reasons:
- The breadth and quality of the assets on offer will attract a wide universe of buyers - even in this distressed environment there is a strong bid for quality, cash flowing assets.
- The enormous discount at which the senior unsecured debt is trading provides FCX with a considerable buffer on asset disposal prices - it can afford significant asset sale discounts and still de-lever efficiently.
- There is no obvious "liquidity crunch" event that could derail or weaken FCX's negotiating position on the asset sales over the next 12 months. In particular, FCX has a $4bn unused loan facility at its disposal and hardly any debt repayments due over the next 12 months.
These three points are explored in more detail below:
a) The breadth and quality of the assets on offer will attract a wide universe of buyers:
In our opinion, one of the most important statements made in the Q4 earnings call was the fact that management had opened up the possibility of selling any asset and business within the firm, as opposed to just the oil assets; and that they would consider both partial and full disposals.
Effectively, this opens up the door to a wide universe of prospective buyers both in terms of the type of buyer - miners, energy companies and private equity - as well as the scale. Indeed, FCX can cater to the full spectrum of buyers, from those looking for a jumbo-sized transformational acquisition (similar to Shell's (RDS.A) recently approved acquisition of BG Group (OTCQX:BRGXF)), to local partners aiming for a partial stake in an existing operation (such as the recently reported bid interest for up to $3bn in PT Newmont Nusa Tenggara, the second largest copper mine in Indonesia after FCX's Grasberg).
Crucially, it's not just the breadth but also the quality of the assets on offer that will attract a wide spectrum of buyers. Virtually every business segment in FCX's copper portfolio is expected to be net cash flow positive after CAPEX in 2016.
At a spot price currently hovering around the $2.0/lb area, FCX's portfolio of assets offers significant cash flow enhancement from the outset to a prospective buyer with the right capital structure. This is, in our opinion, the defining trait for the type of assets that oil and mining majors are actively seeking even in this distressed market environment - the likes of BHP Billiton (BHP), who have been recently reported to consider all avenues (including dividend cuts and equity issuance) in order to be able to acquire top quality assets at what they see as a bottom of cycle.
b) The large discount of FCX's debt provides the company with a large buffer versus asset valuation/market moves:
This is perhaps best illustrated through an example - as is well known, FCX is in discussions with the Indonesian government with regards to the acquisition by the latter of a further 10% stake in FCX's Indonesian operating unit. This stake has been recently valued by FCX at $1.7bn using (in their own words) market-standard methods of valuation.
The Indonesian government, as one would expect, is asking for a price concession as it feels it has significant leverage over FCX stemming from its authority to renew export licenses and extend the continuation of the operations beyond 2021.
While a substantive discount over FCX's initial offer might therefore be inevitable, effective deleveraging is still possible thanks to the fact that FCX's senior unsecured debt is trading at high discounts to par:
For instance, FCX could sell the $1.7bn stake to the Indonesian government at a 25% discount to fair value, use 50% of the proceeds to repay $0.64bn of term loan as per their covenants, and still be left with another $0.64bn of proceeds that can be used to buy a $1.06bn basket of 6-9 yr bonds at a price of 60% (a 41% premium over their 29-Jan market value of 42.6%).
This would result in a decrease of $1.7bn in assets on balance sheet versus a corresponding decrease of $1.7bn in debt. As a consequence, leverage as measured by the total debt: total equity ratio would fall leverage from 1.59x (=20428 / 12808) to 1.46x (=18728 / 12808). Crucially, this deleveraging has been achieved even at the expense of accepting a substantial discount on the assets (25%) and paying a substantial premium on the market value of the bond debt (41%).
Note that this is probably an extreme example in the sense that the Indonesian government is one of the most difficult counterparties that FCX will have to negotiate with. In actual fact, we expect that the majority of FCX's counterparties will act at arms' length and that the trophy nature of FCX's assets will incentivize them to bid reasonably close to fair value, creating value for the equity. But the crucial point is that FCX does not need to sell at fair value for the deleveraging to happen. It can afford a significant margin of error and still succeed.
c) Liquidity events are unlikely over the next 12 months:
Notwithstanding the attractive portfolio of assets, FCX's disposal plan could run into trouble if it somehow found itself in a liquidity crunch - short of cash and having to fire-sale assets to repay scheduled debt maturities.
In our view, this is very unlikely to happen. There are only $200mm of scheduled debt redemptions over the next 12 months, FCX has a $4bn unused liquidity line at its disposal, and operating cash flows at realistic spot prices ($2.0/lb copper and $34/bbl Brent) are projected by FCX to be sufficient to match the $3.4bn of 2016 budgeted capex outflows. Furthermore, the recent downgrade to B1 by Moody's is also unlikely to be a game changer, as management has already expressed to have adequate contingency plans in place for the anticipated increase need for letters of credit.
What could go wrong from this forecast? The main risk is clearly for copper and oil spot prices to collapse further, impairing operating cash flows and possibly breaching the net debt/EBITDA covenants of the revolver loan facility (5.9x for H1 2016, reducing to 5x by year-end, 4.25x in 2017 and 3.75x thereafter).
Our views on this point are as follows:
- We believe any downside in the oil market is unlikely to drive prices below $20/bbl based on the effect it would have on Russia and most OPEC members. Even at this distressed level, FCX's operating cash flow would only decrease by about $380mm on the basis of its current assumptions ($34/bbl) and sensitivities ($135mm per $5 change in price).
- While the company's stated sensitivity to copper is much larger ($440mm per 0.10 change in price/lb), we believe this market is much closer to being balanced both on the demand and on the supply side. Based on management's projections, FCX will be one of the lowest cost producers in 2016 ($1.1/lb net cash costs). We have no doubt that 2016 will bring defaults amongst copper producers, but it will be the higher cost ones and this in itself will act as a rebalancing factor on the supply side to the benefit of FCX.
- The company has in any case a good amount of flexibility in slashing the capex budget further in the event of a cash flow squeeze. We estimate that at most half of the $3.4bn capex represents essential maintenance capex, with the rest being discretionary capex.
- Finally, FCX has been able to re-strike covenants in the recent past, demonstrating a good relationship with its lenders that can be leveraged in case of a covenant breach - it won't be cheap for them, but absent a market meltdown they should be able to obtain covenant relief from its lenders.
Finally, we consider the Indonesian situation as another potential risk to FCX's liquidity situation. At the time of writing, FCX's export license to export had just expired after demands from the Indonesian government for a $530mm deposit had been turned down by FCX, who believes this is a departure from what was previously agreed. If unresolved, this may lead to a cash crunch given the considerable proportion of FCX's production coming out of Grasberg (18% in 2015, and projected by FCX to raise to 29% in 2016). However, we don't think it'll ever come to this given how much both sides have to lose if it were the case. Hence we believe that the worst case scenario is one where FCX has to capitulate and pledge the deposit to the Indonesian government. Although not ideal, it'd be something the company can cope with given the large liquidity line at its disposal.
In our view, the risk of a liquidity event for FCX is fairly remote over the next 12 months, and this will allow the company to focus on an orderly disposal plan of its portfolio of oil and copper assets in order to achieve their target debt reduction.
3. The trading opportunity - FCX stock:
Although we believe FCX is likely to succeed in its efforts to reduce debt, this process is not necessarily going to be kind on the stock price. Indeed, we see few catalysts in the near term to reprice the stock upwards from its current level ($4.6 at the time of writing) and quite a few risks on the downside:
- Equity investors are highly leveraged to the discount on asset sales and premium required on debt repurchases; while we think that FCX's assets will garner good interest, every adverse development will significantly impact shareholders.
- If events beyond those discussed above eventually place FCX into bankruptcy, equity investors are unlikely to secure any meaningful recovery given the high levels of debt at face value (although Mr. Icahn's negotiating ability can never be underestimated).
This is not to say that FCX is a bad investment - in fact, we see it as a relatively cheap (but somewhat binary) option on the long-term prospects of copper and oil. But the payoff for such strategy is far in the future and in the meantime, there is a clearly superior strategy in terms of risk-return.
We refer, of course, to buying FCX's debt before FCX does.
4. The trading opportunity - FCX bonds:
Senior unsecured bonds in FCX have experienced a precipitous decline over the last 3 months, as shown in the price chart for one of the more liquid medium term bonds (2022 maturity).
Source: Bloomberg, data as of 29-Jan-16
The extent of this decline is, in our view, only consistent with a near certain expectation of default, as the bonds are trading pretty much in line with the recovery rate we would expect upon default (40% area).
This is reinforced by the strongly inverted credit curve, which shows bond prices tailing off around 40 cents on the dollar at all maturities beyond 5 years.
Source: Bloomberg, data as of 29-Jan-16
This creates a unique risk-return opportunity for bond investors:
- Controlled downside: If the company defaults, investor losses are expected to be minimal with the price entry point being at expected recovery rate levels.
- Significant long-term upside: If FCX pulls through, there is enormous upside potential on a hold to maturity basis (price appreciation in excess of 2x).
- Significant short-term upside: Investors may not have to wait to maturity to realize outsized gains - a successful asset disposal and debt reduction program over the next 6-12 months will strongly reprice the bonds.
- Investors get paid to wait: cash on cash yield in the bond example above is above 8% (3.55% coupon/42% cash price) - this is on top of any price appreciation potential and it of course helps to further reduce downside risk.
In our view, this is a superior risk profile both on an absolute and relative basis: on the one hand, we believe the market is assigning a 100% probability to FCX defaulting, and this is absurd; and on the other hand, buying the debt is by far the most efficient way to take advantage of this mispricing - the alternative of investing in FCX's stock leads to a much worse outcome in all but the most optimistic scenarios.
The rest of this article assesses the investment opportunity in FCX bonds on a 6-12 month horizon, looking in particular at what we see as the main catalyst for repricing and investor profits: the debt reduction initiative.
5. Debt buy back mechanisms and implications:
While FCX is constrained to use 50% of any asset disposal proceeds to repay its term loan (until redeemed in full), it has full discretion on how to apply the rest of the proceeds.
Given an overwhelming imperative to reduce debt, and the fact that the average senior unsecured bond of the company is trading at ca. 48 cents on the dollar, it is clear that the optimal path for FCX both from an equity value creation and deleveraging/survival perspective is to buy back these bonds at a discount as high as possible.
Assuming a $10bn debt reduction target, this would imply paying back the entire term loan ($4.7bn) and buying back an additional $5.3bn of bonds. Given securities regulations, the magnitude of the buy back and the liquidity of secondary debt markets, an auction mechanism is the only practical way for FCX to go about it.
Two questions arise in this context:
- Which bonds are most likely to be targeted; and
- What premium over market levels FCX will need to pay to encourage note holders to tender the notes back at a discount to par.
a) Bonds most likely to be targeted in a debt buy back auction
In order to answer the first question, we consider the debt maturity profile for FCX:
The table above covers $19.4bn of debt (approx. 95% of FCX's total), giving us a good indication of where the pressure points lie.
Up until 2019, the combination of a $4bn liquidity line and forced early repayment of the term loan (with 50% any asset sales) means that FCX should already have enough instruments to manage its financial situation without resorting to further buy debt backs, which are quite expensive anyways given the average price at which bonds trade in that bucket. If anything, FCX could target a small amount of 2017 securities as insurance in case the asset disposal process extends for longer than anticipated, but we don't envision this to form the bulk of its debt buy back activity.
By contrast, there is a big spike in redemptions in 2020 and then 2022/23 which will need to be addressed, as the liquidity line will be gone by then. This is where the true liquidity crunch kicks in and the debt can be purchased at almost terminal recovery prices (40% area), therefore we think that this will represent the bulk of FCX's debt purchases.
Finally, we think that FCX will probably ignore any maturities longer than that (2031 and onwards). There are only marginal benefits in terms of debt discount vs. the 2020-24 segment, and the debt is too far in the future to be of any immediate concern.
In sum: all bonds in the 2020-2024 range are in our view strong candidates for a debt buy back. Having said that, we think that the FCX 3.55 03/01/2022 is a particularly good pick for investors given its balance between short maturity (pull to par effect), decent liquidity and low entry price/low downside risk.
b) Estimated auction premium
As mentioned above, FCX will have to pay a substantive premium to investors in order to be successful in buying back debt. Even at a premium to current market levels, the company is still aiming to buy back the debt at a substantial discount to par. This will be quite painful (to say the least) for long-term debt holders, most of whom will be deeply underwater vs. their initial entry price.
The scale of the buy back (between $2.7 and $5.3bn depending on the final total debt reduction) is such that the company will need substantial note holder participation to achieve its goals and, unless a considerable sweetener is put on the table, this is just not going to happen.
There is, however, a level of buy back premium that would balance FCX and the note holders' interests.
Barrick Gold (ABX) recently initiated a similar $1.15bn debt tender offer. As per their announcements on Dec 1st and Dec 15th, Barrick chose to focus the bulk of their buy back efforts on the medium term (2022-2023 maturities) and a smaller amount of shorter term maturities, possibly for similar reasons to the ones we outlined for FCX. Looking in particular at their most liquid medium term bond (ABXCN 4.1 05/01/23), we estimate based on Bloomberg data that the premium offered was ca. 6-7 points over the previous day closing price, plus an early tender premium of 3 points.
We see this ca. 10 point premium as a worst case scenario level for FCX, given that:
- Barrick's exercise was discretionary; in many ways, FCX's buy back is compulsory, i.e. they have no choice but to do it and they need to ensure its success.
- Barrick's noteholders were asked to crystallize a small loss versus par, since the all-in repurchase price was in the 90s. FCX's noteholders are being asked to shoulder a much bigger loss given the current trading levels around the low 40 mark.
In our view, a more reasonable buy back premium for FCX's medium term bonds would be around 20 points, for an all-in buy-back purchase price in the 60-65 area. This represents a premium of about 40-50% to current market prices but still allows FCX to lock the bulk of the discount, hence it would achieve the objective of balancing noteholder's and FCX's interests.
6. Putting it all together: risk-return analysis for FCX 3.55 03/01/2022:
Our view of the risk-return of this trade is summarized below.
We show the impact of both a conservative bond tender premium (10 points) as well as our base expectation (20 points). In this case, total returns over a year would amount to 32% and 56% respectively.
We also show the hold-to-maturity economics, with 189% total return over 6 years (assuming 0% coupon reinvestment rate and no default).
These are outsized returns by any metric, but it is important to put them in the context of the possible downside, which is essentially the case where FCX defaults.
As mentioned before, we believe that recovery rates for FCX in the event of default are likely to be at or above 40%. We are mindful that most of the bankruptcies of the last 12 months in the energy sector are exhibiting lower recoveries, but these are typically high cost producers and/or exploration companies with higher levels of embedded leverage in their debt securities. In our view, FCX's recovery upon default will substantively exceed those levels bar a meltdown on the underlying commodity markets.
We can always stress this recovery rate view, and this is what we do on our second default scenario above (25% recovery rate). In this case, investors will lose just over 1/3 of their capital. Given that we see this as a fairly extreme case, it compares remarkably well with our conservative and expected upside (32% and 56% respectively), to which we attach a much higher probability.
7. What could go wrong?
Although we think the odds are heavily stacked in favor of investors entering at current market levels, there are a number of scenarios that could derail the analysis. Below we note what we think are the main ones:
- Problems with Indonesia: we see this as the biggest wild card in FCX's prospects. A substantial failure to find a rational agreement on the export license or extension of operations beyond 2021 could have a highly detrimental effect on the prospects of the company despite its best efforts to reduce debt.
- Collapse in oil and/or copper prices: see analysis above. We think this is relatively unlikely from current market levels but they always remain a possibility, for instance in the case of a China hard landing.
- Failure of management to pursue the asset disposals: again, we think this is relatively unlikely, particularly with Carl Icahn involved.
- Lack of market interest in FCX's assets: as discussed above, this is unlikely to be the case and in our view would be tied to a general market collapse rather than being an idiosyncratic risk factor.
- FCX reduces debt but not via a buy back auction: for instance, it could stick to the lower bound of its debt reduction target ($5bn) by solely repaying the term loan. While this scenario would present a lower upside for bond investors, they would still benefit from the resulting credit improvement and likely tightening in bond yields.
- Impairment of debt hierarchy: by this we mean any attempts by the company to subvert the seniority of bonds vs. the equity, for instance by trying to deplete the assets securing the debt through corporate restructuring. We believe this is highly unlikely given the legal challenges it would experience (but other companies have tried before).
- Aggressive bankruptcy filing: This remains more of a risk given the involvement and bargaining acumen of Mr. Icahn. If FCX were to default, equity holders might try to extract a softer dilution on any debt-for-equity swap, reducing the recovery rate in the short term.
8. Alternative trade entry points:
Given the fluidity of the FCX situation and general market volatility, it is possible that the entry price points described in this article are obsolete by the time it is published. Hence it is worth considering the limit prices at which the trade would still make sense.
In our opinion, any entry price at or below 50% for the FCX 3.55 03/01/22 still offers a risk-return that is significantly skewed in favor of investors.
At this level, our expected upside would still be ca. 27% (assuming a 60% buy back price), versus a base case downside of around 13% (assuming a 40% recovery rate and 1 year of coupons received before default)
We believe that the market is fundamentally mispricing the probability of default and recovery prospects of FCX.
This creates a valuable opportunity for the company to restructure itself into a viable and profitable company.
Most importantly, it also offers a very attractive opportunity for investors who are willing to step out of the stock market and into trading the debt of FCX.
In our view, a return range of 32-56% is feasible over a one year horizon on the basis of the prospects of FCX implementing its asset disposal and debt reduction targets.
Furthermore, we believe that investors that enter the position at current market levels have a relatively low downside should FCX's situation materially worsen relative to our expectations.
For these reasons, we find this trade opportunity to be one of the most compelling risk-returns available to investors in what are unquestionably very challenging market conditions.
Disclosure: I am/we are long FCX BONDS, INCLUDING FCX 3.55 03/01/22.
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.
Additional disclosure: I wrote this article for the sole reason of testing my investment thesis externally. As such, any comments and feedback (positive or negative) are greatly appreciated. Most importantly, nothing in this article should be construed as financial advice or the solicitation of investment business or otherwise. I only trade for my own (and my family’s) account. Equally, all forward-looking statements and calculations reflect my own opinions, but should not be relied upon in any way by any prospective investors. If you are interested in trading any FCX securities, please conduct your own research and/or obtain independent financial advice before deciding if it is appropriate for you.