Freeport-McMoRan And The Bond Vs. Equity Debate

| About: Freeport-McMoRan Inc. (FCX)

Summary

Investments should carry a margin of safety, but FCX no longer has one.

Shareholders are now in the strange position of desiring volatility in commodity prices because of limited downside risk.

The bonds maintain more of the characteristics of an investment since bondholders do not desire more volatility.

Freeport-McMoRan (NYSE:FCX) is a company that produces copper, oil and gold. However, shares no longer trade as interests in a company that is expected to survive over the next several years. Shares have often traded below $5 on the basis that shareholders (including me) are becoming legitimately concerned about Freeport-McMoRan's future as a company. They major questions are:

Can they avoid bankruptcy?

Can they do it without issuing disastrous amounts of common stock?

Margin of Safety

Benjamin Graham discussed value investing as the premise that an investor would only buy things where they had significant opportunities for a return on investment and a sufficient margin of safety. One area that he warned investors about was the fallacy of relying on analysis that could be completely invalidated by a sudden change in the market. The idea of investing was to find investments that would withstand those sudden changes rather than attempting to predict the sudden changes.

The problem for investors in Freeport-McMoRan is that the rapidly changing outlook for copper and oil prices results in dramatic changes any fundamental valuation of the company. For speculators, this isn't a problem at all. Freeport-McMoRan is acting largely like a leveraged position in the underlying commodities with the exception that it will occasionally deviate from the value implied by the commodities.

The most notable case may be when negotiations with Indonesia are controlling expectations. When Indonesia and Freeport-McMoRan are arguing over Freeport-McMoRan's right to export materials it results in stronger copper prices on that theory that supply may be decreased. Clearly that is one scenario where declining supply would not help FCX.

The Future

The way shares are priced reflects the extreme volatility of the scenario. In the bond markets the debt of FCX has often been trading around 45% to 89% of face value and producing exceptional yields if the company is able to make the payments.

The Risk Profile

The equity and the bonds have exceptionally different risk characteristics. The bonds have limited upside potential since they are unlikely to ever trade above par value. Theoretically a sharp move upwards could create capital gains for a trader, but over the longer term the expectation for bond holders is to manage the risk of default and expected recovery rate with the potential for significant rewards if the company does not default. The equity on the other hand carries a very substantial risk of either being wiped out or diluted to the point of being almost wiped out. At this point, I think the odds of equity being decimated are more likely than not. The only rationale for holding onto the shares is the potential for them to triple or quadruple within a couple years.

How Bonds Can Win

The real case for bond holders is the possibility to be paid off at par value when the bond matures. As the commodity prices decline the odds of bond holders getting paid off is also declining. On the other hand, FCX has demonstrated a willingness to issue equity at very low prices to bring in enough cash to keep the company operating. From a cynical perspective, this is entirely logical. If the company goes bankrupt, where will executives go to get paid any kind respectable compensation package for decimating an enormous copper producer, buying oil assets that were relatively overpriced even at the peak of the oil market, and slashing dividends to pay out termination benefits when an executive voluntarily retires?

It would appear that management is more incentivized to worry about the bond holders than the shareholders. Since the shareholders get wiped out in a bankruptcy anyway, there is little argument against issuing equity at exceptionally low prices to acquire more cash to pay bondholders.

A Huge Word of Caution

The bonds for FCX are dramatically less liquid than the stock and going through dealers is an inherently poor system. When I was contemplating the FCX bonds, I checked prices through my brokerage. The yields on short maturity debt were exceptionally poor, so I checked through FINRA for bond pricing for FCX. If you're contemplating buying bonds from FCX, check the FINRA page and make sure the quotes you are getting are competitive with market prices. I can't stress this enough. If you are contemplating buying these bonds, you will need to do proper due diligence to ensure competitive pricing.

Speculation or Investing

In my opinion, spending cash on the bonds can still be considered an investment if it is done with proper due diligence. Shares of FCX on the other hand can only be considered speculation. In an ironic twist, shareholders in FCX want volatility now. This is fundamentally the opposite of investing and is a clear sign that shares are speculative.

Proof in a Strange Example

Relax from all the analysis for a moment and just think about this on a theoretical level. As a shareholder, if I could flip a coin where heads sent the value of copper to 0 and tails doubled the copper price, I'd be flipping that coin instantly. Wouldn't you? If copper went back above $4 shares of FCX would be worth vastly more than double the current price. Since my shares can't be worth less than $0, the coin flip would be highly appealing. The exact opposite is true for the bondholders since their upside potential is limited.

Conclusion

Shares of FCX can most accurately be categorized as speculation now rather than an investment. If the company survives without issuing disastrous amounts of stock it would be expected to increase several fold over the next few years. That enormous potential for gains if offset by a significant chance for declines in commodity prices to push the company to the point where it would need to effectively wipe out most of the stake held by current shareholders.

Because the business has reached the point where exceptional volatility in commodity prices would be favorable to equity, it is no longer reasonable to treat FCX as a normal investment. The future value of shares of FCX will be determined by their ability to avoid massive equity dilution and the changes in the fair value of the commodities. On the other hand, investment in the bonds allows investors to reduce fear about the impacts of equity dilution.

Investing in FCX on the premise "copper prices will rebound" is a faulty premise since one potential catalyst for copper prices rebounding would be a bankruptcy by FCX. There is nothing wrong with holding shares of FCX. I still have a small position, but it is no longer feasible to treat shares as a simple investment. The important factor for potential shareholders is being able to recognize and admit whether they are investing or speculating.

Perhaps we should add one final question to the list of things potential shareholders must ask themselves: Do you feel lucky?

Disclosure: I am/we are 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.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.