Freeport-McMoRan Inc.: High Risk, High Reward

| About: Freeport-McMoRan Inc. (FCX)

Summary

Active traders say the downtrend will continue.

I assess the value for long-term investors.

The stock seems to be undervalued by the stock market.

Freeport-McMoRan Inc. (NYSE:FCX) is a natural resource company with an industry portfolio of mineral assets, oil & natural gas resources, and a production profile. It has organized its operations into six primary divisions: North America copper mines, South America mining, Indonesia mining, Africa mining, molybdenum mines, and United States oil & gas operations. Freeport's portfolio of assets includes the Grasberg minerals district in Indonesia, mining operations in North and South America, the Tenke Fungurume (Tenke) minerals district in the Democratic Republic of Congo (DRC) in Africa, and oil & natural gas assets in North America. It is also engaged in operating copper conversion facilities located in North America, and a refinery, three rod mills and a specialty copper products facility. The company's Atlantic Copper smelts and refines copper concentrates and markets refined copper and precious metals in slimes.

Strengths:

  • Freeport-McMoRan's revenues come from several products and mines:

(Source: 2015 financial statement)

  • The company has operations in 4 continents, which should reduce the country risk:

Click to enlarge

(Source: Company website)

Weaknesses:

Freeport-McMoRan has cash & equivalents of $224.00 million at the end of 2015. Taking into consideration this amount just as an index of how much the company can save for short-term needs, I am concerned whether the cash generated from operations is giving to the company enough maneuver in order to:

  1. Reinvest into the business.
  2. Repay debts. The total amount of long-term debt is $19.8 billion at the end of 2015. The long-term Debt-to-Equity (MRQ) is 252.67, versus 53.41 (industry) and 14.51 (sector).
  3. Develop existing projects.
  4. Eventually buy back shares. This will boost the EPS and DPS figures.

Freeport has two ways of increasing cash at this point:

  1. Issuing new debt. But its recent efforts to maintain investment-grade ratings are failing; and/or
  2. Divesting assets. But it seems the company is selling parts of those assets (such as Morenci) that have higher grades and a low-cost profile, thereby eroding its net asset value.

FCX is seen by active traders as trading within a clearly identified downtrend.

Click to enlarge

(Source: Investopedia)

Active traders combined two go-to tools - the long-term moving averages and descending trend lines - in the process of testing key resistance levels for Freeport-McMoRan, one of the most significant players in the copper space.

Most bearish traders will likely look to enter a position as close to the trendline as possible to maximize the risk/reward of the trade. Stop-loss orders will probably be placed above the 200-day moving average, which is currently trading at $10.63.

I want to assess this stock and determine if the currently trading price could also be an entry point for a buy-and-hold investor. I assess the value of the stock with a EPS growth capitalization method that I will modify a little bit.

I need two rates: the discount rate and the growth rate.

Since 82% of total company's sales come from the metals & mining industry and 11% from oil, as a discount rate I use the cost of capital of metals & mining industry, which is 8.40%, and the cost of capital of oil/gas (production and exploration), which is 8.37%. As a unique discount rate, I use a cost of capital of 8.4%. The data used is as of January 2016.

Assuming an industry retaining ratio (RR) of 88% for the next 5 years, I can calculate the growth ratio as industry's 5-year average return on equity x RR:

12.08 x 88% = 10.6%

(Data taken from Reuters)

Since the growth ratio looks excessive to me, I will use a ratio of 5.89% as estimated a year ago.

Determining the 5-year EPS:

As you can see from the table below, Freeport-McMoRan is a cyclical stock, and this presents the obvious problem of valuation: how much should an investor be willing to pay for a cyclical business?

Click to enlarge

Benjamin Graham had a solution to assess cyclical stocks:

"Ben Graham, the "Dean of Wall Street" and father of value investing, came up with a solution almost seventy years ago. He maintained that an investor should pay based upon the average earnings of a cyclical business for the past ten years. Historically, this timeframe has covered an entire business cycle, evening out the highs and lows." (here).

But if I calculate the average EPS for the past ten years, I obtain a negative value. I need a positive value. Then, I will consider an average of EPS as an arithmetical mean between the 2013 EPS (the last positive value of EPS during a downtrend period) and the 2009 EPS (the first positive value during an up-trend period):

($2.93 + $2.64)/2 = $2.79

EPS (2020) = $2.79 x (1 + 0.0589)^5 = $3.71

This value of EPS makes sense considering FCX is a cyclical stock.

Determining the 5-year P/E:

I consider an average between 11.15 (2013) and 7.54 (2009), which is 9.35.

Year

Share Price

EPS

P/E

2015

$14.48

-11.31

-1.28

2014

$30.92

-1.26

-24.54

2013

$29.45

2.64

11.15

2012

$32.06

3.19

10.05

2011

$39.06

4.77

8.19

2010

$32.46

4.57

7.10

2009

$22.10

2.93

7.54

2008

$30.97

-29.72

-1.04

2007

$32.54

7.5

4.34

2006

$21.46

6.63

3.24

Click to enlarge

Future stock price = EPS (2020E) x P/E (2020E):

$3.71 x 9.35 = $34.69.

Now, I discount the future stock price by 8.4%.

Present value (PV):

$34.69 / (1+0.084)^5 = $23.18.

If I discount this value by 50% (margin of safety), I obtain a share price of $11.59.

On March 17, 2016, the stock closed at $10.90 per share, up $0.68 (+6.65%) from the previous close, with 52,971,317 shares traded on the New York Stock Exchange.

According to a recent analysis by active traders, $10.63 (stop-loss order) is the price that can be used for a short position.

Since the discounted value I have assessed is $11.59, the stock apparently seems to be undervalued by the stock market. This might be an interesting entering point for an investor, but the risk is very high.

Everything depends on the price of copper and the pace of the urbanisation process in emerging economies like China, India and Brazil.

The long-term investor has two options:

  1. Buy shares of Freeport-McMoRan at the current prices (maybe have only a small percentage of the portfolio invested in this stock). However, the risk of investment failure is very high, due to the fact that "at this time no meaningful catalyst is seen that will improve the overall market dynamics given weak global growth rates and slowing demand in China," and that the company doesn't have any other choice than disinvesting parts of its assets to improve its liquidity and pay debts. Rating agencies carry a negative outlook on Freeport, which will put more pressure on the possibility of getting more credit. It's a 50-50 chance to either make a considerable capital gain or to lose money. I make a very simple calculation. Let's assume you buy one share at the current price. If the present value of $23.2 becomes a reality, you can make a capital gain of 120% in 5 years. Let's say 25% every year. The present value (intrinsic value) also represents the company's debt, which will give you, let's say, 10% till 2020. In the end, bondholders may not carry less risk than shareholders if the company is divesting its higher-grade assets.
  2. Wait to see what happens on the demand side of copper. But as the overall situation becomes more clear, the risk-reward ratio may increase and sacrifice your winning percentage.

Disclaimer: This does not constitute any investment recommendations or professional advice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.