Credit markets are grossly overstating Freeport-McMoRan, Inc.'s (NYSE:FCX) fundamental credit risk with a CDS of 645bps relative to an Intrinsic CDS of 235bps, and a cash bond YTW of 7.564% relative to an Intrinsic YTW of 3.524%. Our fundamental analysis highlights a much safer credit market risk for FCX. Their relatively young asset base would afford them some flexibility in cutting their maintenance capex over the next several years, despite their cash flows falling short of obligations starting in 2017. We therefore rate FCX at HY2+, or a B1 equivalent using Moody's ratings scale.
Cash Flow Profile
We produced a Credit Cash Flow Prime™ chart for Freeport-McMoRan, as we do for every company we evaluate. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. It shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (Valens' scrubbed cash flow number) expected to be generated based on consensus analyst estimates and Valens Research's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.
The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.
If the company generates and has cash levels that are above their obligations, the risk of default is extremely low. Even if the cash generated yearly is close to the levels of the stacked bars, a company generally has the flexibility to defer payments of various kinds. For example, they can allow assets to age a little longer, or they can cut certain maintenance costs such as maintenance capex. While decisions such as those can create other business concerns, the issue in credit risk is simply this: Does the company have enough cash to service their credit obligations?
FCX's cash flows would exceed all operating obligations in 2016, but would fall short in the following years. Moreover, their cash build would only assist in servicing debt through 2017, but their combined cash flows and cash on hand fall short in the years thereafter. However, significant capex flexibility, robust recovery rate, and sizable market capitalization should facilitate access to credit markets to refinance if needed.
Like most people, senior executives and board members do what they are paid to do. This is why FCX's Form DEF 14A is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Our Incentives Dictate Behavior™ analysis focuses on FCX's senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, how aligned a management team may be with shareholder interests, and the potential consequences of a management compensation framework to the business.
FCX management's short-term compensation is based on operating cash flow net of working capital, copper and oil equivalent production, safety, and social responsibility. Meanwhile, their long-term compensation is composed of stock options and PSUs based on TSR relative to industry peers.
This should incentivize management to improve margins and asset utilization while also growing the business. This focus on all three value drivers should lead to higher cash flows available to fulfill debt obligations. However, most members of management are not material holders of the company's equity, indicating that may not be aligned for long-term value creation.
We provide analyses of companies' statements on earnings calls, termed Earnings Call Forensics™. This analysis is meant to help assess a management team's confidence in their conference calls when discussing certain areas of the business such as operations, stability, strategies, their ability to manage business risks, and especially, their liquidity and solvency.
In the case of FCX, the analysis of their Q1 2016 earnings call highlights highly questionable signals from management. They appear concerned about their ability to meet the expected copper supply gap, and may be exaggerating the value of their assets in California and the Deepwater Gulf of Mexico. Additionally, they appear concerned about their ability to further reduce capex in 2017.
Ultimately, a company's credit risk (or lack thereof) is driven by cash available against cash obligations. FCX's credit risk is being grossly overstated by credit markets. Given FCX's significant capex flexibility, and robust recovery rate, market spreads are expected to tighten once the company's fundamentals are recognized.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Melvin Yubal. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
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.