While many analysts dutifully track production levels, cash production costs, and global inventory changes, sometimes that seems all but fatuous when it comes to stocks in the industrial materials sector. Although production disruptions and higher costs would indeed be bad for Freeport McMoRan (FCX), ultimately it's going to be the investor outlook for copper prices that moves the stock.
A Good Quarter, For What It Matters
Freeport delivered a pretty strong report for the fiscal first quarter. Revenue fell 19% from last year, but rebounded 11% from the prior quarter as lower production, sale, and realized prices hurt the core copper business on the annual comparison. On a sequential basis, prices were better (up 11%) and production was slightly lower. Gold production rebounded significantly on a sequential basis (up 52%), while realized pricing ticked up a bit.
Costs were a mixed bag. EBITDA rose 29% from the fourth quarter, on a 12% decline in cash copper production costs, but the year-on-year comparisons were definitely not so favorable. This was as expected, though, so it is likely that more attention is going to be paid to the lower (and back end loaded) production guidance for the full year, as well as the $0.05 incremental increase in copper cash cost guidance.
Headline Risks From Supply And Demand Sides
Freeport McMoRan stock has been buffeted by a series of headlines that suggest tough sledding for this company. On one side, some sell-side firms (notably Credit Suisse) are calling the end of the China-fueled commodity supercycle. On the other side, there have been noises in Indonesia about changing the rules governing foreign interest in mineral assets.
The China issue is a legitimate one, and one that will have a huge impact on Freeport, BHP Billiton (BHP), Rio Tinto (RIO), Xstrata, and AngloAmerican, if not the entire industrial materials sector. At present, China is definitely struggling with both a coastal property bubble, rebounding inflation, and the prospect of an outright recession.
Still it seems premature to call the end of the China commodity cycle. As Xstrata recently projected, demand growth is likely to drop from the low teens to the high single-digits. This drop could be even worse if bearish assumptions about Chinese inventory levels and excess buying (due in part to window dressing trade numbers and in part to build inventories against another spike in price) prove true, but even inflated estimates of inventory stocks cover about three to four months' usage.
I'm not suggesting that the CEOs of Freeport, BHP, or Xstrata have flawless insight into the future of Chinese demand. Nor am I suggesting copper can't touch $3.00/lb again in the short term. I'm just saying that development demand alone (housing, electricity generation and transmission, etc.) should support a relatively healthy long-term price.
The Indonesia Issue
The second issue, foreign ownership in Indonesian mines, is more volatile but likely a lot less serious. Politicians in Indonesia have talked about forcing companies to sell below 50% ownership over time and build smelters in the country.
That sounds bad, but Freeport has a few factors in its favor. First, there's a contract of work (COW) in place with the Indonesian government that would preclude this. Skeptics can argue that plenty of developing country governments have shredded such contracts when it suited them, but Indonesia is not exactly a tin-horn African dictatorship, and they have a long-term vested interest in being seen as playing by the rules.
Second, Freeport has intimated that it would be willing an additional stake (around 9%) in the Grasberg mine to the government (municipal or national) if need be. This could be a win-win - it lets the Indonesian politicians look strong in front of the voters and doesn't really harm the economics of the Grasberg operation - a critical asset given its rock-bottom production costs ($0.33/lb versus a company-wide average of $1.26/lb and $1.51/lb in North America).
The Bottom Line
Expectations have certainly come down on this stock due to both production revisions, cost increases, and copper price movements. In fact, sell-side EBITDA estimates for 2012 are now about 8% lower than they were three months ago.
I won't pretend to know where copper is going, though the chart is a little unnerving as it looks like a head-and-shoulders formation is developing. Certainly the market is expecting worse prices - with an estimated sensitivity where a $0.10/lb change in copper equates to a $375M change in EBITDA, it looks like the market may be pricing for copper in the $3.10 - $3.30 range before the year's out.
Taking the current average 2012 EBTIDA estimate and applying a 5x multiple (lower than the historical rate of 7x, but closer to the average of recent years) suggests fair value of nearly $50. Given the skepticism in the stock and in the copper market, not to mention management's intention to increase production 25% over the next three to four years, this is close to a price where I'd be tempted to take a flyer on it.