Freeport-McMoRan Looks Significantly Undervalued

Apr.29.12 | About: Freeport-McMoRan Inc. (FCX)

Freeport-McMoRan (NYSE:FCX) is the world's largest publicly traded copper miner, selling roughly four billion pounds of copper annually.

click to enlarge image

Click to enlarge

Freeport stock was hit hard towards the end of 2011, dropping from around $55 a share to as low as $30 a share. The stock currently trades at $38.13 after trading over $46 as recently as February. Let's look at the recent financial results:

(In Million $) 2007 2008 2009 2010 2011
Revenue $16,939 $17,796 $15,040 $18,982 $20,880
Operating Cash Flow $6,225 $3,370 $4,397 $6,273 $6,620
Capital Expenditure $-1,755 $-2,708 $-1,587 $-1,412 $-2,534
Free Cash Flow $4,470 $662 $2,810 $4,861 $4,086
Click to enlarge

With the exception of 2009 revenue has been growing each year, increasing by about 10% in 2011. Free cash flow has been inconsistent because of large variations in capital expenditures.

Owner Earnings

Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:

These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.

I'll calculate Owner earnings by taking the Net Income and adding back various non-cash items, such as depreciation, and then subtracting the 5-year average Capital Expenditures. I'll also add interest payments adjusted for taxes since interest is tax deductible.

(In Million $) 2007 2008 2009 2010 2011
Net income $2,977 $-10,450 $3,534 $5,544 $5,747
Depreciation & amortization $1,309 $1,871 $1,137 $1,036 $1,022
Investment/asset impairment charges $0 $16,854 $0 $0 $0
Stock based compensation $144 $98 $102 $121 $117
Other non-cash items $1,049 $615 $259 $120 $-328
Interest Payments $513 $584 $586 $462 $312
Avg Capital Expenditure $-2,000 $-2,000 $-2,000 $-2,000 $-2,000
Owner Earnings $3,790 $7,447 $3,385 $5,121 $4,760
Click to enlarge

Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the Owner Earnings figures to determine Freeport's Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the Owner Earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which can be a poor measure of profitability.

(In Million $) 2007 2008 2009 2010 2011
Owner Earnings $3,790 $7,447 $3,385 $5,121 $4,760
Invested Capital $40,661 $23,353 $25,996 $29,386 $32,070
CROIC 9.32% 31.89% 13.02% 17.43% 14.84%
Click to enlarge

Freeport's CROIC in 2011 was 14.84%. This means that given, say, $1 million of invested capital (retained earnings for example) the company will generate $148,400 in cash on that investment. This is a solid return on investment and has been fairly consistent over the past five years. Here's the latest balance sheet for Freeport:

Cash and Cash Equivalents $4,822
Investments $0
Debt $3,537
Pension Obligations $0
Minority Interest $2,911
Net Cash (Debt) $-1,626
Diluted Float 955
Cash/Share $-1.7
Click to enlarge

Freeport has more cash then debt but including minority interests as a liability puts the cash/share at $-1.70. With $4.8 billion in cash and interest payments taking up only 7.5% of the free cash flow Freeport's balance sheet is strong.

Valuation

I use a discounted cash flow analysis to estimate the fair value of a company. I will use a discount rate of both 12% and 15% and use the results to define a fair value range. You can read about my view on discount rates here. I will assume the initial owner earnings growth rate to be 6% and allow that rate to decay over 20 years to a perpetual growth rate of 3%, as per the growth table below.

Year 1 2 3 4 5 6 7 8 9 10
% 6% 5.85% 5.7% 5.55% 5.4% 5.25% 5.1% 4.95% 4.8% 4.65%
Year 11 12 13 14 15 16 17 18 19 20
% 4.5% 4.35% 4.2% 4.05% 3.9% 3.75% 3.6% 3.45% 3.3% 3.15%
Click to enlarge

Using these parameters I arrive at a fair value range for Freeport of $49.27-$67.72 per share. The current market price of $38.13 falls below the lower end of my fair value range. Below is a list of buy targets for various margins of safety.

Margin of Safety Buy Target
10% $44.35
15% $41.88
20% $39.42
25% $36.95
Click to enlarge

Conclusion

Freeport-McMoRan offers more than a 20% discount to the lower bound of my fair value range. It appears that at this time the stock is significantly undervalued. Being a company tied to the price of copper adds a layer of uncertainty, but with a significant margin of safety Freeport looks like a good value play.

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