Freeport-McMoRan: A Stock With Strong Upside

Jun.21.12 | About: Freeport-McMoRan Inc. (FCX)

Wow, the data coming out of China has been horrible. Even though China's growth and GDP data was solid, leading indicators such as electricity usage, import data, and housing starts have been horrible. While the S&P 500 and its tracking exchange traded fund, SPY (NYSEARCA:SPY), has rallied over 15% since the summer lows of last year, and stocks such as Apple (NASDAQ:AAPL) are up over 30% in the last year, Chinese equities have rallied very little.

China's real estate and construction industry was massively overbuilt after the 2008 recession as part of the government's coordinated stimulus program. While the U.S. allocated less than a third of the nearly $800 billion Recovery and Reinvestment Act to infrastructure spending, Chinese provinces took on massive amounts of debt with interest rates at very low levels, and built ghost towns throughout the country's major cities.

Still, while Chinese demand for raw materials and commodities such as iron ore and copper has fallen significantly over the last couple years, copper prices appear to be stabilizing at around $3.50 a pound. Many leading commodity and bulk metal companies, such as Freeport-McMoRan (NYSE:FCX), Rio Tinto (NYSE:RIO), and BHP Billiton (NYSE:BHP), are also now trading at or near these stocks' 52-week lows. Many steel companies and iron ore producers, such as Arcelor-Mittal (NYSE:MT), Cliffs Natural Resources (NYSE:CLF), and Patriot Coal (PCX), have also sold-off over 50% in the last year.

Freeport-McMoRan is a nearly $33 billion company that primarily produces copper and gold. While Freeport-McMoRan also produces cobalt, silver, molybdenum, and other metals, over 70% of the company's reserves are copper. Freeport-McMoRan hedges very little of its copper production.

Freeport-McMoRan's recent fourth quarter earnings report was one of the worst reports in the company's history. In addition to facing falling copper prices, the company saw its energy and labor costs rise nearly 30%, and copper production at some of the company's biggest mines in Indonesia faced huge supply disruptions with major strikes and significant disruptions in fuel supply resulting from the civil strife.

Still, while Freeport-McMoRan's recent earnings results have been disappointing, there are some strong signs the company's worst challenges are behind it. Freeport-McMoRan's costs exploded in the fourth quarter primary because of the labor settlement the company reached in Indonesia, which included a 3 month bonuses paid up front, and rising energy costs, primarily driven by oil prices spiking in October of last year. Freeport also faced labor strife in Peru.

While oil prices rose significantly more than copper prices rallied over the last year, oil prices have collapsed as the dollar has risen, oil inventories have reached their highest levels in nearly a year, and Iran has begun to cooperate with International Authorities on its nuclear program. Freeport-McMoRan actually saw the average price of copper drop during the last year, while energy prices rose 30%. Now that China appears to be stabilizing and copper companies such as Freeport continue to face supply issues, copper prices are likely to hold up fairly well even as energy prices continue to decline.

Freeport-McMoRan's labor issues are also likely to be resolved more favorably in the future. While the company faced major strikes in Indonesia, the company has agreed to significant wage increases with a large up front payment. The strike in Indonesia impacted Freeport-McMoRan's operations massively, with copper production in Indonesia dropping from nearly 300 million pounds in the fourth quarter of 2010, to just 68 pounds in the fourth quarter 2011.

The company's costs in Indonesia exploded because of the company decision to pay a significant up front bonus payment to labor groups, with Freeport-McMoRan facing nearly $7.00 a pound in costs in the fourth quarter of 2011, compared to nearly $1.50 a pound in the fourth quarter of 2010. Still, while Freeport-McMoRan was unable to reach a multi-year pact with labor groups in Indonesia, in addition to paying nearly three months wages up front, the company agreed to index future wages to the cost of living and raise wages by 24% in the first year, and 14% next year. Freeport-McMoRan also agreed to extend benefits such as pension, housing allowances, and educational benefits.

Additionally, the company is also in discussions with the government of Indonesia over a possible 25% royalty tax, but the company remains confident the government will honor the 2011 agreement the company reached with government leaders not to impose significant new taxes or royalty charges. In Peru, Freeport-McMoRan was able to reach a multi-year labor agreement with unions at the company's Cerro Verde mine.

Still, despite Freeport-McMoRan's labor and cost struggles, the company was able to generate nearly $5 billion in cash flow, and management recently raised the dividend by 25% in February. Freeport-McMoRan has raised its dividend by 10% on average over the last five years, and the company's payout ratio of 25% is conservative. The company also refinanced its long-term debt at 3%, enabling the company to call its long-term bonds that were paying out over 8%.

To conclude, while Freeport-McMoRan has faced spiking energy costs, labor disputes, and falling copper prices, the company's costs are falling and copper prices appear to be stabilizing. Freeport-McMoRan's refusal to hedge prices positioned the company strongly for the rise in copper prices after 2008, but the company's hedging policies also made it more vulnerable to the recent decline in copper prices.

Still, China comprised nearly 40% of the global copper demand in 2011, and Chinese copper imports increased by 52% year-over-year during the first five months of 2012. Brazilian copper use also increased nearly 12% from 2010 to 2011, rising from 360 million tons to nearly 400 million tons. While demand for bulk and base metals will likely remain volatile as the growth outlook continues to weaken, supply concerns should likely keep copper prices from falling significantly from today's levels, and the company's earnings could accelerate significantly if copper prices rise in the second half of the year because of stimulus or improving growth.

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