It may sound sarcastic or cynical, but if the news flow around copper miner Freeport-McMoRan (NYSE:FCX) is terrible, it's probably time to think about a good entry price. Certainly, there are worries pushing down on valuation today -- worries tied to production costs, worries tied to global growth and implied demand, and worries tied to ongoing saber-rattling from the Indonesian government. The reality, though, is that this is what it looks and sounds like when companies like this bottom out. When the news turns positive, that may just be a signal to look for the exit.
Q2 Pretty Good, But Costs Keep Rising
All in all, Freeport-McMoRan delivered a solid second quarter, though the reported numbers surely don't look good at first glance.
Revenue fell 28% from last year and 9% from the first quarter, as weak price realizations in copper (down about 16%) and softer than expected production volumes in gold offset good copper production results. Freeport also saw significantly higher production costs, as the cash cost of producing a pound of copper jumped 65% from last year and 22% from the first quarter. That, in turn, led to a 45% year-on-year decline in adjusted EBITDA and a 15% sequential decline as well.
All in all, that was good enough for the company to post a slight beat relative to analyst expectations.
Indonesia Still The Talking Point
Aside from generalized anxiety about global growth and its implications for copper prices, the Street seems most concerned with the steady drumbeat of scary words coming out of Indonesia. The squabble isn't anything new. Indonesia has been trying to work itself out of laws and contracts in the mining industry that seemed like good deals when global copper mining interest was low, but no longer seem like such great deals.
In the case of Freeport and Indonesia, government officials are talking about trying to limit foreign ownership of mineral assets to 49% (thus forcing a significant sale of Freeport's 90%-owned Grasberg property) and implement sizable export taxes. While the company has various agreements with the government that supersede these rules and call for international arbitration, experienced commodity investors know that there's a world of difference between what's on the page and what's enforceable on the ground.
Nevertheless, I think this is a lot of bluster and positioning ahead of a more reasoned (and reasonable) settlement. Freeport may well decide to sell down its ownership stake in Indonesia via a local IPO, as Vale (NYSE:VALE) has done with its nickel assets. Likewise, the tax issue will mostly likely be resolved by a renegotiated royalty agreement. If nothing else, the Grasberg mine is entering a new phase of its life -- one that requires substantial capital investment -- and I'm not sure the government can afford to allow that to go off track.
Even in the worst-case scenario, though, this company is not exactly doomed. Yes, Indonesia accounts for a sizable percentage of Freeport's copper reserves (and nearly all of its gold reserves), but the company has already substantially diversified its production base (less than 20% of this quarter's copper production was in Indonesia). Additionally, growth projects out through 2016 will further lessen the primacy of Indonesia to Freeport-McMoRan.
The Push-Pull Of Demand
Freeport management has maintained that the actual market for copper is healthier than many analysts seem to think it is, and I'm inclined to go along with that. Either way, the reality is that the markets are nervous on the near-term growth outlook for economies like China, but still optimistic on the long-term. Given the unsuitability of recycled copper for many pollution control, electronics, and energy-tech apps, I don't think the copper story is over yet, even if others like BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO) are looking to increase production alongside Freeport.
One other issue of note impacting demand is the possibility of a physical bullion copper ETF. Like the well-known physical precious metal ETFs, this would require the purchase and warehousing of a meaningful amount of copper -- meaningful enough that copper buyers are loudly complaining about the idea and trying to convince regulators to prevent the ETF from being created. Given that I think it's unlikely that these objections will carry the day, the copper market could be getting a boost from a new buyer in the not so distant future.
The Bottom Line
With the sort of production that Freeport intends to bring online through 2016 (increasing overall production by about a third from 2011 levels), it's going to take some truly serious copper price deterioration and cost inflation for Freeport not to show some meaningful growth in the next three to five years.
Of course, skeptics will say that this sort of production increase is exactly what marks the end of the good times. Fair enough. But I do think it's a question of degree.
Large miners like Freeport usually see a 7x forward EBITDA multiple over the full cycle. Even at a trough multiple of 5x, these shares look to be worth nearly $50 today and a 4x multiple will still get you to $40. Unlike coal, there aren't a lot of easy substitutes for copper. And although the turbulence in Indonesia is unnerving, buying into the bad times is often a good strategy with commodity stocks, so long as you can withstand the bad times deteriorating to "even worse" before rebounding to "better."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.