Freeport-McMoRan: Sell-Off Is Justified; Acquisitions Have Little Strategic Rationale

| About: Freeport-McMoRan Inc. (FCX)
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Shares of Freeport-McMoRan Copper & Gold (FCX) lost 16% in Wednesday's trading session. Freeport will acquire Plains Exploration & Production (PXP) for $6.9 billion and acquire McMoRan Exploration (MMR) for another $3.4 billion.

The Deal

Freeport-McMoRan announced two large acquisitions on Wednesday for a total equity value of roughly $10.3 billion. Including the assumption of debt, Freeport will pay $20 billion for both companies.

Shareholders of Plains Exploration & Production will receive $3.4 billion in cash and the remainder in shares. Freeport will offer 0.6531 of its own shares, for each share of Plains. In total the offer values Plains at $50 per share, which represents a 39% premium compared to yesterday's closing price. Freeport will furthermore assume Plain's massive $10.4 billion net debt position, predominantly the result of the acquisition of Royal Dutch's (RDS.A) assets in the Gulf of Mexico.

Freeport will acquire McMoRan for $14.75 per share in cash, and 1.15 units of a royalty trust which holds a 5% overriding royalty interest in future production from existing ultra-deep exploration properties. The offer represents a 74% premium compared to yesterday's closing price.

With the acquisitions, Freeport-McMoRan attempts to create a premier US based natural resource company. High quality US oil and gas assets will be added to its global mining portfolio.

Freeport's Richard C. Adkerson commented on the deal, "The transaction will add a high quality portfolio of assets with strong current cash flows, significant growth options and complementary exposure to markets positioned for global growth in the developed and developing world and reflects our positive view of the factors that will drive demand for copper and other commodities."

Freeport has received $9.5 billion in financing commitments from J.P. Morgan Chase (JPM) to fund the cash portion of the deals and pay off revolving debts.

Freeport made certain assumptions of global commodity prices for its 2013 outlook. Freeport forecasts average prices of $3.50 per pound for copper, $1,500 per ounce of gold, $12 per pound of molybdenum, $100 per barrel of Brent Crude and $4.50 per MMbtu for natural gas.

Based on current production levels, combined EBITDA could come in at $12 billion, with operating cash flows totaling $9 billion.

In total, Freeport will add 575 million barrels of oil-equivalents of proven reserves by making both deals. Proven and unproven reserves combined could almost add 1.6 billion barrels of oil-equivalent. Both companies reported a combined average daily production volume of 182,000 barrels of oil equivalent per day over the past quarter.

The deals will be subject to shareholder approval of both companies and regulatory approval. The deal with Plains is expected to close in the second quarter of next year.


Freeport ended its third quarter of 2012 with $3.7 billion in cash and equivalents. The company operates with roughly $3.2 billion in short term debt for a net cash position of $0.5 billion. The net debt position on a pro-forma basis will increase to $16.3 billion as Freeport will take on a lot of debt to make these acquisitions.

For the first nine months of 2012, Freeport generated revenues of $13.5 billion. The company reported a net income of $3.0 billion, with $2.3 billion attributable to shareholders. Net earnings per share came in at $2.41 per share. Based on a simple extrapolation, full year revenues could come in around $18 billion. Full year earnings to shareholders could total $3.1 billion, or around $3.25 per share.

Factoring in Wednesday's declines, the market values Freeport at $30.5 billion. This values the firm at roughly 1.7 times annual revenues and 10 times annual earnings.

Freeport pays a quarterly dividend of $0.3125 per share, for an annual dividend yield of 3.9%

Some Historical Perspective

Year to date, shares of Freeport have fallen some 13%. Shares started the year around $37 per share in January and reached highs of $47 in February. Shares fell back to lows of $32 during the summer on worries about global economic growth and certain commodity prices. Shares recovered to highs of $42 in recent weeks and are currently exchanging hands at $32 per share.

Shares of Freeport fell from highs of $60 in 2008 and fell to lows of $8 later that year. Shares recovered to highs of $60 in the beginning of 2011, before losing half of their value. An uncertain global economy and volatile commodity prices resulted in volatile earnings, but Freeport has been able to report billion dollar profits over the last four years.

Investment Thesis

The significant addition of debt and weak strategic rationale raised some questions with commentators, analysts and investors on Wednesday. Recent deals between mining and oil and gas companies have not played out well. BHP Billiton took large write downs on natural gas assets acquired for $5 billion from Chesapeake Energy (CHK) in 2011, for example.

It is difficult to justify the control premium on limited synergies and the "strategic" rationale alone. It is quite worrisome that all companies involved are not 100% independent before entering the deals. Freeport and McMoRan split themselves up two decades ago. CEO Jim Moffett of McMoRan currently serves as Freeport's Chairman of board of directors. CEO James Flores of Plains also serves on the board of McMoRan as the company owns a 31.5% stake in the business.

Furthermore, Flores stands to make $150 million from the deal. After the deal has been completed, each executive will remain in a leading job at Freeport. Mofett will be the Chairman, while Adkerson remains CEO. Flores will become the head of the oil division and function as vice-Chairman of the company as well.

Freeport defends the deal rationale by pointing towards the increased risk of nationalization across the globe. The deal would furthermore diversify the geographical operations as well as boost the presence in the oil and gas industry. Geographical risks should furthermore decrease as the acquired assets are located in the politically stable North America.

The company also points out the favorable financial forecasts. EBITDA of the combined entity will increase to an estimated $12 billion in 2013, compared to almost $7 billion over the past year.

I see a few big red flags in these deals including a large assumption of debt, poor strategic rationale, and a questionable corporate governance culture. The sell-off is warranted as acquisition premiums result in multi-million payouts to executives. This is not to say that deal could not become successful. At this moment it seems more like a levered bet on the fate of the world economy in a deal that makes insiders very rich.

I remain on the sidelines.

Disclosure: I 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.