Freeport-McMoRan (NYSE:FCX) reported first quarter results before the opening bell on Thursday, and Wall Street greeted the numbers with some enthusiasm, sending shares up 1.5%. As expected, the first quarter was rather messy. The company is embroiled in a bitter dispute with the Indonesian government regarding an export tax that was implemented in January. To avoid paying this tax, exports from copper and other metal producers have dropped dramatically, which poses a negative risk for the Indonesian economy. There have been negotiations between the miners and the government to cut the tax and restart exports. I expect some deal to be reached within 3-6 months at which point exports would return to normal. In addition to the Indonesian headaches, fears have grown that China's economy is slowing down, which has pushed copper prices lower.
Given these problems, it is unsurprising that earnings were lower year over year with EPS of $0.49 compared to $0.68 a year ago (all financial and operating data available here). Thanks to the acquisition of oil producers, revenue was up 9% to $4.985 billion. Analysts were looking for $0.41 on sales of $4.988 billion, so earnings were a solid beat while revenue was right in-line. Going through the report, there are some signs of strength, and FCX shares continue to be undervalued.
Due to the slowdown at its Indonesian operation, Copper sales were down about 9% to 871 million pounds. Similarly, FCX's gold sales were down 13% to 187,000 ounces. Gold is mainly mined as a byproduct to copper, so its production tends to be highly correlated. It is important to recognize that this decline is not a result of operational weakness; it is the conscious effort to slow down activity in Indonesia to avoid an excessive tax. In North America, copper sales were up 5% and production was up 12%. In South America, sales were up 7% and production was up 5%. In Indonesia, sales were down 45% and production dropped 36%.
FCX's operations in the Americas are showing growth, and the company has cut its activities in Indonesia to avoid the export tax. Once the problem is resolved, Indonesian operations will return to normal, and the company will return to overall production growth. In the second quarter, FCX expects to sell 1.1 billion pounds of copper, up 26% sequentially. This suggests the company expects a resolution of the Indonesian tax situation very shortly. Without Indonesia at full capacity, the company would struggle to get past 1 billion pounds, let alone 1.1 billion. This guidance is very positive for investors.
During the quarter, copper prices declined in part due to a slowdown in China's economy. Averaged realized prices were $3.14 per pound, which is down from $3.51 a year ago. For its cash flow guidance, FCX expects an average price in 2014 of $3.00. In other words, pricing pressure will remain. However, we are seeing improvements in developed economies, and the Chinese economy remains healthy. Over the next three years, I expect solid demand for copper and prices to move back towards $3.50 in 2015. Copper accounts for the vast majority of FCX's revenues, so solid pricing and demand is critical for its future. Freeport has also worked diligently to cut cost from its operations to deal with lower prices, and cash cost per pound came in at an excellent $1.54, down from $1.57 a year ago.
During the quarter, FCX's oil operations continued to be an area of strength. While some analysts and investors were unhappy when FCX moved into oil fifteen months ago, this unit has shown consistently strong results and solid cash flow generation. The company produced 16.1 million barrels of oil equivalents ("MMBOE"). I was looking for a figure closer to 15.3 MMBOE. In the second quarter, FCX is guiding to 15.2 MMBOE, but I expect the company to solidly exceed this figure. FCX had an average selling price of $93.76 compared to a cash cost of $18.51. FCX's oil unit generated $947 million of operating cash flow against $581 million in cap-ex. This unit should provide solid incremental cash flow, which is critical if FCX will pay down its debt, which currently stands at $20.85 billion.
FCX has targeted cutting its debt position to $12 billion by the end of 2016. It will use free cash flow and potential asset sales to meet this target. FCX now expects to generate a bit of free cash flow in 2014, which is a positive development considering the tough pricing environment and Indonesian headwinds. It forecasts $7.7 billion in full year operating cash flow against $7 billion in cap-ex for $700 million of free cash flow. This year should be the peak year for cap-ex. In 2015 and 2016, we should see increasing operating cash flow and declining cap-ex needs, which will lead to a significant expansion in free cash flow.
Over 2014-2016, I now expect FCX to generate operating cash flow of at least $24-25 billion. Its dividend will cost about $4 billion, and cap-ex could total $14 billion, leaving $6 billion to pay down debt. To meet its $12 billion debt target, it would need to sell about $3 billion worth of assets, a very manageable goal. After these earnings, I expect FCX to earn $3.40-$3.50 in 2014, meaning it is trading at 9-10x earnings. Given its strong operations, solid reserve base, and low cash cost, this is an attractive multiple. I expect shares to rally past $40 this year.
Disclosure: I am long FCX. 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.