The story of Freeport-McMoRan (NYSE:FCX) is that of a painful journey for long-term holders of the stock as the company diversified into oil and gas at exactly the wrong moment, incurring a lot of debt before oil prices came crashing down.
Little over a year ago, that is March of 2017, I concluded that the story continues to improve following firmer copper prices and deleveraging efforts, as the situation regarding the ownership and future ownership of Grasberg continues to create an overhang on the stock.
Shares traded around $12 at the time of writing and gradually rose to a peak of $20 in January as they have sold off quite aggressively again to current levels just above the $15 mark at the moment of writing. That is despite the resilient copper prices, which we have witnessed over the past year as Indonesian uncertainty is weighing on the stock.
After having spent $20 billion to built up an oil & gas business, Freeport was forced to sell these assets for just a few billions a few years later, and that does not even include the large capital expenditures being made in the meantime. These deals nearly bankrupted the company as shares plunged to just a few dollars in early 2016 before shares gradually recovered amidst a recovery in commodity prices, the issuance of shares and divestments of non-core assets.
Those actions paid off, as it coincided with a recovery in copper prices, as Freeport was plagued by other issues, mostly a stand-off with the Indonesian government, which remains a very uncertain factor and a party that has great ¨leverage¨ on Freeport.
Ever since a lot of things have changed in the operations, mostly for the good. In January, Freeport posted its results for 2017. The company grew sales from $14.8 billion in 2016 to $16.4 billion last year, driven by higher gold production and higher copper prices, in part offset by declines in copper production.
The vast majority of revenues are derived from copper. While production fell from 4.2 billion pounds in 2016 to 3.7 billion pounds in 2017, this was more than offset by prices per pound having risen from $2.28 per pound in 2016 to $2.93 per pound in 2017. Prices even hit a high of $3.21 per pound in the final quarter of the year.
The company reported operating profits of $3.6 billion last year, for relatively healthy margins as higher prices in the final quarter of 2017 even pushed up operating earnings to nearly $1.5 billion for the quarterly period. After accounting for $800 million in interest and a reasonable 30% tax rate, earnings came in at $2.0 billion in 2017, or even $3.5 billion based on the annualised fourth quarter numbers. With 1.45 billion shares outstanding, that translates into earnings power of $1.40 based on 2017 earnings numbers, or numbers as high as $2.40 per share based on the fourth quarter results.
This earnings power is pretty solid as cash flow conversion is pretty decent as well. Capital spending totalled $2.1 billion in 2017, coming in just $400 million more than actual depreciation charges, resulting in relative decent cash flow conversion. Furthermore, leverage is rapidly coming down. Holding $4.0 billion in cash, Freeport ended the year with net debt of $9.0 billion, although that number excludes roughly $4 billion in environmentally-related liabilities.
With operating earnings of $3.6 billion (as reported in 2017) and adding back $1.7 billion in depreciation charges, leverage ratios are modest at 1.7 times EBITDA (if environmental liabilities are excluded). These ratios stand at just 1.2 times if we look at the annualised fourth quarter results.
First quarter results were pretty solid as well, driven by realized copper prices of $3.11 per pound, ten cents less than Q4 of 2017. These solid prices supported a 45% increase (on an annual basis) in quarterly sales to $4.87 billion, but more importantly allowed operating earnings to more than double to $1.46 billion. While interest expenses are trending at rates closer to $600 million a year, it was a relatively steeper tax rate, which depressed net earnings to $817 million, or $692 million after accounting for non-controlling interests.
This makes that earnings are still trending at close to $2 per share this year, for very decent earnings yields. As copper prices trend at the same levels as the first quarter, there is no reason to assume that second quarter results will change in a meaningful way, absent of large moves to come.
Cash generation and repayment of debt made that cash holdings fell to $3.2 billion at the end of Q1, but as debt has fallen to $11.6 billion, net debt fell to $8.4 billion, while environmental liabilities were flat at $4.0 billion. The good news is that Capex is seen around $2 billion this year, not resulting in significant cash outflows, or any net investment cash outflows at all. That makes that net debt, which has already been cut dramatically from a peak of >$20 billion, is set to come down further.
The problem resides in Indonesia of course in which Freeport co-owns the very profitable Grasberg mine. In essence, Freeport owns 90% of the joint venture which operates the mine, yet the government and the company reached an agreement in August of last year to prolong mining rights to 2041 in exchange for the construction of a smelter at the location. Freeport would furthermore reduce its stake from +90% to 51% by selling it to Indonesian investors at ¨fair¨ market value.
While the Indonesian assets are only responsible for roughly 1.2-1.3 billion pounds in annual production, on the back of a 4 billion production number for all of Freeport's copper businesses, the by-products such as gold and silver make it very lucrative.
This makes that the business in Indonesia was responsible for 70% of the reported operating earnings in Q1. Even as these earnings are taxed at very high rates and a divestment of the stake from 90% to 51% should theoretically take place at fair market value, investors are scared when they hear about complications in this region.
The reason is very simple, if you assume that mining copper is the main business in Indonesia, the sales of by-products such as gold and silver actually already cover the mining costs in their entirety, making that all the copper revenues (and some more) are pure profits!
It seems that the Indonesian government continues to demand greater control and ownership of its natural resources, as export licenses and environmental permits give it a lot of leverage versus Freeport. The demand from the government that Freeport should deposit more of its mined non-usable product to landfills would be really dilutive to earnings of the joint venture, and is a shock for investors even as CEO Mr. Adkerson believes a solution can be found.
Let's assume in a dramatic case that Freeport would have to reduce its stake in the mine from 90% to 51%, which should in theory occur at fair market value, but in reality might not. At the moment, the company earns about $2.8 billion after-taxes and non-controlling interest, of which 70% is generated by Grasberg. If the company would have to give up an additional 39% stake, Freeport's shares of Grasberg's profits would fall by 44%, which would cut its overall earnings by roughly 30%.
Working with that assumption, current annualised earnings power of $1.90 per share (based on Q1 results) would fall towards $1.25 per share. Of course Freeport would probably still obtain quite a few billions from the Indonesian investors in exchange for its 39% stake which it would have to divest, even if this takes place at a valuation, which is lower than "fair."
This makes that proceeds from part of the stake in Grasberg and current earnings power has the potential to nearly wipe out the entire net debt load of the business. Following such a move, the overhang of Indonesia on the stock could fall significantly and $1.25 per share in earnings power with a very clean balance sheet might reveal upside with shares trading at 12 times earnings at current levels around $15 per share. Hence I bought a modest stake following the earnings plunge.
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Disclosure: I am/we are 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.