Overview

A strategic decision to acquire PXP/MMR, fears of China slowdown (copper weakness) and institutional shareholder turnover has resulted in an opportunity to buy FCX for a price ($32 per share) normally associated with S&P at 1000 and a VIX at 40-50. 

FCX is undergoing a strategic transformation from a pure copper equity to a copper/oil/natural gas commodity major.  Its closest comp will be BHP.  FCX currently trades at 3-4X EV/EBITDA while BHP is 6-7X EV/EBITDA.  On an absolute and relative basis FCX is cheap and presents an opportunity over the next 12-24 months to appreciate 50%-75% with minimal permanent loss of capital risk. FCX also has a 3.7% current dividend yield that pays you to wait and very liquid options markets.

Why did FCX do the PXP/MMR deal?

The deal has been criticized as FCX throwing a life preserve to MMR and its driving force Jim Bob Moffett who is also Chairman of FCX. 

Jim Cramer’s outrage http://www.thestreet.com/story/11785017/1/freeports-deals-fail-the-smell-test-jim-cramer.html

My take is FCX did the deal/deals for a much simpler reason – FCX copper/mining operation is generating a lot of cash over the next 3 years that has to be deployed.  There are simply no scale green-field copper assets globally to acquire in safe political jurisdictions.  RIO recent dealing with the Mongolians on Oyu Tolgoi mine shows the risk of developing new world-class copper assets. 

In acquiring PXP/MMR FCX gets safe US legal jurisdiction and helps diversify its corporate risk and cash flow profile in the long run.  FCX is moving closer to BHP just without the valuation multiple for now. 

The deal also allows FCX to lever up its balance sheet and borrow money for 30 years at 4%.  I view the deal more as a LBO of PXP/MMR by FCX than anything else – it’s using some copper cash flows over next 3 years to buy safer jurisdiction cash flow generating oil and gas assets. http://www.fcx.com/ir/2012present/States_IR_DEC12.pdf

I owned PXP prior to the deal in December cause I had the stock valued at between $50-$70.  FCX bought it for the low end of $50.  Currently the risk arb spread is negative implying a bump or voted down deal by PXP shareholders – more on that later.  My view is FCX got a great deal in PXP and was able to retain PXP natural gas assets in the Haynesville.       

MMR has a long write and discussion up on VIC.  I view the MMR transaction as a great long term buy for FCX as only a oil major or FCX/BHP can develop the natural gas fields in the ultra deep (Linehman creek).  MMR has a capital intensity and resource potential than cannot be funded or developed as a standalone company.  FCX has the balance sheet to develop the ultra deep resources to MMR including eventually building with Chevron some form of LNG export facility. 

The tough part has been selling the acquisition to the street, as there is no natural synergy between oil and copper business.  There has been no good pro-forma model put out by the sell side and eventually getting the sell side mining analysts to cover the FCX will require a fair bit of help from their E&P colleagues.   The institutional investors who owned FCX prior to the deal owned FCX cause they wanted a pure copper equity story.  Their view was if they wanted E&P exposure they would have gone and bought E&P equities and did not need FCX to do it for them.  This has caused selling, as investors want a pure copper story – why FCX traded from 38 to 30-32 after the deal and missed the December rally in copper equities. 

FCX unlike me has not come out and said we did this deal as a way of levering the balance sheet, doing an LBO of some cheap oil and gas assets and creating a mini BHP without the bad assets (iron ore).  Now please reduce the valuation discount to BHP given our more diversified asset base and lower country risk. 

Copper

Fears of a China slowdown (its was a hard landing last year) has overshadowed all commodities in the last 12 months.  A year ago there was talk of a China hard landing with a rapid deterioration in economic activity.  Now the talk is of government policy to slow down a rapidly overheating housing sector. 

China is undergoing its next stage of economic development and it will have an impact of the global commodity markets, as China is the marginal buyer of most commodities in the global supply chain.  The transition from fixed asset investment to a more consumer demand driven economy is not going to be smooth or without bumps.  There will be a lot of government involvement in a planned/controlled economy in China.  The transition should be negative for iron ore – see the iron ore short idea on VIC.  However, I expect it to be positive for oil and copper.  Using Japan and Korea, as models for China to develop into a consumer driven economy would require a 5-fold increase in per capita copper consumption.  Now I don’t expect China on a per capita level to become Japan or Korea overnight.  But the path to a consumer demand driven society is very copper intensive – much more than iron ore or steel. 

Add in US housing recovering and eventual European growth the demand picture for copper in the medium and long term is positive.

The supply for copper long term is a messy.  The large scale current copper mines have extracted most of their easy copper and are entering more complicated and difficult extraction of ore bodies.

New large-scale projects like Oyu Tolgoi in Mongolia (RIO/TRQ) are seriously risked by resource nationalism.  Large-scale prospects in safe political jurisdictions like the Pebble Project (NAK) have serious environmental issues limiting development.  As the mining majors scale back projects with new CEOs – the old ones were fired for poor deals/large projects  - the supply of copper should be tight. 

A copper price between $3-$3.50 a pound allows FCX to take debt from 16 bil. to under 2 bil. by 2016.   This is where copper futures are currently trading.  My long term view is copper realized prices will be higher than futures as global economic growth (nominal) averages 3-5 percent, US housing picks up and China transitions (with a lot of government involvement) to a more consumer demand centric economy (more growth in per capita consumption of copper and less growth in per capita consumption of steel)

FCX Value Drivers

Deal closing - The arb pressure that is shorting FCX is reduced.  The negative spread makes no sense to me – FCX by its global emerging market mining business model cannot be seen bumping PXP deal cause arbs have expectation of a bump.  If PXP votes down the deal FCX should go up as it goes back to being a pure copper story. 

Sell side builds pro-forma models for FCX with energy assets being correctly valued. 

Institutional shareholder base is rotated and new value shareholders come into the name.

Value investors see a company trading at sub 4 times ev/ebitda going forward and an asset base and cash flow profile than is more diversified than a pure copper equity. 

Valuation gap with BHP closes.

FCX Risk Factors

 Global economy enters into another 2008 type liquidity event and recession.

Chinese and US nominal economic growth stalls. 

Major copper finds or Oyu Tolgoi phase II is fast tracked.

Deal closing - The arb pressure that is shorting FCX is reduced.  

Sell side builds pro-forma models for FCX with energy assets being correctly valued. 

Institutional shareholder base is rotated and new value shareholders come into the name.

Value investors see a company trading at sub 4 times ev/ebitda going forward and an asset base and cash flow profile than is more diversified than a pure copper equity. 

Valuation gap with BHP closes.