|Shares Out. (in M):||1,458||P/E||5.96||11.64|
|Market Cap (in $M):||14,552||P/FCF||2.4||5.4|
|Net Debt (in $M):||6,571||EBIT||6,200||3,200|
Freeport-McMoRan recently announced the successful completion of a surprisingly favorable transaction with the Indonesian government, removing the most meaningful risk factor depressing the company’s stock price and opening the door to suitors seeking to acquire the company. In fact, after the stock market closed on Christmas Eve, an article in The Sydney Morning Herald, which covers Rio Tinto extensively, speculated that Rio would seek to acquire Freeport-McMoRan. The underlying logic for such an acquisition is as follows:
1) The price outlook for copper is better than that of iron ore, the metal to which Rio Tinto is primarily exposed. “With big new (copper) deposits rare, slow and expensive, supply of the red metal will eventually lag demand as the world further electrifies.” Freeport has an interest in three of the top five producing copper mines in the world, and there are indications that its Lone Star deposit in Eastern Arizona could emerge as an additional world class sulfide resource.
2) Freeport’s long-time CEO, Richard Adkerson, is 71 years old and a sale of Freeport to Rio Tinto could be a superior option to an internal succession plan.
3) Freeport has favorable geographic exposure, with 75% of its production and 71% of its reserves in North and South America.
4) In December 2018, Freeport announced a favorable resolution with the Indonesian government regarding PT Freeport Indonesia’s (PT-FI) long-term mining rights and share ownership of its Grasberg mining operation. Under this agreement, Freeport’s economics were virtually unchanged with a 48.8% share ownership and 81.28% of the economics accruing to the company through 2022. Importantly, the Government of Indonesia granted PT-FI a new special mining license, enabling PT-FI to conduct operations in the Grasberg minerals district through 2041. This deal resolved the most significant overhang plaguing Freeport, and as the article in the Sydney Herald indicates, “Having agreed to cede its majority stake to a local group, Freeport has also paved the way for an eventual full exit.”
It has been evident throughout this year that Rio Tinto is hard at work trying to close a large copper acquisition. In June 2018, for example, a Reuters article titled “Rio Tinto ready to splash out on copper” indicated that “The global miner would be willing to fork out a large premium over market value to secure a prime asset as it tries to reduce its reliance on iron ore, company and banking sources told Reuters.” With respect to potential premiums Rio Tinto might be willing to pay for a copper M&A transaction, “One banker with knowledge of the matter said for high-quality assets, where there are large deposits of high-grade copper, Rio Tinto would be ready to pay a premium of 30-40 percent over any target’s stock market value or, if unlisted, over the value of the project’s copper reserves.” FCX closed at a price of $16.79 at the time the Reuters article was written, implying a potential takeout value of $21.83 to $23.51 at a 30-40 percent premium.
Freeport’s CEO, Richard Adkerson, said on the company’s 3rd quarter conference call, “When we look through projects around the world that we're looking at and others are looking at, we see its $8 to $10 a pound to develop capacity. And that means on that simple high-level metric that the implied replacement cost for our current capacity is on the order of plus or minus $40 billion.” Freeport’s copper equivalent reserves are 4.5 billion lbs. At $8 - $10 per lb, this equates to $36 - $45 billion. The company has 1.458 billion shares outstanding and net debt of $6.571 billion. Hence at no premium to a $40 billion aggregate replacement value, FCX would be worth $22.93.
With 7 to 10 year development periods for new copper resources, a dearth of world class deposits, Freeport’s low cost position virtually assured for the next 22 years with the closure of its deal in Indonesia, and the company’s extensive development pipeline, however, the above analysis is arguably much too conservative.
Freeport’s Fundamental Outlook
Although copper fundamentals are very strong with exchange inventories steadily declining, smelter disruptions and scrap constraints in China, speculators have driven down the price of the base metal from a 2018 high of ~$3.30 per lb in mid-2018 to $2.66 per lb currently. As Richard Adkerson indicated on Freeport’s third quarter conference call, “When you look at the fundamentals, U.S. constructions and manufacturing remained positive, Europe is steady and positive, large Chinese fabricators are running at higher rates. Our customers have strong order books for us in the United States and business in China is good. Cathode availability is tight globally. There's issues with smelters disruptions in Chile and elsewhere in India. China is constraining scrap. Global stocks are down 40%, since the copper price was well over $3, almost $3.30 in early June, and this is a multi-year low stocks.” The long-term outlook for copper has rarely been more constructive and a supply gap is fast approaching. The electrification and renewables themes will continue to propel demand while recent price declines are adversely impacting new project development, making an already benign new supply picture even more favorable.
Freeport is in a unique position of having low unit costs of only $1.06 per lb including by-product credits (at $1,200/oz gold and $12/lb molybdenum), enabling the company to sustain profitability in almost any conceivable market environment. The company’s net debt is down $2 billion since the beginning of 2018 and a whopping $14 billion since 2016 to $6.571 billion. Its leverage ratio based on last twelve month EBITDA has declined to only 0.8X, making the company significantly underleveraged and derisked.
As production from the Grasberg open pit winds down in 2019, Freeport will have two very well telegraphed transition years in replacing production underground with its Deep MLZ startup scheduled for mid-2019 and its Grasberg Block Cave ramping up. Although this will have an adverse effect on Freeport’s near-term cash flow, the company expects copper production to ramp up 50% in 2022 from its impressive 1.2 billion lbs expected in 2018. The 2022 production run-rate should establish a base from which to gradually grow for the remaining 20 years, leading investors and potential acquirers to essentially ignore Freeport’s near-term production decline.
FCX's trailing 12 month adjusted EBITDA from operations was $7.97 billion, implying an EV/TTM EBITDA multiple of just 2.65X. Given that Freeport's copper production is set to rebound to all-time highs in the early 2020's, it could be argued that this EBITDA figure is closer to a normalized number than the expected cash flows over the next two transition years. According to Freeport’s third quarter earnings call, at $3.50/lb copper, the company’s annual EBITDA would be $5.9 billion for the transition years and $9 billion for the subsequent years. Long-term average EV/EBITDA multiples for large cap mining stocks range from 6-8X, implying potential upside of >200% in FCX's share price from current levels.
There are four significant potential catalysts for Freeport:
1) An acquisition of FCX - With a favorable deal for PT Freeport Indonesia’s (PT-FI) long-term mining rights and share ownership of its Grasberg mining operation behind the company, it appears that all of the puzzle pieces are in place for suitors like Rio Tinto to pursue an acquisition of FCX.
2) Market's appreciation of Freeport's Indonesia deal - Freeport's stock declined ~20% in late April largely as a result of uncertainty over Indonesia (it also missed expectations) and this overhang persisted throughout the year. The final resolution was much better than expected, and as Richard Adkerson indicated on the company's third quarter conference call, "We're only having to divest an effective just over 5% interest in the property. A year ago, we thought we might have to divest 27%. So that avoided a very difficult negotiation and so forth." Although this catalyst has already transpired, the final deal was announced during the worst December on record for the stock market. Once the market stabilizes and market participants refocus on fundamentals, it is possible that FCX will be revalued as the magintude of this catalyst is digested.
3) Stronger commodity prices - A rebound in copper and gold prices next year could yield upside to numbers. Each $0.10 change in copper prices is expected to impact Freeport’s EBITDA by $325 million and each $50 per oz change in gold prices by $40 million. The copper market is expected to be in a deficit and prices could surge with increased fiscal and monetary stimulus in China in conjunction with a trade agreement between China and the U.S. in early 2019. Also, gold has been rising beyond Freeport's implied projections recently, as a more dovish Fed and a potential reversal in the dollar have been supportive.
4) Exploration upside - Drilling results in Freeport's Lone Star sulfide ore body have been encouraging, and the company believes that it has the potential to be a world class resource. Continued positive results could drive further upside in FCX shares and accelerate M&A interest in the company.