DOA Dr. Copper part 1: Freeport McMoran (FCX)

Beware to those who ignore historical market cylicality.  I made two late-cycle investments in stocks heavily associated with copper and am paying for it now.  While I hardly bought in at the top, being early doesn’t feel much different from being wrong.  Unlike my previous blow-up with American Capital (ACAS), I do not believe the future prospects for Freeport McMoran Copper & Gold (FCX) or Northgate Minerals (NXG) are permanently impaired.  With enough patience, metals prices will recover and hopefully, share prices with them.

Before delving into the companies, I’d like to bring this quote to readers’ attentions. From NXG’s Q3 release regarding the copper market situation, it is especially pertinent to Freeport’s current dilemma:

“… certain higher-cost copper mines in the United States and other areas of the world that will be forced to close if the current price environment persists, which should reduce near-term copper supply. In addition to these expected closures of producing mines, most, if not all, expansion and greenfield copper projects have been delayed or cancelled as a result of credit market conditions and the falling copper price.”

Freeport McMoran Copper & Gold (FCX) held an investor update conference call on 12/3/2008 and announced drastic actions in response to rapidly deteriorating metals prices:

  • Suspending the dividend, saving $755M per annum.
  • Reducing 2009 capex from $2.3B to $1.1B, deferring several key expansion projects such as the Climax moly mine and El Abra sulfide expansion.
  • Lowering net production output by 5% in 2009, 11% in 2010.  The reduced capacity resides in higher cost regions like North America.
  • Assuming $1.75 cu, $750 au & $10 moly, FCX estimates $2B in cash flow before working capital and ~$1.25B OCF.
  • At those same prices, management is estimating 2009 net unit cash costs @ $0.89/lb cu.
  • Conceding that perhaps all $6B in goodwill from the 2007 Phelps Dodge acquisition could be written off in Q4 if prices remain near current levels.  This would be a noncash charge with no bearing on any debt covenants or cash flow.

I did expect Freeport to cut the dividend but not entirely do away with it altogether. While certainly not a pleasant day for shareholders, management demonstrated responsibility and assertiveness in the face of difficult circumstances.  They are also earlier than some of their peers, who I expect to follow Freeport’s lead in taking decisive action.

At today’s prices ($1.50 cu, $775 au, $8 moly), FCX would generate 2009 cash flow of $1.2B ($455M after working capital) and negative $645M FCF after $1.1B projected capex.  While they have suspended common share dividends, the preferred dividend runs over $200M per annum.  Even though management warned against annualizing certain run rates, we’re looking at $850M cash burn just from capex and preferred payouts.

It is unclear to me whether FCX is obligated to continue paying minority interest dividends, which ran $714M through the first 9 months of 2008.  From a scan of the 10K, it seems the minority interests stem from operations in South America and Indonesia.  If FCX is required to pay out minority interest dividends, Q4 should provide a good basis for a 2009 run rate estimate.  Also note 2009 production is expected to mirror 2008 totals with the notable exception of Indonesian gold production, which is expected to double (and whose price is holding up well relative to other metals).  The net takeaway is that minority interest payouts may not reduce at the same rate as revenue and cash flow.  I will try to get clarification from IR and will post updates in the comments of my blog post.

FCX senior notes are yielding 10-15% in the secondary market so issuing new debt could be rough. The company does have $1.2B cash on hand (as of Q3 2008) and $1.5B bank credit facility with favorable terms.  They have no significant debt maturing until 2011 ($118M), 2014 ($340M) & 2015 ($2.5B).  With nearly $3B in liquidity, the company seems to be OK for the next year or two but if this recession lingers or intensifies, more hard decisions lay ahead.

Bold action notwithstanding, the company finds itself in a tough position.  Management stated they have room to cut further if prices fell even more but I would say, as of now, management has little safety net left.  For example, US unit net cash cost is expected to average $1.86/lb cu in 2009 while current prices hover around $1.50.  As noted at the top of the post, FCX may have to consider closing US mines.

The global economic situation shows little sign of letting up and without improvement there, prices for copper and moly (90% of FCX revenue) are unlikely to recover.  That said, the long-term supply/demand outlook seems favorable.  If the planet is going to support 6B people, we’re going to need a 21st century infrastructure build-out and the world’s two largest copper consumers have telegraphed major stimulus packages forthcoming.  One look at the chart below reveals that copper supplies have hardly kept up even during the boom period and rationalizing supply should provide price support eventually.

With Freeport’s solid assets and prudent management, it doesn’t make any sense to sell now; I have a rough NAV of $50 per share assuming prices lower than today ($1 cu, $600 au, $5 moly). Of course, spreadsheet assumptions don’t translate into real returns and with the dividend now suspended, these shares are probably dead money for the foreseeable future.  At a share price of $18, it’s too late to sell and assuming FCX can stay solvent and ride out this storm, the stock could rebound down the road.

Performance Management:

  • FCX has little control over metals prices so must focus on operations and hope for the best.
  • Hit production and unit cash cost guidance:
    • 4.1B lbs cu, 2.2M oz au, 70M lbs moly
    • $0.89/lb cu assuming $750 au & $10 moly
  • Keep capex under control ($1.1B est 2009) or possibly reduce even further.
  • Lower energy and materials prices should help with operating costs.
  • Hold the line on Tenke, government stake situation.
  • Take further action if conditions worsen.
More on this topic (What's this?)
Copper continues to get clobbered
Capitulation In Freeport McMoran
Read more on Copper Prices, Freeport-McMoRan Copper & Gold at Wikinvest

3 Responses to “DOA Dr. Copper part 1: Freeport McMoran (FCX)”

  1. Sam Says:

    Here’s something relevant I read about FCX:

    I applaud your courage to hold on and analyze the situation quantitatively. To be a value investor, you must be stubborn under adverse conditions. I see you have that mentality. I nearly bought into FCX on the way down but somehow refrained. This year has been such a valuable lesson for anyone starting out in investing like me. I read your blog often, so keep posting!

  2. The Enlightened American » DOA Dr. Copper part 2: Northgate Minerals (NXG) Says:

    [...] DOA Dr. Copper part 1: Freeport McMoran (FCX) [...]

  3. The Enlightened American » Freeport McMoran Reassures With Latest Update Says:

    [...] to see how management is dealing with the new economic reality, post-Lehman.  Readers can review my concerns from Freeport’s December update in a previous post but as stated above, I was reassured by Q4 results for the following [...]

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