Freeport-McMoRan: Waiting Game

Freeport-McMoRan (FCX) shares are down 50% from early 2018 and just dropped below $10.00 for the first time in years. As someone who has followed the company for a decade, I can't help but scratch my head at this one. The company is trading at a small fraction of what it would cost to replicate its assets. Freeport's earnings, cash flows, and dividend, while temporarily low, are sure to be significantly higher going forward.

But now that the stock is so low, a wide range of excuses are surfacing as to why. Everything from bad management to the Indonesian Government, to the trade war with China, to fears of a global recession rule the day. To a short-term trader, these are indeed prime reasons to be bearish.

But if there's one thing I've learned in my nearly 30 years of investing, it's that stock prices are always way ahead of excuses. For Freeport-McMoran, a terrible economic climate is already priced in, and there are very clear reasons why things will improve in the future. It's really just a matter of waiting for them.

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Trading vs. Investing

People trade stocks for lots of reasons. They are constantly making projections about what will happen to a company in the next 12-18 months and those projections push traders to buy, sell, or short a stock with the intentions of being one of the first to act, and the reward is making money if they are correct. Investing, on the other hand, is made with a long-term ownership mentality. While the objective is the same - to make money - the thought process shifts from worrying only about what will happen in the next 12-18 months to concerns about what will happen over the life of the company.

While I both trade and invest, I find myself much more drawn to investing. It simply makes more sense to me, and always has. It's also much easier to be right when you invest, because time is on your side.

A few years ago, Freeport-McMoRan was $4 per share. The company was on death's door, not because their assets were bad or their copper production unwanted, but because of cash burn and debt. At the time, Freeport had $20 billion of net debt, only a minuscule amount of cash, and was cash flow negative. Traders were betting on bankruptcy, or at least betting on things continuing to get worse, while investors like Carl Icahn were buying it to hold.

One of the issues I have with trading is that you are essentially forced to disregard intrinsic value and instead focus on short-term issues. Yes, Freeport has short-term issues today. I mentioned many of them in the opening paragraph. But at a certain price, I don't think it makes any sense to worry about short-term issues when the discount to long-term intrinsic value is so wide. With Freeport dropping below $10 per share, I think we have now reached that point, and I am planning on buying steadily until things improve.

Freeport-McMoRan's intrinsic value

There are a few ways to look at intrinsic value. The gold standard is discounted cash flow analysis. There's also liquidation value, and book value. With liquidation value, or book value, you simply look at the current market value and compare to what it would cost to either recreate the assets, or liquidate the assets. Freeport's book value is $12.30 per share, or 23% higher than today's stock price, but that doesn't give any value to the reality that it would be nearly impossible to recreate Freeport-McMoRan from scratch. There simply aren't enough copper reserves left on earth for someone to go out and replicate Freeport. If it could be done, Freeport estimates that it would cost between $36-$45 billion to replicate their assets and their mining capacity.

Source: Freeport-McMoRan

That slide alone should catch value investors attention, after all, Freeport's market cap is only $14.5 billion. But it gets even better when we look at the potential for Freeport to generate free cash flow. We can't simply look at this year's free cash flow, however. 2019 and 2020 are what Freeport calls "transition years". They are converting production at the Grasberg mine from open-pit to underground mining. This is hurting production temporarily, which obviously hurts revenue and cash flows, and for all of the excuses as to why Freeport-McMoRan's share price is so depressed right now, I believe this is the number one reason. It's like Gordon Gekko said in the movie Wall Street: "It's all about bucks kid, the rest is conversation".

Source: Freeport-McMoRan

Indeed it's all about bucks. How much money will Freeport-McMoRan make this year and next. Management's expectations are for slightly negative free cash flow this year, and back-of-the-envelope math tells us next year will be better, but not much better. By 2021, however, mining output will be not only back to normal, but it will be even higher than it was in 2018, a time when Freeport produced 3.8 billion pounds of copper and generated $3.9 billion of cash from operations.

Source: Freeport-McMoRan

If Freeport can get production up beyond 2018 levels, and we assume stable copper prices and stable capital expenditures, it's not difficult to see free cash flow being higher than the $2 billion it produced in 2018. Just $2 billion of free cash flow would amount to a nearly 14% free cash flow yield on today's sub $10 purchase price, and it wouldn't even represent a banner year for Freeport, which has had many years in its past in which free cash flow exceeded $2 billion, such as the $3.25 billion of free cash flow in 2017 or the whopping $4.86 billion in 2010.

The key here is to understand that this year is not a typical year for Freeport-McMoRan, and to buy it today, regardless of headlines and weak current year earnings, with the intentions of holding it until better days, which will undoubtedly come.

Think about future dividends relative to today's purchase price

One thing I constantly find in Seeking Alpha comment sections is the steady criticism of Freeport-McMoRan's management. While I agree that management made one giant, dumb mistake, (the acquisition of oil and gas assets in 2013), I believe that criticism beyond this issue is unwarranted, and investors should focus on all of history, as opposed to specific points in history. This management team is in fact a very shareholder-friendly team overall, and we can see that evidence in the historical cash distributions that Freeport has made to shareholders over the course of time.

For example, in the flush years of 2006 and 2013, shareholders were paid dividends that would amount to roughly 25% of today's share price. Those weren't isolated years either. Up until 2015, Freeport paid a regular annual payout of $1.25/share, which would amount to a 12.6% dividend yield on today's purchase price. There is no way on earth that Freeport-McMoRan shares would continue to trade at such weak prices if the opportunity to collect a regular 12.6% dividend existed. Shareholders would have long bid the share price higher in anticipation of this payout, and I fully expect that once these transition years are over, shareholders will be doing exactly this.

This time around is truly different

The last time Freeport-McMoRan traded consistently below $10 per share their balance sheet was a mess and their free cash flow was negative. The company had $20 billion of net debt and had to resort to selling off a valuable chunk of their Morenci mine, as well as going to market with multiple secondary offerings in order to raise capital. That dilution is in the past. The balance sheet is drastically better today and net debt is in the $7 billion range. There is no need for investors to worry even slightly about solvency or liquidity at all. The fact that the stock is so low today is actually a gift to investors at the hands of traders, who tend to have no memory from quarter to quarter, month to month, or even day to day.

2019 and 2020 are not representative of the long-term reality for Freeport-McMoRan. I don't know when the market will begin pushing the share price higher in anticipation of better years ahead, but I do know that it will happen. In the meantime, know that Freeport-McMoRan owns irreplaceable assets that, if developed from scratch, would likely cost about triple what it would cost to simply acquire the company at current prices, and that the waiting game, which is only temporary, will soon end.

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.

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