We believe that Freeport-McMoRan’s (FCX) stock is worth a minimum of $34 per share currently based on the replacement cost of the company's irreplaceable world class copper capacity and the implied value of its gold and molybdenum mining operations. By next year, as the growing copper deficit potentially pushes the base metal's price towards $3.50/lb and FCX’s 2021 EBITDA estimates rise to in excess of $8 billion, or 40% of the company’s current EV, the stock price could appreciate towards $57. There has been speculation that Rio Tinto (RIO) is interested in acquiring FCX, and the recent surge in gold prices, adverse developments at RIO’s Oyu Tolgoi mine in the southern Gobi desert of Mongolia, comments by the company’s growth and innovation group executive Stephen McIntosh on the inefficacy of exploration activities, rising iron ore production from Vale’s (VALE) resumption of full operations at its Brucutu mine, and FCX’s 60% discount to the replacement cost of just its copper capacity increase the probability of a near-term acquisition attempt. Lastly, we believe that if it were possible for FCX to confine its gold production and sales into a separate entity, this entity would be valued near the entire company’s market cap despite comprising only ~15% of the company’s sales.
The M&A Case
On Christmas Eve of 2018, an article in The Sydney Morning Herald, which covers Rio Tinto extensively, speculated that Rio Tinto would seek to acquire FCX. The underlying logic for such an acquisition was 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.” FCX 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) FCX’s long-time CEO, Richard Adkerson, is 72 years old and a sale of FCX to Rio Tinto could be a superior option to an internal succession plan.
3) FCX has favorable geographic exposure, with 75% of its production and 71% of its reserves in North and South America.
In December 2018, FCX 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, FCX’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 FCX, 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 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”. We believe that Rio Tinto was forced to sell its 40% stake in Grasberg to Indonesia’s state mining company PT Inalum. Since the divestiture, however, it was revealed that the company’s Oyu Tolgoi mine, which could have served as Rio Tinto's effectively Grasberg replacement, would need to defer full production and require up to $1.9 billion of additional expenditures. Total costsfor the mine have reportedly spiraled from $4.4 billion in the initial feasibility study to more than $11 billion, almost equivalent to FCX’s entire market capitalization.
Earlier this month, Rio Tinto’s head of growth and innovation, Stephen McIntosh, said headwinds pushing against discovery success were stronger than ever and discussed the lack of early-stage development projects in the sector. Why would companies like Rio Tinto and BHP continue to drain money on copper exploration and development in precarious regions like Mongolia when a derisked cash-flow producing company like FCX with long-term, low-cost reserves in favorable jurisdictions could likely be acquired at replacement cost? Mining giants like Rio Tinto and BHP have extraordinarily strong balance sheets, uniquely positioning them to acquire copper assets near a cycle trough (a virtually unprecedented scenario in the mining industry).
Freeport’s CEO, Richard Adkerson, said on a recent 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”. FCX’s 2021 copper capacity is expected to be ~4.2 billion lbs. At $9.65 per lb (which we believe is conservative given FCX's superior copper asset portfolio even excluding byproducts), this equates to $40.5 billion of value. Hence at no premium to a $40.5 billion aggregate replacement value for just its copper production, FCX would be worth $23 per share. We believe that the additional value of FCX's gold and molybdenum production would conservatively add approximately $11 per share to the company's base valuation (more on this later), resulting in a fair value for FCX of $34 per share at a minimum.
With 7 to 10 year development periods for new copper resources, a dearth of new world class deposits, FCX’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, a premium to FCX’s replacement cost is warranted.
FCX’s Fundamental Outlook
The long-term outlook for copper and gold have rarely been more constructive and a supply gap in copper is fast approaching. The electrification and renewables themes will continue to propel demand while recent price declines are adversely impacting new project development and propelling mine closures, making an already benign supply picture even more favorable. According to an International Copper Study Group report released in May, world refined copper is expected to see a supply deficit of about 190,000 metric tons in 2019 and the deficit will widen to 250,000 metric tons in 2020. Exchange inventories, while up from the recent trough, are near decade lows in spite of Chinese consumption concerns. Recent capacity closures like Glencore’s Mutanda mine in the Democratic Republic of Congo and production deferrals like Oyu Tolgoi could further widen the deficit. Meanwhile, CFTC Copper speculative net short positions are greater than they have been in many years, potentially resulting in a parabolic move higher with the addition of Chinese stimulus or a trade war resolution.
FCX is in a unique position of having low normalized copper cash costs of only $1.30 per lb with the ramp of Grasberg underground, enabling the company to sustain profitability in almost any conceivable market environment. The company’s net debt declined by approximately $14 billion since 2016, and we estimate that its EBITDA lift with an appreciation in copper prices to $3.50 per lb beginning in 2021 could enable the company to repurchase more than half of its shares outstanding each year at the current valuation without stretching its balance sheet.
It seems that FCX’s Grasberg open pit transition underground is on or ahead of schedule. This could result in a scramble to acquire the company before the market discounts its higher production trajectory, lower cash costs and surging EBITDA. After several difficult quarters, FCX believes that its production has bottomed and will grow sequentially in Q3 2019 and year-over-year in 2020 before exploding higher in 2021. Though long-term average EV/EBITDA multiples for large cap mining stocks range from 6-8X, FCX is emerging into a unique growth story with a low-cost mine portfolio. Meanwhile, the deficit in the copper market is forecast to continually grow over the next decade, potentially revaluing companies with long-term world class resources. An upside case for FCX would encompass $9 billion of 2021 EBITDA at $3.50 per lb copper and $1,500 gold, a 10X EV/EBITDA multiple, and a $57 share price.
Gold Recharacterization
FCX’s PT-FI assets in Indonesia include one of the world’s largest copper and gold deposits at the Grasberg minerals district in Papua, Indonesia, where PT-FI produces copper concentrate that contains significant quantities of gold and silver. Our analysis on FCX as a gold mining operation projects that cash costs will revert from slightly over $1,000 per oz currently to less than $500 per oz by 2021 as PT-FI transitions mining from the open pit to underground. Production is expected to soar from 830,000 oz’s in 2019 to 1.5 million oz’s in 2021 and 1.8 million oz's in subsequent years.
There are virtually no comps in the gold mining industry with FCX’s low cash costs and rising production profile, but the best comparison we identified to determine an implied value for FCX’s gold mining operations is Kirkland Lake Gold Ltd. (KL). Kirkland Lake is expected to produce 950,000 to 1 million oz’s of gold in 2019, has an operating cash cost of ~$300 per oz, and sports an EV of $8.9 billion. Our comparative analysis indicates that based on Kirkland’s valuation, FCX’s gold operations alone should account for at least $11 billion, or $7.60 per share, once the underground transition at Grasberg is completed. This value is 83% of FCX’s current market capitalization despite the company’s gold mining revenue comprising just 15% of total sales. Hence we believe that investors in FCX are essentially paying nothing for the company’s copper and molybdenum assets at the current valuation.
As gold prices have soared in recent months, FCX's share price has plunged, providing investors with an opportunity to purchase the cheapest gold stock in the market at multi-year low prices. We believe that FCX will either surge towards fair value in the coming months or receive offers to acquire the company at a substantial premium. As CEO Richard Adkerson recently stated, “We are confident in our efforts to create value for our shareholders through investing in our assets and growing our business. But if other alternatives arise in the future, we’re going to be open to considering whatever makes sense for our shareholders”.
Valuation
It is astonishing to us that analysts have not attempted to value FCX's gold production stream as a stand alone entity with the recent divergence between precious and base metals prices and the corresponding equity performance for the respective companies. Our minimum valuation for FCX comprises:
1) $40.5 billion for FCX's copper assets (with byproducts stripped out) based on 4.2 billion tonnes of 2021 production at a replacement cost of $9.65 per lb.
2) $11 billion for FCX's gold production based on 2021 gold production of 1.5 million oz, cash costs of $500 per oz, and a 7.4X multiple on cash flow.
3) $4.6 billion for FCX's molybdenum production based on 95 million lbs of production, a cash cost of $9 per lb, a price of $15 per lb, and an 8X multiple on cash flow.
Deducting FCX's net debt of $7.3 billion, our conservative sum of the parts analysis yields a minimum value of $34 per share.
Why is the Market Undervaluing FCX?
We believe that FCX's past mistakes have clouded the market's views on the company's true underlying value. While CEO Richard Adkerson is hailed as a top mining executive, the company has destroyed an extraordinary amount of value under his reign. In 2007, FCX acquired Phelps Dodge for $25.9 billion. In 2012, FCX acquired Plains Exploration & Production Company and McMoRan Exploration Company for a total of $10.3 billion. In aggregate, these acquisitions account for almost 2X FCX's entire current EV. Investors believed that the company was near bankruptcy in 2016, as it irresponsibly accumulated ~$20.2 billion of net debt before deleveraging two-thirds of it in the subsequent 7 years.
FCX is now finally poised to generate consistent value creation for the foreseeable future, as the company's world class asset portfolio is arguably the best in the industry, a rising copper deficit is emerging partially as a result of exponential growth in electric vehicles (which use about 4 times more copper than gasoline-powered vehicles), copper supply growth in the coming years is anemic, gold prices are surging, Grasberg's underground transition is nearing completion, and the 72 year old Adkerson is finally focused on maximizing the value of the company's existing assets.
The damage done by FCX under Adkerson's reign, however, may end up sealing the company's fate. FCX's stock is trading at multi-year lows right at a juncture when fundamentals are inflecting positively and the balance sheet is better than it has been in many years. An acquisition attempt by Rio Tinto or another mining giant may provide reprieve to impatient shareholders who are frustrated by the company's recurring blunders, resulting in substantial upside to FCX's share price but an anticlimactic ending for a stock that reached $60 per share almost 9 years ago.
Risk Factors
The price of FCX’s stock is correlated with copper prices and the global economy, and a further economic slowdown or decline in copper prices could adversely affect the company’s share price. Also, while FCX’s underground transition at Grasberg is on or ahead of schedule, any setback could delay its production ramp and cause the stock to decline further. A substantial component of our conviction in FCX revolves around the market’s ultimate recognition in the value of its low-cost and rising gold production and the likelihood that the company is acquired in the near-term. If either event fails to materialize, the stock may perform more poorly than we expect. Lastly, there is a risk that shareholders’ frustration with FCX and Richard Adkerson following the company’s incomprehensible decision to spend $10.3 billion on hydrocarbon acquisitions in 2012 and nearly bankrupt FCX could result in their acceptance of an acquisition offer that is below the replacement cost of company’s assets.