In most instances, it pays to focus your investment research on
companies that are delivering great results. Rising profits, thanks
tomarket share gains, hot new products, international expansion and
other factors often lead to a surging valuation for a company.
Yet for some types of stocks, this logic gets turned on its head.
It's more important to see how a stock will be valued when business
conditions are not quite so favorable. If theincome statement takes
a turn for the worse, then a large contingent of investors will
likely head for the exits, revealing the price level in which more
far-sighted investorsspot deep value.
This has been my thinking since I have had a chance to digest the
quarterly results of copper and gold miner
Freeport McMoran (
. A host of factors has just led year-over-year profits to fall
sharply, and it's increasingly clear that investors are misreading
many of the fundamental factors that should drive the company's
results -- and valuations -- in the quarters and years to come.
It's why I can't resist the opportunity to add this global mining
powerhouse to my
$100,000 Real-Money Portfolio
, as it possesses the two key characteristics I look for: robust
potential upside and solid downside protection.
Focus on the assets for now
I have actually written about Freeport McMoran twice recently.
how investors had been selling the stock as profits slumped,
missing the fact that the company's copper and gold mines are
actually worth much more than the current stockmarket value would
Unfortunately, you won't find this value on the company'sbalance
sheet . Indeed the company's $36 billionmarket value is well higher
than its $16 billion in shareholder's equity. But this figure is
quite misleading. It represents what Freeport McMoran has paid for
various mines in the past - not what those mines are worth
Thankfully, we can grasp what mines are really worth. They are
bought and sold every year, and we have a clear read on what
companies pay to acquire various mines. This is where the work
ofWall Street analysts can come in handy. Analysts who follow
Freeport McMoran continually track the global mining industry and
then seek to adjust the relative value of every company's mining
assets -- if they were valued in line with recent deal trends.
For example, as I noted last week, Goldman Sachs says Freeport
McMoran would be worth $50 a share if investors used current
industry transaction trends as abenchmark . Of course, this assumes
that a potential buyer would look to acquire the company at value
accorded to other mining firms that have recently sold off assets.
This seeming undervaluation was one of the reasons why industry
chatter suggested potential buyers were circlingoverhead , which I
. I cautioned that many rumored deals never come to pass, and in
the face of such chatter, Freeport McMoran'sCEO Richard
Adkerson went on
this week to try to cool down the buzz, noting the company wasn't
But then he inadvertently expressed the precise reason I really
appreciate this stock. "Natural resources are short. Companies in
our industry have strong balance sheets and strong cash flows.
Trying to find new deposits is a challenge. We have great assets,"
Let's look at what this means for the coming five years (and why I
think this stock will solidly appreciate a lot more quickly than
that). The globaleconomy rises and sinks every few years, taking
demand for copper, gold (and molybdenum, which Freeport
McMoran also mines) up and down. But if you widen the lens, then
you see that long-term demand tends to move on a more direct path
-- upward. Let's look at copper in particular, which is used in
residential and commercial construction, power lines, health care
and a wide range of technology devices.
The chart above highlights a steady upward move, but there have
been times where it appears as if global copper demand has finally
reached a peak. After World War II, demand slumped as global
defense spending on new equipment pulled back. Demand slumped in
the 1970s as global economies skidded intorecession . It happened
again in 2001 and again in 2009. Even if you assume that growth
won't rise at the steady pace this chart suggests, then it's pretty
clear that the globaleconomy will be consuming more copper in the
years to come -- not less.
And asCEO Adkerson notes, there is a finite amount of copper that
is readily mined. Simply put, the supply and demand picture enables
this company to generate decent profits when the global
is under pressure and copper demand cools, and really solid profits
when demand is at a more normal state (which I'll discuss in a
Yet if you just looked at Freeport McMoran's just-announced
first-quarter profits, you'd hardlycall the results "decent." Work
slowdowns at the company's Grasberg copper and gold mine in
Indonesia (which incidentally holds the largest repository of
copper in the world) led to sharply curtailed output. Management
and labor haven't made peace yet, but continue to talk and have
made major progress. And daily output, which had fallen by half on
many days, is now back near normal levels. Yet the damage was done.
First-quarter net profits fell by half to $764 million ($0.80 a
What does thismean for the future? Well, management's concessions
to labor now means that a typical pound of copper derives a little
more than $2 inprofit (using the Grasberg mine as an example),
compared with $2.50 a pound in previous labor costs were in place.
Rising labor costs are surely an issue for mining firms across the
globe, but not the absoluteprofit killer that some might think.
Lastly, this stock had been under pressure for another reason
beyond labor concerns. The Indonesian government has revised the
laws governing foreign ownership of domestic assets. Management put
this concern to bed this week, noting that after talks with the
Indonesian government, it was decided that previous agreements
supersede the new laws, so Freeport McMoran isn't at risk of having
its mines appropriated by the government. Still, the company aims
to make some sort of concession, perhaps giving up 10% of its
mining stakes in Indonesia.
[block:block=16]The road ahead
When it comes to copper and gold prices, there's no crystal ball
that will underpin profits -- and the stock price -- for
Freeport McMoran. But we know that copper demand remains above
copper supply, according to several industry forecasts and, barring
a major economic slowdown in China, that should be the case in 2013
again as the U.S. and European economies trend a bit higher than
current levels. That's why Freeport McMoran aims to boost output of
copper and gold by roughly 25% during the next three to four
years. This sets a backdrop for steadily improving results,
with the just-released first quarter likely representing the last
weak quarter for this company for some time to come.
The Downside Protection -->
The economic crisis of a few years ago pushed this stock down
deeply as the global economy threatened to tumble into the abyss. A
repeat of this kind of event is extremely unlikely, andshares have
otherwise never slipped below $30 at any point in the past five
years. This can be seen as an absolute floor for this
stock. Shares currently trade about $38, and any slippage into
the mid to lower $30's would bring out a fresh wave of buying
support as long-term investors start to focus on the value of
Freeport McMoran's copper and gold mines.
Upside Triggers -->
Copper and gold prices are an obvious determinant of the direction
of this stock -- with a heavy emphasis on copper. Thanks to the
current supplydeficit for copper, most analysts expect copper
prices to finish 2012 at about $3.80 a pound and stay there in
2013, which is slightly above current levels.
If you exclude the recent challenges in Indonesia, then this is a
company that typically earns roughly $5 a share, meaning
trade for around 7.5 times profits. Shares also trade for less than
five timesEBITDA , on anenterprise value basis. That valuation
assumes copper in the $3.75 a pound range.
Looked at another way, this is a company that generated nearly $4
billion infree cash flow on two occasions in the past five years,
(and close to $2.5 billion infree cash flow in two other years in
the period). But rising production output figures to boost those
numbers to fresh peaks, even with slightly higher labor costs.
free cash flow
could approach a record $5 billion by mid-decade (after a current
spike in capital spending winds down). With a currententerprise
value of around $35 billion, shares sport a projected free cash
flowyield in excess of 10%, perhaps approaching 15% in coming
years. The combination of undervalued mines and tremendous free
cash flow out of those mines, are the main pillars of value in this
currently out-of-favor stock.
To be sure, this has the potential to be a trade more than an
investment. If the stars re-align, and shares move back into the
mid-$50's -- where they stood last summer -- then investors should
book profits. FCX will always gyrate wildly, and the key is to
latch onto this stock when it's out of favor.
Action to Take -->
Two days after you read this, I will buy 200shares (or roughly
$7,600 worth). I also suggest investors put in astop loss at $34,
though as I recently noted, I will not be deploying the stop-loss
limits myself.Shares can be bought under $42.
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.
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