Freeport McMoran Copper (
) surprised many and infuriated others with its recent announcement
about re-entering the energy business by purchasing two oil and gas
exploration companies- McMoran Exploration and Plains Exploration
and Production. Freeport had exited its energy business in 1994 by
spinning off McMoran Exploration as a separate company.
Freeport will pay $6.9 billion in cash and stock for Plains, and
a net $2.1 billion for McMoran, in which both it and Plains already
hold a 36% stake. The deal will be financed using $5.5 billion
in senior unsecured notes and $4 billion in term loans. JPMorgan
served as the sole underwriter for the loan which, as is the usual
practice, is expected to be broadened to many more lenders in the
The additional debt is expected to take Freeport's total debt to
a staggering $20 billion. It would come to approximately $16
billion net of cash. To put these figures in perspective, the
combined company may generate an EBITDA of about $12 billion and
operating cash flows of $9 billion in 2013. Of this, 74% is
expected to be contributed by mining activities and 26% by oil and
gas. Freeport's reported EBITDA for the past 12 months was $6.88
If the oil and gas production gets delayed or mining revenues
are less than expected, it may hamper Freeport's ability to
generate adequate cash flows to service its debt comfortably. The
cost of protecting the company's debt against potential default has
risen sharply following the deal announcement. Five-year credit
default swaps were last trading 15 basis points, or 11%, wider at
152. That means it costs $152,000 a year to protect $10 million of
debt for five years. This reflects decreased market confidence in
Freeport's debt-servicing ability.
Below, we attempt to make sense of the negative activity in
Freeport's stock following announcement of the deals, examine the
company's rationale for its move, try to anticipate potential
pitfalls, and engage in some crystal ball gazing.
See our full analysis for Freeport McMoran
What's Happening To Freeport's Stock Price?
Freeport's stock has tumbled by nearly 16% after the deal was
announced, reflecting the overwhelmingly negative reception of the
deal by investors. The company, now expected to be a nearly $60
billion natural resources conglomerate, has taken on a huge debt
liability to acquire businesses which have no connection to its
core activity of mining copper. There are fears that it has
overpaid for McMoran Exploration and is not going to derive any
business synergies out of these deals.
Also, investors who have bought Freeport stock for exposure to
copper are thoroughly displeased. Their argument is that they would
have bought oil and gas stocks directly without paying any premium
if they wanted exposure to the sector. Freeport has levered up in
order to pay a premium of 39% for Plains and 74% for McMoran based
on their closing share prices on Tuesday. The biggest grouse
investors seem to be having is their complete lack of say in these
deals due to the way they have been structured. The stock component
in the proposed payment structure is not enough to require Freeport
to get shareholder approval for the deals.
The Big Question : Why Do These Deals?
The decision to purchase the two companies is being seen from
two perspectives- business and personal.
There has been concern for some time about growth opportunities
in the copper mining business. Easy to tap reserves are very
difficult to come by these days, especially in countries like Chile
which has been the largest producer of copper for long. Rich
reserves are increasingly being found in remote locations like
Mongolia. Taking the inorganic growth route also isn't very
feasible as there are fewer deal targets after almost a decade
of mega-mergers. Mining assets are essentially depleting in nature
and need to be replaced over a period of 10-20 years to ensure
future growth. The declining grade of copper ore, a simultaneous
increase in costs and political problems are other major problems
facing Freeport. Most recently, its third quarter earnings results
were impacted by the unexpectedly poor quality of ore at its
On the other hand, the oil and gas upstream business can give
potentially much higher returns than copper mining. It is to be
noted that both Plains and McMoran Exploration's have excellent
assets in the U.S. These deals will give Freeport access to
shale formations in Texas and Louisiana that produce both oil and
gas, as well as offshore oil and gas production facilities in the
Gulf of Mexico. The McMoran Exploration portfolio is expected
to provide a large, long-term and low cost source of natural gas
production. McMoran has been developing expertise in drilling
at extreme depths below sea level in the shallow waters of the
gulf. Although commercial success has eluded it thus far, the
potential is estimated to be huge. Naysayers counter that oil
revenues dominate the revenue mix from acquired assets so any
upside resulting from high natural gas prices in future will be
Bad Corporate Governance Practices Makes Market Doubt
The three companies' boards are interconnected in a convoluted
manner which has resulted in the deal receiving a lot of flak.
Jim Moffett is chairman of Freeport-McMoran and also
co-chairman and chief executive of McMoran Exploration. Freeport's
chief executive, Richard C. Adkerson, is also a co-chairman on
McMoran's board. Also, Plains's chairman and chief executive,
James C. Flores, is also a McMoran director.
Plains already owns 36% of McMoran Exploration's shares after a
2010 asset sale deal. McMoran Chairman Moffett could collect
$73 million cash for his shares while Plains Chief Executive Jim
Flores stands to get $65.4 million for his. Flores could also
receive a change-in-control payout of as much as $150 million.
These apparent moral hazards have made investors question whether
the deals have been made more for personal reasons than commercial.
There is no way to prove real intentions either way.
It doesn't help that McMoran Exploration has been plagued by
delays in a Gulf of Mexico well, causing shares to plunge 40% over
the last two months. It also has been burning cash at a rapid rate.
Thus, paying a 74% premium for its shares defies all logic.
What Could Derail Freeport's Ambitions?
If the gas reserves do not turn out to be as rich as expected,
the revenues may not meet expectations. Also, China is a big
determinant of the world demand for oil and thus oil prices. If
Freeport's intent was to diversify from copper due to its
expectations of a lower future Chinese demand, can it be said that
the demand for oil will not be impacted as well in a sluggish
Chinese economy? If so, oil prices may fail to receive the upward
boost necessary to generate adequate cash flows to service debt
comfortably and generate good returns.
At this point, the overwhelming market sentiment is against
Freeport's decision. We don't see the market changing its view
before the acquired assets actually prove their worth by performing
as expected. Since the deal itself is not expected to be closed
before mid-2013, in our view the market will wait till at least the
close of next year before there is any upside in the company's
We have a
Trefis price estimate for Freeport McMoran Copper of
which is nearly 10% above its market price. We will shortly revise
our price estimate for the company in light of the latest
a company's products impact its stock price at Trefis