What's Behind Freeport's Renewed Foray Into Energy?

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Freeport McMoran Copper ( FCX ) 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 coming weeks.

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 billion.

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 here

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 Grasberg mine.

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 limited.

Bad Corporate Governance Practices Makes Market Doubt Motives

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 stock.

We have a Trefis price estimate for Freeport McMoran Copper of $42 which is nearly 10% above its market price. We will shortly revise our price estimate for the company in light of the latest developments.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: ABX , FCX , NEM , RIO , VALE

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