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Friday, August 9, 2013 - 08:30
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Friday, August 9, 2013 - 08:30

It's Time To Buy This Fallen Mining Giant

Friday, August 9, 2013 - 8:30am

Over the past few years, the notion of Murphy's law comes to mind for Freeport-McMoRan (NYSE: FCX), the world's largest copper miner. In that time, the company has witnessed:

  • A sharp drop in copper prices as China worked off overbuilt stockpiles
  • A similar plunge in gold prices (which accounts for roughly a fourth of the company's revenues)
  • A mining accident that took 28 lives in Indonesia
  • A pair of major acquisitions in the oil and gas industry that were greeted by a chorus of boos from shareholders and analysts
  • A rapid spike in the debt load to above $20 billion that raised alarms at a time when revenue and cash flow forecasts were being trimmed

The net result, this stock has lost nearly 40% of its value over the past 2 1/2 years, even as the S&P 500 has moved higher by a similar amount.

The fact that this stock recently tested support at $27, held its own and has drifted closer to the $30 mark in recent weeks implies that the "everything that can go wrong will go wrong" phase of this company's life cycle may have passed.

Indeed a brighter picture is slowly beginning to emerge, and as the pendulum swings back the other way, shares should start to reverse course. In fact, several headwinds could become tailwinds in just the next few months, making this a timely trade as well as a solid long-term investment. The shift backs toward bullishness could be seen a recent $29 million purchase of company stock (at a price just under $30) by Chairman James Moffatt.

With this company, it all starts with copper prices. Freeport-McMoRan produces nearly 4 billion pounds of the metal every year. So a downward move from $4.50 a pound in the summer of 2011 to a recent $3.15 a pound has hurt results. China, which accounts for 40% of global copper demand, is the key culprit. Not only did China sharply slow its purchases of copper this year to reduce stockpiles, but deeper economic weakness in the world’s second-largest economy threatened to make matters worse.

Yet a glimmer of good news has just appeared. A fresh economic report out of China highlighted a stabilizing economy, which gave a modest boost to copper prices. Every 10-cent-per-pound swing in copper prices impacts FCX’s annual EBITDA (earnings before interest, taxes, depreciation and amortization) by $470 million, according to UBS.

Yet even assuming that copper prices merely remain in the current range and don't fall any further, a series of mine expansions should sharply increase Freeport-McMoRan's output by roughly 50% by 2016, according to management.

Notably, management plans to meet that production goal even as it brings much greater discipline to its capital spending programs. Roughly $1.9 billion has been trimmed from the company's annual capital expenditures. How does output go up even as spending goes down? Part of the projected increase will come from greater productivity at a pair of existing major Indonesian mines that had been beset by work stoppages. Freeport-McMoRan is now negotiating with workers in that country, and a "positive resolution would be a major catalyst for shares, in our view," note analysts at Merrill Lynch.

The other looming catalyst for this stock: a change in perception about cash flow. In the past few years, investors have fretted that falling copper prices, undisciplined capital spending, and the purchase of Plains Exploration and McMoRan Exploration were all contributing to downward cash flow projections. Yet FCX's cash flow outlook is a lot more robust than the flagging stock price may indicate. To be sure, 2013 is a "kitchen sink" year as free cash flow will dip to just $600 million (down from $3.9 billion in 2010). Yet that figure should steadily rise to $7 billion per year by 2016, according to analysts at Merrill Lynch. That forecast assumes that copper prices will rise around 5%, and that gold and oil prices will remain near current levels.

What does robust free cash flow lead to? A rising dividend. FCX currently pays $1.25 a share, equating to a 4.3% yield. That figure could move up to $2 a share, or 60%, by 2016, even as the payout ratio returns to its long-term 40% rate. Strong free cash flow also leads to diminished concerns about the company's still high debt load, which has been a key overhang on the stock. Management expects to reduce debt to by $9 billion by 2016, to around $12 billion.

That debt pay down will also come from selected sales of non-core energy fields. "We believe the market will focus on these savings and on the potential asset sales" as an investment positive, note analysts at UBS, which recently boosted its price target from $33 to $35.

Yet even that price target will look too conservative once investors start to shift their focus away from the recent bad news and pivot to better news ahead. When that happens, they'll start to appreciate that the estimated replacement value of Freeport-McMoRan's mining and drilling assets is worth roughly $49 a share, according to Merrill Lynch.

By as soon as the next series of quarterly results, slated for October, look for Freeport-McMoRan to announce certain asset sales, and equally important, maintain or even boost sales and cash flow guidance, now that the company has lowered guidance to very achievable levels. Barring a complete collapse in copper prices, this stock should start working back to the $40 mark or higher.

Action to Take -->

-- Buy FCX at prices up to $34.

-- Set stop-loss at $27.

-- Set initial price target at $40 for a potential 38% gain in 12 weeks.

This article originally appeared on ProfitableTrading.com:
It's Time to Buy a Fallen Mining Giant

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of FCX in one or more of its “real money” portfolios.