Recommendation: BUY Estimated Fair Value: $43 $63*

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Annabella Fields
6 years ago
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1 Recommendation: BUY Estimated Fair Value: $43 $63* 1. Reasons for the Recommendation Based on fundamental analysis, there is much reason to suspect FCX stock is highly undervalued at this point in time. I believe FCX will experience high productivity and growth throughout our current investment time horizon of three to five years. Companies with the best operating track record within the metals and mining industry tend to have a combination of a sizeable market share, substantial mine reserves, and finally strong financials. In terms of the competitive structure and market share distribution, the sub-industry (described in further detail later) in which FCX operates is very top-heavy. For example, the top five copper producers effectively generate nearly 38% of the global copper supply. FCX is the current leader within the subindustry in both copper and molybdenum production (8.8% copper and 12.9% molybdenum globally). In addition to a substantial market share, FCX is also very strongly positioned with their current mine reserves. For instance, Freeport s Grasberg minerals district mine in Indonesia boasts the single largest recoverable copper reserve along with the single largest gold reserve of any mine in the world. With substantial mine reserves, FCX can rely on sure and steady production in the short term. This will provide FCX the opportunity to specifically focus on maximizing output efficiency. As a result, FCX will undoubtedly add to the competitive edge they currently hold against industry peers. The final notable component of strength lies within Freeport s financials. Since the financial crisis in 2008, FCX has generated an average growth rate of 37.8% per year in its bottom line. I expect FCX to continue to remain in its high-growth stage for roughly four to five years. My reasoning stands behind the fact that metal and mining revenue valuations tend to be closely tied to underlying commodity prices. In the years leading up to the global economic slowdown, developing nations have undoubtedly been the predominant force driving up demand for industrial commodities. Asia alone accounts for nearly 60% of the global refined copper demand. In particular, Brazil, Russia, India, and China (BRIC) have fostered an expanding middle class in conjunction with swelling infrastructures to accommodate such growth. Consequently, the demand for copper has increased more than 35% over the course of the past ten years 1. Aside from current and forthcoming economic uncertainty within the United States and abroad, I suspect copper demand will continue to trend upwards in the long-term. While blurring uncertainty has gripped the global economy and slowed infrastructure expansion over the course of the past three years, there remains hope and budding promise for a positive growth outlook in the near future. The World Bank maintains that in the midst of recent turmoil, sustained progress and growth continues to stimulate the slow global recovery. The Global Economic Prospects report released by the World Bank in June 2011states, The global financial crisis is no longer the major force dictating the pace of economic activity in developing countries. The majority of developing countries have, or are close to having regained full-capacity activity levels. As a result, country-specific productivity and sectoral factors are now the dominant factors underpinning growth. Should this favorable outlook hold true, there will be much reason to believe infrastructure growth in developing nations will spur industrial commodity demand to new heights and perhaps unprecedented levels. When assessing the future outlook on copper valuations, it is helpful to be reminded that the industrial metal is not a one dimensional commodity. That is, prices are not solely affected by infrastructural growth as the metal has many functions. Because of its efficient conductivity, copper is highly useful in 1 All demand figures retrieved from Bloomberg Terminal Real-Time Platform

2 electronic development, power generation, and telecommunications to name a few applications. While infrastructural growth has been temporarily stunted abroad over the past quarter or two, I would venture to argue that the technologically hungering countries (specifically China and India - Population: 2.5 billion) will be eager to purchase their smarter than we phones, PDA s, laptops, and hybrids (or any other vehicle for that matter) as the tech craze will soon grow viral within these regions. A closer look into multiples analysis gives deeper insight to Freeport s valuation in relation to its competitors. For example, when comparing between FCX and its most similar competitors, Freeport s PEG ratio hovers extremely close to the sub-group median (within 3%) which suggests the company is fairly valued. However, after sorting the firms by operating margin and profit margin, the respective multiples, enterprise value/sales and price/sales, portrayed FCX as undervalued in comparison to similar competitors. I then sorted the sub-group according to the return on equity for each firm. After analyzing the price to book valuations among the sorted firms, I found this variable suggested FCX is in fact fairly priced in relation to the sub-group. It is also helpful to note that Freeport s trailing twelve month P/E ratio along with its forward P/E ratio are both the median values of all competitors most similar to the FCX which once again suggests it is in fact fairly valued. Next, I sorted the firms according to profit margin and found the companion variable (price/sales) suggested FCX is undervalued as its ratio falls below the median value of all the firms. Finally, when comparing Freeport s ten-year average valuation ratios (including P/E, price/sales, and price/book) against each trailing twelve month (ttm) average, I found that FCX is again seemingly undervalued. All three ttm valuation ratios currently sit below their respectable ten-year averages. When taking all of the information above into account, it is clear that a greater proportion of the multiples suggest FCX is in fact undervalued. I believe the markets currently present the opportunity to take advantage of such profit potential. 2. Company Analysis It is important to highlight the specific aspects of strength that contribute to Freeport s success. As briefly stated earlier, FCX has the largest market share within the diversified metals and mining subindustry. This strength gives FCX the ability to better absorb unforeseen commodity price fluctuations (slumps) in comparison to its competitors. It is imperative for FCX to defend its position as sub-industry leader against its peers. In addition to its sheer size, FCX is also well positioned geographically as it operates out of the world s single largest and most profitable copper and gold mine (Indonesia). FCX also operates out of mines located in Peru, central Africa, Chile, and also the United States rounding out a well-diversified field. Both its size and strategic positioning bring into focus the strength in Freeport s financials. Freeport s bottom line has experienced tremendous growth within the past decade and continues to demonstrate unyielding strength in the meantime. Freeport s main weakness is that the company continues to endure a notable amount of employee unrest and defiance. Over the course of the past few months, there have been labor disputes leading to strikes in each of two mines located in Grasberg, Indonesia and Cerro Verde, Peru 2. These two mines accounted for nearly half of all copper and over 94% of all gold produced by FCX in According to Barrons financial magazine, FCX says it will lose one-hundred million pounds of copper output and one-hundred thousand ounces of gold production this year as a result of the ongoing strikes. Also, in order to have generated such impressive growth, FCX had to incur significant capital expenditures including mine development and maintenance along with the acquisition of Phelps Dodge Corporation. These expenses have inevitably left a significant amount of outstanding debt on the books. 2 Grasberg branch strike currently has extended two and a half months (Mid-September Present). Cerro Verde branch strike began September 29th. Work has since resumed as of November 30th.

3 In spite of these weaknesses, FCX continues to feed off of several opportunities. As a result of rising demand, copper prices have risen over 400% over the past decade. Gold has also seen considerable returns as its value has skyrocketed six-fold since The 2007 acquisition of Phelps Dodge is yet another opportunity for FCX to continue to take advantage of the upward trend in commodity markets as it provides increased output productivity. In order for FCX to continue to thrive against its competition, it must maintain its stronghold as leader of production and output. Ongoing expansion and enhanced efficiency will continue to increase productivity and allow FCX to operate at higher capacity thus increasing output. Apart from these opportunities remain a few inherent threats for FCX. As noted earlier, the hiccup in infrastructure growth overseas presents some concern for the direction of the global economic recovery. China s slowdown is an item of particular interest as its economic influence carries significant weight abroad, along with that of Brazil, Russia, and India. Another notable threat for FCX is the potential failure or inability to discover additional proven mine reserves. Although it is currently well positioned with lush mines in Indonesia and Peru, they will eventually be depleted of their resources. Therefore, unyielding exploration and discovery is imperative for FCX to achieve sustained growth and success. Finally, the industry directly deals with governments as federal and state permits or leases on government land are held in durational periods for the companies to undertake mining operations. As a result, there remains risk of increased regulation within the sub-industry. This could ultimately lead to elevated costs in obtaining and renewing permits for the sustained use of mining operations. 3. Industry Analysis FCX operates within the basic materials sector. This sector involves companies responsible for the discovery, development and processing of raw materials. Such materials include metals, chemical producers and also forestry products. As a whole, the materials sector has significantly outperformed the S&P 500 over the last ten years. While the S&P 500 has raked in a return of 23.36%, the materials sector has drastically outshined with a return of 84.50%. FCX is further classified within the metals and mining industry. The industry boasts a staggering return of 109.6% over the past ten years. FCX falls under the diversified metals and mining sub-industry as the company produces a handful of metals within its operations. The sub-industry consists of 57 firms with a total market capitalization of $ billion. Revenue within the sub industry has experienced an increase in growth of nearly 360% since that of ten years prior, while operating income has increased a daunting 1736%. The sub-industry has fostered consistent growth over this time period. In addition to healthy growth in revenue and operating income, the sub-industry has averaged a 58.38% annual increase in earnings per share over a ten year time span. These numbers, along with a closer look at the sub-industry s profitability ratios, confirm sustained strength in the sub-industry s ability to generate returns on capital, assets, and equity while also widening the margin of return in operations and ultimately profit. The main customers of the sub-industry consist of smelting and refinery firms. FCX, along with the rest of the sub-industry, sells the majority of mined copper in the form of copper concentrate. The smelter and refineries receive the concentrate to then further process the product into copper anodes and cathodes (sheets of copper; both with variations in shape and size). Now, some firms within the diversified metals and mining sub-industry such as FCX have wholly owned subsidiary smelter and refinery firms. As a result, these businesses cover a broader base in the supply chain thus allowing them to also penetrate secondary markets. Companies within the sub-industry are in direct contact with their profit source (the 3 Bloomberg Terminal Real-Time Platform

4 metals mined) and as a result rely on suppliers from whom they purchase and/or lease heavy duty equipment needed to retrieve the product. As developing eastern regions have transitioned into an industrialization phase, global demand for copper has slightly begun to outpace production. Capacity utilization has been down over the past two years hovering at roughly 82% (from 10 year average of 87%) as direct result of technical issues, labor unrest and mine shutdowns. For the time being, output levels have slightly been underperforming. There appears to be a lack of urgency in terms of firms taking action to address this setback. This is a situation that cannot last as demand pressures will eventually force the hands of producers to quickly make up for the widening deficit. This pressure build up, along with bullish trending commodity prices will give firms a much greater incentive (if perhaps no choice) to directly invest to increase capacity. FCX seems to understand such generalized conclusions and continues taking actions to increase capacity and remain ahead of the game. Overall, fundamental analysis suggests FCX embodies a company sure to bring forth a positive return on investments. This company derives profitability from bull-trending commodities which have been and will seemingly continue to remain in their current wealth-generating cycle. I foresee healthy profitability still to come for FCX, and submit the basis of my recommendation on the preceding findings and information.

5 *APPENDIX A: METHODOLOGY The estimated fair value range for FCX was calculated using discounted cash flow analysis. More specifically, I used the free cash flow to equity model (FCFE). I derived values for future free cash flows available to equity by taking into account a three stage growth model (high growth phase, transitional growth phase, and finally terminal/stable growth). My projected high growth rate for the firm was calculated by multiplying Freeport s ROE by its equity reinvestment rate. Instead of only using the 2011 product as my high growth rate benchmark, I took a four year average and ended up with a value of 16.45%. The nominal growth rates used to calculate the free cash flows to equity during terminal growth (phase which carries most weight in the FCFE model) ranged from 5.00% 10.11%. The upper bound growth rate was calculated by taking the nominal growth rates of each country in which FCX operates and assigning a weight to each according to the proportion of total revenue generated by each country. The weighted average nominal growth rates were then simply summed up to produce the projected rate of growth for the firm. The lower bound growth rate was estimated by taking into account the potential of a distressed global economic and/or sub-industry outlook. A mix of the preceding variables was used in multiple scenario analyses to produce the proposed fair value range for FCX.

6 APPENDIX B: MULTIPLES

Freeport-McMoRan Inc.

February 05, 2015 Freeport-McMoRan Inc. Current Recommendation Prior Recommendation Neutral Date of Last Change 11/05/2014 Current Price (02/03/15) $18.98 Target Price $17.00 UNDERPERFORM (FCX-NYSE) SUMMARY