Five years ago, Freeport-McMoRan (NYSE: FCX) decided to diversify into oil and gas in a move that it thought would pay big dividends down the road. Unfortunately, that decision didn't pay off as expected, because commodity prices plunged across the board. That downturn forced the company to shed several assets in recent years to stay afloat, including unloading most of its energy assets for a fraction of their purchase price.
While the company has improved its financial situation dramatically, it still has work to do. Overall, Freeport-McMoRan remains in transition. While it has unwound most of its oil and gas business, it now must sell a majority stake in its crown jewel copper and gold mine in Indonesia as part of a new framework agreement to continue operating in the country. Thus, the company will likely look different in five years.
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The Freeport-McMoRan of today
Currently, Freeport-McMoRan operates 10 mines around the world -- seven in North America, two in South America and one in Indonesia -- that produce copper, gold, and molybdenum. However, its Grasberg mine, in Indonesia, accounted for a quarter of its copper output last year and the bulk of its gold production. Unit costs at that mine were just $0.83 per pound of copper, versus $1.41 per pound across its other mines, which means it makes more money off every pound produced in Indonesia.
At current commodity prices, these mines are on pace to generate $3.8 billion of operating cash flow for the company this year. Given that the miner expects to invest only $1.6 billion on capital projects this year, it's on pace to produce $2.2 billion of free cash flow. That excess will enable the company to continue to improve its balance sheet, with it likely getting net debt below $10 billion by year-end, which would represent a 50% decline over the last two years. That said, even at that level, its leverage ratio would still be high at around 2.0. For perspective, rival global mining giant Rio Tinto's (NYSE: RIO) leverage ratio was just 0.6 at the end of June, while BHP Billiton's (NYSE: BHP) was 1.2. Given its weaker balance sheet relative to those peers, it seems likely that Freeport-McMoRan will continue to divert the bulk of its excess cash toward debt reduction in the near term.
Where Freeport-McMoRan appears to be heading
Aside from bolstering its balance sheet, one of Freeport-McMoRan's other priorities over the past few years has been to secure a new long-term agreement to continue operating the Grasberg mine. After much negotiation, the company recently announced a new framework for an agreement with the Indonesian government. While that deal will provide the company with long-term operating rights through 2041, Freeport-McMoRan had to give up a lot to secure that certainty. It agreed to sell down its 90.64% stake in the operating entity at fair market value so that Indonesian interests own a majority 51% stake in that operating partnership, though the company will retain operational and governing control of the entity.
That agreement to sell down its stake will do two things to Freeport-McMoRan in the future. First, the company should receive a significant cash infusion upon completion of the sale, which the company will likely initially use to bolster its balance sheet. That said, Freeport's future copper output and cash flow will decline since it will only receive 49% of the entity's production instead of 90%.
Once the company completes this transition, it will become a leaner copper producer, with what should be a top-notch balance sheet. That gives the company options for its excess cash flow, including investing to expand production at its other mines to offset the lost output at Grasberg, making acquisitions, buying back stock, and reinstating the dividend. That said, the most likely course of action seems to be that the company will focus its investment dollars toward expansion projects in the Americas as opposed to acquisitions, given the botched oil and gas deals. Meanwhile, shareholder returns will likely come from dividends as opposed to buybacks because that will enable Freeport-McMoRan to draw in income-focused investors since they have few top income-producing options in the mining sector other than Rio Tinto and BHP Billiton.
A lean, mean copper-producing machine
Freeport-McMoRan has learned a valuable lesson over the last five years, that taking on a mountain of debt to acquire a commodity producer when prices are high can blow up should they unexpectedly fall. The miner is unlikely to make that same mistake twice, which is why I believe that it will focus on maintaining a fortress-like balance sheet with growth coming from organic expansion in the coming years. Furthermore, I suspect that it will eventually reinstate its dividend. As a result, the Freeport-McMoRan of five years from now could be a lower-risk, copper-focused producer that offers investors a blend of growth and income, much like BHP and Rio.
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