Accumulate Freeport–McMoRan For The Long Term

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Nov 12, 2014

Commodity-based stocks have taken a hit after a meaningful slowdown in China and Freeport-McMoRan (FCX, Financial) is no exception. The stock has also taken a beating after a significant decline in oil prices recently. The oil and gas sector was shaping up to be a major revenue and EBITDA driver for the company.

However, I believe that the current depression in commodity and energy prices is an excellent opportunity to gradually accumulate Freeport-McMoRan for long term. The stock has been a value creator in the past, and the stock will remain a value creator.

The current EV/EBITDA valuation of 5.5 for Freeport-McMoRan is inexpensive and the stock is worth accumulating. Investors should however go slowly on the accumulation phase as more bad news from China can result in another 5% to 10% correction in the stock.

One of the key factors in times of slow industry growth is how the company adjusts its plans and how it manages its leverage. Freeport-McMoRan has done exceedingly well on that front as the company has realized gross proceeds of $5 billion from asset sales in 2014. A significant part of the net proceeds have been used to pay down debt and Freeport-McMoRan is therefore managing its finances well in difficult times.

If investors look at the stock price movement for Freeport-McMoRan, the stock has fallen by 28% from a peak of $39.04 on July 9, 2014. The big setback for Freeport-McMoRan in the near term has been a sharp decline in oil prices. Looking at the results for the third quarter of 2014, the company’s sales volume for oil has been 12.5mmboe as compared to 16.5mmboe in the third quarter of 2013. Further, the cash operating margin has declined to $48.15 per barrel in 3Q14 from $64.13 per barrel in 3Q13. Therefore, the key EBITDA driver for the company has been negatively impacted due to decline in oil prices.

From an expected deepwater production of 21mmboe in 2014, Freeport-McMoRan expects production in 2015 to be 28mmboe and 46mmboe in 2016. Therefore, the company’s growth driver for revenue and EBITDA is clear. Oil prices remain the key factor and the company will deliver on the production growth targets if oil prices move higher. At current levels, the cash operating margin is relatively depressed.

I strongly believe that oil is oversold at current levels, and oil is due for a rally in 2015 and 2016. If this does happen, Freeport-McMoRan stock is likely to surge over the next 2-3 years even if China’s economic growth remains relatively depressed. It is oil and not copper that can drive strong growth and take valuations higher for Freeport-McMoRan.

I am also of the opinion that asset sales might continue for Freeport-McMoRan in 2015 as the outlook for industrial commodities remains weak. The company needs to get its leverage at comfortable levels where it can sustain with low cash operating margins for copper, oil and gold.

As mentioned earlier, valuation is a key consideration when looking at Freeport-McMoRan. The stock currently trades at a five year forward PEG of 0.34 besides trading at a current EV/EBITDA of 5.51. Once oil prices recover, the EBITDA is likely to surge and the upside potential will be significant. Therefore, current levels, which look oversold, are ideal for accumulation. However, investors should not look for 3-6 month gains as the near-term outlook remains uncertain. The investment perspective has to be 3-5 years and I can say with some conviction that the stock will outperform the broader indices in this time duration. The point is backed by two critical reasons – Valuations and growth from the oil and gas sector.

In conclusion, I remain bullish on Freeport-McMoRan, and the best time to buy a quality stock is when the chips are down. The company has gone through the worst financial crisis in decades and Freeport-McMoRan looks good to overcome the current slowdown as well.