Anchor Slowly Lifting from Freeport

07/25/2012 4:26 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The copper miner is undervalued given the good news investors are likely to hear in coming months, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

I can’t quite say that Freeport McMoRan Copper and Gold (FCX) is priced for the end of the world—if the sun were going to flame out in a nova, I would give the stock a forward multiple of 0.

But the stock price for the world’s best copper miner certainly doesn’t include either a modest recovery in copper demand from China or lower costs on improved ore grades at the company’s Grasberg mine. (Freeport McMoRan Copper & Gold is a member of my Jubak’s Picks portfolio.)

The price-to-earnings ratio of the stocks in the S&P 500 is 14.6. Freeport McMoRan trades at just 7.9 times trailing 12-month earnings per share. The average mining stock goes for a P/E ratio of 8.9. The forward P/E ratio for Freeport McMoRan is just 6.2.

I can’t tell you when the stock market will decide that China’s demand for copper isn’t about to collapse—although I suspect it will be sometime in the third quarter of 2012—but the stock does pay a 3.92% dividend in case you’re early.

The company reported a slight earnings miss for the second quarter on July 19, of 74 cents a share versus Wall Street’s expectations for 79 cents a share. Revenue fell, year over year, by 23% to $4.47 billion against the $4.48 billion expected by Wall Street.

The earnings miss was actually due to gold, rather than copper, as gold sales and prices fell short of company estimates. (The company’s average realized price for copper was $3.50 a pound, and for gold $1,588 an ounce.)

For the fourth quarter, the company lowered its estimate for copper sales to 885 million pounds (down 85 million pounds from the company’s estimate in April) and for gold sales to 225,000 ounces (down 60,000 ounces from April.)

Looking at the global economy, and more specifically at troubles at the company’s Grasberg mine, 2012 could have been/should be a much worse year than it has been so far. After all, 2011 set records for copper prices, with copper averaging $4 a pound for the year.

From the economic headlines, you might expect that copper prices would have collapsed this year, but copper prices averaged $3.57 for the quarter, and look like they’ll finish the year averaging $3.50 a pound.

The end of 2011 brought a violent strike at Grasberg that even when settled resulted in big delays, which have reduced production and increased costs. Costs at Grasberg in 2012 will be 25% higher in 2012, according to Credit Suisse, than the investment bank had originally estimated.

But that will still leave costs at Grasberg more than 15% lower than at Freeport’s North and South American mines. And about 5% lower than the cash costs at Chile’s state-owned Codelco, the world’s bigger producer of copper. Freeport’s cash costs at Grasberg will be 27% to 44% lower than the projected cash costs for copper at Barrick Gold (ABX).

And the costs at Grasberg should start coming down in 2013, as the company increases production and works its way back toward richer ore grades.

Credit Suisse projects that earnings per share will hit $5.11 in 2013, up from $3.34 in 2012, and above the $4.77 earned in 2012. But that doesn’t mean that everything is going to be rosy for Freeport in 2013.

Mining companies in Indonesia are squaring off with the government over demands for higher royalty rates and bigger equity stakes. Freeport McMoRan has maintained that the nature of its lease at Grasberg puts it outside the boundaries of recent rules proposed by Jakarta. (Those rules would require mining companies to sell 51% of their assets to the government after ten years of production.)

I think Freeport’s position is legally accurate and the Grasberg mine is different from most mines in Indonesia. But that doesn’t exempt the company from political pressures to give local governments and local companies controlled by Indonesia’s wealthiest families a piece of Grasberg.

The Indonesian government already owns a 9.4% stake in the mine, and recently Freeport McMoRan offered another 9.4% stake to somebody in some kind of a deal. The deal could take the form of an IPO (initial public offering) by the subsidiary that owns Grasberg, or the sale of a 9.4% stake to local governments near the mine (who don’t have the money to buy the stake themselves), or....

The uncertainty that this creates over the stock sure doesn’t help the share price, but the real issue for shares of Freeport McMoRan remains the price and demand for copper.

Because I see the bottom for China’s economic growth rate now coming in the third quarter of 2012, rather than the second quarter, I’m lowering and stretching out my target price on these shares. My target for July 2013 goes down to $50 a share from my previous target of $61 a share by May 2013.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Freeport McMoRan Copper & Gold as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.

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