Will Freeport’s Big Bet Pay Off?

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Global mining companies are faced with a dilemma.  On the one hand commodity consumers, China in particular, are slowing down as the world still can’t seem to snap out of its economic funk.  This makes planning capital budgets difficult as it’s tough to forecast when and if commodity prices will recover.

Most mining giants are cutting back on those budgets or canceling projects altogether.  As much as those companies would like, none are able to justify the risks of expending the large amounts of capital and time it takes to get large projects into production. 

Just ask Richard Adkerson, the CEO Freeport-McMoRan Copper & Gold (NYSE: FCX), who noted that new “copper investments were limited by the time frame that’s required to take resources and take them into development stage and turn them into cash flow projects.  External growth projects were limited for factors that [the investment community] is well aware about.” It’s a new moment in the mining industry, which VALE (NYSE: VALE) CEO Murilo Ferreira suggested, “requires stricter discipline in capital allocation.” 

The problem is that it’s hard to maintain strict discipline when the world’s central banks are flooding the markets with money.  That easy access to attractive capital is enticing enough to make companies think outside the box.  When Adkerson says that his company is “in a situation where we have attractive financing markets and we’ve been looking at ways to take advantage of those financing markets to produce returns for shareholders,” he’s not kidding.  His firm apparently found what it was looking for, but does the deal really make sense?

At first glance, the deals struck by Freeport-McMoRan to acquire both Plains Exploration & Production (NYSE: PXP) and McMoRan Exploration Co (NYSE: MMR) seem like a bit of a stretch.  Sure, oil and gas are commodities but do they really represent a logical next step and strategic fit or is this signaling a deeper problem in the commodity space?

Adkerson made it a point to emphasize that the deal is “an add-on to our mining business, not a diversion from it.” FCX isn’t the first mining company to diversify into the oil and gas business.  It’s a business that’s worked well over the years for top global mining peer BHP Billiton (NYSE: BHP).  BHP has even beefed up its oil and gas exposure by purchasing Petrohawk Energy last year. 

Investors and analysts can debate whether this deal makes sense all day long.  What’s more important is if this deal will make cents, as in adding to the company’s bottom line.  That’s not as cut and dried, especially in the short term.  According to FCX’s estimates, which are based on $100/bbl Brent Crude and $4.50/MMbtu for natural gas the business will be roughly self-funding for the next two years.  It won’t be until 2015 that investors will see excess cash flowing from the business.  

Instead, the plan is for the excess cash flow from the copper business to be used in paying down the massive debt needed to get these deals done.  After the PXP and MMR deals close the new FCX will have $16.3 billion of debt outstanding.  By 2016 the company will have reduced the debt to anywhere between $7.7 billion to a net cash position of $3.5 billion depending mostly on copper prices. 

It’s not entirely a bad plan.  If commodity prices hit the company’s base targets and everything else goes according to plans, FCX will deliver billions in shareholder value as the company builds equity by taking debt off the balance sheet.  That value could be created even faster if commodity prices move higher. 

The risk is that commodity prices move a lot lower and the company experiences liquidity troubles.  It’s a risk the company has faced before after purchasing Phelps Dodge just before the financial crisis.  Despite the crisis, the company effectively managed to pay down debt.  That highly successful transformative transaction should give investors comfort that management can handle another transformative deal.

With peers like VALE taking a step back to only invest in “world-class assets, with long life, low cost, expandability and high quality output, capable of creating value through the cycles,” it should be noted that FCX is taking a step forward to “add-on to the mining business.” 

It’s aggressive, but it’s a deal that vaults the company to a top five global resources company.  It’s also a deal that likely creates substantial long term value for investors.  I think Freeport’s big bet on oil and gas will pay off, which is why I’m giving the company a green thumb in my CAPS profile. 

latimerburned owns shares of BHP Billiton Limited (ADR). The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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