Freeport McMoran Could be Primed to Move

We recently considered undertaking a detailed look at Freeport McMoran Copper & Gold Inc.(NYSE:FCX), one of the largest producers of copper, gold and molybdenum, and a solid performer in the Ascendere Long/Short Model Portfolio.  But a piece of information from another Seeking Alpha contributor caught our attention and congealed with some other things we were thinking about, compelling us to quickly generate a potential trading thesis instead:  

• FCX is one of the highest quality names in the Materials sector, whether you look at its improving free cash flow and ROIC profile or at its high quality management team.  

• Any significant and positive announcement regarding materials prices and Chinese demand may indirectly have a positive impact on the sector.  

• Various metals prices seem to be inching up across the board, and some material companies have cited expectations for increased demand as depleted inventory needs to be replenished.  Against this backdrop and anecdotal evidence, it is possible that major announcements on higher prices could be made.

• As the highest quality name, FCX may be the safest way to play such speculation in the near term.

• Recent trailing multiples applied to forward looking estimates suggest at least a 2-to-1 risk/reward ratio or $69 to $95 over the next few months, if not higher if multiple continue to expand or using different estimates.  This seems initially reasonable given a range of sell side targets of $85-125. 

• A detailed scenario analysis for various ROIC and cash flows assumptions is required for the prudent investor. 

FCX shares attractive qualities with some other recently successful stock ideas

What first attracted our interest is that some key fundamental attributes of Freeport McMoran closely resemble that of other stocks in other sectors that have suddenly appreciated. To name a few, we are thinking of names such as Seagate (NasdaqGS:STX) which was in the Ascendere Long/Short Model Portfolio in February, and NBTY, Inc. (NYSE:NTY), which we mentioned as a potentially good long idea on February 22 and is in the model portfolio for March. FCX was in our model portfolio for February and remains there for March.

Initially, given our bottom-up approach, it does not matter to us whether these companies are small cap or large cap, mine copper, gold and molybdenum, or manufacture fish oil pills or disk drives. As generalists looking for ideas among 3000+ stocks that trade on major U.S. exchanges, these traits are initially irrelevant.

What matters is that these stocks are: 

• Severely undervalued on an adjusted basis.
• Showing strong operating momentum.
• Ranked very high on our model for analyst revisions. 
• Ranked high on our various models for fundamental quality.
• Showing good or drastically improving balance sheets. 
• Showing decent price momentum. 

The closer we look at such companies, we usually find a track record and forecast for strong free cash flow growth and improving ROIC -- the key attributes that drive any stock's valuation. 

Admittedly, looking at such key factors in a systematic way is fairly elementary. Numeric Investors started doing this in the early 1990s, and Zack's, Starmine, Sabrient, MarketGrader.com, Value Engine, Investor's Business Daily, and a number of others have developed businesses around similar approaches. We find our approach at Ascendere Associates LLC extremely valuable because its simple but unique and powerful process has not been widely disseminated.  Below is a model that generally illustrates our approach.

The company has a strong track record and respected management team

With everyone looking at fundamental factors, there needs to be something more to the story. First of all, it helps that based on our experience we are already familiar with Freeport McMoran. We know that management team is high quality, it has a track record of making good acquisitions, it manages its capital spending, dividend payments and overall cash flow well, and the recent stock price has generally shown some good price momentum.

Attractive anecdotal information

Additionally, we have been thinking about the anecdotal information that we have come across over the last few weeks.  

• A number of "low-quality" Material stocks that have been performing quite well recently -- on a relative basis a "high-quality" name like FCX could be a safer way to potentially participate.

• From our experience covering steel and nonferrous metals companies at PaineWebber more than a decade ago, material company stock prices at times move before there is any underlying economic justification -- up or down.
   
• The general trend of material prices and production generally move in tandem, though as Mineweb explains this is not always the case.

• Various manufacturing indices are moving higher.

• The general trend of various material prices, including copper and gold, are moving higher.

• Stock price momentum in the stock might indicate there are few underlying issues that we are overlooking at this initial stage.

• The stock market overall has recently been moving higher, thereby creating a favorable overall risk backdrop if it continues.

• Citigroup recently raised forecasts for various metals prices and raised its stock price target for FCX to $95 from $85, and the rest of the sell side ranges higher.

• A March 2 StockTalk item by Seeking Alpha contributor David White stated: "Nomura says iron ore prices are set to surge 70%. The major miners were negotiating a 40% increase with China."  This may indirectly benefit the group.

• Other pieces of indirect anecdotal information include a report from the Michelle Applebaum that steel prices are inching up, and a Zack's report that the largest steel company in the world ArcelorMittal (NYSE:MT) expects a pickup in demand in the coming months as inventory destocking completes.  (We understand that supply/demand dynamics differ across various metals groups, and we are not going to attempt a 30-second analysis of a subject that people spend 30-years every day studying.  I would just point out that all eyes seem to be on China right now, and if they need steel, they will need copper too.)  

What about Vale S.A.?

Even though Vale S.A. (NYSE:VALE), as one of the world's largest iron ore producers in the world, would be one of the biggest and beneficiaries of rising iron ore prices, we are not interested in this name because it just does not share a number of these key fundamental characteristics we mentioned above. That does not mean VALE will not move higher, or is a bad idea -- we just prefer to look at stocks in a consistent way. By doing so, we can always build on and improve from our prior mistakes and successes.

We choose to use Nomura's bit speculation as anecdotal information to catalyze a number of things we have been thinking about the last few weeks. Mainly, if this iron ore price increase with China actually occurs, this could be interpreted that there is less near-term risk with general Chinese demand for materials and industrials than previously thought. Perhaps other announcements of significant material price increase could follow. Since we consider Freeport McMoran one of the highest quality names in the Material, we find it the potentially the safest and best way to explore this theme on a near-term and long-term basis.

Citigroup's recent upgrade provides some support to our initial thesis

We must be cautious using anecdotal information. Investors will usually see and hear whatever they want to see and hear, and will find a way to prove their thesis while ignoring pieces of information that could disprove it. Our quoting a February 2 StreetInsider.com article to justify this quickly laid-out thesis could be just another example:

"Citigroup raised its forecast for various base metals and bulk commodities and as a result upgraded both companies from Hold to Buy. The firm raised copper to $3.34/lb in '10 and $3.47/lb in '11, aluminum $0.99/lb in '10 and $1.07/lb in '11 and iron ore +40% fines, +50% lumps, +60% pellets.

On Freeport-McMoRan, the firm said even with yesterday's rebound shares are still trailing the S&P by 8% YTD. Following the firm's commodity revisions, they believe the stock is attractively valued at 9.5x their 2010 estimate of $7.50 and 8.8x their 2011 estimate of $8.15. The firm raised their price target target price increases to $95 from $85."

Moreover, with regards to most companies, especially the cyclicals -- they are almost always optimistic regarding demand and pricing. Even attempts to verify demand data with surveys or expensive consultant dinners are suspect. I point to the numerous sell side reports of employment staffing agency analysts throughout 2007 citing surveys that claimed strong demand, all the while stock prices in the industry were tanking and they were "surprisingly" losing clients. Obviously, what could be anecdotal today could be proven as foolhardy speculation tomorrow.

Multiple valuation is compelling

FCX is trading at a very low multiple relative to its history and its peers when adjusted for various fundamental factors. In addition, its average trailing multiple has been expanding over the last few months. If we apply this multiple to a range of forward estimates, we think the stock price move within $69-$95 or $73-$99 over the next three to six months. If the multiple keeps expanding at its recent rate, it could conceivably range in price $77-$104. If this methodology proves relevant, that's a risk/reward of either 2-to-1, 4-to-1 or 21-to-1.

Anyone reading our previous work on Seeking Alpha, including the Ascendere report on the mid-cap mining equipment company Joy Global Inc. (JOYG) (another beneficiary of the theme mentioned here) will know that we do not favor an approach valuing companies solely on a multiple basis. In our opinion, the only insightful way to value a company is to determine what a realistic range of possible scenarios against a long-term ROIC and discounted cash flow analysis. Multiples should be considered anecdotal to the underlying assumptions of various DCF scenarios, and in times of extreme volatility multiples are completely irrelevant.

Summary

Given that Freeport McMoran is a very-high quality company in an industry with short-term uncertainty and strong long-term fundamentals, coupled with an announcement that could indirectly have a positive impact on the group, FCX deserves to be studied as a potentially good near-term trade or longer-term investment idea.

Investing in any security entails high risk, including the risk of total loss. We make every attempt to provide accurate and relevant analysis, but we do not guarantee this.