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Freeport Fails to Impress

Posted on: July 25, 2008 - Email Article - Printable Version

Darrell Reid

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Freeport McMoRan Copper & Gold [FCX: 28.22, +1.48 (+5.53%)] failed to impress as quarterly earnings dropped 14%. This is the second quarter in a row that they have not only missed Street expectations, but quarterly earnings dropped as well. In a stressful commodities market with energy concerns and financial woes looming over everyone’s head Freeport’s shares definitely paid the price for not meeting Street expectations. Freeport reported earnings of $2.25 per share versus $2.62 for the same quarter last year. Net income for the quarter came in at $4.89 per share versus $4.80 last year- a nominal increase of almost 2%. The drag on this quarter’s earnings was the Grasberg mine of Papua, Indonesia. Due to the size of the mine, the high quality metal is located almost a kilometer deep and Freeport must mine through the low grade materials to reach the rich deposits which greatly affected their volumes for the period. Nevertheless, let’s go through the numbers by region to get a full perspective on what happened this past quarter.

What happened?

Staring with Indonesia, the numbers were horrific. Indonesian production and sales fell 25.5% and 31.4% respectively. Freeport did offer a ray of hope though forecasting 63% of copper and gold production taking place in the second half of 2008- mostly in the fourth quarter. I wish I could tell you that was the worst of it, but net unit cash costs for the production of copper in the second quarter increased over 600% compared to the same time last year! Before you have a heart attack and jump to conclusions I would like to point out that this was due to a significant loss of gold and silver mining credits. Physical production and delivery costs accounted for only 10% of the cost escalation. It’s a no-brainer now why Grasberg was such a drag on earnings- it’s kind of hard to believe Freeport had any earnings at all with such steep cost increases eating into their margins. With that said, the Grasberg mine has significant potential that will be realized within the next two quarters as Freeport descends deeper to the richer deposits of the mine. Freeport maintained expectations of producing over four billion pounds of copper total for the year.

When will they reach Climax?

Thankfully, North America posted more positive results. Copper production and sales increased 4.9% and 4.2% respectively. North America showed the strongest pricing power with the average price of copper rising 25.5% compared to the same quarter last year. Unfortunately, costs rose as well rising over 50%. Molybdenum production was flat while sales rose 25% due to favorable prices. The jewel of the North American operations is definitely the Climax mine which Freeport recently reopened. The Climax mine is believed to be the largest and highest grade molybdenum mine in the world. Production is expected to start in 2010 at which point the mine is expected to produce 30 million pound of molybdenum per year. Realize, the entire molybdenum market is approximately 250 million pounds total! Freeport already supplies nearly 10% of the market as the world leader in production. The inclusion of the Climax mine will make Freeport the dominant powerhouse of molybdenum. Short note for those who are unfamiliar with the metal- it’s used in high stress, high performance alloys commonly found in aircraft parts, electrical contacts, and industrial motors.

What about all those strikes in Peru?

Lastly, moving on to the South American operations- copper production and sales were the strongest of the three regions rising 9.2% and 6.7% respectively while average realized prices for copper rose just over 9%. Gold production and sales dropped 12% and 7.7% while prices rose 35%. The production numbers are a bit surprising considering all the political drama that has occurred in previous months. First, union workers went on strike, then they went back to work. Later they realized they still weren’t satisfied and “agreed” to go on strike again. This plan never really got off the ground. Union workers at the Cerro Verde mine operated by Freeport could not drum up enough support to actually go on strike. Freeport is actually in the process of adding a second mill at the Cerro Verde mine. Freeport was telling the truth when they said operations were unaffected by the strike. As for the cost of however- they rose 27%.

Cost Management

Costs across the board are going to affect miners as they deal with rising labor costs, input costs such as sulfuric acid, and of course energy costs. Oil prices have subsided somewhat in the past few days, but it’s pretty clear they they will be of key concern in the near term. Freeport recently reported energy costs account for 30% of their total costs- a 75% increase from 2007. For instance every dollar increase in the price of gasoline affect $250 million of revenue for the firm. As for the outlook, Freeport expects mining credits to be around $1.10 per pound which will directly decrease the costs of production. Specifically at the Grasberg mine net unit cash costs are expected to drop to $0.80 per pound- a 40% decrease from the second quarter. Overall Freeport expects their cash costs to decrease significantly in the second half of 2008 with a net unit cash cost of $1.24 and $0.92 per pound in the third and fourth quarter.

Final Word

Altogether, Freeport is still in a good strategic positions even though it has been tough the past two quarters. Freeport has been able to take these rising costs in stride utilizing economies of scale, and active inventory management to generate significant operational cash flows. Freeport has kept their estimates in line and they will benefit from net unit cash costs decreasing in the second half of 2008. With an expected realized price of $3.75 per pound of copper- Freeport’s profits should expand as their costs decrease. Freeport still expects to spend $3 billion in capital expenditures their year and they have also increased their dividend from $1.75 to $2.00. Freeport is also expanding their share repurchase program to 30 million shares. By developing the Grasberg mine of Indonesia, reopening their molybdenum mine in North America, and expanding operations at their Cerro Verde mine in South America Freeport is positioning themselves to take advantage of long-term trends in a growing international economy. Don’t be deterred from the recent trading activity, Freeport McMoRan Copper & Gold is a long term stock that belongs in anyone’s portfolio who seeks exposure to emerging economies and a metal with increasingly tight market conditions.

-Darrell Reid

Disclaimer: The author is long of FCX; The mutual fund the author is associated with is long of FCX.

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