Freeport-McMoran is a highly cyclical stock that is subjective to the economic swings in the United States in its housing market and to expansion of projects in Emerging Markets, like India and China. Therefore, a proper projection of economic growth path is essential. In my eyes, a double dip recession is extremely likely and even a depression can still be in the cards. Europe's and United States' economy still need to delever at the consumer, business and government level, which will cause deflationary forces to take the upperhand in 2010 and hence economic growth will at best be anemic and in a worst case scenario will be horribly negative. Furthermore, there is a serious possibility that the asset bubble in China can deflate as well, which can cause trouble in their economy and in the commodity complex. Copper inventories have steadily risen over the last year, while the price of copper soared heavily from its lows. If the economic situation is dire, then the price of copper will take a major hit. This will cause Freeport McMoran, even though it is very well run, to take a major hit in its earnings again and might even have to defer new capital investments. A significant drop is therefore in the cards for Freeport from its recent highs around $90 to a low depending on the economic situation.
The FCX stock is overvalued at this point. At $118, Freeport has a market cap of $53 billion. It earned about $3.5 billion over the last 4 quarters and forecasts $3.5 billion free cash flow for 2008. That gives it a multiple around 15.
That’s already a decent multiple for a cyclical commodities business, but it also depends on commodity prices remaining sky high. Their 2008 forecast assumes $3.75 copper and $900 gold. Every 20 cent per pound change in the price of copper impacts operating cash flow by $450 million.
So, for example, a 60 cent drop in the price of copper would reduce operating cash flow by $1.35 billion. All of a sudden that 15 forward multiple becomes 25 and the stock is really expensive. Of course, if commodity prices go up the valuation is really cheaper. But I think there’s a very thin margin of error here and if copper prices come down, Freeport will get hammered. We’ll see pressure on copper prices and therefore on Freeport shares.