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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

This Controversial Blue-Chip Has 100% Upside Potential

As executives prepare to announce a major multi-billion-dollar acquisition to the public, they usually grow very excited about an enthusiastic response from key shareholders.

But when copper miner Freeport-McMoran Copper & Gold (NYSE: FCX) announced a pair of acquisitions in the oil and gas sector, worth an estimated $20 billion, investors did a spit-take.

At the time, investors wondered why the world's largest copper miner would diversify away into a completely unrelated industry. And they grew alarmed at the amount of debt taken on to complete the deal.

More than a year later, shares remain below where they were before the deal was announced, and many investors still see the deal as a head-scratcher. Yet in coming years, these bold strokes are likely to be seen in a much better light.

Static Enterprise Value -- Higher Market Value?
Although Freeport-McMoran eventually announced plans to sell some assets to raise cash, the company's long-term debt spiked from $3.5 billion at the end of 2012 to $20.7 billion at the end of 2013. In tandem with the current market value for its equity, FCX's total enterprise value stands at around $53 billion.

There is no need to argue that this company deserves a higher enterprise value, but simply maintaining that level of value constant will yield significant upside for the stock. A look at the projected balance sheet and cash flow statements explains why.

Starting this year, the combined entity is on track to generate at least $10 billion in annual earnings before interest, taxes, depreciation, and amortization (EBITDA), rising to $13 billion by 2020, according to Merrill Lynch's forecasts. Much of the cash flow gains are likely to come form the acquired oil and gas properties. To be sure, FCX must maintain a considerable amount of annual capital spending.

Management expects to spend around $7 billion in capital expenditures (capex) this year and next, though that figure should steadily drop in subsequent years. Yet rising EBITDA against that falling capex means that free cash flow will surge, from $1.2 billion this year to $4.7 billion by 2017 and $8 billion by 2020.

Management thinks it can aggressively tackle the $20 billion debt load through rising free cash flow. Merrill's analysts agree, estimating that by 2020, FCX will have net cash on the books, not net debt.

Freeport's Strengthening Balance Sheet

Remember that high debt loads argue for lower EBITDA multiples and low debt loads argue for higer EBITDA multiples. So let's revisit that long-term EBITDA figure again. By 2020, with no debt on the books, that $13 billion in annual EBITDA generation should merit an EV/EBITDA multiple of around 5.

That implies an enterprise value of $65 a share. Again, with no net debt, that will directly equate to the company's market value. The company has roughly 1 billion shares outstanding, so that equates to a target stock price of around $65.

Will investors need to wait until 2020 to see that kind of move? No. The steadily improving balance sheet should lead investors to look ahead, and shares will likely reflect that set of pro forma financial statements by 2017 or 2018. Thay may seem to be a long time to wait, but 100% potential upside for a three- to four-year time horizon is impressive.

Copper Noise
The reality is that few investors ever think about a stock like this in the context of long-term value creation and financial engineering. Instead, FCX is always seen as a short-term proxy for copper demand from China, and is often dogged by labor and production issues in copper mines in Indonesia and elsewhere. These are important factors if you have a three-month time horizon. Shares might not even budge in coming months, especially if copper prices are flat.

Yet for a stock like this, it's crucial to take the long-term view. Whether $29, $31 or $33 is the right entry point for a stock like this is largely irrelevant. The fact that analysts issue price targets for where they think shares will be trading in a quarter or two further obscures the long-term view that investors should hold.

Risks to Consider: These cash-flow assumptions are based on the expectation that copper prices and oil and gas prices will stay constant at current levels for the next half-decade.

Action to Take --> This is an exercise you can do for nearly any major firm that has borrowed heavily in pursuit of a major acquisition. These deals often end up paying for themselves out of cash flow, and it's a good strategy for long-term value creation. The merits of combining two disparate businesses under one corporate umbrella still may not make absolute sense, but if management can deliver on these cash flow targets, then management's strategy will have been vindicated.

P.S. My colleague Dave Forest is always on the lookout for undervalued commodities firms in his premium Scarcity & Real Wealth advisory. One subscriber raves, "Scarcity & Real Wealth provides analysis unmatched anywhere." Click here to see how Dave is earning his readers' praise.

This article was originally published on StreetAuthority under the title: Is This Controversial Blue-Chip Company Set To Crush The Skeptics?