We now know inflation is at the highest level in forty years following December’s record-shattering consumer price report. The consumer price index is currently up nearly 8% YoY, while producer prices are up almost 10%. With prices rising at such a fast pace, essentially no dividend-paying assets deliver a positive return after inflation and taxes. Accordingly, investors benefit from shifting their exposure toward stocks, particularly those that gain directly from rising prices.
Investors may find one key area attractive in this challenging environment: commodity producers such as mining and energy companies. In general, most of these firms have seen their profits soar since 2020 as the dearth of most natural resources has led to skyrocketing commodity prices. Surprisingly, crude oil and most base metals have continued to rise in value despite the recent rise in long-term interest rates. An economic recession caused by rising interest rates and ending Q.E. could eventually bring commodities lower, but their impeccable resilience over recent months indicates the fundamental shortages are unlikely to subside so easily.
In recent research, I have described the potential value of energy producers as a means of hedging against inflation risk. However, further benefits can be found in base metal mining companies such as the copper giant Freeport-McMoRan (FCX). Copper is fascinating since it is currently hovering around its all-time high at ~$4.5/lbs. Freeport now trades at an attractive forward “P/E” of 14.7X and would be even more undervalued if copper breaks to an all-time high. Of course, tremendous shifts and dislocations in the global economy may make or break the copper rally. Indeed, while base metals can be an excellent inflation hedge, they’re also prone to massive declines during economic declines. As such, I believe investors would gain from taking a closer look at Freeport-McMoRan and the ongoings in the copper market.
Will Copper Continue Higher In 2022?
Over the past decade, copper’s price has been tightly correlated to both the inflation expectation rate (measured using inflation-indexed bond yields) and the U.S ISM Manufacturing PMI (a strong leading economic indicator). Since 2020’s huge global production cuts, all three have surged simultaneously, leading to widespread and ongoing commodity shortages. See below:
The U.S manufacturing PMI has declined slightly recently, indicating that the manufacturing boom may be on the verge of peaking. Historically, this does suggest that copper and other base metals may lose value as economic demand declines. Of course, while there are reasons to believe an economic slowdown may occur in 2022, impacts of depressed mining activity may manage to keep copper up.
Like most commodities, the copper market was in a significant glut from 2014-2019 following years of immense production growth followed by waning demand in China, which currently consumes over half of the world’s copper output per year. China’s demand for copper was slowing before 2020 with its economy; however, China’s growing property crisis and its huge recent factory-shuttering lockdowns will likely result in lower copper imports. That said, the current wave of lockdowns and shutdowns will likely negatively impact mining activity. Additionally, Goldman Sachs recently stated that it believes that China’s stimulus efforts and green energy efforts worldwide will keep copper demand high.
Personally, I do not believe that China can print its way out of its colossal property glut. While growing demand for electric vehicles may aid copper demand in the U.S, it seems this trend is not strong enough to impact the copper market substantially in 2022. Truthfully, there are few indications that demand for copper will rise this year, while weak economic data in both Asia and the U.S/Europe indicate a potential decline. From a longer-term perspective, it seems China is likely on the verge of a multi-year slowdown as it shifts away from pursuing “make work” construction activities. While this would undoubtedly result in a significant decline in copper demand, demand growth from western nations’ electrification goals may offset it.
While I don’t have a strong outlook for copper consumption, the fact remains that the London Metal’s Exchange is beginning 2022 with abysmal copper inventories (roughly 50% of normal seasonal levels – a 47 year low). Even more, Chile and Peru, which produce most of the world’s copper, have seen populist political shifts threatening copper production. With this has come labor disputes that temporarily halted copper production in one of Peru’s largest mines. Such issues are not necessarily contained to South America, as Teck Resources (TECK) recently received a strike notice from workers in Canada’s largest copper mine.
Overall, while I see few strong reasons to believe copper demand will rise, there appear to be abundant signals of continued declines in global supply. Additionally, years of low profits caused most miners to reduce capital investment dramatically since 2012, meaning copper production may continue to decline over the coming years. If Freeport can maintain its output despite headwinds, then it may see stellar profits in 2022 and beyond.
Freeport Still Has Upside Potential
Freeport is one of the largest global producers of copper and is the largest molybdenum miner. Roughly 80% of its overall sales come from copper (the rest are divided between gold and molybdenum). The company’s operations are split nearly evenly between North America (~1455MM lbs), South America (~1030MM lbs), and Indonesia (~1327 MM lbs). This is key as it reduces the firm’s direct risk from efforts to increase taxes on copper production in South America. Indeed, such measures are potentially bullish for Freeport as mining taxes in South America would likely result in lower competition for its North American business.
Unlike many other copper miners, the company has also made considerable efforts to maintain and grow its output. See below:
Once again, if Freeport manages to expand production while many of its peers struggle to maintain output, the firm will have a substantial competitive advantage. Based on this expected output, the company estimates that it should generate an annual EBITDA of ~$15B and an operating cash flow of ~$10B as long as copper remains around $4.5/lbs. This earnings outlook gives the firm a forward “EV/EBITDA” of ~5.1X and a forward price-to-cash flow of ~6.6X based on its current market value. This compares to Southern Copper (SCCO) with a higher forward “EV/EBITDA” of 8X, though this metric may be lower considering copper rose recently.
Freeport also has a strong balance sheet with minimal significant debt maturities over the next five years. Even more, immense cash-generation and improved EBITDA have caused its net debt to adj. EBITDA ratio to decline from 2.4X in Q3 2020 to only 0.2X in Q3 2021. Of course, if there is a slip in the copper market, then this ratio would rise. However, Freeport has a solid position overall which reduces its downside risk. As implied during the Q3 conference call (and investor presentation), Freeport may look to increase its dividend or pursue buybacks following its coming 2021 annual report. Indeed, while Freeport has a lower valuation than Southern Copper, Southern has a 4% yield while Freeport’s is only ~60 bps. As such, its value may rise by a bit if it raises its dividend closer to its peers.
The Bottom Line
Overall, it appears that Freeport-McMoRan may still be a value opportunity considering its low valuation, strong profit growth, and slight discount to its peers. Additionally, while political and labor disputes in South America may create some issues for the firm, they may also give it a solid competitive advantage due to its diversified footprint in North America and Indonesia. This is particularly true considering Freeport is forecasted to expand production in 2022 while overall global output is expected to remain lackluster. Most of all, like all base…