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It's Time to Buy a Fallen Mining Giant

David Sterman

Over the past few years, the notion of Murphy's Law -- anything that can go wrong, will go wrong -- comes to mind for Freeport-McMoRan Copper & Gold Inc. (FCX), the world's largest copper miner. In that time, the company has witnessed:

-- a sharp drop in copper prices as China worked off overbuilt stockpiles.

-- a similar plunge in gold prices (which accounts for roughly a fourth of the company's revenues).

-- a mining accident that took 28 lives in Indonesia.

-- a pair of major acquisitions in the oil and gas industry that were greeted by a chorus of boos from shareholders and analysts.

-- a rapid spike in the debt load to above $20 billion that raised alarms at a time when revenue and cash flow forecasts were being trimmed.

As a result, FCX stock has lost nearly 40% of its value over the past two and a half years, even as the S&P 500 has moved higher by a similar amount.

The fact that this stock recently tested and help support at $27 and has drifted closer to the $30 mark in recent weeks implies that the "everything that can go wrong will go wrong" phase of this company's life cycle may have passed. In fact, a brighter picture is slowly beginning to emerge, and as the pendulum swings back the other way, shares should start to reverse course.

Several headwinds could become tailwinds in just the next few months, making this a timely trade as well as a solid long-term investment. The shift back toward bullishness could be seen in a recent $29 million purchase of company stock (at a price just under $30) by FCX's board chairman, James Moffett.

With this company, it all starts with copper prices. Freeport-McMoRan produces nearly four billion pounds of the metal every year. So a downward move from $4.50 a pound in the summer of 2011 to a recent $3.15 a pound has surely hurt results. China, which accounts for 40% of global copper demand, is the key culprit. Not only did China sharply slow its purchases of copper this year to reduce stockpiles, but deeper economic weakness in the world's second-largest economy threatened to make matters worse.

Yet a glimmer of good news has just appeared. A fresh economic report out of China highlighted a stabilizing economy, which gave a modest boost to copper prices.

Every $0.10 per pound swing in copper prices impacts FCX's annual EBITDA by $470 million, according to UBS. Yet Freeport-McMoRan's management has said a series of mine expansions should sharply increase the company's output by roughly 50% by 2016, assuming copper prices merely remain in the current range and don't fall any further.

Notably, management plans to meet that production goal even as it brings much greater discipline to its capital spending programs. Roughly $1.9 billion has been trimmed from the company's annual CapEx efforts. How does output go up even as spending goes down? Part of the projected increase will come from greater productivity at a pair of existing major Indonesian mines that had been beset by work stoppages. FCX is now negotiating with workers in that country, and analysts at Merrill Lynch have noted a "positive resolution would be a major catalyst for shares."

The other looming catalyst for this stock: a change in perception about cash flow. In the past few years, investors have fretted that falling copper prices, undisciplined capital spending and the purchase of Plains Exploration and McMoRan Exploration were all contributing to downward cash flow projections. Yet FCX's cash flow outlook is much more robust than the flagging stock price may indicate. To be sure, 2013 is a "kitchen sink" year, as free cash flow will dip to just $600 million (down from $3.9 billion in 2010). Yet that figure should steadily rise to $7 billion per year by 2016, according to analysts at Merrill Lynch. That forecast assumes that copper prices will rise about 5%, and that gold and oil prices will remain near current levels.

What does robust free cash flow lead to? In many cases, a rising dividend. FCX currently has a $1.25 a share payout (equating to a 4.3% yield), though that figure could move up to $2 a share by 2016, even as the payout ratio returns to its long-term 40% rate. Strong free cash flow should also lead to diminished concerns about the company's still high-debt load, which has been a key overhang on the stock. Management expects to reduce debt by $9 billion to around $12 billion by 2016.

That debt pay-down will come from selected sales of non-core energy fields. "We believe the market will focus on these savings and on the potential asset sales," as an investment positive, note analysts at UBS, which recently boosted their price target from $33 to $35.

Yet even that price target may look too conservative once investors start to shift their focus away from the recent bad news and pivot to better news ahead. When that happens, they'll start to appreciate that the estimated replacement value of FCX's mining and drilling assets is worth roughly $49 a share, according to Merrill Lynch.

As soon as the company releases its next series of quarterly results, scheduled to be reported Oct. 21, I'll be looking for FCX to announce certain asset sales, and equally important, maintain or even boost sales and cash flow guidance, now that the company has lowered guidance to very achievable levels. Barring a complete collapse in copper prices, I believe this stock should start working back to the $40 mark -- or higher.

Recommended Trade Setup:

-- Buy FCX at prices up to $34
-- Set stop-loss at $27
-- Set initial price target at $40 for a potential 18% gain in 12 weeks

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