Friday, November 24, 2006

More on Freeport-McMoRan.

From the Morningstar Investment Report:

"Freeport-McMoRan's management describes its sole mine, Grasberg, as a blessing and a curse. We agree. The fantastic economics of the Indonesian mine help Freeport generate substantial cash flow throughout the entire commodity cycle. However, the geopolitical risks and insufficient operational diversification make this investment an all-or-nothing proposition. We'd recommend these shares only to risk-tolerant investors.

"Not only does Freeport's Grasberg mine boast the largest single gold reserve and the second-largest copper reserve in the world, but also the geology of the mine is noteworthy. First, copper grades at Grasberg are among the best in the world--above 1% compared with less than 0.8% in most other mines. Second, significant quantities of gold and silver are mixed with copper in the mine, and the byproduct revenue helps boost margins. This competitive advantage is hard to beat and is the primary reason we think Freeport has a narrow economic moat. The company's returns on invested capital further testify to the existence of a moat. These returns have averaged 20.9% over the past six years, clearing the company's cost of capital hurdle, which we reckon to be 10.6%.

"We are impressed by management's approach to acquisitions during the current commodities boom. The mining sector has seen its share of merger and acquisition activity recently; Freeport has remained one of the few watching from the sidelines. We applaud management's disciplined strategy of evaluating potential targets strictly on return metrics. This approach gives us confidence that management will not dilute Grasberg's profitability for the sake of top-line growth.

"Still, we have several concerns. First, Freeport essentially operates one mine--and a mature one at that. This limits the company's flexibility to respond to dynamic market conditions. Second, any operational hiccup, like the slippage in late 2003, could have a significant impact on revenue and profits. We're also concerned about the mine's significant geopolitical risk. Freeport's Contract of Work, the Indonesian doctrine that allows the company to exploit Grasberg's resources, has been under attack by activist groups and the media. Even if these allegations of environmental damage and political interference carry little clout, the company might not be able to fend off similar attacks in the future. We therefore think an investment in this firm should be made only by investors who can tolerate significant event risk."

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