Investors didn't hear what they wanted from copper miner Freeport-McMoRan's (FCX -0.22%) first-quarter earnings presentation. The main problem came from the guidance -- the near and mid-term sales outlook is down, and near-term costs are going up. As such, it's no surprise to see the stock pummeled more than most in the latest market sell-off. So is it a buying opportunity, or does the guidance change materially impact the investment thesis? Let's take a closer look.
The case for Freeport-McMoRan
As a reminder, the investment case for Freeport-McMoRan rests on the idea that copper demand is headed higher due to underlying industrial demand coupled with its increased use in electric vehicles, renewable energy, and the trend toward electrification in the economy. Meanwhile, on the supply side, rising regulations and political opposition to new projects are seen as curtailing overall industry supply. However, Freeport-McMoRan's relatively strong position -- significant producing assets in the U.S. and Indonesia and expansion opportunities -- puts it in a relatively stronger position.
In short, the outlook for copper prices is good, and Freeport-McMoRan stands well placed to benefit due to its production capability.
Unfortunately, that thesis took a hit recently due to management lowering its 2022 and 2023 copper sales estimates (in terms of copper volume) and increasing its cost assumption for 2022 on rising energy and commodity-related costs.
Starting with the reduction in sales volume guidance, it primarily comes down to constrained mining rates due to COVID-19 outbreaks in Q1. Copper sales in Q1 were notably ahead of guidance at 1,024 million pounds compared to guidance for 970 million pounds, but as President Kathleen Quirk said on the earnings call, "We benefited from strong U.S. demand in the quarter, which allowed us to reduce inventories." However, you can only rely on inventories for so long, and management lowered its sales volume estimates for every future quarter of 2022 in the Q1 earnings presentation.
It gets worse. Management also raised its cost expectations in terms of net unit cash costs in 2022 from $1.35 to $1.44. A breakout of the company's cost components shows that material and supplies make up 32%. Energy makes up 21%, so there's little doubt that the miner is exposed to a general rising tide of energy and other raw material price rises -- Quirk referred to " sulfuric acid, explosives, grinding media, and other consumables" on the earnings call.
The market doesn't want to hear about falling sales-volume expectations and rising costs, and at the time of this writing, the stock is down nearly 20% since the earnings release. It represents a whopping $13.7 billion reduction in the market cap.
A buying opportunity?
The question then turns to whether the sell-off is overdone and the stock represents a good value opportunity. I think the answer to both questions is yes. There are three reasons why.
First, the reduction in sales volume is estimated at a combined 100 million pounds over 2022 and 2023. Using management's assumption for the price of copper in 2022 of $4.75 per pound, it equates to $475 million. Assuming an operating profit margin of 40%, it represents $190 million in lost earnings. Wiping off $13.7 billion from the market cap due to $190 million in "lost" earnings over a couple of years seems overly dramatic.
Second, the reduction in sales volume in 2022 and 2023 doesn't mean the Freeport-McMoRan won't eventually realize those sales volumes of copper. It just means they will push out, as they are due to temporary issues.
Third, it's far from clear that the cost increases aren't temporary issues that will diminish over time. Indeed, CEO Richard Adkerson and Quirk believe these cost issues are transitory and have been exacerbated by the conflict in Ukraine. For example, the energy supply chain dislocations created by the sanctions on oil and gas from Russia have been a factor.
A stock to buy
Due to the reasons above, it's hard not to think the sell-off is overdone. However, it's worth noting a couple of cautionary points. First, just as the company's cost increases may prove temporary, it's also possible that the current strength in the price of copper could prove temporary too. For example, Ukraine is a major exporter of copper wiring harnesses to the automotive industry. The war has caused dislocations and created an increased demand for copper elsewhere.
Moreover, the conflict is also causing many economic forecasters to lower expectations for global growth, and if it occurs, demand for copper could moderate too.
All told, buying into the sell-off makes sense for investors who continue to believe in the long-term case for copper and a scenario of ongoing economic growth, albeit with some temporary supply chain disruptions caused by events in Ukraine.