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How Low Can They Go? -- Base Metals

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October 21, 2008 – Comments (3) | RELATED TICKERS: FCX

Bloomberg has a story on Freeport's profits, which are down by 33%.

I was very bullish on the mining industry 2 years ago, but I always had my eye on the exit because I always looked at what the bears were saying so I'd know where to look for the problems.  Two years ago it was hard to see the problems, but within months it was easy to see that the industry's predictions about certain things weren't exactly right.  For example, they said they could only grow at about 3% per year, but they all ramped up with the high prices and it looked like they were growing production much faster then they said they could.  To me that was a problem, and by 18 months ago you could predict that the squeeze supply numbers that favoured high prices would not be so much of a squeeze if industry was growing twice as fast as predicted. 

And then there was signs a slow down was coming, for example, the metals were still being sold but now companies were not selling everything and inventory levels were growing.  So supply growing faster then expected and a slow down already here, but hidden by increasing inventory levels.  That's about when I figured I was out.  By this time last year I was 90% cash and by November 100% cash.

The carnage to base metal prices is much higher then I expected, and the carnage to mining company profits is going to be brutal.  American companies will be hardest hit because the surge in the US dollar means that the price they get for metals has declined the most.  Countries where the currency has decline a lot will have reduced costs relative to the US dollar so although they will be hit hard, there will be a reduced cost to very partly offset it.

I wouldn't be buying companies highly dependent on American production right now.  They are getting way less and American workers are some of the best paid in the industry so they also have higher labour costs.  I predict the companies that almost went bankrupt with the last decline in price will face the same pressures.  High cost mines will close.

Bloomberg reports:

Net income applicable to common stock slipped to $523 million, or $1.31 a share, from $775 million, or $1.87, a year earlier, Phoenix-based Freeport said today in a statement. Profit before one-time items was $1.42 a share, the company said. 

This was awesome for investors (not!)

Share Buybacks Suspended

The company spent $500 million buying back its shares during the quarter at an average price of $79.15. No shares have been bought since Sept. 15 ``because of the recent financial market turmoil'' and no additional stock will be bought in the near term, Freeport said.

In this case the buyback has done just what I predicted the buy backs would do -- reward investors that sold at the expense of the buy and hold investors. It is currently at $32.74, 60% off the average buyback price! 

This is interesting:

Copper prices in New York averaged $3.42 a pound during the third quarter, 1.5 percent lower than a year earlier. The metal has since extended its decline and traded as low as $1.992 a pound today on the Comex division of the New York Mercantile Exchange, the first time the price was below $2 since December 2005. 

For the quarter reported the price of copper is only marginally different (1.5% lower) then a year earlier, but get a load of the headline, profits down 33% because of copper.  Really dumb headline, it is a combination of costs up due to the US dollar being weaker during the quarter compared to a year earlier and production in foreign companies, increased debt servicing costs (10x more long term debt then a year earlier), and the decline in copper price. 

Looking even closer, it looks like production was up about 12% yet profit declined 33%.

Copper averaged $3.42 but they averaged $3.14.  This difference between what they were getting and what the LME price is enormous.  It begs an answer as to whether the LME price was being manipulated to hide the degree of the true price decline.

In any event, their guidance is that every 5c will cut profits by $13 million. ( Well, right about now you have 20x13 reductions, or $260 million.  Guidance doesn't make sense because a billion pounds at a $1/lb less is a billion less dollars.  I find it hard to believe that 3/4rds of the lost revenue is recovered somehow, and my bet is that earnings decline way more then $260 million.  My bad, a misread, that is for the copper forward price which means that the price reduction is averaged somehow.  So I read this as how much they might have to give back if prices decline before the contract is completely closed. 

And they say each 20c decline affects cash flow by $250 million, so look for a $1.25 billion hit to cash flow.

I don't see how they make money at current prices without some creative accounting practices.

3 Comments – Post Your Own

#1) On October 21, 2008 at 8:56 PM, Imperial1964 (97.76) wrote:

I sold FCX back in July as soon as I was eligible for the long-term capital gains rate.  What fortuitous timing!

I knew when the commodity bubble burst they would fall hard.  This credit crunch will also hit them hard.  Last I checked they still had a whole lot of outstanding debt.

Paying back more of the debt would have made a whole lot more sense than share buybacks.

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#2) On October 21, 2008 at 9:29 PM, nuf2bdangrus (< 20) wrote:

I boought at 40 and am wondering if I paid too much.  20 may be a fairer price.  

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#3) On October 21, 2008 at 9:39 PM, dwot (67.78) wrote:

nuf2bdangrus,  I think you may have...  I wouldn't touch them until after Q4 reports, and with that I would cautious that they don't hide the state of the finances in the annual report, by averaging it out.

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