Divestment of Freeport shares could impose a loss to the State

186
Anthony Budiawan
Managing Director Political Economy and Policies Studies (PEPS)

IO – Indonesia has finally acquired a 51.23% stake in PT Freeport Indonesia (PTFI), through a sale and purchase (acquisition) transaction for 45.62% of PTFI shares at a price of USD 3.85 billion. How come the Indonesian government was forced to buy 45.62% of PTFI shares to achieve 51.23% ownership? Didn’t the Government’s initial ownership of PTFI stand at 9.36%? Why is this now only 5.62% (= 51.23% – 45.62%)?

Here is how it goes:
Initially, Indonesia did have 9.36% shares of PTFI, while Freeport-McMoRan Inc (FCX) had 90.64% of the shares: 81.28% in direct ownership, and 9.36% indirect ownership, through PT Indocopper Investama. Later, in 1996, Rio Tinto agreed to invest USD 184 million in PTFI in order to obtain Participation Rights (profit-sharing) of 40% of PTFI profits, with provisions as follows: for 1996-2021, Rio Tinto’s profit share is calculated from production exceeding a certain production limit, i.e. 118,000 tons of ore a day; and from 2021 to 2041, Rio Tinto’s profit share will be calculated based on total production.

With Rio Tinto’s 40% Participation Rights, the profit rights of the earlier shareholders (Indonesian government and FCX), particularly after 2021, are diluted to a mere 60%, or from 9.36% to 5.62% (9.36% x 60%), while FCX’s share of profits is diluted from 90.64% to 54.38% (90.64% x 60%). This is broken down into direct ownership at 48.77% (= 81.28% x 60%) and indirect ownership, through Indocopper, at 5.62% (9.36% x 60%).

And here a question raises itself: “Can PTFI conclude an agreement with a third party (Rio Tinto) diluting Indonesia’s portion from 9.36% to 5.62% (as explained above) after 2021?” Secondly, “Can PTFI conclude a Participation Right agreement with Rio Tinto for 2021-2041, which is actually outside of PTFI’s period of authority, since the Work Contract (Kontrak Kerja – “KK”) will end on 30 December 2021?” “Will this agreement be considered to be legally flawed?” I would seriously ask the law experts among us to analyze and answer these questions.

From the above explanation, it is understandable why the Indonesian government must acquire 45.62% of PTFI shares in order to achieve 51.23% share ownership. They are still categorized as majority shareholders, even though in this case PTFI, as the majority shareholder, does not have operational rights. For this acquisition, the Government, through Inalum, must spend USD 3.85 billion, which is paid out through two transactions: 1) acquisition of 40% Participation Rights belonging to Rio Tinto (later converted into shares) at a price of USD 3.5 billion, and 2) acquisition of 5.62% of the shares belonging to Indocopper at a price of USD 350 million.

This means that the price of the shares originating from Rio Tinto’s Participation Rights is much higher than the price for the Indocopper shares belonging to FCX: the price of 1% of the shares of the Rio Tinto Participation Right is USD 87.5 million, while the price of 1% of the shares of Indocopper is USD 62.32 million: thus, Rio Tinto’s shares are 40.4% more expensive than Indocopper shares, while these two types of shares actually have identical rights. We humbly request an explanation from the authorities for the reasoning behind their awarding a premium of 40.4% to Rio Tinto.

On the other hand, some would say that the acquisition of PTFI shares at USD 3.85 billion is very beneficial for Indonesia. If it benefits Indonesia, then does it mean that it is disadvantageous to FCX and Rio Tinto? Is that the case?

In compliance with the US Security Exchange Commission (SEC)’ information transparency regulation, FCX made a News Release stating that:

At closing, Rio Tinto will receive $3.5 billion, and FCX will receive $350 million, in cash proceeds.

Following completion of the transaction, FCX expects its share of future cash flows of the expanded PT-FI asset base, combined with the cash proceeds received in the transaction, to be comparable to its existing share of future cash flows under the current Joint Venture arrangements. FCX will continue to manage the operations of PT-FI.

This means that after the handover of shares, FCX’s total cashflow income in the future plus the USD 350 million from the sale of shares, would be about the same as if there is no acquisition. This means that FCX does not lose substantial income, or they have nothing to lose, with this acquisition. Therefore, we might conclude that the acquisition does not benefit Inalum much. On the other hand, because the price of Rio Tinto’s Participation Right shares is 40.4% higher than that of FCX’s, does it mean that the purchase of Rio Tinto’s Participation Right is a disadvantage to Inalum?

Maybe many could question why FCX should feel that their cashflow income rate would remain indifferent with or without the acquisition. The answer is very easy: PTFI share price was calculated using a Discounted Cash Flow (DCF) method, which is the projected cash flow until the end of the Contract Period, discounted with a specific cost of capital (interest rate) in order to arrive at a fair market value. The implication of this method is that the buyer would basically earn no profit whatsoever. I repeat: the buyer would gain no profit whatsoever.

As proof of my words, here is a simple example for calculating the acquisition price, according to DCF:

PT-F has a mining permit with a validity period ending in a year, and PT-F’s owners want to sell the company now. It has spent Rp 10 billion to administer the permit and buy operational assets. Cashflow income in the upcoming year is projected to be Rp 16.5 billion. Using the DCF method, with a 10% cost of capital, the acquisition price becomes Rp 15 billion (Rp 16.5 billion/ (1+0.1)).

Mr. John, the extremely intelligent man interested in buying out PT-F, feels that this is a very good and fair price (because it is calculated using DCF). He agreed to buy PT-F shares at Rp 15 billion, with money obtained from a commercial loan at an interest rate of 10% per annum.

But what happens? PT-F’s cashflow really did generate Rp 16.5 billion according to projection. Mr. John is happy, but only temporarily. The Rp 16.5 billion gets spent out for Rp 1.5 billion credit interest (Rp 15 billion x 10%) and credit principal at Rp 15 billion. On the other hand, the former owner of PT-F is very satisfied with the transaction, because he gets his Rp 5 billion in profits now. However, the former owner of PT-F is actually indifferent to whether he receives Rp 15 billion or Rp 16.5 billion a year from now.

This condition is as stated by FCX in its News Release. That is the essence of selling shares using the DCF method: the buyer receives no profit.

The next question is, “Isn’t buying PTFI shares the same as buying our own asset?” According to the DCF method, PTFI cashflow is calculated from the yield of its mining activity generated from the underground reserves within Indonesia soil until 2041. Therefore, it is not wrong if somebody should state that Inalum is paying for its own asset, in this case the mineral reserves within Indonesian soil. Furthermore, Inalum, as in the above example, will not get any profit whatsoever, because the share price is calculated using the DCF method.

The, is there another way so that Inalum/the Indonesian government does not lose out in this acquisition? How much of the divested shares should be acquired?

Indonesia should raise its share ownership at PTFI by the end of 2021, with an acquisition price calculated according to the net book value of the Company’s assets. This is the way to buy shares so that we do not buy our own assets with our money.