Nomura Coal mining Indonesia (Update 1)

Key value drivers
We initiate coverage of Indonesia’s coal mining sector with a Bullish sector stance. We select Adaro Energy (ADRO IJ) and Indo Tambangraya Megah (ITMG IJ) as our top picks in the sector, with price targets of Rp3,700 and Rp73,000, respectively.

Our Bullish sector stance hinges upon:
 Positive global sector outlook. We believe that supply/demand imbalances in the sector will persist, supporting higher coal prices in the medium term.
 Structural changes in the domestic market. A combination of pressure from high oil prices plus abundant coal reserves in Indonesia is likely to drive robust domestic demand growth.
 Strong earnings growth prospects. We forecast a sector EBITDA CAGR of 60- 74% over 2010-12F, underpinned by higher volumes and improving ASPs.
 Higher dividends, although selective. We expect coal companies to enjoy better leverage, and as such lower balance-sheet risk, on stronger coal prices. That should enable self-funding capex and the return of more money to shareholders, in our view.

Catalysts
Several factors, in our view, stand as positive catalysts to our call:
 Better-than-expected term price negotiation. Consensus, in our opinion, is far too conservative on coal price assumptions.
 Significant progress in projects. Organic and non-organic volume growth would be positive for earnings enhancements.
 Continued supply-demand imbalance. The imbalance between supply and demand will only drive up coal prices and sector performance, in our view.
 M&A deals. Indonesia is a major M&A target for supply security due to its competitive location relative to major coal-importing countries.
 Market sentiment. Positive market sentiment, despite having little impact on fundamentals, could be another major catalyst, in our view.

Sector performance
The coal sector, as proxied by the JAKMINE Index on the Indonesia Stock Exchange (IDX), performed in line with the overall market in 2010. We expect the coal sector to outperform the market in 2011F, with higher volumes and improving ASPs leading to stronger earnings growth.
We believe Indonesian coal companies look reasonably valued at current levels on EV/EBITDA relative to the current coal price. We find they are also at 27% and 17% discounts, based on FY12F EV/EBITDA and P/E, to peers in China.

Risks to our investment view
We note several risk factors to our investment view, including coal price volatility, disconnect between coal and oil prices, weather conditions, regulations and coal data reliability.