Nomura Coal mining Indonesia (Update 3) Adaro Energy

The premier coal
 Strong operations to support expansion
We believe ADRO’s integrated business, good track record and expanding infrastructure will support an almost doubling of the company’s production over the next 4-5 years to feed strong demand for its environmentally friendly coal. Cost reduction initiatives are also in the pipeline, and we think these should lower production costs that are already the lowest among Indonesian coal companies under our
coverage.

 Improved balance sheet
Strong cash flows, leading to self-financing capex, have led to lower balance-sheet risk, we believe. With no expected major M&A transactions and no major debt repayments, higher dividends — subject to lenders’ and shareholders’ approval — are possible, especially post FY12F when ADRO, on our estimates, will be in a net cash position.

 Lower-than-peer valuations look unjustified to us
Prevailing valuations are still in the mid-cycle of the stock’s historical valuation range. Relatively speaking, lower-than-peer valuations for ADRO are unjustified, in our view, given the company’s track record
and positive outlook.

 Risk factors
Key risk factors to our target price include coal price volatility, a decoupling between coal prices and oil prices, weather conditions, regulation and project execution.

Earnings to recover strongly in FY11-12F
Having posted negative core earnings growth (-37% y-y) in FY10 on bad weather, which led to flat volume growth, lower ASP and higher production cash cost, ADRO’s profitability will, on our forecasts, bounce back and post a CAGR of 98% over FY10-12F. We see this being driven by a combination of higher volume from 42.6mn tons to 53.9mn tons (12% CAGR 2010-12F), higher ASP from US$57.0/tonne to
US$90.2/tonne (26% CAGR) and lower financing charges, despite higher production cash costs (6% CAGR). We forecast the higher volume will contributed by both Tututpan and Wara mines from 40.6mn tons and 2.0mn tins in 2010 to 43.9mn tons and 10mn tons, respectively in 2012F. Having said that, we forecast EBITDA and net margins will widen from 39% and 12%, respectively, in FY10F to 52% and 25% in FY12F.

Balance sheet getting stronger
A combination of relatively strong profitability – compared with historical levels – and repayments of debt principals in FY10F brought down ADRO’s gearing (debt/equity) to 68%, on our estimates, from 86% in FY09. We expect ADRO’s balance sheet to get stronger in the future due to stronger operations, enabling it to finance its capex internally and lower debt levels. We forecast gearing will come down to 47% and 26%
in FY11-12F, respectively, and estimate ADRO will be in a net cash position by end-FY12F.

In terms of cash cycle period (we define the cash cycle as receivable days plus inventory days minus payable days), we assume it was -2 days at end-FY10F and will remain the same for FY11-12F.

Sensitivity analysis
We have run several FY11-12F earnings sensitivities on changes in coal price, production volume, oil price and exchange rate assumptions.
 Coal price
Coal price volatility has a big impact on our earnings forecasts. Our sensitivity analysis suggests that for every 10% change to our 2011-12F coal price assumptions, our earnings projections change by 23% and 18%, respectively.

 Production volume
Though not as sensitive as changes in ASP assumptions, our earnings estimates are also quite sensitive to changes in production volume assumptions. Our sensitivity analysis suggests that for every 10% change to our 2011-12F production assumptions, our earnings estimates will change by 12% and 11%, respectively.

 Oil price
Our sensitivity analysis suggests that for every 10% change to our 2011-12F oil price assumptions, our earnings estimates will change by 2% for each year. The earnings sensitivity is not high because, on our estimates, fuel costs account for 13% of ADRO’s 2010 production cost.

 Exchange rate
Our earnings estimates are sensitive to changes in our exchange rate assumptions. Our sensitivity analysis suggests that for every 10% depreciation of the rupiah (vs the US dollar), our FY11-12F core earnings estimates would rise by 13% and 12%, respectively, and vice-versa.

Risk factors
Coal price volatility
Coal is a new growing asset class, and as such its price movements can be affected by non-fundamental factors. Our sensitivity analysis suggests that for every 10% change to our 2011-12F coal price assumptions, our earnings projections will change by 23% and 18%, respectively.

Decoupling of coal price and oil price could dent ADRO’s results
We have assumed that the strong positive correlation between coal and oil prices (coefficient correlation = 0.90) will continue in the future. A decoupling between these two commodity prices, ie, higher oil price not followed by higher coal price, can have a significant impact on ADRO’s financials. Our sensitivity analysis suggests that for every 10% decrease in coal price and 10% increase in oil price, our 2011-12F earnings estimates will decline by 26% and 20%, respectively.

Weather
Bad weather in 2010 prompted ADRO to revise down its coal production target. Starting this year, we have assumed that weather conditions will improve and production will grow by 11% and 14% in 2011-12F, respectively. But weather is a noncontrollable and unpredictable factor that can have a significant impact on ADRO’s operations. Our sensitivity analysis suggests that for every 10% change to our 2011-
12F production assumptions, our earnings estimates will change by 12% and 11%, respectively.

Regulatory risk
Regulatory risk in the mining sector in Indonesia, in our view, is probably greater than in other sectors. The risk lies not only in the implementation of mining regulations but on synchronisation of the mining sectors with regulations in other sectors that impact the mining sector as well.

Execution risk
ADRO intends to double its production from 40mn tons to 80mn tons over the next 4-5 years. The success of its production upgrade will depend on several factors, such as availability of required equipment, performance of contractors and other factors, which to an extent are beyond the company’s control.

Wara performance
The production expansion to 80mn tons pa will be highly reliant on Wara’s ability to significantly ramp up its annual production from 2mn tons in 2010 to 30mn tons in the future (by 2016F). This is because production upside from the existing Tutupan mine has become limited.

Mining contractor risk
ADRO has a high dependence on external mining contractors, as close to 70% of its coal production is mined by external contractors; the rest (30%) is mined by its subsidiary, Saptaindra Sejati (SIS).

Exchange rate volatility
ADRO’s financial performance is tethered to exchange rate volatility, as most of its revenue is in US dollars or linked to the dollar, while some of its expenses are paid in rupiah. Our sensitivity analysis suggests that for every 10% depreciation in the rupiah relative to the US dollar, our FY11-12F core earnings estimates will be up by 13% and 12%, respectively, and vice-versa.

Valuation methodology
We set our 2011-end target price for ADRO at Rp3,700, which implies FY11-12F EV/EBITDA of 8.3-4.7x and P/E of 19.6-10.5x. We derive our target price using a DCF methodology, with discount rates of 10.0% and 11.3% for the coal and non-coal businesses, respectively. We set 8% and 0% terminal value growth rates for coal and non-coal businesses, respectively. For ADRO’s stake at the IndoMet Coal project, our valuation is based on acquisition cost.