UBS INDO Indo Tambangraya Megah (Neutral, PT Rp57,000, 12% upside)

ITM’s shares have risen 61% since January 2010, which is an overall outperformance versus the sector. We maintained a Buy on the company throughout most of last year before downgrading to Sell in November 2010. Our investment case was primarily based on the company’s ability to extract higher coal prices and further increase its reserve life.

However, as coal prices kept rising along with assets prices, we were disappointed that ITM was unable to grow reserves beyond its 12-year reserve life. Consequently we downgraded the rating as the company was trading at 14-15x PE implying 14-15 years of earnings, despite only 12 years of earnings left in reserves. Given our 2011 Japanese benchmark contract upgrade, we raise our rating from Sell to Neutral, as we raise our earnings estimates.

􀁑 Price revision. We revise our 2010-12 ASP assumption from US$71/t, US$83/t and US$80/t to US$74/t, US$99/t and US$84/t, in line with our higher contract estimate. We believe ITM is currently receiving over US$110/t for its 6,200kca/kg product, while 75% of 2011 volumes are still un-priced.

􀁑 Production weakness. The excess rain in H210 is likely to have pressured production throughout 2010. In our experience, production pressure in one year negatively affects the subsequent years due to overall infrastructure capacity constraints, and thus we downgrade production from 23mt, 25mt and 27mt to 22mt, 24mt and 26mt in 2010-12.

􀁑 Cost inflation. Sector costs remain under pressure from higher fuel prices as well as costs associated with H210 deteriorating weather. We increase our 2010-12 cash cost estimate from US$35/t, US$36/t and US$37/t to US$41/t, US$42/t and US$44/t respectively, excluding royalties. ITMG’s production costs are relatively less exposed to fuel price volatility versus the sector, given the implementation of a mine-site coal-fired power plant.

Our earnings estimate is 12% below and 9% above consensus forecast for 2010 and 2011, respectively.
With a 2011 earnings sensitivity of 2.1% for a 1% change in coal prices, ITM is in the low end of the Indonesian sector range.

We raise our price target from Rp44,000 to Rp57,000 per share, which incorporates our earnings revision, a lower risk-free rate from 10% to 7.6% and a lower beta from 1.4x to 1.2x, which reduces the WACC from 10.1% to 9.7%.

The higher price target also reflects a 12-month earnings rollover from a lower mid-2011 to a higher end-2011 EPS. We employ a 12-month target PE valuation multiple of 12.0x, which is in the upper band of the historical trading range. For a check on our PE valuation, we run a life-of-mine DCF valuation based on
the UBS VCAM model, which renders a valuation of Rp56,000 per share, in line with our price target.