Nomura Coal mining Indonesia (Update 2) ADRO and ITMG are our top picks

Bullish on the coal sector
We like the coal sector for its attractive supply-demand dynamics in both global and domestic markets. The sector, as proxied by the JAKMINE Index on the Indonesia Stock Exchange (IDX), performed relatively in line with the overall market in 2010. We expect the sector to perform more strongly in 2011F, on higher volumes and better ASPs leading to stronger earnings growth.

We believe the companies that will benefit most from the positive coal market conditions are those with: 1) a strong business model, with installed and expanding capacity; 2) exposure to the seaborne market to feed strong demand; 3) competitive costs; and 4) a strong financial position so that upsides in the coal market will benefit shareholders.

Among the coal miners under our coverage, we have Adaro Energy (ADRO IJ) and Indo Tambangraya Megah (ITMG IJ) as our top sector picks, with price targets of Rp3,700 and Rp73,000, respectively.

Valuations
Indonesian coal companies look reasonably valued on EV/EBITDA relative to the current coal price. PTBA and ADRO, despite trading higher than peers on EV/EBITDA, are still trading below their end-2009 multiples. BUMI is trading below its historical average EV/EBITDA despite expectations of lower balance-sheet risk. While ITMG is trading above its historical average EV/EBITDA, we think this is justified given the current higher coal price and expected stronger coal prices going forward.

Key catalysts
We highlight several factors/variables which could be positive catalysts for the sector:
 Better-than-expected term price negotiation. We believe the street assumption of only US$100-110/tonne for the 2011F term price is still conservative, considering that Xstrata has agreed to supply coal to Tepco at US$115/tonne.
 Significant progress in projects. The industry is building up higher capacity, both organically and non-organically, to meet strong coal demand. Significant progress in the capacity upgrade programme should be positive for the sector.
 Supply-demand imbalance. We expect the coal market situation to remain tight as strong demand is likely to be followed by major capacity expansion in Australia and South Africa. Any supply disruption would likely lift coal prices.
 M&A deals. The tight coal market has pushed buyers from China, India, and other countries looking for assets globally to secure future coal supplies. Indonesia, due to its competitive location, is a strong candidate for M&A deals, we believe.
 Market sentiment. The floods in Queensland of Australia are a good example of how market sentiment can have an influence, we believe. Even though the floods will affect supplies of coking coal (and not thermal coal), thermal coal players’ shares have reacted positively to the developments.

Risks to our investment view
Coal price volatility
We assume that coal price movements will be affected by fundamental factors, supply and demand. But we note that non-fundamental factors, such as asset class and trading volatility, can also affect coal price volatility.
Disconnect between coal and oil prices Coal price and oil price have had a strong positive correlation in the past (coefficient correlation = 0.90). We expect the strong positive correlation between the two commodity prices to continue. Any disconnect — eg, a higher oil price is not followed by a higher coal price — could have a major impact on coal company financials.

Weather
After the very bad weather conditions of 2010, we assume the weather will be better in 2011F, and as such forecast 15% y-y production growth in Indonesia. But weather is unpredictable and can have a significant impact on the industry.

Regulatory risk
In Indonesia, we believe that regulatory risk is highest in the mining sector compared with other sectors. The risk lies not only in implementation of mining regulations but in synchronising the mining sector regulations with those in other related sectors.

Industry data reliability
It is difficult to find reliable data on Indonesia’s coal industry. Data from one source can vary significantly from that of another. Given Indonesia’s position as the world’s largest coal exporter, miscalculation in industry statistics can have a significant impact on the global coal market, in our view.