UBS INDO Adaro Energy (Neutral, PT Rp2,800, 8% upside)

Adaro remained our top Indonesian coal pick throughout last year, while shares grew 51% from January 2010. Our investment case is primarily based on the company’s high-quality infrastructure, which should allow Adaro to reach its target to double production in the medium term. Thus, seeing that much of the capex will require mobile equipment rather than land acquisition investment, capital expenditure should remain relatively low thus resulting in superior free cash flow generation.

However, Adaro has rallied close to our price target and we consequently downgrade the rating from Buy to Neutral, while revising our earnings estimates for 2010-12. We incorporate the most recent beta values to reflect changes since the timing of our last valuation for the individual companies.

􀁑 Price revision. We revise our 2011 average selling price assumption (ASP) from US$66/t to US$67/t in line with our Japanese benchmark contract upgrade. We note that the increase in our ASP estimate is limited as Adaro has priced 50% of its 2011 sales volume based on the 2010 benchmark price,
while remaining volumes have yet to be priced.

􀁑 Production weakness with reserve potential. Excess rain in H210 is likely to lower management’s initial production target of 45-46mt for the full year. In our experience, production pressure in one year negatively affects the subsequent years due to overall infrastructure capacity constraints, and thus we lower production estimates from 44mt/50mt/58mt to 42mt/47mt/52mt in 2010/11/12. Incremental production growth is likely to be sourced from the Wara mine as the Tutupan mine appears to have reached maximum production capacity of 42-44mt. Wara coal is significantly lower quality and lower cost coal than Tutupan, which will reduce Adaro weighted average selling prices in the long term, all factors being equal. Following the continuous exploration of Wara, we anticipate additional reserve upgrades over time.

􀁑 Cost inflation. We note that Adaro’s management has revised its infrastructure development plan once more, which now entails the muchdebated conveyor belt transporting growing overburden volumes to the
landfills rather than coal to the Barito river. The decision is based on growing land constraints to offload over 200mt of annual overburden, which will increase hauling distances and in turn overburden costs. We increase our 2011 and 2012 cash cost estimate from US$38/t and US$40/t to US$39/t and US$41/t, respectively.

􀁑 Tax revision. Based on 9M10 results, we note that Adaro is currently paying 53% corporate taxes, well above its contractual 45% obligation. Management attributes the additional expense to a significant amount of goodwill amortisation, which is non-deductable and putting downward pressure on earnings.

Our earnings estimate is 13% and 5% below consensus forecast for 2010 and 2011, respectively.  We raise our price target slightly from Rp2,700 to Rp2,800 per share, which incorporates our earnings revision, a lower risk-free rate from 10% to 7.6% and a slightly higher beta from 1.0x to 1.1x, which reduces the WACC from 9.5% to 8.3%. We employ a 12-month target PE valuation multiple of 15.5x, 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 Rp2,500 per share, slightly below our price target.