UBS INDO Bumi Resources (Sell, PT Rp2,800, 11% downside)

Bumi’s shares have risen 30% since January 2010, which is an overall underperformance versus the sector, while we maintained a Buy on the company throughout most of last year. Our investment case was primarily based on the company’s ability to extract higher coal prices and recover from its trough of 2009.

However, although Bumi maintains control of high quality assets that are likely to exhibit strong production growth in the medium term, we believe there is a major overhang risk pertaining to the government’s current tax investigation.

More specifically, Bumi is being investigated for tax evasion in 2007, while additional tax evasion charges are not unlikely pertaining to years prior to 2007. Following the company’s aggressive debt-raising throughout 2010, we downgrade our rating from Buy to Sell, as we revise our earnings estimates.

􀁑 Price revision. We revise our 2010-12 ASP assumption from US$72/t, US$88/t and US$85/t to US$80/t, US$99/t and US$90/t, in line with our higher contract estimate. We believe Bumi is currently receiving over US$100/t on average for its 5,600kca/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. Furthermore, we believe it will take 18-24 months to complete the current conveyor belt expansion after existing capacity is shut down for maintenance. Thus we downgrade production from 67mt, 74mt and 81mt to 60mt, 63mt and 66mt in 2010-12.

􀁑 Cost inflation. Sector costs remain under pressure from higher fuel prices as well as costs associated with deteriorating weather in H210. We increase our 2010-12 cash cost estimate from US$34/t, US$36/t and US$39/t to US$44/t, US$48/t and US$50/t respectively, excluding royalties. Furthermore, Bumi raised US$3bn over the past 18 months with a weighted average cost of debt above 10%, which is putting downward pressure on net earnings. As such, we note that the potential for refinancing the high-cost CIC debt would serve as a positive catalyst.

Bumi is highly exposed to fuel price volatility on account of its high stripping ratio, which requires significant overburden removal per tonne of coal mined.

Our earnings estimate is 3% and 5% above consensus forecast for 2010 and 2011. With a 2011 earnings sensitivity of 3.3% for a 1% change in coal prices, Bumi is in the high end of the Indonesian sector range.

We lower our price target from Rp3,200 to Rp2,800 per share, which incorporates our earnings revision, a lower risk-free rate from 10% to 7.6% and a lower beta from 1.8x to 1.4x, which reduces the WACC from 15.1% to 13.4%. We employ a 12-month target PE valuation multiple of 12.1x, 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 Rp2,900 per share, slightly above our price target.