INDO COAL: less downside risk from here on; time to relook at ADRO, ITMG? - BoA Merrill Lynch

Score card for our 7 February 2011 note Indo coal 2011 and beyond:
1. We have advised clients to enter Indo coal after Indonesia's inflation and monetary tighetening measures peak out, effects from bad weather on prices are normalized, & earnings are adjusted downward. We had kept our Buy rating unchanged, but highlighting clients to look for better buying opportunity (or buy on weakness).
2. For Indo inflation, we have seen 2 months of deflation and government has pushed back the fuel subsidy rationing indefinitely (although we may see inflation rise again closer to Ramadhan)...I/R has been kept unchanged since Febr...
3. Coal price has dropped from US$138/t down to US$123/t. We now no longer see much downside in coal price.
4. We have seen quite massive downgrade in Indo coal names by the Street post 2010 FY result in March and April....With a strong 1Q numbers (which supposedly the lowest for the whole year), we see minimal downside on earnings....
5. YTD SAR, BUMI outperforming the JCI by 12%. PTBA, ITMG, ADRO, INDY underperform the JCI by 10%, 12%, 14%, 16% respectively.
6. SAR has outperformed because: 1) they finally got the final forestry permit and 2) 1Q numbers beat expectatio. We upgraded SAR a month ago on these reasons and our rising confidence on SAR mgmt for giving better guidances moving forward.
7. BUMI (Neutral) has outperformed because of market's expectation on turnover after Vallar deal...But To us, risk reward not enough...Our calculation upside no more than 10%...FY10 results still saw high debt despite company's saying of debt reduction ahead of the results. Numbers beat consensus but it's below the operating profit line....

Now, we no longer think much downside in coal price. We think seaborne coal price looks pretty stable, at US$123/t:
1. China has come back to the market...The offering price by them has shot up by up to US$10/t in the last two weeks. Its up to US$96/t for 5000kcal NAR coal, or US$115/t on index basis, but the ash content is likely at ~20% vs. index quality of <12%. It could be over speculation by traders (who dominate China coal import) ahead of hot summer, but the momentum seems to be just starting.
2. The pricing arbitrage with Aussie coal not yet opened. Still another US$10 gap but it continues to narrow, with Chinese coal prices continuing to rise.
3. Japan pricing for Indo coal still quoted at US$130-136/t (factoring in pricing advantage for low freight rate/ash content). It seems some of the coal mines have been over committed for delivery ahead of the Japan tsunami, softening the blow for coal price correction. Since one coal owner can own more than one mine, he/she is able to arrange the coal alllocation strategically to one buyer from different coal mines.
4. There are talks that 2 of the 4 JPUs impacted by the tsunami (Joban and Tepco) will resume operation by July/August.
5. But be warned pricing volatility still seen in 3Q: traders could overspeculate on China demand for the summer; China inventory de-stocking, and recall coal supply tend to be the highest (except in 2010).
6. Topping all of these, our Australian strategist Tim Rocks think there is a possibility for AUD to head $1.5 over three years if US interest rates stay near zero for an extended period and this causes a surge in investment into Australia from central banks, sovereign wealth funds and the private sector.
7. We still see coal price to rise in 4Q driven by seasonality.
8. Our forecast for 2012 JFY price is US$129/t, but we see upside risk to our numbers.

How do you play into Indo coal names:
1. Stick with NPV to look beyond the current phase of pronounced volatility to seek long term growth!
2. We have used DCF up to end of contract life or reserve liefe (whichever is faster) to value all Indo coal companies, with the exception of BUMI.
3. Our pecking orders: SAR, ITMG, and ADRO are still trading at 5-12% discount to NPV. Share prices tend to overhoot NPV when coal prices rise.
ITMG, ADRO the underperformer can surprise on the upside!! We believe for these two to perform, you need to feel assured that coal price is bottoming.....
4. Look out for some consolidation story plus big dividend....Most companies, barring BUMI are now sitting on huge cash piles. Even ADRO, it can still raise US$2.5bn in loan...no problem, before they have to raise any equity in the case of any acquisition potential. In any case, market talks there is one relatively sizeable coal asset up for sale now......

What happened with coking coal:
1. We see more downside risk compared to thermal coal. More sensitive to China's FAI and we havent seen much correction post Queensland....
2. In any case, we still like BORN, the premium HCC producer. We believe premium HCC will be prioritized over semi soft/PCI as buyers in such tight capacity will allow zero tolerance of operation failure...
3. Indeed premium HCC price still stands firm at US$320/t....