We initiate coverage on Adaro Energy with an Outperform recommendation and a Rp1,000 target price, representing 35% potential upside. We like the company’s operations which benefit from a strong production growth outlook, scale, ownership of infrastructure, increasing 2009 prices, a low cost base and attractive valuation.
However, the jury is out as to whether Adaro is just a good trade, or an investment grade company due to corporate governance concerns. We provide a roadmap for investors to take a view on management.
Production to double given infrastructure and reserves
Adaro is an integrated coal producer which owns key infrastructure including its ports. This, combined with its impressive production track record, gives us confidence that the company can increase production from an estimated 38mt pa in 2008 to 50mt in 2010E and 80mt in 2015. Adaro is Indonesia's second-largest producer and a top ten global exporter, with 928m tonnes of reserves and 2.8bn tonnes of resources.
Large price increases in 2009 to drive earnings growth
We forecast Adaro's average selling price in 2009 to increase 47% to US$61/t leading to 2009 EPS increasing over 200%, partly due to low-priced legacy contracts being renegotiated at the request of the government.
Low cost base buffers falling coal price & lower coal quality
Adaro is a low-cost operator (due to its low strip ratio of 4–5x vs the Indonesian average of 8–9x) with production cash cost per tonne of roughly US$26 and US$29/t (2008–09E) vs the Indonesian industry average of US$33–35/t. This helps defend the company against falling prices and its lower quality coal product.
Attractive valuation vs regional peers
We believe the stock is attractively valued on a 4.3x adjusted PER, 10% dividend yield and 29% FCFE in 2009E, roughly a 34% discount to the regional coal sector.
Experienced management; corporate governance catalyst
The founding shareholders (the Soeryadjawa, Thohir, Rachmat and Subianto families) are respected by investors given their links to the Astra group. Also, in recent years there has been consistent reporting to leveraged buyout banks and cornerstone investors such as GIC, Citigroup, Farallon, Goldman Sachs and Kerry Coal.
However, we remain concerned (in light of recent events at Bumi) about the potential for related-party transactions and therefore rate Adaro “middle of the pack” vs other Indonesian coal names. We highlight the roadmap for the company to potentially become investment grade:
Redeem US$100m short-term investment in Recapital (potential related party).
Minority approval requested for potential related-party transactions.
Transparent placement of cornerstone investors’ stakes providing liquidity.
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