We downgrade Adaro from Outperform to Neutral and cut our price target from Rp940 to Rp890. This is to reflect the recent 30% share price rally, oversupplied coal outlook, increased pricing risk, stretched 2010 valuation, poor 2008 FCFE generation, and unproven governance.
Impact
Cautious coal outlook in 2009/10. We believe the coal market will be significantly oversupplied in 2009 and see the potential for supply cuts to be delayed as producers benefit from 2008 high-priced legacy contracts.
Adaro's prices could come under pressure in a loosening market given its relatively low calorific value coal. We highlight that two-tiered market forming with the Japanese paying premiums for Australian high-quality coal, but other negotiations (eg, Korea) being settled below these benchmark levels.
Valuation appears stretched in 2010E, as evidenced by a 13x PER (clean), 2.8% dividend yield and 1% FCFE yield, a 30% premium to the Indonesian average.
Poor FCFE generation in 2008 leading to net debt being US$300m higher than expected. This is due to higher working capital but also a tax liability arising from the former LBO structure valued at US$90m.
IPO skeletons emerge. In our initiation, we noted that Adaro was a good trade but an unproven investment grade company. This has been reinforced by the tax liability that new minorities will have to bear from the former LBO structure valued at US$90m. This is the second adjustment post IPO, after the company revised its intangible accounting policy.
Earnings revision
We downgrade our 2009 earnings estimates by 8%, reflecting a slightly lower realised price and higher cash production costs. The higher-than-expected net debt is the predominant cause for the change to our valuation.
Price catalyst
12-month price target: Rp890 based on a DCF methodology.
Catalyst: + Strong 2009 results; - Related party acquisition; - Spot price weakness.
Action and recommendation
We downgrade Adaro from Outperform to Neutral and cut our price target from Rp940 to Rp890. This is on the back of the expensive 2010 valuation, increased pricing risk and higher-than-expected net debt in 2008.
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