YTD, we saw the indo coal sector underperforming the JCI index by 11% primarily because of a dull coal price (stayed flattish most of the time).
The decline in the Indo coal sector is consistent with our thesis and was the reason we had brought the rating back to Neutral in early February.
But we have recently shifted our stance on the Indo coal sector back to being more positive.
5 key factors that support our positive stance:
1. Our conviction that coal price is close to bottoming out.
* Weather is not conducive; limited coal supply from Indonesia.
* Recent price settled at a high level (US$80/t FOB for 4900kcal/kg NAR).
* Most Indo players are fully sold out for the year.
* We see strong underlying demand from China if coal price falls below US$90/t
* We see coal price going up in 4Q, driven by higher consumption during winter and annual Chinese pricing negotiation for domestic needs.
2. Despite near term headwind, things are still looking good for 2011-13.
* If the rest of 2010 is left unscatched, we think Indo coal miners will just go sailing through 2011-13.
* We see strong underlying demand that it should be able to absorb the coal ramp-up from Indonesia.
* We note that at least 50% of those volumes being ramped up already have ready buyers.
3. M&A deal heating up
* Major coal producers, we think will go direct to the source and buy coal assets in Indonesia.
* The first M&A announced this year was that of KEPCO acquiring 20% stake in Bayan Resources. On a P/E basis, it implies 26x 2010E PE, but this kind of deal is likely valiued on assets rather than earnings.
* We see more M&A coming in Indonesia coal for the rest of the year.
4. Macro bad newsflow easing
* Our European mining team highlighted 4 data points for them to turn into more positive: 1) Newsflow from China less negative; 2) lead indicators hit inflection point; 3) commodity prices find support level; 4) positive newsflow from Europe on credit and banking system.
* It seems our strategists and economists think these are nearing inflection point and we see equity market pricing this in early.
5. Attractive valuation
* The street has yet to factor in higher coal price settlement for JFY11.
* Indo coal are trading at 10-30% discount to their historical peak in 2008.
* Current share price implies US$90/t coal price, except SAR at US$70/t.
* We expect share prices to move higher in tandem with spot coal prices and we see room for the street to upgrade coal price and earnings towards ours.
Our top pick in the sector are: SAR, ADRO, ITMG, and INDY.
We see Indo coal mines spending at least US$3bn in heavy equipment over the next two years to support 12% compounded annual output growth rate.
That should translate into 3600-4800 units of heavy equipment.
This has not factored in the replacement cycle every five years, or after 20,000 hours.
That's a bullish call for heavy equipment seller.
We think mining contractors will also benefit, but given the rising competition, we advise investors to stick with experienced players and those that have a strong balance sheet.
UNTR fits all those criteria, and therefore deserves a premium.
Reiterate Buy on UNTR.
Since we are bullish on Indo coal, we are bearish on Tenaga.
In light of stronger coal price, we see downside risk to tenaga's earnings.
We believe Tenaga needs to reform its electricity tariff pricing mechanism to ensure sustained earnings growth.
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