Dig Up 8.9% Yields With Berau Coal's Short 44-Month Yankee Bonds

by: Randy Durig

Each week we screen thousands of corporate bond listings to find what we believe are currently the best corporate bonds for investors needing or seeking higher yields with the least amount of risk possible relative to their projected return. This week, we look at 3⅔-year Yankee bonds (in U.S. dollars) from Berau Coal Energy PT (BRAU:JKT), an Indonesian-based company engaged in producing thermal coal in Indonesia. Although the nearly 9% yields currently indicated with this bond only carry a BB- rating from Standard & Poor's, the following review shows why we see these 44-month high-yield notes are a good choice to both increase cash flow and preserve capital. We also believe this debt instrument offers sound diversification away from the financial services sector of the global economy, and that it makes a good addition to our Foreign and Global Fixed-Income Investments.


A look at the Issuer

Berau Coal signed a contract with the Indonesian government in 1983 in which it was appointed as the sole contractor for a specific mining area in Berau regency, East Kalimantan Province. The concession area covers some 1,200 square kilometers. Berau Coal's long-term production plans were developed in consultation with the U.S.-based mining consultant Marston & Marston, and its 20-year plans are based on the mature production level of eight million tons per annum for the Lati mine and five million tons per annum for the Binungan operation. Part of the due diligence process required by the operating consortium in the country's independent power producers, necessitated Berau Coal's mine plans to have been reviewed and scrutinized by various consultants that include the John T. Boyd Company, Norwest Mine Services, Inc., Morrison Knudsen Corporation, and Barlow Jonker Pty Limited.

As part of the its community development program, Berau Coal reached an agreement in 2002 with the local Berau regency administration and state-owned power firm PT Indonesia Power to supply between 100,000 to 200,000 tons of low grade coal per year to a 2x7 MW power plant to be set up in the Lati mine mouth area. Berau Coal has established a good reputation in the marketplace as a reliable supplier of coal with consistent quality, and the coal has been successfully introduced and marketed in Chile, Hong Kong, Japan, Korea, Philippines, Taiwan, Thailand and other countries, as well as in the domestic market. The coal is mainly used for power generation, and the majority of coal sales are on a long-term contract basis.

In Indonesia, Berau Coal supplies coal for the Suralaya power plant in Banten, and Paiton II power plant in East Java. Since April 7, 2005, the concession area has been reduced to 118,400 hectares. Berau is entitled to take 86.5% of total coal produced from the final production processes established by Berau and available for sale in each calendar year, while the government reserves and retains the remaining portion (i.e., 13.5%) as its share of total production. Berau Coal is currently Indonesia's fifth biggest coal producer.

PT Berau Coal Energy Tbk (formerly PT Risco) was established in the Republic of Indonesia in 2005, although the company's Articles of Association have been amended several times, including recent changes in the members of the boards of directors and commissioners of the company. The company conducted an IPO of 10% of its shares in August 2010, and was listed on the Indonesia stock exchange. In April 2012 Bumi Plc (OTCPK:PBMRF), a company listed on the London Stock Exchange, acquired about 75% of the Berau Coal Energy's shares from PT Bukit Mutiara as well as nearly all of the previously issued 10% IPO shares, for a combined holding equal to 84.7% of the company's outstanding shares. Consequently, the company's ultimate parent entity is Bumi Plc, a company incorporated in the United Kingdom. Berau Coal Energy and its subsidiaries had 1,053 employees as of June 2012.

Berau Coal Energy delayed the submission of its annual financial statements for the fiscal year 2012, and boardroom fighting between Bumi Plc owners has been subject to global media in recent months. Bumi Plc stated early last month (June 2013) that a review of spending at PT Berau Coal Energy found $201 million of outlays had "no clear business purpose," $152 million of which was determined to be missing from Berau Coal Energy's 2012 finances and $49 million from 2011, and that the review had delayed Bumi's results by more than two months. Since that time, Rosan Roeslani, who had stepped down as CEO of Berau in January, has agreed to pay $173 million in cash and assets to Berau, Bumi said. The amount is expected to be paid within six months, while the remaining $28 million are said to have occurred before Bumi acquired its 85% stake in Berau.

At its recent shareholder's meeting, Berau's president director Eko Santoso Budianto stated that "efforts to improve the situation include changes and more roles for commissioners" so as to not see a repeat of what happened. He also stated that Berau is targeting to produce up to 23 million tons of coal by the end of 2013, a 9% increase from 21 million tons in 2012. The company already produced 9.4 million tons in the first five months of the year, up by 5.6% from 8.9 million tons in the same period last year. He further announced that sales are higher than expected, and that the cost of production is lower than what was expected.

Finance Director Scott Merrillees said the company aimed to lower its production cost to up to $42 per ton compared to its initial target of $45 per ton this year. He also said Berau would likely exercise an option to redeem its debt papers, and that shareholders had granted their approval for the debt paper refinancing. Berau, through its completely owned subsidiary Berau Capital Resources Pte. Ltd., issued $450 million guaranteed senior secured notes in 2010, with a yield of 12.5%. According to its 2012 financial report, the company had an option to entirely or partly redeem the notes on or after July 8, 2013. Merrillees said the company expected to offer the new debt papers with an interest rate of around 7% to 7.5%.

2012 revenues for the Berau Coal Energy Group were $1.531 billion, compared to $1.657 billion for 2011, and operating profit was $191 million, compared to $527 million for the year prior. As of Dec. 31, 2012, the Group had net debt of $514m, with gross debt levels of $971m. Operating margins for 2012 were 12.5% compared to 31.8% for 2011. PT Berau issued $500 million of bonds at a fixed rate of 7.25% in March 2012 to repay $340m of existing debt and finance capital projects which increased overall net debt, and at year end 2012, the Group had $364 million cash and short term equivalents and long term debt levels of $954 million. EBITA for 2012 was $225 million, compared to $556 million for 2011.

As a result of market conditions, Berau is deferring a number of capital expenditures and undertaking a comprehensive review of future spending plans. Over the medium term, (although the rate of growth reduced during 2012) both India and China are expected to increase coal demand as new power stations are completed. Peabody Energy (BTU) last week surprised the market by reporting a profit as it takes advantage of growing coal demand from China and India, and looking ahead to the third quarter adjusted its earnings per share estimate from a 16-cent loss to a nine cent profit. While Peabody also plans to scale back its capital expenditures this year, it is striving to reduce its Australian cost targets to the mid-$70 per ton range, this still appears to be nearly twice the production cost that Berau might be able to achieve for its lower quality coal.

Marred by actions from a trio of coal miner unions, higher costs have continued to cut into the profit margins of BHP Billiton (NYSE:BHP). After resolving its two-year spat with the unions last year, BHP pushed an agenda of increasing productivity and has been reporting an increase in production for the last three months. Fortunately, demand for sub-bituminous coal has remained buoyant especially in India, which is a particularly price sensitive market. Indonesia has maintained economic growth of above 6% for 10 consecutive quarters since October 2010, thanks to strong domestic consumption that accounts for almost 60% of its gross domestic product (GDP).

Interest Coverage Ratios

Berau Coal's 2012 finance costs were about $99 million and its 2012 EBITDA of $225 million appears to be provides a more than adequate 2x's coverage ratio. We expect that lower production costs and scaled back capital expenditures, combined with increased production tonnage and sales will sufficiently offset lower coal prices so as to maintain a good interest coverage ratio. We also think that the reduction or possible elimination of any additional accounting irregularities at the company will further increase its EBITDA and operating profitability.

We Like Companies With Lower Debt-to-Cash Ratio

Berau's cash position of $364 million at the end of 2012 puts its debt-to-cash ratio at less than 3-to-1. We like the company's stated intent to lower its current financing costs through the replacement of its high-cost 2015 bonds.

We Like Companies That Have Good Balance Sheets

The total market capitalization of Berau Coal Energy currently appears to be Rp 5,830 billion, or about US$571 million. Therefore, we estimate its net debt to enterprise value to be about 51%. We think the company's recovery of $173 million in assets from the previous CEO will mark a notable turn not only in the profitability of the company, but it will also strengthen and improve an already sound balance sheet.

We Like Higher Yields

This five-year, $500 million USD-denominated debt of Berau Coal Energy was issued in March 2012 at the coupon rate of 7.50%. After considering the circumstances surrounding last year's financials and very solid profit margins of this company, we believe that acquiring this bond at or below par represents a strong addition to the high cash flow instruments in our client's foreign and world fixed income holdings.

Risks Considerations

The default risk is Berau Coal Energy's ability to perform. Considering their historical and recent performance, their sound balance sheet, their good cash position, and the cash flow that is projected to service their interest bearing debt, as outlined above, it is our opinion that the default risk for this short-term bond is minimal relative to its more favorable return potential. Berau's BB- credit rating is only two notches below the BB+ rating given to the country of Indonesia. It is our opinion that if or when the credit rating of Indonesian sovereign debt improves, it will increase the possibility of a more favorable rating for Berau Coal Energy.

A harder risk for us to identify is the geopolitical risk. Since we find it hard to understand many of the political changes even in our own country, perhaps the uncertainties of changes on a foreign soil become less formidable. That said, it is our opinion that diversification into other forms often serves to reduce risk. Our strategy here, as with other Yankee bonds, is to focus on unique or required services that can be seen as a adding key economic value to the society it's associated with. Berau's coal is basic to the energy needs of not only its own country, but that of China, India, and numerous other Asian economies. Furthermore, it is one of the most fundamentally sound and profitable coal companies in Indonesia.

Berau Coal is relatively small compared to some of its competitors, and it is likely to face increasing competition from other coal mining companies, such as Peabody Energy and BHP Billiton, also seeking to substantially increase production and capture larger percentages of the Asian thermal coal market. However, it does have an advantage of having lower production costs and of being less leveraged than many of its larger competitors.

The commodity pricing for thermal coal has a material impact on the margins that Berau Coal Energy is able to achieve, and we acknowledge that lower commodity prices may significantly reduce the company's operating profits. We believe that these Berau Coal Energy bonds have similar risks and maturities to other Yankees bonds such as the 10.5% Myria Agro, 7.7% Vendanta, or 8.5% Avangardco Holdings bonds, all of which we have reviewed previously on our blog.

Summary and Conclusion

It is our opinion that Berau Coal Energy is positioned well for the future with its lower production costs and the recent restructuring of its management team. Although China recently reported lower imports of coal last month, consumption there is expected to rise modestly in the second half of 2013. India, which relies on coal to fuel more than half of its power generation, recently reported that its thermal coal imports for May rose 18.9% from a year ago. In light of this and its fundamentally sound metrics, we believe these short 44-month Berau Coal Energy Yankee bonds offer an excellent yield relative to the financial risks that we can identify. We have chosen them for addition to our Foreign and World Fixed-Income holdings.

Issuer: Berau Coal Energy
Coupon: 7.50%
Maturity: 03/13/2017
Ratings: B1/BB-
Pays: Semi-Annual
Price: 95.0
Yield to Maturity: ~8.9 %

Disclosure: Durig Capital and certain clients may have positions in Berau Coal Energy's 2017 bonds. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.