Bukit Asam's Production And Delivery Growth Offset Weak Pricing

| About: PT Bukit (TBNGY)
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Summary

Indonesia has coupled strong production growth, logistics de-bottlenecking, and competitive cash costs to generate strong revenue and EBITDA growth so far in 2014.

Contracts with the state power company lock in attractive prices for about half of the company's production, but higher royalties threaten to take a big bite out of future EBITDA.

Weak coal prices have pressured near-term EBITDA, but the shares still offer long-term potential above $6 for the ADRs and a decent dividend.

The coal market has been lousy for most of the major U.S. and international producers, but PT Tambang Batubara Bukit Asam ("Bukit Asam") (OTCPK:TBNGY) has been a notable exception. Between organic production growth, strong domestic prices, and good cost control, Bukit Asam shares have jumped 50% since I wrote about the company in January, handily beating China Shenhua (OTCPK:CSUAY), Peabody (NYSE:BTU), and U.S. producers like Cloud Peak and Arch Coal (ACI). I do see some long-term upside from the company's aggressive production growth plans and an eventual seaborne thermal coal price recovery, but I don't see as much near-term value in the shares right now.

Offsetting Weak Export Prices With Domestic Sales

Indonesian coal miners have been responsible for about two-thirds of the incremental additions to global seaborne thermal coal supply in recent years, helping contribute to price erosion. Most Indonesian coal exports are tied to Newcastle prices, which have declined about 20% year to date.

Bukit Asam has been able to offset this in part by through its exposure to the domestic market. About half of Bukit Asam's coal goes to PLN (the Indonesian government-owned electricity company) under long-term supply contracts that currently offer a 70% premium to recent realized export prices. With three major power plant projects coming online in southern Sumatra fairly soon, and more coal-fired projects on the books, domestic demand should remain a solid positive for Bukit Asam.

On the export side, it is likely going to take longer for prices to recover. More than 15% of Bukit Asam's coal goes to Taiwan, with a further 10% going to India, 9% to Malaysia, and 5% going to China and Vietnam (each). Overall demand growth from India should provide some support to seaborne prices, but China remains a big unknown. Chinese producers (including Shenhua) have been ramping up production, while Chinese officials have been looking more toward gas-fired and nuclear power generation as a way to control air pollution. We'll see - I expect Chinese demand for thermal coal to remain pretty healthy, but I don't expect a rapid turnaround in seaborne prices and Chinese power companies may favor Australian coal over Indonesian coal.

Removing Bottlenecks And Improving Costs, But Royalties Are A Risk

Cash costs have remained fairly attractive for Bukit Asam so far this year, at around $49.50/t (versus recent Newcastle spot prices in the high $60's/t). Although the company's strip ratio has declined, it hasn't declined as rapidly as for other Indonesian producers. At the same time, the company has been moving forward with on-site power projects (to power its mining operations) and improvements to rail and port infrastructure. Railway costs were up 21%/2% in the second quarter, but capacity is improving nicely.

Where I have less confidence in Bukit Asam's cost structure is at the royalty line. With elections looming, the Indonesian government held off on hiking royalty rates from 3%-7% to 10%-13.5% but there is still a risk that the government moves ahead with those hikes. Unlike ITMG, where only about 12% of production is exposed to royalties, Bukit Asam could see an EBITDA hit of 30% if the government goes with the high end of the royalty range. That's a significant risk, but the government may decide to tie the royalty increases to coal prices to mitigate the potential job losses at smaller miners.

Strong Growth Prospects

If Bukit Asam stays on track, the company will increase its output by almost 150% between 2013 and 2017. I'm a little concerned about the quality mix, as the higher-quality Tanjung Enim mine will account for a lower percentage of overall production. One of the key advantages to Australia-based producers like Peabody Energy, Rio Tinto (NYSE:RIO), and BHP Billiton (NYSE:BHP) is the higher quality of the coal, giving them an edge if China is serious about switching to higher-quality coal.

On the other hand, governments in India, Malaysia, and Vietnam seem relatively less concerned about coal quality versus increased power generation and these should remain strong export markets for Bukit Asam. I'd also note that the Indonesian government is also looking to increase its power capacity and domestic coal is a cost-effective option for PLN (even at the higher rates it pays Bukit Asam under current contracts).

Estimating The Value

Between its rail and port capacity expansions, as well as expansion projects at mines like Lampung, Bukit Asam should able to deliver double-digit annual production growth over the next five years. On the bearish side, there are ongoing risks to seaborne thermal coal prices though many marginal producers are under real stress at current prices. Also on the bearish side are concerns about higher royalties, higher production costs, and adverse currency moves (Bukit Asam's exports are priced in dollars, while the costs are in rupiahs).

The near-term outlook for coal prices isn't very strong and that has pressured EBITDA forecasts. With that, the shares already trade at more than 12x 2014 EBITDA expectations. Using a NAV approach and factoring in higher long-term thermal prices, I believe Bukit Asam is worth around $6.20/ADR.

The Bottom Line

Between double-digit volume growth potential and a competitive cost structure compared to other Indonesian producers (as well as the Australian operations of BHP Billiton, Rio Tinto, and Peabody), I think Bukit Asam has a better future than many coal companies. The better-than-50% move in the shares already factors in a lot of Bukit Asam's previously undervalued qualities, though, and I'm not as bullish on the shares at this price.

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