Cutting our FY12/13 earnings estimates by 25-28%. With the revision in our average coal price assumptions for FY12/13 by about 10-15% to US$100/ton, we cut our FY12/13 earnings estimates by 25-28%, given the high sensitivity of SAR’s earnings to coal prices. However, spot coal prices should find a floor at US$80/ton and we expect a mild recovery in coal prices in 2H12 from current lows, as government policies spur growth in China and as high-cost coal producers in countries like Australia, US and South Africa limit their exports.
Increasing production is not the priority, producing smartly is more important. Given finite coal reserves, producing more in a low price environment may not be ideal over the long term. Hence, management should retain flexibility in managing production levels, especially at Jembayan, where margins will be tight at current spot prices owing to high cash costs. Production can be increased if coal prices rebound. Sebuku mine, with its higher-grade coals and low cash costs, remains very profitable even at current prices and should be the key driver for SAR’s profitability in the near term.
Limited downside at these levels. SAR’s share price has declined close to 50% from its peak in 2012 and has priced in much of the impact of coal price weaknesses on earnings. At current share price of S$1.35, we reckon the market is already pricing in another
US$5/ton decline in coal prices from the current level of US$83/ton. Hence downside risk is limited at the current share price, and we expect a short-term rebound in share prices in anticipation of coal prices bouncing off current lows. Cut TP to S$1.80 (-0.5 S.D. valuations); but maintain BUY for the decent dividend yield of 6% and potential run-up in the case of a stimulus-driven commodity price rebound.
Coal prices have slid sharply in the last few months. After a short run upwards to levels of close to US$120/ton in early 2012, coal prices have steadily slid downwards over the first six months of 2012, and is now down 25% YTD to US$83.75/ton, its lowest level since November 2009. The slide has been similar in direction to oil prices, though larger in magnitude, as demand for energy has slowed amid a global economic slowdown led by Europe.
Slowing economic growth in China plays its part. One of the reasons for the slide in coal prices is the slower demand from China, which has emerged as one of the key players in the sea-borne coal market in recent years, especially for spot trades. However, the slower growth in China in 1H12 has resulted in high coal stockpiles at Chinese ports and power plants amid weak electricity demand. As of last week, the stockpile at Qinhuangdao Port, China’s largest coal importing port, had reached a record high of 9.5m tons (vs maximum capacity of 10.5m tons). That level exceeds the high of 9.3m tons, seen in November 2008, at the height of the last global financial crisis.
Abundant supplies. The other reason for the slack in coal prices is the unusually high supply from unconventional sources into Asia, especially from the U.S. As natural gas prices plummet in the US on new shale gas discoveries, natural gas-fired power plant economics have improved and owing to the substitution effect, surplus coal exports from the U.S. have been finding their way to Asian and Chinese buyers. Recent low freight rates, caused by the supply glut in the dry bulk shipping space, has added to the attractiveness of shipping U.S. coal over large distances to Asia.
Downgrading our coal price assumptions for 2012/13. Coal prices have averaged around US$102/bbl in 1H12. Our coal price assumption for 2H12 is around US$95/bbl, for a full-year average of around US$100/bbl, down from US$115/bbl earlier. We have cut our FY13 coal price assumption to US$105/bbl from US$115/bbl earlier. With increased natural gas production and consumption in the US from shale gas reserves, we expect the upside in coal prices to be capped in the medium-term outlook owing to the structural changes in the usage of various energy sources. In the near term, however, coal prices will still remain volatile, with significant upside potential from current lows once economic conditions stabilise.
Demand should also pick up from coal-fired power plants in China during summer as the hydropower generation (14% of China’s power generation) slows down seasonally in Southern China. Coal prices have been increasing by an average of 10% in the summer months over the past three years. We believe that this may help lift up coal prices in the near term.
Moreover, we feel at levels of US$80/ton, supply should take a hit, as cash cost levels for U.S. and Australian miners are around US$80/ton, and this should be the support level. At lower prices, some miners may reduce production until prices improve again. Also, U.S. miners will have less incentive to export and we should see less supply from the U.S. in the seaborne coal market. Note that the U.S. accounts for only 3% of the world’s coal export market.
Cutting our FY12/13 earnings estimates by 25-28%, 2Q12 results for Sakari unlikely to look good. With the revised coal price assumptions (and slightly lower cash costs to account for lower oil prices), we have cut our FY12/13 earnings estimates as outlined above. Though the Sebuku Northern Leases mine will continue to drive production growth at Sebuku, Jembayan mine production in FY12 will likely be flattish at best and likely lower, compared to FY11 levels, as new pits are being developed. As the existing pits at Jembayan are constrained and preparation works for new pits are the priority in the early part of the year, we are likely to see a trend of lower production at Jembayan seen in 1Q12 continuing into 2Q12. And with coal prices averaging US$96/ton compared to US$112/ton in 1Q12, we reckon 2Q12 earnings could potentially disappoint some of the more bullish street estimates.
Share price decline has priced in a lot of the coal price weaknesses. With coal prices in free fall, it is not a surprise that the share price of coal miners like Sakari has seen steep declines as well. The stock price has historically trended upwards or downwards ahead of expected similar movement in spot coal prices and has a relatively strong correlation with benchmark spot coal price, as evident in the charts below. We estimate the strength of the relationship to be about 70% (73% if we strip out currency effects).
At current share price levels of S$1.30, implied coal price is about US$78-80. This is lower than the current spot coal price of US$83/ton. Thus, the share price is already pricing in another US$5/ton decline in coal prices, and hence downside risk is limited at current share price levels. Any upside in coal prices in 2H12 is currently far from being priced in, and this could thus provide a good entry point for those investors willing to bet on a rebound in commodity prices.
Jembayan margins will be tight at current prices but management retains flexibility. Management has been focusing on preparation works for new pits in the early part of the year, in order to lower the costs of production at Jembayan over the long term. Though the initial cash cost guidance at Jembayan in excess of US$60/ton does not leave much room for comfort if benchmark prices were to hover around US$80/ton (Jembayan coal sells at around 20-25% discount to benchmark), we expect the benefits from pit preparation works and lower coal prices could drive down cash costs at Jembayan to US$55/ton. If the margins are too thin, management retains the flexibility to scale down production and sales targets at Jembayan in 2H12. We believe this is a smart move by management to enhance value and is counter to what some other miners in Indonesia are thinking (increasing production to counter falling margins).
Sebuku remains very profitable even at current prices. Volumes at Sebuku, driven by the new Northern Leases extension, are expected to hit about 2.5m tons in FY12, up from 1.7m tons in FY13. Given the low cash costs of mining at Sebuku (around S$35-40/ton), and the high quality coal (only 5% discount to benchmark), we expect gross margins at Sebuku will still be close to 50% even at spot prices of US$80/ton. Thus, Sebuku mine will provide the bulk of SAR’s profitability in FY12, if coal prices remain subdued.
Overall, we expect a short-term rebound in anticipation of coal prices bouncing off current lows. SAR has significant exposure to spot coal prices with about 60% of sales on an index-linked basis, and given its high cost base, earnings are more highly leveraged to coal prices than Indonesian peers. Thus, if coal prices rebound to levels of US$90-95/ton in 2H12 from current lows of around US$84/ton, share price could see a sharper rebound than the market. There is also potential upside to our volume assumptions for Sebuku in FY12, and if the ramp up is fasterthan- expected, high-margin coal can still make a positive impact on earnings.
Cut TP to S$1.80; but maintain BUY for limited downside, decent dividend yield of 6% and potential run-up in case of a stimulus-driven commodity price rebound. We do not expect a repeat of the 2008-09 crisis level valuations seen in the post Lehman-crisis era, as the Euro crisis is not an overnight affair and the world has had two years now to prepare for it. Our TP of S$1.80 is based on – 0.5 S.D. valuations (blended 10x FY12 PE, 3.0x FY12 P/B). We like management’s strategy in managing production levels in line with coal price movements to enhance long-term value.
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