Straits Asia Resources Limited (CIMB)

UNDERPERFORM Downgraded
S$3.14 @04/06/11
Target: S$3.29
Coal Mining

Growth priced in

• Recent rally calls for caution. We adopt caution on the stock following its sharp appreciation, which in our view has not been supported by significant fundamental improvements. SAR has climbed to a 52-week high despite a 15% retreat in the benchmark Newcastle Coal price from its January highs. It now trades at 12.5x CY12 P/E, above its peers’ 10.2x average. We resume coverage with new earnings forecasts, an Underperform rating (from Neutral) and DDM-derived target price of S$3.29 (discount rate 9.8%), expecting de-rating catalysts from lower-thanexpected ASPs or delays in production ramp-up.

• How realistic are expectations? Expectations that China will increase its imports following attractive price arbitrage, coupled with anticipation of a switch from nuclear to thermal energy, have been fuelling thermal coal price expectations higher. In reality, Newcastle Coal has declined from US$138.50/tonne in January to US$118.40. We expect Newcastle Coal to hover at US$100-130/tonne between 2011 and 2013, implying limited medium-term upside.

• Near-term cost challenges persist, fanned by high fuel costs and inflationary pressure in Indonesia. We are projecting a 14% increase in unit production costs in FY11. Our projections imply a ramp-up from Northern Leases in 2H11; any delays could pose risks to volumes and unit production costs.

Share price up despite falling coal price Favourable events drive sentiment. Sentiment surrounding thermal coal has been buoyant, fuelled by: 1) expectations that China will resume imports as the price arbitrage between its domestic and import prices has become attractive; and 2) anticipation of spillover demand for thermal coal as nations grow increasingly wary of nuclear energy following Japan’s disasters. These could have spurred SAR’s recent outperformance, in our opinion.

Reality bites. However, that could be changing. While we remain sanguine over the long-term outlook for thermal coal, current expectations could be too high. First, Newcastle Coal has fallen from its 52-week high of US$138.50/tonne in January to US$118.40. Second, our longer-term thermal coal price forecasts of US$100-130/tonne for the next three years suggest limited upside. Third, even if thermal coal prices spike momentarily, SAR may not be in the position to benefit from higher ASPs since some 40% of its 2011 output has already been priced.

Undeserved recent outperformance versus peers. SAR’s stock has been outperforming peers even though fundamentally, there have not been significant drivers. The benchmark Newcastle Coal has been reversing from its January high. SAR has outperformed the Newcastle Coal benchmark and several of its Indonesian peers over the past 12 months. We are increasingly cautious as the risk-reward proposition has become less appealing.

Attractive growth profile, but in the price Leap in earnings widely expected, but also priced in. We expect FY11 earnings to jump 77% yoy to US$156m, powered by higher volumes and ASPs as more output from Sebuku comes on stream. However, strong output growth is reflected in its above-industry valuations at 12.5x CY12 P/E vs. its peers’ 10.2x average.

All eyes on Sebuku; no room for disappointment. The risk stems from negative earnings surprises, given such tall expectations. SAR’s growth prospects are premised on improvements in ASPs, margins and volume, which in turn hinge on successful expansion at Sebuku. Any hiccups over developments at Sebuku could threaten our projections.

We forecast sales volume growth of 16% CAGR for the next three years, primarily on increased production from Sebuku. Having been granted Pinjam Pakai permits in 2Q11, exploration of the Northern Leases has commenced and we anticipate initial output in 2H11. Any delays in ramp-up, for instance due to wet weather or execution, could pose risks to volume, unit production costs and ASPs.

Our projection of higher blended ASPs is also premised on increased contributions from Sebuku, whose output fetches higher selling prices (due to better quality) and margins. As such, should Sebuku fall short of expectations, this would have negative implications on group ASPs, margins and volumes.

Risk-reward proposition less appealing. With lofty expectations already built in, any disappointment could deal a blow to the stock. Industry watchers remain generally cautious, citing weather as the main source of uncertainty. Rising costs due to costlier fuel, parts and labour are another concern.

We are projecting a 14% increase in unit production costs in FY11, and our projections imply a ramp-up from Northern Leases in 2H11. Risks to our assumptions are higher-than-expected costs, wet weather, and delays in ramp-up at Northern Leases.

Valuation and recommendation

Resume coverage with Underperform rating and S$3.29 target price. Our negative view is due to its relatively more expensive valuations versus peers, which make further outperformance difficult. In our view, the stock’s rapid ascent has also not been supported by a stark improvement in fundamentals. Rising coal prices typically lift all industry peers together but Straits Asia Resources have been outperforming despite falling coal prices. Events that have catalysed its recent outperformance, such as the receipt of Pinjam Pakai permits, have already been incorporated in our assumptions. SAR now trades at a 23% premium to its peers in terms of CY12 P/E.

We derive a target price of S$3.29 based on DDM (discount rate 9.8%, growth 4%). De-rating catalysts could arise from: 1) lower-than-expected thermal coal prices; 2) delays in ramp-up at Sebuku; and 3) higher-than-expected costs, in our view.