Background – Adaro Energy is a top-down, thematic stock idea centred around Indonesia coal
In this piece, I am going to explore a top-down, thematic stock idea centred around Indonesia coal.
I will focus on 4 key segments – (i) why I am bullish on Indonesian coal, (ii) how I shortlisted Adaro Energy out of all the Indonesian coal stocks and (iii) exploring Adaro Energy’s fundamentals and (iv) other considerations (risks, mitigation, entry, limitations of my analysis).
Why Indonesian coal? – Despite general sentiments of coal being a sunset industry, I am bullish on Indonesia coal due to its innate competitive advantages and favourable macro backdrop.
At face value, coal might appear to be a sunset industry given the significant global emphasis on climate change. Unsurprisingly, this sentiment is evident in how the market has been punishing coal mining stocks. Below, you can clearly see that the forward P/E valuation multiples of Indonesian coal miners have been on a general downward trend.
Yet, I think that this pessimism is overblown. I am bullish on Indonesia coal for 2 reasons. (i) Innate competitive advantages of Indonesian coal, coupled with (ii) favourable macro backdrop. Let’s dive deeper into each point.
[Innate competitive advantages of Indonesia coal] Indonesia coal enjoys cost advantage from transportation due to proximity to major coal-importing countries.
Buyers of coal tend to price sensitive, given that coal is a commodity. While there are differing quality of coal, graded on energy content, buyers tend to focus on cost, especially for thermal coal, which are used to produce steam to generate electricity. Buyers may focus more on the quality of coal if they are looking for coking coal, which is mined to produce the carbon used in steelmaking.
Therefore, Indonesia has a big advantage over peers like Australia and South Africa in being able to offer lower cost. Indonesia enjoys substantial freight cost advantage due to being closer to buyers – the price to ship a ton of coal from Indonesia to China can be 50% lower than Australia. Furthermore, Indonesian coal is also typically lower grade, which makes them cheaper and more attractive for cost sensitive buyers. These 2 factors are natural competitive advantages that are difficult to erode even with the test of time.
[Favourable macro backdrop] Indonesia’s international and domestic demand for coal is likely to remain robust going forward, at least in the medium term.
Despite Indonesia’s ambitious 2060 net-zero vision, I am of the view that domestic demand for coal will remain robust, at least in the medium term, due to strong inertial to transition to renewable energy.
- Firstly, there is a heavy reliance on coal for cheaper (subsidised) energy cost. Coal-fired power plants still contribute almost 70% of Indonesia’s energy source. The abundant coal supply coupled with government policies (imposed cap of US$70/ton for coal sold in Indonesia) allow PLN (Indonesia’s state electricity company) to produce electricity cheaply vs renewable sources.
- Secondly, there is strong lobbying power to prolong status of coal. Leading coal producers, including Adaro are backed by highly powerful families who are closely connected to the policymakers and decision makers. For instance, Adaro’s CEO Garibaldi Thohir is brothers with Indonesian Minister of State-Owned Enterprises, Erick Thohir.
- Thirdly, Indonesia’s coal power plants are still too young, making it impractical to retire them. The average age of Indonesia’s coal power plants is only 12 years. 75% of the power plants are built after 2005. For context, the life cycle of a typical coal power plant is around 50-60 years.
On the international front, I am of the view that Indonesia’s top coal buyers (largely emerging markets) will likely continue to heavily rely on coal as a cheap source of energy to fuel industrialization, at least in the medium term.
We focus on China and India, which as seen above, are the two biggest needle movers in coal imports.
- China is Indonesia’s largest importer of coal. Coal still makes up 55% of China’s energy mix and despite global coal-phase out, China approved another 114GW of coal power plants last year, up 10% from 2022. Moreover, the 14th Five-Year Plan did not set any limits for domestic coal production.
- India is Indonesia’s second largest importer of coal and is slowly playing a more important role than China. Coal makes up ~70% of its power generation. India’s Union Environment Minister, Bhupender Yadav, have openly said that India will continue to rely on coal power until it achieves developed country status. He further adds that India “strongly resisted” the rich nations’ call for limitations on new and unabated coal power generation.
Putin once famously criticized Greta Thumberg’s UN speech on climate change by arguing that “People in Africa and in many Asian countries want to be as wealthy as people in Sweden. How can it be done? By making them use solar energy, which is plentiful in Africa? People there want to live like in Sweden and nothing can stop them.” This basically captures the essence of my argument above.
Shortlisting Indonesian coal stocks – Adaro Energy stands out because of its foothold in overseas markets, higher margins vs peers and reasonable valuations
I conducted a preliminary screening of the most prominent Indonesian coal stocks by looking at three factors.
- Geographical focus. I am bias towards stocks with greater overseas foothold given that domestic sales have a price cap.
- Profitability metrics as an indicator of cost advantage. This is especially important given the cost sensitive profile of coal buyers.
- Valuation multiples as an indicator of under/over-valuation by the markets.
[Filter #1 – Geographical focus] I am bias towards stocks with stronger international (especially India and China) foothold.
Given the Indonesian government’s cap on price at US$70/ton for domestically consumed coal, upside on domestic sales is limited. Furthermore, given India’s rise (recent beneficiary of China+1 and US-China trade war) and China’s continued influence in coal demand (currently largest importer of coal), I am bias towards stocks with stronger international (especially India/China) foothold.
That is why I prefer stocks like Adaro, Indika, Indo Tambangraya Megah and Bayan Resources over ABM, Bumi and Bukit Asam.
[Filter #2 – Profitability] I am bias towards stocks with a clear cost advantage – especially for a price sensitive product like coal.
Especially for a commodity like coal, which buyers tend to be more price sensitive towards, the only viable way to be competitive is via having cost advantages (e.g. logistics, labour, etc.). Cost advantage shows up most obviously in the stock’s profitability metrics.
Out of Adaro, Indika, Indo Tambangraya Megah and Bayan Resources, which I have earlier shortlisted using my geographical focus criteria, only Adaro and Bayan Resources seem have possess cost advantages.
[Filter #3 – Valuations] I am bias towards stocks trading at lower valuation multiples (obviously).
Out of Adaro and Bayan Resources, it is clear that the markets are placing a significant (and likely unsustainable) premium on Bayan Resources. Hence, this leaves us with Adaro Energy as a viable exposure to Indonesian coal.
Adaro Energy’s fundamentals – Signs of strong downside risk insulation and cost advantage moat
A brief background of Adaro Energy
Adaro Energy is a fully integrated coal mining and energy company. Adaro Energy conducts business in coal mining and trading, mining services, logistics and power generation – with an overwhelming focus on the former 2 segments.
The company is owned by 4 influential families in Indonesia – the Rachmats and Thohirs (who acquired their shares from Australian mining company, New Hope), Subiantos and Soeryadjaya.
[Investment Thesis #1] Strong downside insulation stemming from extremely high dividend yield (being a cash cow) alongside political lobbying power and strong balance sheet.
Firstly, Adaro Energy’s dividend yield of 15.09% as of writing is easily higher than any S-REITs or bank stocks that are popular amongst dividend investors. Unsurprisingly, Adaro is extremely cash flow generating to be able to support such a high dividend profile. Last twelve months operating cash flow margin stands at 33.3%. This means that Adaro Energy generates $33 of cash for every $100 of revenue it earns.
However, do note of withholding tax on dividend distribution that may reduce the effective net dividend yield. For Singapore (non-Indonesia resident) investors, the withholding tax is 15%, down from 20% because of a tax treaty. Refer here to see if your country has a tax treaty with Indonesia. Therefore, as a Singapore investor, the effective net dividend yield is really 12.82%, down from 15.09%.
Secondly, strong lobbying power (e.g. CEO is brothers with Indonesia’s Minister of State-Owned Enterprises) as I explained earlier will shield Adaro from unfavourable policy changes. Business and politics are extremely intertwined especially in Indonesia. Many in Indonesia’s cabinet are/were prominent businessmen. Even Prabowo Subianto, Indonesia’s newly elected President, held positions in several companies before politics and may possibly still be indirectly controlling them via his family members and close associations. Specific to the coal industry, as many as half of the 575 lawmakers in Indonesia’s parliament have connections with the mining sector (according to the Indonesia Mining Advocacy Network).
Thirdly, Adaro Energy’s strong balance sheet. As of 31-Mar-2024, Adaro Energy has US$3.16b in cash and cash equivalents. Adaro’s total liabilities (current + non-current) stands at merely US$3.33b. This means that Adaro’s cash alone can repay all of its liabilities – including loans, employee benefits, trade payables, lease liabilities, etc.
[Investment Thesis #2] Heavy emphasis on cost discipline helps Adaro defend earnings during times of coal price volatility.
Cost discipline is a theme that has consistently been emphasized by Adaro. After all, Adaro is at the mercy of coal price volatility (read more below) and cost is the only variable in the profit equation that they can really influence or have control over. Adaro has taken this very seriously. In fact, Adaro’s Indonesian thermal and metallurgical coal operations are in the first quartile of the industry’s global cost curve.
There are a few key drivers of this:
- Vertical integration “from pit to port to power”: Acquisition of logistics companies and other mining-related entities have helped Adaro gain more control over the supply chain and therefore maintain cost efficiency.
- Lower stripping ratios: Adaro’s strip ratio (which measures the amount of waste material that must be removed for a given amount of ore) is pretty low at 4.51x in 2023. Bayan Resources, which boast even higher margins than Adaro is at 4.4x (too high valuations). Companies with lower margins like Bumi Resources (10.9x), Bukit Asam (6.24x), ITM (>10x), tend to have higher stripping ratios as well.
Other considerations – Risk, Mitigation, Entry and Limitations of my analysis
[Risk + Mitigation #1] FX risk for foreign investors is mitigated by USD being the functional currency of Adaro.
FX risk (or rather, specifically IDR depreciation risk) is typically a top-of-mind concern especially for foreign investors considering Indonesian equities. IDR has not historically performed the best (-2.8% annualized FX change vs USD from 2000-2021) and the government does not have significant foreign reserves (especially given its size) to intervene and protect the IDR in times of market volatility.
While the stock is trading in and dividends are paid in IDR, Adaro’s functional currency is the USD. This means that business is conducted in USD. Most of its revenue is in USD. The financial statements are denominated in USD rather than IDR and cash held in the bank are also largely in USD. As of 31-Dec-23, US$2.2b of US$2.8b of cash in bank are in USD accounts.
[Risk + Mitigation #2] Coal Price fluctuation heavily influences Adaro’s stock price.
As you can clearly see from the chart above, Adaro’s stock price is highly correlated to coal price. After all, coal price heavily influences the revenue generating (and hence earnings) potential of Adaro. Hence, Adaro can be at the mercy of macro volatility.
The best way to mitigate this risk is trying to time the market cycle and entering when coal price bottoms. Coal prices are normalising from 2022 highs (caused by the energy crisis/natural gas crunch amidst the Russia-Ukraine war) and it might be interesting to hold for a few months to monitor price movements.
[Risk + Mitigation #3] Regulatory change can dramatically impact earnings of coal stocks.
Coal miners like Adaro pay huge amounts of taxes to the Indonesian government. There’s always a risk of the government adjusting taxes upwards given how profitable coal companies are.
Before the conversion of CCOW to IUPK, Adaro pays a stunning 45% corporate income tax alongside 13.5% royalty rate to the government. Regulatory changes on this can dramatically impact Adaro’s earnings.
Nevertheless, I have repeatedly mentioned that Adaro is owned by very influential businessmen in a country where politics and business are highly intertwined. Hence, I don’t believe that this risk is alarming, but it is definitely non-zero.
Further due diligence to be done and limitations of my analysis – Valuation, sensitivity analysis and speaking with experts
While I did not do this (due to time constraint), it is a good idea to do a sum-of-the-parts valuation for Adaro Energy to further validate its intrinsic value.
- DCF on the coal mining business, assuming complete reserves monetization
- DCF on the power business
- Multiple-based valuation on the mining services and logistics business
On this point, I want to caution using trailing P/E. Coal stocks like Adaro benefitted tremendously in 2021 – 2022 due to sky high coal prices due to the energy crisis/natural gas crunch in Europe. Those earnings will normalize. Hence, trailing P/E might not be a good indication of forward P/E.
Furthermore, it will be interesting to model out different scenarios and earnings sensitivity on key assumptions/risks variables – e.g. coal price, coal volumes, fuel cost, royalties and taxes charged by the government.
Additionally, I am no expert on coal, and I definitely am not the most informed of the industry’s nuances (e.g. weather affecting coal production, demand/supply dynamics and drivers of coal markets internationally). A good way to pick this up is to speak to experts, sell-side analysts, people working at Adaro, etc. Please conduct your own due diligence before making any investment decisions.
