Fitch Affirms Adaro Indonesia at 'BBB-'; Outlook Stable

(Fitch Ratings - Singapore - 15 Apr 2021)--Fitch Ratings has affirmed Indonesia-based PT Adaro Indonesia's (AI) Long-Term Issuer Default Rating at 'BBB-'. The Outlook is Stable. The agency has also affirmed AI's US dollar notes that are guaranteed by parent PT Adaro Energy Tbk (AE) at 'BBB-'.

Fitch assesses AI based on the consolidated credit profile of AE due to the strong linkages between the two, in line with the agency's Parent and Subsidiary Linkage Rating Criteria. The Stable Outlook reflects our expectation that AE's credit profile will remain intact over the medium term, based on Fitch's commodity price assumption (see "Fitch Ratings Revises Global Metals and Mining Price Assumptions", dated 25 February 2021, at www.fitchratings.com/site/pr/10153632).

Fitch expects AE to maintain minimal leverage (measured by funds from operations (FFO) net leverage) of below 1x over the medium term, with positive free cash flow (FCF) profile even without considering AE's capex flexibility. Its cost competitive profile provides flexibility during commodity downturns, as witnessed in 2020, and strong liquidity will help absorb any short-term shocks, in our view.

The ratings reflect AE's leading market position, robust integrated operations, competitive cost position of its mine, adequate reserve life, robust financial profile including minimal leverage and robust FCF through-the-cycle.

KEY RATING DRIVERS

Strong Linkages with Parent: AI is the largest contributor to AE's profit, making up around 50% of AE's EBITDA in 2020. AE's service businesses (coal-mine contracting and logistics) derive the majority of their revenue from AI, reflecting strong operating linkages. In addition, AI has raised debt on behalf of AE to invest in other coal resources and support logistics operations. AE has management control over AI's policies, and full and unrestricted access to AI's cash flow through dividends and inter-company loans.

Moderate Impact of Coronavirus: Fitch expects coal prices to recover in 2021 after pandemic-related declines in 2020. We expect AE's sales volume to remain flat in 2021 (2020: 54 million tonnes (MT)) and increase to around 60 MT a year over the medium term. AE plans to focus on catching-up with its original mining plan in 2021 that was partly affected by weather in 2020, which will lead to a higher strip ratio of 4.8x (2020: 3.84x) and flat coal volumes. The weakness in coal prices in 2020 was countered by AE lowering costs from a reduction in the strip ratio and flexible capex, resulting in a positive FCF profile.

Flexible Capex: AE has meaningful flexibility in managing its capex plan, as the majority is for increasing capacity with the rest for replacing the machinery of the logistics and services segment. AE plans to incur up to USD300 million in capex in 2021. The annual maintenance capex for AE is around USD100 million-150 million with the rest being discretionary. Capex in 2020 was below USD200 million or 50% lower than its original plan.

Competitive Cost Position; Integrated Operations: AE has exhibited low volatility in its trough-to-peak unit profitability and FCF generation. Fitch expects AE's average EBITDA/tonne to remain around USD17 over the medium term (2020: USD15).

AI's cost position is around the 60th percentile of the global seaborne cost curve on an energy-adjusted basis, according to CRU, including cash costs related to mining, inland freight, port fees, royalties, marketing and financing. The cost position, in combination with AE's integrated operations, including its ownership of a well-connected transportation infrastructure, enables AE to capture the benefits across the coal value chain. This further benefits AE's cost position while also providing greater control over operations and improving flexibility.

Asset-Concentration Risk Manageable: AI accounts for around 86% of AE's coal production, but we think the potential risk of business disruption from AE's asset concentration is manageable. AI's main pit, Tutupan, covers a large area with its northern and southern areas operating independently, minimising risks of simultaneous disruptions.

Large Reserves; Licence Renewal Risk: AE had 976 MT of proven coal reserves (1P) at end-2020 (2P or proven and probable reserves of 1,024 MT). AI accounted for the majority of the reserves (2020: 685 MT of 2P reserves). Fitch does not foresee any major risks to AI's renewal of a first-generation coal contract of works (CCOW) licence due in October 2022 with clarity on license renewal under the regulations, even though uncertainty on royalty and tax rates remains.

Leading Coal Player; Diversified Customers: AE is one of the largest coal producers in Indonesia and among the top-five largest seaborne coal exporters globally, with exports of about 40 MT in 2020. AE also has a well-diversified customer base, including end-markets, compared with domestic peers. No overseas market accounts for more than 15% of AE's total sales volume. About 35% of volume off-takers are sovereign-backed entities and 40% are investment-grade buyers.

Single-Commodity Exposure: AE remains exposed to the coal-commodity cycle, with the majority of its earnings and cash flow linked to thermal coal prices and volume. We expect exposure to thermal coal to remain high over the medium term, despite efforts to diversify into metallurgical coal and power.

DERIVATION SUMMARY

The rating of US-based Freeport-McMoRan Inc. (BB+/Positive) reflects its concentration in copper, the broad geographical diversity of its mines in the US and Indonesia, a solid reserve life and low-cost position. Its recent Outlook revision to Positive is due to substantial advancement in transitioning to underground mining at its Grasberg copper mine, providing visibility in the remaining ramp-up and cash flow. Fitch believes the timing and quantum of spending to satisfy the Indonesian smelter requirement are important variables in analysing future consolidated financial leverage. Freeport's higher leverage in 2021, due to the ramp up in underground mining at Grasberg, will start to improve from 2022, but will remain higher than AE over next three to four years.

AE's licence-renewal risks are much lower than those faced by the Grasberg mine. Freeport was required by Indonesian regulation to reduce its shareholding in Grasberg to a non-controlling stake when its CCOW was converted to a new concession structure. It was also asked to increase the value of its Indonesian operations, resulting in large capex to set up a copper smelter, a requirement that would not be needed for coal. We also believe the Kalimantan area, where AI is located, offers a more stable business environment due to its political stability compared with the Papua region, where Freeport is located.

AE's closest Indonesian coal-mining peer is PT Indika Energy Tbk (BB-/Negative). Indika is smaller than AE, with annual production of around 32 MT, a small reserve life of 15 years and a contracting business almost half that of AE. Indika's financial profile is weaker than that of AE, with Fitch expecting FFO net leverage to remain above 3.0x over the next three to four years against less than 1.0x for AE. As a result, AE is rated multiple notches higher than Indika.

KEY ASSUMPTIONS

Fitch's Key Assumptions Within Our Rating Case for the Issuer:

- Coal price assumptions in line with Fitch's mid-cycle hard coking coal and Newcastle 6000kcal price assumptions, adjusted for the difference in calorific value. Newcastle per tonne coal price assumption of USD72 for 2021, USD66 for 2022-2024 and USD63 thereafter, and hard coking coal per tonne price assumption of USD135 for 2021-2022, and USD140 thereafter;

- Coal production to increase to around 60 MT a year over the medium term after a flat 2021;

- Dividend payout to remain high at around 55%;

- Cumulative capex of around USD1 billion during 2021-2024.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

- Positive rating action is unlikely in the near to medium term, due to the constraints of AE's operating scale and its limited business and geographical diversification. However, positive action may be considered if AE achieves a material increase in business or geographical diversification while maintaining a low-cost position, consistently positive FCF and FFO net leverage below 1.0x.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

- FFO net leverage of above 1.5x for a sustained period; or

- Sustained negative FCF.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

LIQUIDITY AND DEBT STRUCTURE

Robust Liquidity: The group had a strong cash balance of around USD1.2 billion as of end-2020 against its current debt maturity of around USD588 million. Consistent, robust operating cash flow generation covers the group's capex requirements comfortably, with minimal reliance on external funding.

ESG CONSIDERATIONS

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg. (ends)