Fitch Affirms Adaro Indonesia at BBB-'; Outlook Stable

(Fitch Ratings - Singapore - 22 Sep 2022)--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 its parent PT Adaro Energy Indonesia Tbk (AEI) at 'BBB-'.

AI's ratings reflect the consolidated credit profile of its parent AEI given our assessment of the latter's high incentives to support AI in line with our Parent and Subsidiary Linkage Rating Criteria. AEI's credit profile reflects its leading market position, robust integrated operations, competitive cost position of its mine, adequate reserve life, and a solid financial profile underpinned by stable and solid FCF generation through-the-cycle.

We expect AEI to maintain its net cash position over the medium term, based on Fitch's coal price assumptions. This will support AEI's investments to transition away from thermal coal. While thermal coal companies' funding access is likely to narrow over the medium term, we expect AEI to enjoy stronger access than most peers due to its leading market position, while financial flexibility will also be supported by its net cash position and strong free cash flow from coal-related operations.

Key Rating Drivers

Parent's High Incentives to Support: We believe AEI has 'High' legal, operational and strategic incentives to support AI. The legal incentives stem from a full and irrevocable guarantee provided to AI's entire debt. AI is the largest contributor (about 50%) to AEI's EBITDA and AEI's coal-mine contracting and logistics segment derives the majority of its revenue from AI. AI has extended intercompany loans to AEI and its subsidiaries to support their operations, liquidity and investment in other coal resources. AEI has management control over AI.

Competitive Cost Position; Integrated Operations: AEI's trough-through-peak FCF generation has been quite stable, supported by its competitive cost position and integrated operations. Fitch expects AEI's EBITDA/tonne to remain robust at above USD20 (2022 forecast: USD60; 2021: USD40; 2020: USD15) after 2022 despite moderation in our coal price assumptions. The unit profitability will also benefit from increasing metallurgical coal volumes. AEI has some flexibility to adjust its strip ratios during coal-price downturns to curb costs, as seen in 2020.

Solid Cash Flows: Fitch expects AEI to generate strong annual cash flows from operation of over USD1 billion over the next four years. The company has the flexibility to curtail its capex plan, as the majority is for increasing capacity and replacing machinery of the logistics and services segment and infrastructure development for its metallurgical coal mines. The group plans to incur average annual capex of USD300 million for its existing businesses (maintenance capex of USD150 million-200 million) over the next four years, which supports positive free cash flows.

Diversification Plan: AEI plans to spend USD50 million during 2022-2024 to boost production at Adaro Metcoal, which holds the group's metallurgical coal mines, to 6 million tonnes (MT) by 2025 (2021: 2.3MT). Fitch expects AMC to reach 4MT of output in the medium term and contribute over 17% of AEI's EBITDA (2021: 11%). AEI also owns 34.6% of Kestrel Coal, an Australian metallurgical coal producer that sold 5.67MT of coal in 2021. Fitch expects AEI to receive average annual dividends of USD50 million from Kestrel after 2022, which will diversify AEI's earnings away from thermal coal.

AEI plans to build a greenfield aluminium smelter (capacity: 500,000 tonnes) with an initial investment of USD728 million. AEI aims to retain a majority stake in the project with strategic partners holding the rest. AEI's long-term plan includes raising the smelter's capacity to 1.5 million tonnes with subsequent phases to be powered by renewable energy. AEI expects the smelter of 500,000 tonnes capacity to start operations in 1Q25. This will keep AI's contribution to AEI's earnings high for the next three to four years. AEI plans to use its internal cashflows to fund part of the investment.

Net Cash Position: We expect AEI to maintain its net cash position on strong operating cash flows, even with its investment plans. AEI's financial profile has improved over the last 18 months with strong coal prices. It turned to a net cash position in 2021, and we expect this to support AEI's investments beyond the aluminium smelter, if any, once it finalises its transition strategy in the near term. Fitch believes AEI's shift away from coal will be key to maintaining its credit profile in the medium term, including managing continuing tightening in funding access for the thermal coal sector.

Licence Renewed; Higher Royalty Rates: AI said on 16 September 2022 that its mining licence has been renewed for 10 years and converted to a Special Mining Licence (IUPK-KOP). This removes lingering regulatory uncertainty, but results in a new royalty (effective from 2023) and tax structure. The new royalty structure, announced in April 2022, is tiered, with higher royalty payments when coal prices are high but a lower tax rate would mitigate the impact on cash flows when coal prices are low. We expect minimal impact on AEI's financial profile from the new royalty and tax rates.

Leading Position; Manageable Asset Concentration: AEI is one of the largest coal producers in Indonesia, and the third-largest seaborne coal exporter globally. AI accounts for about 80% of AEI's coal production, but we think the potential risk of business disruption from AEI'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.

Derivation Summary

AEI's closest Indonesian coal-mining peer is PT Indika Energy Tbk (BB-/Stable). Indika is smaller than AEI, with annual production of around 34MT, a small reserve life of 16 years, and a contracting business that is almost half that of AEI's, which Indika is in midst of selling. Indika's financial profile is weaker, with FFO net leverage expected to remain around 2x after 2022 against AEI's net cash position. Both plan to diversify away from thermal coal, but their plans are in the early stages. With its significantly stronger business and financial profile, AEI is rated multiple notches higher than Indika.

The rating of PT Freeport Indonesia (PTFI, BBB-/Stable) reflects its concentration in copper, reliance on a single asset, solid reserve life, low-cost position and large EBITDA base. Fitch views PTFI's capex flexibility as lower than AEI's due to PTFI's ongoing smelter and refinery projects, which will keep its capex high at above USD2.5 billion annually until 2023 and turn FCF negative. Nevertheless, we expect PTFI's net leverage to remain at below 1x until 2024 against the net cash position of AEI. PTFI and AEI are rated at the same level based on their comparable profiles.

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 USD360 for 2022, USD240 for 2023, USD90 for 2024 and USD83 for 2025, and hard coking coal per tonne price assumption of USD370 for 2022, USD200 for 2023 and USD140 thereafter;

- Coal production to reach 60 MT a year over the medium term;

- Dividend pay-out to remain high at around 60% of net profit;

- Cumulative capex of around USD1 billion during 2022-2024.

- Total cash outlay of USD1.5 billion in 2022-2024 for aluminium smelter and jetty construction.

RATING SENSITIVITIES

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

- Fitch does not expect an upgrade in the foreseeable future

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

- Failure to progress on a credible energy transition plan over the next 12 months

- Weaker-than-expected funding access to banks and capital markets

- FFO net leverage or net debt-to-EBITDA of above 1.3x for a sustained period

- Sustained negative FCF (post-dividends) before investments in non-coal operations

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: AEI had a robust cash balance of USD2.2 billion as of June 2022, with undrawn committed facilities of USD212 million that mature after more than 12 months. Fitch expects AEI's annual debt maturities to remain below USD200 million except in 2024 when its only US dollar note of USD750 million matures. AEI recently refinanced most of it 2022 debt maturities with an amortising bank facility of USD350 million. We expect AEI to retain its funding access to bank and capital markets over the next four to five years, which, together with its consistent and robust operating cash flow generation, will cover the group's debt maturities and capex requirements comfortably.

Issuer Profile

AEI is an integrated coal company that owns 88.5% of AI, one of Indonesia's largest coal mines. AEI has a solid reserve life of about 20 years, based on 1,041MT of proven and probable reserves (2P) and 52.7MT of 2021 coal production. AI accounted for the majority of the reserves (2021: 647 MT of 2P reserves).

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

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)