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

(Fitch Ratings - Singapore - 17 Nov 2023)--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 rating is aligned with Fitch's internal assessment of AEI, given our assessment of the parent'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 mines, adequate reserve life, and a solid financial profile underpinned by a net cash position and consistent positive free cash flow (FCF) generation through the cycle.

The Stable Outlook reflects Fitch's expectation that AEI will maintain its net cash position in the medium term, even as it increases its capex to raise non-thermal coal revenue. We believe strong cash flow generation from its coal-related business will continue to support AEI's financial flexibility to manage its bond maturity next year despite its capex plans and will mitigate risks from tightening funding access for thermal coal companies.

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 inter-company loans to AEI and its subsidiaries to support their operations, liquidity and investments in other coal resources. AEI has management control over AI.

Net Cash Position: We expect AEI to maintain a net cash position supported by strong operating cash flow despite its large investment plans. The net cash position should support AEI's investments to achieve its energy transition target, including an aluminium smelter that is under construction. AEI's shift away from thermal coal will be key to maintaining its credit profile over the medium term. We believe the shift will mitigate the continued tightening in funding access for the thermal coal sector.

Solid Cash Flow: Fitch expects AEI to generate strong annual cash flow from operations of over USD1 billion over the next four years. The company has the flexibility to curtail its capex plan for existing business, as the majority is for replacing machinery in the logistics and services segment and infrastructure development for its metallurgical coal mines.

The group plans to incur average annual capex of USD400 million for existing mining-related businesses, with maintenance capex of USD100 million. We expect AEI to incur over USD1.8 billion of capex on aluminium smelter and coal-fired power plant (CPP) construction during 2023-2025, in proportion to its stakes of 65% and 84%, respectively, in these projects. We believe capex will peak in 2024, which would lead to a temporary FCF deficit before turning around from 2025. AEI has a long history of generating positive FCF through the cycle.

Aluminium Smelter Key for Diversification: AEI expects its greenfield aluminium smelter to play a key role in achieving its target of generating half of its revenue from non-thermal coal business by 2030. The project is to be 70% funded by debt and has recently secured over USD1.6 billion of amortising bank loans, guaranteed by all the partners in proportion to their stake. The involvement of PT CITA Mineral Investindo Tbk (12.5% stake in smelter and 16% in CPP) and PT Aumay Mining Pte Ltd (22.5% in smelter) should facilitate the project's execution, as they operate in the metal mining value chain.

The aluminium smelter, which will have a capacity of 500,000 tonnes, is under construction and slated to start operations in 2025. Fitch's base case assumes no earnings from the smelter until 2026. AEI's long-term plan includes raising the smelter's capacity to 1.5 million tonnes (MT), with subsequent phases to be powered by renewable energy. Consequently, AI's contribution to AEI's earnings would remain high over the coming three to four years.

Metallurgical Coal Expansion: AEI plans to spend USD150 million in 2023-2024 to boost metallurgical coal production at Adaro Metcoal (AMC) to 6MT by 2025 (9M23: 4.0MT). Fitch expects AMC to reach 5MT of output by 2025 and contribute over a quarter of AEI's EBITDA, from 10% in 2022. We also expect AEI to receive average annual dividends of USD20 million from its 34.6%-owned Kestrel Coal, an Australian metallurgical coal producer that sold 4.4MT of coal in 9M22.

Competitive Cost Position; Integration: AEI's trough-through-peak stable FCF generation is supported by its competitive cost position and integrated operations. We believe AEI's EBITDA/tonne will remain robust at above USD15 (2023 forecast: USD26; 2022: USD65) despite moderation in our coal price assumptions from 2024. 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.

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 the 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 an annual production of around 34MT and a marginally smaller reserve life of 16 years.

AEI's integrated coal-mining operations and relatively lower mining costs drives its stronger profitability compared with Indika, a pure coal miner. We expect Indika's EBITDA net leverage to remain less than 1x, against AEI's net cash position. Both companies are in the early stages of plans to diversify away from thermal coal. AEI is rated multiple notches higher than Indika to reflect its significantly stronger business and financial profile.

The rating of PT Freeport Indonesia (PTFI, BBB-/Positive) reflects its concentration in copper, reliance on a single asset, solid reserve life, low-cost position and large EBITDA base. Fitch views PTFI's regulatory risk as higher because it was required to undertake smelter construction to extend its current mining license beyond 2031, whereas AI did not face such a requirement when its license was renewed in 2022.

Fitch believes PTFI's capex flexibility is lower than that of AEI, as PTFI's smelter and refinery projects will keep its capex high at above USD3.5 billion in 2023 and FCF negative until 2024. Nevertheless, we expect PTFI's net leverage to remain below 1x until 2024, compared with AEI's net cash position. PTFI and AEI are rated at the same level based on their comparable profiles. The Positive Outlook on PTFI reflects the potential positive rating action resulting from any positive rating action on its 48.76% shareholder, Freeport-McMoRan Inc. (BBB-/Positive).

Key Assumptions

- 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 USD165 for 2023, USD95 for 2024, USD85 for 2025 and USD75 for 2026, and hard coking coal per tonne price assumption of USD250 for 2023, USD190 for 2024, USD180 for 2025 and USD170 for 2026.

- Annual thermal coal production to stay at around 58MT over the medium term, and metallurgical coal production to reach above 4MT in 2024, rising to over 5MT by 2026.

- Dividend pay-out of at least 30% of net profit (2022: 63%).

- Cumulative capex of around USD3 billion during 2023-2025, including USD1.8 billion for the aluminium smelter and CPP projects.

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:

- Material challenges in the execution of non-thermal coal projects, leading to a delay in achieving energy transition targets;

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

- Funds from operations net leverage or net debt/EBITDA of above 1.3x for a sustained period;

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

Liquidity and Debt Structure

Large Cash Balance Supports Liquidity: AEI had a robust cash balance of USD3.4 billion as of end-September 2023, with annual debt maturities of below USD200 million, except in 2024 when the company's only US dollar note matures. We believe AEI's funding access will remain adequate 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 based in Indonesia that owns 88.5% of AI, one of the country's largest coal mines. The majority of the group's earnings will be linked to thermal coal over the next three to four years.

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.

Public Ratings with Credit Linkage to other ratings

AI's ratings are linked to the credit strength of its parent, AEI. A deterioration in Fitch's assessment of the credit strength of AEI would result in a negative rating action for AI.

ESG Considerations

AI's ESG Relevance score for Greenhouse Gas Emissions and Air Quality was changed to '4', from '3', due to AEI's revenue concentration in thermal coal, which faces the risk of declining demand in the medium term because of its high carbon footprint. Funding access for thermal coal companies has progressively tightened, which has a negative impact on AEI's credit profile and is relevant to the rating in conjunction with other factors.

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' 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. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/topics/esg/products#esg-relevance-scores. 9ends)