Fitch Assigns Adaro Indonesia's USD750 Million Notes Final 'BBB-'

(Fitch Ratings - Singapore - 30 October 2019)--Fitch Ratings has assigned PT Adaro Indonesia's (AI, BBB-/Stable) USD750 million 4.25% senior notes due 2024 a final rating of 'BBB-'. The notes are guaranteed by PT Adaro Energy Tbk (AE), which owns 88.5% of AI. The rating on the notes is at the same level as AI's Issuer Default Rating as the notes constitute its direct, unsubordinated and unsecured obligations. The assignment of the final rating follows a review of final documents conforming to information already received and is in line with the expected rating assigned on 15 October 2019. AI will use the proceeds for debt repayment, general corporate purposes and capex.

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-subsidiary linkage rating criteria. The 'BBB-' rating reflects AE's leading market position in the Indonesian seaborne coal market, and operational and financial resilience through the cycle due to its vertically integrated operations, the competitive cost position of its mine, and prudent financial policies. AE has maintained a robust financial profile including low leverage and mostly positive free cash flows through the cycle. Nevertheless, AE's credit strengths are counterbalanced by its limited business and geographical diversification.

The Stable Outlook reflects our expectation there will be no material change in AE's credit profile over the medium term. AI - AE's largest mine - operates under a first-generation coal contract of works (1G CCOW) expiring in 2022. Fitch believes there is limited risk of AI's licenses not being renewed, considering its position as one of the largest Indonesian coal producers and exporters. Fitch would treat non-renewal risk, if any, as event risk for AI's rating.

Coal is one of the key foreign-exchange contributors to the Indonesian economy and Fitch believes any major disruptions to mining operations will have a significant impact on the economy. It can also affect the country's position as a reliable commodity exporter. The 1G CCOW concessionaires are among the largest coal producers in Indonesia and pay high taxes and royalties compared with other recent coal licensees, which reduces the risk of licence non-renewal. The top-three 1G CCOW concessionaires contribute approximately 34% of Indonesia's total annual coal production.

CCOW concessionaries are allowed to apply for a renewal two years before expiry. There is a risk that AI's mining license may be renewed for a smaller operating area in the absence of clarity in Indonesia's latest regulations, but our view is that this would not have a material impact on AI's credit profile including its reserve base, production level, and cash flow generation. We expect AE's coal production to remain stable at around 55 million tonnes (MT) to 60MT (2018: 54MT; 1H19: 28.5MT) over the medium term.

Key Rating Drivers

Strong Linkages with Parent: AI is the largest contributor to AE's profit, making up 65% of AE's EBITDA in 2018. AE's service businesses (coal-mine contracting and logistics) derive the majority of their revenue from AI. The subsidiary has raised debt on behalf of AE, including providing related-party loans to other entities in the group. AE has management control over AI's policies, and full and unrestricted access to AI's cash flow through dividends and inter-company loans.

Leading Coal Player; Diversified Customers: AE is one of the largest coal producers in Indonesia, and the third-largest seaborne coal exporter globally with exports of about 40MT in 2018. AE also has a well-diversified customer base (including end-markets) compared with its domestic peers. No country, excluding the domestic market, accounts for more than 20% of AE's total sales volume; about 35% of volume off-takers are sovereign-backed entities and 40% are investment-grade buyers. AE has maintained long-standing relationships with its customers, and most of its volume is on medium- to long-term contracts of three to five years.

Competitive Cost Position; Integrated Operations: AE has exhibited relatively low volatility in its trough-through-peak unit profitability and free cash flow (FCF) generation. Its EBITDA/tonne remained comfortable at USD14 during 2015 when Newcastle 6,000kcal benchmark prices fell to around USD51 per tonne, supporting positive FCF.

AI's cost position is around the 54th 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. This - 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, further benefitting AE's cost position while also providing greater control over its operations and improving its flexibility.

Asset-Concentration Risk Manageable: AI contributes more than 80% of AE's coal production, although we think the potential risk of business disruption from AE's asset concentration is manageable. AI is located in Kalimantan, one of Indonesia's main coal-mining areas, which has been less prone to earthquakes and other natural catastrophes. AI's main pit - Tutupan - stretches across a large area, with the northern and southern portions operating independently and covering each other in times of slower production due to circumstances such as 'haze' or heavy rainfall.

AE's ownership and operation of the key transport infrastructure include the road from the mine pits to the barging port as well as the surrounding land, which are independent of its AI concession. We believe AE's control over the infrastructure will enable it to address temporary service disruptions more quickly. AE also faces relatively low risks of operational disruptions as its mining operations are carried out by three separate contractors.

Resilient FCF; Strong Financial Profile: We expect AE's FCF to remain positive over 2020-2022 despite its large planned capex of about USD1 billion over the next two years for raising the capacity and replacing the machinery of the logistics and services segment, investment in its power business and developing metallurgical coal-mine infrastructure. AE recorded positive FCF in eight out of the last 10 years across the commodity cycle, reflecting its operating resilience and financial flexibility. AE's FFO adjusted net leverage declined from a peak of 2.6x in 2012 to 1.0x by end-2018, and we expect it to maintain its strong financial profile with FFO adjusted net leverage below 1x over the next three years.

Large Reserves; CCOW Renewal Risk: AE had 1,228MT of proven coal reserves (1P) at end-2018 (2P or proven and probable reserves of 1,482MT), resulting in 1P reserve life of about 22 years based on 2018 production. AI accounted for the majority of the reserves (2018: 866.7MT of 2P reserves). Fitch does not foresee any major risks to AI's renewal of the 1G CCOW licence.

The terms of a contract extension remain unclear, including the potential of a smaller operating area. Fitch does not expect the potential changes to be material or have a significant impact on AI's operating and financial profile, due to the concession's importance to state revenue and Indonesia's coal industry. We believe a curtailment in AI's concession area is also not likely to have a material impact on its production because of the current concentration of its coal reserves within its approximately 31,000 hectare concession.

Single-Commodity Exposure: AE remains exposed to the coal-commodity cycle, with the majority of its earnings and cash flow linked to thermal-coal price and volume movements. We expect exposure to thermal coal to remain high over the medium term despite efforts to diversify into metallurgical coal and power. AE has started production at its wholly owned metallurgical coal mine in Indonesia, and has also taken a minority stake in Kestrel Coal, an Australian metallurgical coal producer, and two power plants. Fitch does not expect any material cash flows or dividends from these businesses over the medium term.

Derivation Summary

The rating of the US's Freeport-McMoRan Inc. (BB+/Stable) 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 ratings are constrained by our expectations of high capex, and the impact on production volume and the execution risk of the transition of its Grasberg copper mine to underground mining from its current open-cut mining. We believe AE has a stronger credit profile than Freeport, due to the risks from Freeport's transitioning operations and relatively weaker financial profile over the next three years.

AE's licence-renewal risks are considerably 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 offers a more stable business environment due to its relative political stability compared with the Papua region where Freeport is located.

PT Indika Energy Tbk (BB-/Stable) has a much weaker credit profile than AE, with lower annual production of around 35MT; a shorter reserve life of 10 years; a smaller degree of vertical integration as Indika's contracting business is almost half of that of AE's wholly owned subsidiary, PT Saptaindra Sejati; and a higher cost position. Indika's financial profile is also weaker, as we expect its FFO adjusted net leverage to remain above 2.0x over the long term and the company has been more vulnerable to coal-price downturns than AE. (ends)