Straits Asia Resources: Improving outlook

Energy markets tightening. Straits Asia Resources Ltd (SAR) has seen its share price more than doubled since its March lows, in tandem with the resurgence of oil prices. The impact of global economic stimulus plans has started to flow into the real economy, leading to tighter energy markets. Improvements in fundamentals bode well for SAR, as firmer coal prices will boost its revenue. Management holds the view that energy markets will continue to tighten in 2H09 and is optimistic that its FY10 output will be priced at more favourable levels than recent spot prices of around US$60 / ton.

FY09 output fully committed. Since our last update, SAR has entered into sales agreements for the remaining 27% of its FY09 output. We estimate a blended ASP of US$85/ton for its FY09 output, slightly lower than our previous US$87 forecast due to recent weak coal prices. Nevertheless, this is still above FY08's ASP of US$70.50/ton, putting the group on track to deliver record earnings in FY09. This is also well above its breakeven cost of approximately US$38/ton. Production volumes have picked up in 2Q09 following a seasonally wet and slow 1Q09, and we expect output to gain momentum from 2H09 onwards on the back of more favourable weather conditions and increased production capacity.

Increased production volumes to propel earnings. SAR has recently installed additional infrastructure at its mines. The enlarged capacity will enable it to produce up to 19mt of coal per year, more than double its targeted FY09 production volume of 9mt. Management targets to ramp up its production to 19mt by FY12, pending the resolution of forestry boundary restrictions at Sebuku. We expect growing production volumes to drive SAR's earnings in FY10 and beyond. A sustained recovery of energy prices will serve as an added boost to its earnings. Nevertheless, we are assuming a moderation of coal prices given that energy prices have fallen way below their peak levels attained in 2008.

Improving outlook; upgrade to BUY. We have adjusted our earnings estimates by -20% to +2% as we lower our FY09 ASP assumption and tweak our cost projections, but raise our ASP assumptions for FY10 and beyond. This lifts our DCF-based fair value estimate to S$2.07 (previously S$1.38). Given the stabilisation of oil prices and the improving outlook for global energy markets, we upgrade SAR to a BUY. Dividend yield remains attractive at 5.2%. Key risks to our assumptions include a reversal of energy prices and refinancing risk.

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