Rio Tinto (RIO, Not Rated) earlier this year agreed to sell its subsidiary, Coal & Allied (C&A), to Yancoal Australia, a controlled subsidiary of China's Yanzhou Coal Mining Co. (1171:HK, Not Rated) for $2.4 billion. The C&A assets include a 67.6% stake in the Hunter Valley Operations, an 80% share in the Mt. Thorley mine, and a 55.6% stake in the Warkworth mine. Combined, these mines produced 16.3 million metric tons (Rio's share) of thermal and semi-soft coking coals in 2015. Rio's Australian coal portfolio, which includes C&A but also operations in Queensland more focused on coking coal, had adjusted EBITDA of $893 million in 2016. This week, Glencore (GLEN, Not Rated) entered the fray and made an unsolicited offer for C&A for $2.5 billion, effectively starting a bidding war.
Peabody Energy Corporation (NYSE:BTU) boasts coal mining operations in both Queensland and New South Wales, and is Australia's fifth largest coal miner. The thermal coal operations are generally in NSW, and include 23 million metric tons/year that is split roughly 8 million metric tons/year sold domestically and the balance sold to export markets. These export sales typically garner 90-95% of the Newcastle thermal coal market price, while the domestic sales are far below that. Thermal coal costs are in the low $30/ton range, and margins in the first quarter were $16.38/ton for an adjusted segment EBITDA of $75.6 million. MKM Partners models full-year adjusted EBITDA for Australian thermal of $321 million, dropping to $279 million next year to reflect the backwardation in the Newcastle forward curves.
Glencore's interest in C&A stems in part from the fact that they have adjacent mines to many C&A operations and would therefore have the opportunity to realize sizeable synergies. If the firm conservatively assumes that half of the Australian coal EBITDA last year for Rio was from C&A, or roughly $446 million, that would put the deal at roughly 5.6x on an EV/EBITDA basis. The firm would expect Peabody's thermal assets to fetch a discounted multiple due to the lack of port ownership and lower likely synergies. If the firm assumes a 5x multiple on its ~$300 million of EBITDA run rate it contributes to Aussie thermal ops, the balance of the company, even if burdened with total net debt and legacy liabilities, would need a 6.5x EV/EBITDA multiple in order for the two parts to reach the firm’s $34/share price target.
MKM initiated coverage of Peabody recently with a Buy rating that was more reflective of valuation than of quality of coking coal exposure. Its coal mining coverage generally favors coking coal exposure over domestic thermal coal end markets. The firm also highlighted Peabody's strong export thermal coal business in Australia, and believes the current bidding for Coal & Allied is supportive of a solid valuation for the segment. The valuation implied in the C&A process leaves a resulting valuation for the rest of Peabody's businesses that MKM views as reasonable, and it reiterates its Buy rating and its $34/share price target. The firm’s 2018 estimate moves down slightly on a minor model adjustment. It would be buyers of the stock at current levels.