Flash Alert: No Deal Down Under, But Plenty of Upside

Wildcatters Portfolio holding Peabody Energy (NYSE: BTU) has offered AUD13 per share for Australia’s Macarthur Coal (Australia: MCC).

The proposed transaction should come as no surprise to readers; Macarthur was one of the 10 takeover plays I highlighted in a special Flash Alert issued on Dec. 17, 2009, Ten Takeover Plays. Macarthur is the second name highligted in that report to be the subject of takeover speculation: Smith International (NYSE: SII) has already agreed to be acquired by Wildcatter Portfolio recommendation Schlumberger (NYSE: SLB).

The deal makes strategic sense. Peabody Energy established its position in Australia via a series of acquisitions that included the $1.3 billion purchase of Excel Coal in 2006. As discussed in the Feb. 3, 2010, issue Earning Their Keep, Peabody has made no secret of its plans to expand operations in Australia–a region with attractive growth opportunities.

There are basically two ways to make steel: in blast furnaces or in electric arc furnaces.

To use electric arc furnaces, a steel producer must have access to scrap steel; electric arc furnaces are common in the US and other developed countries where scrap is available in abundance.

A lack of scrap steel coupled with strong demand for steel forces China and other emerging Asian economies to rely primarily on blast furnaces, which require the use of a high-quality coal known as metallurgical (met), or coking coal. Peabody Energy produces met coal from its Australian mines, as well as thermal coal used in power plants. Macarthur focuses primarily on a third type of coal known as pulverized coal injection (PCI) coal.

PCI coal is crushed and injected into steel blast furnaces as a replacement for expensive metallurgical coal; Macarthur’s mines produce roughly one-third of Australia’s exports of PCI-grade coal.

Macarthur’s management rejected the $3 billion deal and noted that the offer fails to fully value the company’s growth prospects. As Peabody is in the Wildcatters Portfolio, I would love the company to buy Macarthur for AUD13. That being said, I agree with Macarthur’s management; Peabody’s offer was too low.

The market seems to agree: When the news of the bid leaked on Wednesday, Macarthur’s stock jumped above AUD14. Interestingly, shares in Peabody traded slightly higher today despite the bid. Because the knee-jerk reaction is to sell shares of the company making an acquisition, this suggests that the market recognizes the deal’s value. I expect Peabody to make a higher bid eventually.

This proposed transaction reaffirms my investment thesis for Peabody Energy–the company is the only US miner with a significant Australian presence. Although US coal inventories have begun to fall from glutted levels, Asian coal markets offer superior growth prospects; I regard any expansion Peabody makes in Australia as good news for the stock. Buy Peabody Energy under 52. 

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