Considerations in Valuing Massey's Produced Coal Unit

Massey Energy ( MEE ) is the 4th largest coal company in the United States and the largest in Central Appalachia based on produced coal revenue. Earlier this year, Alpha Natural Resources announced that it had struck an agreement with Massey for a $7.1 billion takeover which we discussed in a recent note titled Looking at Massey's Value Following Alpha Takeover Announcement . Massey and Alpha compete with companies like Peabody Energy ( BTU ), Arch Coal ( ACI ) and CONSOL ( CNX ) Energy.

We estimate that the produced coal division constitutes around 84% of our $55.08 price estimate for Massey's stock . Our price estimate is around 15% shy of the current market price and implies a market cap of $5.6 billion. The announced takeover is around a 26% premium to our estimated value for Massey, and the current market price is just about 10% below the proposed takeover price implying that the market is pricing in a small chance that this deal does not go through at the proposed price.

Here we take a look at the produced coal division which is the largest driver of value for the company.

The produced coal division is further divided into Utility Coal, Metallurgical Coal and Industrial Coal, each of which constitute around 45%, 30% and 9% of our price estimate, respectively.

Why is this division important?

The produced coal revenue per ton sold to metallurgical customers was nearly twice that of industrial customers and nearly 1.3 times that for utility customers over the last few years. However, the total coal sold to utility customers was around 3.6 times that for metallurgical customers and nearly 10 times that for industrial customers, making utility coal the most valuable division for Massey Energy.

What is the total coal sold to utility customers?

This refers to the amount of coal sold to utility customers and is measured in tons. Utility coal, often referred to as steam coal, refers to the coal used by power plants and industrial steam boilers to produce electricity or process steam. It generally is lower in BTU heat content and higher in volatile matter than metallurgical coal. Primarily electric power utility companies buy it.

How has it trended historically and how we expect it to change in the future?

The total amount of coal sold to utility customers has been relatively stable between 2005 and 2009, averaging around 28 million tons as Massey maintained its production levels to support strong global demand. The total amount of coal sold to utility customers was not impacted during the economic downturn as utility coal is used in power plants for generating electricity, the demand for which is largely inelastic.

Going forward, we expect the total coal sold to utility customers to increase slightly to 30 million tons, as the company expands its production capacity to support further growth in global demand.

What are the driving factors behind our forecast?

1) Rising oil prices can increase demand for coal

o As prices of crude oil are expected to increase in future, there will likely be an increase in demand for coal, as coal can act as a substitute for crude oil in many instances.

2) Massey has large proven reserves of coal

o As Massey controls around 1/3rd of the coal reserves in the Central Appalachia region, it can benefit from the increasing scarcity of coal, which is a non-renewable resource.

o Massey's competitors could face higher costs when exploiting higher cost reserves in other regions.

3) Economic recovery can stimulate demand for coal

o Economic growth is a key driver for electricity demand, which in turn is a key driver for coal demand.

o Though there was a fall in electricity demand during the recent economic downturn, as the economy rebounds, demand for electricity is expected to increase, which would in turn increase demand for coal.

o As demand increases, Massey, which is one of the top 4 coal producers in the US currently is expected to increase capacity to meet the growing demand.

Are there any downsides to our forecasts?

1) Threat of coal substitutes

o Environmental factors and high coal acquisition costs have led to a considerable amount of research being done to find feasible substitutes for coal, which has the potential of reducing demand for coal in the long term

2) The Upper Big Branch disaster can subject Massey to government regulations

o Massey's Upper Big Branch coalmine exploded in April 2010, killing 29 workers. Though Massey attributed this to be a natural event, federal mine safety officials are claiming safety violations as the cause. Events like these can impact Massey's production capabilities

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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