Peabody Energy Should Run From Tavan Tolgoi Fiasco

by: Peter Epstein

Last Tuesday I posted about a Bloomberg article which explained that the Mongolian National Security Council has rejected a proposed mining plan that envisioned Peabody Energy, (NYSE:BTU) Shenhua and a Russian/Mongolian group combining forces to develop the Tavan Tolgoi west concession. This announcement sets back the project considerably. In previous posts, I speculated that this project would be very difficult, time consuming and costly to get off the ground and I questioned Peabody's involvement. Why is Peabody even bothering to pursue this, I asked.

As a recently retained consultant for SouthGobi Resources, (OTC:SGQRF) I increasingly am of the opinion that the Company will be taken out. That's why I wrote an article for SA a few days ago suggesting that Teck Resources acquire SouthGobi. A bold move by Teck may or may not be in the cards, and I have not spoken with anyone at Teck about my idea. Peabody however, has a history of making bold moves.

Now, with the Tavan Tolgoi (west) project further delayed and even more uncertainty on multiple fronts, I again question Peabody's involvement. Peabody is a great company, their knowledge of the global coal markets is unparalleled. They have wisely determined that Mongolia is a key country to do business in. In partnership with ArcelorMittal (NYSE:MT), they are buying Australia's Macarthur Coal, a top producer of premium PCI coal. Peabody gets it, they realize that the global landscape requires diversification of coal operations. That is why they are in the U.S., China, Australia, Mongolia and Indonesia. Diversification Hedges their business and gives them options, which is especially important as Peabody has an active coal trading division.

Peabody should take this opportunity to run, not walk, from Tavan Tolgoi and acquire an established Mongolian player instead. SouthGobi Resources (OTC:SGQRF) is 1 of 2 significant coal producers in the country, the other is a company named Mongolian Mining. SouthGobi is already in production at a run-rate of almost 6mm tonnes per year. If Peabody sticks with the Tavan Tolgoi horror show, they can expect to control 6mm tonnes of coal by roughly 2020. Alternatively, Peabody can acquire a company that will be exporting 10mm tonnes of coking coal within 3 years and 12-13mm tonnes within 5 years. 12mm tonnes is more than half of what Peabody currently produces in Australia. Combined, Peabody and SouthGobi would be a top 5 producer globally,perhaps even a top 3 if one includes the attributable PCI tonnes from the Macarthur acquisition.

Best of all, an acquisition of SouthGobi would be easy to finance. SouthGobi could be acquired for less than half of the $5b that ArcellorMittal and Peabody are paying for Macarthur. Yet, SouthGobi will be producing twice the annual volumes of coking coal by 2014-15 then Peabody's share of Macarthur. Peabody should take a very close look at this, perhaps they already are. Interested parties are already kicking the tires.

Potential acquirers of SouthGobi doing due diligence will likely find that the company is a low-cost producer on a global scale with cash costs in the low $20's per tonne. The company's all-in delivered cost to end-users in China is hard to beat because they are just 45km from the Chinese border. Infrastructure is already in place, and in about 1 year SouthGobi will be a JV partner in a 4 lane paved toll road to China that will have capacity of more than 20mm tonnes. Unlike many gloabl coal producers, SouthGobi effectively has no logistical constraints on production growth whatsoever. Comparing a, "build vs. buy" strategy for entering Mongolia is heavy weighted towards BUY.

I mentioned that Peabody would be acquiring 10mm tonnes of coking coal production within 3 years. What about SouthGobi's earnings? In 2011, EBITDA will be less than $100mm as the company is still ramping up. However, by 2014, I estimate that SoutGobi could be generating a run-rate of $500mm EBITDA. Thus, Peabody would be acquiring SouthGobi for roughly a 3x multiple of 2014 run-rate EBITDA. This compares favorably to the 8.5x multiple of 2014 EBITDA that Peabody and Mittal are aying for Macarthur Coal and the 8x multiple that Rio Tinto paid for Mozambique coking coal producer Riversdale Mining. Global mining and steel companies are desperate to get a foothold in Mongolia. SouthGobi is up for sale and I believe it will be acquired within 6-12 months, the only questin is who the acquirer will be.

Peabody is doing a great job building their coking coal business in the countries mentioned above. Two countries that they are not yet exposed to in any meaningful way are Mozambique and Mongolia. Acquiring SouthGobi is a very cheap option on Mongolia and on coking coal that is completely consistent with Peabody's strategy. I imagine that Peabody is well aware of what SouthGobi is up to and the decision to pursue Tavan Tolgoi was made in lieu of a run at SouthGobi. However, the SouthGobi story keeps getting better, while Tavan Tolgoi keeps getting pushed back. Bailing on the fiasco of Tavan Tolgoi to revisit the acquisition of a major producer located just 45km from the Chinese border seems like a no-brainer. What am I missing here?

Disclosure: I am long BTU, OTC:SGQRF, TCK.

Additional disclosure: I am a consultant for SouthGobi and I am long SouthGobi stock.