UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2003 ------------------------------------------------ Commission File Number 1-16463 ------------------------------------------------ PEABODY ENERGY CORPORATION - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) DELAWARE 13-4004153 - --------------------------------------- ------------------------------ (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 701 MARKET STREET, ST. LOUIS, MISSOURI 63101-1826 - -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (314) 342-3400 - -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. X Yes No --- --- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). X Yes No --- --- Number of shares outstanding of each of the Registrant's classes of Common Stock, as of October 20, 2003: Common Stock, par value $0.01 per share, 54,239,150 shares outstanding. INDEX PART I. FINANCIAL INFORMATION Item 1. Financial Statements Page ---- Unaudited Condensed Consolidated Statements of Operations for the Quarters and Nine Months Ended September 30, 2003 and 2002..................................... 2 Condensed Consolidated Balance Sheets as of September 30, 2003 (unaudited) and December 31, 2002................................................................. 3 Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2003 and 2002................................................. 4 Notes to Unaudited Condensed Consolidated Financial Statements.................... 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........................................................................ 24 Item 3. Quantitative and Qualitative Disclosures About Market Risk........................ 32 Item 4. Controls and Procedures........................................................... 33 PART II. OTHER INFORMATION Item 1. Legal Proceedings................................................................. 33 Item 6. Exhibits and Reports on Form 8-K.................................................. 34 PART I -- FINANCIAL INFORMATION Item 1. Financial Statements. PEABODY ENERGY CORPORATION UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except share and per share information) Quarter Ended Nine Months Ended September 30, September 30, 2003 2002 2003 2002 ------------ ------------ ------------ ------------ REVENUES Sales $ 682,034 $ 688,967 $ 2,010,825 $ 1,967,541 Other revenues 19,921 25,644 65,669 79,776 ------------ ------------ ------------ ------------ Total revenues 701,955 714,611 2,076,494 2,047,317 COSTS AND EXPENSES Operating costs and expenses 578,997 579,449 1,725,620 1,640,670 Depreciation, depletion and amortization 61,224 59,099 176,789 176,415 Asset retirement obligation expense 7,542 -- 20,633 -- Selling and administrative expenses 22,590 25,132 76,416 72,193 Net gain on property and equipment disposals (3,987) (389) (23,376) (3,475) ------------ ------------ ------------ ------------ OPERATING PROFIT 35,589 51,320 100,412 161,514 Interest expense 22,347 25,813 77,391 76,754 Early debt extinguishment costs -- -- 53,513 -- Interest income (371) (5,535) (2,549) (6,603) ------------ ------------ ------------ ------------ INCOME (LOSS) BEFORE INCOME TAXES AND MINORITY INTERESTS 13,613 31,042 (27,943) 91,363 Income tax provision (benefit) (8,598) (1,465) (49,621) 4,568 Minority interests 693 3,471 2,401 10,948 ------------ ------------ ------------ ------------ INCOME BEFORE ACCOUNTING CHANGES 21,518 29,036 19,277 75,847 Cumulative effect of accounting changes, net of taxes -- -- (10,144) -- ------------ ------------ ------------ ------------ NET INCOME $ 21,518 $ 29,036 $ 9,133 $ 75,847 ============ ============ ============ ============ BASIC EARNINGS PER COMMON SHARE: Income before accounting changes $ 0.40 $ 0.56 $ 0.36 $ 1.46 Cumulative effect of accounting changes, net of taxes -- -- (0.19) -- ------------ ------------ ------------ ------------ Net income $ 0.40 $ 0.56 $ 0.17 $ 1.46 ============ ============ ============ ============ WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 54,002,659 52,176,646 53,062,052 52,106,359 ============ ============ ============ ============ DILUTED EARNINGS PER COMMON SHARE: Income before accounting changes $ 0.39 $ 0.54 $ 0.35 $ 1.41 Cumulative effect of accounting changes, net of taxes -- -- (0.18) -- ------------ ------------ ------------ ------------ Net income $ 0.39 $ 0.54 $ 0.17 $ 1.41 ============ ============ ============ ============ WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 55,225,879 53,649,383 54,540,603 53,777,145 ============ ============ ============ ============ DIVIDENDS DECLARED PER SHARE $ 0.125 $ 0.10 $ 0.325 $ 0.30 ============ ============ ============ ============ See accompanying notes to unaudited condensed consolidated financial statements. 2 PEABODY ENERGY CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share information) (Unaudited) September 30, 2003 December 31, 2002 ------------------ ----------------- ASSETS Current assets Cash and cash equivalents $ 105,829 $ 71,210 Accounts receivable, less allowance for doubtful accounts of $1,361 at September 30, 2003 and $1,331 at December 31, 2002 154,082 153,212 Materials and supplies 43,029 39,416 Coal inventory 202,795 190,272 Assets from coal trading activities 43,664 69,898 Deferred income taxes 10,750 10,361 Other current assets 23,019 15,554 ----------- ----------- Total current assets 583,168 549,923 Property, plant, equipment and mine development, net of accumulated depreciation, depletion and amortization of $998,307 at September 30, 2003 and $858,187 at December 31, 2002 4,290,103 4,273,042 Investments and other assets 332,768 317,212 ----------- ----------- Total assets $ 5,206,039 $ 5,140,177 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Short-term borrowings and current maturities of long-term debt $ 20,031 $ 47,515 Liabilities from coal trading activities 24,084 37,008 Accounts payable and accrued expenses 551,889 547,013 ----------- ----------- Total current liabilities 596,004 631,536 Long-term debt, less current maturities 1,180,666 981,696 Deferred income taxes 438,056 499,310 Asset retirement obligations 382,757 386,777 Workers' compensation obligations 213,499 209,798 Accrued postretirement benefit costs 958,271 959,599 Obligation to industry fund 46,278 49,760 Other noncurrent liabilities 294,621 303,442 ----------- ----------- Total liabilities 4,110,152 4,021,918 Minority interests 1,398 37,121 Stockholders' equity Preferred Stock - $0.01 per share par value; 10,000,000 shares authorized, no shares issued or outstanding as of September 30, 2003 or December 31, 2002 -- -- Series Common Stock - $0.01 per share par value; 40,000,000 shares authorized, no shares issued or outstanding as of September 30, 2003 or December 31, 2002 -- -- Common Stock - $0.01 per share par value; 150,000,000 shares authorized, 54,360,140 shares issued and 54,235,611 shares outstanding as of September 30, 2003 and 150,000,000 shares authorized, 52,417,483 shares issued and 52,400,278 shares outstanding as of December 31, 2002 543 524 Additional paid-in capital 988,729 958,567 Retained earnings 192,730 200,859 Employee stock loans (30) (1,142) Accumulated other comprehensive loss (83,830) (77,627) Treasury shares, at cost: 124,529 shares and 17,205 shares as of September 30, 2003 and December 31, 2002, respectively (3,653) (43) ----------- ----------- Total stockholders' equity 1,094,489 1,081,138 ----------- ----------- Total liabilities and stockholders' equity $ 5,206,039 $ 5,140,177 =========== =========== See accompanying notes to unaudited condensed consolidated financial statements. 3 PEABODY ENERGY CORPORATION UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Nine Months Ended September 30, ------------------------------ 2003 2002 ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 9,133 $ 75,847 Cumulative effect of accounting changes, net of taxes 10,144 -- ----------- ----------- Income before accounting changes 19,277 75,847 Adjustments to reconcile income before accounting changes to net cash provided by operating activities: Depreciation, depletion and amortization 176,789 176,415 Deferred income taxes (50,428) 2,741 Early debt extinguishment costs 53,513 -- Amortization of debt discount and debt issuance costs 5,935 7,400 Net gain on property and equipment disposals (23,376) (3,475) Minority interests 2,401 10,948 Changes in current assets and liabilities: Accounts receivable (4,470) 13,121 Materials and supplies (3,613) (327) Coal inventory (12,523) (14,101) Net assets from coal trading activities (20,334) (16,339) Other current assets (6,561) (3,956) Accounts payable and accrued expenses 7,713 (24,309) Asset retirement obligations (10,192) (4,075) Workers' compensation obligations 3,701 (331) Accrued postretirement benefit costs 165 (137) Obligation to industry fund (3,482) (5,866) Other, net (18,737) (4,962) ----------- ----------- Net cash provided by operating activities 115,778 208,594 ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES Additions to property, plant, equipment and mine development (118,817) (161,332) Additions to advance mining royalties (7,706) (8,052) Acquisitions, net (90,000) (45,537) Investments in joint ventures (1,400) (475) Proceeds from property and equipment disposals 34,722 16,521 ----------- ----------- Net cash used in investing activities (183,201) (198,875) ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES Net change in revolving lines of credit (121,584) 6,492 Proceeds from long-term debt 1,102,735 -- Payments of long-term debt (866,134) (17,976) Increase of securitized interests in accounts receivable 3,600 -- Payment of debt issuance costs (23,632) -- Distributions to minority interests (4,063) (7,868) Dividends paid (17,262) (15,632) Proceeds from stock options exercised 24,599 1,239 Other 2,849 1,262 ----------- ----------- Net cash provided by (used in) financing activities 101,108 (32,483) ----------- ----------- Effect of exchange rate changes on cash and cash equivalents 934 22 Net increase (decrease) in cash and cash equivalents 34,619 (22,742) Cash and cash equivalents at beginning of year 71,210 38,622 ----------- ----------- Cash and cash equivalents at end of period $ 105,829 $ 15,880 =========== =========== See accompanying notes to unaudited condensed consolidated financial statements. 4 PEABODY ENERGY CORPORATION NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2003 (1) BASIS OF PRESENTATION The condensed consolidated financial statements include the accounts of Peabody Energy Corporation (the "Company") and its controlled affiliates. All significant intercompany transactions, profits and balances have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform with the current year presentation. The accompanying condensed consolidated financial statements as of September 30, 2003 and for the quarters and nine months ended September 30, 2003 and 2002, and the notes thereto, are unaudited. However, in the opinion of management, these financial statements reflect all normal, recurring adjustments necessary for a fair presentation of the results of the periods presented. The balance sheet information as of December 31, 2002 has been derived from the Company's audited consolidated balance sheet. The results of operations for the quarter and nine months ended September 30, 2003 are not necessarily indicative of the results to be expected for future quarters or for the year ending December 31, 2003. (2) LONG-TERM DEBT During March 2003, the Company entered into a series of transactions, discussed in detail below, to refinance a substantial portion of its outstanding indebtedness. The refinancing expanded the Company's revolving line of credit capacity and lowered its overall borrowing costs. The Company's total indebtedness (in thousands) consisted of the following at: September 30, 2003 December 31, 2002 ------------------ ----------------- Term Loan under Senior Secured Credit Facility $ 447,750 $ -- 6.875% Senior Notes due 2013 650,000 -- Fair value of interest rate swaps - 6.875% Senior Notes 7,285 -- 9.625% Senior Subordinated Notes redeemed in 2003 -- 391,490 8.875% Senior Notes redeemed in 2003 -- 316,498 5.0% Subordinated Note 78,273 85,055 Senior unsecured notes under various agreements -- 58,214 Unsecured revolving credit agreement -- 116,584 Other 17,389 61,370 ------------------ ----------------- $ 1,200,697 $ 1,029,211 ================== ================= The following table shows the sources and uses (in thousands) of cash related to the refinancing transactions: Sources: Revolving Credit Facility $ -- Term Loan under Senior Secured Credit Facility 450,000 6.875% Senior Notes due 2013 650,000 ---------- Total $1,100,000 ========== Uses: Repayment of 9.625% Senior Subordinated Notes $ 392,219 Repayment of 8.875% Senior Notes 317,098 Repayment of Black Beauty indebtedness 203,215 Fees and prepayment premiums paid in connection with refinancing 63,667 Acquisition of 18.3% interest in Black Beauty Coal Company 90,000 Cash 33,801 ---------- $1,100,000 ========== 5 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued Use of Proceeds The Company used the $1.1 billion of proceeds from the $450.0 million term loan under its Senior Secured Credit Facility and the $650.0 million in 6.875% Senior Notes primarily to repay and retire indebtedness. During March 2003, the Company completed a tender offer to retire $134.0 million of its 9.625% Senior Subordinated Notes and $109.1 million of its 8.875% Senior Notes. On May 15, 2003, the remaining $258.2 million of 9.625% Senior Subordinated Notes and $208.0 million of 8.875% Senior Notes were redeemed. Early prepayment premiums of $12.0 million were paid related to the tender offer and early prepayment premiums of $21.7 million were paid in connection with the May 15, 2003 redemption. Also during March 2003, $203.2 million of Black Beauty indebtedness was repaid, along with $6.3 million of related early prepayment premiums. In addition to the retirement of the debt described above, the Company paid $23.6 million in fees associated with issuing the new debt instruments. On April 7, 2003, the Company used $90.0 million to acquire the remaining 18.3% of Black Beauty (see Note 4 below). The remaining cash of $33.8 million was primarily used to pay accrued interest on the debt instruments that were repaid. The Company's new debt instruments are described in greater detail below. Senior Secured Credit Facility On March 21, 2003, the Company entered into a new Senior Secured Credit Facility that consists of a $600.0 million revolving credit facility and a $450.0 million term loan. The new revolving credit facility, which currently bears interest at LIBOR plus 2.0% and expires in March 2008, provides for maximum borrowings and/or letters of credit of $600.0 million. The Company had letters of credit outstanding under the facility of $241.0 million at September 30, 2003, leaving $359.0 million available for borrowing. The new $450.0 million term loan currently bears interest at LIBOR plus 2.5%. The applicable rate was 3.64% as of September 30, 2003. Principal of $4.5 million per year, which is paid in quarterly installments, is due through March 31, 2009. The remaining principal of $423.0 million is due in quarterly installments of $105.8 million to be paid from June 30, 2009 through March 31, 2010. The facility is secured by the capital stock and certain assets of the Company's "restricted subsidiaries" (as defined in the facility). These restricted subsidiaries are also guarantors of the facility. Under the facility, the Company must comply with certain financial covenants on a quarterly basis. These covenants include a minimum EBITDA (as defined in the facility) interest coverage ratio, a maximum "total obligations" (as defined in the facility) to EBITDA ratio and a maximum senior secured debt to EBITDA ratio. The Company was in compliance with these covenants as of September 30, 2003. 6.875% Senior Notes due March 2013 On March 21, 2003, the Company issued $650.0 million in senior notes, which bear interest at 6.875% and are due in March 2013. The notes were initially sold in accordance with Securities and Exchange Commission Rule 144A, and the Company filed a registration statement in June 2003 with the Securities and Exchange Commission that enabled the holders of the notes to exchange them for publicly registered notes with substantially the same terms. The notes, which are unsecured, are guaranteed by the Company's "restricted subsidiaries" as defined in the note indenture. The note indenture contains covenants which, among other things, limit the Company's ability to incur additional indebtedness and issue preferred stock, pay dividends or make other distributions, make other restricted payments and investments, create liens, sell assets and merge or consolidate with other entities. The notes are redeemable prior to March 15, 2008 at a redemption price equal to 100% of the principal amount plus a make-whole premium (as defined in the indenture) and on or after March 15, 2008 at fixed redemption prices as set forth in the indenture. Early Debt Extinguishment Costs In connection with the refinancing, the Company incurred early debt extinguishment costs during the nine months ended September 30, 2003 of $53.5 million, comprised of the following: - the excess of prepayment premiums over the carrying value of the debt retired of $41.8 million; - non-cash charges to write-off debt issuance costs associated with the debt extinguished of $17.5 million; and - a $5.8 million gain related to the termination and monetization of interest rate swaps associated with the debt extinguished. As a result of the adoption on January 1, 2003 of Statement of Financial Accounting Standards ("SFAS") No. 145 "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections," gains or losses on debt extinguishment are presented as a component of results from continuing operations unless the 6 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued extinguishment meets the criteria for classification as an extraordinary item in Accounting Principles Board Opinion No. 30. The effect of the adoption and application of this new standard was to decrease income before income taxes and minority interests for the nine months ended September 30, 2003 by $53.5 million. Prior year results of operations included no early debt extinguishment costs. Interest Rate Swaps In May 2003, the Company entered into and designated four interest rate swaps with notional amounts totaling $100.0 million as a fair value hedge of our 6.875% Senior Notes. Under the swaps, the Company pays a floating rate that resets each March 15 and September 15, based upon the six-month LIBOR rate, for a period of ten years ending March 15, 2013 and receives a fixed rate of 6.875%. The applicable floating rate was 4.25% as of September 30, 2003. In September 2003, the Company entered into two $400.0 million interest rate swaps. One $400.0 million notional amount floating-to-fixed interest rate swap, expiring March 15, 2010, was designated as a hedge of changes in expected cash flows on the term loan under the Senior Secured Credit Facility. Under this swap, the Company pays a fixed rate of 6.764% and receives a floating rate of LIBOR plus 2.5% (3.64% at September 30, 2003) that resets each March 15, June 15, September 15 and December 15 based upon the three-month LIBOR rate. Another $400.0 million notional amount fixed-to-floating interest rate swap, expiring March 15, 2013, was designated as a hedge of the changes in the fair value of the 6.875% Senior Notes due 2013. Under this swap, the Company pays a floating rate of LIBOR plus 1.97% (3.11% at September 30, 2003) that resets each March 15, June 15, September 15 and December 15 based upon the three-month LIBOR rate and receives a fixed rate of 6.875%. The swaps will lower the Company's overall borrowing costs on $400.0 million of debt principal by 0.64% over the term of the floating-to-fixed swap. Because the critical terms of the swaps and the respective debt instruments they hedge coincide, there was no hedge ineffectiveness recognized in the statement of operations during the nine months ended September 30, 2003. As of September 30, 2003, the balance sheet reflects a net unrealized gain on the fair value hedges discussed above of $7.3 million, which is reflected as an adjustment to the carrying value of the Senior Notes (see table above). Related to the cash flow hedge, the balance sheet at September 30, 2003 reflects a net unrealized loss of $14.5 million, which is recognized net of a $5.8 million tax benefit, in other comprehensive income (see Note 8). (3) CUMULATIVE EFFECT OF ACCOUNTING CHANGES On January 1, 2003, the Company adopted SFAS No. 143, "Accounting for Asset Retirement Obligations," which addresses accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. For the Company, asset retirement obligation expense represents the systematic accretion and depreciation of future mine reclamation costs, which includes the costs to reclaim the land disturbed during the mining process and the removal of mine facilities, equipment, transportation and other support facilities. SFAS No. 143 requires the fair value of a liability for an asset's retirement obligation to be recorded in the period in which it is incurred if a reasonable estimate of fair value can be made, and that the corresponding cost is capitalized as part of the carrying amount of the related long-lived asset. The liability is accreted to its then present value each period, and the capitalized cost is depreciated over the useful life of the related asset. If the liability is settled for an amount other than the recorded amount, a gain or loss is recognized. Under its previous accounting method, the Company accrued the estimated future costs to reclaim the land as the acreage was disturbed at surface mine operations and the estimated costs to reclaim support acreage and to perform other related functions at both surface and underground mines ratably over the lives of the mines. Pursuant to the January 1, 2003 adoption of SFAS No. 143, the Company: - recognized a credit to income during the first quarter of 2003 of $9.1 million, net of tax, for the cumulative effect of the accounting change; - increased total liabilities by $0.5 million to record the asset retirement obligations; - increased property, plant and equipment by $12.1 million to add the asset retirement costs to the carrying amount of our mine properties and investments and other assets by $6.5 million to reflect the incremental amount of reclamation obligations recoverable from third parties; and 7 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued - increased accumulated depreciation, depletion and amortization by $2.9 million for the amount of expense previously recognized. Adopting SFAS No. 143 had no impact on the Company's reported cash flows. The Company's reclamation liabilities are unfunded. On October 25, 2002, the Emerging Issues Task Force (EITF) rescinded EITF Issue No. 98-10 "Accounting for Contracts Involved in Energy Trading and Risk Management Activities." As a result of the rescission, trading contracts entered into prior to October 25, 2002 that did not meet the definition of a derivative under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" (as amended) were no longer accounted for on a fair value basis, effective January 1, 2003. In the first quarter of 2003, the Company recorded a cumulative effect charge in the statement of operations of $20.2 million, net of income taxes, to reverse the unrealized gains and losses on non-derivative energy trading contracts recorded prior to December 31, 2002. Effective January 1, 2003, the Company changed its method of amortizing actuarial gains and losses related to net periodic postretirement benefit costs. The Company previously amortized actuarial gains and losses using a 5% corridor with an amortization period of three years. Under the new method, the corridor has been eliminated and all actuarial gains and losses are now amortized over the average remaining service period of active plan participants, which is currently estimated at 9.5 years. The Company considers this method preferable in that the elimination of the corridor allows a closer approximation of the fair value of the liability for postretirement benefit costs, and the amortization of actuarial gains and losses over the average remaining service period provides a better matching of the cost of the associated liability over the working life of the active plan participants. As a result of this change, the Company recognized a $0.9 million cumulative effect gain in the first quarter of 2003. The effect of the changes for the quarter and nine months ended September 30, 2003 was to increase income before accounting changes by $5.2 million, or $0.09 per diluted share, net of income taxes and $17.4 million, or $0.32 per diluted share, net of income taxes, respectively. The cumulative effect charge of $10.1 million (net of income tax benefit of $6.8 million) to apply retroactively the new methods described above was included in results of operations for the nine months ended September 30, 2003. Below are pro forma net income and earnings per share results for the Company assuming the new methods had been retroactively applied (dollars in thousands, except per share data): Quarter Ended Nine Months Ended September 30, September 30, -------------------------- -------------------------- 2003 2002 2003 2002 ---------- ----------- ---------- ---------- Net income: As reported $ 21,518 $ 29,036 $ 9,133 $ 75,847 Pro forma 21,518 26,490 19,277 61,190 Basic earnings per share: As reported $ 0.40 $ 0.56 $ 0.17 $ 1.46 Pro forma 0.40 0.51 0.36 1.17 Diluted earnings per share: As reported $ 0.39 $ 0.54 $ 0.17 $ 1.41 Pro forma 0.39 0.49 0.35 1.14 (4) BUSINESS COMBINATIONS On April 7, 2003, the Company purchased the remaining 18.3% of Black Beauty Coal Company and affiliated entities not owned by it for $90.0 million and contingent consideration. The additional consideration is contingent on Black Beauty's achievement of certain levels of operating profit in 2003 and 2004, as set forth in the purchase and sale agreement. As a result of the acquisition, the Company now owns 100% of Black Beauty Coal Company. The acquisition was accounted for as a purchase. 8 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued (5) COAL INVENTORY Inventories consisted of the following (dollars in thousands) at: September 30, December 31, 2003 2002 -------- -------- Raw coal $ 17,891 $ 13,935 Work in process 149,676 143,963 Saleable coal 35,228 32,374 -------- -------- Total $202,795 $190,272 ======== ======== (6) ASSETS AND LIABILITIES FROM COAL TRADING ACTIVITIES On October 25, 2002, the EITF rescinded EITF Issue No. 98-10 "Accounting for Contracts Involved in Energy Trading and Risk Management Activities." As a result of the rescission, trading contracts entered into prior to October 25, 2002 that did not meet the definition of a derivative under SFAS No. 133 (as amended) were no longer accounted for on a fair value basis effective January 1, 2003. The Company recorded a cumulative effect charge of $20.2 million, net of income taxes, effective January 1, 2003 to reverse the net unrealized gains on non-derivative energy trading contracts recorded prior to December 31, 2002. Substantially all of these non-derivative energy trading contracts will settle in 2003 and 2004. The fair value of coal trading derivatives as of September 30, 2003 are set forth below (dollars in thousands): Fair Value ------------------------------- Assets Liabilities ----------- ----------- Forward contracts $ 43,631 $ 23,161 Option contracts 33 923 ----------- ----------- Total $ 43,664 $ 24,084 =========== =========== Ninety-nine percent of the contracts in the Company's trading portfolio as of September 30, 2003 were valued utilizing prices from over-the-counter market sources, adjusted for coal quality, and less than one percent of the Company's contracts were valued based on similar market transactions. As of September 30, 2003, the timing of the estimated future realization of the value of the Company's trading portfolio was as follows: Year of Percentage Expiration of Portfolio ---------- ------------ 2003 13% 2004 84% 2005 3% --- 100% === At September 30, 2003, 52% of the Company's credit exposure related to coal trading activities was with counterparties that are investment grade. Where practical, the Company takes steps to reduce its credit exposure to customers or counterparties whose credit has deteriorated and who may pose a higher risk, as determined by the Company's credit management function, of failure to perform under their contractual obligations. These steps include obtaining letters of credit or cash collateral, requiring prepayments for shipments or the creation of customer trust accounts held for the 9 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued Company's benefit to fund the payments required under existing contracts. To further reduce credit exposure in its trading business, the Company also seeks to enter into netting agreements with counterparties that permit the Company to offset receivables and payables with such counterparties. The Company's coal trading operations traded 5.3 million tons and 10.6 million tons for the quarters ended September 30, 2003 and 2002, respectively, and 28.7 million tons and 55.8 million tons for the nine months ended September 30, 2003 and 2002, respectively. (7) EARNINGS PER SHARE AND STOCKHOLDERS' EQUITY Weighted Average Shares Outstanding A reconciliation of weighted average shares outstanding follows: Quarter Ended September 30, Nine Months Ended September 30, --------------------------- ------------------------------- 2003 2002 2003 2002 ----------- ----------- ----------- ----------- Weighted average shares outstanding - basic 54,002,659 52,176,646 53,062,052 52,106,359 Dilutive impact of stock options 1,223,220 1,472,737 1,478,551 1,670,786 ----------- ----------- ----------- ----------- Weighted average shares outstanding - diluted 55,225,879 53,649,383 54,540,603 53,777,145 =========== =========== =========== =========== Stock Compensation These interim financial statements include the disclosure requirements of SFAS No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." The Company applies Accounting Principles Board ("APB") Opinion No. 25 and related interpretations in accounting for its equity incentive plans. The Company recorded $0.1 million of compensation expense for granted stock options during each of the quarters ended September 30, 2003 and 2002, and $0.2 million of compensation expense for granted stock options during the nine months ended September 30, 2003 and 2002. The following table reflects pro forma net income and basic and diluted earnings per share had compensation cost been determined for the Company's non-qualified and incentive stock options based on the fair value at the grant dates consistent with the methodology set forth under SFAS No. 123, "Accounting for Stock-Based Compensation"(in thousands, except per share data): Quarter Ended Nine Months Ended September 30, September 30, -------------------------- ------------------------- 2003 2002 2003 2002 ---------- --------- ---------- ---------- Net income: As reported $ 21,518 $ 29,036 $ 9,133 $ 75,847 Pro forma 19,866 27,814 4,369 72,195 Basic earnings per share: As reported $ 0.40 $ 0.56 $ 0.17 $ 1.46 Pro forma 0.37 0.53 0.08 1.39 Diluted earnings per share: As reported $ 0.39 $ 0.54 $ 0.17 $ 1.41 Pro forma 0.36 0.52 0.08 1.34 Treasury Stock During the nine months ended September 30, 2003, the Company received 107,324 shares of common stock as consideration for employees' exercise of stock options. The value of the common stock tendered by employees to exercise stock options was based upon the closing price on the dates of the respective transactions. The common stock tenders were in accordance with the provisions of the 1998 Stock Purchase and Option Plan, which was previously approved by the Company's Board of Directors. 10 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued (8) COMPREHENSIVE INCOME The following table sets forth the components of comprehensive income for the quarters and nine months ended September 30, 2003 and 2002 (in thousands): Quarter Ended Nine Months Ended September 30, September 30, ---------------------- ---------------------- 2003 2002 2003 2002 -------- -------- -------- -------- Net income $ 21,518 $ 29,036 $ 9,133 $ 75,847 Foreign currency translation adjustment (3,622) (2) 2,478 (2) Cash flow hedge: Comprehensive pre-tax loss from decrease in fair value of cash flow hedge (14,469) -- (14,469) -- Income tax benefit 5,788 -- 5,788 -- -------- -------- -------- -------- Comprehensive income $ 9,215 $ 29,034 $ 2,930 $ 75,845 ======== ======== ======== ======== (9) SEGMENT INFORMATION The Company reports its operations primarily through the following reportable operating segments: "U.S. Mining," "Trading and Brokerage," and "Australian Mining" The principal business of the U.S. Mining segment is mining, preparation and sale of its steam coal, sold primarily to electric utilities, and metallurgical coal, sold to steel and coke producers. The Trading and Brokerage segment's principal business is the marketing and trading of coal and contract restructuring activities. The Australian Mining segment consists of the operations of the Wilkie Creek Mine. This segment's principal business is the same as the U.S. Mining Segment. "Corporate and Other" consists primarily of corporate overhead not directly attributable to the U.S. Mining or Trading and Brokerage operating segments, and resource management activities. In some cases, the Company's brokerage operation acts as the sales agent for the U.S. Mining and Australian Mining operations. For purposes of the presentation below, intercompany sales between the mining operations and Trading and Brokerage Operations have been eliminated, and the third party sales are reflected in the mining operations' revenues. The U.S. Mining segment results below also include costs related to past mining activities and a portion of consolidated net gains on property disposals. Past mining activities and net gains on property disposals are discussed separately from U.S. Mining results in "Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations." 11 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued Operating segment results for the quarters and nine months ended September 30, 2003 and 2002 are as follows (in thousands): Quarter Ended Nine Months Ended September 30, September 30, ----------------------------- ----------------------------- 2003 2002 2003 2002 ----------- ----------- ----------- ----------- Revenues: U.S. Mining $ 622,311 $ 658,339 $ 1,793,970 $ 1,877,444 Trading and Brokerage 66,002 51,443 248,187 152,182 Australian Mining 7,746 1,435 20,594 1,435 Corporate and Other 5,896 3,394 13,743 16,256 ----------- ----------- ----------- ----------- Total $ 701,955 $ 714,611 $ 2,076,494 $ 2,047,317 =========== =========== =========== =========== Operating Profit: U.S. Mining $ 39,078 $ 69,950 $ 105,560 $ 193,116 Trading and Brokerage 9,138 4,920 40,081 33,159 Australian Mining 2,374 357 1,554 357 Corporate and Other (15,001) (23,907) (46,783) (65,118) ----------- ----------- ----------- ----------- Total $ 35,589 $ 51,320 $ 100,412 $ 161,514 =========== =========== =========== =========== A reconciliation of segment operating profit to consolidated income (loss) before income taxes follows (in thousands): Quarter Ended Nine Months Ended September 30, September 30, ----------------------------- ----------------------------- 2003 2002 2003 2002 ----------- ----------- ----------- ----------- Total segment operating profit $ 35,589 $ 51,320 $ 100,412 $ 161,514 Interest expense 22,347 25,813 77,391 76,754 Early debt extinguishment costs -- -- 53,513 -- Interest income (371) (5,535) (2,549) (6,603) Minority interests 693 3,471 2,401 10,948 ----------- ----------- ----------- ----------- Income (loss) before income taxes $ 12,920 $ 27,571 $ (30,344) $ 80,415 =========== =========== =========== =========== (10) COMMITMENTS AND CONTINGENCIES Environmental Environmental claims have been asserted against a subsidiary of the Company, Gold Fields Mining Corporation ("Gold Fields"), at 22 sites in the United States. Gold Fields is a dormant, non-coal producing entity that was previously managed and owned by Hanson PLC, a predecessor owner of the Company. In the February 1997 spin-off of its energy businesses, Hanson PLC combined Gold Fields with the Company. These sites are related to activities of Gold Fields or its former subsidiaries. Some of these claims are based on the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended, and on similar state statutes. The Company's policy is to accrue environmental cleanup-related costs of a noncapital nature when those costs are believed to be probable and can be reasonably estimated. The quantification of environmental exposures requires an assessment of many factors, including changing laws and regulations, advancements in environmental technologies, the 12 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued quality of information available related to specific sites, the assessment stage of each site investigation, preliminary findings and the length of time involved in remediation or settlement. For certain sites, the Company also assesses the financial capability of other potentially responsible parties and, where allegations are based on tentative findings, the reasonableness of the Company's apportionment. The Company has not anticipated any recoveries from insurance carriers or other potentially responsible third parties in the estimation of liabilities recorded on its consolidated balance sheets. The undiscounted liabilities for environmental cleanup-related costs recorded as part of "Other noncurrent liabilities" were $40.8 million and $42.1 million at September 30, 2003 and December 31, 2002, respectively. These amounts represent those costs that the Company believes are probable and reasonably estimable. Navajo Nation On June 18, 1999, the Navajo Nation served the Company's subsidiaries, Peabody Holding Company, Inc., Peabody Coal Company and Peabody Western Coal Company ("Peabody Western"), with a complaint that had been filed in the U.S. District Court for the District of Columbia. Other defendants in the litigation are one customer, one current employee and one former employee. The Navajo Nation has alleged 16 claims, including Civil Racketeer Influenced and Corrupt Organizations Act, or RICO, violations and fraud and tortious interference with contractual relationships. The complaint alleges that the defendants jointly participated in unlawful activity to obtain favorable coal lease amendments. Plaintiff also alleges that defendants interfered with the fiduciary relationship between the United States and the Navajo Nation. The plaintiff is seeking various remedies including actual damages of at least $600 million, which could be trebled under the RICO counts, punitive damages of at least $1 billion, a determination that Peabody Western's two coal leases for the Kayenta and Black Mesa mines have terminated due to Peabody Western's breach of these leases and a reformation of the two coal leases to adjust the royalty rate to 20%. On March 15, 2001, the court allowed the Hopi Tribe to intervene in this lawsuit. The Hopi Tribe has asserted seven claims including fraud and is seeking various remedies including unspecified actual damages, punitive damages and reformation of its coal lease. On March 4, 2003, the U.S. Supreme Court issued a ruling in a companion lawsuit involving the Navajo Nation and the United States. The Court rejected the Navajo Nation's allegation that the U.S. breached its trust responsibilities to the Tribe in approving the coal lease amendments and was liable for money damages. On May 2, 2003, the Company's subsidiaries filed a renewed motion to dismiss the Navajo Nation's lawsuit against them based on the Supreme Court's decision. While the outcome of litigation is subject to uncertainties, based on the Company's preliminary evaluation of the issues and their potential impact on the Company, the Company believes this matter will be resolved without a material adverse effect on the Company's financial condition, results of operations or cash flows. Mohave Generating Station Peabody Western has a long-term coal supply agreement with the owners of the Mohave Generating Station that expires on December 31, 2005. There is a dispute with the Hopi Tribe regarding the use of groundwater in the transportation of the coal by pipeline to the Mohave plant. Southern California Edison (the majority owner and operator of the plant) is involved in a California Public Utilities Commission proceeding related to recovery of future capital expenditures for new pollution abatement equipment for the station. Alternatively, Southern California Edison has asked for authorization to spend money for the shutdown of the Mohave plant. In a July 2003 filing with the California Public Utilities Commission, the operator affirmed that the Mohave plant is not forecast to return to service as a coal-fired resource until mid-2009 at the earliest. The Company is in active discussions to resolve the complex issues critical to the continuation of the operation of the Mohave Generating Station and the renewal of the coal supply agreement after December 31, 2005. There is no assurance that the issues critical to the continued operation of the Mohave plant will be resolved. If these issues are not resolved in a timely manner, the operation of the Mohave plant will cease or be suspended on December 31, 2005. The Mohave plant is the sole customer of the Black Mesa Mine, which sold 4.6 million tons of coal in 2002. If the Company is unable to renew the coal supply agreement with the Mohave Generating Station, our financial condition and results of operations could be adversely affected after 2005. Citizens Power In connection with the August 2000 sale of the Company's former subsidiary, Citizens Power LLC (Citizens Power), the Company has indemnified the buyer, Edison Mission Energy, from certain losses resulting from specified power contracts and guarantees. Other than those discussed below, there are no known issues with any of the specified power contracts and guarantees. 13 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued During the period that Citizens Power was owned by the Company, Citizens Power guaranteed the obligations of two affiliates to make payments to third parties for power delivered under fixed-priced power sales agreements with terms that extend through 2008. Edison Mission Energy has stated and the Company believes there will be sufficient cash flow to pay the power suppliers, assuming timely payment by the power purchasers. The power purchasers have made timely payments to the Citizens Power affiliates and Edison Mission Energy has not made a claim against the Company under the indemnity. Also during the ownership period, a Citizens Power subsidiary, now called Edison Mission Marketing & Trading ("EMMT"), entered into a power purchase agreement to sell power in connection with a restructured power supply agreement that runs through 2016. The Citizens Power subsidiary subsequently entered into a power purchase agreement with NRG Power Marketing Inc. (NRG Power Marketing) for the same term. NRG Power Marketing filed a Chapter 11 bankruptcy petition and on August 6, 2003, NRG Power Marketing obtained bankruptcy court approval to reject the power purchase agreement. The bankruptcy court also rejected EMMT's request to file a complaint with FERC seeking an order limiting NRG Power Marketing's ability to cease deliveries under the contract without FERC approval. EMMT has appealed that bankruptcy court's decision. The NRG Power Marketing power sales contract is one of the contracts covered by the indemnity provision, but the Company indemnity does not apply to losses caused by the negligent act or omission of EMMT, Edison Mission Energy or its affiliates. The Company authorized EMMT to purchase power through March 31, 2004 to cap the exposure of the Company during that time. NRG Power Marketing is no longer delivering power to EMMT and the power is being supplied by EMMT as discussed above. The Company is responsible for the incremental costs incurred by EMMT related to the authorized power purchases; however, the Company does not believe its exposure under the authorized power purchase agreement is material and has reserved its rights against EMMT and Edison Mission Energy. The power supply obtained by EMMT is sold to CL Power Sales 8 LLC ("CL8"), which sells power to Central Maine Power ("CMP"). On November 4, 2003, CL8 and CMP executed documents to restructure their power sales agreement for deliveries commencing in March 2005. CMP has sought Maine Public Utility Commission approval for the restructuring. The Company believes the power sales agreement will be restructured, which is expected to result in the termination in March 2005 of EMMT's power sales obligation. Other steps are being taken to resolve the issues surrounding EMMT's power sales obligation through March 2005. Due to the length and specific requirements of the contracts covered by the indemnity, the impact of the power purchase transactions and the uncertainty surrounding the NRG Power Marketing situation, the Company cannot reasonably estimate its exposure under the indemnity beyond March 31, 2004. Other Accounts receivable in the consolidated balance sheets as of September 30, 2003 and December 31, 2002 included $13.0 million and $8.6 million, respectively, of receivables billed during 2001 through 2003 that have been disputed by two customers who have withheld payment. The Company believes these billings were made properly under the respective coal supply agreements with each customer. The Company is in arbitration and litigation with these customers to resolve this issue, and believes the receivables to be fully collectible. In addition, the Company at times becomes a party to claims, lawsuits, arbitration proceedings and administrative procedures in the ordinary course of business. Management believes that the ultimate resolution of pending or threatened proceedings will not have a material effect on the financial position, results of operations or liquidity of the Company. At September 30, 2003, purchase commitments for capital expenditures were approximately $67.7 million. (11) SECONDARY OFFERINGS On May 7, 2003, certain shareholders of the Company, including the Company's largest shareholder, Lehman Brothers Merchant Banking Partners II L.P. and affiliates, sold 5,750,000 shares of common stock, including sales under an over-allotment option of 750,000 shares. The selling shareholders received all net proceeds. The Company did not sell any shares through the offering. Lehman Brothers Merchant Banking Partners II L.P. and affiliates sold, in the aggregate, 5,617,825 shares in the offering, and their beneficial ownership of the Company declined from 41% to 29%. On August 4, 2003, the Company's largest shareholder, Lehman Brothers Merchant Banking Partners II L.P. and affiliates, sold 5,400,000 shares of common stock. Lehman Brothers Merchant Banking Partners II L.P. and affiliates received all net proceeds. The Company did not sell any shares through the offering. Lehman Brothers Merchant Banking Partners II L.P. and affiliates' beneficial ownership of the Company declined from 29% to 19%. 14 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued (12) RELATED PARTY TRANSACTIONS Lehman Brothers Inc. is an affiliate of Lehman Brothers Merchant Banking Partners II L.P. As discussed in Note 2 above, the Company refinanced a substantial portion of its indebtedness by entering into a new Senior Secured Credit Facility and issuing new Senior Notes. Based upon a competitive bidding process conducted by members of management and reviewed by members of the Company's Board of Directors not affiliated with Lehman Brothers Inc., the Company appointed Wachovia Securities, Inc., Fleet Securities, Inc. and Lehman Brothers Inc. as lead arrangers for the Senior Secured Credit Facility, and Lehman Brothers Inc. and Morgan Stanley as joint book running managers for the Senior Notes. Lehman Brothers Inc. received total fees of $7.4 million for their services in connection with the refinancing; such fees were consistent with the fees paid to other parties to the transaction for their respective services. In May 2003 and July 2003, Lehman Brothers Inc. served as the lead underwriter in connection with the secondary offerings discussed in Note 12 below, and fees for their services were paid by the selling shareholders and not by the Company. The Company paid incidental expenses customarily incurred by a registering company in connection with the secondary offerings. As discussed in Note 2 above and in the "Liquidity and Capital Resources" section of Part I, Item 2 of this report, in May 2003 the Company entered into four $25.0 million fixed to floating interest rate swaps as a hedge of the changes in fair value of the 6.875% Senior Notes due 2013. Lehman Brothers Inc. was chosen as one of the swap counterparties as part of a competitive bidding process among eight financial institutions. (13) SUBSEQUENT EVENT The Company filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission on October 22, 2003. Under the registration statement, the Company may offer and sell from time to time unsecured debt securities consisting of notes, debentures, and other debt securities; common stock; preferred stock; warrants; and/or units totaling a maximum of $1.25 billion. Related proceeds would be used for general corporate purposes including repayment of other debt, capital expenditures, possible acquisitions and any other purposes that may be stated in any prospectus supplement. In addition, under the registration statement, Lehman Brothers Merchant Banking Partners II L.P. and affiliates may offer up to 10.3 million shares of the Company's common stock through transactions that may include underwritten offerings. If the Lehman Brothers Merchant Banking Partners II L.P. and affiliates offer and sell the maximum shares under this registration statement, this would complete their planned exit strategy to return the investment to its partners over time. 15 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued (14) SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION In accordance with the indentures governing the 6.875% Senior Notes, certain wholly-owned U.S. subsidiaries of the Company have fully and unconditionally guaranteed the 6.875% Senior Notes, on a joint and several basis. Separate financial statements and other disclosures concerning the Guarantor Subsidiaries are not presented because management believes that such information is not material to the holders of the 6.875% Senior Notes. The following unaudited condensed historical financial statement information is provided for the Guarantor/Non-Guarantor Subsidiaries. After the Company's acquisition on April 7, 2003 of the remaining 18.3% of Black Beauty, this subsidiary became a Guarantor subsidiary of the 6.875% Senior Notes. Prior year amounts have been reclassified to conform with the current year presentation. PEABODY ENERGY CORPORATION UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS QUARTER ENDED SEPTEMBER 30, 2003 (In thousands) Parent Guarantor Non-Guarantor Company Subsidiaries Subsidiaries Eliminations Consolidated ------------ ------------ ------------ ------------ ------------ Total revenues $ -- $ 680,974 $ 35,910 $ (14,929) $ 701,955 Costs and expenses Operating costs and expenses -- 563,582 30,344 (14,929) 578,997 Depreciation, depletion and amortization -- 60,354 870 -- 61,224 Asset retirement obligation expense -- 7,480 62 -- 7,542 Selling and administrative expenses 130 21,952 508 -- 22,590 Net gain on property and equipment disposals -- (3,864) (123) -- (3,987) Interest expense 32,797 30,605 521 (41,576) 22,347 Interest income (20,866) (17,346) (3,735) 41,576 (371) --------- --------- --------- --------- --------- Income (loss) before income taxes and minority interests (12,061) 18,211 7,463 -- 13,613 Income tax provision (benefit) (9,957) 2,400 (1,041) -- (8,598) Minority interests -- 693 -- -- 693 --------- --------- --------- --------- --------- Net income (loss) $ (2,104) $ 15,118 $ 8,504 $ -- $ 21,518 ========= ========= ========= ========= ========= 16 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued PEABODY ENERGY CORPORATION UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS QUARTER ENDED SEPTEMBER 30, 2002 (In thousands) Parent Guarantor Non-Guarantor Company Subsidiaries Subsidiaries Eliminations Consolidated ------------ ------------ ------------ ------------ ------------ Total revenues $ -- $ 691,713 $ 38,423 $ (15,525) $ 714,611 Costs and expenses Operating costs and expenses -- 562,710 32,264 (15,525) 579,449 Depreciation, depletion and amortization -- 58,375 724 -- 59,099 Selling and administrative expenses 71 24,046 1,015 -- 25,132 Net gain on property and equipment disposals -- (280) (109) -- (389) Interest expense 34,678 27,798 953 (37,616) 25,813 Interest income (17,139) (22,068) (3,944) 37,616 (5,535) --------- --------- --------- --------- --------- Income (loss) before income taxes and minority interests (17,610) 41,132 7,520 -- 31,042 Income tax provision (benefit) 947 (2,156) (256) -- (1,465) Minority interests -- 3,471 -- -- 3,471 --------- --------- --------- --------- --------- Net income (loss) $ (18,557) $ 39,817 $ 7,776 $ -- $ 29,036 ========= ========= ========= ========= ========= 17 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued PEABODY ENERGY CORPORATION UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS NINE MONTHS ENDED SEPTEMBER 30, 2003 (In thousands) Parent Guarantor Non-Guarantor Company Subsidiaries Subsidiaries Eliminations Consolidated ------------ ------------ ------------ ------------ ------------ Total revenues $ -- $ 1,998,070 $ 123,176 $ (44,752) $ 2,076,494 Costs and expenses Operating costs and expenses -- 1,660,050 110,322 (44,752) 1,725,620 Depreciation, depletion and amortization -- 174,091 2,698 -- 176,789 Asset retirement obligation expense -- 20,447 186 -- 20,633 Selling and administrative expenses 492 74,261 1,663 -- 76,416 Net gain on property and equipment disposals -- (23,264) (112) -- (23,376) Interest expense 107,253 88,775 1,981 (120,618) 77,391 Early debt extinguishment costs 46,164 7,349 -- -- 53,513 Interest income (60,081) (52,257) (10,829) 120,618 (2,549) ----------- ----------- ----------- ----------- ----------- Income (loss) before income taxes and minority interests (93,828) 48,618 17,267 -- (27,943) Income tax provision (benefit) (51,328) 721 986 -- (49,621) Minority interests -- 2,401 -- -- 2,401 Cumulative effect of accounting changes, net of taxes 6,762 (16,349) (557) -- (10,144) ----------- ----------- ----------- ----------- ----------- Net income (loss) $ (35,738) $ 29,147 $ 15,724 $ -- $ 9,133 =========== =========== =========== =========== =========== 18 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued PEABODY ENERGY CORPORATION UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS NINE MONTHS ENDED SEPTEMBER 30, 2002 (In thousands) Parent Guarantor Non-Guarantor Company Subsidiaries Subsidiaries Eliminations Consolidated ------------ ------------ ------------ ------------ ------------ Total revenues $ -- $ 1,988,100 $ 105,126 $ (45,909) $ 2,047,317 Costs and expenses Operating costs and expenses -- 1,597,563 89,016 (45,909) 1,640,670 Depreciation, depletion and amortization -- 174,267 2,148 -- 176,415 Selling and administrative expenses 340 69,789 2,064 -- 72,193 Net gain on property and equipment disposals -- (3,378) (97) -- (3,475) Interest expense 103,394 82,811 2,801 (112,252) 76,754 Interest income (51,437) (56,249) (11,169) 112,252 (6,603) --------- ----------- ----------- ---------- ---------- Income (loss) before income taxes and minority interests (52,297) 123,297 20,363 -- 91,363 Income tax provision (benefit) (2,522) 6,013 1,077 -- 4,568 Minority interests -- 10,948 -- -- 10,948 --------- ----------- ----------- ----------- ----------- Net income (loss) $ (49,775) $ 106,336 $ 19,286 $ -- $ 75,847 ========= =========== =========== =========== =========== 19 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued PEABODY ENERGY CORPORATION UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 2003 (In thousands) Parent Guarantor Non-Guarantor Company Subsidiaries Subsidiaries Eliminations Consolidated ------------ ------------ ------------ ------------ ------------ ASSETS Current assets Cash and cash equivalents $ 100,205 $ 1,313 $ 4,311 $ -- $ 105,829 Accounts receivable 52 126,005 28,025 -- 154,082 Inventories -- 242,488 3,336 -- 245,824 Assets from coal trading activities -- 43,664 -- -- 43,664 Deferred income taxes -- 10,101 649 -- 10,750 Other current assets 66 19,589 3,364 -- 23,019 ------------ ------------ ------------ ------------ ------------ Total current assets 100,323 443,160 39,685 -- 583,168 Property, plant, equipment and mine development, at cost -- 5,229,649 58,761 -- 5,288,410 Less accumulated depreciation, depletion and amortization -- (979,588) (18,719) -- (998,307) ------------ ------------ ------------ ------------ ------------ Property, plant, equipment and mine development, net -- 4,250,061 40,042 -- 4,290,103 Investments and other assets 3,540,298 218,432 2,567 (3,428,529) 332,768 ------------ ------------ ------------ ------------ ------------ Total assets $ 3,640,621 $ 4,911,653 $ 82,294 $(3,428,529) $ 5,206,039 ============ ============ ============ ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Short-term borrowings and current maturities of long-term debt $ 4,500 $ 13,568 $ 1,963 $ -- $ 20,031 Payables and notes payable to affiliates, net 1,359,749 (1,371,479) 11,730 -- -- Liabilities from coal trading activities -- 23,631 453 -- 24,084 Accounts payable and accrued expenses 4,064 537,989 9,836 -- 551,889 ------------ ------------ ------------ ------------ ------------ Total current liabilities 1,368,313 (796,291) 23,982 -- 596,004 Long-term debt, less current maturities 1,100,535 76,578 3,553 -- 1,180,666 Deferred income taxes -- 432,349 5,707 -- 438,056 Other noncurrent liabilities 7,923 1,882,693 4,810 -- 1,895,426 ------------ ------------ ------------ ------------ ------------ Total liabilities 2,476,771 1,595,329 38,052 -- 4,110,152 Minority interests -- 1,398 -- -- 1,398 Stockholders' equity 1,163,850 3,314,926 44,242 (3,428,529) 1,094,489 ------------ ------------ ------------ ------------ ------------ Total liabilities and stockholders' equity $ 3,640,621 $ 4,911,653 $ 82,294 $(3,428,529) $ 5,206,039 ============ ============ ============ ============ ============ 20 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued PEABODY ENERGY CORPORATION SUPPLEMENTAL CONDENSED CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2002 (In thousands) Parent Guarantor Non-Guarantor Company Subsidiaries Subsidiaries Eliminations Consolidated ------------ ------------ ------------ -------------- ------------ ASSETS Current assets Cash and cash equivalents $ 60,666 $ 5,365 $ 5,179 $ -- $ 71,210 Accounts receivable 836 102,917 49,459 -- 153,212 Inventories -- 227,075 2,613 -- 229,688 Assets from coal trading activities -- 69,898 -- -- 69,898 Deferred income taxes -- 10,101 260 -- 10,361 Other current assets 260 12,039 3,255 -- 15,554 ------------ ------------ ------------ -------------- ------------ Total current assets 61,762 427,395 60,766 -- 549,923 Property, plant, equipment and mine development, at cost -- 5,079,997 51,232 -- 5,131,229 Less accumulated depreciation, depletion and amortization -- (841,781) (16,406) -- (858,187) ------------ ------------ ------------ -------------- ------------ Property, plant, equipment and mine development, net -- 4,238,216 34,826 -- 4,273,042 Investments and other assets 3,448,319 279,216 17,835 (3,428,158) 317,212 ------------ ------------ ------------ -------------- ------------ Total assets $ 3,510,081 $ 4,944,827 $ 113,427 $(3,428,158) $ 5,140,177 ============ ============ ============ ============== ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Short-term borrowings and current maturities of long-term debt $ -- $ 44,441 $ 3,074 $ -- $ 47,515 Payables and notes payable to affiliates, net 1,626,695 (1,643,593) 16,898 -- -- Liabilities from coal trading activities -- 37,008 -- -- 37,008 Accounts payable and accrued expenses 9,427 521,917 15,669 -- 547,013 ------------ ------------ ------------ -------------- ------------ Total current liabilities 1,636,122 (1,040,227) 35,641 -- 631,536 Long-term debt, less current maturities 714,571 263,826 3,299 -- 981,696 Deferred income taxes -- 495,284 4,026 -- 499,310 Other noncurrent liabilities 623 1,906,050 2,703 -- 1,909,376 ------------ ------------ ------------ -------------- ------------ Total liabilities 2,351,316 1,624,933 45,669 -- 4,021,918 Minority interests -- 37,121 -- -- 37,121 Stockholders' equity 1,158,765 3,282,773 67,758 (3,428,158) 1,081,138 ------------ ------------ ------------ -------------- ------------ Total liabilities and stockholders' equity $ 3,510,081 $ 4,944,827 $ 113,427 $(3,428,158) $ 5,140,177 ============ ============ ============ ============== ============ 21 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued PEABODY ENERGY CORPORATION UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2003 (In thousands) Parent Guarantor Non-Guarantor Company Subsidiaries Subsidiaries Consolidated ------------ ------------ ------------ -------------- Net cash provided by (used in) operating activities $ (56,273) $ 150,841 $ 21,210 $ 115,778 ------------ ------------ ------------ -------------- Additions to property, plant, equipment and mine development -- (114,962) (3,855) (118,817) Additions to advance mining royalties -- (7,706) -- (7,706) Acquisition, net -- (90,000) -- (90,000) Investment in joint venture -- (1,400) -- (1,400) Proceeds from property and equipment disposals -- 34,063 659 34,722 ------------ ------------ ------------ -------------- Net cash used in investing activities -- (180,005) (3,196) (183,201) ------------ ------------ ------------ -------------- Net change in revolving lines of credit -- (121,584) -- (121,584) Proceeds from long-term debt 1,100,000 2,735 -- 1,102,735 Payments of long-term debt (745,259) (120,345) (530) (866,134) Increase of securitized interests in accounts receivable -- -- 3,600 3,600 Payment of debt issuance costs (23,632) -- -- (23,632) Distributions to minority interests -- (4,063) -- (4,063) Dividends paid (17,262) -- -- (17,262) Proceeds from stock options exercised 24,599 -- -- 24,599 Transactions with affiliates, net (245,483) 268,369 (22,886) -- Other 2,849 -- -- 2,849 ------------ ------------ ------------ -------------- Net cash provided by (used in) financing activities 95,812 25,112 (19,816) 101,108 ------------ ------------ ------------ -------------- Effect of exchange rate changes on cash and equivalents -- -- 934 934 Net increase (decrease) in cash and cash equivalents 39,539 (4,052) (868) 34,619 Cash and cash equivalents at beginning of period 60,666 5,365 5,179 71,210 ------------ ------------ ------------ -------------- Cash and cash equivalents at end of period $ 100,205 $ 1,313 $ 4,311 $ 105,829 ============ ============ ============ ============== 22 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued PEABODY ENERGY CORPORATION UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2002 (In thousands) Parent Guarantor Non-Guarantor Company Subsidiaries Subsidiaries Consolidated ------------ ------------ ------------ -------------- Net cash provided by (used in) operating activities $ (49,420) $ 231,177 $ 26,837 $ 208,594 ------------ ------------ ------------ -------------- Additions to property, plant, equipment and mine development -- (158,083) (3,249) (161,332) Additions to advance mining royalties -- (8,052) -- (8,052) Acquisitions, net -- (45,537) -- (45,537) Investment in joint venture -- (475) -- (475) Proceeds from property and equipment disposals -- 15,760 761 16,521 ------------ ------------ ------------ -------------- Net cash used in investing activities -- (196,387) (2,488) (198,875) ------------ ------------ ------------ -------------- Net change in revolving lines of credit 25,702 (19,210) -- 6,492 Payments of long-term debt -- (15,453) (2,523) (17,976) Distributions to minority interests -- (7,868) -- (7,868) Dividends paid (15,632) -- -- (15,632) Proceeds from stock options exercised 1,239 -- -- 1,239 Transactions with affiliates, net 12,115 4,904 (17,019) -- Other 1,262 -- -- 1,262 ------------ ------------ ------------ -------------- Net cash provided by (used in) financing activities 24,686 (37,627) (19,542) (32,483) ------------ ------------ ------------ -------------- Effect of exchange rate changes on cash and equivalents -- -- 22 22 Net increase (decrease) in cash and cash equivalents (24,734) (2,837) 4,829 (22,742) Cash and cash equivalents at beginning of period 28,121 6,501 4,000 38,622 ------------ ------------ ------------ -------------- Cash and cash equivalents at end of period $ 3,387 $ 3,664 $ 8,829 $ 15,880 ============ ============ ============ ============== 23 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS This quarterly report includes statements of our expectations, intentions, plans and beliefs that constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 and are intended to come within the safe harbor protection provided by those sections. These statements relate to future events or our future financial performance. We use words such as "anticipate," "believe," "expect," "may," "project," "will" or other similar words to identify forward-looking statements. Without limiting the foregoing, all statements relating to our future outlook, anticipated capital expenditures, future cash flows and borrowings, and sources of funding are forward-looking statements. These forward-looking statements are based on numerous assumptions that we believe are reasonable, but they are open to a wide range of uncertainties and business risks and actual results may differ materially from those discussed in these statements. Among the factors that could cause actual results to differ materially are: - growth in coal and power markets; - coal's market share of electricity generation; - the extent of the economic recovery and future economic conditions; - milder than normal weather; - railroad and other transportation performance and costs; - the ability to renew sales contracts upon expiration or renegotiation; - the ability to successfully implement operating strategies; - the effectiveness of our cost-cutting measures; - regulatory and court decisions; - future legislation; - changes in postretirement benefit and pension obligations; - credit, market and performance risk associated with our customers; - modification or termination of our long-term coal supply agreements; - reductions of purchases by major customers; - risks inherent to mining, including geologic conditions or unforeseen equipment problems; - terrorist attacks or threats affecting our or our customers' operations; - changes in interpretation of tax law, including changes in Internal Revenue Service interpretations related to synfuel activities; - replacement of reserves; 24 - implementation of new accounting standards; - inflationary trends and interest rate changes; - the effects of interest rate changes on discounting future liabilities; - the effects of acquisitions or divestitures; and - other factors, including those discussed in "Legal Proceedings." When considering these forward-looking statements, you should keep in mind the cautionary statements in this document, the "Risks Relating to Our Company" section of Item 7 of our 2002 Annual Report on Form 10-K filed with the Securities and Exchange Commission and all documents incorporated by reference in this quarterly report. We will not update these statements unless the securities laws require us to do so. QUARTER ENDED SEPTEMBER 30, 2003 COMPARED TO QUARTER ENDED SEPTEMBER 30, 2002 Sales. Sales for the quarter ended September 30, 2003 of $682.0 million were $6.9 million below the corresponding prior year quarter. The prior year quarter included $27.7 million in revenue related to a favorable arbitration ruling that resulted in a retroactive price adjustment to our Navajo station coal supply agreement. Excluding the revenue related to the arbitration ruling, sales increased $20.8 million due to higher volume and pricing at our Powder River Basin operations and higher brokerage sales volume. Mining and brokerage operations' sales volume totaled 49.3 million tons for the current year quarter, a 6.9% increase over the prior year level of 46.1 million tons. The increase was due to higher demand-driven volume at our Powder River Basin operations and higher volume from our brokerage operations. Our average sales price decreased 7.5% from the prior year quarter, primarily due to the effect of the arbitration ruling in the prior year quarter and changes in sales mix. Shipments from the Appalachia and Midwest regions represented a lower percentage of overall sales in the current year, due to the increase in Powder River Basin sales volume in the current year. Average prices in our brokerage operations also decreased in the current year, as more Powder River Basin products were shipped in the current year. Excluding the effect of the arbitration ruling in the prior year, our average sales price decreased 3.6%. U.S. Mining operations' sales were $4.5 million above the prior year quarter, after excluding the effect of the arbitration ruling on prior year sales. In the west, sales in the Powder River Basin operations increased $15.2 million on improved pricing and volume in the third quarter. Strong demand was reflected in higher prices and record shipments of 28.3 million tons in the quarter. Sales in the Southwest region decreased $30.7 million; however, sales were comparable to the prior year after excluding $27.7 million in sales related to the arbitration ruling in the prior year quarter. Sales in the Appalachian region were $4.6 million lower than the prior year quarter, as lower production at the Harris and certain contract mines resulted from a tear in a conveyor belt. The Midwest region's sales were $3.1 million less than the prior year quarter due to longer than expected ramp-up of production due to equipment problems at the Highland Mine, and the ramp-up of production at the Vermilion Grove portal of the Riola Mine. Sales from brokerage operations increased $10.0 million over the prior year quarter due to higher U.S. brokerage sales and Australian brokerage export sales. Sales from our Australian Mining operations, which were acquired in the third quarter of 2002, increased $6.3 million from the prior year quarter. Other Revenues. Other revenues decreased $5.7 million from the prior year quarter. The prior year quarter included a $15.1 million gain related to a mediated settlement regarding the Mohave Generating Station coal supply agreement. Excluding the $15.1 million gain in the prior year quarter, other revenues increased $9.4 million, due to higher mark-to-market revenues from trading operations, coal royalties and coalbed methane revenues. 25 Asset Retirement Obligation Expense. We recognized asset retirement obligation expense of $7.5 million during the current year quarter, comprised of the accretion of the asset retirement obligation liability and the amortization of the asset retirement obligation asset recognized in accordance with SFAS No. 143. Expense in the prior year related to reclamation activities was $4.1 million and was included in "operating costs and expenses" in the statement of operations for the quarter ended September 30, 2002. The adoption of SFAS No. 143 is discussed in Note 3 to the unaudited condensed consolidated financial statements included in this report. Selling and Administrative Expenses. Selling and administrative expenses decreased $2.5 million due to lower headcount in 2003 and expenses related to incentive plans based on our common stock price. Net Gain on Property and Equipment Disposals. Net gain on property and equipment disposals related to our resource management business increased $3.6 million due to a $1.4 million gain on the sale of surplus surface land in the Midwest, combined with other miscellaneous asset sales. Operating Profit. Operating profit decreased $15.7 million to $35.6 million for the quarter ended September 30, 2003. The prior year quarter includes $37.1 million of profit related to the arbitration ruling and mediation settlement described above. Excluding these two items, operating profit increased $21.4 million. Operating profit related to U.S. Mining operations (which excludes operating costs related to past mining activities and net gains on property disposals) increased $14.6 million, excluding the $37.1 million of profit in the prior year related to the arbitration ruling and mediation settlement. The increase was driven by improved margins in the Powder River Basin and Southwest regions. Overall, our U.S. Mining operations held the line on costs compared with the prior year, despite higher healthcare, pension, fuel and explosives costs. The Powder River Basin region's operating profit increased $10.6 million from improved prices and volume and lower repair and maintenance expense. The Southwest region's operating profit, excluding the $37.1 million of profit related to the arbitration ruling and mediation settlement in the prior year quarter, increased $9.5 million, primarily due to lower repair and maintenance expenses. In the east, the Appalachia region's operating profit approximated prior year results as improved results at the Federal and Big Mountain mines helped offset the effects of lower production at the Harris and contract mines from a tear in a conveyor belt. Operating profit in the Midwest region decreased $4.6 million compared to the prior year quarter. Production was lower than expected at the new Highland Mine due to equipment performance problems. Operating profit from Trading and Brokerage operations increased $4.2 million. Trading profits were comparable with the prior year, while current year brokerage results were favorably impacted by adopting EITF Issue 02-3 "Accounting for Contracts Involved in Energy Trading and Risk Management Activities." Current quarter Trading and Brokerage results included $2.5 million in unrealized profit related to a contract restructuring wherein a derivative contract was modified to include tonnage from a non-derivative contract, which increased the mark-to-market profit required to be recognized on the derivative contract. The unrealized profit related to this contract will be converted to cash by the end of 2004. Operating profit for the current year period was also affected by higher net gains on property and equipment disposals of $3.6 million and lower selling and administrative expenses of $2.5 million discussed above, offset by asset retirement obligation expense of $7.5 million. Finally, operating costs related to past mining activities were comparable with the prior year quarter, as higher reclamation expense at closed mine locations in the prior year was offset by higher retiree healthcare costs in the current year. Interest Expense. Interest expense decreased $3.5 million from the prior year quarter, to $22.3 million. Lower borrowing costs of $4.9 million resulted from the refinancing of our debt (see complete discussion in Note 2 to the unaudited condensed consolidated financial statements). Lower borrowing costs 26 were partially offset by $1.4 million in higher costs in the current quarter related to surety bonds and letters of credit used to secure our obligations for reclamation, workers' compensation and lease commitments. Income Taxes. For the quarter ended September 30, 2003, we recorded an income tax benefit of $8.6 million on income before income taxes and minority interests of $13.6 million, compared to an income tax benefit of $1.5 million on income before income taxes and minority interests of $31.0 million in the prior year quarter. The tax benefit recorded in the third quarter of 2003 as a percentage of income before income taxes and minority interests is greater than the tax benefit recorded in the same quarter for the prior year primarily as a result of the magnitude of the percentage depletion deduction (which is a permanent difference) relative to pre-tax income. The income tax benefit for the current year quarter results primarily from the magnitude of the percentage depletion deduction. Minority Interests. For the quarter ended September 30, 2003, minority interests expense decreased $2.8 million to $0.7 million. The reduction was due to the purchase of the remaining 25% of Arclar Coal Company in September 2002 and the acquisition in April 2003 of the remaining 18.3% of Black Beauty Coal Company. The minority interest expense that continues to be recorded subsequent to April 2003 relates to a 75%-owned subsidiary of Black Beauty Coal Company. NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2002 Sales. Sales for the nine months ended September 30, 2003 of $2,010.8 million were $43.3 million, or 2.2%, above the corresponding prior year period, as higher pricing and volume in the Powder River Basin, higher brokerage volume and higher Australian export volume overcame lower production at our Appalachia operations related to weather-related production disruptions and at our Midwest operations related to customer repairs and lower than expected production at the Highland Mine, the Vermilion Grove portal of the Riola Mine and the Willow Lake Mine. The prior year period included $27.7 million in sales related to the favorable arbitration ruling discussed above. Mining and brokerage operations' sales volume totaled 143.5 million tons for the current year period, a 4.7% increase over the prior year level of 137.0 million tons. Higher volume from our brokerage and Australian Mining operations more than offset slightly lower volume at our U.S. Mining operations. Our average sales price decreased 2.5% over the prior year period, due mainly to the effect of the favorable arbitration ruling in the prior year and sales mix, as higher priced tons in the Appalachia and Midwest regions represented a lower percentage of overall sales in the current year compared to the prior year period. Additionally, average prices in our brokerage operations decreased, as our volume was more heavily weighted toward western coal shipments in the current year. U.S. Mining operations' sales were $71.3 million below the prior year period, primarily as a result of the prior year arbitration ruling and lower volume in Appalachia and the Midwest, which more than offset higher prices and volume in the Powder River Basin. Sales in the Appalachian region were $55.1 million lower than the prior year period, as production was reduced by mine disruptions caused by weather in both the first quarter and second quarter, along with the installation of new longwall equipment and development of a new reserve area at the Federal Mine. Midwest sales decreased $11.9 million, as the new Highland mine's production has not yet reached levels comparable with production in the prior year period at the predecessor Camp No. 11 mine, which ceased operations during the fourth quarter of 2002. In addition, customer repairs lowered volume in the first half of 2003. Sales in the Powder River Basin increased $33.2 million as improved pricing for the current year period and record volume in the second and third quarters more than offset lower volume in the first quarter as a result of heavy snowfall. Sales in the Southwest region decreased $37.5 million as a result of the prior year arbitration ruling ($27.7 million) and lower volume in the current year due to two customers performing major repairs in the first half of the year. Sales from brokerage operations increased $95.5 million over the prior year period due to higher U.S. brokerage sales and Australian brokerage export sales. Our Australian Mining operations, which were acquired in the third quarter of 2002, contributed higher year-over-year sales of $19.2 million. 27 Other Revenues. Other revenues decreased $14.1 million from the prior year period due to the $15.1 million gain related to the mediated settlement discussed above. In addition, slightly higher trading and coalbed methane revenues were offset by lower revenues related to a royalty agreement that expired in 2002. Asset Retirement Obligation Expense. We recognized asset retirement obligation expense of $20.6 million during the current year, comprised of the accretion of the asset retirement obligation liability and the amortization of the asset retirement obligation asset recognized in accordance with SFAS No. 143. Expense in the prior year related to reclamation activities was $12.8 million and was included in "operating costs and expenses" in the statement of operations for the nine months ended September 30, 2002. The adoption of SFAS No. 143 is discussed in Note 3 to the unaudited condensed consolidated financial statements included in this report. Selling and Administrative Expenses. Selling and administrative expenses increased $4.2 million due to higher costs associated with salaried pensions, incentive compensation, litigation, additional healthcare cost controls and Sarbanes-Oxley compliance. Lower headcount in 2003 helped offset some of these cost increases. Net Gain on Property and Equipment Disposals. Net gain on property and equipment disposals related to our resource management business increased $19.9 million primarily due to a sale of land and coal reserves in Appalachia in the second quarter of 2003 and the sale of oil and gas rights in Appalachia in the first quarter of 2003, combined with the net gain on property and equipment disposals discussed above. Operating Profit. Operating profit decreased $61.1 million to $100.4 million for the nine months ended September 30, 2003. The prior year period includes $37.1 million of profit related to the arbitration ruling and mediation settlement described above. Operating profit from U.S. Mining operations (which excludes operating costs related to past mining activities and net gains on property disposals) decreased $50.9 million, which includes the $37.1 million benefit from the arbitration ruling and mediation settlement in the prior year. In addition, the current year was impacted by operating below optimal levels as a result of customer repairs and weather disruptions in the first half of the year, higher reclamation costs related to the adoption of SFAS No. 143, and higher pension and retiree healthcare costs. In the west, the Powder River Basin region's operating profit increased $23.9 million on improved prices, record volume in the second and third quarter, and lower maintenance and repair costs, which overcame higher fuel and explosives costs. The Southwest region's operating profit, excluding the $37.1 million of profit related to the arbitration ruling and mediation settlement in the prior-year period, increased $5.0 million, as lower maintenance and repair expense more than offset lower volume from outages at two customer plants in the first half of the current year period. In the east, the Appalachia region's operating profit decreased $28.7 million due to lower volume from geologic difficulties and weather disruptions at the Harris Mine, lower shipments from contract mines and the conveyor belt tear previously mentioned. Operating profit in the Midwest region decreased $14.0 million compared to the prior year period due to higher fuel and explosives costs at our Black Beauty operations and lower volume due to customer repairs and ramp-up issues at the new Highland Mine and the Vermilion Grove portal of the Riola Mine, which have not reached full production capacity. Operating profit from Trading and Brokerage operations increased $6.9 million over the prior year, primarily due to higher profit from improved brokerage volume and the impact of adopting EITF Issue 02-3 "Accounting for Contracts Involved in Energy Trading and Risk Management Activities." Current year Trading and Brokerage results included $6.8 million in unrealized profit related to a contract restructuring wherein the new contract's terms and conditions required it to be classified as a derivative and marked to market for accounting purposes. The unrealized profit related to this contract will be converted to cash by the end of 2005. An additional $4.1 million of unrealized profit related to two other contract modifications, including the modification described above in the analysis of results for the quarter ended September 30, 2003. The unrealized profit related to these two contract modifications will be converted to cash by the end of 2004. 28 Operating profit for the current year period was also affected by higher net gains on property and equipment disposals of $19.9 million offset by asset retirement obligation expense of $20.6 million and higher selling and administrative expenses of $4.2 million. Operating costs related to past mining activities were $10.9 million higher in the current year period, due to $7.8 million of higher retiree healthcare costs in the current year, driven by lower interest discount rate and higher inflation trend assumptions, combined with $7.0 million in excise tax refunds included in the prior year. Finally, prior year resource management results included royalty income of $4.0 million related to a royalty agreement that expired in 2002. Interest Expense. Interest expense increased $0.6 million compared to the prior year period, to $77.4 million. Interest savings from the March 2003 refinancing were not fully realized until the third quarter (discussed above) because the second quarter included $5.3 million in interest costs for the notes not redeemed until May 15, 2003. In addition, we incurred $5.3 million in higher costs in the nine months ended September 30, 2003 related to surety bonds and letters of credit used to secure our obligations for reclamation, workers' compensation and lease commitments. These additional expenses were partially offset by lower interest on $650 million of 6.875% Senior Notes issued in March 2003 and lower overall interest costs of $4.9 million in the third quarter, discussed above. Early Debt Extinguishment Costs. Pursuant to our debt refinancing transactions discussed in Note 2 to the unaudited condensed consolidated financial statements, we incurred early debt extinguishment costs of $53.5 million during the nine months ended September 30, 2003, which were comprised of $41.8 million of early prepayment premiums and fees paid to retire debt, $17.5 million of debt issuance costs that were written off in conjunction with the early extinguishment of debt, partially offset by a gain on the termination of related interest rate swaps of approximately $5.8 million. Income Taxes. For the nine months ended September 30, 2003, there was an income tax benefit of $49.6 million on a loss before income taxes and minority interests of $27.9 million, compared to income tax expense of $4.6 million on income before income taxes and minority interests of $91.4 million in the prior year period. The tax benefit recorded in the first nine months of 2003 differs from the tax expense in the prior year nine-month period primarily as a result of the magnitude of the percentage depletion deduction (which is a permanent difference) relative to pre-tax income. The income tax benefit for the current year period results primarily from the magnitude of the percentage depletion deduction and a $10.0 million adjustment to our tax reserves. Minority Interests. For the nine months ended September 30, 2003, minority interests expense decreased $8.5 million to $2.4 million. The reduction was due to the minority interest acquisitions discussed above and the impact of $7.3 million of early debt extinguishment charges incurred at Black Beauty during 2003. Cumulative Effect of Accounting Changes, Net of Taxes. As of January 1, 2003, we recognized expense relating to the cumulative effect of accounting changes, net of income taxes, of $10.1 million. This amount represents the aggregate amount of the recognition of accounting changes pursuant to the adoption of SFAS No. 143, the change in method of amortization of actuarial gains and losses related to net periodic postretirement benefit costs and the effect of the rescission of EITF No. 98-10, as discussed in Note 3 to the unaudited condensed consolidated financial statements. 29 LIQUIDITY AND CAPITAL RESOURCES Cash provided by operating activities was $115.8 million for the nine months ended September 30, 2003, a decrease of $92.8 million from the corresponding prior year period. The decrease is primarily due to lower income from continuing operations in the current year, and the prior year period's cash flows include $26.8 million of excise tax refunds and $22.1 million received related to the arbitration ruling previously mentioned. Net cash used in investing activities was $183.2 million for the nine months ended September 30, 2003, $15.7 million lower than the corresponding prior year period. Capital expenditures decreased $42.5 million, to $118.8 million, in the current year period. Major expenditures incurred in the nine months ended September 30, 2003 related to the startup of the Highland Mine and the installation of new longwall equipment and development of a new reserve area at our 5 million ton per year Federal Mine. Other capital expenditures were primarily for the replacement of mining equipment, the expansion of capacity at certain mines and projects to improve the efficiency of mining operations. Acquisition expenditures increased $44.5 million in the current year, due to the current year $90.0 million acquisition of the remaining 18.3% of Black Beauty Coal Company, discussed in Note 4 to the unaudited condensed consolidated financial statements. The prior year included $44.5 million of expenditures related to the acquisitions of Beaver Dam Coal Company, remaining 25% interest in Arclar Coal Company and our Australian Mining operations. Finally, the current year period included $18.2 million higher proceeds from property and equipment disposals as a result of sales of land, coal reserves and oil and gas rights during the period. Net cash provided by financing activities was $101.1 million for the nine months ended September 30, 2003, a $133.6 million increase over the corresponding prior year period. The current year included proceeds from long-term debt of $1.1 billion from the refinancing transactions. A detailed discussion of the sources and uses of proceeds from the refinancing transactions is included in Note 2 to the unaudited condensed consolidated financial statements. The refinancing proceeds were used, among other things, to repay line of credit borrowings of $121.6 million, long-term debt of $831.0 million and to pay $23.6 million in debt issuance costs in connection with the new debt issued. The current year includes other debt repayments of $35.1 million, while the prior year includes net repayments of $11.5 million. Financing cash flows in the current and prior year periods reflect dividends paid of $17.3 million and $15.6 million, respectively. Finally, the current year period included $24.6 million of proceeds from the exercise of stock options. As of September 30, 2003 and December 31, 2002, our total indebtedness consisted of the following (dollars in thousands): September 30, 2003 December 31, 2002 ------------------ ----------------- Term Loan under Senior Secured Credit Facility $ 447,750 $ -- 6.875% Senior Notes due 2013 650,000 -- Fair value of interest rate swaps - 6.875% Senior Notes 7,285 -- 9.625% Senior Subordinated Notes redeemed in 2003 -- 391,490 8.875% Senior Notes redeemed in 2003 -- 316,498 5.0% Subordinated Note 78,273 85,055 Senior unsecured notes under various agreements -- 58,214 Unsecured revolving credit agreement -- 116,584 Other 17,389 61,370 ------------------ ----------------- $ 1,200,697 $ 1,029,211 ================== ================= During the nine months ended September 30, 2003, we completed a comprehensive debt refinancing to lower our borrowing costs, expand our borrowing capacity, extend our debt maturities and simplify our capital structure. Our Senior Secured Credit Facility and 6.875% Senior Notes have been rated Ba1 and BB-, respectively, by Moody's Investors Service, BB+ and BB- by Standard & Poor's and BB+ and BB by Fitch. Recently, Moody's reaffirmed our SGL-1 liquidity rating. Under Moody's rating system, SGL-1 means "very 30 good" liquidity. Moody's SGL ratings are used to supplement their credit ratings for companies rated from "Ba1" to "C." These security ratings reflect the views of the rating agencies only. An explanation of the significance of these ratings may be obtained from each rating agency. Such ratings are not a recommendation to buy, sell or hold securities, but rather an indication of creditworthiness. Any rating can be revised upward or downward or withdrawn at any time by a rating agency if it decides that the circumstances warrant the change. Each rating should be evaluated independently of any other rating. In July 2003, our board of directors approved a 25% increase in the regular quarterly dividend on common stock, to $0.125 per share. The increased dividend was paid on August 26, 2003, to shareholders of record on August 5, 2003. In May 2003, we entered into and designated four interest rate swaps with notional amounts totaling $100.0 million as a fair value hedge of our 6.875% Senior Notes. Under the swaps, the Company pays a floating rate that resets each March 15 and September 15, based upon the six-month LIBOR rate, for a period of ten years ending March 15, 2013 and receives a fixed rate of 6.875%. The applicable floating rate was 4.25% as of September 30, 2003. At current LIBOR levels, we would realize annualized savings of approximately $2.6 million over the term of the swaps. In September 2003, the Company entered into two $400.0 million interest rate swaps. One $400.0 million notional amount floating-to-fixed interest rate swap, expiring March 15, 2010, was designated as a hedge of changes in expected cash flows on the term loan under Senior Secured Credit Facility. Under this swap, the Company pays a fixed rate of 6.764% and receives a floating rate of LIBOR plus 2.5% that resets quarterly based upon the three-month LIBOR rate. Another $400.0 million notional amount fixed-to-floating interest rate swap, expiring March 15, 2013, was designated as a hedge of the changes in the fair value of the 6.875% Senior Notes due 2013. Under this swap, the Company pays a floating rate of LIBOR plus 1.97% that resets quarterly based upon the three-month LIBOR rate and receives a fixed rate of 6.875%. The effect of the swaps was to lower the Company's overall borrowing costs on $400.0 million of debt principal by 0.64% as of September 30, 2003, which will result in annualized interest savings of $2.6 million over the term of the fixed-to-floating swap. As of September 30, 2003, there were no outstanding borrowings under our Revolving Credit Facility. We had letters of credit outstanding under the facility of $241.0 million, leaving $359.0 million available for borrowing. We were in compliance with all of the covenants of the Senior Secured Credit Facility and 6.875% Senior Notes as of September 30, 2003. We had $67.7 million of commitments for capital expenditures at September 30, 2003, that are primarily related to acquiring additional coal reserves and mining equipment. The majority of these commitments relate to spending targeted for 2003. Total projected capital expenditures for calendar year 2003 are approximately $175 million to $190 million, and have been and will be primarily used to develop existing reserves, replace or add equipment and fund cost reduction initiatives. We anticipate funding our capital expenditures primarily through operating cash flow. Off-Balance Sheet Arrangements In March 2000, we established an accounts receivable securitization program. Under the program, undivided interests in a pool of eligible trade receivables that have been contributed to our wholly-owned, bankruptcy-remote subsidiary are sold, without recourse, to a multi-seller, asset-backed commercial paper conduit ("Conduit"). Purchases by the Conduit are financed with the sale of highly rated commercial paper. We used proceeds from the sale of the accounts receivable to repay long-term debt, effectively reducing our overall borrowing costs. The securitization program is currently scheduled to expire in 2007, and the maximum amount of undivided interests in accounts receivable that may be sold to the Conduit is $140.0 million. Under the provisions of SFAS No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," the securitization transactions have been recorded as sales, with those accounts receivable sold to the Conduit removed from the consolidated balance sheet. The amount of 31 undivided interests in accounts receivable sold to the Conduit was $140.0 million and $136.4 million as of September 30, 2003 and December 31, 2002, respectively. There were no other material changes to our off-balance sheet arrangements during the nine months ended September 30, 2003. All off-balance sheet arrangements are discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Form 10-K for the year ended December 31, 2002. OTHER Mohave Generating Station See Note 10 to the unaudited condensed consolidated financial statements included in this report relating to the potential cessation or suspension of the operations of the Mohave Generating Station on December 31, 2005. The Mohave Generating Station is the sole customer of our Black Mesa Mine, which sold 4.6 million tons of coal in 2002. Big Sky Mine Our Big Sky Mine, which is located in the northern Powder River Basin near Colstrip, Montana, sold 2.8 million tons of medium sulfur coal during 2002. As disclosed in our Form 10-K for the year ended December 31, 2002, the mine is near the exhaustion of its economically recoverable reserves. The mine's current sales contract expires on December 31, 2003, and we anticipate that we will close the mine after that sales contract expires. The mine's closure will not have a material adverse effect on our financial condition, results of operations or cash flows. Gibraltar P&L Mine Our Gibraltar P&L Mine, which is a small surface pit located near our former Gibraltar Mine near Graham, Kentucky, will close in the fourth quarter of 2003 as it exhausts its economically recoverable reserves. The mine sold 0.8 million tons of coal during 2002. The Gibraltar P&L Mine closure will not have a material adverse effect on our financial condition, results of operations or cash flows. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Trading Activities Our coal trading activities give rise to commodity price risk, which represents the potential loss that can be caused by a change in the market value of a particular commitment. We actively measure, monitor and adjust traded position levels to remain within risk limits prescribed by management. For example, we have policies in place that limit the amount of total exposure we may assume at any point in time. We account for coal trading derivatives under SFAS No. 133 (as amended), which requires us to reflect derivatives, such as forwards, futures, options and swaps, at market value in the consolidated financial statements. We perform a value at risk analysis on our trading portfolio, which includes over-the-counter and brokerage trading of coal. The use of value at risk allows us to quantify in dollars, on a daily basis, the price risk inherent in our trading portfolio. Our value at risk model is based on the industry standard risk-metrics variance/co-variance approach. This captures our exposure related to both option and forward positions. Our value at risk model assumes a 15-day holding period and a 95% one-tailed confidence interval. The use of value at risk allows management to aggregate pricing risks across products in the portfolio, compare risk on a consistent basis and identify the drivers of risk. Due to the subjectivity in the choice of the liquidation period, reliance on historical data to calibrate the models and the inherent limitations in the value at risk methodology, including the use of delta/gamma adjustments related to options, we perform regular 32 stress, back testing and scenario analysis to estimate the impacts of market changes on the value of the portfolio. The results of these analyses are used to supplement the value at risk methodology and identify additional market-related risks. During the nine months ended September 30, 2003, the low, high and average values at risk for our coal trading portfolio were $0.4 million, $1.3 million and $0.8 million, respectively. As of September 30, 2003, 13% of the value of our trading portfolio was scheduled to be realized by the end of calendar year 2003, and 97% of the value of our trading portfolio was scheduled to be realized by the end of calendar year 2004. We also monitor other types of risk associated with our coal trading activities, including credit, market liquidity and counterparty nonperformance. Non-trading Activities We manage our commodity price risk for non-trading purposes through the use of long-term coal supply agreements, rather than through the use of derivative instruments. As of September 30, 2003, we had sales commitments for substantially all of our planned calendar 2003 production. We have committed and priced 168 million tons of planned 2004 production of 190 million to 200 million tons. Some of the products used in our mining activities, such as diesel fuel and explosives, are subject to price volatility. We, through our suppliers, utilize forward contracts to manage the exposure related to this volatility. We have exposure to changes in interest rates due to our existing level of indebtedness. As of September 30, 2003, after taking into consideration the effects of interest rate swaps, we had $647.4 million of fixed-rate borrowings and $553.3 million of variable-rate borrowings outstanding. A one percentage point increase in interest rates would result in an annualized increase to interest expense of $5.5 million on our variable-rate borrowings. With respect to our fixed-rate borrowings, a one-percentage point increase in interest rates would result in a $49.7 million decrease in the fair value of these borrowings. ITEM 4. CONTROLS AND PROCEDURES. The Chief Executive Officer and Executive Vice President and Chief Financial Officer have evaluated our disclosure controls and procedures as of September 30, 2003 and have concluded that the disclosure controls and procedures were effective. Our disclosure controls and procedures are designed to, among other things, provide reasonable assurance that material information, both financial and non-financial, and other information required under the securities laws to be disclosed is identified and communicated to senior management on a timely basis. Additionally, during the most recent fiscal quarter, there have been no changes to our internal control over financial reporting that could materially affect, or are reasonably likely to materially affect, our internal control over financial reporting. PART II -- OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. Navajo Nation See Note 10 to the unaudited condensed consolidated financial statements included in Part I, Item 1 of this report relating to certain legal proceedings brought against us by the Navajo Nation and Hopi Tribe. 33 Oklahoma Lead Litigation One of our subsidiaries, Gold Fields, was named in June 2003 as a defendant, along with five other companies, in a class action lawsuit filed in the U.S. District Court for the Northern District of Oklahoma. The plaintiffs have asserted nuisance and trespass claims predicated on allegations of intentional lead exposure by the defendants, including Gold Fields, and are seeking compensatory damages for diminution of property value, punitive damages and the implementation of medical monitoring and relocation programs for the affected individuals. A predecessor of Gold Fields formerly operated two lead mills near Picher, Oklahoma prior to the 1950's. The plaintiff classes include all persons who have lived in the vicinity of Picher within a specified time period. Gold Fields has agreed to indemnify one of the other defendants, which is a former subsidiary of our company. Gold Fields is also a defendant, along with other companies, in 17 individual lawsuits arising out of the same lead mill operations involved in the class action. Plaintiffs in these actions are seeking compensatory and punitive damages for alleged personal injuries from lead exposure. Four of those lawsuits have been consolidated for a trial set for November 17, 2003 in the U.S. District Court for the Northern District of Oklahoma. While the outcome of litigation is subject to uncertainties, based on the Company's preliminary evaluation of the issues and their potential impact on the Company, the Company believes this matter will be resolved without a material adverse effect on the Company's financial condition, results of operations or cash flows. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits See Exhibit Index at page 36 of this report. (b) Reports on Form 8-K On July 17, 2003, we furnished a Form 8-K under Item 9, Regulation FD Disclosure and Item 12, Disclosure of Results of Operations and Financial Condition announcing our issuance of a press release setting forth our second quarter 2003 earnings, and providing guidance on our third quarter and full year 2003 forecasted results. The press release was included as an exhibit under Item 7, Financial Statements, Pro Forma Financial Information and Exhibits. On August 4, 2003, we filed a Form 8-K under Item 5, Other Events and Regulation FD Disclosure, announcing an underwriting agreement between the Company, certain stockholders and certain named underwriters, pursuant to the secondary offering as discussed in Note 12 to the unaudited condensed consolidated financial statements. The underwriting agreement was included as an exhibit under Item 7, Financial Statements, Pro Forma Financial Information and Exhibits. 34 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PEABODY ENERGY CORPORATION Date: November 13, 2003 By: /s/ RICHARD A. NAVARRE ------------------------------------ Richard A. Navarre Executive Vice President and Chief Financial Officer (Principal Financial Officer) 35 EXHIBIT INDEX The exhibits below are numbered in accordance with the Exhibit Table of Item 601 of Regulation S-K. Exhibit No. Description of Exhibit --- ---------------------- 3.1 Third Amended and Restated Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 of the Company's Form S-1 Registration Statement No. 333-55412). 3.2 Amended and Restated By-Laws of the Registrant (Incorporated by reference to Exhibit 3.2 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002 filed on November 14, 2002). 4.29 Second Supplemental Senior Note Indenture dated as of September 30, 2003 among Peabody Energy Corporation, the Guaranteeing Subsidiaries (as defined therein) and US Bank National Association, as trustee (incorporated by reference to the Exhibit 4.198 of the Company's Form S-3 Registration Statement on No. 333-109906, filed on October 22, 2003). 10.47* Agreement between Peabody Energy Corporation and Richard A. Navarre dated August 29, 2003. 10.48* Agreement between Peabody Energy Corporation and Richard M. Whiting dated September 24, 2003. 31.1* Certification of periodic financial report by Peabody Energy Corporation's Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2* Certification of periodic financial report by Peabody Energy Corporation's Executive Vice President and Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1* Certification of periodic financial report pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, by Peabody Energy Corporation's Chief Executive Officer. 32.2* Certification of periodic financial report pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, by Peabody Energy Corporation's Executive Vice President and Chief Financial Officer. * Filed herewith. 36