Coal bubble rears head in Arch’s $3.4 bln ICG bid

May 2, 2011

By Christopher Swann
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The coal bubble has reared its blackened face yet again, if the reaction of Arch Coal’s shareholders to its $3.4 billion takeover of a rival is any indication. The company is paying a premium to International Coal Group that’s well above the capitalized value of potential synergies. And though investors belatedly bid down shares of Arch, they have yet to fully recognize the extent of value destruction.

Even taking the upper estimate of Arch’s synergies, $80 million, the promised savings have a net present value of about $500 million. This is below the premium of almost $730 million that Arch is offering. Yet so far Arch investors have marked down the firm by only about half that level.

Shareholders have other reasons for skepticism. The purchase price is at the upper end of other recent deals, at an enterprise value of around 6.6 times EBITDA, according to Brean Murray. That’s higher than what Alpha Natural Resources <ANR.N> paid for Massey or Walter Energy offered for Western Coal. And Arch is buying after a bull run in ICG. The stock had doubled in value over the past year — far outpacing the 25 percent rise in Arch.

Of course, there are reasons for Arch to want to participate in the recent burst of coal mergers. Adding bulk makes it easier to cope with a stricter regulatory climate and rising extraction costs from older mines. And hooking up with ICG does have additional attractions — most notably its deep reserves of metallurgical coal. Surging demand from steelmakers in Asia has made this the hottest part of the industry. Now Arch will become the second largest U.S. producer of this high-value commodity.

Arch could scarcely have remained aloof from the industry’s merger frenzy. But investors have good reason to feel irked by the generous all-cash price they are paying. Coal prices will need to surpass the hype to prevent this deal destroying value.

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