PEABODY ENERGY CORP - 10-Q Quarterly Report

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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, 2002
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Commission File Number 1-16463
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PEABODY ENERGY CORPORATION
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)

DELAWARE 13-4004153
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

701 MARKET STREET, ST. LOUIS, MISSOURI 63101-1826
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(Address of principal executive offices) (Zip Code)

(314) 342-3400
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(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 31, 2002: Common Stock, par value $0.01 per share,
52,311,855 shares outstanding.

INDEX

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

PEABODY ENERGY CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except share and per share information)

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)

See accompanying notes to unaudited condensed consolidated
financial statements.

3

PEABODY ENERGY CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

See accompanying notes to unaudited condensed consolidated
financial statements.

4

PEABODY ENERGY CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002

(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 current year presentation.

The consolidated statements of operations and cash flows for the nine
months ended September 30, 2001 include the results of the operations of Peabody
Resources Limited, located in Australia, which were sold in January 2001.

The accompanying condensed consolidated financial statements as of
September 30, 2002 and for the quarters and nine months ended September 30, 2002
and 2001, 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, 2001 has been derived from the
Company's audited consolidated balance sheet. The results of operations for the
quarter and nine months ended September 30, 2002 are not necessarily indicative
of the results to be expected for the year ending December 31, 2002.

In July 2001, the Company changed its fiscal year-end from March 31 to
December 31. This change was first effective with respect to the nine months
ended December 31, 2001.

(2) ACQUISITIONS

Allied Queensland Coalfields Party Limited

On August 22, 2002, the Company purchased Allied Queensland Coalfields
Party Limited ("AQC") and its controlled affiliates from Mirant Corporation for
$21.2 million. As a result of the acquisition, the Company now controls the 1.3
million metric tonne per year Wilkie Creek Coal Mine and 680 million metric
tonnes of in-place coal resources in Queensland, Australia. The acquisition was
accounted for as a purchase, and the results of AQC's operations are included in
the Company's Australian Mining Operations segment.

Arclar Company, LLC

On September 16, 2002, the Company purchased a 25% interest in Arclar
Company, LLC ("Arclar"), for $14.9 million. The Company's 81.7%-owned Black
Beauty Coal Company subsidiary owns the remaining 75% of Arclar. Arclar owns the
Willow Lake and Cottage Grove mines in Southern Illinois and more than 50
million tons of coal reserves. With the Arclar purchase, the Company also
acquired controlling interest of an entity that resulted in the consolidation of
$12.5 million of long-term debt and related assets. The acquisition was
accounted for as a purchase.

Beaver Dam

On June 26, 2002, the Company purchased Beaver Dam Coal Company, located
in Western Kentucky, for $17.7 million. Through the acquisition, the Company
obtained ownership of more than 100 million tons of coal reserves and 22,000
surface acres. The acquisition was accounted for as a purchase.

The results of operations for each of these entities are included in the
Company's consolidated results of operations from the effective date of each
acquisition. Had the acquired entities' results of operations been included in
the Company's results of operations since January 1, 2002, there would have been
no material effect on the Company's consolidated statement of operations,
financial condition or cash flows.

(3) SECONDARY OFFERING

On April 5, 2002, certain shareholders of the Company, including the
Company's largest shareholder, Lehman Brothers Merchant Banking Partners II L.P.
and affiliates (collectively "Lehman Brothers") sold 9,000,000 shares of common
stock. Selling shareholders received all net proceeds. The Company did not sell
any shares through the offering.

5

The underwriters of the secondary offering were granted the right to purchase up
to an additional 1,100,000 shares of common stock to cover over-allotments. The
underwriters exercised the over-allotment option, and on May 8, 2002, purchased
an additional 148,000 shares. Lehman Brothers sold, in the aggregate, 8,155,000
shares in the offering, and their beneficial ownership of the Company's
outstanding common stock declined from 57% to 41% immediately following the
offering.

(4) PREFERRED SHARE PURCHASE RIGHTS PLAN

On July 23, 2002, the Board of Directors of the Company adopted a
preferred share purchase rights plan (the "Rights Plan"). In connection with the
Rights Plan, the Board of Directors of the Company declared a dividend of one
preferred share purchase right (a "Right") for each outstanding share of common
stock, par value $0.01 per share, of the Company. The Rights dividend was
payable on August 12, 2002 to the stockholders of record on that date. The
description and terms of the Rights are set forth in an Agreement, dated as of
July 24, 2002, between the Company and EquiServe Trust Company, N.A., as Rights
Agent.

The Rights have certain anti-takeover effects. The Rights will cause
substantial dilution to a person or group that attempts to acquire the Company
on terms not approved by the Company's Board of Directors, except pursuant to
any offer conditioned on a substantial number of Rights being acquired. The
Rights should not interfere with any merger or other business combination
approved by the Board of Directors since the Rights may be redeemed by the
Company at a redemption price of $0.001 per Right prior to the time that a
person or group has acquired beneficial ownership of 15% or more of the common
stock of the Company. In addition, the Board of Directors is authorized to
reduce the 15% threshold to not less than 10%.

(5) EXTRAORDINARY LOSS FROM EARLY EXTINGUISHMENT OF DEBT

During the nine months ended September 30, 2001, the Company used
substantially all of the net proceeds from its initial public offering and the
sale of its Peabody Resources Limited operations to repay debt. The Company
repaid the remaining $580.0 million in outstanding term loans under its Senior
Credit Facilities and used $100.0 million to repay borrowings under the
revolving credit facility that were used to repay a portion of the Company's 5%
Subordinated Note. The Company also used $173.0 million of proceeds from the
offering to repurchase $80.0 million in principal of the Senior Notes and $80.0
million in principal of the Senior Subordinated Notes pursuant to a tender
offer. All of these debt repayments, except for $455.0 million of the term loan
repayments, took place in the quarter ended June 30, 2001. The extraordinary
loss of $36.1 million, net of income taxes, for the nine months ended September
30, 2001, represents the excess of cash paid over the carrying value of debt
retired and the accelerated write-off of debt issuance costs related to the debt
repaid.

(6) ADOPTION OF NEW ACCOUNTING STANDARDS

Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 141, "Business Combinations," and SFAS No.
142, "Goodwill and Other Intangible Assets." The adoption of SFAS Nos. 141 and
142 did not have a material effect on the Company's financial condition or
results of operations.

Also effective January 1, 2002, the Company adopted SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets." The provisions
of this statement provide a single accounting model for measuring impairment of
long-lived assets. The adoption of SFAS No. 144 did not have a material effect
on the Company's financial condition or results of operations.

(7) COAL INVENTORY

Inventories consist of the following (dollars in thousands):

6

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

(8) ASSETS AND LIABILITIES FROM COAL AND EMISSION ALLOWANCE TRADING ACTIVITIES

For periods covered by this report, coal and emission allowance trading
activities are accounted for using the fair value method, as required by
Emerging Issues Task Force (EITF) Issue No. 98-10, "Accounting for Contracts
Involved in Energy Trading and Risk Management Activities." Under such method,
the derivative commodity instruments (forwards, options and swaps) with third
parties are reflected at market value and are included in "Assets and
liabilities from coal and emission allowance trading activities" in the
consolidated balance sheets. In the absence of quoted values, financial
commodity instruments are valued at fair value, considering the net present
value of the underlying sales and purchase obligations and the volatility of the
underlying commodity. Subsequent changes in market value are recorded as
unrealized gains or losses in "Other revenues" in the period of change. Realized
gains and losses on financially settled transactions are recorded as part of
"Other revenues" as they occur.

On October 25, 2002, the EITF rescinded EITF Issue No. 98-10. The
rescission is effective for all energy trading contracts entered into after
October 25, 2002. As a result of the rescission, energy trading contracts will
be evaluated under SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities." The rescission is effective January 1, 2003 for contracts
entered into prior to October 25, 2002. Accordingly, the effect of this
rescission on energy trading contracts entered into prior to October 25, 2002
will be recorded as a cumulative effect of a change in accounting principle in
January 2003.

The accounting changes required by the ruling are anticipated to primarily
affect the timing of the recognition of income or loss in earnings and not
change the underlying economics or cash flows of transactions entered into by
the Company's trading operations. The Company does not anticipate that the
rescission of EITF Issue No. 98-10 will have a material effect on its results of
operations in 2002 for transactions entered into after October 25, 2002. The
Company is currently assessing the impact of this rescission on transactions
entered into prior to October 25, 2002.

EITF Issue No. 98-10 previously permitted the reporting of gains or losses
on energy trading contracts on a gross or net basis in the statement of
operations. In June 2002, the EITF discussed Issue No. 02-3, "Issues Related to
Accounting for Contracts Involved in Energy Trading and Risk Management
Activities." EITF Issue No. 02-3 reexamined the issue of whether gains and
losses on energy trading contracts should be reported gross or net in the
statement of operations. In July 2002, the EITF published its consensus that all
mark-to-market gains and losses on energy trading contracts should be shown net
in the statement of operations, even if settled physically. This new consensus
was effective for financial statements issued for periods ending after July 15,
2002 and requires reclassification of amounts in all prior periods presented.
Since the Company already reports financially settled transactions and
unrealized mark-to-market gains on a net basis, this revision had no impact on
those transactions. However, beginning in the quarter ended September 30, 2002,
the Company's physically settled trading transactions were recorded on a net
basis as a part of "Other revenues," rather than on a gross basis within "Sales"
and "Operating costs and expenses." This accounting change had no effect on
operating profit or net income.

For the quarter and nine months ended September 30, 2002, the Company had
physically settled coal trades of 3.6 million tons and 10.5 million tons,
respectively. In the corresponding prior periods, physical settlements were 2.4
million and 5.6 million tons, respectively. As a result of adopting EITF Issue
No. 02-3, revenues and operating costs were reduced by $40.5 million and $121.3
million for the quarter and nine months ended September 30, 2002, respectively,
and $26.7 million and $61.5 million for the corresponding prior periods.

The fair value of the financial instruments related to coal and emission
allowance trading activities as of September 30, 2002, are set forth below
(dollars in thousands):

Eighty-six percent of the contracts in the Company's trading portfolio as
of September 30, 2002 were valued utilizing prices from over-the-counter market
sources. The remaining 14% of the Company's contracts were valued based on
over-the-counter market source prices adjusted for differences in coal quality
and content, as well as contract duration.

7

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

As of September 30, 2002, the timing of the realization of the value of
the Company's trading portfolio was as follows:

At September 30, 2002, 67% of the Company's credit exposure related to
coal and emission allowance trading activities was with counterparties that are
investment grade.

The Company's coal trading operations traded 10.5 million tons and 13.8
million tons for the quarters ended September 30, 2002 and 2001, respectively,
and 55.8 millions tons and 35.9 million tons for the nine months ended September
30, 2002 and 2001, respectively.

(9) EARNINGS PER SHARE

Quarter and Nine Months Ended September 30, 2001

Prior to its initial public offering in May 2001, the Company applied the
"two-class method" of computing earnings per share as prescribed in SFAS No.
128, "Earnings Per Share." In accordance with SFAS No. 128, income or loss was
allocated to preferred stock, Class A common stock and Class B common stock on a
pro-rata basis. Basic and diluted earnings per share is calculated by dividing
income from continuing operations, gain from disposal of discontinued
operations, extraordinary loss from early extinguishment of debt and net income
(loss), respectively, that was attributed to the Company's Class A and Class B
common shares by the weighted average number of common shares outstanding for
each class of common stock.

A reconciliation of income from continuing operations, gain from disposal
of discontinued operations, extraordinary loss from early extinguishment of debt
and net income (loss) follows (dollars in thousands):

8

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

In connection with the Company's initial public offering, all outstanding
shares of preferred stock, Class A common stock and Class B common stock were
converted into a single class of common stock on a one-for-one basis. For
purposes of the weighted average share calculations for the quarter and nine
months ended September 30, 2001, this conversion was assumed to have occurred as
of April 1, 2001. A reconciliation of the weighted average shares outstanding as
of September 30, 2002 and 2001, respectively, follows:

(10) COMPREHENSIVE INCOME

The following table sets forth the components of comprehensive income for
the quarter and nine months ended September 30, 2002 and 2001, respectively
(dollars in thousands):

As a result of the sale of its Peabody Resources Limited operations, the
Company recorded a reduction of the foreign currency translation adjustment
account during the nine months ended September 30, 2001.

(11) SEGMENT INFORMATION

The Company reports its operations primarily through the following
reportable operating segments: "U.S. Mining," "Trading and Brokerage," and
"Australian Mining Operations." 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 emission allowances. The Australian Mining Operations
segment for 2002 consists of the operations of Allied Queensland Coalfields
Party Limited and in 2001 consisted of the operations of Peabody Resources
Limited. 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.

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."

9

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

Operating segment results for the quarters and nine months ended September
30, 2002 and 2001 are as follows (dollars in thousands):

(1) Includes the pretax gain on the sale of the Company's Peabody Resources
Limited operations of $171.7 million.

A reconciliation of segment operating profit to consolidated income before
income taxes follows (dollars in thousands):

(12) COMMITMENTS AND CONTINGENCIES

Environmental

Environmental claims have been asserted against a subsidiary of the
Company at 18 sites in the United States. 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 majority of these sites are related
to activities of former subsidiaries of the Company.

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 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 "Accrued reclamation and
other

10

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

environmental liabilities" were $44.7 million and $46.6 million at September 30,
2002 and December 31, 2001, respectively. This amount represents 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 a breach of these leases and a
reformation of the two coal leases to adjust the royalty rate to 20%. All
defendants have filed motions to dismiss the complaint. On March 15, 2001, the
court denied the Peabody defendants' motions to dismiss. Discovery for this
litigation has commenced.

In March 2000, the Hopi Tribe filed a motion to intervene in this lawsuit.
The Hopi Tribe has alleged seven claims, including fraud. The Hopi Tribe is
seeking various remedies, including unspecified actual and punitive damages and
reformation of its coal lease. On March 15, 2001, the court granted the Hopi
Tribe's motion. On April 17, 2001, the Company filed a motion to dismiss the
Hopi complaint. On October 31, 2001, the court denied the Company's motion to
dismiss the Hopi complaint.

On February 21, 2002, the Company's subsidiaries commenced a lawsuit
against the Navajo Nation in the U.S. District Court for the District of Arizona
seeking enforcement of an arbitration award or, alternatively, to compel
arbitration pursuant to the April 1, 1998 Arbitration Agreement with the Navajo
Nation. The Company subsequently filed a motion for summary judgment in that
litigation. Briefing of that motion was completed in June 2002 and oral
arguments were held in July. The parties are now awaiting a decision by the
court. On February 22, 2002, the Company's subsidiaries filed in the U.S.
District for the District of Columbia a motion for leave to file an amended
answer and conditional counterclaim. The counterclaim is conditional because the
Company's subsidiaries contend that the lease provisions the Navajo Nation seeks
to invalidate have previously been upheld in an arbitration proceeding and are
not subject to further litigation. The U.S. District Court subsequently allowed
our subsidiaries to file the amended answer and conditional counterclaim. On
March 4, 2002, the Company's subsidiaries filed in the U.S. District Court for
the District of Columbia a motion to transfer that case to Arizona or,
alternatively, to stay the District of Columbia litigation. On March 29, 2002,
the Navajo Nation filed a motion to dismiss the Arizona litigation and an
alternative motion to transfer the Arizona litigation to the District of
Columbia. On June 24, 2002, the U.S. District Court for the District of Columbia
denied the Company's subsidiaries' motion to transfer and motion to stay. On
July 15, 2002, the Company's subsidiaries filed an appeal of that decision with
the District of Columbia Court of Appeals.

While the outcome of litigation is subject to uncertainties, based on the
Company's preliminary evaluation of the issues and the potential impact on us,
we believe this matter will be resolved without a material adverse effect on the
Company's financial condition or results of operations.

Salt River Project Agricultural Improvement and Power District-Navajo Generating
Station

In May 1997, Salt River Project Agricultural Improvement and Power
District, or Salt River, acting for all owners of the Navajo Generating Station,
exercised their contractual option to review certain cumulative cost changes
during a five-year period from 1992 to 1996. Peabody Western sells approximately
7 to 8 million tons of coal per year to the owners of the Navajo Generation
Station under a long-term contract. In July 1999, Salt River notified Peabody
Western that it believed the owners were entitled to a price decrease of $1.92
per ton as a result of the review. Salt River also claimed entitlement to a
retroactive price adjustment to January 1997 and that an overbilling of $50.5
million had occurred during the same five-year period. In October 1999, Peabody
Western notified Salt River that it believed it was entitled to a $2.00 per ton
price increase as a result of the review. The parties were unable to settle the
pricing dispute and Peabody Western filed a demand for arbitration in September
2000. The arbitration hearing was held from April 8 to April 12, 2002. On July
20, 2002, Peabody Western received a favorable decision from the arbitrators.
The decision increases the price of coal by approximately $0.50 per ton from
1997 through 2001 and thereafter. As a result of the decision, the Company
received pre-tax earnings of approximately $22 million during the quarter ended
September 30, 2002. The exact impact of the ruling on the pricing of coal sales
from January 1, 2002

11

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

forward will not be determined until Salt River completes a review of the
cumulative cost changes under the contract for the years 1997 through 2001.

On February 12, 2001, in a related action, Salt River, again acting for
all owners of the Navajo Generating Station, filed a lawsuit against Peabody
Western in the Superior Court in Maricopa County in Arizona. This lawsuit sought
to compel arbitration of issues that Peabody Western did not believe were
subject to arbitration, namely, (1) the effective date of any price change
resulting from the resolution of the price review arbitration discussed above
and (2) the validity of Salt River's $50.5 million claim for alleged overcharges
by Peabody Western for the period from 1992 through 1996 (the five-year period
that was the subject of the price review). If the court declined to compel
arbitration of these issues, the lawsuit alternatively requested that the court
find in favor of Salt River on these issues. The Company removed this matter to
the U.S. District Court for the District of Arizona.

On October 3, 2001, the U.S. District Court issued an order that compelled
arbitration with respect to the effective date of any price change and
conditionally compelling arbitration with respect to the validity of Salt
River's $50.5 million claim. Although we filed an appeal of this decision with
the U.S. Ninth Circuit Court of Appeals, the arbitrators received testimony on
these claims during the April hearing. The arbitrators' July 20, 2002 ruling
rejected Salt River's $50.5 million overcharge claim and stated that the
effective date of the price change resulting from the review was January 1,
1997. The Company intends to seek a dismissal of its pending appeal.

Southern California Edison Company-Mohave Generating Station

In response to a demand for arbitration by one of our subsidiaries,
Peabody Western, Southern California Edison and the other owners of the Mohave
Generating Station filed a lawsuit on June 20, 1996 in the Superior Court of
Maricopa County, Arizona. The lawsuit sought a declaratory judgment that mine
decommissioning costs and retiree health care costs are not recoverable by
Peabody Western under the terms of a coal supply agreement dated May 26, 1976.
The contract expires in 2005.

Peabody Western filed a motion to compel arbitration which was granted by
the trial court. Southern California Edison, acting on behalf of all the owners
of the Mohave Generating Station, appealed this order to the Arizona Court of
Appeals, which denied its appeal. Southern California Edison, again acting on
behalf of all the owners of the Mohave Generating Station, then appealed the
order to the Arizona Supreme Court which remanded the case to the Arizona Court
of Appeals and ordered the appellate court to determine whether the trial court
was correct in determining that Peabody Western's claims are arbitrable. The
Arizona Court of Appeals ruled that neither mine decommissioning costs nor
retiree health care costs are to be arbitrated and that both issues should be
resolved in litigation. The matter has been remanded to the Superior Court of
Maricopa County, Arizona, where a trial was set for May 20, 2002. Peabody
Western answered the complaint and asserted counterclaims. The court then
permitted Southern California Edison, acting on behalf of all the owners of the
Mohave Generating Station, to amend its complaint to add a claim of overcharges
of at least $19.2 million by Peabody Western.

By order filed July 2, 2001, the court granted Peabody Western's motion
for summary judgment on liability with respect to retiree healthcare costs.
Southern California Edison filed a motion for reconsideration, which was denied
by the court on October 16, 2001. Peabody Western filed a supplemental motion
for summary judgment on liability with respect to mine decommissioning costs.
The court denied Peabody Western's supplemental motion for summary judgment in
an order filed on February 6, 2002.

The Company reached a mediated settlement with the owners of the Mohave
Generating Station which resulted in the recognition of $15.1 million in pre-tax
earnings during the quarter ended September 30, 2002. The settlement provides
for customer reimbursement of mine decommissioning and certain other post-mining
expenditures. The reimbursements will commence in January 2003 and continue on a
monthly basis through December 2005, although the owners of the Mohave
Generating Station have a prepayment option.

The Mohave coal supply agreement is scheduled to expire on December 31,
2005. In addition, 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.
The plant's owners have recently sought permission from the California Public
Utilities Commission for authorization to begin certain interim spending on air
pollution controls if the coal supply and water issues are resolved by December
31, 2002. The plant's owners and the Company are in active discussions to
resolve the complex issues critical to the continuation of the operation of the
Mohave plant 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 operations of the Mohave plant will cease or be delayed
beginning on December 31, 2005. The Mohave plant is the sole customer of the
Black Mesa Mine, which produces and sells 4.5 to 5 million tons of coal per
year.

12

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

Citizens Power

In connection with the sale of Citizens Power, the Company has indemnified
the buyer from certain losses resulting from specified power contracts and
guarantees. No claims have been asserted against the Company under this
indemnity.

Social Security Administration

In 1999, Eastern Associated Coal Corp. and Peabody Coal Company filed a
lawsuit in the U.S. District Court for the Western District of Kentucky against
the Social Security Administration asserting that the Social Security
Administration, under the Coal Act, had improperly assigned certain
beneficiaries to us. Subsequently, Peabody Coal and Eastern Associated moved for
summary judgment on this claim. Summary judgment was granted and in 2000, the
Social Security Administration filed an appeal of the district court's decision
with the U.S. Court of Appeals for the Sixth Circuit. On June 21, 2001, the
Sixth Circuit Court denied the Social Security Administration's appeal. The U.S.
Supreme Court granted the federal government's petition for certiorari in
January 2002 and the case was argued before the Supreme Court on October 8,
2002. We believe that the matter will be resolved without a material adverse
effect on our financial condition or results of operations. However, should the
Court rule against the Company's subsidiaries, earnings for the quarter ended
December 31, 2002 would be affected by the ruling and resulting claim determined
by the Social Security Administration.

Other

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, 2002, purchase commitments for capital expenditures were
approximately $97.2 million.

13

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

(13) SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION

In accordance with the indentures governing the Senior Notes and Senior
Subordinated Notes, certain wholly-owned U.S. subsidiaries of the Company have
fully and unconditionally guaranteed the Senior Notes and Senior Subordinated
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
Senior Notes and Senior Subordinated Notes. The following unaudited condensed
historical financial statement information is provided for such
Guarantor/Non-Guarantor Subsidiaries.

PEABODY ENERGY CORPORATION
UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 2002
(In thousands)

14

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

PEABODY ENERGY CORPORATION
UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
QUARTER ENDED SEPTEMBER 30, 2001
(In thousands)

15

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)

16

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

PEABODY ENERGY CORPORATION
UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 2001
(In thousands)

17

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

PEABODY ENERGY CORPORATION
UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2002
(In thousands)

18

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

PEABODY ENERGY CORPORATION
SUPPLEMENTAL CONDENSED CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2001
(In thousands)

19

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)

20

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

PEABODY ENERGY CORPORATION
UNAUDITED SUPPLEMENTAL CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2001
(In thousands)

21

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:

o growth in coal and power markets;

o coal's market share of electricity generation;

o timing of reductions in customer coal inventories;

o the pace and extent of the economic recovery;

o severity of weather;

o railroad and other transportation performance and costs;

o the ability to renew sales contracts upon expiration or
renegotiation;

o the ability to successfully implement operating strategies;

o the effectiveness of our cost-cutting measures;

o regulatory and court decisions;

o future legislation;

o credit, market and performance risk associated with our
customers;

o modification or termination of our long-term coal supply
agreements;

o reduction of purchases by major customers;

o risks inherent to mining, including geologic conditions or
unforeseen equipment problems;

o replacement of recoverable reserves;

o implementation of new accounting standards;

o inflationary trends and interest rates; and

o 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 and all documents incorporated by
reference. We will not update these statements unless the securities laws
require us to do so.

22

FISCAL YEAR CHANGE

In July 2001, we changed our fiscal year end from March 31 to December 31.
The change was first effective with respect to the nine months ended December
31, 2001.

FACTORS AFFECTING COMPARABILITY

Sale of Peabody Resources Limited Operations

In December 2000, we signed a share purchase agreement for the transfer of
the stock in two U.K. holding companies which, in turn, owned our Peabody
Resources Limited subsidiaries, to a subsidiary of Rio Tinto Limited. Our
Peabody Resources Limited operations consisted of interests in six coal mines,
as well as mining services in Brisbane, Australia. During the quarter ended
March 31, 2001, we received $455.0 million related to the sale, which closed on
January 29, 2001. We recorded a $171.7 million pretax gain on the sale.

Discontinued Operations

In August 2000, we sold Citizens Power, our subsidiary that marketed and
traded electric power and energy-related commodity risk management products, to
Edison Mission Energy. We classified Citizens Power as a discontinued operation
as of March 31, 2000, and recorded an estimated loss on the sale of $78.3
million, net of income taxes. During the fiscal year ended March 31, 2001, we
reduced our loss on the sale by $12.9 million; $1.2 million of the loss
reduction was recorded in the quarter ended March 31, 2001. These reductions of
the estimated loss reflected higher estimated proceeds from the monetization of
Citizens' power contracts as part of the wind-down of Citizens' operations.

QUARTER ENDED SEPTEMBER 30, 2002 COMPARED TO QUARTER ENDED SEPTEMBER 30, 2001

Sales. Sales for the quarter ended September 30, 2002 increased $58.0
million, to $689.0 million, a 9.2% increase from the prior year quarter. The
sales increase was driven by pricing increases in all regions, and a $27.7
million increase related to a favorable arbitration ruling resulting in a
retroactive price increase on our Navajo station coal supply agreement. This
ruling is discussed in detail in Note 12 to the unaudited condensed consolidated
financial statements included in Part I, Item 1 of this report. Our average
sales price was 11.0% higher than the prior year quarter. The average price
increase was favorably impacted by the arbitration ruling, and was negatively
impacted by sales mix, as higher priced tons in the Appalachia and Midwest
regions represented a lower percentage of overall sales in the current quarter
compared to the prior year quarter.

Beginning with the quarter ended September 30, 2002, the Company's
physically settled trading transactions were recorded on a net basis as a part
of "Other revenues," rather than on a gross basis within "Sales" and "Operating
costs and expenses." This accounting change, discussed in Note 8 to the
unaudited condensed consolidated financial statements included in Part I, Item 1
of this report, had no effect on operating profit or net income. All prior
period amounts were reclassified to conform with the current period
presentation.

U.S. mining and broker operations' sales volume was 46.1 million tons for
the current quarter, compared to 46.9 million tons for the prior year quarter, a
decrease of 1.7%. Volume at our Powder River Basin and Southwest operations
increased slightly from prior year levels, while volume at our Appalachia and
Midwest operations decreased from prior year levels as we reduced production to
match softer than expected demand and encountered geologic difficulties at two
of our eastern longwall mines.

Sales in the Southwest region were $33.1 million higher than the prior
year, primarily due to the effect of the arbitration ruling discussed
previously. Powder River Basin sales increased $32.6 million, due to improved
pricing combined with slightly higher sales volume. Appalachia region sales
decreased $10.3 million as a result of lower volume driven by the suspension of
the Big Mountain Mine in response to soft demand, and geologic problems at our
Harris Mine. The effect of decreased volume in Appalachia more than offset
improved per-ton pricing. Midwest region sales decreased $6.5 million, as higher
prices were offset by lower volume due to geologic problems at the Camp No. 11
Mine, combined with softer demand for coal. Finally, sales from coal brokerage
activities increased $7.7 million due to a favorable change in sales mix.

Other Revenues. Other revenues increased $1.0 million to $25.6 million in
the current quarter. The current quarter includes a $15.1 million gain related
to a mediated settlement regarding the Mohave station coal supply agreement.
This settlement is discussed in detail in Note 12 to the unaudited condensed
consolidated financial statements included in Part I,

23

Item 1 of this report. Revenues from trading operations decreased $4.0 million
in the current quarter, due to lower mark-to-market income on our trading
portfolio. Trading activities were scaled back in the quarter in response to a
decreasing number of creditworthy counterparties and lower liquidity in the
traded coal market in the current year. Our trading volume decreased 3.3 million
tons to 10.5 million tons traded during the quarter. The prior year quarter
included $4.8 million related to the monetization of a coal brokerage agreement
that had increased in value due to favorable market conditions. Finally, coal
royalty income decreased $3.4 million as the prior year quarter included a $3.0
million non-refundable advance royalty payment.

Operating Profit. Operating profit increased $15.0 million, or 41.3%, for
the quarter ended September 30, 2002. U.S. mining operations' (excluding
operating costs related to past mining activities and net gains on property
disposals) operating profit increased $29.1 million. The increase was driven by
the effect of the Navajo station arbitration ruling and Mohave station mediated
settlement, which increased operating profit by $37.1 million. Partially
offsetting the favorable resolution of these two customer issues were the
effects of lower production, geologic difficulties, and higher maintenance and
repairs expense, discussed in more detail below.

In the west, the Southwest's operating profit increased $29.9 million, as
the $37.1 million increase related to the Navajo station arbitration ruling and
Mohave station mediated settlement was partially offset by higher expenses for
truck, dragline and shovel maintenance and repairs. Powder River Basin region's
operating profit increased $5.5 million as improved prices and slightly higher
volume overcame higher repair and maintenance costs and higher royalty and tax
expenses associated with improved prices.

In the east, the Appalachia region's operating profit decreased $9.4
million due to higher per-ton mining costs related to the Big Mountain Mine
suspension, geologic difficulties at the Harris longwall and lower than planned
production levels. Operating profit in the Midwest region increased $3.2 million
compared to the prior year quarter as improved pricing at our Black Beauty
operations was partially offset by geologic difficulties at the Camp No. 11
mine, which lowered volume and increased per ton mining costs.

Operating profit from trading and brokerage operations decreased $4.7
million over the prior year quarter, primarily due the scaling back of trading
activities in response to a decreasing number of creditworthy counterparties and
lower liquidity in the traded coal market in the current year.

Operating costs related to past mining activities were $5.5 million higher
in the current quarter, primarily due to $5.7 million of excise tax refunds
included in the prior year quarter. In addition, net gain on property disposals
were $1.4 million lower in the current year quarter.

Interest Income. Interest income increased $5.3 million to $5.5 million in
the current quarter, primarily due to $4.6 million in interest income related to
excise tax refunds received during the quarter.

Interest Expense. Interest expense for the quarter was $25.8 million, a
$3.1 million decrease, or 10.7%, from the prior year quarter. The decrease in
interest expense was primarily due to lower short-term interest rates in the
current year quarter, which decreased the cost of our floating-rate debt.

Income Taxes. For the quarter ended September 30, 2002, there was an
income tax benefit of $1.5 million on income before income taxes and minority
interests of $31.0 million, compared to income tax expense of $1.0 million on
income before income taxes and minority interests of $7.6 million in the prior
year quarter. The tax benefit recorded in the current quarter reflects the
reduction of our effective tax rate from 10.0% for the six months ended June 30,
2002 to 5.0% for the nine months ended September 30, 2002. The reduction in our
effective tax rate reflects the increase in the benefit from the percentage
depletion tax deduction as a percentage of our pretax income, as well as our
ability to utilize existing net operating loss carryforwards. We had $630.9
million of net operating loss carryforwards available for federal income tax
purposes as of December 31, 2001.

NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2001

Sales. Sales for the nine months ended September 30, 2002 increased $86.7
million, or 4.6%, to $1,967.5 million. Excluding Australian mining operations,
sales increased $101.4 million, a 5.4% increase from the prior year period. The
sales increase was driven by pricing increases in all regions. Average sales
price was 6.9% higher than the prior year period. The average price increase was
impacted by the $27.7 million arbitration ruling on pricing under the Navajo
station coal supply agreement, but was slightly mitigated by sales mix, as
higher priced tons in the Appalachia and Midwest regions represented a lower
percentage of overall sales in the current period compared to the prior year
period.

24

U.S. mining and broker operations' sales volume for the nine months ended
September 30, 2002 was 137.3 million tons which approximated prior year volume
of 138.4 million tons. We had lower sales volume at our Appalachia and Midwest
operations, driven by softened market demand as a result of mild weather early
in the year, a slower U.S. economy, and more recently, the aggressive management
of stockpile levels by customers. These volume decreases more than offset
slightly higher sales volume at our Powder River Basin operations.

Powder River Basin sales increased $110.7 million, due to improved pricing
and slightly higher volume in the current year period. Sales in the Southwest
region were $35.5 million higher than the prior year, primarily due to the
effect of the arbitration ruling discussed previously, combined with slightly
higher pricing and volume. Appalachia region sales decreased $1.1 million, as a
result of lower volume from the suspension of the Big Mountain mine in response
to soft demand and longwall difficulties on the Harris longwall. Midwest region
sales decreased $29.2 million, as higher prices were more than offset by lower
volume due to geologic problems at the Camp No. 11 Mine and a delay in the
startup of two new mines in the region, combined with softer coal demand in the
current year. Finally, sales from coal brokerage activities decreased $14.6
million due to a change in sales mix.

Sales from our Australian mining operations decreased $14.6 million
compared to the prior year period. The current nine-month period includes $1.4
million of sales related to the AQC operations purchased in the current quarter,
while the prior year period includes $16.0 million of sales from our Peabody
Resources Limited operations that were sold in January 2001.

Other Revenues. Other revenues for the nine months ended September 30,
2002 decreased $2.5 million from the prior year period, to $79.8 million. The
current quarter includes a $15.1 million gain related to a mediated settlement
regarding the Mohave station coal supply agreement. Revenues from trading
operations increased $8.2 million, primarily due to improved year over year
trading results, including $10.0 million related to a forward sale that will
settle during 2003 and 2004. These improvements were offset by significantly
lower coal royalty revenues. Other revenues in the prior year period included
$12.0 million in non-refundable advance royalties, $9.9 million related to the
monetization of coal brokerage agreements that had increased in value due to
favorable market conditions and $4.5 million of mining services revenues from
our Peabody Resources Limited operations.

Selling and Administrative Expenses. Selling and administrative expenses
of $72.2 million for the nine months ended September 30, 2002 were $8.3 million
lower than the prior year period, due to the reduction of corporate expenses in
response to difficult market conditions in the current year, combined with stock
compensation charges recorded in the prior year period related in part to our
initial public offering.

Gain on Sale of Peabody Resources Limited Operations. On January 29, 2001,
we sold our Peabody Resources Limited operations to Coal & Allied, a 71%-owned
subsidiary of Rio Tinto Limited. The selling price was $446.8 million, plus the
assumption of all liabilities. We recorded a pretax gain of $171.7 million on
the sale. The gain on sale was $124.2 million after taxes, or $2.42 per diluted
common share for the nine months ended September 30, 2001.

Net Gain on Property and Equipment Disposals. Net gain on property and
equipment disposals of $3.5 million was $6.1 million lower than the prior year
period. The current period included a $2.4 million gain related to a rail track
sale, while the prior year period included a $6.4 million gain on the sale of
certain idle coal reserves and other small reserve and equipment sales.

Operating Profit. Excluding the effect of the gain on sale of Peabody
Resources Limited operations, operating profit increased $38.1 million, or
30.9%, to $161.5 million. Operating profit from U.S. operations increased $42.1
million, or 35.3%, to $161.2 million for the nine months ended September 30,
2002. The prior year period included operating profit of $4.3 million from
Peabody Resources Limited operations. The increase at the U.S. operations was
driven by higher operating profit of $65.1 million from U.S. mining operations
(excluding operating costs related to past mining activities and net gains on
property disposals) as a result of higher overall pricing due to contracts
signed in 2001, combined with the effect of the Navajo station arbitration
ruling and Mohave station mediated settlement, which increased operating profit
by $37.1 million.

In the west, the Powder River Basin region's operating profit increased
$23.5 million as improved prices and higher volume overcame higher royalty and
tax expenses associated with improved prices and higher repair and maintenance
costs. The Southwest region's operating profit increased $21.4 million as the
$37.1 million increase related to the Navajo arbitration ruling and Mohave
mediated settlement was partially offset by higher truck, dragline and shovel
maintenance and repairs expense. In addition, two outages of the Southwest
region's coal transportation pipeline contributed to higher costs in the current
year period.

25

In the east, operating profit in the Midwest region increased $11.8
million compared to the prior year period, as lower overall sales levels and
geologic difficulties at the Camp No. 11 mine were more than offset by improved
pricing and lower fuel and maintenance and repair costs at Black Beauty. The
Appalachia region's operating profit increased $8.3 million due to strong sales
price improvement, which overcame higher per ton mining costs due to lower than
planned production volume, the suspension of the Big Mountain mine in response
to lower demand and difficulties at the Harris mine's longwall.

Operating profit from trading and brokerage operations increased $8.3
million over the prior year period, primarily due to the $10.0 million
transaction discussed above in "Other Revenues." Our trading volume increased
from 35.9 million tons traded in the prior year period to 55.8 million tons
traded in the nine months ended September 30, 2002.

Operating costs related to past mining activities were $19.0 million
higher