DBRS Downgrades Massey to BB (low)

DBRS has downgraded the Senior Unsecured Debt rating of Massey Energy Company (Massey or the Company) to BB (low) from BB. The trend is Stable. The rating action reflects DBRS’s concern over Massey’s aggressive leverage and the Company’s inability to sufficiently improve earnings performance. Previously, DBRS expected that the Company would improve profitability and reduce debt levels through higher realized coal prices and margins. However, while coal prices have trended upward, this has been largely offset by increasing costs and productivity difficulties.

Massey, in contrast to the other major U.S. coal companies, lacks geographic diversification, with its operations almost exclusively based in the region of Central Appalachia (CAPP). CAPP coal commands higher prices due to its combination of high energy (Btu) and low sulphur content. CAPP is also the only U.S. source of metallurgical coal, which has seen very sharp price increases owing to continued robust demand by steel producers, particularly those based in Asia. However, production costs are also significantly higher in CAPP given the long-term mining that has progressively degraded the reserve base. This is exacerbated by labour shortages, although DBRS notes that the Company has made progress on this front the past few months.

Over the past few years, Massey has consistently generated negative free cash flow as it incurred significant capital expenditures in an effort to improve productivity and increase capacity. This notwithstanding, 2006 production actually decreased approximately 10% year-over-year given ongoing geological difficulties and the closure (due to fire) of the Aracoma mine from January to July. Furthermore, despite a material increase of approximately 15% in realized prices, margins were flat in 2006 as cost increases wholly offset the higher realizations.

With the significant majority of the Company’s production subject to fixed-price contracts, improved realizations should lead to moderate revenue and earnings growth in 2007. However, lower spot coal prices (given mild weather and increasing inventories) may impact future contracts and affect profitability in 2008. Additionally, over the medium term, the relative pricing premium of CAPP coal is likely to decrease as a result of the planned rollout of emission-reducing scrubbers in the United States, which will effectively reduce the discount of Northern Appalachian coal (attributable to its higher sulphur content).

In the event that Massey were to generate free cash flow, it would potentially be allocated toward share buybacks given the Company’s existing $500 million share repurchase program, announced in November 2005. DBRS notes that the program initially stipulated that free cash flow be used for share repurchases, yet this was subsequently modified by the Company’s board of directors to include existing cash balances, resulting in $50 million of share repurchases in the second quarter of 2006. DBRS therefore expects the balance sheet to move sideways, with no material improvement in credit metrics in the near to medium term. (DBRS notes that the Company recently announced fourth quarter 2006 earnings in line with expectations.)

Note:
All figures are in U.S. dollars unless otherwise noted.