UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ___to ___

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 incorporation or organization)		(I.R.S. Employer 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)

(Former name, former address and former fiscal year, if changed since last report)

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. Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ       Accelerated filer o       Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

There were 263,814,300 shares of common stock with a par value of $0.01 per share outstanding at October 27, 2006.

 

 

INDEX

			Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2006 and 2005			2
Condensed Consolidated Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005			3
Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005			4
Notes to Unaudited Condensed Consolidated Financial Statements			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			28
Item 3. Quantitative and Qualitative Disclosures About Market Risk			44
Item 4. Controls and Procedures			46
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			47
Item 1A. Risk Factors			47
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			47
Item 6. Exhibits			47
SIGNATURE			48
EXHIBIT INDEX			49
Deed of Variation
Senior Notes Due 2016 Nineth Supplemental Indenture
Senior Notes Due 2013 Eleventh Supplemental Indenture
Amendment No.1 to Third Amended and Restated Credit Agreement
Certification of CEO Pursuant to Rule 13a-14(a)
Certification of EVP/CFO Pursuant to Rule 13a-14(a)
Certification of CEO Pursuant to 18 U.S.C. Section 1350
Certification of EVP/CFO Pursuant to 18 U.S.C. Section 1350

PART I – FINANCIAL INFORMATION

     Item 1. Financial Statements.

PEABODY ENERGY CORPORATION

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
REVENUES
Sales		$	1,223,274			$	1,191,282			$	3,805,838			$	3,343,620
Other revenues			41,714				32,228				87,348				66,156
Total revenues			1,264,988				1,223,510				3,893,186				3,409,776
COSTS AND EXPENSES
Operating costs and expenses			1,003,004				986,093				3,078,880				2,778,078
Depreciation, depletion and amortization			90,664				77,159				263,103				232,421
Asset retirement obligation expense			7,068				7,394				25,911				23,751
Selling and administrative expenses			31,488				57,009				118,793				135,440
Other operating income:
Net gain on disposal or exchange of assets			(35,040	)			(47,577	)			(94,309	)			(95,151	)
Income from equity affiliates			(5,200	)			(7,453	)			(19,132	)			(25,760	)
OPERATING PROFIT			173,004				150,885				519,940				360,997
Interest expense			26,392				25,327				79,130				76,088
Interest income			(1,886	)			(3,218	)			(6,026	)			(6,401	)
INCOME BEFORE INCOME TAXES AND MINORITY INTERESTS			148,498				128,776				446,836				291,310
Income tax provision			2,657				14,714				10,905				29,300
Minority interests			3,833				722				10,267				1,526
NET INCOME		$	142,008			$	113,340			$	425,664			$	260,484
EARNINGS PER SHARE:
Basic		$	0.54			$	0.43			$	1.61			$	1.00
Diluted		$	0.53			$	0.42			$	1.58			$	0.97
WEIGHTED AVERAGE SHARES OUTSTANDING:
Basic			263,444,254				262,432,394				263,631,134				261,591,722
Diluted			268,822,681				268,521,976				269,320,801				267,711,408
DIVIDENDS DECLARED PER SHARE		$	0.06			$	0.0475			$	0.18			$	0.1225

See accompanying notes to unaudited condensed consolidated financial statements.

PEABODY ENERGY CORPORATION

		(Unaudited)
		September 30, 2006				December 31, 2005
ASSETS
Current assets
Cash and cash equivalents		$	317,405			$	503,278
Accounts receivable, net of allowance for doubtful accounts of $11,164 at September 30, 2006 and $10,853 at December 31, 2005			244,730				221,541
Inventories			181,444				389,771
Assets from coal trading activities			96,087				146,596
Deferred income taxes			94,124				9,027
Other current assets			84,409				54,431
Total current assets			1,018,199				1,324,644
Property, plant, equipment and mine development, net of accumulated depreciation, depletion and amortization of $1,910,429 at September 30, 2006 and $1,627,856 at December 31, 2005			5,565,540				5,177,708
Investments and other assets			644,798				349,654
Total assets		$	7,228,537			$	6,852,006
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Current maturities of long-term debt		$	77,691			$	22,585
Liabilities from coal trading activities			80,695				132,373
Accounts payable and accrued expenses			853,003				867,965
Total current liabilities			1,011,389				1,022,923
Long-term debt, less current maturities			1,624,912				1,382,921
Deferred income taxes			254,387				338,488
Asset retirement obligations			407,365				399,203
Workers’ compensation obligations			240,312				237,574
Accrued postretirement benefit costs			975,413				959,222
Other noncurrent liabilities			329,621				330,658
Total liabilities			4,843,399				4,670,989
Minority interests			15,506				2,550
Stockholders’ equity
Preferred Stock – $0.01 per share par value; 10,000,000 shares authorized, no shares issued or outstanding as of September 30, 2006 or December 31, 2005			—				—
Series A Junior Participating Preferred Stock - 1,500,000 shares authorized as a subset of the preferred stock, no shares issued or outstanding as of September 30, 2006 or December 31, 2005
Series Common Stock – $0.01 per share par value; 40,000,000 shares authorized, no shares issued or outstanding as of September 30, 2006 or December 31, 2005			—				—
Common Stock – $0.01 per share par value; 800,000,000 shares authorized, 266,251,651 shares issued and 263,544,333 shares outstanding as of September 30, 2006 and 400,000,000 shares authorized, 263,879,762 shares issued and 263,357,402 shares outstanding as of December 31, 2005			2,667				2,638
Additional paid-in capital			1,562,113				1,497,454
Retained earnings			956,790				729,086
Accumulated other comprehensive loss			(48,245	)			(46,795	)
Treasury shares, at cost: 2,707,318 shares as of September 30, 2006 and 522,360 shares as of December 31, 2005			(103,693	)			(3,916	)
Total stockholders’ equity			2,369,632				2,178,467
Total liabilities and stockholders’ equity		$	7,228,537			$	6,852,006

See accompanying notes to unaudited condensed consolidated financial statements.

PEABODY ENERGY CORPORATION

		Nine Months Ended
		September 30,
		2006				2005
Cash Flows from Operating Activities
Net income		$	425,664			$	260,484
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, depletion and amortization			263,103				232,421
Deferred income taxes			(74,753	)			28,406
Amortization of debt discount and debt issuance costs			5,146				5,177
Net gain on disposal or exchange of assets			(94,309	)			(95,151	)
Income from equity affiliates			(19,132	)			(25,760	)
Dividends received from equity affiliates			9,935				6,082
Stock-based compensation			12,687				1,207
Changes in current assets and liabilities, net of acquisitions:
Accounts receivable, net of sale			4,990				(67,754	)
Inventories			(36,312	)			(46,204	)
Net assets from coal trading activities			(1,169	)			7,444
Other current assets			(26,458	)			(18,625	)
Accounts payable and accrued expenses			(30,136	)			119,229
Asset retirement obligations			(5,476	)			(4,082	)
Workers’ compensation obligations			2,738				6,943
Accrued postretirement benefit costs			16,191				6,167
Other, net			(18,411	)			6,185
Net cash provided by operating activities			434,298				422,169
Cash Flows from Investing Activities
Acquisitions, net (including acquisition of 19.99% of Excel Coal Limited)			(352,367	)			—
Additions to property, plant, equipment and mine development			(292,444	)			(228,339	)
Federal coal lease expenditures			(178,193	)			(118,364	)
Proceeds from disposal of assets			70,385				71,185
Purchase of mining assets			—				(56,500	)
Increase in note receivable			(17,077	)			—
Additions to advance mining royalties			(6,650	)			(9,061	)
Investment in joint venture			(1,471	)			(2,000	)
Net cash used in investing activities			(777,817	)			(343,079	)
Cash Flows from Financing Activities
Payments of long-term debt			(483,320	)			(15,621	)
Proceeds from long-term debt			440,750				11,459
Change in revolving line of credit			312,000				—
Common stock repurchase			(99,775	)			—
Dividends paid			(47,628	)			(32,041	)
Increase of securitized interests in accounts receivable			—				25,000
Excess tax benefit related to stock options exercised			30,775				—
Proceeds from stock options exercised			12,834				19,958
Payment of debt issuance costs			(8,621	)			—
Proceeds from employee stock purchases			4,518				3,010
Distributions to minority interests			(3,887	)			(1,750	)
Net cash provided by financing activities			157,646				10,015
Net increase (decrease) in cash and cash equivalents			(185,873	)			89,105
Cash and cash equivalents at beginning of period			503,278				389,636
Cash and cash equivalents at end of period		$	317,405			$	478,741

See accompanying notes to unaudited condensed consolidated financial statements.

PEABODY ENERGY CORPORATION

(1) Basis of Presentation

     The consolidated financial statements include the accounts of Peabody Energy Corporation (“the Company”) and its controlled affiliates. All intercompany transactions, profits, and balances have been eliminated in consolidation.

     Effective February 22, 2006, the Company implemented a two-for-one stock split on all shares of its common stock. The Company had a similar two-for-one stock split on March 30, 2005. All share and per share amounts in these unaudited condensed consolidated financial statements and related notes reflect the stock splits.

     The accompanying condensed consolidated financial statements as of September 30, 2006 and for the three and nine months ended September 30, 2006 and 2005, 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, 2005 has been derived from the Company’s audited consolidated balance sheet. The results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of the results to be expected for future quarters or for the year ending December 31, 2006. Certain amounts in prior periods have been reclassified to conform to the report classifications as of September 30, 2006 and for the three and nine months ended September 30, 2006, with no effect on previously reported net income or stockholders’ equity.

(2) New Accounting Pronouncements

     In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS No. 158”). SFAS No. 158 requires recognition of the funded status of pension and other postretirement benefit plans (an asset for overfunded status or a liability for underfunded status) in a company’s balance sheet. In addition, recognition of actuarial gains and losses, prior service cost, and any remaining transition amounts from the initial application of SFAS No. 87, “Employers’ Accounting for Pensions” (“SFAS No. 87”) and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” (“SFAS No. 106”) when determining a plan’s funded status is required, with the offset to accumulated other comprehensive income. SFAS No. 158 also requires fiscal-year-end measurements of plan assets and benefit obligations, eliminating the previously allowed use of earlier measurement dates.

     The Company is required to recognize the funded status of its defined benefit postretirement plans in its balance sheet for its fiscal year ending December 31, 2006. The requirement to measure plan assets and benefit obligations on fiscal-year-end balance sheets is effective for fiscal years ending December 31, 2008. The Company is currently evaluating the impact of this standard on its financial statements.

     In June 2006, the FASB issued Interpretation No. 48 “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN No. 48”). This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This interpretation is effective for fiscal years beginning after December 15, 2006 (January 1, 2007 for the Company). Any adjustments required upon the adoption of this interpretation must be recorded directly to retained earnings in the year of adoption and reported as a change in accounting principle. The Company is currently evaluating the impact of this interpretation on its financial statements.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

(3) Business Combinations and Acquisitions

     On July 5, 2006, the Company signed a Merger Implementation Agreement (the “Merger Implementation Agreement”) to acquire Excel Coal Limited (“Excel”), an independent coal company, by means of a scheme of arrangement transaction under Australian law (the “Transaction”). The Merger Implementation Agreement was amended on September 18, 2006, and the Company agreed to pay A$9.50 per share (US$7.16 as of the amendment date) for the outstanding shares of Excel. On September 20, 2006, as part of the amended agreement, the Company acquired 19.99% of the outstanding shares of Excel at A$9.50 per share (the “Advance Purchase”), resulting in payment of A$408.3 million, or US$307.8 million. The Company financed the Advance Purchase with borrowings under its new Senior Unsecured Credit Facility (see Note 7). The Company’s investment in Excel acquired under the Advance Purchase was recorded using the equity method of accounting as of September 30, 2006, and is included in Investments and other assets on the condensed consolidated balance sheet. On October 25, 2006, the Company acquired the remaining interest in Excel. See Note 15 for additional details of the Transaction.

(4) Resource Management and Other Commercial Events

     During the third quarter of 2006, the Company sold non-strategic coal reserves and surface lands located in Kentucky and West Virginia for proceeds of $34.6 million and recognized a gain of $30.0 million. Also, in June 2006, the Company exchanged with the Bureau of Land Management approximately 63 million tons of leased coal reserves at its Caballo mining operation for approximately 46 million tons of coal reserves contiguous with our North Antelope Rochelle mining operation. Based on the fair value of the coal reserves exchanged, the Company recognized a gain on assets exchanged totaling $39.2 million. This non-cash transaction is excluded from the statement of cash flows. The gains from these transactions are included in Gains on disposal or exchange of assets in the condensed consolidated income statements.

     The Company recognized $24.3 million and $35.8 million in the three and nine months ended September 30, 2006, respectively, in gains related to the settlement of commitments by a third party coal producer following a contract restructuring. The gains are included in Other revenues in the condensed consolidated income statements.

     In September 2005, the Company exchanged certain idle steam coal reserves for steam and metallurgical coal reserves as part of a contractual dispute settlement. Under the settlement, the Company received $10.0 million in cash, a new coal supply agreement that partially replaced the disputed coal supply agreement, and exchanged the idle steam coal reserves. As a result of the final settlement and based on the fair values of the items exchanged in the overall settlement transaction, the Company recorded net contract losses of $4.0 million and a gain on assets exchanged of $37.4 million. Also, in March 2005, the Company sold its remaining 0.838 million Penn Virginia Resource Partners, L.P. units for net proceeds of $41.9 million and recognized a $31.1 million gain on the sale. The gains from these transactions are included in Gains on disposal or exchange of assets in the condensed consolidated income statements.

(5) Inventories

     Inventories consisted of the following:

		September 30,				December 31,
		2006				2005
Saleable coal		$	76,714			$	64,274
Materials and supplies			82,180				65,942
Raw coal			22,550				14,033
Advance stripping			—				245,522
Total		$	181,444			$	389,771

     Advance stripping consisted of the costs to remove overburden above an unmined coal seam as part of the surface mining process. In March 2005, the Emerging Issues Task Force (“EITF”) issued EITF Issue No. 04-6, “Accounting for Stripping Costs in the Mining Industry” (“EITF Issue No. 04-6”). EITF Issue No. 04-6 and its interpretations require stripping costs incurred during a period to be attributed only to the inventory costs of the coal that is extracted during that same period. The Company adopted EITF Issue No. 04-6 on January 1, 2006 and utilized the cumulative effect adjustment approach whereby the cumulative effect adjustment reduced retained earnings by $150.3 million, net of tax. This non-cash

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

item is excluded from the statement of cash flows. Advance stripping costs are no longer included as a component of inventory.

(6) Assets and Liabilities from Coal Trading Activities

     The Company’s coal trading portfolio included forward and swap contracts as of September 30, 2006 and forward contracts as of December 31, 2005. The fair value of coal trading derivatives and related hedge contracts is set forth below:

		September 30, 2006								December 31, 2005
		Assets				Liabilities				Assets				Liabilities
Forward contracts		$	90,187			$	71,449			$	146,596			$	131,988
Other			5,900				9,246				—				385
Total		$	96,087			$	80,695			$	146,596			$	132,373

     Of the contracts in the Company’s trading portfolio as of September 30, 2006, 99.5% were valued utilizing prices from over-the-counter market sources, adjusted for coal quality and traded transportation differentials, and 0.5% of the Company’s contracts were valued based on similar market transactions.

     As of September 30, 2006, the estimated future realization of the value of the Company’s trading portfolio was as follows:

Year of		Percentage
Expiration		of Portfolio
2006			19	%
2007			31	%
2008			40	%
2009			10	%
			100	%

     At September 30, 2006, 72% of the Company’s credit exposure related to marked-to-market coal trading activities was with investment grade counterparties and 28% was with non-investment grade counterparties, which were primarily other coal producers. The Company’s coal trading operations traded 19.8 million tons and 13.7 million tons for the three months ended September 30, 2006 and 2005, respectively, and 48.5 million tons and 31.4 million tons for the nine months ended September 30, 2006 and 2005, respectively.

(7) Long-Term Debt

     The Company’s total indebtedness as of September 30, 2006 and December 31, 2005, consisted of the following:

		September 30,				December 31,
		2006				2005
Term Loan under Senior Unsecured Credit Facility		$	440,000			$	—
Term Loan under Senior Secured Credit Facility			—				442,500
Borrowings under Revolving Credit Facility			312,000				—
6.875% Senior Notes due 2013			650,000				650,000
5.875% Senior Notes due 2016			231,845				239,525
Fair value of interest rate swaps			(16,198	)			(8,879	)
5.0% Subordinated Note			58,805				66,693
Other			26,151				15,667
Total		$	1,702,603			$	1,405,506

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

Credit Facility

     On September 15, 2006, the Company entered into a Third Amended and Restated Credit Agreement (the “Agreement”), which established a $2.75 billion senior unsecured credit facility (the “Senior Unsecured Credit Facility”) and which amended and restated in full the Company’s then existing $1.35 billion senior secured credit facility (the “Senior Secured Credit Facility”). The Senior Unsecured Credit Facility provides a $1.8 billion Revolving Credit Facility (the “Revolver”) and a $950.0 million Term Loan Facility (the “Term Loan Facility”).

     The Revolver replaced the Company’s previous $900.0 million revolving credit facility, and the increased capacity is intended to accommodate working capital needs, letters of credit, the funding of capital expenditures and other general corporate purposes. The Revolver also includes a $50.0 million sub-facility available for same-day swingline loan borrowings. In September 2006, the Company borrowed $312.0 million under the Revolver.

     The Term Loan Facility consists of an unsecured $440.0 million portion (the “Term Loan”), which was drawn at closing to replace the previous term loan ($437.5 million balance at time of replacement; $442.5 million at December 31, 2005) issued under the Senior Secured Credit Facility. The Term Loan Facility also includes a Delayed Draw Term Loan Sub-Facility of up to $510.0 million, which is available only if used for the acquisition of Excel (see Note 15). The Company incurred $8.6 million in financing costs, of which $5.6 million related to the Revolver and $3.0 million related to the Term Loan. These debt issuance costs will be amortized to interest expense over five years, the term of the Senior Unsecured Credit Facility.

     Loans under the facility are available to the Company in U.S. dollars, with a sub-facility under the Revolver available in Australian dollars, pounds sterling and Euros. Letters of credit under the Revolver are available to the Company in U.S. dollars with a sub-facility available in Australian dollars, pounds sterling and Euros. The interest rate payable on the Revolver and the Term Loan under the Senior Unsecured Credit Facility is LIBOR plus 1.0% with step-downs to LIBOR plus 0.50% based on improvement in the leverage ratio, as defined in the Agreement. The applicable rates for the Revolver and the Term Loan were 6.33% and 6.39%, respectively, at September 30, 2006.

     Under the Senior Unsecured Credit Facility, the Company must comply with certain financial covenants on a quarterly basis including a minimum interest coverage ratio and a maximum leverage ratio, as defined in the Agreement. The financial covenants also place limitations on the Company’s investments in joint ventures, unrestricted subsidiaries, indebtedness of non-loan parties, and the imposition of liens on Company assets. The new facility is less restrictive with respect to limitations on the Company’s dividend payments, capital expenditures, asset sales or stock repurchases. The Senior Unsecured Credit Facility matures on September 15, 2011.

Interest Rate Swaps

     Prior to completion of the Senior Unsecured Credit Facility, the Company had two $400.0 million interest rate swaps. A $400.0 million notional amount floating-to-fixed interest rate swap was designated as a hedge of changes in expected cash flows on the previous term loan under the Senior Secured Credit Facility. Under this swap, the Company paid a fixed rate of 6.764% and received a floating rate of LIBOR plus 2.5% that reset each March 15, June 15, September 15 and December 15 based upon the three-month LIBOR rate. A $400.0 million notional amount fixed-to-floating interest rate swap 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 paid a floating rate of LIBOR plus 1.97% that reset each March 15, June 15, September 15 and December 15 based upon the three-month LIBOR rate and received a fixed rate of 6.875%.

     In conjunction with the completion of the new Senior Unsecured Credit Facility, the $400.0 million notional amount floating-to-fixed interest rate swap was terminated and resulted in payment to the Company of $5.2 million. The Company recorded the $5.2 million fair value of the swap in Other comprehensive income (loss) on the condensed consolidated balance sheet and will amortize this amount to interest expense over the remaining term of the forecasted interest payments initially hedged. The Company then entered into a $120.0 million notional amount floating-to-fixed interest rate swap with a fixed rate of 6.25% and a floating rate of LIBOR plus 1.0%. This interest rate swap was designated as a hedge of the variable interest payments on the Term Loan under the new Senior Unsecured Credit Facility.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

     The Company also terminated $280.0 million of its $400.0 million notional amount fixed-to-floating interest rate swap designated as a hedge of the changes in the fair value of the 6.875% Senior Notes due 2013. Reducing the notional amount of the interest rate swap to $120.0 million resulted in payment of $5.2 million to the counterparty. Reduction of the notional amount of the swap did not affect its floating and fixed rates. The $5.2 million of fair value associated with the termination of the $280.0 million portion of the swap was recorded as an adjustment to the carrying value of long-term debt and will be amortized to interest expense through the maturity of the 6.875% Senior Notes due 2013.

(8) Earnings Per Share and Share-based Compensation

Weighted Average Shares Outstanding

     A reconciliation of weighted average shares outstanding follows:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2006				2005				2006				2005
Weighted average shares outstanding — basic			263,444,254				262,432,394				263,631,134				261,591,722
Dilutive impact of stock options			5,378,427				6,089,582				5,689,667				6,119,686
Weighted average shares outstanding - diluted			268,822,681				268,521,976				269,320,801				267,711,408

Common Stock Repurchase

     In July 2005, the Company’s Board of Directors authorized a share repurchase program of up to 5% of the then outstanding shares of its common stock, or approximately 13.1 million shares. The repurchases may be made from time to time based on an evaluation of the Company’s outlook and general business conditions, as well as alternative investment and debt repayment options. During the three and nine months ended September 30, 2006, the Company repurchased 1.9 million and 2.2 million of its common shares at a cost of $88.3 million and $99.8 million, respectively.

Adoption of SFAS No. 123 (revised 2004), “Share-Based Payment”

     On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). SFAS No. 123(R) supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB Opinion No. 25”) and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including employee stock options, to be recognized ratably over the service period in the income statement based on their fair values at the grant date.

     The Company adopted SFAS No. 123(R) on January 1, 2006 and used the modified prospective method, in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123(R) for all share-based payments granted or modified after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date. Prior to January 1, 2006, the Company had elected to apply APB Opinion No. 25 and related interpretations in accounting for its stock option plans, as permitted under SFAS No. 123 and SFAS No. 148 “Accounting for Stock-Based Compensation-Transition and Disclosure.” Beginning in 2006, SFAS No. 123(R) also requires that excess income tax benefits from stock options exercised be recorded as financing cash inflow on the statements of cash flows. The excess income tax benefit from stock option exercises during 2005 is included in operating cash flows, netted in deferred tax activity.

     As part of its share-based compensation program, the Company utilizes restricted stock, nonqualified stock options, an employee stock purchase plan and performance units (discussed further below). The Company began utilizing restricted stock as part of its equity-based compensation strategy in January 2005. Accounting for restricted stock awards was not changed by the adoption of SFAS No. 123(R). The Company recognized $1.1 million and $0.2 million of expense, net of taxes, for the three months ended September 30, 2006 and 2005, respectively, and $3.1 million and $0.7 million of expense, net of taxes, for the nine months ended September 30, 2006 and 2005, respectively, related to restricted stock. For share-based payment instruments excluding restricted stock, the Company recognized a $1.4 million (or $0.01 per diluted share) reversal of expense and $11.2 million (or $0.04 per diluted share) of expense, net of taxes, for the three months ended September 30, 2006 and 2005, respectively, and $11.0 million (or $0.04 per diluted share) and $17.8 million (or $0.07 per diluted share) of expense, net of taxes, for the nine months ended September 30, 2006 and 2005, respectively. As a result of adopting SFAS No. 123(R), the Company’s net income for the three and nine months ended September 30, 2006 was $5.5 million (or $0.02 per diluted share) and $4.3 million (or $0.02 per diluted share) lower, respectively, than if it had continued

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

to account for share-based compensation under APB Opinion No. 25. Share-based compensation expense is recorded in Selling and administrative expenses in the condensed consolidated income statements. The Company used the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan share-based payments made before and after the adoption of SFAS No. 123(R). As of September 30, 2006, the total unrecognized compensation cost related to nonvested awards was $28.1 million, net of taxes, which is expected to be recognized over 5.0 years with a weighted-average period of 1.3 years.

     Stock Options

     Employee and director stock options granted since the Company’s initial public offering (“IPO”) of common stock in May 2001 generally vest ratably over three years and expire after 10 years from the date of the grant, subject to earlier termination upon discontinuation of an employee’s service. Options granted prior to the IPO generally cliff vest between 2007 and 2010. Of the 9.6 million options outstanding at September 30, 2006, 4.1 million options cliff vest in November 2007. Option grants are typically made in January of each year. The Company granted 0.5 million options during the nine months ended September 30, 2006, with a fair value of approximately $16.90 per option. These options were granted in the first quarter of 2006. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2006 and 2005, respectively; dividend yield of 0.8% and 1.0%; expected volatility (based on historical volatility) of 36% and 40%; risk-free interest rate of 4.3% and 3.6%; and an expected life of 5.3 years and 5.7 years. The Company recognized $1.2 million and $3.6 million of expense, net of taxes, for the three and nine months ended September 30, 2006, related to stock options.

     A summary of option activity under the plans as of September 30, 2006 is as follows:

										Weighted
						Weighted				Average
						Average				Remaining				Aggregate
		Nine Months Ended				Exercise				Contractual				Intrinsic Value
		September 30, 2006				Price				Life				(in millions)
Beginning balance			10,783,786			$	6.37
Granted			530,848				43.10
Exercised			(1,693,233	)			7.58
Forfeited			(33,990	)			5.88
Outstanding			9,587,411			$	8.19				4.3			$	277.5
Vested and Exercisable			2,717,122			$	8.65				6.2			$	76.4
Outstanding options:
Granted Pre-IPO			5,609,020
Granted Post-IPO			3,978,391
			9,587,411
Vested and exercisable options:
Granted Pre-IPO			237,468
Granted Post-IPO			2,479,654
			2,717,122

During the nine months ended September 30, 2006, the total intrinsic value of options exercised, defined as the excess fair value of the underlying stock over the exercise price of the options, was $76.9 million.

     Employee Stock Purchase Plan

     During 2001, the Company adopted an employee stock purchase plan. Eligible full-time and part-time employees are able to contribute up to 15% of their base compensation into this plan, subject to a limit of $25,000 per person per year. Employees are able to purchase Company common stock at a 15% discount to the lower of the fair market value of the Company’s common stock on the initial or ending dates of each six-month offering period. Offering periods begin on January 1 and July 1 of each year. The fair value of the six-month “look-back” option in the Company’s employee stock purchase plan is estimated by adding the fair value of 0.15 of one share of stock to the fair value of 0.85 of an option on one share of stock. The Company recognized $0.3 million and $0.9 million of expense, net of taxes, for the three and nine month periods ended September 30, 2006, respectively, related to its employee stock purchase plan.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

     Performance Units

     Performance units, which are typically granted annually in January by the Company, vest over a three year measurement period, subject to the achievement of performance goals and stock price performance at the conclusion of the three years. Three performance unit grants were outstanding during 2005 (the 2003, 2004 and 2005 grants) and 2006 (the 2004, 2005 and 2006 grants). The payout related to the 2003 grant (which was settled in cash in February 2006) was based on the Company’s stock price performance compared to both an industry peer group and an S&P Index. The payouts related to the 2004 grant (which will be settled in cash in February 2007) and 2005 and 2006 grants (which will be settled in common stock in 2008 and 2009, respectively) are based 50% on stock price performance compared to both an industry peer group and an S&P Index (a “market condition” under SFAS No. 123(R)) and 50% on a return on capital target (a “performance condition” under SFAS No. 123(R)). The Company granted 0.2 million performance units during the nine months ended September 30, 2006. Under APB Opinion No. 25, all of the performance unit awards were accounted for as variable awards. Under SFAS No. 123(R), the awards settled in cash are accounted for as liability awards and adjusted to fair value at each period-end, and the awards settled in common stock are accounted for based on their grant date fair value. The performance condition awards were valued utilizing the grant date fair values of the Company’s stock adjusted for dividends forgone during the vesting period. The market condition awards were valued utilizing a Monte Carlo simulation which incorporates the total shareholder return hurdles set for each grant. The assumptions used in the valuations of the 2005 and 2006 grants, respectively, were as follows: dividend yield of 0.8% and 1.0%; expected volatility of 36% and 40%; and risk-free interest rate of 4.25% and 3.25%. The Company recognized a reversal of expense of $2.9 million and an expense of $11.2 million, net of taxes, for the three months ended September 30, 2006 and 2005, respectively, and $6.5 million and $17.8 million of expense, net of taxes, for the nine months ended September 30, 2006 and 2005, respectively, related to performance units.

     As noted above, prior to adopting SFAS No. 123(R), the Company applied APB Opinion No. 25 and related interpretations to account for its equity incentive plans. The following table reflects 2005 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:

		Three Months Ended				Nine Months Ended
		September 30, 2005				September 30, 2005
Net income:
As reported		$	113,340			$	260,484
Pro forma			112,041				256,500
Basic earnings per share:
As reported		$	0.43			$	1.00
Pro forma			0.43				0.98
Diluted earnings per share:
As reported		$	0.42			$	0.97
Pro forma			0.42				0.96

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

(9) Comprehensive Income

     The following table sets forth the after-tax components of comprehensive income for the three and nine months ended September 30, 2006 and 2005:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Net income		$	142,008			$	113,340			$	425,664			$	260,484
Increase (decrease) in fair value of cash flow hedges, net of tax provision (benefit) of ($11,080) and $11,231 for the three months ended September 30, 2006 and 2005, respectively, and ($967) and $24,303 for the nine months ended September 30, 2006 and 2005, respectively			(16,620	)			16,757				(1,450	)			36,367
Comprehensive income		$	125,388			$	130,097			$	424,214			$	296,851

     Comprehensive income differs from net income by the amount of unrealized gain or loss resulting from valuation changes of the Company’s cash flow hedges (which include fuel and natural gas hedges, currency forwards and interest rate swaps) during the period. Changes in interest rates, crude oil, heating oil and natural gas prices and the U.S. dollar/Australian dollar exchange rate affect the valuation of these instruments.

(10) Pension and Postretirement Benefit Costs

Components of Net Periodic Pension Costs

     Net periodic pension costs included the following components:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Service cost for benefits earned		$	3,058			$	2,964			$	9,175			$	8,890
Interest cost on projected benefit obligation			11,508				11,373				34,525				34,119
Expected return on plan assets			(13,647	)			(13,203	)			(40,940	)			(39,609	)
Amortization of prior service cost			(8	)			(4	)			(24	)			(12	)
Amortization of net loss			5,671				6,147				17,013				18,441
Net periodic pension costs			6,582				7,277				19,749				21,829
Curtailment charges			—				—				—				9,527
Total pension costs		$	6,582			$	7,277			$	19,749			$	31,356

Curtailment

     The curtailment loss occurring during the nine months ended September 30, 2005 resulted from the termination of operations at two of the three operating mines that participate in the Western Surface UMWA Pension Plan (the “Plan”) during 2005. The loss is actuarially determined and consists of an increase in the actuarial liability, the accelerated recognition of previously unamortized prior service cost and contractual termination benefits under the Plan resulting from the termination of operations.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

Contributions

     The Company previously disclosed in its financial statements for the year ended December 31, 2005 that it expected to contribute $6.6 million to its funded pension plans and make $1.3 million in expected benefit payments attributable to its unfunded pension plans during 2006. As of September 30, 2006, $0.8 million of expected benefit payments attributable to the unfunded pension plans were made and $5.0 million in contributions were made to the funded pension plans.

Components of Net Periodic Postretirement Benefit Costs

     Net periodic postretirement benefit costs included the following components:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Service cost for benefits earned		$	1,880			$	1,355			$	5,639			$	4,004
Interest cost on accumulated postretirement benefit obligation			18,465				18,154				55,391				54,505
Amortization of prior service cost			(1,333	)			(1,355	)			(4,002	)			(4,004	)
Amortization of actuarial losses			8,012				6,579				24,036				19,729
Net periodic postretirement benefit costs		$	27,024			$	24,733			$	81,064			$	74,234

Cash Flows

     The Company expects to pay $86.2 million attributable to its postretirement benefit plans during 2006, which reflects an increase of $11.2 million from its previously disclosed amount in the financial statements for the year ended December 31, 2005. This increase in expected payments includes approximately $3 million of refunds under a dispute resolution relating to payments made by retirees over the last six years; and the remainder relates to higher than anticipated costs and utilization. As of September 30, 2006, payments of $64.7 million attributable to the Company’s postretirement benefit plans were made.

(11) Segment Information

     The Company reports its operations primarily through the following reportable operating segments: “Western U.S. Mining,” “Eastern U.S. Mining,” “Australian Mining” and “Trading and Brokerage.” Western U.S. Mining operations reflect the aggregation of the Powder River Basin, Southwest and Colorado operating segments, and Eastern U.S. Mining operations reflect the aggregation of the Appalachia and Midwest operating segments. The principal business of the Western U.S. Mining, Eastern U.S. Mining and Australian Mining segments is the mining, preparation and sale of steam coal, sold primarily to electric utilities, and metallurgical coal, sold to steel and coke producers. Western U.S. Mining operations are characterized by predominantly surface mining extraction processes, lower sulfur content and Btu of coal, and longer shipping distances from the mine to the customer. Conversely, Eastern U.S. Mining operations are characterized by a majority of underground mining extraction processes, higher sulfur content and Btu of coal, and shorter shipping distances from the mine to the customer. Geologically, Western operations mine bituminous and subbituminous coal deposits, and Eastern operations mine bituminous coal deposits. Australian Mining operations are characterized by surface and underground extraction processes, mining primarily low sulfur, high Btu coal sold to an international customer base. The Trading and Brokerage segment’s principal business is the marketing, brokerage and trading of coal. “Corporate and Other” includes selling and administrative expenses, net gains on property disposals, costs associated with past mining obligations, joint venture earnings related to the Company’s 25.5% investment in a Venezuelan mine and revenues and expenses related to the Company’s other commercial activities such as coalbed methane, generation development and resource management.

     The Company’s chief operating decision maker uses Adjusted EBITDA as the primary measure of segment profit and loss. Adjusted EBITDA is defined as income from operations before deducting net interest expense, income taxes, minority interests, asset retirement obligation expense and depreciation, depletion and amortization.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

     Operating segment results for the three and nine months ended September 30, 2006 and 2005 are as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Revenues:
Western U.S. Mining		$	428,263			$	403,214			$	1,260,670			$	1,184,445
Eastern U.S. Mining			505,603				452,825				1,537,561				1,315,480
Australian Mining			191,517				146,146				562,408				390,314
Trading and Brokerage			132,957				216,098				515,514				506,960
Corporate and Other			6,648				5,227				17,033				12,577
Total		$	1,264,988			$	1,223,510			$	3,893,186			$	3,409,776
Adjusted EBITDA (1) :
Western U.S. Mining		$	112,589			$	104,213			$	340,384			$	330,277
Eastern U.S. Mining			68,397				96,865				309,053				287,569
Australian Mining			75,248				39,780				188,932				101,345
Trading and Brokerage (2)			39,347				26,132				76,725				19,703
Corporate and Other (3)			(24,845	)			(31,552	)			(106,140	)			(121,725	)
Total		$	270,736			$	235,438			$	808,954			$	617,169

A reconciliation of Adjusted EBITDA to consolidated income before income taxes and minority interests follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Total Adjusted EBITDA		$	270,736			$	235,438			$	808,954			$	617,169
Depreciation, depletion and amortization			90,664				77,159				263,103				232,421
Asset retirement obligation expense			7,068				7,394				25,911				23,751
Interest expense			26,392				25,327				79,130				76,088
Interest income			(1,886	)			(3,218	)			(6,026	)			(6,401	)
Income before income taxes and minority interests		$	148,498			$	128,776			$	446,836			$	291,310

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

(12) Commitments and Contingencies

Commitments

     As of September 30, 2006, purchase commitments for capital expenditures were $90.8 million and federal coal reserve lease payments due over the next three years totaled $479.8 million.

Oklahoma Lead Litigation

     Gold Fields Mining, LLC (“Gold Fields”), one of the Company’s subsidiaries, is a dormant, non-coal producing entity that was previously managed and owned by Hanson PLC, a predecessor owner of the Company. In a February 1997 spin-off, Hanson PLC transferred ownership of Gold Fields to the Company, despite the fact that Gold Fields had no ongoing operations and the Company had no prior involvement in its past operations. The Company has agreed to indemnify a former affiliate of Gold Fields for certain claims. A predecessor of Gold Fields formerly operated two lead mills near Picher, Oklahoma prior to the 1950s and mined, in accordance with lease agreements and permits, approximately 1.5% of the total amount of the ore mined in the county.

     Gold Fields and two other companies are defendants in two class action lawsuits. The plaintiffs have asserted claims predicated on allegations of intentional lead exposure by the defendants and are seeking compensatory damages, punitive damages and the implementation of medical monitoring and relocation programs for the affected individuals. Gold Fields is also a defendant, along with other companies, in several personal injury lawsuits involving over 50 children, arising out of the same lead mill operations. Plaintiffs in these actions are seeking compensatory and punitive damages for alleged personal injuries from lead exposure. In December 2003, the Quapaw Indian tribe and certain Quapaw land owners filed a class action lawsuit against Gold Fields and five other companies. The plaintiffs are seeking compensatory and punitive damages based on a variety of theories. Gold Fields has filed a third-party complaint against the United States, and other parties. In February 2005, the state of Oklahoma on behalf of itself and several other parties sent a notice to Gold Fields and other companies regarding a possible natural resources damage claim. All of the lawsuits are pending in the U.S. District Court for the Northern District of Oklahoma.

     The outcome of litigation and these claims are subject to numerous uncertainties. Based on the Company’s evaluation of the issues and their potential impact, the amount of any future loss cannot be reasonably estimated. However, the Company believes this matter is likely to be resolved without a material adverse effect on the Company’s financial condition, results of operations or cash flows.

Navajo Nation

     On June 18, 1999, the Navajo Nation served three of the Company’s subsidiaries, including Peabody Western Coal Company (“Peabody Western”), with a complaint that had been filed in the U.S. District Court for the District of Columbia. The Navajo Nation has alleged 16 claims, including Civil Racketeer Influenced and Corrupt Organizations Act (“RICO”) violations and fraud. The complaint alleges that the defendants jointly participated in unlawful activity to obtain favorable coal lease amendments. 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 have terminated due to Peabody Western’s breach of these leases and a reformation of these leases to adjust the royalty rate to 20%. Subsequently, the court allowed the Hopi Tribe to intervene in this lawsuit and the Hopi Tribe is also seeking 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 rejecting the Navajo Nation’s allegation that the United States breached its trust responsibilities to the Tribe in approving the coal lease amendments.

     On February 9, 2005, the U.S. District Court for the District of Columbia granted a consent motion to stay the litigation until further order of the court. Peabody Western, the Navajo Nation, the Hopi Tribe and the owners of the power plants served by the suspended Black Mesa mine and the Kayenta mine are in mediation with respect to this litigation and other business issues.

     The outcome of litigation, or the current mediation, is subject to numerous uncertainties. Based on the Company’s evaluation of the issues and their potential impact, the amount of any future loss cannot be reasonably estimated. However, the Company believes this matter is likely to be resolved without a material adverse effect on the Company’s financial condition, results of operations or cash flows.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

The Future of the Mohave Generating Station and Black Mesa Mine

     The Company had been supplying coal to the Mohave Generating Station pursuant to a long-term coal supply agreement through its Black Mesa Mine. The mine terminated operations on December 31, 2005, and the coal supply agreement expired on that date. As a part of the alternate dispute resolution referenced in the Navajo Nation litigation, Peabody Western has been participating in mediation with the owners of the Mohave Generating Station and the Navajo Generating Station and the two tribes to resolve the complex issues surrounding groundwater and other disputes involving the two generating stations. On June 19, 2006, the owners of the Mohave Generating Station announced that they were halting efforts to reopen the plant and that they would try to sell it. On September 26, 2006, Salt River Project, one of the owners of the Mohave Generating Station, announced that it was attempting to form a new ownership group to operate the plant. There is no assurance that the Mohave Generating Station will resume operations. The Mohave plant was the sole customer of the Black Mesa Mine, which sold 4.6 million tons of coal in 2005. During 2005, the mine generated $29.8 million of Adjusted EBITDA, which represented 3.4% of the Company’s total 2005 Adjusted EBITDA of $870.4 million.

Salt River Project Agricultural Improvement and Power District — Mine Closing and Retiree Health Care

     Salt River Project and the other owners of the Navajo Generating Station filed a lawsuit on September 27, 1996, in the Superior Court of Maricopa County in Arizona seeking a declaratory judgment that certain costs relating to final reclamation, environmental monitoring work and mine decommissioning and costs primarily relating to retiree health care benefits are not recoverable by the Company’s subsidiary, Peabody Western, under the terms of a coal supply agreement dated February 18, 1977. The contract expires in 2011. The trial court subsequently ruled that the mine decommissioning costs were subject to arbitration but that the retiree health care costs were not subject to arbitration. The Company has recorded a receivable for mine decommissioning costs of $76.3 million and $74.2 million included in Investments and other assets in the condensed consolidated balance sheets as of September 30, 2006 and December 31, 2005, respectively.

     The outcome of litigation and arbitration is subject to numerous uncertainties. Based on the Company’s evaluation of the issues and their potential impact, the amount of any future loss cannot be reasonably estimated. However, the Company believes this matter is likely to be resolved without a material adverse effect on its financial condition, results of operations or cash flows.

Gulf Power Company Litigation

     On June 21, 2006, a Company subsidiary filed a complaint in the U.S. District Court, Southern District of Illinois, seeking a declaratory judgment upholding its declaration of a permanent force majeure under a coal supply agreement with Gulf Power Company. On June 22, 2006, Gulf Power Company filed a breach of contract lawsuit against the Company’s subsidiary in the U.S. District Court, Northern District of Florida, contesting the force majeure declaration and seeking damages for alleged past and future tonnage shortfalls of nearly 5 million tons under the coal supply agreement, which would have expired on December 31, 2007. The parties have filed motions to determine which court will hear the lawsuits. On October 6, 2006, the Florida District Court stayed Gulf Power’s lawsuit until the Illinois court decides whether it has jurisdiction.

     The outcome of these lawsuits is subject to numerous uncertainties. Based on the Company’s evaluation of the issues and their potential impact, the amount of any future loss cannot reasonably be estimated. However, the Company believes this matter is likely to be resolved without a material adverse effect on its financial condition, results of operations or cash flows.

Environmental

     The Company is subject to federal, state and local environmental laws and regulations, including the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (“CERCLA” or “Superfund”), the Superfund Amendments and Reauthorization Act of 1986, the Clean Air Act, the Clean Water Act and the Conservation and Recovery Act. Superfund and similar state laws create liability for investigation and remediation in response to releases of hazardous substances in the environment and for damages to natural resources. Under that legislation and many state Superfund statutes, joint and several liability may be imposed on waste generators, site owners and operators and others regardless of fault. These regulations could require the Company to do some or all of the following:

	•		remove or mitigate the effects on the environment at various sites from the disposal or release of certain substances;
	•		perform remediation work at such sites; and
	•		pay damages for loss of use and non-use values.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

     Environmental claims have been asserted against Gold Fields related to activities of Gold Fields or its former affiliates. Gold Fields has been named a potentially responsible party (“PRP”) based on CERCLA at five sites, and claims have been asserted at 18 other sites. The number of PRP sites in and of itself is not a relevant measure of liability, because the nature and extent of environmental concerns varies by site, as does Gold Fields’ estimated share of responsibility.

     The Company’s policy is to accrue environmental cleanup-related costs of a non-capital 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 the nature and extent of contamination, the timing, extent and method of the remedial action, 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. The Company also assesses the financial capability and proportional share of costs of other PRPs 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 in the estimation of liabilities recorded in its condensed consolidated balance sheets. Undiscounted liabilities for environmental cleanup-related costs for all of the sites noted above totaled $40.2 million as of September 30, 2006 and $42.5 million as of December 31, 2005, $21.8 million and $23.6 million of which was reflected as a current liability, respectively. These amounts represent those costs that the Company believes are probable and reasonably estimable. In September 2005, Gold Fields and other PRPs received a letter from the U.S. Department of Justice alleging that the PRPs’ mining operations caused the Environmental Protection Agency (“EPA”) to incur approximately $125 million in residential yard remediation costs at Picher, Oklahoma and will cause the EPA to incur additional remediation costs relating to historic mining sites. Gold Fields has participated in the ongoing settlement discussions. A predecessor of Gold Fields formerly operated two lead mills near Picher, Oklahoma prior to the 1950s and mined, in accordance with lease agreements and permits, approximately 1.5% of the total amount of the ore mined in the county. Gold Fields believes it has meritorious defenses to these claims. Gold Fields is involved in other litigation in the Picher area, and the Company has agreed to indemnify one of the defendants in this litigation as discussed under the “Oklahoma Lead Litigation” caption above. Significant uncertainty exists as to whether claims will be pursued against Gold Fields in all cases, and where they are pursued, the amount of the eventual costs and liabilities, which could be greater or less than this provision.

     Although waste substances generated by coal mining and processing are generally not regarded as hazardous substances for the purposes of Superfund and similar legislation, some products used by coal companies in operations, such as chemicals, and the disposal of these products are governed by the statute. Thus, coal mines currently or previously owned or operated by the Company, and sites to which the Company has sent waste materials, may be subject to liability under Superfund and similar state laws.

Other

     In addition, the Company at times becomes a party to other claims, lawsuits, arbitration proceedings and administrative procedures in the ordinary course of business. Management believes that the ultimate resolution of such other pending or threatened proceedings is not reasonably likely to have a material effect on the financial position, results of operations or liquidity of the Company.

(13) Guarantees

     In the normal course of business, the Company is a party to the following guarantees:

     The Company owns a 30.0% interest in a partnership that leases a coal export terminal from the Peninsula Ports Authority of Virginia under a 30-year lease that permits the partnership to purchase the terminal at the end of the lease term for a nominal amount. The partners have severally (but not jointly) agreed to make payments under various agreements which in the aggregate provide the partnership with sufficient funds to pay rents and to cover the principal and interest payments on the floating-rate industrial revenue bonds issued by the Peninsula Ports Authority, and which are supported by letters of credit from a commercial bank. As of September 30, 2006, the Company’s maximum reimbursement obligation to the commercial bank is in turn supported by a letter of credit totaling $42.8 million.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

     The Company has guaranteed the performance of Asset Management Group (“AMG”) under its coal purchase contract with a third party, which has terms extending through December 31, 2006. Default occurs if AMG does not deliver specified monthly tonnage amounts to the third party. In the event of a default, the Company would assume AMG’s obligation to ship coal at agreed prices for the remaining term of the contract. As of September 30, 2006, the maximum potential future payments under this guarantee are approximately $0.7 million, based on recent spot coal prices. As a matter of recourse in the event of a default, the Company has access to cash held in escrow and the ability to trigger an assignment of AMG’s assets to the Company. Based on these recourse options and the remote probability of non-performance by AMG due to its prior operating history, the Company has valued the liability associated with the guarantee at zero.

     As part of arrangements through which the Company obtains exclusive sales representation agreements with small coal mining companies (the “Counterparties”), the Company issued financial guarantees on behalf of the Counterparties. These guarantees facilitate the Counterparties’ efforts to obtain bonding or financing. In July 2006, the Company issued $5.2 million of financial guarantees, expiring at various dates through July 2013, on behalf of a certain Counterparty to facilitate its efforts in obtaining financing. In the event of default, the Company has multiple recourse options, including the ability to assume the loans and procure title and use of the equipment purchased through the loans. If default occurs, the Company has the ability and intent to exercise its recourse options, so the liability associated with the guarantee has been valued at zero. The Company also guaranteed bonding for a partnership in which it formerly held an interest. The aggregate amount guaranteed by the Company for all such Counterparties was $11.5 million, and the fair value of the guarantees recognized as a liability was $0.4 million as of September 30, 2006. The Company’s obligations under the guarantees extend to September 2015.

     In March 2006, the Company issued a guarantee for certain equipment lease arrangements on behalf of one of the sales representation parties with maximum potential future payments totaling $2.9 million at September 30, 2006, and with lease terms that extend to April 2010. The Company has multiple recourse options in the event of default, including the ability to assume the lease and procure use of the equipment or to settle the lease and take title to the assets. If default occurs, the Company has the ability and intent to exercise its recourse options, so the liability associated with the guarantee has been valued at zero.

     The Company is the lessee under numerous equipment and property leases. It is common in such commercial lease transactions for the Company, as the lessee, to agree to indemnify the lessor for the value of the property or equipment leased, should the property be damaged or lost during the course of the Company’s operations. The Company expects that losses with respect to leased property would be covered by insurance (subject to deductibles). The Company and certain of its subsidiaries have guaranteed other subsidiaries’ performance under their various lease obligations. Aside from indemnification of the lessor for the value of the property leased, the Company’s maximum potential obligations under its leases are equal to the respective future minimum lease payments and assume that no amounts could be recovered from third parties.

     The Company has provided financial guarantees under certain long-term debt agreements entered into by its subsidiaries, and substantially all of the Company’s subsidiaries provide financial guarantees under long-term debt agreements entered into by the Company. The maximum amounts payable under the Company’s debt agreements are equal to the respective principal and interest payments. Supplemental guarantor/non-guarantor financial information is provided in Note 14.

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 due 2013 and the 5.875% Senior Notes due 2016, certain wholly-owned U.S. subsidiaries of the Company have fully and unconditionally guaranteed the 6.875% Senior Notes and the 5.875% 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 and the 5.875% Senior Notes. The following unaudited condensed historical financial statement information is provided for the Guarantor/Non-Guarantor Subsidiaries.

Peabody Energy Corporation
Unaudited Supplemental Condensed Consolidated Statements of Operations

		Three Months Ended September 30, 2006
		Parent				Guarantor				Non-Guarantor
		Company				Subsidiaries				Subsidiaries				Eliminations				Consolidated
Total revenues		$	—			$	1,005,582			$	286,246			$	(26,840	)		$	1,264,988
Costs and expenses:
Operating costs and expenses			(2,416	)			835,195				197,065				(26,840	)			1,003,004
Depreciation, depletion and amortization			—				76,181				14,483				—				90,664
Asset retirement obligation expense			—				6,772				296				—				7,068
Selling and administrative expenses			3,056				27,594				838				—				31,488
Other operating (income) loss:
Net gain on disposal or exchange of assets			—				(24,521	)			(10,519	)			—				(35,040	)
(Income) loss from equity affiliates			—				1,250				(6,450	)			—				(5,200	)
Interest expense			41,109				13,688				3,286				(31,691	)			26,392
Interest income			(4,916	)			(21,963	)			(6,698	)			31,691				(1,886	)
Income (loss) before income taxes and minority interests			(36,833	)			91,386				93,945				—				148,498
Income tax provision (benefit)			(11,055	)			(5,613	)			19,325				—				2,657
Minority interests			—				—				3,833				—				3,833
Net income (loss)		$	(25,778	)		$	96,999			$	70,787			$	—			$	142,008

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

Peabody Energy Corporation
Unaudited Supplemental Condensed Consolidated Statements of Operations

		Three Months Ended September 30, 2005
		Parent				Guarantor				Non-Guarantor
		Company				Subsidiaries				Subsidiaries				Eliminations				Consolidated
Total revenues		$	—			$	958,723			$	288,488			$	(23,701	)		$	1,223,510
Costs and expenses:
Operating costs and expenses			(12,025	)			778,312				243,507				(23,701	)			986,093
Depreciation, depletion and amortization			—				68,482				8,677				—				77,159
Asset retirement obligation expense			—				8,049				(655	)			—				7,394
Selling and administrative expenses			1,288				53,753				1,968				—				57,009
Other operating income:
Net gain on disposal or exchange of assets			—				(47,516	)			(61	)			—				(47,577	)
Income from equity affiliates			—				(2,393	)			(5,060	)			—				(7,453	)
Interest expense			39,163				13,606				5,463				(32,905	)			25,327
Interest income			(6,255	)			(22,941	)			(6,927	)			32,905				(3,218	)
Income (loss) before income taxes and minority interests			(22,171	)			109,371				41,576				—				128,776
Income tax provision (benefit)			(5,694	)			13,128				7,280				—				14,714
Minority interests			—				—				722				—				722
Net income (loss)		$	(16,477	)		$	96,243			$	33,574			$	—			$	113,340

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

Peabody Energy Corporation
Unaudited Supplemental Condensed Consolidated Statements of Operations

		Nine Months Ended September 30, 2006
		Parent				Guarantor				Non-Guarantor
		Company				Subsidiaries				Subsidiaries				Eliminations				Consolidated
Total revenues		$	—			$	2,994,463			$	978,810			$	(80,087	)		$	3,893,186
Costs and expenses:
Operating costs and expenses			(14,746	)			2,434,734				738,979				(80,087	)			3,078,880
Depreciation, depletion and amortization			—				222,523				40,580				—				263,103
Asset retirement obligation expense			—				25,249				662				—				25,911
Selling and administrative expenses			12,525				104,577				1,691				—				118,793
Other operating (income) loss:
Net gain on disposal or exchange of assets			—				(83,822	)			(10,487	)			—				(94,309	)
(Income) loss from equity affiliates			—				2,882				(22,014	)			—				(19,132	)
Interest expense			121,232				42,233				10,198				(94,533	)			79,130
Interest income			(15,624	)			(63,834	)			(21,101	)			94,533				(6,026	)
Income (loss) before income taxes and minority interests			(103,387	)			309,921				240,302				—				446,836
Income tax provision (benefit)			(30,288	)			(2,951	)			44,144				—				10,905
Minority interests			—				—				10,267				—				10,267
Net income (loss)		$	(73,099	)		$	312,872			$	185,891			$	—			$	425,664

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

Peabody Energy Corporation
Unaudited Supplemental Condensed Consolidated Statements of Operations

		Nine Months Ended September 30, 2005
		Parent				Guarantor				Non-Guarantor
		Company				Subsidiaries				Subsidiaries				Eliminations				Consolidated
Total revenues		$	—			$	2,723,479			$	751,058			$	(64,761	)		$	3,409,776
Costs and expenses:
Operating costs and expenses			(19,416	)			2,225,082				637,173				(64,761	)			2,778,078
Depreciation, depletion and amortization			—				207,868				24,553				—				232,421
Asset retirement obligation expense			—				23,251				500				—				23,751
Selling and administrative expenses			2,836				128,109				4,495				—				135,440
Other operating income:
Net gain on disposal or exchange of assets			—				(94,994	)			(157	)			—				(95,151	)
Income from equity affiliates			—				(9,664	)			(16,096	)			—				(25,760	)
Interest expense			114,939				41,336				16,824				(97,011	)			76,088
Interest income			(16,349	)			(67,656	)			(19,407	)			97,011				(6,401	)
Income (loss) before income taxes and minority interests			(82,010	)			270,147				103,173				—				291,310
Income tax provision (benefit)			(23,463	)			37,715				15,048				—				29,300
Minority interests			—				—				1,526				—				1,526
Net income (loss)		$	(58,547	)		$	232,432			$	86,599			$	—			$	260,484

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

Peabody Energy Corporation
Unaudited Supplemental Condensed Consolidated Balance Sheets

		September 30, 2006
		Parent				Guarantor				Non-Guarantor
		Company				Subsidiaries				Subsidiaries				Eliminations				Consolidated
ASSETS
Current assets
Cash and cash equivalents		$	298,883			$	3,737			$	14,785			$	—			$	317,405
Accounts receivable, net			1,153				20,636				222,941				—				244,730
Inventories			—				145,564				35,880				—				181,444
Assets from coal trading activities			—				96,087				—				—				96,087
Deferred income taxes			—				94,124				—				—				94,124
Other current assets			24,761				43,478				16,889				(719	)			84,409
Total current assets			324,797				403,626				290,495				(719	)			1,018,199
Property, plant, equipment and mine development — at cost			—				6,894,262				581,707				—				7,475,969
Less accumulated depreciation, depletion and amortization			—				(1,748,431	)			(161,998	)			—				(1,910,429	)
Investments and other assets			5,483,638				96,637				393,832				(5,329,309	)			644,798
Total assets		$	5,808,435			$	5,646,094			$	1,104,036			$	(5,330,028	)		$	7,228,537
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Current maturities of long-term debt		$	16,500			$	60,019			$	1,172			$	—			$	77,691
Payables and notes payable to affiliates, net			1,700,096				(2,124,830	)			424,734				—				—
Liabilities from coal trading activities			—				80,695				—				—				80,695
Accounts payable and accrued expenses			19,621				697,167				136,934				(719	)			853,003
Total current liabilities			1,736,217				(1,286,949	)			562,840				(719	)			1,011,389
Long-term debt, less current maturities			1,601,148				12,274				11,490				—				1,624,912
Deferred income taxes			14,055				224,960				15,372				—				254,387
Other noncurrent liabilities			21,293				1,923,568				7,850				—				1,952,711
Total liabilities			3,372,713				873,853				597,552				(719	)			4,843,399
Minority interests			—				—				15,506				—				15,506
Stockholders’ equity			2,435,722				4,772,241				490,978				(5,329,309	)			2,369,632
Total liabilities and stockholders’ equity		$	5,808,435			$	5,646,094			$	1,104,036			$	(5,330,028	)		$	7,228,537

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS, continued

Peabody Energy Corporation
Supplemental Condensed Consolidated Balance Sheets

		December 31, 2005
		Parent				Guarantor				Non-Guarantor
		Company				Subsidiaries				Subsidiaries				Eliminations				Consolidated
ASSETS
Current assets
Cash and cash equivalents		$	494,232			$	2,500			$	6,546			$	—			$	503,278
Accounts receivable, net			4,260				78,544				138,737				—				221,541
Inventories			—				329,116				60,655				—				389,771
Assets from coal trading activities			—				146,596				—				—				146,596
Deferred income taxes			—				9,027				—				—				9,027
Other current assets			21,817				23,347				9,267				—				54,431
Total current assets			520,309				589,130				215,205				—				1,324,644
Property, plant, equipment and mine development — at cost			—				6,081,631				723,933				—				6,805,564
Less accumulated depreciation, depletion and amortization			—				(1,541,834	)			(86,022	)			—				(1,627,856	)
Investments and other assets			4,971,500				292,105				63,432				(4,977,383	)			349,654
Total assets		$	5,491,809			$	5,421,032			$	916,548			$	(4,977,383	)		$	6,852,006
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Current maturities of long-term debt		$	10,625			$	11,034			$	926			$	—			$	22,585
Payables and notes payable to affiliates, net			1,875,361				(2,355,653	)			480,292				—				—
Liabilities from coal trading activities			—				132,373				—				—				132,373
Accounts payable and accrued expenses			24,560				732,317				111,088				—				867,965
Total current liabilities			1,910,546				(1,479,929	)			592,306				—				1,022,923
Long-term debt, less current maturities			1,312,521				69,014				1,386				—				1,382,921
Deferred income taxes			12,903				304,740				20,845				—				338,488
Other noncurrent liabilities			11,282				1,908,158				7,217				—				1,926,657
Total liabilities			3,247,252				801,983				621,754				—				4,670,989
Minority interests			—				—				2,550				—				2,550
Stockholders’ equity			2,244,557				4,619,049				292,244				(4,977,383	)			2,178,467
Total liabilities and stockholders’ equity		$	5,491,809			$	5,421,032			$	916,548			$	(4,977,383	)		$	6,852,006