West Virginia-based International Coal (NYSE: ICO) mines both thermal coal used in power plants and metallurgical (met) coal used in steel blast furnaces. The company’s main mines are located in Central and Northern Appalachia (CAPP and NAPP) in the eastern US, though the company also has exposure to the Illinois Basin.

There are three reasons to buy International Coal. First, the company vastly improved its financial position in late 2009 and early 2010 by eliminating much of its excessive debt and replacing that financing with equity (shares of stock). Second, the company is opening new mines and expanding existing operations, moves that will significantly increase the quantity of high-value met coal it produces. 

Finally, International Coal is a likely acquisition target for a host of US-focused producers, with Massey Energy (NYSE: MEE) considered a possible suitor.

The stock should do well, even if the company continues as a standalone entity. But given the pick-up in merger and acquisition (M&A) activity, the odds that International Coal is snapped up before the end of 2011 are better than 50-50. In such a transaction, International Coal would fetch a significant premium.

Financial Recapitalization

At the end of the third quarter of 2009, International Coal had some $426 million in long-term debt and less than $100 million in cash on the balance sheet. To make matters worse, weak fundamentals for the US coal market meant the company was at risk of violating financial covenants governing much of its outstanding debt, including a $100 million revolving credit line due to expire in June 2011. At the time, bankruptcy was a distinct possibility.

But International Coal successfully navigated the credit crisis. The company renegotiated debt covenants to prevent default and eventually reset its revolving credit line, increasing the size to $125 million and extending the maturity to February 2014.

Through a series of deals in late 2009 and early 2010, the firm restructured many of its bonds, exchanging the debt for shares of stock. As credit markets strengthened in early 2010, the company issued new bonds. This repositioning removed any pressing debt maturities that could have threatened the company’s expansion plans or financial stability.

As of the end of the third quarter of 2010, International Coal’s balance sheet is far healthier than it was a year ago. The company has more than $200 million in cash on the books and about $310 million in long-term borrowings, with no sizeable bond maturities until 2017.

For years I rated the company a sell in the Energy Watch List, primarily because of its weak financial state. This was one major reason the stock underperformed from 2005 to early 2009. But International Coal’s successful restructuring has transformed its prospects.

Growing Met Coal Production

In the Nov. 17, 2010, issue of The Energy Strategist, Buy Coal-Related Stocks This Holiday Season, I analyzed the fundamentals for both thermal and met coal in the US and abroad. Here’s a quick synopsis.

US thermal coal markets are slowly recovering from their post-recession hangover. During the severe recession of 2007-09, demand for electricity collapsed, and stocks of coal on hand at US utilities ballooned to glutted levels, pressuring prices.

Winter 2009-10 was unusually cold, while summer 2010 was abnormally hot. This extreme weather drove stronger seasonal demand for electricity, reducing utilities’ coal inventories. In addition, the US economic recovery has led to an uptick in power demand.

Coal markets have also been aided by an unlikely source: the US government. New environmental and safety regulations have raised the cost of mining coal and delayed planned mine expansions, particularly in CAPP. That’s driven out many smaller producers, reducing production and normalizing coal stockpiles.

US thermal coal prices are still weak and are likely to recover only gradually through the first half of 2011. But as inventories continue to normalize and electricity demand recovers, the latter half of next year is shaping up to be a much more hospitable market for producers of thermal coal. Over the long term the US could become an important exporter of thermal coal to Europe and Asia, where supplies are much tighter and prices are far more favorable.

The outlook for met coal is completely different. Met coal prices have soared, as global steel output has bounced back from its recessionary nadir. In particular, imports to China, India and other emerging economies have surged amid increasing demand. Meanwhile, in the second half of 2010 heavy rains in Australia and Indonesia hampered exports from these key markets, further tightening global supplies and pushing up prices. Exports of met coal from the US have helped to fill that supply gap.

Met coal has a much higher per-ton value than thermal coal, and the US is already a major exporter. US met coal prices reflect strong global demand; thermal coal prices hinge on domestic supply and demand.

International Coal boasts met coal reserves of 325 million short tons and steam coal reserves of 765 million tons. In addition, the company owns about two-thirds of its total coal reserves and three-quarters of its met coal reserves; leased reserves account for the remainder. Most Appalachian producers lease 60 to 70 percent of their reserves, so International Coal is in a favorable position.

In 2009 the company sold 16.8 million tons of coal, 15.8 million tons of steam coal and 1 million tons of met. But met coal’s share of total production is rising rapidly. In 2010 met coal will account for 2.4 to 2.5 million tons of International Coal’s output. Next year management expects the company to sell 16 to 17 million tons of coal, including as much as 3.4 million tons of met coal.

The company’s most exciting growth project is the Tygart No. 1 mine in northern West Virginia, a $300 million endeavor that should begin commercial production by late 2012. The underground mine is expected maximum annual output of 3.5 million tons per year by mid-2014. Half of this output will be met coal. Better yet, the mine is close to export terminals in Baltimore and Norfolk, Va.

International Coal will use longwall mining to extract coal from Tygart No. 1. This approach involves specialized machinery that cuts coal from the mine’s walls. The coal is then transported to the surface via conveyor belt. Longwall mining is cheaper than many underground mining techniques but requires certain geological conditions.

At the end of the third quarter, International Coal had already sold about three-quarters of its planned 2011 output under long-term contracts, protecting the company from near-term weakness in thermal coal prices. But roughly 40 percent of its projected met coal output is unsold; the firm boasts plenty of leverage to further improvement in met coal prices.

International Coal will benefit directly from ongoing improvement in met coal prices as it boosts production of this high-value coal. And although the thermal coal market will likely remain weak in the near term, the firm should benefit as the supply-demand balance improves toward the end of 2011.

Valuation and Target

M&A activity in coal mining and related industries has picked up in recent months.

Walter Energy’s (NYSE: WLT) proposed purchase of Canada’s Western Canadian Coal Corp (TSX: WTN) is the most recent North American deal. Both outfits are major producers of metallurgical coal. The combined company could produce as much as 20 million tons of coal per year by the end of 2013. Walter Energy’s bid represents a 50 percent premium to Western Canadian Coal’s closing price before the deal was announced.

Meanwhile, as I explained in the Nov. 23, 2010, installment of The Energy Letter, M&A Boom: The Next Takeover Targets in the Energy Sector, Caterpillar (NYSE: CAT) agreed to purchase former Portfolio Holding Bucyrus International (NSDQ: BUCY), a leading manufacturer of coal mining equipment.

A perennial takeover prospect, International Coal has an enterprise value (EV)–the total value of all of its stock and outstanding debt–of just $1.57 billion. That’s much smaller than several other Appalachian operators, including Massey Energy, which boasts an EV of almost $6 billion, and Virginia-based Alpha Natural Resources (NYSE: ANR), which has an EV of $6.5 billion.

International Coal could also be an attractive target for a foreign mining firm looking for a US foothold or a steel company looking to lock in met coal supplies.

The ratio of EV to earnings before interest, taxation, depreciation and amortization (EBITDA) is a common valuation metric for coal markets. On this basis, shares of International Coal trade at about 4.7 times forward EBITDA, a significant discount to some peers. For example, shares of Alpha Natural Resources trade at about 5.8 times 2011 EBITDA estimates, while shares of Massey Energy, itself the subject of serious takeover speculation, fetch 6.5 times 2011 EBITDA estimates.

In a strengthening coal market, I expect shares of International Coal to be worth roughly 6 to 7 times forward EBITDA. Based on expectations for 2012 EBITDA, the stock could be worth as much as $12 per share at some point next year. Today, an acquirer would likely have to pay north of $10 per share today. This premium will only increase as the coal market heats up.

Now marks an opportune time to establish a position in International Coal. WL Ross & Co and Fairfax Financial Holdings (TSX: FFH)–two key shareholders–sold 12.27 and 22.6 million shares of International Coal, respectively.

These sales didn’t change the total number of International Coal shares outstanding; the shares simply pass from these two major shareholders to other owners. However, many investors took the sale as a sign that an acquisition of International Coal isn’t imminent.

But WL Ross and Fairfax Financial are taking significant profits in the stock. It’s not unusual for early supporters of a company to take profits after a major run-up and plow the proceeds into new holdings. And both firms retain large stakes in the company as well as board representation–neither stakeholder is jumping ship. In fact, the stock remains WL Ross & Co’s third-largest holding and Fairfax Financial’s fifth-largest position.

The move suggests that rumors of an imminent acquisition in early December were overplayed; however, it doesn’t change the possibility that a takeover offer could emerge at some point in 2011.

I’ve been looking for an opportunity to add International Coal to the model Portfolios for some time. The recent pullback provides an excellent opportunity to buy a solid play on improving coal markets and a potential takeover target. International Coal, the latest addition to the Gushers Portfolio, is a buy under 8.

Deepwater Drilling and the Bakken Shale

Over the past two weeks I’ve received several queries about a deepwater contract driller and Bakken Shale producer mentioned in recent promotional efforts for The Energy Strategist.

My favorite deepwater driller remains Gushers Portfolio recommendation Seadrill (NYSE: SDRL). Seadrill owns the most modern fleet of deepwater drilling rigs in the industry and has minimal exposure to the Gulf of Mexico.

New regulations governing deepwater drilling in the Gulf of Mexico are likely to require state-of-the-art rigs equipped with powerful blowout preventers capable. Although West Africa and other markets may not pass similarly strict rules, producers have evinced a marked preference for the latest rigs. In the wake of the Macondo spill, I suspect producers will continue to pay up for advanced rigs.

In addition, Seadrill’s rigs are leased under long-term contracts, ensuring a reliable stream of guaranteed cash flow. The company recently upped its quarterly dividend to $0.65 per share. At the stock’s current price, that amounts to a yield of more than 8 percent. The firm also has the scope to support a dividend of $0.70 to $0.75 per quarter; further boosts to the payout could be in order. Seadrill rates a buy under 35.

I dedicated the Oct. 20, 2010, installment of The Energy Strategist, Rough Guide to Shale Oil, to the Bakken Shale and other unconventional oil plays in the US. This issue contains several specific recommendations for investing in these fast-growing fields.

Finally, I would recommend that all new subscribers check out the Fresh Money Buys list that appears at the end of every issue. This table lists my top picks in the three model Portfolios. It’s an excellent place to start for anyone looking to build a portfolio of energy stocks.