(Coal story updated with IBISWorld market analysis.)
NEW YORK (TheStreet) -- Why invest in coal stocks? For one thing, coal stocks could certainly help diversify the investment portfolio. "More positive investors could opt to increase exposure to copper and met coal related equities, as tight markets are forecast to result in higher prices," BMO Capital Markets analyst Meredith Bandy said in an October client note.

Standard & Poor's analyst Mathew Christy echoed those thoughts, telling TheStreet that significant reduction of coal inventories in the U.S. should provide some support for pricing and demand over the next twelve months.

According to Christy, steel production, a major source of coal demand, heated up in 2010, after seeing significant reductions through 2009. Although production has leveled off to a degree from earlier in the year, Christy noted that metallurgical coal should remain in demand if steel production capacity utilization rates stay over 70%; based on recent industry reports, capacity utilization rates for steel production has indeed been over 70% thus far.

IBISWorld said that the coal mining industry should generate revenue of about $40.15 billion in 2010 compared with $30.79 billion in 2005, reflecting average annualized growth of 5.4% over the period. The firm said production is expected to pick up steam during 2010, with demand moving toward low sulfur-type coals normally found in Wyoming. IBISWorld said coal exports have been rising over the past five years, given that firms have been serving the Asia emerging markets where steel production is still booming relative to the U.S. markets.

At this point, IBISWorld expects coal exports to increase at an annual rate of 12.7% in the five years to 2010.

Read on to for insight into the four coal stocks that TheStreet believes bear the strongest fundamentals...

Peabody Energy ( BTU


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Number of Analysts: 24

Average Recommendation: Outperform

Stock Price/Earnings Ratio vs. Industry's: 105.51%

Market Cap: $13.9 billion

Trailing Twelve-Month Operating Margin: 15.3%

Trailing Twelve-Month Revenue: $6.4 billion

Why Peabody Is a Strong Stock: Mathew Christy, Coal Industry Equity Analyst at Standard & Poor's Equity Research said, "I just downgraded Peabody Energy from a strong buy to a buy, but that was more for valuation reasons. The stocks had appreciated about 21% since Sept. 1, but if you do look at the underlying fundamentals of the company, I think that that's probably one of the better coal stocks out there."

One reason for that assessment is its overall size. Coal mining is a very capital-intensive business so that leads me to conclude that companies with a lot of productive capability, a lot of operational scale, tend to have a better fundamental outlook relative to their peers, so Peabody being one of the largest publicly-traded U.S. coal companies fits that bill.

"Secondly, Peabody Energy has -- relative to its U.S. peers -- direct exposure to some of the higher-growth international markets such as India and China via its Australian operations. Peabody has direct ownership in mines in Australia, which produces a mix of thermal and metallurgical coal."

"Going forward those two areas in China and India now are probably going to have the higher growth profiles for coal usage vs. the U.S., which is going to remain -- in my estimation -- relatively stagnant due to a number of factors such as green initiatives, what some of the rules are coming from the EPA (Environmental Protection Agency) and general overall slowing production in some regions of the U.S.

How Morningstar Views Peabody's Financial Health: "Peabody has relatively low debt, giving it a nice cushion for times when adverse coal industry conditions restrain cash flows. This is important in an industry with high fixed costs and exposure to commodity prices," Morningstar analyst Michael Tian wrote in an analyst note.

What Investors Should Focus On: S&P's Christy said, "continue to look at growth in Chinese consumption and look at the build out of thermal coal usage in India. Those I think are the key two focus areas that investors should watch going forward. Over the last month or so, China had come out and said they were going to slow their energy usage due to carbon emissions ... which seemed to be more or less a non-event.

Based on industry information, they've re-entered the market. They're still going to demand thermal coal and metallurgical coal, which are the two main types of quality coals. You also have India, which is embarking on a major build out of their thermal coal capabilities and their thermal coal usage in the next few years."

Arch Coal ( ACI


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Number of Analysts: 25

Average Recommendation: Outperform

Stock Price/Earnings Ratio vs. Industry's: 192.17%

Market Cap: $4.4 billion

Trailing Twelve-Month Operating Margin: 7.7%

Trailing Twelve-Month Revenue: $2.82 billion

Why Arch Coal Is a Strong Stock: Mathew Christy, Coal Industry Equity Analyst at Standard & Poor's Equity Research said, "Arch Coal had in the last year acquired Jacobs Ranch -- it was a mine owned by Rio Tinto ( RTP and that expanded their Powder River Basin operations, which adds a lot of scale and enables them to reduce their overall cost. I think that adds to the company going forward -- i.e. pricing and production costs." Christy has a buy opinion for Arch Coal.

How Morningstar Views Arch Coal's Financial Health: "Arch's debt burden is higher than most of its peers'. We are not worried about 2010, and the company's debt maturity profile is modest until 2013. But if the coal market shows little improvement in 2010, Arch may need to renegotiate some of its debt covenants," Morningstar analyst Michael Tian wrote in an analyst note.

What Investors Should Focus On: S&P's Christy said, "For all the names, the two points that I would really focus on are:

"One, the level or value of the U.S. dollar and the Dollar Index. Coal stocks tend to have an inverse correlation to the U.S. dollar. As the dollar goes down, coal stock prices, coal stock multiples tend to rise. So with the recent decline of the dollar, you see the coal stock prices react. Most of them react in kind."

"Two, the other thing ... to watch is inflation expectations. On a daily basis, I watch the spread between the ten-year treasury and the ten-year TIPS (Treasury Inflation Protected Securities) to ... gauge investor inflation expectations. As inflation expectations rise, coal stock prices, coal stock multiples tend to rise.

James River Coal ( JRCC


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Number of Analysts: 9

Average Recommendation: Outperform

Stock Price/Earnings Ratio vs. Industry's: 40.98%

Market Cap: $481.2 million

Trailing Twelve-Month Operating Margin: 11%

Trailing Twelve-Month Revenue: $685.4 million

Why James River Coal is a Strong Stock: Mathew Christy, Coal Industry Equity Analyst at Standard & Poor's Equity Research said, "For James River now, I think that's a little bit more of a valuation stock. On an EV(Enterprise Value)/EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) basis, it's trading at about 3.1 x my 2010 EV/EBITDA estimate, which relative to the rest of the coal stocks is significantly low -- and I think the market's underestimating its ability to produce PCI coal, which is a lower-grade metallurgical coal -- and I think that's going to help the company's earnings prospects going forward and in the next 12 months."

Christy has a buy opinion for James River Coal.

How Morningstar Views James River Coal's Financial Health: "We are not concerned about financial health for the immediate future, as James River will probably generate decent free cash flows in 2010 and 2011. However, in the long run, James River's asset base will not allow it to support any more than a modicum of debt," Morningstar analyst Michael Tian wrote in an analyst note.

Alpha Natural Resources ( ANR


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Number of Analysts: 20

Average Recommendation: Strong Buy, 70% of Analysts

Stock Price/Earnings Ratio vs. Industry's: 1,097.55%

Market Cap: $5.9 billion

Trailing Twelve-Month Operating Margin: 3.6%

Trailing Twelve-Month Revenue: $3.54 billion

Why Alpha Natural Resources Is a Strong Stock: Mathew Christy, Coal Industry Equity Analyst at Standard & Poor's Equity Research said, "they had completed about a year ago a purchase of Foundation Coal, which was a Powder River Basin, Central Appalachian coal producer, which added more scale to their operations and provided a little more diversity because Alpha Natural, previous to the acquisition, had been more of a Central Appalachian, Northern Appalachian producer -- just an Appalachian coal producer with a large focus on metallurgical coal.

"The Foundation purchase gave them more scale, which I said is a positive for coal companies -- also aside from a little diversity -- that should add to the multiple going forward."

Christy has a buy opinion for Alpha Natural Resources.

How Morningstar Views Alpha Natural Resources' Financial Health: "Alpha will have a strong balance sheet after acquiring Foundation, as the deal is largely stock-funded," Morningstar analyst Michael Tian had written in an analyst note. "However, it is assuming about $530 million of net debt from Foundation. We expect this to pose no problems. However, the firm will still be pressured if coal prices remain low for a number of years."

-- Written by Andrea Tse in New York.

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