The merger activity in the coal sector has been hot lately.  Some of the notable deals include Walter Energy’s (NYSE:WLT) $3.3 billion purchase of Western Coal as well as Alpha Natural Resources’ (NYSE:ANR) $8.5 billion deal for Massey Energy (NYSE:MEE).

And the spending spree continued this week.  Arch Coal (NYSE:ACI) announced a $3.4 billion purchase of International Coal Group (NYSE:ICO). 

Yet investors showed some skepticism.  On the news of the deal, the stock price of Arch Coal fell about 2.24%. 

Then again, Arch Coal’s stock had a strong run from 2009 to 2010.  Can it turn things around in 2011?

Here’s a look at the pros and cons:

Pros

Leader.  Arch Coal is the No. 2 U.S. coal producer, with about 15% of the overall supply.  The company is known for its efficient system and its low-sulfur coal.  Arch has mining complexes in places like Utah, West Virginia, Colorado, Kentucky and Wyoming. 

Safety.  Over the past few years, there have been several fatal coal mining accidents.  The worst was an explosion at a Massey location, which resulted in the death of 29 workers.

But in the case of Arch Coal, it has invested heavily in its safety programs, and the company has been recognized with various awards.

The International deal.  The company’s key asset is its reserves of metallurgical coal, which are used to make steel.  When combined with Arch Coal, the reserves will be a massive 5.5 million tons.

The prices of metallurgical coal have been soaring.  Of course, the main driver has been the industrialization in China and India. 

Cons

Prices.  Coal is an extremely volatile commodity.  A global recession would certainly result in a big drop. 

Consider that interest rates have been increasing during the past few months, so as to combat rising inflation.  This has been in areas like China and Brazil.  If the monetary policies are too tight, there will be an inevitable slowdown in growth.

Debt.  With the deal for International, Arch Coal will have a debt load of roughly $5 billion.  There will also be significant obligations from leases and royalty payments. 

True, Arch Coal has strong cash flow generation, which makes the debt manageable.  But there could be some pressure if the global economy falters.

Regulations.  These are stringent and vary from country to country.  Violations can definitely have a harsh impact on a company like Arch Coal.

One of the biggest wild cards is with air emissions standards.  They are still evolving and could be a big burden, in terms of higher costs and lower output.

Verdict

While the deal for International is not cheap — coming at 17 times pretax earnings — the fact is that the company is in a growth industry.  What’s more, the company will see new production come on line over the next few years.

But Arch Coal also has a strong business in coal for electric power generation, which also has bright prospects.  And the company has an extensive infrastructure for exports. 

When taking account of these positive factors, the pros outweigh the cons on Arch Coal’s stock.

Tom Taulli’s latest book is “All About Short Selling” and his Twitter account is @ttaulli.  He does not own a position in any of the stocks named here.