James River Coal Company - Finally A Buy

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It's easy to see that the coal industry has suffered devastating losses during the past two years. Shares of James River Coal Company (JRCC) have shed over 90% of their value during the downturn in the industry for a multitude of reasons, namely lower natural gas prices (which is used as a substitute/alternative to coal), increased governmental regulations under the Obama administration, and the economic uncertainties facing Europe, China, and India.

It was fairly easy to make money with JRCC during the downturn. For the past six months, the stock traded nicely within a range (with the exception of a few breakouts), so moves were predictable in both directions when the range was played conservatively. After announcing quarterly earnings last week (a significant bottom line beat), however, the stock has shown signs of strength and recovery. Is it time to buy JRCC?

My bearish stance that JRCC was trending negatively was justified in the price movement of the stock. When I began writing articles on the company, the stock was trading at $2.80. My bearish view may have upset readers who were calling a bottom, but the stock fell nearly an additional 50% from those levels in just two months to lows of $1.46. Those pundits who attacked my bearish stance will now be happy - the bottom is in on JRCC and, while there is certainly mid-term risk of insolvency, the long-term reward scenario now overshadows that risk.

The coal industry is still hurting, and its hurting bad. Regulations are significantly increasing the cost of mining coal within the United States, and there is still uncertainty abounding overseas. While the biggest driver of growth for the coal industry is, of course, China, investors are still giving much credence to the situation in Europe as a negative catalyst for coal. It is my assessment that the impact Europe will have on coal prices is overshot, which creates a divergence in pricing and actuality. Additionally, the price of natural gas continues to rise. Investors who don't want to risk being in coal names should certainly consider a play on the natural gas commodity - it is showing signs of a secular bull movement.

As for JRCC as an individual company involved in the coal recovery, let's take a look at the risk-reward scenario. With the recent run-up in shares (64% since reaching the aforementioned lows in the past month), investors might become worried that the short-term top might be in. That's not the case - in fact, there's a lot more room to run. The major question, as noted, is solvency. Will the company be able to sustain through more trouble until a full recovery in coal takes place?

One of the major notes about JRCC's solvency issue is that their debt is mostly long-term. The first notes expire in 2015 and then not again until 2018 and 2019 after that. In addition to the debt the company has a revolving line of credit. The three notes and line of credit are all that the company will be able to raise. Essentially, JRCC can't issue any more debt, so if the company has yet to recover by 2015, it will go bankrupt.

That all being said, there is a resurgence occurring in the coal industry. Both metallurgical and thermal coal demand are increasing - the US is bolstering the demand with solid economic growth. As noted, the uncertainty comes from abroad, but a significant portion of the business done by JRCC is within the confines of the US.

From a technical perspective, the share price has finally broken through the 50-day moving average in a positive way, signaling that the bulls are ready to add new money into the company. It is an especially encouraging sign, because that hasn't happened since the run-up to the election on hope of a Romney win.

An investment in JRCC is a risky one, but one perhaps that could provide excellent returns. I have taken a long position with long-term out-of-the-money call options - December $4 calls. My risk is hedged with a minimal investment, but a significant rise in the underlying share price will yield high profits. It is essentially now or never for JRCC - while the company doesn't face immediate bankruptcy issues, any hindrance in the coal recovery will have severe negative implications for the company. This investment is banking on a recovery in coal - at least enough to bring JRCC out of fear of insolvency. If that happens, the stock could quickly move to $8 by the end of this year, over triple its current level.

Disclosure: I am long JRCC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.