Alpha Natural Resources Inc said Tuesday it will acquire Foundation Coal Holdings Inc for $1.5 billion in an all-stock deal to create the third-largest U.S. coal producer, signaling an expected wave of consolidation in the fragmented industry.

Both sides said the strategy behind the acquisition is to position the merged company to benefit from an expected rebound in demand from steelmakers and power plants for coal.

Alpha offered a 35 percent premium, based on Monday's closing price, for Foundation in what was seen as the first in an anticipated spate of deals to allow smaller players in the industry to better compete.

Foundation Coal's stock was up $4.39 or 18.9 percent at $27.63 in afternoon trade on the New York Stock Exchange after reaching $31.53 earlier in the session. Alpha was down $2.36 or about 8.2 percent at $26.50.

It is unequivocally positive for Foundation as they are very hedged on production, said analyst Jeremy Sussman of Natixis Bleichroeder. They would have had a hard time with potential upside, even if (coal) prices rise.

Sussman said Alpha would benefit from greater production and geographic diversity by acquiring coal deposits in the western United States as well as in the Appalachians.

It's not cheap, but they didn't overpay, and they get some high-quality Northern Appalachian reserves, he said.

TIMES ARE CHANGING

The merger, expected to close in August or September, comes at a time of economic downturn when coal prices have slumped and demand for electricity and steel -- the two biggest customers for coal -- has dropped off.

The coal industry is also facing growing opposition from environmentalists, leading to more protracted permitting processes that have pushed up the cost of mining and left some smaller mining companies struggling to survive.

There has been talk of more coal consolidation since Patriot Coal Corp acquired Magnum Coal Co for about $695 million last July.

Alpha itself was nearly acquired six months ago by iron ore pellet producer Cliffs Natural Resources Inc, but the planned $8.3 billion merger was terminated because of economic conditions and the objection of Cliffs' biggest shareholder.

Alpha and Foundation have been in talks over a possible combination for several years, according to a source familiar with the situation. Indeed, the two companies had been close to a similar deal last year, but Alpha chose to proceed with the failed Cliffs deal instead, the source said.

The potential upside is that Alpha is the largest producer of (steelmaking) metallurgical coal, James Roberts, Foundation's chairman and chief executive, told analysts on a conference call.

Electricity demand is forecast to grow again in 2010 and beyond ... and when the economy recovers, (coal) supply will struggle to keep up with demand, so prices will recover, he said.

The deal's value would top $2 billion after adding in $530 million in debt. Based on Monday's closing price, it values Foundation at $31.28 a share, compared with its close of $23.24 a share.

The combined company would operate 59 coal mines and 14 preparation plants across the United States, with reserves of more than 2.3 billion tons of coal, Alpha said.

It forecast production this year of between 92 million and 98 million tons, making it the third-largest U.S. coal producer. The new Alpha expects to have revenue this year of $3.4 billion to $4.2 billion, it said.

BREAKING DOWN THE DEAL

Under the terms of this transaction, Foundation stockholders would receive 1.084 shares of the new company for each share held, while each share of Alpha would automatically become one share of the combined company.

Alpha Natural expects the deal would add to adjusted earnings and cash flow earnings in 2010.

The total consideration would consist of about 50 million shares of the new company's stock and the assumption about $530 million of Foundation Coal's debt, Alpha Natural said.

The combined company would have a market capitalization of $3.5 billion. Alpha Natural shareholders would own 59 percent of the company and Foundation shareholders the rest.

The combined company would retain the Alpha name and continue to trade on the NYSE under its current ticker symbol. Alpha's current president Kevin Crutchfield would become chief executive of the merged company.

Alpha was advised by Citi in the deal and Foundation Coal was advised by Barclays Capital. (Additional reporting by Michael Erman in New York and Chakradhar Adusumilli in Bangalore, Editing by Gerald E. McCormick and Gunna Dickson)