Beleaguered shareholders of this coal miner probably feel like Lee Dorsey in the classic 1966 song “Working in the Coal Mine”:

“Lord! I’m so tired! How long can this go on?”

That’s a good question. It’s been a wild ride for Walter Energy (NYSE: WLT) over the past seven years.

The share price is lower than it was during the apex of the financial crisis. But while there was a massive sell-off of all types of assets in 2008 and 2009, current conditions seem much more stable.

So what gives?

The End Of The Supercycle
With explosive economic growth in emerging markets such as the BRIC nations (Brazil, Russia, India and China) has come a rapid escalation in commodity prices based on what has seemed like an insatiable need for raw materials. Commodity producers and investors have enjoyed very good returns. How good? This 10-year chart of the S&P GSCI Commodity Index says it all.

But these days? Not so much.

As the U.S. dollar strengthens, commodity prices (contracts are priced in dollars) soften internationally by sheer market mechanics.

However, the psychological reasons for the downturn stem mainly from the fear of an economic slowdown in the emerging markets (primarily China) and the continued weakness in global demand due to the slow recovery in the U.S. and the persistent malaise in the eurozone economies.

But what does all of this have to do with a coal producer in Birmingham, Ala.? Plenty.

The Other ‘Clean Coal’?
An important input commodity, coal — especially U.S.-produced coal — has seen its price rise and fall violently in recent years. The first part of the 21st century saw thermal coal prices rise nearly fourfold from around $40 per short ton to $140 in 2008, which coincided with the global financial crisis. Since then, prices have settled back to around $55 per short ton.#-ad_banner-#

In the industrialized world, coal is primarily used for two things: as fuel to help generate electricity and to make coke for steel manufacturing.

A large, fast-growing economy such as China uses a lot of coal for both purposes. However, China is also the world’s largest coal producer, with the United States a distant second.

Should a slowdown in China affect what happens to coal domestically? Not really, but federal government regulation can.

Since both Bush administrations and the first Obama administration, the U.S. has had virtually no concrete energy policy. It’s no secret that the current administration is no fan of coal from an environmental standpoint.

Compounding those worries, large power producers have switched en masse to natural gas as a cheap, clean fuel source. Obviously, that doesn’t help prop up prices. So it makes sense that the stocks of domestic coal producers have been beaten up over the past few years.

However, Walter produces primarily high-quality metallurgical coal that is used in steelmaking. Is the market throwing the baby out with the bathwater?

Buried Treasure
The company’s numbers look terrible: negative earnings for 2013 with an analyst consensus of a loss of $1.43 a share; weak Chinese demand (although China is a large coal producer, they produce very little high-quality metallurgical coal); and coking coal prices down 18% to a recent price of around $140.

To give the market even less confidence, Walter recently postponed proposed refinancing of $1.6 billion in term loans, citing market conditions. Most investors wouldn’t touch this idea with a 10-foot pole. But look beneath the surface.

	This overland conveyer transports coal from Walter Energy’s mining operations in Alabama.

Walter Energy is in a fairly simple business: It owns and produces a tangible asset. Conservative estimates put Walter Energy’s tangible book value at around $16 a share. Much of that is tied to the company’s coal reserves (coal in the ground). That wasn’t a big deal when shares were trading north of $100, but with shares staggering around $11.50, it’s a different story — that’s 45% upside. The value is literally buried in the ground. But the story gets better.

As far as the metallurgical segment — Walter’s bread and butter — goes, demand has stabilized, albeit at lower levels. According to the U.S. Energy Information Administration, coking coal domestic demand for 2013 should slip about 1.4% from last year, to 20.5 million tons. Not a disaster. 

Imports are a different story. Last year, import demand stood at 125.7 million tons. This year’s forecast is pretty grim at 107.1 million tons, a 14.8% drop. However, the 2014 forecast for coking coal imports appears stable at 108.4 million tons. A modest increase of just 1.2% leaves some room for an upside surprise. 

As far as Walter Energy is concerned, the picture, believe it or not, is getting brighter. Forget about 2013: Sales should come in at around $2.1 billion versus $2.5 billion last year, which would be an ugly 16% drop. However, forecasts for 2014 call for sales of $2.3 billion, which would be an impressive 9.5% improvement over 2013. 

Cash flow is also improving. After a negative 98 cents per share last year, free cash flow has turned positive to about 48 cents per share. That’s expected to climb more than 170% next year to a projected $1.31 per share. The company will accomplish this through tighter capital controls and eliminating the dividend. 

While I normally don’t like to see dividend cuts, this is necessary for the survival of the company and actually adds more value to a deeply undervalued stock.

Last, the hope of all stock investors: Walter Energy is rumored to be a takeover candidate. Whenever certain sectors become depressed, consolidation often follows. Possible suitors have included Alpha Natural Resources (NYSE: ANR), Brazilian miner Companhia Siderurgica Nacional (NYSE: SID) and Warren Buffett‘s Berkshire Hathaway (NYSE: BRK). Based on the unlocked assets at Walter, that idea is right up the Oracle of Omaha’s alley.

Risks to consider: By its nature, contrarian deep-value investing is extremely risky. As an investor, you’re buying into an idea or event that may very well fail to materialize. As a business, Walter Energy is in a precarious position. One way to protect yourself would be to use a stop-loss order 15% to 20% below your purchase price. Another way would be to use options to hedge your long position. (My colleague Amber Hestla-Barnhart covered this in great depth.) Finally, the coal industry is depressed and very sensitive economically. Continued global economic weakness would likely suppress this idea.

Action to take –> Walter Energy is clearly undervalued, based on the company’s improving internals and improving macro conditions, a 12-month price target of $16 would bring the company back to its book value. Shares currently trade around $11.50. This would represent a 40% return. The annual 50-cent-a-share dividend gives the stock a yield of about 4.4%. Don’t count on it being that high forever, but this will help the company in the long run.

P.S. — While coal mining has put investors in position to profit big from Walter Energy, we’ve discovered another natural resource in the U.S. that could lead to a third industrial revolution. One analyst is predicting a stock could rise 1,566%. Another stock has already jumped over 1,000% and is expected to keep going. To learn more, click here.