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Alpha Natural Resources Inc. (ANR) on Tuesday said it will buy Foundation Coal Holdings Inc. (FCL) for about $1.5 billion in stock as it looks to diversify and expand its operations.

The combined company will be the third-largest coal producer in the U.S., with reserves of more than 2.3 billion tons. The deal brings together Alpha Natural's leading position in eastern coal used for steel production with Foundation's mining operations in Wyoming's Powder River Basin.

The announcement comes as U.S. coal producers, which boast strong cash reserves after garnering record prices last year, hunt for merger and acquisition opportunities. Massey Energy Co. (MEE) and Peabody Energy Corp. (BTU) have expressed interest amid a tumble in coal prices and demand. Arch Coal Inc. (ACI) is expanding its production in the Powder River Basin, buying a mine there from Rio Tinto (RTP).

Shares of Foundation surged following the announcement before retreating slightly, recently trading up 21.2% to $28.16. Shares of Alpha Natural were down 6.2% to $27.06.

Under the deal, Foundation shareholders will get 1.084 shares of the new company for each share of Foundation. Based on Monday's closing prices, the offer amounts to a 36% premium, valuing each share of Foundation at $31.28.

Foundation shareholders will own 41% of the combined company. Alpha Natural will also take on about $530 million of Foundation debt and use cash on hand to repay $233 of its borrowings.

The deal won't require financing, although the companies do expect to renegotiate certain debt covenants with bank lenders and bondholders. These changes, however, aren't required for the deal to be completed, company executives said in an interview with Dow Jones Newswires.

Standard & Poor's placed the credit ratings of both companies on watch with positive implications following the deal's announcement.

Alpha Natural was being watched particularly closely for M&A activity because of its strong liquidity position. The company at the end of the first quarter had $693 million in cash and cash equivalents and $521 million in long-term debt.

The combined companies expect about $45 million a year in annual revenue and cost savings starting in 2010 and for the deal to add to earnings and cash flow next year. The companies said they don't anticipate staff cuts once they combine. The deal is expected to close in the second half of the year.

"For [Foundation] shareholders, the transaction makes sense as they receive a nice 35% premium to yesterday's closing price and are able to be a part of a larger organization with a sound balance sheet," analysts at Simmons & Co. wrote in a note to clients.

The companies said the deal provides Alpha Natural with an opportunity to enter the Powder River Basin, getting access to low-cost surface mining operations that supply power plants. Trying to open a mine in this region without a partner is extremely difficult, said Michael Quillen, chairman and chief executive of Alpha Natural, during the interview.

"To start from scratch is almost impossible," he said.

Foundation's western operations help reduce the risk Alpha Natural faces in the eastern U.S. amid tighter environmental regulations. Alpha Natural already is the largest U.S. supplier of metallurgic coal to the steel industry, a smaller but more lucrative coal market. Both companies mine coal for power plants and steel production in the eastern U.S. but don't expect antitrust concerns.

Alpha Natural also said it doesn't expect the resistance from shareholders that a failed deal last year with Cliffs Natural Resources Inc. (CLF) faced.

In November, Alpha and Cliffs terminated their $10 billion merger pact, citing the economic environment and other concerns. The deal faced pushback from Cliffs' largest shareholder, Harbinger Capital Partners. The deal's end also came as the market for iron ore almost collapsed and metals prices plunged.

Although concentrating on this deal, Alpha Natural said the combined company would be interested in additional M&A activity, including the purchase of distressed assets. Executives said the combined company will be focused on coal but over time may look at biomass and natural gas among other options.

Under the deal, Quillen will become chairman of the combined company and Kevin Crutchfield, Alpha's president, will become chief executive. James Roberts will become a member of the combined company's board of directors and Kurt Kost, Foundation's president and chief operating officer, will become president of the combined company.

-By Mark Peters, Dow Jones Newswires; 201-938-4604; mark.peters@dowjones.com

(Kerry E. Grace contributed to this report.)