U.S. Steel: Growing by LEAPS and Bounds

U.S. Steel Corporation (X) shares jumped higher yesterday after the company reported second quarter profits (see conference call transcript) that more than doubled while also increasing its dividend in a vote of confidence. The domestic steel company announced net income of $668 million, or $5.56 per share, compared to analyst estimates of only $3.80 per share. U.S. Steel also boosted its earnings forecast for the third quarter, citing a positive pricing environment.

The big question now is whether or not steel prices are sustainable at these levels. Harbor Intelligence analyst Rodrigo Vazquez told SteelGuru.com that he expects sheet prices to soften in the fourth quarter due to continued economic weakness in the U.S. that could further erode end user buying activity and slow demand for steel. The analyst forecasts that the U.S. will show an overall steel demand decline of 3.6% for 2008.

Global steel demand, however, continues to show strong growth because of newly industrialized areas like China, Asia and the Middle East. Those areas alone are expected to consume 35% of the world’s steel for the year with Russia, South America, Saudi Arabia, and South East Asia also predicting growth of 10%. Combined, all of these forces are putting pressure on the supply of steel, which has resulted in the huge price increases we’ve seen in 2007 and so far in 2008.

Investors looking to get in on this action have a few options. Purchasing a block of U.S. Steel at current prices would cost around $16,540, which is much more than many investors feel comfortable spending. Purchasing the stock on margin is another option that would cost around $8,000, but also involve the additional risk of a margin call. A third option - and perhaps the best - is purchasing LEAPS calls as a stock substitute.

The 160 January ‘10 LEAPS are currently trading at around $50 per contract. This means that long-term investors can purchase the right to buy U.S. Steel at $160 anytime between now and January of 2010 for only $5,000. The breakeven on the trade is around $210 per share, which means shares need to move up 27.7% within two years in order to make money. Considering shares have already increased some 30% so far this year (and 13% as of yesterday), this may not be a far-fetched bet.

LEAPS also offer a lot of additional leverage and protection, since only $5,000 in investment is required. If shares move to $250 per share, the LEAPS investor will have made an 80% return on their investment. This compares to a 51% return on the underlying shares if purchased right now. Meanwhile, if the stock declines, LEAPS investors can only lose the $5,000 they put in, which means underlying shares would lose more if they dropped more than 30% within the same timeframe.

In the end, U.S. Steel LEAPS can be an effective way to play the global demand for steel prices without spending a huge amount of cash and taking on a huge amount of risk. See Using LEAPS as a Stock Substitute for more information on this strategy and LEAPSInvestor for more LEAPS strategies trading ideas.

Disclosure: I do not own any shares or options in U.S. Steel.

Comments

[Jase:]

US Steel has an excellent outlook IMHO, however I feel more comfortable holding a basket of steel and steel related plays. GSI is very volatile, but the technicals look positive. Also among my favorite picks is Largo Resources... based in S.A. it's a vanadium/moly play (used in making lightweight steel). It's well-financed and an excellent takeover candidate. Irrespective of the price of oil, the global demand for lightweight steel is growing at a rapid pace. Please share any other steel-related plays if you have any.

2008 Jul 30 06:55 AM

[kkin365:]

How liquid is LEAP for X? One may be locked in without a buyer to close the position. Is GSI a steel-focused ETF?

2008 Jul 30 09:40 AM

[Jake Taylor:]

@ Jase: I do like Largo Resources and some of the other South American plays. MT and GSI are also two others that I follow.

@ kkin365: LEAPS are never as liquid as options, but they do trade roughly at value (after all, they can technically be exercised anytime if the discount is too great). The idea behind buying the LEAPS through is that (1) it leverages your returns long-term (2) you can afford to diversify. GSI = General Steel Holdings.

2008 Jul 30 10:45 AM