Over the past six months, the S&P 500 index has risen a touch over 12%. That's not bad for such a short period of time. Shares of United States Steel(NYSE: X) have advanced 103% over the same span. Wow!
There's a specific reason for U.S. Steel's skyrocketing stock price, one that both limits the opportunity for further advances and -- more importantly -- increases the downside risk for investors that buy it now. Here's what you need to know.
U.S. Steel's big transition was nearly complete
The story around United States Steel actually goes back about 100 years ago. Back then, steelmaking technology was less advanced and the company invested heavily in what was then the leading-edge process. However, the blast furnaces that have underpinned the business for years are a feast-or-famine affair, exposing the company to lofty operating costs in what is a highly cyclical business. When steel prices are low, U.S. Steel often bleeds red ink. And when steel prices are high, it can be a cash machine. The swings between the extremes can be brutal.
Eventually, steelmaking technology advanced and more nimble peers were able to build steel businesses that were more resilient to the industry's swings. Highly flexible electric arc mini-mills are the backbone of some of the steel industry's most exciting competitors, including Nucor and Steel Dynamics. U.S. Steel probably stuck to its blast furnaces for too long, but in recent years it has been attempting to diversify its business by adding in the electric arc mini-mills that underpin the most resilient steel companies.
Building a steel mill is an expensive and time-consuming process because they are large and complex. However, U.S. Steel is nearing the end of a big investment cycle that will leave it a more agile competitor. And, as if on cue, the company has started to receive takeover offers just as it is about to turn into what is likely to become a more resilient competitor. That is what accounts for the huge price advance over the past six months.
U.S. Steel picked a winner
The eventual winner of the bidding war for U.S. Steel was Japan's largest steelmaker, Nippon Steel. It is a $55-per-share all-cash offer, which amounted to a 40% premium to U.S. Steel's stock price. But notably, that premium comes on top of the already large share-price advance that took place after Wall Street learned that the company was reviewing takeover bids. At this point, U.S. Steel's stock is trading hands at around $46 per share, which suggests there is upside of around 20% for investors willing to jump aboard today.
While that may sound attractive, the problem is that the $55-per-share offer from Nippon Steel essentially caps the upside that investors can achieve here. The bigger question to ask is: Why is the stock currently sitting at a massive discount to the offer price? The answer is that the deal could face significant regulatory scrutiny that might lead to it being called off. This is a very real risk; JetBlue's attempted acquisition of Spirit was recently blocked for this very reason.
This is where things get interesting. After JetBlue's deal to buy Spirit was scuttled, the latter's shares plunged. If regulators decide that U.S. Steel being acquired by Nippon Steel isn't good for the U.S. steel industry, the same exact thing could happen to U.S. Steel's stock price. There's no way to know what will happen with the U.S. Steel deal, but it is very clear that investors are already worried that it won't be consummated as planned. Even with the roughly 20% discount, however, the risk/reward balance will still be unattractive for most investors.
U.S. Steel is a special situations stock
At this point, U.S. Steel falls into the ranks of special situations stocks. There's a huge amount of uncertainty that only the most aggressive investors should be willing to shoulder for what amounts to fairly limited upside. The downside, however, could be very painful if things don't work out as planned. That's the hidden risk that should keep most investors on the sidelines.
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Reuben Gregg Brewer has positions in Nucor. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
