Investment thesis While OST has had a strong recent run compared to peer BSL, returns have been modest compared increases in iron ore spot prices given its considerable net long iron ore position. The chart below shows OST?s indexed share price performance versus spot iron ore fines prices and pure play iron ore company FMG. The underperformance is notable.
Is OST now an undervalued iron ore play primed for a re-rating? We think there are several factors relating to OST's steel manufacturing and distribution businesses that have to date prevented such a re-rating and we believe will continue to weigh on the stock post its 1HFY11 results. These factors include:
? Jun-11Q Whyalla blast furnace outage. OST is planning a shut down lasting approximately 7 weeks to replace and update corroded refractory panels. The timing of the shutdown is ideal as OST will be able to offset the lost production by selling magnetite pellets, hematite lump and coke that would otherwise have been used in the furnace. Additionally, the forthcoming shutdown will be a controlled event rather than the uncontrolled shutdown which resulted in a protracted outage last year. Despite all efforts by OST, blast furnace repairs do however carry with them an inherently high risk and we think the market may be hesitant to hold the stock while these repairs are incomplete.
? Domestic steel demand environment. OST's core exposures are residential construction, commercial construction, infrastructure and mining construction/consumables. We think the commercial construction remains very weak in Australia and infrastructure investment (notwithstanding the Australian Rail Track Corporation supply deal - ~120kt of carbon rail over the next 18 months) has suffered deferrals post-GFC. We are concerned that the outlook statement provided with OST's 1HFY11 results will point to continued weakness in these key market segments.
? Impact of high A$ on import competition. OST is impacted by a high A$ both directly in terms of the revenue translation effect on export iron ore sales and indirectly in the form of increasing the competitiveness of imported products. The most recent ABS figures point to a surge in Dec-10 monthly long steel imports into Australia as shown in the chart below. We note that the bulk of the import increase is in the pipe & tube segment, with rebar and other products remaining relatively flat. OST has had issues with pipe and tube dumping in the past (from China primarily). We believe that a significant part of the Dec-10 increase in pipe & tube imports may be explained by product specifically imported for the new Epic Energy pipeline project in Queensland. OST is supplying ~50kt of the total ~155kt pipe requirement for the project and is coordinating the import of the remaining product. Despite the plausible explanation for the increase in Dec-10 imports, we think the high A$ will continue to raise concerns about the ability of OST to push through domestic price increases to recover margin levels.
We are retaining our Neutral recommendation on OST. Our DCF valuation of A$3.32/shr offers comparatively less upside to current share price levels than our DCF valuation for BSL.
Accounting of Moly-Cop acquisition and restatement of Manufacturing segment The acquisition of the Moly-Cop and AltaSteel businesses from Anglo was completed at the end of 2010. As such, cash flows from 1 July 2010 until end 1HFY11 will be included in the OST balance sheet as an offset against the asset purchase price. Despite the transaction having an effective date of 1 July 2010, OST did not have control of the assets for most of the reporting period therefore it cannot eports the earnings through the P&L. We note that OST?s 1H11 earnings guidance of ~A$117m (in line with 1HFY10) excludes any contribution from the new grinding media businesses over the period. OST will provide pro-forma earnings for 1HFY11 and three prior years reflecting the new grinding media business which will include Moly-Cop and AltaSteel and OST's current Waratah mining consumables business. We believe that the restatement of accounts will magnify the poor operating environment and performance of the manufacturing business excluding what was likely to have been a high margin earning mining consumables business.
Queensland flood impacts We believe that OST will see a long run net benefit in demand from the recent Queensland floods, there will however likely be a short term negative impact. Queensland comprises approximately 20% of OST's national and the period of disruption and subsequent inactivity post floods will reduce this have an impact on sales in the short term. The longer term rebuild effort should result in a sales uplift that will more than offset the initial period of weakness. Of the estimated ~30,000 homes that have been inundated (pre-Cyclone Yasi) approximately one quarter will need to be reconstructed which will support rebar demand. Large numbers of wharves, rail infrastructure and fencing will need replacing which will support structurals, pipe & tube and wire demand.
OST Price at posting:
$2.77 Sentiment: Buy Disclosure: Held
