Safer earnings in uncertaintyWe believe OST's exposure to...

Safer earnings in uncertainty
We believe OST's exposure to upstream iron ore will provide greater earnings security vs peers in what we expect will be a challenging 1QFY11 environment for steelmaker margins. With attractive valuations now appearing, and a stronger outlook for steel demand in 2QFY11, we upgrade to a Buy recommendation.

Best placed to manage near-term uncertainty, in our view
We view OST as best placed to manage near-term earnings uncertainty due to contracting steel prices and production margins based on: 1) 6mtpa of upstream iron ore sales with less risk to volume demand; 2) current lower unit cost of EAF-based steel production compared to blast furnace; and 3) a domestic lag to falling offshore steel prices. While we believe OST will not be immune to lower steel and spot iron ore prices in 1QFY11, we expect earnings are likely to be more resilient in this environment vs domestic peer BSL.

Earnings lowered on a more conservative near-term view
We have lowered our NPAT forecasts by 8.9% in FY10 and 7.5% in FY11 reflecting lower near-term steel margin expectations. While we are cognisant of challenges presented in the current quarter, we believe the earning outlook turns more positive towards 2QFY11.

Outlook brightens towards 2QFY11
The outlook for steel prices and demand appears more positive past September. We expect a seasonal destocking cycle in Asia and the US to end, with buyers returning to market to replenish inventories. This should help stimulate higher regional prices. Domestically, steel demand conditions should begin to improve as larger infrastructure projects like ARTC rail track upgrades begin to ramp up over FY11.

Upgrade to Buy, as valuation shows appeal, in our view
We believe OST is the best defensive play in the steel sector due to upstream exposure to iron ore sales, while steelmakers face near-term margin pressure. Longer term, we see value on a P/NPV basis earnings recovery cycle for the steel sector, with our forecast EPS growth of 127% in FY11 and 24% in FY12. We move to a Buy recommendation with a DCF-based price target of A$3.95 (from A$4.25).