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Insteel Industries, Inc. (NASDAQ:IIIN)

F2Q10 (Qtr End 04/03/10) Earnings Call Transcript

April 22, 2009 10:00 am ET

Executives

H. Woltz – Chairman, President and CEO

Mike Gazmarian – VP, CFO and Treasurer

Analysts

Tim Hayes – Davenport & Company

Robert Kelly – Sidoti

Nat Kellogg – Hudson Securities

John Cawler – Oppenheimer

Operator

Good day ladies and gentlemen, and welcome to your Insteel Industries second quarter 2010 conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session, and instructions will be given at that time. (Operator Instructions). And as a reminder, this is being recorded. I'd now like to introduce Mr. H.Woltz. Please go ahead, sir.

H. Woltz

Thank you, good morning and thank you for your interest in Insteel, and welcome to our second quarter 2010 conference call, which will be conducted by Mike Gazmarian, our Vice President, CFO, and Treasurer and me.

Before we begin, let me remind you that some of the comments made in our presentation are considered to be forward-looking statements. Forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those projected. These risk factors are described in our periodic filings with the SEC.

I'll now turn it over to Mike to review our second quarter financial results in the macro environment, and then will follow-up to comment more on market conditions, the PC strand trade cases and our business outlook.

Mike Gazmarian

Thank you. H. As we reported earlier this morning, Insteel returned to profitability during the second quarter of fiscal 2010 and further strengthened its financial position despite the continuation of challenging business condition. Net earnings for the quarter ended April 3rd, were $1.6 million or $0.09 per share, compared with the net loss of $16.4 million or $0.94 per share for the same period last year.

The prior year loss for the quarter includes the pretax charge of $16.1 million or $0.58 per share after tax for inventory write-downs to reduce the carrying value of inventory to the lower cost-to-market, excluding these write-downs; the year ago loss would have been $0.36 per share.

Insteel results for the second quarter were favorably impacted by higher shipment wider spreads between selling prices and raw material cost, lower unit conversion cost and the lower effective income tax rate. Net sales for the quarter increased 3.7% from the prior year driven by 34.7% increase in shipment, which more than offset at 23% decrease in average selling prices.

On a sequential basis, net sales rose 26.9% from the first quarter of fiscal 2010. Despite the adverse weather conditions that we experienced during the quarter, Q2 shipments were up 25.7% sequentially from Q1. The sequential increase in shipments were significantly higher than the usual seasonal improvement we experienced between Q1 and Q2 which prior to 2009 had ranged from 8% to 13% over the previous five years.

We believe the larger increase this year was driven by customer inventory restocking and hedge buying in anticipation to future price increases, which more than offset the negative impact of the unusually severe winter weather in most of our markets. Even with the pickup in volume for the quarter, our Q2 shipments were still anywhere from 27% to 36% under the comparable period in 2006 to 2008.

Average selling prices for the second quarter rose 0.9% sequentially from Q1 due to the price increases that were implemented during the quarter in response to the escalation in the cost of our primary raw material, hot-rolled steel-wire rod. The timing of our increases has lagged somewhat behind the announced increases for wire rod due to competitive pricing pressures.

We've announced additional price increases that have or will be going into effect to recover this higher cost. Gross profit for the second quarter was $6.2 million or 11.9% of net sales compared with the gross loss of $21 million in the prior year. Gross profit for the prior year quarter includes the $16.1 million charge for inventory write-downs diluted to earlier.

Excluding these write-downs to prior year growth loss would have been $4.9 million. The year-over-year improvement in gross profit was driven by the lack of inventory write-downs in the current year period. The increase in shipments, wire spread between average selling prices and raw material costs and lower unit conversion costs.

Our overall capacity utilization remained at depressed levels for the quarter were showed some improvement increasing to 49% and 33% in the first quarter and 35% a year ago. As a result, total unit production for the quarter was up 39% from last year and 35.3% on a sequential basis from Q1, which translated into sizeable reductions in our unit conversion cost.

SG&A expense for the second quarter decreased $0.2 million from the prior year, primarily due to the relative changes in the cash surrender value of life insurance policies, which depreciated in value in the current year quarter of decreasing in the prior year. Our effective income tax rate for the quarter dropped to 17.8%, compared with 35.8% a year ago due to changes in the federal tax regulations regarding the carry back of net operating losses, which increased the amount of the tax refund that we received during the quarter relative to the prior year loss together with changes and permanent book versus tax differences.

Our effective tax rate will be subject to further fluctuations due to remainder of the year depending upon the level of future earnings, which could amplify or reduce the impact of permanent differences or as our adjustments in the estimates that entered into our tax provision calculation.

Moving to the cash flow statement of balance sheet; operating activities provided $29.2 million of cash for the quarter or using $0.7 million in the prior year quarter. The cash provided by operating activities in the current year quarter was primarily attributable to the receipt of the $13.3 million income tax refund that I referenced earlier and an increase in accounts payable resulting from higher raw material purchases.

Although accounts receivable rose $5.4 million from the end of Q1 due to the increases in shipment and too much lesser extent average selling prices. Our DSO declined during the quarter as a result of improvements in our receivables ageing. Inventories at the end of the quarter were down $6.3 million, a 16.4% from Q1 due to a 27.7% reduction in unit inventories, which is partially offset by 15.6% increase in average unit values driven by the increase in wire rod cost.

A portion of the inventory reduction was related to late deliveries on import purchases that have been scheduled to arrive before the end of the quarter based on our current forecasted run rate for Q3, our inventory position at the end of the second quarter represented about 2.3 months of shipment.

As we move into the second half of the year, we expect a significant increase in inventories from Q2 to Q3 due to the stepped up requirements associated with our busy season and the receipt of the imported material that I just alluded to. Accounts payable rose $10.5 million from the first quarter to $19.4 million due to higher raw material purchases over the course of the quarter.

Prepaid expenses and other drop by $14.1 million during the quarter to $2.4 million, which is included in the other change of line item on our cash flow statement. $13.3 million of the decrease was related to the receipt of the tax refund. Capital expenditures for the quarter rose slightly from the prior year bringing the six months year-to-date totaled to$0.9 million.

Looking ahead through the remainder of the year, we continued to expect CapEx to come in at less than $5 million for fiscal 2010. We do not repurchase any shares or stock during the quarter under $25 million share repurchase authorization. Going forward, we will continue to be opportunistic in repurchasing shares based on our business outlook and cash flow expectations.

We will also ensure that we maintain ample borrowing capacity and financial flexibility to capitalize on any growth opportunities that may arrive. We ended the quarter debt free with $52.3 million of cash and cash equivalent up $27.9 million from Q1, which represents about $3 a share.

In comparison as with the end of the prior year quarter, cash on hand amounted only $8,000 and we had $400,000 outstanding on our revolving credit facility. We've had favorable discussions with the number of lenders and expect to either extend or replace our revolving credit facility prior to its June 2nd maturity date.

As we move into the second half of our fiscal year, we expect business conditions to remain challenging due to ongoing weakness in construction markets. In the latest monthly report from the Department of Commerce which was for February, total construction spending fell to $846.2 billion, the lowest level since 2002.

Private non-residential construction spending the primary demand driver for our products was down 24.3% year-over-year, and has now fallen for 11 consecutive months. Public construction fell 5.4% year-over-year as any favorable impact from the federal stimulus has been largely offset by reduced spending at the state and local level due to budget constraint. Our near term outlook for infrastructure construction is clouded by the continued uncertainty regarding the timing for the passage of a new multi-year federal transportation funding authorization.

The funding levels provided for under the previous safety reauthorization which expired last September have been extended on an interim basis through the end of this year. However, states and municipalities remain hesitant to make project commitment until a longer term fix is in place. I will now turn the call back over to H.

H. Woltz

Thank you, Mike. Despite operating at less than 50% of capacity and encountering challenging weather conditions, shipments for our second quarter exceeded expectations by a considerable margin. Our analysis of the drivers of stronger shipping performance would indicate that inventory restocking and purchasing in advance of potential price increase announcements together with the favorable impact of the pending trade cases against China were responsible for the uptick, rather than any recovery of underlying real demand. You may recall that shipments during our first quarter were unexpectedly weak as customers reacted to slow business conditions and the normal lull surrounding the holiday season by reducing inventories to the full extent possible.

We believe that customers return to work after the holidays facing unsustainably lean inventories and beginning in early January, a widely held sentiment that the significant upward momentum in steel scrap prices would continue for the foreseeable future. A combination of these factors in our estimation drove purchasers not only to replenish inventory to levels adequate to meet production requirements, but also to increases purchases to hedge against the potential for rising transaction prices.

Given the pattern of incoming orders through the second quarter and continuing into our third quarter, we see no signs of a recovery in real demand. In fact order entry across all of our product lines has been slow through the first three weeks of our third quarter. Despite weak demand for reinforcing products, steel scrap prices and wire rod prices have risen substantially over the last few months. Our wire rod suppliers have successfully increased transaction prices to recover rising steel scrap cost, aided by higher capability utilization rates following the closure of two mills in 2009 that represented approximately 20% of domestic production capacity.

While construction market fundamentals are weak, it's important to note that economic growth has resumed and the general manufacturing sector is reporting capacity utilization rates above 73%. In the flat products market, steel mill capacity utilization rates exceed 80%.

These improving fundamentals contribute to stronger conditions in the steel market and improved pricing power for producers of wire rod and other hot-rolled products, not withstanding continuing weakness in the construction sector where unemployment has spiked to nearly 25%. Insteel has announced price increases in each of its product lines that are at least sufficient to recovery higher wire rod prices, although it is proving considerably more difficult to actually implement increasers than to announce them.

Competitive dynamics during 2010 have resulted in prices for our reinforcing products rising at a slower rate than the announced increases in our raw material prices, although we're making steady progress. At this point we're cautiously optimistic that we'll eventually recover our higher costs but it is possible that we could experience a period of spread compression until the market stabilized.

Moving to the pending trade cases against PC strand from China, the international trade commission has scheduled its final injury hearing for May 6th and we expect the cases to be wrapped up no later than early July. While it's impossible to predict the ultimate outcome of the cases, we believe the facts supporting our allegations are solid and that prospects for a successful outcome are favorable.

Up to this point the cases have without question impacted Chinese imports where for the six month period ending February 2010, Chinese imports accounted for only 2% of total imports entering the U.S. as compared to 92% in 2008. As we look forward to the next couple of quarters, we believe the macro indicators for our markets point to the continuation of depressed demand for our products.

Typically the non residential construction market lags a general economic recovery by 18 to 24 months. This cycle is certainly not typical, given the large number of commercial loan defaults expected through 2011 or 2012 that will exacerbate the excess supply of developed properties and defer the need for new construction.

We're hopeful that some positive signs of increased activity emerge related to the American reinvestment and recovery act but believe any impact is likely to be overshadowed by declining spending in the private sector, together with the adverse impact of the short term extension in federal highway funding to December 2010, rather than a new multi year authorization.

With the die seemingly cast for lackluster demand over the coming months, the most important factor affecting Insteel's near term financial performance will be our ability to recover higher costs in the marketplace. While the logic for higher transaction prices is clear, Insteel is subject to market forces that will determine the rate at which we can move. We're fortunate to maintain a strong competitive position with world class operating costs and ample financial flexibility and we remain hopeful that the difficult business conditions will serve as a catalyst for growth opportunities.

This concludes our prepared remarks and we'll now take your questions. Mary, would you please explain the procedure for asking questions?

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Tim Hayes from Davenport & Company. Mr. Hayes, your line is open.

Tim Hayes – Davenport & Company

Good morning.

H. Woltz

Good morning, Tim.

Tim Hayes – Davenport & Company

A couple questions. Given there are so many moving parts, with the bad weather and pre-buying and the trade case, what would you expect for shipments for the upcoming quarter in terms of, relative to the normal seasonal uptick that you get? Do you think that we could actually see a below seasonal uptick because we had so much pre-buying in the fiscal second quarter?

H. Woltz

Yes, I think that's possible Tim, that particularly January and February were far more robust than we expected.

Tim Hayes – Davenport & Company

And when we look back, we're showing maybe an average sequential increase for the fiscal third quarter of low teens. Is that about the range that you have normally seen in the past?

Mike Gazmarian

It has actually fluctuated quite a bit over the past few years, due not only to market forces, but also inventory changes which have been a pretty significant factor. So I don't know that there is really a set percentage or a narrow range that we could really lock into because it has been pretty volatile. If you went back to earlier years, it's been in the low double digit range but the past two or three years have been pretty volatile.

Tim Hayes – Davenport & Company

Sure. It is with only a few years of data from our end. And the markets that we've seen, it's tough to really get a good number from just a few years of data. The next question, in terms of the supply of wire rod, what's your expectations of the mills that have shut down? Might they, in your view, be inclined to restart, given the higher prices that we've seen?

H. Woltz

I think that's possible for one of the two mills Tim. The mill in New Jersey as I understand it is being dismantled. That's a permanent closure. I think there is a possibility that the South Carolina facility could reopen at some point in time but it's not on our purchasing horizon at this point in time.

Tim Hayes – Davenport & Company

And my final question. With as much cash as you have on the balance sheet, any plans to deploy that or do you still want to hold that back to get through these challenging times?

H. Woltz

I think our first consideration is maintaining adequate financial flexibility to execute on any growth opportunities that may become available and at this point I would say we're more inclined to be comfortable where we are than to take any other action.

Tim Hayes – Davenport & Company

All right. Thank you.

H. Woltz

Thank you.

Operator

Our next question comes from Robert Kelly from Sidoti.

Robert Kelly – Sidoti

Good morning guys.

H. Woltz

Good morning Bob.

Robert Kelly – Sidoti

Just had a question. You talked about the price increases that you're seeing on raw materials and how they are rising at a slower rate than your prices. So are January, February, March – are spreads widening?

Mike Gazmarian

Actually Bob, it's the other way around. Our price increases have actually lagged somewhat behind the increases for wire rod.

Robert Kelly – Sidoti

Right. So what I'm trying to get a sense of, are March spreads narrower than January spreads or you're expecting some sort of compression going into 3Q?

H. Woltz

Well our price increase announcements for our products really, I believe the first one was effective February 15th, March 15th, end of April. So we went through a sizable part of the second quarter without even having a price increase effective date through half the quarter.

Robert Kelly – Sidoti

Right.

H. Woltz

So I think we're going to have this FIFO impact going forward and I think the point that we try to convey in the prepared comments is just that it's a real struggle to get these prices up and we are making progress, but it is slow and it has been slower than our suppliers have been able to increase transaction prices to us.

Robert Kelly – Sidoti

Right, I understand that. And the reason for that slower price improvement on your part is the competitive response? You have competitors that are trying to discount?

H. Woltz

That's correct.

Robert Kelly – Sidoti

Okay.

H. Woltz

Or its not discount, just lag behind the effective dates that have been put out there by Insteel and other companies.

Mike Gazmarian

Yes, they may be approaching it from a standpoint of a lower carrying value in their inventories.

Robert Kelly – Sidoti

Okay understood. Now, you will see a seasonal pickup. You've seen slowness in April. Is that on a sequential basis or year-over-year? How do you quantify slower demand in the first three weeks of April?

H. Woltz

It's really about consistent with expectations which has been for lack luster demand.

Robert Kelly – Sidoti

Right, so it is kind of on pace with your budget, not necessarily slowing down from what you've seen?

H. Woltz

That's correct.

Robert Kelly – Sidoti

Okay, thank you. Now, assuming you see the normal seasonal uptick, I mean weather had to be quite a bear in this 2Q. Does utilization get over and above 60% in the second half of the year? Is that kind of your expectation at this point?

H. Woltz

Maybe somewhat Bob and it's really difficult to give an accurate answer on it. We could find ourselves in the mid-50s.

Robert Kelly – Sidoti

Okay, understood. And that is kind of what you're budgeting for at this point?

H. Woltz

In that range.

Robert Kelly – Sidoti

Okay, great. Now, just on the tax rate, should we expect a 15% tax rate for the bulk of F10 or at least for the second half?

Mike Gazmarian

The year-to-date percentage will continue to fluctuate and we are been skewed by those factors that we mentioned in the release and in our comments and relating to the change in the adjustment in the refund amount. But on an incremental basis I think it would be reasonable to assume that it falls somewhere in the 38% to 40% range if we are just applying that to the quarterly pretax number that would probably be a reasonable assumption but due to those factors that I mentioned it's going to skew the year-to-date amount just the way calculation flow.

Robert Kelly – Sidoti

Okay, thanks. And then just on – it seems like scrap prices have settled down in April a little bit. Do you see a little bit of sluggishness in your orders because of that? Is that the response you hear? Steel prices aren't moving up right now, and that is why you see the order flow slow down. Because I think that is kind of how you explained how the first fiscal quarter played out.

H. Woltz

Could you just restate the question for me?

Robert Kelly – Sidoti

You've seen a little bit of a plateau short-term with steel scrap. Does that translate into kind of a sluggish order book?

H. Woltz

Well, I think probably we have more significance and that is just whatever over-purchasing was done during the second quarter, that those inventories at customers factories are going to be worked off at some point. I think it has a moderating impact on the order entry rate for April and May.

Robert Kelly – Sidoti

Okay, got it. And then I don't know if you can get into this. You talked about how current volumes are 27% to 30% below where we were in 2006 to 2008. Where are we compared to last year, to F09, like the second half?

Mike Gazmarian

I don't know whether we want to draw a percentage range on that at this point just given the uncertainty.

Robert Kelly – Sidoti

You're not far off the pace, though.

Mike Gazmarian

No.

Robert Kelly – Sidoti

Okay.

Mike Gazmarian

We had – I mean looking back at last years trends we had I think we had a pretty healthy increase in volume from Q3 to Q4, Q3 was relatively low and then we had pick you in Q4. So, now we could see a similar pattern this year to the extent that these restocking in Q2 has pulled away some of the Q3 volume. We could see a similar trend or maybe more back end and again.

Robert Kelly – Sidoti

Okay. Thanks guys.

Mike Gazmarian

Thank you.

Operator

Our next question comes from Nat Kellogg from Hudson Securities.

Nat Kellogg – Hudson Securities

Morning guys how are doing?

Mike Gazmarian

Good, good morning Nat.

H. Woltz

Good morning.

Nat Kellogg – Hudson Securities

Just on the shipments – the imports that you guys are expecting to receive, I assume that is a price at given where the market is today, is relatively attractive.

H. Woltz

That's correct.

Nat Kellogg – Hudson Securities

And then just on the working capital side, I mean it looks like you guys are about as – ended the quarter about as lean as you could possibly go. So and I would assume that we'll see an increase in receivables and inventory and a decrease in payables over the next three months. Is that correct, if we are looking to know what capital is going to look like?

Mike Gazmarian

Yeah that's correct and as we mentioned part of this inventory increase is really timing and in nature where we had made some commitments that we thought would be here by the end of the quarter that's moved out a little later.

Nat Kellogg – Hudson Securities

Okay. All right. That is helpful and so I think, you sort of referenced this with the FIFO issue. But even though you guys are maybe having a little bit of trouble getting the price increases through you would like, given where inventory pricing is likely to be. It wouldn't be unreasonable to assume some continued margin expansion going forward in the short term.

H. Woltz

Yeah I mean as we have stated previously the FIFO effect is going to be there and as we push some more of this price increases through; it is going to have an impact. I mean it's just mathematical.

Nat Kellogg – Hudson Securities

Right. Okay. And then just on the cash and the acquisition, you guys have, I think, steered the ship very nicely through this downturn. But I just, I can't imagine that if – I guess – here's my question. It doesn't seem like any of your competitors have been shaken free yet, and I can't imagine you're going to go through an 18 months that has been worse than the last 18 months. So, what is going to eventually spur one of these guys loose, shake one of these guys loose that you can do an acquisition, which I think obviously would make a lot of sense given where your capacity utilization is and given where industry pricing trends and all that kind of stuff. It seems like it would make a lot of sense and I just – what is going to be the catalyst going forward, because I can't imagine it or more pointed catalyst than we've had over the last 18 months.

H. Woltz

Well I will just pointed that the last 18 months were preceded by 60 months that were pretty strong and I suspect that as Insteel did well during this period so did our competitors and depending on the uses of cash by far other companies that went into this downturn property and pretty solid financial shape. I would also point out that as we evaluate what we believe is the most imperative for the company not just now but it's been this way for several years is looking for growth opportunities and as we thin through that right now we really believe that, that we are in a long distance race here in terms of waiting for recovery in our markets that is difficult is as the last 18 months have been.

I think we've the prospect for a difficult next 18 to 24 months as well and internally we're counseling patients and we are counseling evaluating these opportunities based on what the new reality in the market is rather than looking at trailing five years earnings. So, I think there is – I think the conditions are going to remain pretty harsh and that the fact that the companies have made up to this point doesn't necessarily mean that's it over for them and that things are going to get better.

I would also point out that it's not just companies that may wind up with a balance sheet problem that open the door for opportunities. I think as forward thinking people look at these markets going forward the road to success could be some consolidation not necessarily just having to bail out of a difficult situation. So, we are going to try to be patient and look for opportunities.

Nat Kellogg – Hudson Securities

Fair enough. Okay. That's helpful. All right well that's all I got. Thanks for the color, as always and I'll hop back in the queue. Thanks, guys.

H. Woltz

Thanks Nat.

Mike Gazmarian

Thanks.

Operator

Our next questions comes from John Cawler from Oppenheimer.

John Cawler – Oppenheimer

Good morning gentlemen. How are you?

H. Woltz

Good morning.

John Cawler – Oppenheimer

Two quick questions. I was wondering if you could highlight any areas of geographic strength or weakness and then sort of characterize the inventories in the channel. I think you sort of alluded to the fact that they are a little higher than what you normally might see, given a pre-buy?

H. Woltz

In terms of geographic strength or weakness, that I don't think that there is a specific area that I would highlight as a less impacted by this downturn than another. The nature of our products means that the coastal areas are strong markets for Insteel and that would still be the case although customer serving those markets are effective on a relative basis just like they are everywhere else.

So, I can't really point out any particular strength or weakness there. In terms of the inventories they are actually lower than would be normal given the delayed receipt of some of these offshore purchases that we made and the point we are trying to convey is that a we look toward the third quarter you will see an increase in the inventory levels but we are perfectly comfortable with who ever we expect to be.

John Cawler – Oppenheimer

Okay. Great. Thanks very much.

Operator

(Operator Instructions). I am not showing any further question.

H. Woltz

Okay. Well, we appreciate your interest in the company and look forward to the next conference call. Thank you.

Operator

Ladies and gentlemen this does conclude today's program. You may now disconnect and have a wonderful day.

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