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Insteel Industries Inc. (NASDAQ:IIIN)

F3Q10 (Qtr End 31/06/10) Earnings Call

July 22, 2010 10:00 am ET


H. O. Woltz III - President and CEO

Mike Gazmarian - VP, CFO and Treasurer


Chris Haberlin - Davenport & Company

Robert Kelly - Sidoti

John Kohler - Oppenheimer & Close


Good day ladies and gentlemen and thank you for standing by. Welcome to the Insteel Industries third quarter conference call. At this time all participants are in a listen-only mode. Later we will conduct the question-and-answer session and instructions will follow at that time. (Operator Instructions) As a reminder, this conference may be recorded.

I would now like to introduce your host for today Mr. H. O. Woltz III, President and CEO. Sir, please go ahead.

H. O. Woltz III

Thank you, Karen. Good morning. Thank you for your interest in Insteel and welcome to our third 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 will turn it over to Mike to review our third quarter financial results and the most recent indicators for the macro drivers of our business and then follow up to comment more on the PC strand trade cases, market conditions and our business outlook.

Mike Gazmarian

Thank you H. As we reported earlier this morning, despite the continuation in severely depressed market conditions, Insteel [upholds] to the second consecutive quarter of earnings. Net earnings for the third quarter ended July 3rd, were $1.6 million or $0.09 a share compared with the net loss of $1.7 million or $0.10 a share for the same period last year.

The prior loss for the quarter included a pre-tax charge of $2.9 million or $0.10 a share after tax for inventory write-downs to reduce the carrying value of inventory to the lower cost to market. Excluding these write-downs, last year’s results would have essentially been at a breakeven level.

Insteel’s results for the third quarter were favorably impacted by higher shipments and spreads between selling prices and raw material costs and lower unit conversion costs. Net sales for the quarter increased 8.8% from the prior year driven by 8.5% increase in shipments and a 0.3% increase in average selling prices.

On a sequential basis, net sales were up 18.3% from the second quarter of fiscal 2010. Q3 shipments rose 8% sequentially from Q2, reflective of the usual seasonal pick-up that we experienced between the quarters. However, even with the higher volume for the quarter, our Q3 shipments were still 40% under the peak level for the previous five years.

Average selling prices for the third quarter rose 9.7% sequentially from Q2, due to the price increases that we implemented during the quarter to recover escalating raw material costs. Gross profit for the third quarter increased to $7.7 million from $6.2 million in the second quarter and $1.2 million in the prior year, while gross margins rose to 12.4% in net sales from 11.9% in the second quarter and 2.1% in net sales in the prior year.

Gross profit in the prior year quarter included the $2.9 million for inventory write-downs that I that alluded to earlier. Excluding these write-downs, last year’s gross profit would have been $4.1 million or 7.2% in net sales.

The year-over-year improvement in gross profit was driven by the absence of inventory write-downs in the current year quarter, the increase in shipments, wider spreads between average selling prices and raw material costs and lower unit conversion costs.

Total unit production for the third quarter was up 22% from last year and 6% on a sequential basis from Q2, which increased our overall capacity utilization at 52% from 49% in the second quarter and 42% a year ago, and reduced our unit conversion costs relative to both periods.

SG&A expense for the quarter increased $0.3 million or 7.5% from the prior year, primarily due to the relative changes in the cash surrender value of life insurance policies which was partially offset by a reduction in bad debt expense. Cash surrender values depreciated during the current year quarter due to the drop-off in the financial markets while increasing in the prior year.

Our effective income tax rate for the third quarter rose to 50.8% from 41.5% a year ago, primarily due to about 150,000 of tax reserve adjustments that were recorded during the current year period together with changes in permanent book versus tax differences. If we were to exclude the reserve adjustments and the 501,000 benefit that was recorded in the second quarter relating to the increase in our prior year federal tax refund, our effective tax rate would have been in the 44% to 45% range for both Q3 and the nine month period. These percentages are still higher than our effective rate for the past few years which was in the neighborhood of 36% due to the amplified impact of permanent book versus tax differences resulting from the lower pre-tax earnings in the current year.

Moving to the cash flow statement and balance sheet, operating activities used $6.8 million of cash for the third quarter, while providing $23.1 million in the prior year quarter, primarily due to the year-over-year changes in net working capital.

Net working capital used $10.7 million of cash during the current year quarter, primarily due to a $9.7 million increase in inventories from the reduced levels as of the beginning of the period. In the prior year quarter, net working capital provided $20.7 million, largely due to a $17 million decrease in inventories, resulting from the inventory reduction initiative that we were pursuing at that time.

Accounts receivable at the end of Q3 were up $5.2 million from the second quarter due to the sequential increases in shipments and average selling prices, although our day's sales outstanding decreased during the quarter as a result of improvements in our receivables aging.

Q3 inventories were up $9.7 million from the second quarter, due to 20.3% increase in unit inventories and an 8.1% increase in average unit values driven by increasing wire rod costs. A portion of the unit increase in inventories was related to late deliveries on import purchases that were scheduled for receipt in Q2, but did not arrive until the third quarter.

Based on our forecasted run rate for Q4, our inventory position at the end of the third quarter represented about 80 days of shipment with raw materials at about 44 days with the 4 days and the finished goods at 32 days.

Accounts payable at the end of the third quarter were up $2.1 million from Q2 due to higher raw material purchases. Capital expenditures for the third quarter rose slightly from the prior year, bringing the nine month year-to-date, till it was $1.2 million.

Looking forward, we expect CapEx for fiscal 2010 to come in at less than $3 million. We did not repurchase any shares of our stock during the third quarter under a $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 while maintaining ample borrowing capacity and financial flexibility to capitalize on any growth opportunities that may arise.

We ended the quarter debt free with $44.2 million of cash and cash equivalents or about 250 a share, down $8.1 million from Q2, primarily due to the inventory increase that I commented on earlier. In comparison, our cash balance amounted to $21.6 million at the end of the prior year quarter. On June 2nd, we closed an amendment to our revolving credit facility which among other changes extended the maturity date by five years to June 2nd, 2015, reduced the commitment amount from $100 million to $75 million and released the equipment real estate and fixtures that were previously pledged as collateral.

The facility will continue to serve as a source of funding to cover our expected working capital, capital expenditure, general cooperating growth requirements. Given the current credit environment we are pleased with the five year extension, which attests Insteel's financial strength and stability.

As we move into the second half of the calendar year, the most recent indicators and forecasts for the construction sector imply continued weakness in our markets. In the latest month we reported from the department of commerce which was for May. Total construction spending dropped 8% from the prior year.

Private non-residential construction spending, the primary demand driver for our products was down almost 25% from last year with every category reflecting year-over-year decreases, while public construction fell about 4% as a favorable impact from federal stimulus funding was offset by reduced spending at the state and local levels.

Yesterday, the American Institute of Architects reported at its Architectural Billings Index or ABI which serves as a leading indicator for non-residential construction, rose slightly in June to 46, from 45.8 the previous month or continue to trend below the 50 threshold that constitutes growth.

The ABI has now remained in negative territory for 29 consecutive months. Assuming the approximate 9 to 12 month lag time between architecture, billings and construction spending continues to hold true. The depressed level on non-residential activity is likely to persist for sometime.

Last week, the AIA issued a semi-annual consensus construction forecast in which it surveyed five of the nations leading construction forecasting firms. Non-residential construction was projected to decline 20% in 2010 as compared to the 13% decrease that had been forecasted in the previous report, reflective of the deteriorating outlook for the year.

Drilling down to individual sectors. The latest forecast projects close to a 30% reduction for the commercial sector over 20% for manufacturing and 12% for institutional construction. Although we continue to believe the long-term prospects for infrastructure construction are promising in view of the apparent deficiencies that need to be addressed. The near term outlook continues to be uncertain, pending the resolution of a new multi-year federal highway funding authorization, which is likely to remain in a holding pattern until sometime after the mid-term election.

I will now turn the call back over to H.

H. O. Woltz III

Thank you, Mike. I want to focus my comments on results of the PC strand cases and expectations for market conditions over the next couple of quarters. Concerning the trade cases, we are pleased with the outcome which supports our contention, the Chinese PC strand competitors sprouted US trade laws in expanding the market presence to where they represented 92% of the imports entering the country in 2008 and 41% of apparent domestic consumption. We believe that combined anti-dumping and countervailing duties which range from 70.32% to 221.79% depending on producer, will be sufficient to offset the impact of the illegal benefits available to the Chinese, and that if they elect to compete in the US market going forward, it will be on a more leveled playing field.

As we pointed out previously, the immediate impact of the cases on the domestic market and on Insteel will be minimal given the fact that the Chinese have been out of the US market the tendency of the cases. Longer term however, China's massive strand over capacity will likely be targeted at markets other than the US and the European Union which imposed duties on Chinese producers several quarters ago.

While on the subject of imports, I should mention that imports of non-Chinese origin PC strand continued to enter the US market at elevated volumes relative to depress domestic demand with European producers representing slightly over half the volume, most likely due to weak conditions in their home markets. We will continue to monitor these trends.

Let me turn my comments now to current market conditions and our outlook for demand over the next few quarters. As we discussed on our previous conference call, raw material costs had risen substantially since December 2009 and Insteel had initiated a series of price increases with the objective of recovering these higher costs in its markets.

We also reported that competitive dynamics had resulted in some compression and spreads as selling prices for our reinforcing products rose to a lesser extent than increases in our raw material costs.

As reflected in our results today, the trend persisted through the third quarter, although it was mitigated to some extent by the consumption of lower cost material from inventory. And as pointed out in the release today, these pressures have carried over into the first few weeks of the fiscal fourth quarter.

We are frequently asked by investors whether rising or falling raw material prices are more favorable for the company. There is no absolute generalization that can be made in response to the question, because the real driver of pricing and margins in our business is the relative balance between supply and demand for the reinforcing products we produce. In the case of our third quarter, we operated at slightly over 50% of capacity and we suspect the same held true for most of our competitors, giving rise to significant excess supply in all of our markets.

In this weak environment, it’s apparent that some competitors have become more volume driven as they seek to recover market share that was lost over recent quarters, and others appear to be pursuing cash flow at the expense of margins.

In response, we made the appropriate commercial adjustments, consistent with our commitment to keep our customers competitive in their markets during this intensely competitive period. As we pointed out in the release, it’s likely that these competitive dynamics will have an adverse impact on margins during the fourth quarter.

Looking out further, there are indications that raw material pricing may moderate due to declining prices for steel scrap and lower demand for wire rod driven by weakening conditions in the automotive sector and continued anemic conditions in construction markets. Whether moderating raw material prices mitigate the margin compression we are experiencing, will be determined by the competitive dynamics at that time.

As we have said before, our customers can depend on Insteel to keep them competitive in both up and down market cycles.

Turning to the longer term outlook for demand for our reinforcement products, Mike provided a number of data points that point to the continuation of depressed conditions for the next few quarters.

Non residential construction is a lagging industry, typically trailing trends in the general economy by 12 to 24 months. The current cycle we are experiencing however is anything but typical given the large number of commercial loan defaults that are anticipated which will exacerbate the excess supply of developed properties and dampen demand for new construction.

We are hopeful that some positive signs of increased activity emerged related to the American Reinvestment and Recovery Act, but believe any impact is likely to be muted by reduced spending in the product sector together with adverse impact of state budget shortfalls. Infrastructure spending has also been negatively impacted by the short term extension in federal highway funding to December 2010, which creates uncertainty for states and municipalities regarding the timing and availability of project financing. Congress and the administration need to put in place a new six year funding plan without delay.

In view of the weak outlook, we will continue to focus our efforts on minimizing our cash operating costs, maintaining our strong balance sheet and preserving our financial flexibility so we are able to pursue any attractive growth opportunities that may arise during this downturn.

This concludes our prepared remarks and we will now take your questions. Karen, would you please explain the procedure for asking questions.

Question-and-Answer Session


Certainly. (Operator Instructions) Alright, we do a question in queue from the line of Chris Haberlin of Davenport & Company.

Chris Haberlin - Davenport & Company

I just wanted to see if you all could give some tax rate guidance for Q4 and then for fiscal ‘11, just given the kind of ups and downs you have seen in the past few quarters?

Mike Gazmarian

I don’t know that we’d be able to give any more specifics just due to the nature of the prominent book tax differences which have a disproportionate impact when our pre-tax earnings are at a lower level. If you go back to the prior years, when the pre-tax numbers was at a much higher level. We were pretty consistent in the 36 range, but I don’t know that I’d want to throw the range for Q4 or for next year at this point.

Chris Haberlin - Davenport & Company

Okay. And then, can you just talk about what you are seeing on the wire rods supply side. I know that the supply had been tight in just kind of what you are seeing there. I think there’s the mills coming back.

H. O. Woltz III

The supply had been tight and we would attribute that mainly to the 2009 closure of two producing facilities, together with the simultaneously uptick in the automotive market. That seemed to be disproportionately strong, beginning in August or September of 2009 and actually running through the spring. We are seeing now that some of the automotive applications are seeing weaker demand and the wire rod market has loosened up some as a result. We also mentioned that there is the prospect for lower steel scrap prices going forward, so those things are having some effect on the market.

Chris Haberlin - Davenport & Company

Okay. And then finally, can you just give us an idea of what's your geographic exposure kind of on a state-by-state basis? Are there any states that you are much more exposed to than others or is it pretty kind of consistent along the East Coast and South East?

H. O. Woltz III

No. If you look at our shipments where we are stronger in the states that use a high percentage of concrete and construction activities like Texas, like Florida, so I wouldn’t say that we are exposed to any particular state as much as I would say we are exposed to concrete construction.


Thank you. Our next question comes from the line of Robert Kelly of Sidoti.

Robert Kelly - Sidoti

A question on the trends, maybe into the end of your third fiscal quarter and a comment on how you are seeing the supply channel inventories there?

H. O. Woltz III

You mean the trends in the inventories in the third fiscal quarter?

Robert Kelly - Sidoti

About order trends at the end of the third quarter and what the channel inventory looks like.

H. O. Woltz III

I think, unit shipments have been reasonably close to expectations just on well off the pace of more normal markets, Bob.

Robert Kelly - Sidoti

Did they accelerate in the middle of the third quarter and trail off by June? You know that’s kind of what I’m looking for, were they balanced throughout the quarter?

Mike Gazmarian

I don’t think there was much volatility period-to-period within. Within the quarter we experienced the usual seasonal rise, but nothing beyond that.

Robert Kelly - Sidoti

How about your customers inventory position?

H. O. Woltz III

It’s hard to gather any objective evidence on it, Bob, but generally our customers are intensely aware of inventory levels and working to keep them in manageable ranges and I would tell you that just anecdotally we don’t detect out of balance conditions with our customers.

Robert Kelly - Sidoti

As far as the pricing action that you took, I mean when you talk about the fork, do you spread compression that the pressure is carrying over. Is that a function of your raw material costs rising and you are still trying to -- you are being behind the curve on price. The price increases that you try to institute just didn’t get through and are unlikely to.

H. O. Woltz III

I think it’s more the latter, Bob. The raw material prices did rise. We have been unsuccessful in fully recovering those in the marketplace despite, what I would tell you is a good effort and the realization that our competitors didn’t want to do that is a reality we’d have to deal with.

Robert Kelly - Sidoti

So, it’s the reverse kind of going on. You’ve seen scraps, scraps starting to drop-off and wire rod is expected to weaken a little bit. I mean how is your pricing trended in this environment towards the end of the quarter? Would you be able to hold the line on pricing like you have in the past?

H. O. Woltz III

It’s hard to tell. It’s sort of a day-to-day story, Bob, but we were pursuing price increases sufficient to recover our raw material costs up through probably the second half of June, and as we begin to see that the market wasn’t necessarily moving in that direction, we begin to reflect those commercial realities in the marketplace.

Robert Kelly - Sidoti

Can you just talk about the strand actions? Have you seen an increase in volume in that market as a result?

H. O. Woltz III

No. As I mentioned in my comments and as we have said on previous calls, the Chinese have basically been out of the market during the tendency of the trade actions, which is typically the way that these things work. We have also mentioned on a number of occasions that the strand market is a significant lagging market where customers generally had pretty significant backlogs and what we have seen over the last year is that customers have generally been liquidating those backlogs at rates that exceed their acquisition of new business. So, we have not seen any measurable impact of the trade cases on our shipments.


Thank you. Our next question comes from the line of John Kohler of Oppenheimer & Close

John Kohler - Oppenheimer & Close

I was wondering if you could talk about maybe some areas that geographically are showing strength. I imagined Texas probably one compared to others.

H. O. Woltz III

Relative to more normal market conditions, I wouldn’t say that we are seeing strength in any geographies. I mean, I think you look and Florida and Texas, both of which are big consumers and construction is weak in both of those areas as it is up the East Coast. So, there is no particular geographic bright spot that I could point you to.

John Kohler - Oppenheimer & Close

Okay. So, those two are the composition for a moment. If you look at it, do you see anyone that might be stressed in the environment where it might begin to reduce the capacity or is it still some ways away or not likely at all?

H. O. Woltz III

There is no real good visibility into that. I would tell you that conditions are difficult as we stated in the last call. Conditions are likely to remain difficult for a protracted period of time and just looking at the industry fundamentals, you would think certainly there some companies out there that are feeling the strings. But we don’t have enough good data on it to be able to answer the question definitively.

John Kohler - Oppenheimer & Close

Okay. Well, you are in a great position with the balance sheet the way it is. If I could sort of get some more, I’d say color, but more background there. If you were looking at an acquisition, what type of hurdle rate are you looking to achieve if you see any out there, or how important is it for you in this environment with, it’s just so bleak to maintain the balance sheet in its current state?

H. O. Woltz III

Well, I think clearly that we would avoid taking any action that put us behind the ball with respect to financial flexibility. We have stated previously and it’s still the case that the growth opportunities that interest Insteel are in its core businesses and as you would expect that any acquisition would come with substantial synergies. I think that we have the financial flexibility to take the long view, but overtime, we are driven by cost of capital as our hurdle rate and I wouldn’t foresee that changing.

John Kohler - Oppenheimer & Close

I mean you are doing a great job in a really horrid environment. So, thanks very much.


Thank you. (Operator Instructions) And I see no further questions in the queue at the moment.

H. O. Woltz III

Okay. Thank you for your participation and your interest in the company and we look forward to talking to you next quarter.


Ladies and gentlemen, thank you for participating in today's meeting. This does conclude the program. You may now disconnect. Everyone have a great day.

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Source: Insteel Industries Inc. F3Q10 (Qtr End 31/06/10) Earnings Call Transcript

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