Insteel's (IIIN) CEO H.O. Woltz on Q3 2014 Results - Earnings Call

| About: Insteel Industries, (IIIN)

Insteel Industries, Inc. (NASDAQ:IIIN)

Q3 2014 Earnings Conference Call

July 17, 2014 10:00 AM ET

Executives

H.O. Woltz III - Chairman, President and CEO

Michael Gazmarian - VP, CFO, and Treasurer

Analysts

Tim Moore - Rutabaga Capital

Tyson Bauer - KC Capital

Jonathan Evans - JWest

Operator

Good day, ladies and gentlemen and welcome to the Insteel Industries' Third Quarter 2014 Conference Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow that time. (Operator Instructions). As a reminder, this conference is being recorded.

Now I would like to turn the call over to H. Woltz, President and CEO of Insteel Industries. Mr. Woltz, you may begin.

H.O. Woltz III

Thank you, Kevin. Good morning. Thank you for your interest in Insteel and welcome to our third quarter 2014 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 on today's call are considered to be forward-looking statements, which 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. All forward-looking statements are based on our current expectations and information that is currently available. We do not assume any obligation to update these statements in the future to reflect the occurrence of anticipated or unanticipated events or new information.

I'll now turn the call over to Mike to review our third quarter financial results and the macro indicators for our construction end markets. Then I'll follow-up to comment more on market conditions and our business outlook.

Michael Gazmarian

Thank you, H. As we reported earlier this morning, Insteel posted strong results for the third quarter of fiscal 2014, with net earnings rising to $5.8 million or $0.31 per diluted share, from $3.5 million or $0.19 a share in the second quarter and $3.3 million or $0.18 a share in the prior year quarter, excluding a net gain from insurance proceeds related to the fire at our Gallatin manufacturing facility, net earnings for the third quarter were $5.3 million or $0.28 per diluted share, the highest level since fiscal 2008, before the onset of the recession in the non-residential construction sector.

Net sales for the quarter rose 16.8% from last year to a record high of $113 million driven by 16% increase in shipments, which also reached an all time high and a 0.7% increase in average selling prices. The previous highs however were not on a comparable basis, as they were achieved prior to our November 2010 acquisition of Ivy Steel & Wire. Since Ivy was generating over $200 million of revenues on a standalone basis in 2008, our pro forma combined revenues were approaching $600 million, which is still significantly higher than our current run rate.

Although demand in our markets remains well under pre-recession levels, we are encouraged by the continued recovery in shipments, which have now risen year-over-year for five consecutive quarters, and in seven of the previous eight quarters.

On a sequential basis, net sales were up 23.8% from the second quarter on a 25.2% increase in shipments, partially offset by a 1.1% reduction in average selling prices, driven by a less favorable product mix relative to Q2.

Gross profit for the quarter improved to $14.3 million from $10.9 million a year ago, with gross margins widening 130 basis points to 12.6% from 11.3%, due to the increase in shipment, higher spreads between selling prices and raw material costs, and lower unit conversion costs and higher operating volumes, relative to the prior year quarter.

Our overall capacity utilization for the quarter improved to 58%, its highest level since 2008. The Gallatin fire and insurance claim did not impact our operating costs for the quarter or the nine month period, as the out of pocket expenses recorded in cost of sales and SG&A expense were offset by insurance proceeds.

Other income for the quarter includes net gain that I alluded to earlier of $0.8 million, representing the excess of the insurance proceeds attributable to the replacement of property and equipment over the carrying value of the assets that were destroyed in the fire.

SG&A expense for the quarter rose $0.8 million from a year ago, primarily due to higher incentive compensation expense, driven by our improved results, partially offset by an increase in the cash surrender value of life insurance policies.

Our effective income tax rate for the quarter fell to 34.4% versus 35.5% in the prior year, primarily due to changes in permanent tax differences. Going forward our effective rate will continue to be subject to fluctuations based upon the level of future earnings, changes in permanent tax differences, and adjustments to the other assumptions and estimates entering into the tax provision calculation.

Moving to the cash flow statement and balance sheet, cash provided by operating activities improved to $14.2 million for the quarter, due to $6.9 million of cash provided by net working capital, and the increase in earnings.

Accounts receivable rose $5.5 million, driven by the sequential increase in sales; inventories rose $7.8 million and accounts payable and accrued expenses increased $20.1 million, largely due to higher raw material purchases, and higher proportion of import receipts during the quarter.

Our inventory position at the end of Q3, represented about 3.4 months of shipment on a forward-looking basis, calculated off of forecasted shipments for the fourth quarter.

Capital expenditures for the first nine months of the year totaled $5.8 million, which includes $1.9 million of outlays related to the Gallatin fire. We have scaled down our CapEx estimate for the year, to less than $5 million, excluding the fire-related outlays, largely due to changes in the anticipated timing of certain payments, previously forecasted for Q4 into early next year.

We ended the quarter with $31.4 million of cash on hand, up $12.3 million from the previous quarter, and no borrowings outstanding under $100 million revolving credit facility, providing us with plenty of liquidity.

As we move into the last quarter of our fiscal year, the macro indicators for our construction end markets are reflecting continued improvement. After dropping into negative territory for two straight months, the architectural billings index moved back into positive territory in May, rebounding to 52.6. It has now remained above the 50 growth threshold for 17 of the previous 22 months, its longest positive streak since 2007, implying increased construction spending for non-residential buildings in the coming months.

Private non-residential construction spending through the first five months of the year was up 12.5% from last year, and a seasonally adjusted annual rate has now risen year-over-year for 10 straight months, and at a double digit rate over the past five months.

Public construction spending however has remained relatively weak on an overall basis. The May (7:39) year-to-date total fell about a percent from last year, although the highway and street and transportation carryovers were up around 4%.

The outlook for federal transportation infrastructure construction spending continues to be clouded by uncertainty in view of the upcoming expiration of the current MAP-21 funding authorization in September, and recent forecasts indicating that the Federal Highway Trust Fund could be depleted by the end of August.

As we had anticipated on our last call, it now appears likely that a short term extension will be enacted, that provides additional time for the development of a longer term funding plan.

You may recall that following the expiration in the previous SAFETEA-LU highway bill in September 2009, a series of nine short term extensions were required, before MAP-21 was enacted almost three years later in July 2012.

Although, the limited duration of the extension is likely to be passed as disappointing, we are encouraged by the increased dialog in Washington regarding longer term funding solutions, particularly the bipartisan Corker/Murphy proposal, which had increase the gas and diesel tax by $0.12 over a two year period, and then index the taxes to inflation.

The resulting revenue infusion has been estimated to range from $160 billion to over $200 billion over a 10-year period, which would be sufficient to offset the anticipated shortfall in the highway trust fund, that has required over $54 billion of transfers from the general fund of the treasury since 2008.

I will now turn the call back over to H.

Michael Gazmarian

Thank you, Mike. As reflected in our release and in Mike's comments, we are encouraged by the continued improvement in market conditions during the third quarter. These favorable trends are largely consistent with the various macro-indicators and forecasts for the construction sector, and our previously stated view that demand for our reinforcing product should improve over the next few quarters.

While our capacity utilization improved to 58% in Q3, it remains depressed on an absolute basis relative to pre-recession levels, and we suspect that competitors are operating at comparable rates.

Taken together, slow growth, capacity additions by certain competitors and concerns about the resilience of the construction recovery, have contributed to highly competitive pricing environment that prevails in our markets. We expect that these conditions will persist, until there are further meaningful improvements in demand.

With that said, the pricing environment during our third quarter was relatively stable, reflecting growing demand for reinforcing products and lower volatility in pricing for our principal raw material, hot rolled wire rod, contributing to the more stable pricing environment has then reduced volatility in the steel scrap markets, which have traded at a narrow range over the past few months. We welcome the stability, and would like to see it continue.

Ultimately, we would expect to see the opportunity to expand margins, as market conditions continue to improve, and capacity utilization rates rise, providing the industry with the opportunity to sell more selectively.

As we reported previously, last January, a group of domestic wire rod producers filed anti-dumping and countervailing duty cases against China, which has been the primary source of imported wire rod to the U.S. market for the last two years. On July 8, the Department of Commerce published its preliminary determination in the CBD case, indicating subsidy rates between 10% and 81%. Commerce is scheduled to make its preliminary determination in the anti-dumping case on August 29. We expect that the anti-dumping duties will be substantial and that domestic producers will prevail in their injury argument, causing China to exit the U.S. wire rod market. Final determinations in the cases are expected some time between November and January.

In anticipation of successful Chinese trade cases, we elevated our import purchases and inventory levels to bridge the transition from China to other offshore sources for the portion of our material requirement that is imported, which can vary depending on market conditions from about 15% to 30%. In assessing the attractiveness of offshore purchases, we consider the working capital implications and pricing exposure that are inherent due to the longer lead times and larger order quantities relative to domestic purchases.

Predictably, other foreign sources have replaced Chinese producers, and we expect a continuation of ample availability. Transaction prices for imported material have risen by approximately $60 per ton, implying the need for us to increase selling prices for our product lines that consumer foreign rod, in order to avoid margin compression, and that process is currently underway. Although it's too soon to comment on the likelihood that we will recover these additional costs, cyclical and seasonal factors cause us to be optimistic.

Mike mentioned that we scaled down our CapEx forecast due to timing issues associated with payments for machinery commitments. Going forward, CapEx will continue to be focused on maintaining our facilities and our information systems infrastructure, expanding capacity where warranted, improving quality and reducing operating costs. We continue to view maintenance CapEx in the range of $5 million to $6 million annually.

Finally, Mike touched on the financial impact of the fire that we experienced in January at the Gallatin, Tennessee PC strand facility. The repair work on the facility is approximately 60% complete and we continue to expect the startup of the reconstructed cleaning operation will occur during the fourth fiscal quarter. Our people working in cooperation with the responsive group of outside tool processors have done an excellent job of making this unfortunate incident a non-event for our customers.

To summarize, the recovery in non-residential construction markets has accelerated somewhat, resulting in an uptick in our capacity utilization rate, although the market environment remains highly competitive. Our most immediate external concern relates to the looming crisis with the Federal Highway Trust Fund, an unfavorable outcome for discussions to shore up federal infrastructure funding, to begin negatively impacting certain Insteel customers late in the first fiscal quarter or early in second fiscal quarter of 2015.

Consistent with prior periods, we will continue to focus on achieving further improvements in the effectiveness of our manufacturing operations and identifying additional opportunities to broaden our product offering and grow through acquisition.

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

Question-and-Answer Session

Operator

Certainly. (Operator Instructions). And our first question comes from Tim Moore of Rutabaga Capital. Your line is now open.

Tim Moore - Rutabaga Capital

Yes thank you, appreciate it. Congratulations on the quarter's top line growth acceleration and the nice rise in utilization, but I was just wondering you know, with so much net cash now and your untapped revolver, as well as interest rates low, can you kind of may be share with us, if you give me consideration to may be doing a buyback and how you weight that against, maybe a strategic tuck-on acquisition?

H.O. Woltz III

Our view on that is consistent with past periods, where we view the number one objective of the company for use of its resources to be finding growth opportunities going forward. Once we believe that we have adequate liquidity to accommodate those; as you know, we have a buyback resolution in place. We also have a history of returning cash to shareholders through special dividends as warranted. So I don't think the company's position has changed at all, those are the priorities or the continuing priorities, and I think you can expect us to act in the future as we have in the past on those issues.

Tim Moore - Rutabaga Capital

Great. Thank you.

Operator

Thank you. And our next question comes from Tyson Bauer of KC Capital. Your line is now open.

Tyson Bauer - KC Capital

Good job gentlemen, and hopefully, better quarters ahead.

H.O. Woltz III

Thanks Tyson.

Tyson Bauer - KC Capital

Couple of quick questions, we talked about the private there or non-public activity in the construction site. Do you have a sense of any pockets of greater strength and others, maybe on the commercial or institutional or industrial segments that you've seen a greater benefit, given the location of your manufacturing facilities?

H.O. Woltz III

I would say that disparity is more geographic than by construction. And I don't know that we have tremendous visibility into each construction segment, except for the data that's Department of Commerce oriented. Geographically, we continue to see Texas and the surrounding areas as the strongest market, but recovery elsewhere as well.

Tyson Bauer - KC Capital

Okay. Nice segue with Texas you mentioned that in your answer. We are seeing more states independently not -- basically counting on the federal government to provide funding for infrastructure needs and doing special activities raising funds, doing their own bills that are more state oriented, and so, looking for matching federal funds, they seem to be the leader in the country of doing that. You are ideally located in Texas. Is that going to be a growing theme, if the best that we are hoping for on the federal policy is just to maintain previous spending levels, and they may do add on bills there specific to bridges or otherwise, but the general highway funding seems to be, best case scenario just maintaining. Will we see a greater percentage then going on to the states and the local municipalities to meet their infrastructure needs?

H.O. Woltz III

Yes. I mean, we would expect that to be an ongoing theme, where there has been a lot of situations and then the states really don't have a choice, because they can no longer defer certain outlays. So you're seeing a lot of alternative approaches being pursued to raise revenues through the various means and to the extent there is continued uncertainty at the federal level, we expect the states will get more aggressive.

Tyson Bauer - KC Capital

We are also seeing a trend in the oil-energy markets, having to provide funding for states, as they use the infrastructure for a lot of their trucking needs in fracking operations and otherwise. Is that a pocket of strength that you're also participating in?

H.O. Woltz III

We believe we are benefiting from that, but it's difficult for us to get that granular and pinpoint like how much demand or consumption is driven by that specifically.

Michael Gazmarian

Tyson, I am sure you've read about some of the mega chemical projects that are underway in the shale oil geographies and those facilities do require a lot of underground infrastructure that consume our products. So to the extent that those facilities wouldn't be built or [indiscernible] for the fracking and the shale oil phenomenon, then we are definitely benefiting, although its impossible to quantify.

Tyson Bauer - KC Capital

Okay. The higher shipments you had in the quarter obviously have a seasonal benefit there. Did you see any outsize increase, because we had the weather situation earlier in the year, or do you think what you saw was really reflective of the industry gaining some momentum, and that's what we should continue to see as we go forward?

H.O. Woltz III

Yeah, that sequential shipment increase of 25% that's significantly higher than what we would typically experience. So it is a combination of factors, whether there is definitely some effect from pent-up demand due to the adverse weather in the previous quarter, but the increase was above and beyond that, reflecting continued improvement in activity.

Tyson Bauer - KC Capital

Okay. Last question, you talked about some of the industrial, the chemical plants, some of the other growth areas. Are you seeing a better adoption rate and better reception to your ESM product line, and do you think that will facilitate better margins as we go forward?

Michael Gazmarian

Yeah, we continue to make good progress with state DOTs and individual customers to adopt ESM as alternative means of reinforcing, and we expect growth out of that sector and I'd say, we are proceeding on the expected schedule.

Tyson Bauer - KC Capital

Sounds great. Thanks a lot gentleman.

Operator

Thank you. (Operator Instructions). And we do have a question from Jon Evans of JWest. Your line is now open.

Jonathan Evans - JWest

I am sorry. This may be a silly question, but especially in Texas, it seems like the cement companies and the readymix guys are getting pretty aggressive on pricing and start to push pricing. Does that give you any ability to have cover to push price for your product in Texas as opposed to other markets, or could you give us any insights into that?

Michael Gazmarian

I would say, it doesn't really give us any color. I think the same market for us is that are allowing the cement related industries to raise prices are positively affecting our business, but there is no direct linkage. So I would take that as a positive underlying fundamental of the market, but I wouldn't infer anything about our ability to price our product from it.

Jonathan Evans - JWest

And then just relative to spreads, I mean, with what you see, relative to scrap pricing? Would you think spreads get better in Q3 as opposed to Q2? I mean, relatively or sequentially?

Michael Gazmarian

Well its hard to say and we make a habit of not forecasting spreads and margins, but if you go back to the comment that I made on what its going to take for us to see that opportunity to expand our margins, we are really going to need to see the industry operating at better levels of capacity utilization and I think that just implies the need for continued market improvement.

Jonathan Evans - JWest

Got it, great. Thank you for the answers. I appreciate it.

Michael Gazmarian

Okay, thank you.

Operator

I am not showing any further questions at this time.

H.O. Woltz III

Okay. In that case, we appreciate your interest in Insteel, and we look forward to talking to you next quarter. Thank you.

Operator

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

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