Insteel industries (NASDAQ:IIIN) is the nation's largest producer of steel wire reinforcement products, having nation-wide market presence. Headquartered in Mount Airy, North Carolina, the firm has ten manufacturing facilities across different cities and states in United States. Seven out of ten facilities are dedicated in the production of welded wire reinforcement products (WWR) whereas remaining three are engaged in the manufacturing of Prestressed concrete strand (PC strand) products. Since 2006, the firm has been expanding through acquisitions and enhancement of existing capacities solely in the area of concrete reinforcement products.
The company operates in a cyclical industry with the top-line being highly correlated with the growth in private non-residential construction sector, following expansion in the overall economy. This industry is fragmented with a large number of smaller players, having higher operating costs per unit due to low volumes.
Insteel's main business strategy is to have a dominant share in the market through attaining cost leadership together with continuous capital investments in the core business.
57% of the firm's sales mix consists of WWR products while the remaining portion is made up of PC strand. Segment wise, Insteel's main customers are non-residential construction sector, which comprises of 85% of the total sales revenue whereas rest is residential construction sector. Furthermore, it is to be noted that approximately 30% to 35% of the firm's revenues also come from infrastructure related projects.
Quarterly results snapshot:
Insteel's revenues plunged by 16.48% YoY, owing to decrease in volumetric dispatches and dip in average selling price by 9% and 8.3% respectively. Lower volumes in QoQ basis is merely a function of chilling weather and holiday schedules up to this point. However, company's gross profit improved by ~689 bps, primarily due to increase in spread between the selling price and the raw materials. According to the financial statements of the company, the decline in volumetric sales was largely due to the seasonal downturn and inclusion of the additional slowest week at the end of the quarter whiles dropping the strongest week (in terms of sales) at the beginning of the quarter.
SG&A expenses edged up by 175 bps largely due to increase in compensation expense, following better performance by the company. There has been net profit accretion by whopping 351 bps, primarily on account of expansion in gross profit margin by 689 bps, which was partially offset by increase in more than proportionate increase in SG&A expenses. Effective tax rate has a slight ascend of 10 bps on YoY basis.
The company's bottom-line boosted by ~62% over the same period last year, clocking in at $6.7 million earnings in 1QFY16 against $4.15 million in 1QFY15.
Going forward, I expect gross margin accretion due to lower conversion costs following modernization of inefficient operations and continuous pressure on input prices. Additionally, a rise in SG&A expense would persist, owing to better compensations due to improved financial performance of the company.
I foresee expansion in spreads (difference between raw material and selling price) due to favorable demand trends for reinforcement steel producers as compared to the scrap steel and hot wire rod suppliers. According to the company, weak demand of the scrap steel and wire rod would ultimately assist the arrest of the recent rise in the prices of these metal products as the incumbent spike was largely due to the constricting supply in the winter season.
Going forward, the company is aiming a huge increase in its capital expenditure of CY16 which is $20 million. Bulk of this expenditure would be $9 million investment in the Huston's PC strand manufacturing facility to upgrade an equipment and install new state of the art wire rod cleaning process, which would be comparable to Gallatin and Sanderson PC strand facility. This improvement would lower the per unit cost of production in the Huston plant and would increase its output and productivity, following an increase in the capacity of this plant by 40%. The work is expected to complete by the end of the first quarter of FY17.
Furthermore, the Hazelton facility, which faced under-utilization of capacity owing to delays in commissioning of a replaced modern line following technical facilities confronted by the vendor, is now running at 100% of the expected output level.
In the analyst's conference call, company officials mentioned that one of their competitor is installing additional line of PC strand products in South Carolina to enhance its capacity. However, the management of the firm do not feel that this expansion would have any impact on their sales revenue, assuming the overall continual growth in the market size.
Additionally, passing of the FAST act would also supplement the increase in the firm's top line. Primary product lines that would most likely to benefit because of an increase in infrastructural spending are PC strand, Engineered structural Mesh and concrete pipe reinforcement.
I have used Architecture Billing Index, a diffusion index that serves as a leading indicator, leading the non-residential construction activity by 9-12 months. In its last issue of December 2015, an index depicted modest improvement by giving a score of 50.9, which is above 50 growth threshold. The primary driver in the non-residential construction category was the surge in institutional activity, receiving a score of 52.2.
Furthermore, another leading indicator for non-residential construction activity is Dodge Momentum Index, which is up 1.7% YoY in January 2016, even though the commercial activity has declined 6.8% YoY.
Thus, as aforementioned leading indicators coupled with YoY rising trends in the construction activity, according to the US Census Bureau, are pointing towards an increase in growth of construction activity which is a primary driver for the revenues of Insteel industries.
Valuation: The stock is trading at a P/E ratio of 19.74x against the sector average of 24x, EV/EBITDA ratio of 8.8x. I expect the EPS of FY16 to clock in at $1.70 against FY15 basic EPS of $1.18, an increase of whopping ~44% on YoY basis. The stock has a buy rating with a target price that has been derived through discounted cash flow method, which is estimated to be $35 with the time horizon of December 2016.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.