Insteel Industries, Inc. (NYSE:IIIN) Q2 2020 Earnings Conference Call April 16, 2020 10:00 AM ET

Company Participants

H. Woltz - President and Chief Executive Officer
Mike Gazmarian - Vice President, Chief Financial Officer and Treasurer

Conference Call Participants

Julio Romero - Sidoti & Company
Tyson Bauer - KC Capital

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Insteel Industries Second Quarter 2020 Conference Call. At this time, all participants’ lines are in a listen-only mode. After speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions]

I would now like to hand the conference over to your speaker today, H. Woltz, Insteel President and CEO. Thank you. Please go ahead, sir.

H. Woltz

Good morning. Thank you for your interest in Insteel, and welcome to our second quarter 2020 earnings 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 second quarter financial results and market outlook, then I'll follow up to comment more on business conditions and other recent developments.

Mike Gazmarian

Thank you, H, and good morning to everyone joining us on the call. As we reported earlier today, despite continued margin pressure in our markets subject to import competition, Insteel posted strong results for the second quarter of fiscal 2020. Excluding the nonrecurring charges and gains that were referenced in our release, net earnings rose to $0.29 a share from $0.01 a share last year.

The earnings improvement for the quarter was driven by wider spreads between selling prices and raw material costs and strengthening demand for our concrete reinforcing products. Shipments for the quarter rose 19.2% from last year and 19.7% sequentially from Q1, rising to their highest level since the third quarter of 2018 and the third highest in our history for the second quarter. The strong shipping performance was driven by increased construction activity across most of our markets, supported by the generally more favorable weather conditions this year.

Average selling prices fell sequentially for the fifth straight quarter, but to a lesser extent, declining 1.2% from Q1. The pricing pressure continued to be more severe in certain of our PC strand and standard welded wire reinforcement markets susceptible to import competition, which represented around 25% of our overall sales for the quarter.

ASPs for these markets dropped 22% year-over-year, which was double the 11% reduction for the remainder of our business. As we've conveyed on previous calls, import competition in these markets has intensified in the wake of the Section 232 tariffs on imported steel, which apply to imports of our primary raw material, hot-rolled steel wire rod, but not to our finished products.

The program has incentivized foreign competitors to ramp up their downstream exports and aggressively undersell U.S. producers, resulting in material injury to the domestic PC strand industry. Gross profit for the quarter increased $8.3 million from a year ago and gross margin widened 700 basis points to 13.3% from 6.3%, primarily due to the higher spreads, and to a lesser extent, the increase in shipments while on a sequential basis, gross profit rose $9 million from the first quarter and gross margin widened 690 basis points, driven by the same factors, together with lower manufacturing costs. There continue to be a wide disparity in the relative profitability of our plants during the quarter with the locations supplying markets subject to import competition, significantly underperforming our other facilities.

If you roll up the plants that have been more adversely affected by imports, the combined gross profit amounted to $0.7 million or a gross margin of only 2.3% on around a quarter of our sales as compared to $14.6 million of gross profit or a 17.2% gross margin for the remainder of our business.

SG&A expense for the quarter rose $3 million to $9.6 million from $6.6 million or 8.4% of net sales from 5.9% last year. The sharp increase was primarily driven by an unfavorable $1.8 million year-over-year change in the cash surrender value of life insurance policies due to the downturn in the financial markets, with the remainder largely from increases in incentive and stock-based compensation and legal expense.

Our effective tax rate through the first half of the year fell to 21.4% from 23.9% last year due to a $0.2 million benefit recorded in the quarter related to the NOL carryback provisions of the Cares Act. Excluding this benefit, our effective rate for the first half of the year would have been 24.4% as compared to last year's 23.9%.

Looking ahead to the remainder of the year, we expect our effective rate will run around 23%, subject to the level of pretax earnings, book-tax differences and the other assumptions and estimates entering into our tax provision calculation.

Moving to the balance sheet and cash flow statement. Operating activities used $3 million of cash for the quarter due to a $13.8 million build in working capital, driven by increases in receivables and, to a much lesser extent, inventories on the higher sales. Based on our sales forecast for Q3, our quarter end inventories represented 2.5 months of shipments compared with 2.9 months at the end of the first quarter, and on an overall basis, average unit carrying values relatively close to the amounts reflected in Q2 cost to sales.

After funding the Strand-Tech acquisition, we ended the quarter with $40.4 million of cash on hand or over $3 a share and no borrowings outstanding on our $100 million revolving credit facility, providing us with ample financial flexibility and the ability to pursue additional growth opportunities that may develop in this challenging environment. In allocating our cash flow and managing the cyclical nature of our business, we remain focused on three objectives, reinvesting in the business for growth and to improve our cost and productivity; maintaining adequate financial strength and flexibility; and returning capital to our shareholders in a disciplined manner.

Going forward, we will continue to balance these objectives in deploying capital and any excess cash. As we look ahead to the second half of the fiscal year, our visibility is limited due to the heightened uncertainty resulting from the COVID-19 outbreak and the actions taken by governmental authorities to control the spread of the virus.

With our business deemed to be critical infrastructure by the Department of Homeland Security, the pandemic has had a minimal effect on Insteel thus far as we have not experienced any disruptions in our operations and our customers have remained busy working through backlogs. Going forward, however, its eventual impact will be determined based on future developments that are highly uncertain, depending on the severity and duration of the outbreak and the effectiveness of the actions that are taken to contain or mitigate it.

In view of our debt-free balance sheet, our high liquidity and undrawn credit facility and our highly variable cost structure, we believe that we are ideally positioned to navigate through these challenges and remain hopeful they could be a catalyst for further growth opportunities to become available.

I will now turn the call back over to H.

H. Woltz

Thank you, Mike. As Mike indicated, our second quarter results reflect strong shipment growth relative to the prior year, driven by favorable underlying demand for our concrete reinforcing products and a return to more normalized seasonal weather patterns. We also benefited from closer alignment between our raw material costs and average selling prices. We're pleased with the solid underlying demand for our products and our Q2 financial performance.

In response to the COVID-19 outbreak, we've implemented and are observing CDC-recommended procedures for managing our exposure to the pandemic and its transmission at our plants as well as at our administrative offices. With our industry deemed essential, all our manufacturing facilities have continued to operate on regular schedules and order entry has remained robust although we've seen some moderation over the last week in those geographic regions of the country that have been most impacted by COVID-19.

Although, we're unable to predict the ultimate impact of the virus on our business, the overwhelming majority of our customers intend to adhere to their normal operating schedules while observing the requisite procedures to address its spread. We remain committed to fulfilling their requirements, provided that we can do so without compromising the safety of our people. Should we eventually experience a precipitous drop-off in demand, we're prepared to make the appropriate adjustments to our operating plans.

Last month, we completed the acquisition of certain assets of Strand-Tech Manufacturing, a competing PC strand producer located in Summerville, South Carolina. As we indicated in our release announcing the transaction, we plan to close the Summerville facility and service STM’s customers from our other three PC strand plants. We expect that manufacturing activities will cease tomorrow following the conversion of remaining work in process into finished goods.

Additionally, a significant portion of our engineering group has been deployed in Summerville, refining our plans to upgrade certain of the equipment prior to its relocation to other Insteel facilities, a process that will continue for several weeks. Up to this point, we believe the transition for STM’s former customers has been seamless and we’re pleased with our retention rate.

We’re continuing to pursue employment operation – opportunities for former STM employees who have expressed interest in relocating to Insteel facilities, although that process has been complicated by the challenges posed by COVID-19. We plan on listing the Summerville real estate for sale in the very near future and are evaluating options for disposing of the excess machinery equipment and other assets located at the facility. We’re pleased with the substantial progress that’s been made in executing our integration plans, and we’re confident that the transaction will generate attractive returns for our shareholders.

Shifting to another recent development. Today, Insteel, together with two other domestic PC strand producers, filed antidumping petitions against 15 countries, representing 89% of total PC strand imports entering the U. S. in 2019, in addition to a countervailing duty petition alleging illegal subsidies against Turkey. The scope of the filings, which alleged dumping margins from 24% to 194%, reflects the egregious behavior of PC strand producers from these countries in the U.S. market over the 2017 to 2019 investigation period.

We expect the Department of Commerce investigation will run from the first half of May until around the end of May 2021, with milestones tentatively scheduled for June, July and September 2020 and April and May 2021. I should point out, however, that the time line for the cases could be impacted by procedural considerations at the Department of Commerce and the International Trade Commission. As with any litigation, it’s not possible to predict the outcome of these cases, but we believe the allegations are strongly supported by underlying facts and our extensive analysis.

Turning to CapEx. We have previously estimated 2020 expenditures of approximately $17 million, subject to revisions as we move through the year. Our progress on certain significant projects was delayed following the failure of a new production line, which came online a year ago to meet all our acceptance criteria.

During the second quarter, the equipment vendor completed substantial modifications to the line, which resolved the performance deficiencies. As a result of the delay, a significant portion of this year’s outlays are now expected to fall into 2021, and our 2020 CapEx is likely to come in under our initial estimate. I should note, however, that we are not deferring or canceling any planned projects. We are pushing ahead aggressively with our plans, which are focused on significantly reducing our production costs, in addition to broadening our product capabilities in certain markets, expanding our engineered structural mesh capacity and upgrading our information systems technology.

In summary, the outlook for 2020 has become highly uncertain. While our business has remained strong up to this point, we expect to see some softening in coming months as the economy bears the full weight of the COVID-19 mitigation measures. We’ll continue to closely monitor market conditions and aggressively pursue the appropriate actions to optimize our costs. We’ll also continue to be vigilant in pursuing attractive growth opportunities, both organic and through acquisition.

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

Question-and-Answer Session

Operator

Thank you, sir. [Operator Instructions] And our first question comes from Julio Romero from Sidoti & Company. Your line is now open.

Julio Romero

Hey, good morning, everyone. Hope you’re staying healthy.

H. Woltz

Yes. Good morning, Julio.

Julio Romero

Just to start, can you just talk about the current operating environment at your facilities? I understand things are changing pretty rapidly, but are you having social distancing in your manufacturing lines? Are you seeing any distribution challenges, et cetera?

H. Woltz

Yes. We’ve adopted and are observing all the procedures that have been recommended by CDC as well as other knowledgeable sources, which includes social distancing and aggressive cleaning procedures. We’ve also staggered shift reporting where required, but we’re doing everything that we possibly can to mitigate the risk that’s posed by COVID-19.

Julio Romero

Okay. Fair enough. I guess, turning over to Strand-Tech, can you maybe talk about the margin profile of that business and how we should think about – I know they did $29 million in sales last year, but who captures those sales, right? Do you guys expect to capture most of that? Or does that kind of become a jump ball for the industry?

H. Woltz

Well, I think in one respect, our timing was favorable with Strand-Tech as the entire industry has developed concerns that go beyond simply sourcing. And I think, as a result, the environment has been favorable for us. But at the end of the day, customers buy because your service meets their expectations, your pricing meets their expectations and your quality meets their expectations. And we’re convinced that we can offer Strand-Tech’s customer base improvements in the overall value that we deliver to them. So we’re pleased with the retention rate up to this point, but it’s one of these things where we have to earn their confidence every day, Julio.

Mike Gazmarian

Julio, with regard to the margin profile, it should be pretty attractive following the reassignment of that business to our facilities where we’ll just gain from the operating leverage benefit, and the incremental costs associated with that additional volume should be pretty favorable. So I would expect that just from a margin standpoint, it should be positive relative to our overall business.

Julio Romero

Got it. That’s helpful. And then, I guess, just on CapEx, I know you talked about in your prepared remarks that as a result of the delay, 2020 CapEx likely to come in under the $17 million you had initially expected. But I know in the Strand-Tech press release, you talked about how that deal, [indiscernible] that equipment lowers your CapEx requirements going forward. So I guess, how does – can you just talk about how that – the Strand-Tech acquisition also affects your CapEx outlook going forward?

H. Woltz

Yes. Well, first, I would tell you that the statement about CapEx avoidance through the Strand-Tech transaction is absolutely correct. But the CapEx that we will avoid was not necessarily planned for 2020. It would have come at us on – in 2021 and 2022 for the most part. So the timing is an issue there and it’s hard to say exactly what some project delays will mean to 2020 CapEx. It all depends on when we make deposits for new equipment, whether that falls in this year or next year, it’s hard to say.

Julio Romero

Understood, I appreciate that. I’ll hop back into the queue and let others ask some questions. Thanks very much.

Operator

Thank you. [Operator Instructions] Our next question comes from Tyson Bauer from KC Capital. Your line is now open.

Tyson Bauer

Good morning, gentlemen.

H. Woltz

Good morning, Tyson.

Tyson Bauer

On the STM, the $29 million, since they’re feeling the same impacts from the tariffs and the imports, would you suggest that $29 million is a level that is pretty well insulated because they were doing much more years prior, when we didn't have the tariffs and those things. And what do you suggest that would be somewhat stable as we go forward, because they've already taken the brunt of the industry hits that they were going to take.

H. Woltz

Yes, I think the market had not been kind to Strand-Tech over the last couple of years and volume had declined for them, hard to say whether they had reached bottom, but we don't expect any deterioration of the underlying customer base that was there when we made the acquisition.

Tyson Bauer

And, does their customer base pretty well mirror your own?

H. Woltz

It actually is more favorable than ours and they had minimal presence in the posttension segment of that market, which is the segment which is generally been subject to the most import competition.

Tyson Bauer

Okay. Would you expect minimal SG&A increases going-forward as there seems to be a more of an asset versus and you're just incorporating it back to your own facilities?

H. Woltz

Yes, that's correct.

Mike Gazmarian

Yes, there wouldn't be any SG&A impact other than to the extent it contributes to improved results and that impacts the performance incentive plans, but no incremental staffing requirements associated with absorbing the additional volume.

Tyson Bauer

Okay. In the original press release, you talked about some clawbacks to your purchase price, which included the potential 8 million sale of the facility, that you'll do market willing, other assets sales, did they also have any excess net working capital that we could add back or net out to the purchase price?

Mike Gazmarian

No, I think their net working capital position was really right in line with what you would expect. So I wouldn't anticipate any adjustments relating to that.

Tyson Bauer

Okay. At least here in the Midwest, which is probably obviously much different than the Northeast, there's been discussions and news items regarding infrastructure projects that are actually been pulled forward, one, because of the weather; two, because of less traffic and other impediments that may have created at night only work or otherwise. Have you seen that in other areas too? And have you seen a benefit of speed up on certain projects?

H. Woltz

Tyson, we read the same information and we're aware of the acceleration of certain projects. My sense is most of those are repair in nature and that they wouldn't really affect underlying demand for our products, which typically go in the ground or are cast in place in nature and not subject to rapid schedule acceleration based on short-term events.

Tyson Bauer

Okay. And then have you also seen, at least in talking to the various industries, it seems like what's on schedule will occur as it is scheduled to occur, things that did not have a schedule, those are the ones at risk of postponement or delays, not necessarily cancellation, but just a cautious stance on starting something new that wasn't already scheduled. Are you seeing that also?

H. Woltz

Well, I think we're aware of those concerns, but are we actually seeing it, I don't think so. And I think the real matter is funding and what's the funding outlook over time as a result of depressed tax receipts across the board.

Tyson Bauer

Okay.

Mike Gazmarian

Yes. I don't think we've seen any impact from that thus far. I mean in the end, it's just going to be a function of how long the pandemic persists and when we get a resolution and because, as it stands now, I think our customers have largely remained busy working through their existing backlog. It's more an issue of the flow of new projects into the pipeline and the extent to which that gets impacted and that switch doesn't turn off immediately, there's a time lag there. So I mean, I think it will just be a function of the duration of COVID-19.

Tyson Bauer

Alright. Characterize kind of the domestic wire rod supply and pricing. And I think we have facilities that will be shutting down here or has shut down, and kind of the margin implications does that help you keep your pricing a little more sticky due to that situation?

H. Woltz

Well. I think that's a good question and it's going to play out over time. I mean, clearly we've seen dramatic downward moves in scrap. We've seen a great deal of uncertainty in the market, which is expected under the circumstances, I sense that capacity is not a problem at all, delivery times are short and for anyone who needs wire rod in this environment, you probably have a more competitive situation for supply than you would have prior to all of this happening.

Tyson Bauer

Okay. And the next question is a loaded question for you. The discussion of a stimulus for –seems to both parties include some type of infrastructure component to it Administration seems on board, leadership in the house seems to be on board for that, would you think that's more likely to occur or being successful on your anti-dumping filing against those 15 countries on the PC strand or can you get both?

H. Woltz

Well, I think they're independent of one another and certainly not mutually exclusive. I don't see how the federal government doesn’t ante up here on an infrastructure bill under the circumstances. I think that will happen, although it's still speculative. On the anti-dumping cases, I really see they are having nothing to do with any infrastructure bill, this is a matter of the facts that are on the record and whether the allegations can be supported by those facts and we believe strongly that they can.

Tyson Bauer

Well, they could certainly make the infrastructure more of Buy America component as we've seen in the past. That would certainly help you out and not requiring that anti-dumping immediately.

H. Woltz

Well, I mean for the Buy America coverage to be expanded would take a legislative act that I wouldn't expect and I've heard no rumblings on the dumping cases. The impact there, if we're successful should be simply that our foreign competitors are forced to play by the rules rather than it can't play at all. So we just have to see what happens, we've competed with imports in PC strand for 25 years and we've done so successfully until recently when they really didn't play by the rules. So we're hoping just to restore a level playing field here.

Tyson Bauer

All right. Thank you, gentlemen.

Operator

Thank you. And I'm showing no further questions. I would now like to turn the call back to H. Woltz, Insteel, President and CEO for closing remarks.

H. Woltz

Thank you. We appreciate your interest in the company. And we look forward to talking to you next quarter. In the meantime, don't hesitate to contact us if you have questions. Thank you.

Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.