Insteel Industries Inc (IIIN) Q2 2021 Earnings Call Transcript

Good day, and thank you for standing by. Welcome to the Insteel Industries Second Quarter 2021 Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Mr. H. Woltz, President and CEO. Please go ahead.

Thank you. Good morning, and thank you for your interest in Insteel, and welcome to our second quarter 2021 conference call, which will be conducted by Mark Carano, our Senior 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 that are subject to various risks and uncertainties, which could cause actual results to differ materially from those projected. The risk factors are described in our periodic filings with the SEC. We're pleased with our second quarter performance that was driven by strong underlying demand for our reinforcing products and escalating steel prices. We expect both trends to continue through our third quarter and likely through the end of the fiscal year. In environments of strong demand and escalating pricing, the company's results are typically favorably impacted by the implementation of price increases sufficient to recover the higher replacement costs for our raw materials, together with the consumption of lower-cost inventories under the first-in, first-out accounting method. I'm going to turn the call over to Mark to comment on our financial results for the quarter and the macro environment, and then I'll pick it back up to discuss our business outlook.

Thank you, H, and good morning to everyone joining us today. As we reported earlier this morning, Insteel posted exceptionally strong results, driven by continued robust demand for its concrete reinforcing products, which has remained resilient over the last 4 quarters, and a widening of spreads between selling prices and raw material costs. Net earnings for the quarter more than tripled from a year ago, rising to $14.9 million or $0.76 per diluted share from $4.4 million or $0.23 per share. Shipments for the quarter increased 5% from last year and 3.1% sequentially from Q1. Volume growth for the quarter was broad-based across our footprint and consistent during all 3 months of the quarter despite very minor disruptions from the inclement weather in Texas and much of the middle of the United States. Average selling prices increased 15% from last year and 12.7% sequentially from Q1 due primarily to price increases implemented in the latter half of the first quarter and throughout the second quarter to offset the rapidly escalating raw material costs. The supply of wire rod in the U.S. market has become progressively more constrained during the quarter, given strong overall demand leading to substantial price increases. To add some perspective to this, steel scrap, the primary input in production of wire rod has increased in price by more than 60% over the last 6 months relative to the benchmark Chicago shredded index. Gross profit for the quarter increased $15 million from a year ago, and gross margin expanded to 21.7% due primarily to widening in spreads as average selling prices outpaced rod cost increases during the period. Gross margin remained consistently above 20% during each month of the second quarter, reflecting the underlying strength of demand for our reinforcing products and our success in passing rising costs through the supply chain. On a sequential basis, gross profit increased $10.6 million, and gross margin widened 500 basis points, again, due to both an incremental relative widening of spreads and increased shipments. Gross margin is at the high end of recent historical results and while sustainable in the near term, we would expect some normalization once raw material prices stabilize. SG&A expense for the quarter increased $0.7 million to $10.3 million but declined as a percentage of sales to 7.4% from 8.4% last year. The increase was largely a result of higher compensation costs under our return on capital-based incentive plan driven by our strong results this year. As you may recall, we did not incur any incentive compensation expense in the second quarter of last year. In addition, we continue to incur higher legal expenses relative to our normal run rate in support of our ongoing trade cases. And these costs were partially offset by a favorable $2 million change in the cash surrender value of life insurance policies. Our effective tax rate for the quarter increased marginally to 22.5% from 21.2% last year due to changes in permanent book tax differences and discrete tax benefit recorded in Q2 2020 in connection with the CARES Act. Looking ahead to the remainder of the year, we expect our effective tax rate will run around 23%, subject to the level of pretax earnings, book tax differences and other assumptions and estimates that compose our tax provision calculation. Moving to the balance sheet and cash flow statement. Cash flow from operations for the quarter generated $15.3 million, largely due to earnings with a minimal change in working capital, given the strong quarterly performance, as compared to using $3 million last year when net working capital increased $13.8 million. Based on our sales forecast for the third quarter of 2021, our quarter end inventories represented 2 months of shipments compared with 2.4 months at the end of the first quarter. The tight supply market referenced earlier has impacted our inventory levels, which are trending below normalized levels of forecasted shipments at the end of the second quarter. Finally, our inventories at the end of second quarter of 2021 were valued at an average unit cost that was higher than our first quarter cost of sales but remain favorable relative to current replacement costs. We concluded the quarter with $58.9 million of cash on hand or just over $3 per share and no borrowings outstanding on our $100 million revolving credit facility, providing us with ample financial flexibility to support our strategic initiatives. Looking ahead, our optimism has increased given the steady demand we are experiencing in our markets. Although we are still early in the third quarter, our order book has remained strong, and shipments have continued to trend above forecast levels. Recent leading market indicators like ABI and Dodge have finally rebounded to levels not seen since the start of the pandemic in March of 2020. Both indices have been trending steadily upward since the start of the year and typically would be a harbinger for growth in the private nonresidential construction markets in the next 9 to 12 months. Spending in key areas like highway and street construction, one of the largest consumers of our products over the last 12 months through February 2021, have remained on par with the level in the prior comparable 12-month period through February 2020, and it remains 5% above the average annual spend over the last 5 years. And as H will cover in more detail, we have received favorable determinations with respect to the PC strand trade and standard welded wire cases, which should favorably impact these markets going forward. With the uncertainties of COVID-19 – while the uncertainties of COVID-19 are not behind us, our markets and operations have seen limited negative impact from it over the last 12 months. With the vaccine rollout progressing steadily across the nation, we hope this risk will remain contained and within a few quarters, no longer pose any material risk. And finally, the tight supply environment for rod and the rapid escalation in this raw material cost is an area we are actively managing across our markets and plant footprint, as there does not appear to be any sign that these trends will abate in the near term. To date, we've been successful in passing those incremental costs through the supply chain, although inadequate supplies could have an adverse impact on operations at certain manufacturing facilities over the next 2 months. With that, I'll now turn the call back over to H.

Thank you, Mark. As reflected in the release, our strong second quarter results were driven by robust nonresidential construction markets and escalating steel prices. We're pleased with the solid underlying demand for our products and our financial performance, and we thank our Insteel teammates for their focus on execution excellence and working safely. Looking out through the end of our fiscal year, we expect continued market strength driven by significantly improved public finances at the state and local levels together with elevated activity in the distribution, e-commerce segment of the private nonresidential construction market. We are particularly gratified by the growth of our engineered structural mesh products and cast-in-place applications, where we have expanded our technical capabilities and are serving markets nationwide. Increasingly, we expect our markets to be favorably impacted by significant federal COVID recovery expenditures, and we expect the administration in Congress to agree on an infrastructure initiative although it's difficult to project its scale and the timing for any impact on our markets. While robust demand for our reinforcing products has stretched lead times significantly, steel wire rod prices have also escalated sharply over the last 6 months, and supplies are extremely tight. We expect to experience scheduling-related inefficiencies during the third and fourth quarters related to the uncertain timing of wire rod deliveries, and we expect pricing to continue to rise, driven by strong demand in practically all end markets and potential supply constraints due to planned maintenance and facility upgrade outages at several steel mills during this period. Additionally, our market is experiencing a chronic shortage of flatbed truck capacity and sharply escalating transportation costs. Until we develop more competitive sourcing opportunities, we expect the robust demand we are experiencing to support passing escalating costs throughout the supply chain. Turning to CapEx. We continue to expect 2021 to come in at approximately $20 million, subject to the timing of certain planned expenditures. The engineered structural mesh project underway at our Dayton, Texas plant is on track for commissioning during the current quarter, and we expect to pursue additional investments in 2021 to support our growth in this market. During the quarter, we also continued the process of commissioning the major production equipment we acquired through the Strand-Tech Manufacturing acquisition in March 2020. Our progress has been slowed by European COVID-related travel restrictions, which have adversely affected the availability of commissioning technicians. While we had expected all the relocated production lines to be up and operational by the end of March, it now looks like it will be June before we wrap up these projects. We're already realizing a favorable impact on unit conversion costs at the plants where relocated equipment is up and running. Our CapEx strategy continues to be focused on reducing cash cost of production, improving the quality of our products, supporting growth initiatives and improving our information technology infrastructure and capabilities. Over the course of the last 4 earnings calls, we've reported that Insteel, along with other U.S. producers, had filed antidumping and countervailing duty cases to address illegally traded imports of PC strand and standard welded wire reinforcement. The PC strand cases were filed in April 2020 against 15 countries that represented 89% of PC strand imports during 2019. On January 8, the International Trade Commission issued its affirmative final injury determination with respect to 8 countries resulting in the implementation of duties ranging from 24% to 194% of value, which we believe are sufficient to address the injurious behavior of these countries. Earlier this month, the Commerce Department informed us of final dumping margins calculated for the remaining 7 PC strand cases that had extended deadlines. The final margins ranged from 4% to 155% with several increasing from their preliminary levels based on arguments advanced by our economists and attorneys. Significantly, we obtained margins on every company and every country we targeted. While the cases in the orders have already had a positive impact on the market, over time, they will serve to deter illegal behavior in U.S. markets in the case of higher margins or substantially raise the risk of misbehavior in U.S. markets in the case of lower margins. Because our system is retrospective and exporter to the U.S. market that has a dumping order in place can never be certain of its duty exposure, except after the fact. We expect affirmative decisions to be rendered in each of the remaining 7 strand cases before the end of May. In June 2020, Insteel and 4 other producers of standard welded wire reinforcing filed antidumping and countervailing duty petitions against Mexico. In March, we received the final affirmative determination with respect to the countervailing duty cases resulting in duties ranging from 1% to 102%. We expect the final determination with respect to the antidumping cases by the middle of June, and we're optimistic that the preliminary dumping margins of 24% to 153% will become final. And as with the PC strand cases, the dependency of the standard welded wire reinforcing cases has had a favorable impact on the market. Looking through the balance of our fiscal year, we'll closely monitor market conditions and aggressively pursue the appropriate actions to maximize our shipments and optimize our costs, and we're well positioned to pursue attractive growth opportunities, both organic and through acquisition. This concludes our prepared remarks, and we'll now take your questions. Brian, would you please explain the procedure for asking questions?

First question, we have Julio Romero.

First question is just going to be on demand trends. Can you maybe speak to the demand trends you're seeing in the horizontal market? I think you mentioned e-commerce in your prepared remarks. Does that continue to be robust? And then secondly, could you also speak to what you're seeing on the vertical structure portion of non-res?

Yes. The distribution and not just e-commerce, but distribution as a larger category has been extremely robust over really over the last year. While it's difficult to know how it's going to pan out going forward, our research indicates that it has a long run in front of it. So we're optimistic and we're well organized to continue to prosper from that market and the robust demand that we see there. And when you say vertical structures, Julio, exactly what are you referring to?

Yes. I'm referring to like office, hotels, et cetera.

Okay. Well, okay. We're seeing a lot of work. We're looking at high-rise projects now. It continues to be robust, probably not as robust as some of the distribution and e-commerce, which I'll point out is also multistory.

Got it. I think you mentioned sharply increasing transportation costs due to maybe lack of some trucks out there. And you spoke of your ability to kind of pass through those costs along the value chain. Is there any concern in terms of availability of trucking on your side? Or would it just be a concern of kind of passing those costs through?

No. I mean, I think the 2 go together, Julio. The cost is driven by the availability, and it's extremely tight, and we're leaving loads on the ground that we need to ship. So yes, so the availability is extremely tight. There's insufficient capacity, and that's driven the cost up considerably.

Okay. And on the Strand-Tech acquisition from a year ago, I think you've just lapped a year of having that under your belt. Can you just maybe talk about how that's progressing? And I think you mentioned there was a COVID-related impact on getting some folks involved in that. If you could give us a little more into that, please?

Yes. So all of the major equipment refurbishment and relocations have been accomplished. The equipment's in the ground at our legacy plants. And in 3 or 4 cases, we are awaiting commissioning technicians to help us start that equipment up because it's very important that it's done right. And there are COVID-related travel restrictions that have hampered our ability to bring technicians into the U.S., primarily from Italy, to help us get that equipment started up. We're now expecting those technicians to be in our plants during the month of May, and we should be running the remaining pieces of equipment before the end of June. I would say that overall, we are thrilled with the result of the STM transaction of a year ago. It's going to be meaningful in almost every respect that we thought it would be meaningful. We have maintained the customer base that we inherited. The equipment refurbishment has gone according to plan, both schedule and budget. So the remaining piece that we need to take care of is selling the real estate in Summerville, South Carolina, which we are very focused on getting done.

Okay. My last question would be regarding your strong execution and demand trends, which are clearly reflected in your results this quarter. Could you please discuss the risks you see in the current environment, particularly concerning elevated steel prices and the lack of steel supply?

Well, we've been through these cycles on a number of occasions where steel prices run up dramatically, as they have now. The thing that would be different about this, and I would add, in those past cycles, they've never ended well with prices actually collapsing, I think, at some point. The thing that's different this time is both Section 232 tariffs and in wire rod, the existence of 16 or 18 dumping orders against countries that were primary suppliers to the U.S. market over time; those dumping cases are in place as of about 2018. So the combination of 232 and the dumping orders would lead me to believe that it's unlikely that we see a surge of imported material that changes the balance of supply and demand significantly and quickly, which we have seen in the past when domestic prices ran up so high so quickly. So I'm hoping for a smoother landing than some of those that we've experienced over time, but I would tell you our view of the risk is quite high and that our approach to manage that risk is going to be through managing the quantities of steel that we purchase. Otherwise, I don’t know of a hedging mechanism or I don’t know another business practice that will allow us to fulfill the commitments we have to our customers, which is our very first priority. But I don’t know of another tactic that we could employ other than quantity management to minimize and manage the risk that is definitely out there.

Next question, we have Tyson Bauer.

Would you consider the rulings on the trade actions probably as good as you could have hoped for or as you expected?

Yes. I mean I think they're basically in line with the margins that we alleged. I mean there's some individual companies that are lower in the single-digit level. We would like to see those in the double-digit level. But just obtaining an order against those countries is really quite a success because, as I pointed out in my comments, a dumping order just really raises the risk for exporters to the U.S. market exponentially because they never really know what their actual exposure is until the end of the year. So yes, I mean, I would say we're very happy with the results of the cases. And we, as I said, got orders against every company and every country that we targeted. So yes, I consider it a solid B+ or A.

Given your strong position in many of the markets you serve, aside from a few isolated cases where you're competing with companies like Nucor, your ability to navigate price and inventory risks is likely much better than that of your smaller competitors. Has the situation reached a point where the pricing model feels almost like a cost-plus arrangement, considering that everyone is facing freight challenges and issues with steel wire rod? With your scale, you can effectively manage these aspects through your sales and deliveries.

Let me provide this perspective. Reflecting on 2019, we experienced significant weakness in steel prices, which led to our margins and spreads shrinking to unsustainable levels during that difficult time. Currently, we are focused on restoring our spreads and margins to acceptable levels. In this regard, it's not a cost-plus environment. Instead, we are working to position these products appropriately for sustainability. So far, we've seen some reasonable success in this effort, but competition remains fierce, and that reality persists.

Okay. In the past, we've experienced peak periods where gross margins reached around 24, although that was only for a brief moment. As the situation stabilizes, considering trade and seasonality, are you expecting to operate within a normalized range? It seems like the upper end may be high-teens to low 20s, which shouldn't be unusual for your business, especially given the current environment.

Yes, I think that's a fair statement. As we've mentioned a few times, there's definitely a benefit from FIFO in this environment. However, I believe it's accurate to say that a normalized gross margin in the high-teens to 20% is a realistic expectation for this business.

And would you anticipate an even stronger seasonal impact this year? We got 23 states that have big budgets, surpluses from a year ago. A lot of attention, of course, on residential, some of the other government spending programs that they're trying to enact. Should we see a more amplified effect?

I'm uncertain about how quickly the government stimulus will reach our markets and customer order books. It would surprise me if we saw that in the third and fourth quarters, but it's possible. State and local governments are in a stronger financial position compared to previous periods. I see the funding from Washington as more of a way to extend and enhance that pipeline rather than providing a quick boost. Otherwise, I expect the seasonality to align with what we've seen historically. Assuming there are no weather issues that might cause delays at job sites and our customers' plants, we don't foresee any problems. However, as you know, there's always some uncertainty.

Would you agree that states and local municipalities have been conditioned over the past several years that they're going to have to flip more of the bill and fund a lot of these projects through the bonding markets and municipality bonds, that anything that should, if it does happen, come from the federal side as increase, is purely incremental?

Well, I would definitely agree that states and local governments have given up on Washington carrying the biggest part of the load for infrastructure kinds of expenditures. Those will always be important dollars. But there are many, many examples where the states are taking the initiative to fund their own requirements, which I think was inevitable and certainly is positive for our business.

There are no more questions. Presenters, please continue.

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

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