Insteel Industries Inc (IIIN) 2016 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to Insteel Industries' third quarter 2016 conference call. (Operator Instructions) As a reminder, this conference call may be recorded. I would now like to turn the conference over to H. Woltz, Insteel President and CEO. Please begin.

Thank you. Good morning. Thank you for your interest in Insteel and welcome to our third-quarter 2016 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 will now turn it over to Mike to review our third-quarter financial results and macro indicators for our construction markets, then follow up to comment more on market conditions and our business outlook.

Thank you, H.

As we reported earlier this morning, Insteel's net earnings for the third quarter of fiscal 2016 more than doubled from a year ago to $13.5 million or $0.71 a diluted share, rising to the highest level since 2008, driven by widening spreads between selling prices and raw material costs, higher shipments and lower conversion costs. Conditions in our construction and markets remained strong during the quarter with shipments rising 8.8% sequentially from Q2, which benefited from the relatively mild winter weather, and 9.8% from a year ago.

Both the current and prior year volumes were unfavorably impacted by the heavy rainfall and flooding in the South Central states, particularly in our largest market, Texas, which brought customer operations to a standstill for intermittent periods, although to a lesser extent this year. NOAA reported that rainfall in Texas for the April to May period was 62% above the historical average this year, or the sixth wettest in history, while last year's total for the same period represented an all-time high that was more than double the usual level.

Average selling prices fell 1.1% sequentially from the second quarter, largely due to a less favorable product mix, but gradually rose during the period as a result of the price increases that were implemented with June ASPs up 3.5% from the March level. Our Q4 ASPs should benefit from the full-quarter impact of these increases, together with additional adjustments that became effective at the beginning of July.

Gross profit for the quarter nearly doubled from a year ago to $27.5 million with gross margin widening to 23.8% from 13.4% due to the higher spreads in shipments and lower conversion costs.

Spreads for the quarter benefited from the consumption of lower-cost inventory that was purchased prior to the full impact of the previous price increases for wire rod. Since we are typically carrying around three months of inventory valued on a FIFO basis, there is usually around a one-quarter lag before our raw material purchases are reflected in cost of sales.

On a sequential basis, gross profit was up $8.9 million from Q2 and interest margin rose 650 basis points from 17.3%, due to the same factors. Our inventory position at the end of the third quarter represented 94 days of shipments or just over three months, calculated off our Q4 forecast, and reflected higher average unit costs in the beginning of the period, although we have been able to mitigate the extent of the increase through the purchase of lower-priced offshore material.

As we move into our fourth fiscal quarter, spreads are likely to narrow from the levels of Q3 as the higher-end cost inventory is consumed. We believe, however, that the pricing adjustments that were made during the quarter and that will become effective in the fourth quarter are sufficient to recover the net increase in raw material costs that has occurred since the beginning of the year and should maintain margins at improved levels.

SG&A expense for the quarter rose $0.4 million from a year ago to $7.6 million, primarily due to higher expense under our return on capital incentive compensation plan, driven by our improved results, partially offset by a $0.2 million favorable year-over-year change in the cash surrender value of life insurance policies, and a $0.2 million reduction in employee health insurance costs related to the high dollar claims that were incurred last year.

On a sequential basis SG&A expense was down $0.8 million from Q2, largely due to lower stock-based compensation expense.

Equity awards under our plan are typically granted on a semiannual basis in our second and fourth fiscal quarters, which drives SG&A expense higher in these periods. Our cash flow from operations for the quarter improved to $21.9 million from $18.1 million a year ago, largely due to the increase in earnings, leaving us with $53.8 million of cash at the end of the quarter or close to $3 a share and no borrowings outstanding under our $100 million credit facility, providing us with plenty of liquidity and financial flexibility.

As previously reported, we are proceeding with the termination of the defined-benefit pension plan for the former employees at the Wilmington, Delaware facility to eliminate the ongoing investment risk and administrative costs. Benefits under the plan had been frozen in 2008 and the plant was subsequently closed in 2011, following the IV acquisition. We expect to make the contribution sufficient to fully fund the plan and settle the liabilities by the end of September, which will result in an estimated settlement charge of around $1.9 million in Q4.

As we move into our fourth quarter we expect continued strength in our construction end markets. The trends reflected in the monthly construction spending data have been somewhat distorted by the unusually mild winter weather earlier in the year followed by the excessive rainfall and flooding in the South-Central states during April and May.

On a year-to-date basis total construction spending through May was up 8.2% from last year with private nonresidential up 9.2%, public up 3.8% and private residential up 9.9%.

Public spending on highway and street construction, which had risen 15.8% year-over-year during the first quarter, moderated in April and May, leaving the five-month year-to-date total up 6.9% from last year. The most recent reports for the architectural Billings Index and Dodge Momentum Index reflect favorable trends that imply further improvement in nonresidential building construction during 2017.

Yesterday the American Institute of Architects reported another positive reading for the AVI, which came in at 52.6 for June. It has now remained above the 50 growth threshold for five straight months in 10 of the previous 12 months, and the three-month average of 52.1 was at its highest level since last August. The Dodge Momentum Index rose for the third straight month in June, increasing 11.2% to its highest level since the beginning of 2009 and 18% year-over-year. The three-month average, which smoothes out the month-to-month volatility, was up 6.9% from the same period last year, reflecting similar increases in both the commercial and institutional components.

As we move further into the year, we expect the federal highway funding provided for under the recently passed FAST Act will begin to have a favorable impact on infrastructure construction activity and demand for our products. The five-year duration represents a significant improvement over the 36 short-term extensions since the last long-term deal expired back in September 2009.

We continue to believe that the higher degree of funding certainty will benefit Insteel by shifting the project mix toward larger, longer-term projects that require greater usage of our concrete reinforcing products.

I will now turn the call back over to H.

Thank you, Mike. As reflected in our release and Mike's comments, our third-quarter results benefited from higher shipments, lower unit conversion costs and wider spreads resulting from the downturn in wire rod costs earlier in the year.

In view of the continuing recovery in our markets, we expect to finish fiscal 2016 with another strong quarter and get off to a good start in fiscal 2017. In our last few earnings calls we commented on the potential for widening spreads driven by declining prices for steel scrap and our primary raw material, steel wire rod, together with stable or more slowly declining selling prices for our audits, has resulted in continuing recovery in the construction sectors.

Our Q3 2015 results reflected the initial impact of these favorable trends, which became more pronounced with each successive quarter over the last year. Improved volume trends driven by the higher level of construction activity served to amplify the positive impact of widening spreads on our financial results. Over the course of January through May, raw material pricing trends reversed course with scrap escalating to levels that were in the range of $120 per ton above the December lows. Our wire rod costs generally tracked this upward trend.

As we reported on our last call, in April we began pursuing price increases to recover these higher costs. Following our initial increases, raw material markets reversed course in June and again in July with scrap prices declining over the two-month period. Early indications are that August scrap settlements will be down from the July level, which would imply a further reduction in our raw material costs.

With respect to the impact of this volatility on our margins, we believe the cumulative pricing adjustments we have made will be sufficient to recover the net raw material cost increase that we expect to incur. Spreads and margins are expected to moderate from the levels of the third quarter as wire rod that was purchased at the peak of this cycle flows through cost of sales around the end of our fiscal year.

Assuming continuing strength and demand for our products, the impact of these higher costs will be alleviated, should scrap drift downward in August, as appears likely at this time, and to the lower-priced import purchases that have been made. In any event, we expect margins to remain at attractive levels over the next couple of quarters.

We mentioned in our previous call that a PC strand competitor was starting up a new South Carolina manufacturing plant during our second quarter. Events unfolded substantially as expected and we continue to experience pricing pressure related to their ramp up during the third quarter. We believe that the growth of the PC strand market will be adequate to mitigate the impact of this additional domestic capacity.

Turning to CapEx, we previously indicated that outlays would rise to approximately $20 million in 2016, which includes an investment of $9 million in our Houston PC strand facility to upgrade equipment and installed a new state of the art wire rod cleaning process comparable to our Gallatin and Sanderson strand plants. Based on our current view of equipment delivery schedules and construction progress on the timing of anticipated payments around the end of our fiscal year, it now appears likely that 2016 CapEx will not exceed $18 million, with the shortfall rolling into fiscal 2017.

The Houston project, which is our largest 2016 investment, is well underway and on budget. We continue to expect the first phase of the project to be completed by the end of the first fiscal quarter of 2017 and to generate ultimately $5 million of annualized cost savings.

Looking forward to 2017, we expect CapEx to remain elevated, relative to the recent past as we complete the Houston project and continue upgrading our production technology and information systems to reduce operating costs and improve our manufacturing capabilities and the quality of our products. We will provide more specific CapEx guidance during our Q4 earnings call.

To conclude our prepared remarks, we are pleased by the continued strength we are seeing in our markets and are optimistic that the recently passed FAST Act provided certainty to infrastructure funding, thereby favorably impacting demand for our products during fiscal 2017.

Additionally, we should begin to realize the anticipated benefits from several important investment initiatives that are underway. We expect to deliver strong results over the course of the next couple quarters and will continue our efforts to further improve the effectiveness of our manufacturing operations, identify additional opportunities to broaden our product offering and to grow through acquisition.

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

(Operator Instructions) Michael Conti, Sidoti.

So, obviously, huge improvement within the gross margin. Can you just take out how much of the gross margin improvement was due to lower conversion costs, leverage from your shipments and then, obviously, from the consumption of lower-priced inventory?

I don't know that we would be able to precisely quantify it. But the most significant portion would have been driven by the widening in spreads and then, to a lesser extent, the other two drivers, the increase in shipments in conversion costs. I believe they both had a similar impact on margin for the quarter.

Okay. And then, just given the run-up in scrap and your corresponding selling price increases?

I don't think it's a material matter, Mike. We haven't seen hedge buying occur, nor have we felt the need to try to hedge buy.

Okay. And then can you just comment on maybe customer inventory levels heading into the September quarter just compared to, say, inventory levels historically?

Yes. First, let me just point out that we don't have excellent insight into that. But our observations just from the field and anecdotally would be that there has been no unanticipated build in customer inventories. And as I mentioned before, we have not seen any real inclination of customers to feel like they needed to hedge buy.

So I think their volumes are running at reasonable levels. And they are buying what they need to make their schedules and that we are unaware of any bulge there.

Sure. And last one before I hop off queue, just switching over to the infrastructure side, can you just quantify for us your order book for growth on a year-over-year basis, specifically related to government-backed projects, just to give us an idea on the potential increase in volumes related to the FAST Act?

I'm not so sure we can drill to that level of detail. But I think that, as you know, we believe around 35% of our shipments go into the infrastructure sector. I don't think that that has changed materially. And there could be some upside there as we look at 2017. But for the time being I wouldn't tell you that there has been any dramatic change.

Okay, great. I'll hop back in queue. Thanks.

Tyson Bauer, KC Capital.

Good morning, gentlemen. An excellent quarter. In regards to your comments on the margins, you just came off a very healthy 23.8%. Your comp going from last year's Q4 was 10.5%. Is the suggestion that it would land somewhere in between that range?

Yes, I think the expectation is that we will see some moderation from the 23.8% but that it will still remain at attractive levels. I think that would probably be a reasonable assumption.

Okay. The initial price increases that went through and obviously were well received in the marketplace was during the period, as you described, where you saw increases in scrap prices. And the previous questioner commented that you may have seen some forward buying, we don't know if that happened or not. Now you are in a reverse situation, where you are trying to get in some recent price increases with the underlying raw material softening.

Does that make it a little more difficult to get those price increases through? Or is there enough volume demand currently that we haven't really seen in prior years where you can be a little more sticky on those prices and force them through?

Well, price increases are always difficult in our industry. It's highly competitive. It is today, and it always has been. But certainly, the reversal of the trends in the scrap market have had an impact on the intensity with which we've seen competitors try to raise prices. So the answer is certainly that reversal in course in scrap has had an adverse impact on our ability to raise prices.

Okay. The Texas market -- our calculation is it probably cost you about 1%-2% of your revenue. Does that get made up in this fiscal quarter or is it kind of a drawn-out period where the next couple of quarters will receive that benefit of displaced volumes?

Again, it's hard to give you a real accurate answer. But just knowing that at this time of year seasonal uptrends that all of our customers are experiencing -- I don't think they have the capability to wrap up to a significant degree beyond what they had previously planned. So I think that just implies that that recovery will take place over a longer period than in the same quarter.

Okay, last question -- you talked about the infrastructure, 35% of the business. Does that -- are you seeing greater acceptance of your ESM product now that it has been in the marketplace longer and some of these projects are larger in scope and then duration, where that may be a more important cost component as far as reducing overall object cost? Have you seen a pickup in demand and interest in using your ESM product?

Well, certainly our ESM product has continued to grow and we expect it to grow further. I don't think that ramped-up infrastructure spending itself will have a material impact on that. It's more an internal job of promoting the product and promoting its acceptance. Certainly, there will be more targets to shoot at as the market grows, and that's favorable for us.

But in and of itself, the infrastructure growth, I don't think, is a material impact on us.

Have you received more DOT, at the state level, acceptance and the qualification to utilize some of those products?

We continue to work on that and continue to receive more acceptance, yes.

Okay. And on the PC strand, if I'm correct, a lot of that is in bridges and some of those that are bigger projects. With the growth from FAST that you mentioned, is that what gives you the confidence that we can absorb more industry capacity coming online because it should be greater use in the type of projects that utilize that product?

Certainly that's an impact, Tyson. But I wouldn't discount the impact of just the continuing recovery in our markets as well. I think that that's equally important.

And any ideas -- obviously this is your opinion -- where the reversal in the scrap -- did it just get a little ahead of itself and now we are just trying to get into a more stabilized environment? Or do you see anything longer-term in the trends that could lead to further softening through the end of the year?

In my experience, long-term trends in the scrap market are around 30 days. So we have very little insight into the drivers behind this. And when I mentioned at the early indications are that the August pricing will trend downward, it's market speculation more than any scientific analysis that we are privy to.

All right, that was it. Excellent, gentlemen.

Lance James, RBC Global Asset Management.

A number of my questions have been answered but I will also echo congratulations not just on a very strong quarter but really your steadfastness through a number of years to bring the Company to this place. So congratulations.

My question would be -- or the remaining question would be, in terms of your capacity utilization of your current existing physical plants, any comment on where you are in terms of your own capacity utilization and whether there would be any larger capital outlays necessary in the foreseeable future to have to expand that?

We continue to have ample capacity to grow and to ramp our revenues up. We have stated in our investor presentations that we could see between $600 million and $700 million of revenue on an annual basis from existing facilities, and we continue to believe that that is the case.

A lot of the capital investments that we are making in machinery and equipment are to take advantage of lower operating costs and higher quality products, and that is going to continue. So I think, as we stated, CapEx will be elevated in 2017 relative to recent years, but certainly we would not anticipate it [threatening] positive free cash flow.

Terrific. And again, this question is more from my ignorance of just the general, your general manufacturing losses. But is there operating leverage there if your orders go up 10% or so? Will the gross margin on those orders typically be similar to the rest of your output, or is there some operating leverage that additional dollars or additional orders would actually help improve your overall gross margins by spreading costs over an existing production base?

There would be some operating leverage benefit where, when you break out the components of our cost structure and just focus on that conversion cost component at our plants, on an overall basis probably around half of it would be variable versus fixed. So we get some leverage benefit there as well as on our SG&A expense where, when we are making a statement about having the ability to ramp up to $700 million of revenues, that could be done without any additional staffing requirements. So we get an added leverage benefit there as well.

Terrific. Very helpful and congratulations again, thanks.

Fran Okoniewski, Friess Associates.

Just curious -- if you have covered this already, what kind of impact did you guys have in weather-impacted markets in the quarters? Your shipments were impressive, but what kind of magnitude impact did you guys see, due to the weather in the quarter?

It's difficult to precisely quantify it, but just in terms of order of magnitude, we referenced the differences in the rainfall levels this year. Last year was an all-time high, the flooding was more severe. This year was the sixth wettest on history, so pretty unusual as well. But just in terms of order of magnitude, last year would have had a more significant impact. But I don't know that we can precisely quantify it beyond that.

Could it have been a couple of -- one or two or three points?

Potentially. Texas is our largest market, so just depending on the assumed impact it could amount to that much.

Okay. And you guys are showing some really nice operating leverage. I'm just curious; is it more from some of the efficiency upgrades that you guys have talked about in previous quarters at some of your facilities? Or are you guys adding lines or maybe a little bit of both? Can you give us a little color on that?

We have added several highly flexible and efficient production lines in the last few years. We continue to do that. So it's probably a combination of the factors that you point out.

But more recently we would attribute a larger portion to the widening in spreads. The operating improvement in the conversion cost reductions have had a positive impact as well, but the spreads have been the primary driver here recently.

Now, when we move into next year and we wrap up this first phase of use and expansion, we're expecting to realize another significant reduction related to that, in annualized cost reduction of around $5 million that would begin after its completion, beginning in the second quarter. So that would be, I guess, the other significant reduction that we see on the horizon.

Okay. And I know you guys were talking with -- on a previous question about utilization. Are there plans or are you in the sense of adding lines in any of the facilities right now, just given current market conditions?

Yes. We are constantly underway with additions, and there are those in the pipeline right now.

Okay. Great. Thanks. Congratulations.

(Operator Instructions) Chris Olin, Rosenblatt Securities.

I just had a couple of quick follow-up questions and wanted to focus first on just your steel wire purchases. There's been a lot of talk within the carbon steel industry that the spreads between domestic pricing and imports has gotten to a very wide level. And I was curious if you are seeing levels where you could continue to benefit from sourcing from outside the US. And are you seeing spreads continue to expand even with your thoughts on scrap going over?

Suffice it to say that, Chris, that the spreads are adequate to justify our continued participation in the offshore market. And almost without regard to spreads, we would always participate in that market anyway, just to assure ourselves of adequate supplies.

But spreads haven't widened to the point that we would try to ratchet up their participation offshore. It's ample to cover the risk that we perceive from the longer lead times, but it hasn't varied greatly from its historical levels.

Okay. And then, just to be clear on your pricing comments, there were two price increases announced, one on the welded wire and then the other on the PC strand. And that was under your assumption that it could be more challenging to get the full price increases on PC strand because of some new competition in the marketplace as well as imports. I was just wondering if you are just as confident on that side as you are on the other side of the business.

Well, we really want to speak on it just in terms of the overall impact on our margins across all product lines because they all act differently at certain times. So, I think we should just leave it to say that we believe we are going to cover, on average, the increases that we expect to have to pay.

In terms, again, on an overall basis in terms of our Q4 expectations we are expecting an increase in ASPs where -- we only realized a portion of the increases that were implemented in Q3, and then there will be another increase that became effective at the beginning of this month.

So we are expecting a net increase sequentially, which should serve to offset the higher raw material costs coming out of inventory.

Okay, that's all I have. Thank you.

(Operator Instructions) And I'm showing no further questions at this time.

Okay, thank you. We appreciate your participation today and your interest in Insteel, and we look forward to speaking with you for the Q4 call. Thank you.

Ladies and gentlemen, thank you for separating today's conference. That does conclude today's program. You may all disconnect. Have a great day, everyone.