Insteel Industries - Q1 2023

Transcript

Moderator (participant)

Good morning. Thank you for attending today's Insteel Industries' first quarter 2023 earnings call. My name is Forum, and I will be your moderator for today's call. All lines will remain muted during the presentation portion of the call, with an opportunity for questions and answers at the end. If you would like to ask a question, please press star 1 on your telephone keypad. It is now my pleasure to pass the conference over to our host, H.O. Woltz, President and Chief Executive Officer of Insteel Industries. Mr. Woltz, please proceed.

H.O. Woltz III (President and CEO)

Thank you, Forum. Good morning. Thank you for your interest in Insteel, and welcome to our first quarter 2023 conference call, which will be conducted by Scott Ciafardini, our Vice President, CFO, and Treasurer, and me. While Scott has only recently been named CFO, he is a longtime Insteel employee who is intimately familiar with company markets and operations. We congratulate Scott on his elevation to CFO, and we're confident he will add value to the company. 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. These risk factors are described in our periodic filings with the SEC.

Beginning in Q3 of 2022, residential-related markets began to weaken as interest rates rose, and those markets remained weak through the first quarter of 2023. We do not expect significant recovery of residential markets until there are signs that the interest rate environment is changing. Unlike residential markets, we believe the shipment weakness we experienced in non-residential markets is related to customer inventory management and destocking rather than impaired demand for our products. Following several quarters of extended lead times and inadequate supplies, customers found that excessive inventory levels and purchase commitments could be safely curtailed as lead times normalized. Notwithstanding the weakness that is apparent in Q1 results, we believe that 2023 will be a good year for our non-residential markets and for the company.

I'm going to turn the call over to Scott 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.

Scott R. Ciafardini (VP, CFO, and Treasurer)

Thank you, H.O. Woltz, and good morning to everybody joining us on the call. I'm pleased to be here participating in my first earnings call as the CFO of Insteel. As we reported earlier today, our results for the quarter were unfavorably impacted by a decline in shipments and a narrowing of spread between selling prices and raw material costs. Net earnings for the first quarter fell to $11.1 million from record earnings of $23.1 million a year ago, and earnings per share dropped to $0.57 from $1.18 per diluted share in the prior year. As referenced in our release, earnings for the current year quarter benefited from a $3.3 million or $0.13 per share gain on the sale of property, plant, and equipment. Net sales for the quarter fell 6.5% from last year on a 10% decrease in shipments, partially offset by a 3.9% increase in average selling prices.

Our shipping volume for the first quarter, which has historically been our slowest period of the year due to the onset of winter weather and holiday schedules, was adversely impacted by the previously noted inventory management and destocking measures pursued by our customers, along with the continued weakness in the residential construction market that first began in the second half of fiscal 2022. On a sequential basis, net sales were down 19.8% from the fourth quarter due to a 12% drop-off in shipments and an 8.8% decrease in average selling prices. Falling raw material costs and competitive pricing pressures eroded ASPs during the quarter, with the largest decline in average selling prices from Q4 within our product line most exposed to the residential markets.

Gross profits for the quarter fell $24.6 million from a year ago, and gross margin narrowed to 10.7% from 23.7% due to lower spreads between Average Selling Prices and raw material costs, along with a reduction in volume and higher overall plant operating costs resulting from lower production levels. On a sequential basis, gross profits fell $22 million from the fourth quarter, and gross margin decreased 840 basis points. As we have highlighted throughout the prior year, during environments of strong demand and escalating steel prices, our results are favorably impacted by both the implementation of price increases sufficient to recover the higher replacement costs for our raw material and the consumption of lower-cost inventories under first-in, first-out accounting methodology.

However, during periods of declining steel prices as we had during our first quarter, we experienced the opposite effect under FIFO, and our gross margins narrowed due to the consumption of higher-cost inventories matched against lower average selling prices for our products. As we have noted in our fourth quarter earnings call, we finished fiscal 2022 with 4.3 months of inventory on hand valued on a FIFO basis. As such, our first quarter spreads and margins have been adversely impacted by the matching of higher-cost inventory purchased in fiscal 2022 against lower average selling prices for our products. Going forward, we should benefit from a gradual reduction in these costs as more recent lower-priced raw material purchases are consumed from inventory, assuming our selling prices remain flat or fall to a lesser extent.

SG&A spends for the quarter decreased $5.2 million to $7.2 million, or 4.3% of net sales, from $12.3 million or 6.9% of net sales last year, mainly due to lower compensation expense under our return on capital-based incentive plan, which was driven by weaker results in the current year. To note, our return on capital-based incentive plan was fully expensed in the first quarter of the prior year given the record financial performance. As we have highlighted in our release, other income for the quarter includes a $3.3 million net gain on the sale of property, plant, and equipment. Our effective tax rate was virtually unchanged at 22.9%, which is down from 23% last year.

Looking ahead to the balance of the year, we expect our effective rate will remain steady at 23% subject to the level of pre-tax earnings, book tax differences, and the other assumptions and estimates that compose our tax provision calculation. Moving to the cash flow statement and balance sheet. Cash flow from operations provided $33 million of cash in the first quarter due to a working capital reduction that was driven by a $26.5 million decrease in inventories, along with a $12.9 million decrease in accounts receivable. You may recall we had ended the previous quarter with an elevated inventory balance, largely due to the increase in raw material purchases as we replenished our inventories from depressed levels earlier in 2022. Over the course of the first quarter, we scaled back our inventory purchases, particularly during December.

As of the end of the first quarter, our inventory position represented 3.9 months of shipments on a forward-looking basis calculated from our Q2 sales forecast. Finally, our inventories at the end of the first quarter were valued at an average unit cost lower than the beginning of the quarter, but still unfavorable relative to current replacement costs. We incurred $8.2 million in capital expenditures in the first quarter and remain committed to our full-year target of $30 million, given the many initiatives that we have underway. H.O. will provide more detail on this topic in his remarks.

In December, we returned $39.5 million of capital to our shareholders through the payment of a $2 per share special cash dividend in addition to our regular quarterly dividend, marking a 6-year over the last 7 years we have paid a special dividend and the second year in a row we paid a $2 per share special dividend. During the quarter, we repurchased $916,000 of our common equity, equal to approximately 32,000 shares. From a liquidity perspective, we ended the quarter with $42.6 million of cash on hand and no borrowings outstanding on our $100 million revolving credit facility. As we move into the second quarter of fiscal 2023, our market outlook for the remainder of the year remains positive as we are encouraged by continued strong demand and backlog in our non-residential construction market.

The most recent reports from the third-party leading indicators for non-residential construction spending, ABI and Dodge, have been somewhat mixed. In November, ABI remained in negative territory for the second straight months, falling to 46.6. The Dodge Momentum Index, another leading indicator for non-residential building construction, has rebounded over the last several months, rising to 222.3 in December. On a year-over-year basis, the overall index was up 40%, driven by strength in both the commercial component, which was up 51%, and the institutional projects, that was 20% higher. Last week, the AIA released a semi-annual construction forecast for non-residential building construction for 2023 and 2024, reflecting continued growth for the current year. Spending on non-residential building was projected to increase 5.8% during 2023, driven by gains in the industrial, institutional, and commercial sectors. This concludes my prepared remarks. I'll now turn the call back over to H.

H.O. Woltz III (President and CEO)

Thank you, Scott. While we're not pleased by our first quarter results, we do not think our markets are deteriorating under pressure of macroeconomic weakness that jeopardizes performance for fiscal 2023. Rather, we think underlying demand from residential markets has stabilized at a lower level and that demand is robust in non-residential markets. Under these circumstances, inventory corrections should be expected following an extended period of constrained supply conditions when customers made purchases and commitments just in case, rather than following more typical demand-pull purchasing tactics. Our view of the market is formed by conversations with many customers focusing on their projected operating rates, backlogs, and overall expectations for business conditions during the year. Recovering customer activity and internal order entry levels support the hypothesis that the inventory correction is running its course.

Scott mentioned in his comments that we have 3.9 months of inventory on hand, which is more than is required based on business conditions. Insteel's inventory and balance is centered primarily in residential-related markets, while inventories for non-residential construction markets are much more appropriate relative to business levels. Recall that we turned to offshore wire rod markets last year beginning in fiscal Q2 when domestic sources were unable to assure us of adequate supplies for our third and fourth fiscal quarters. As is our normal practice, we targeted imported volumes toward our housing-related markets, which are generally make-to-stock products that rarely require certification of compliance with Buy America regulations. Our plan to supplement domestic supplies was upended when housing markets turned down sharply beginning in May 2022.

Subsequent deterioration of ASPs in these markets created significant margin pressure exacerbated by lower production volumes that extended the time horizon for resolving the inventory imbalance. We continue to be optimistic about the impact on our markets of the Infrastructure Investment and Jobs Act and believe it will positively impact our markets during 2023. The need for infrastructure investment in the U.S. has been obvious for decades, but funding has consistently been inadequate. It now appears that funding shortfalls will decline in significance as obstacles to investment in view of the strong fiscal condition of state and local governments together with new funding provided by the Infrastructure Investment and Jobs Act. Turning to CapEx, we believe that 2023 should come in at about $30 million, subject to uncertainties related to vendor performance and supply chain issues.

These investments in state-of-the-art technology will expand our product capabilities and favorably impact our cash cost of production. As we mentioned in an earlier call, new production lines will be installed at the Missouri, Kentucky, and Arizona plants to better address market needs. We're evaluating additional projects that would have similar beneficial impacts on our market position and cost profile. Going forward, we are aware of rising risks related to the future performance of the U.S. economy and are carefully monitoring the environment. At the same time, we plan to aggressively pursue actions to maximize shipments and optimize our costs, and to pursue attractive growth opportunities both organic and through acquisition. This concludes our prepared remarks and will now take your questions. Forum, would you please explain the procedure for asking questions?

Scott R. Ciafardini (VP, CFO, and Treasurer)

My pleasure. If you would like to ask a question, please press star followed by 1 on your telephone keypad. If, for any reason, you would like to remove that question, please press star followed by 2. Again, to ask a question, press star 1. As a reminder, if you are using a speakerphone, please remember to pick up your handset before asking your question. Our first question comes from the line of Tyson Bauer with Kansas City Capital. Tyson, your line is now open.

H.O. Woltz III (President and CEO)

Good morning, gentlemen.

Scott R. Ciafardini (VP, CFO, and Treasurer)

Good morning, Tyson.

H.O. Woltz III (President and CEO)

Morning.

Scott R. Ciafardini (VP, CFO, and Treasurer)

As we've seen in years past, we've been accustomed to these kinds of adjustment, inventory adjustment orders that periodically take place. Typically, the thought process and the question always becomes the duration of that adjustment to a stabilized pricing environment. Can you give us a little bit of how the quarter progressed as we got into December, and was December impacted more materially because of weather holidays and just the slowdown destocking at the year-end for most of your customer base, and how that kind of progresses into the fiscal second quarter? Will we see a snapback, basically, as we get into the warmer months in the second half of the year, or is this something more of a modest change for you?

H.O. Woltz III (President and CEO)

Well, let me try to address it like this Tyson first. Q1 is always our lowest volume quarter. I attribute it primarily to holiday schedules more so than weather, because typically October and November are not bad weather months for construction. Holiday schedules just dramatically reduce operating days. I would say this year is not much different than any other year with respect to that, except there has been some inventory liquidation going on by our customers as the supply environment changed from 1 of highly constrained to not so constrained, with lead times returning to more normalized levels. In terms of inventory levels, as I mentioned in my comments, the over-inventory situation that we're facing is primarily centered in our residential standard welded wire reinforcement market.

Of course, as we purchase based on forecast and when we don't meet the forecast, the inventory pipeline lengthens in an unplanned way, which is what happened to us. We will be through the second quarter in working that off. I would say that these markets, residential markets, seem to have stabilized at levels that are higher than we expected when we did our last forecast. That overall, we would be cautiously optimistic about where we see those markets going. In the non-residential markets, they just continue to perk along at nice levels. Maybe the inventory reductions in the non-residential area aren't completely finished at this point, but the underlying level of demand for the product, I think, is robust enough so that it shouldn't be a material factor for us going forward.

Scott R. Ciafardini (VP, CFO, and Treasurer)

Okay. We've seen mortgage rates drop 100 basis points recently from its peak over 7% on the 30-year. That obviously doesn't hurt our cause going forward. 3.9-month turns, you mentioned. Are you targeting a certain level of getting it back down toward 3, which implies a $30 million-$40 million benefit from the reduction in inventories? Just give us a little more color on where you want to be at your inventory levels by the end of Q2.

H.O. Woltz III (President and CEO)

Yeah. Well, of course, that is highly dependent on whether we meet our shipment forecasts. Whether it is February or March or April, about 3 months, I think, is a more reasonable level for the business than close to four. Of course, that assumes that service levels from the steel producers that we do business with remain reasonable, which it appears will be the case.

Scott R. Ciafardini (VP, CFO, and Treasurer)

Are you anticipating then by the second half of this year that we'll get to more historical margin levels and those high double digits? On a stabilized level?

H.O. Woltz III (President and CEO)

Yeah, we don't forecast margins for these purposes.

Scott R. Ciafardini (VP, CFO, and Treasurer)

Yeah. Last question for me, obviously. It appears no accrual for incentive comp in the Q1. Should you hit targets, what's kind of that maximum level that would be taken this year if you hit those incentive comp levels for the overall year that will have to true up later this year?

H.O. Woltz III (President and CEO)

Well, it'll be on a quarter-by-quarter, month-by-month basis. There'll be no big surprises.

Scott R. Ciafardini (VP, CFO, and Treasurer)

Right. Let me say this also, Tyson. As we look at the business and we look at the spreads that are implied by contemporaneous purchases and sales of product, the business has not been impaired by any kind of macroeconomic weakness or downturn. We like where we are, but for a little extra inventory. Okay. Your price, you talked about the overall average price being down 8.8%. We've never really gotten the shipments up like we wanted to see over the past year plus due to supply constraints and otherwise. Across different product categories like PC strand versus your standard welded wire that's more residential focus, give us kind of the range of what you're seeing on the pricing environment. Has PC strand held much more favorably than the standard welded? That is disproportionately lowering your average price?

H.O. Woltz III (President and CEO)

Well, I think what we said was that ASPs fell pretty significantly in Standard Welded Wire Reinforcing product line and not so much in other product lines, just reflecting the state of supply and demand in those various markets.

Scott R. Ciafardini (VP, CFO, and Treasurer)

Okay. Thank you, gentlemen.

H.O. Woltz III (President and CEO)

Thank you, Tyson.

Scott R. Ciafardini (VP, CFO, and Treasurer)

Thank you for your question. Our next question comes from the line of Julio Romero with Sidoti. Mr. Romero, your line is now open.

Julio Romero (Analyst)

All right. Good morning, everyone.

H.O. Woltz III (President and CEO)

Morning, Julio.

Scott R. Ciafardini (VP, CFO, and Treasurer)

Morning.

Julio Romero (Analyst)

My first question is, what is your sense for how much of the weakness you realize in non-resi shipments during the quarter was due to customer destocking versus easing supply chain constraints?

H.O. Woltz III (President and CEO)

In the residential-related markets, Julio, beginning last May, when interest rates began to really affect that market, we saw a significant reduction in shipments relative to our forecast to the tune of around 40%. Subsequently, those markets seemed to have recovered and stabilized, although at lower levels than they were running prior to the downturn, but they've taken the brunt of the weakness in that marketplace.

Julio Romero (Analyst)

Thank you. My second question is, how do you expect price to change sequentially over the next few quarters?

H.O. Woltz III (President and CEO)

It's unknown and not forecastable. Typically, when demand for our products is strong, we don't see significant price competition. Our order book and our competitors' order books are such that pricing is not so much of an issue.

Julio Romero (Analyst)

All right. Thank you so much for taking my questions.

Scott R. Ciafardini (VP, CFO, and Treasurer)

Thank you.

Thank you for your question, Julio. There are currently no further questions registered. As a brief reminder, it is star 1 on your telephone keypad. There are no further questions waiting at this time, I will pass back for any final remarks. Thank you.

Okay. Thank you, Forum. We appreciate your interest in Insteel. As always, we welcome your contacts and your calls for any follow-up questions that you have. Thanks, we'll look forward to talking to you next quarter.

This concludes today's Insteel Industries First Quarter 2023 earnings call. Thank you for your participation. You may now disconnect your line.