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Insteel Industries Inc  (NASDAQ:IIIN)
Q4 2018 Earnings Conference Call
Oct. 18, 2018, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, ladies and gentlemen, and welcome to the Insteel Industries Fourth Quarter 2018 Conference Call. (Operator Instructions) As a reminder, today's conference is being recorded.

I would now like to turn this conference call to H. Woltz, Insteel's President and CEO. You may begin, sir.

H. Woltz -- President & CEO

Good morning. Thank you for your interest in Insteel, and welcome to our fourth quarter 2018 earnings call, which will be conducted by Mike Gazmarian, our VP, CFO and Treasurer, and me.

(Forward-Looking Cautionary Statements)

I'll now turn it over to Mike to review the fourth quarter financial results and outlook for our markets, and I'll follow up to comment more on business conditions.

Mike Gazmarian -- VP, CFO & Treasurer

Thank you, H., and good morning to everyone joining us on the call.

As we reported earlier today, Insteel posted solid results for the fourth quarter of fiscal 2018, despite a drop-off in shipments. Earnings per share came in at $0.49, which is more than double the prior year level, but down $0.18 from the third quarter.

Shipments for the quarter fell 13.9% sequentially from Q3, due to the factors referenced in our earnings release: increased pricing pressure, particularly in those markets susceptible to import competition; operational issues, largely due to tight labor markets that restrained production volumes at certain locations; raw material supply constraints early in the quarter, resulting from the Section 232 tariffs on imported steel; and customer inventory rebalancing related to pre-buying activity during the previous quarter, driven by availability concerns and the likelihood of rising prices. On a year-over-year basis, shipments were down 1.6%.

From a geographic standpoint, shipments into Texas, our largest market, were unfavorably impacted by the unusually wet weather, particularly in September, which was the wettest month on record for the state as a whole.

Average selling prices rose another 11.3% from the third quarter, following Q3's 12% sequential increase, reflecting the series of price increases we've implemented in response to the escalation in our raw material costs. As we indicated on our previous call, these cost pressures have been spurred by the imposition of the Section 232 tariffs on imported steel and subsequent tightening in the availability of our primary raw material, hot-rolled steel wire rod, which has driven US prices above world market levels. On a year-over-year basis, Q4 ASPs were up 27.3% from 2017.

Gross profit was up $7.7 million from a year ago and gross margin rose 390 basis points, driven by the widening in spreads. On a sequential basis, gross profit fell $4.6 million from the third quarter and gross margin narrowed 300 basis points due to the drop-off in shipments and higher unit manufacturing costs on lower production volume.

SG&A expense for the quarter was up $1.6 million from a year ago due to higher incentive compensation costs under our return on capital plan, driven by this year's improved results together with higher salary and health insurance expanse. The increase in salary expense was largely related to the additional resources we've deployed through the November Ortiz Engineered Products acquisition to accelerate the growth of our engineered structural mesh product line in the cast-in-place market.

On a sequential basis, SG&A expense was relatively unchanged from Q3. Excluding the deferred tax remeasurement adjustments related to the reduction in the federal rate under the new tax law, our effective tax rate for the year wound up at 22.7% versus the 24% we had estimated through the first nine months of the year, which reduced the Q4 rate to 19.3%.

Looking ahead to fiscal 2019, we currently expect our effective rate to run at around 23%, subject to future adjustments related to the level of earnings, changes in permanent 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 provided $4.1 million of cash in the fourth quarter, while using $1.2 million of cash in the same period last year, primarily due to the increase in earnings. Our year-end balance sheet reflects a significant inventory build from the depressed level of Q3 and the related increase in accounts payable.

You may recall that our inventories had fallen to suboptimal levels in the third quarter as a result of the strengthening in shipments and tightening in the availability of wire rod from our domestic suppliers related to the 232 tariffs. We expect the elevated payables balance will gradually return to normalized levels in the coming months with the anticipated drop-off in raw material purchasing volumes.

Based on our Q1 sales forecast, our year-end inventories represented 3.4 months of shipments compared to about two months at the end of the third quarter, and were valued at an average unit cost that was higher than our beginning inventory balance and Q4 cost of sales. We could experience some margin compression during the first quarter as the higher cost material is consumed, depending on our ability to push through additional price increases.

In allocating our cash flow and managing the cyclical nature of our business, we focus on three objectives: reinvesting in the business for growth and to improve our costs and productivity; maintaining adequate financial strength and flexibility; and returning capital to our shareholders in a disciplined manner.

During the year, we invested $18.4 million in our business, which was primarily targeted for various growth cost and productivity initiatives. We ended the year with $43.9 million of cash on hand or over $2 a share and we are debt-free with no borrowings outstanding on our $100 million credit facility, and we returned $21.3 million of capital to our shareholders through the payment of a $1 a share special dividend in addition to four regular quarterly dividends, marking the third straight year we paid a special dividend of at least $1 a share.

Going forward, we will continue to balance these objectives in deploying capital in any excess cash balances. As we move into fiscal 2019, the outlook for our construction end markets remain strong, with the leading indicators and forecasts pointing to continued growth in the coming year.

We're encouraged by the recent pickup in public construction spending, which should favorably impact the infrastructure-related portion of our business. The seasonally adjusted annual spending rate for public construction has now risen year-over-year for nine straight months after trending negative for the previous 12 months. Public highway and street construction spending for August was up 13.9% from a year ago, rising to its highest level in over 2.5 years.

State contract lettings through September were up double digits from a year ago on a trailing 12-month basis, with the average project size reflecting a similar increase. Lettings are a leading indicator for highway and bridge construction as contract awards impact our customers' order books and ultimately demand for our reinforcing products.

At the federal level, we remain hopeful that the administration and Congress will be able to reach agreement on a fiscal 2019 transportation spending bill in a timely manner with the current two-month continuing resolution scheduled to expire on December 7.

The most recent reports for the Architecture Billings and Dodge Momentum Index continue to signal additional growth in non-residential building construction in the coming year. In August, the ABI improved to 54.2, marking the 11th consecutive month that's remained above the 50 growth threshold, with the greatest strength reported for the Southern region. On a year-to-date basis, the Index has averaged 52.3, which is up slightly from 52.2 last year and 51.2 in 2016.

The Dodge Momentum Index, another leading indicator for non-residential building construction, appears to be returning to a more sustainable level following the robust gains that occurred beginning in late spring. Following two consecutive decreases, the Index was up 47.2% from a year ago, with both the commercial and institutional components rising by about the same percentages.

I'll now turn the call back over to H.

H. Woltz -- President & CEO

Thank you. As Mike indicated, construction markets continued to grow during our fourth quarter, creating solid demand for our products on construction sites and at our customers' manufacturing facilities. The favorable demand environment was overshadowed, however, by the impact of the Trump administration's Section 232 tariff program, which has distorted our markets since its imposition early in our third quarter.

As we reported last quarter, uncertainties surrounding the availability of our primary raw material, hot-rolled steel wire rod, resulted in speculative purchasing throughout the supply chain and sharp price increases, reflecting the 25% tariff that was applied to practically all imports of carbon steel products. These supply concerns were exacerbated by the Antidumping and Countervailing Duty Orders entered in April, following the conclusion of trade cases that had been filed by domestic producers in January 2017.

Based on customer purchasing patterns over the second half of the year, we believe that concerns about inadequate supply and rising prices drove many of our customers to accumulate excess inventories during Q3 that began to be liquidated later in our fourth quarter, depressing shipments and obscuring healthy demand for our products. We believe the impact from this inventory rebalancing is largely behind us.

We reported last quarter that the supply problems we experienced with certain domestic wire rod producers caused production interruptions at several of our facilities. While these disruptions continued into Q4, they were much less severe, and by August, inventories had been sufficiently replenished to where operating schedules returned to nearly normal. While the return of the steel mill in Georgetown, South Carolina, should further alleviate supply concerns, its restart had a minimal impact during Q4 as the initial ramp-up of the mill appeared to proceed slower than expected.

In addition to market distortions caused by the Section 232 tariff regime, shipments during Q4 were adversely impacted by isolated operational issues. We experienced production inefficiencies at two facilities during the quarter, which adversely affected shipments, and in early August, we experienced a power outage at our Dayton, Texas, facility due to the failure of a transformer in an electrical substation.

The plant was completely offline for a week, after which we gradually resumed operations using onsite industrial generators to supply power. While we were fortunate to resume production while the substation was rebuilt, productivity during the seven weeks we operated on generators was suboptimal due to complexities related to regulating the voltage provided to our production equipment and generator downtime required by frequent scheduled maintenance events.

Fortunately, the new substation came online last week and the plant is back to normal operations. We appreciate the intense efforts of our team members as well as the outside partners who worked with us to bring the plant back online safely and expeditiously.

Turning to CapEx. As reflected in our earnings release, capital outlays totaled $18.4 million for the year, somewhat under our earlier estimate of $21 million. The shortfall is timing related and does not imply cancellation or deferral of any projects. We completed important projects for PC strand production, upgraded our wire production technology at several plants and are installing a new engineered structural mesh production line, which should come online during the current quarter.

As reported previously, early in the year we also exercised our option to purchase the previously leased Houston facility. Our initial estimate for CapEx for fiscal 2019 is $22 million, subject to revisions as we move through the year. Investments will continue to be targeted toward expanding our product capabilities, lowering the cash cost of production and updating technology, including our information systems.

Looking forward, we expect continued growth in our markets during 2019 and are encouraged by recent indications of accelerating demand in our infrastructure related business. We also look forward to smooth start-up of the new ESM production line during this quarter along with expected reductions in our operating costs.

Market timing appears to be favorable and should support our projected ramp-up timeline. Despite the favorable macro outlook, we are concerned about the impact of market distortions created by the 232 tariff program and its impact on Insteel's financial performance in 2019. As mentioned in the press release, the import tariff has driven domestic hot-rolled wire rod prices well above world market levels.

As we had predicted, since an import tariff was not applied to most downstream products, including welded wire reinforcing and PC strand, the resulting supply chain asymmetry has opened the door for low-priced imports to gain market share, resulting in margin compression for domestic producers.

Considering that millions of US jobs at downstream producers are dependent on the competitive sourcing of hot-rolled steel versus less than a hundred thousand jobs in the steel melting end of the supply chain, it's difficult to envision how the tariff program supports the job creation objectives of the administration, and we're working with them to identify potential solutions to the unsustainable environment that now exists. We believe that it's time to either terminate the 232 program or extend tariffs to downstream products derived from wire rod that have become susceptible to low-priced import competition.

Notwithstanding our tariff concerns, we will continue to be vigilant in pursuing attractive growth opportunities both organic and through additional acquisitions and remain focused on improving our operational effectiveness and realizing the anticipated benefits from the substantial investments we've made in our facilities to lower manufacturing costs, reduce lead times and improve quality.

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

Questions and Answers:

Operator

(Operator Instructions) Julio Romero, Sidoti & Company.

Julio Romero -- Sidoti & Company -- Analyst

So if we could start on Section 232, can you just remind us which of your product lines would be susceptible to the import competition? As I understood, it's mostly PC strand, but there may be some products in welded wire rod that can be affected as well?

H. Woltz -- President & CEO

Yes. That's correct. You could generally say that. Our make-to-stop products on PC strand and then standard welded wire reinforcement is also experiencing import competition from Mexico, primarily. Most of that product is coming into the Texas market, where we are not active in standard welded wire reinforcing. But we do see its impact in Florida and permeating up through the eastern part of the States. But the situation for us is probably not as dire as it is for producers of that product in Texas.

Julio Romero -- Sidoti & Company -- Analyst

Got it. And can you give us a sense of how much US prices are compared to world market levels?

H. Woltz -- President & CEO

You're speaking wire rod?

Julio Romero -- Sidoti & Company -- Analyst

Correct, yes.

H. Woltz -- President & CEO

Yes, 25% to 30%, about the amount of the tariff.

Julio Romero -- Sidoti & Company -- Analyst

Got it. That's helpful. And then maybe how receptive has the Commerce Department been to implementing tariffs to downstream products? I know, H., you've been working at it since 2016, but it really hasn't seemed to be much of a priority for them up to this point. Is that fair?

H. Woltz -- President & CEO

I think there's a genuine interest in the situation that exists now and there's a genuine desire not to injure downstream producers. However, the mechanics of those issues are difficult for the Department of Commerce and the administration to deal with. And that doesn't mean that they're impossible to deal with, but there are certain complexities there that just exist and have to be dealt with.

Julio Romero -- Sidoti & Company -- Analyst

Got it. That's helpful. Maybe if we could just turn to shipments. Can you maybe give us a breakdown of how much of the year-over-year decrease was -- I know you call it a couple of different, maybe whether, de-stocking by customers and operational issues. Was one of those factors maybe a bigger factor than the others?

H. Woltz -- President & CEO

It's really hard to drill down and quantify by reason, Julio. But I would tell you that significantly less than half was a result of any operational issues, and the balance was weather, inventory rebalancing and that type of driver.

Julio Romero -- Sidoti & Company -- Analyst

Got it. And then maybe in regards to weather, I know that Texas had a rough September, but I believe the prior year still had a pretty -- if I believe the wettest August on record for Texas. So maybe you can talk about the weather impact specific to Texas, maybe quantify if you can, or to the best that you can, the shipment impact there.

Mike Gazmarian -- VP, CFO & Treasurer

Yes. It's really -- I don't know whether it's possible to precisely quantify it on a year-over-year basis just due to the difference between the weather in September this year versus the hurricane last year. I don't know that we could normalize both amounts to come up with a precise comparison. But, generally that from a geographic standpoint, the softening was across the board due to those factors that we mentioned. I don't know that there are any other areas, any other regions that really stood out.

Julio Romero -- Sidoti & Company -- Analyst

Got it. And then if I could just ask you about the CapEx, $22 million, how much of that would you say is related to the productivity improvements that are planned versus maybe just maintenance CapEx?

H. Woltz -- President & CEO

No. Our run rate on just basic maintenance CapEx is in the range of $10 million to $11 million. So the balance of it would be related to productivity projects, expanding product capabilities and that sort of thing.

Operator

Tyson Bauer, KC Capital.

Tyson Bauer -- KC Capital -- Analyst

Just a couple of follow-ups also on the 232 impact. Do you believe you've seen the full extent of that impact or is this something that could continue to erode your ability within the market or of your competitors as we go through the subsequent quarters here?

H. Woltz -- President & CEO

If you're referring to the impact of low-price import competition, we have seen that steadily through the last few months. I would tell you, it's probably increasing in magnitude in the PC strand market, but with respect to standard welded wire reinforcement, I think it's probably hit its run rate at this point.

Tyson Bauer -- KC Capital -- Analyst

Okay. And on PC strand, what percentage or what kind of magnitude impact does it have on you overall? (inaudible) these are probably more on the coastal areas that you're feeling a bigger impact?

H. Woltz -- President & CEO

Well, you'd like to think so, but that's not correct. We're actually seeing the importers pushing to Portland to a certain extent. And you can see the import statistics are (inaudible) rising, prices are depressed. And you get to the point, there's a Buy America component to this market, and what we've referred to is our commercial component or segment to the market. And when the importers take enough of the commercial segment, it begins to impact domestic producers who are scrambling more over the Buy America segment of the market and so the imports are really affecting the entire market.

Tyson Bauer -- KC Capital -- Analyst

Okay. And just as a procedural question if you know, what you're asking for in the downstream products being protected, is that something that could be an addendum to the existing tariffs that are in place? Or is this something that would be treated separately where you've got to go through the 90-day public comment period and you're looking at six plus months before you could ever get to implementation?

H. Woltz -- President & CEO

Well, I think that's a matter of your interpretation of the law. But we do not believe that an extensive waiting period would be required.

Tyson Bauer -- KC Capital -- Analyst

Okay. And last year when you announced your Q4, you had the special dividend included in that announcement. This year you end the year with $12 million more in cash, generally still positive end market outlooks. Obviously, you've got the competitive pressures, but you're still in good position, good margin still. Any reason we do not see that dividend in this announcement? And is that something that's still on the table before the end of this calendar year?

H. Woltz -- President & CEO

I'm sure we'll discuss it at our upcoming Board meeting in November and we will have something to say then.

Tyson Bauer -- KC Capital -- Analyst

Okay. Q1, just as we look forward, you've had -- you talked about weather impacts has been -- a wider geographic range of weather impacts. Last year, you had the hurricanes (inaudible) in Texas and the Houston area, more widespread throughout Texas, up the Midwest all the way to Canada, Carolinas obviously. Is that creating a slower start to fiscal Q1 here?

H. Woltz -- President & CEO

Yes. I mean, certainly Michael and Florence both have had an impact on shipments into the regions that were affected. I mean, the flooding and the devastation certainly affects consumption of the product. But as I've stated before, these are matters of timing. Ultimately, the hurricanes typically generate some demand for our product in the long run, but they don't destroy demand in the long run. So we may see shipments shifted from one period to another, but overall they generally create demand.

Operator

And I'm not showing any further questions at this time. Would you like me to repeat the instructions?

H. Woltz -- President & CEO

We appreciate your interest in the Company, and don't hesitate to call with any follow-ups. Thank you.

Operator

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.

Duration: 72 minutes

Call participants:

H. Woltz -- President & CEO

Mike Gazmarian -- VP, CFO & Treasurer

Julio Romero -- Sidoti & Company -- Analyst

Tyson Bauer -- KC Capital -- Analyst

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