Insteel Industries (IIIN) Q3 2022 Earnings Call Transcript

Insteel Industries (IIIN -2.12%)
Q3 2022 Earnings Call
Jul 21, 2022, 10:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Hello, and welcome to the Insteel Industries third quarter 2022 earnings call. My name is Katy, and I'll be coordinating your call today [Operator instructions] I'll now hand over to your host, H. Woltz, president and CEO to begin. H., please go ahead.

H Woltz -- President and Chief Executive Officer

Good morning. Thank you for your interest in Insteel, and welcome to our third quarter 2022 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. These risk factors are described in our periodic filings with the SEC.

We're pleased with our third quarter results that were driven by surging demand for our reinforcing products and escalating steel prices. We believe the outlook for our markets is highly positive and has been materially enhanced by the passage of the Infrastructure Investment and Jobs Act. 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.

Mark Carano -- Senior Vice President, Chief Financial Officer, and Treasurer

Thank you, H., and good morning to everyone joining us for the call. As we highlighted in the release earlier today, the third quarter of 2022 was another historically strong period of financial performance, only exceeded by a record second quarter of this fiscal year. We reported quarterly revenue of $227.2 million or an increase of 41.3% from $160.8 million in the prior year and net earnings of $38.6 million or $1.96 per diluted share as compared to $18.4 million or $0.84 per diluted share in the prior year period, representing 109% in earnings per share. Our results continue to be favorably impacted by strong demand and incremental price increases to recover the continued escalating in raw material and operating costs.

Average selling prices in the third quarter increased 53.9% relative to the prior year and were broad-based across all product lines. Sequentially, from Q2 2022, average selling prices increased 6.3%, which represents our eighth sequential quarter of rising ASPs. These increases support an expansion of our spread between average selling prices and raw materials relative to the prior year quarter, resulting in strong profitability. Despite the robust demand environment, shipments for the quarter decreased 8.2% from last year.

Sequentially, from Q2 2022, our shipments were essentially unchanged. This lack of shipment momentum resulted from two unanticipated challenges. First, we experienced some softness in our standard welded wire mesh product line beginning in the latter half of the quarter following an unprecedented level of demand during the first half of this fiscal year. As we highlighted in our release, this is our most commodity-like product and the only one that is sold through distribution channels rather than directly to end customers.

We believe a moderation in homebuilding activity over the last few months slowed demand, and the distribution chain -- supply chain, which was no longer combating limited product availability began to manage their inventory down to more normalized levels. The second driver of the shipment decrease was directly related to labor availability and turnover across our plant footprint. With an adequate supply of raw materials from offshore sources to complement our domestic sources now available and thus no longer a production constraint, labor emerged as the key governor on ramping up plant production levels. The unusually tight labor market, which is being felt across all industries and regions in the United States restricted our plant's ability to increase production to a capacity level consistent with customer demand.

Turning to gross profit. Gross profit for the quarter increased $26.6 million or 84% from the same period last year to a record level of $58.1 million, and gross margin expanded over 600 basis points to 25.6%. This increase was due to widening in spreads as average selling prices outpaced rod cost increases during the period. On a sequential basis, gross profit increased $1 million or 2%, and gross margins remained above 20% for the fourth consecutive quarter.

SG&A expense for the quarter increased $2.1 million to $8.2 million, but as a percentage of sales, it decreased marginally to 3.6%. The dollar increase was primarily the result of an increase in compensation and benefit, expenses and the relative quarterly change in the cash surrender value of life insurance policies of $1.3 million, which, from an accounting perspective, is reflected as an increase in SG&A expense. These costs were partially offset by a reduction in legal expenses related to our successful PC strand trade case actions that were concluded last year. Our effective tax rate for the quarter was largely unchanged at 22.7% which is up minimally from 22.4% last year.

Looking ahead to the balance of the year, we expect our effective tax rate will remain steady at around 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 for the quarter used $5 million. Increased working capital due to higher inventory levels offset strong earnings performance.

Inventories increased as we added primarily to our raw materials balances and marginally to our finished goods balance. Based on our sales forecast for Q4, our quarter end inventories represented 3.4 months of shipments compared with 2.2 months at the end of the second quarter and 1.7 months at the end of the first quarter. While our raw material inventories have recovered to more normalized levels for the seasonally strongest portion of our fiscal year, our finished goods inventories remain low. The combination of the lingering impact of constrained raw material supply in much of Q2, which prevented us from building finished goods inventory into the start of the third quarter, and the previously noted labor-driven production challenges muted our finished goods inventory levels during this period.

Finally, our inventories at the end of the third quarter of 2022 were valued at an average unit cost that was higher than our second quarter cost of sales and remain on par with current replacement costs. We incurred $3.6 million in capex in the third quarter for a total of $12.3 million through the first half of our fiscal year. From a liquidity perspective, we ended the quarter with $63 million of cash on hand and no borrowings outstanding on our $100 million revolving credit facility. Looking ahead to our fourth quarter, we expect another period of strong financial performance.

First, shipments and pricing trends in the first few weeks of the fourth quarter are trending around expected levels. Second, our customers remain optimistic with extended backlogs across both the private and public nonresidential markets which has yet to feel the impact of any projects funded by the Infrastructure Investment and Jobs Act. While the residential market appears to be transitioning to a slower growth period in the near to medium term, most of the economists believe it will continue to expand steadily. Regardless, the residential market only represents about 15% of our revenue, so we do not expect this impact to be meaningful.

And finally, the third-party leading indicators and forecast for nonresidential construction reflects a strong outlook for demand in our markets in the calendar year 2023. That concludes my prepared remarks. I will now turn the call back over to H.

H Woltz -- President and Chief Executive Officer

Thank you, Mark. As reflected in the release, our strong third quarter results were driven by robust nonresidential construction markets and escalating steel prices. Above all, we thank our Insteel teammates for their perseverance through challenging circumstances and their focus on execution excellence and working safely. Over the past few quarters, we identified inadequate supplies of our primary raw material, hot-rolled wire rod, as a constraint to production and shipments, and we indicated we had turned to offshore markets to supplement domestic supplies.

By the end of the third quarter, receipts of imported wire rod had filled most of our supply gaps and we expect to avoid further operating disruptions related to raw material supplies over the next few months. Once our raw material shortfall was resolved, we experienced staffing-related difficulties in ramping up operating hours to meet market demand at certain facilities. We've responded by implementing more flexible work schedules and adjusting compensation, although it's too soon to know the extent to which our actions will result in a material increase in operating hours, production and shipments. Also during the quarter, we experienced softening conditions in the market for standard welded wire reinforcing, which is our most commodity-like product line.

As Mark indicated, this is the only product we produce that is sold through distribution channels rather than direct to end users, and it is the product which is most heavily influenced by housing construction. For the last three or four quarters, supplies of standard welded wire reinforcing have been extraordinarily tight, prices rose sharply and purchasing behaviors were frantic. We believe that during Q3, supply began to catch up with demand, while at the same time, housing starts softened. The combination of these changes caused purchasers to become ultraconservative and tightly manage inventories which adversely affected our production and shipments.

The condition is carried over into our fourth fiscal quarter. Customer inventories continue to be uncomfortably high, a condition which must be resolved before we can expect volumes to recover. As we stated in the release, we've experienced no softening in our other welded wire reinforcement or PC strand markets where our backlogs -- our customer backlogs are at near-record levels, and there's considerable optimism that demand will continue to be robust into calendar 2023. Our task in these markets is to ramp up operating hours and increase production in shipments.

Consistent with our past practice, we do not plan to disclose or discuss additional product line details. Our offshore raw material purchases, together with the slowdown in activity in the standard welded wire reinforcement market, have resulted in elevated inventory balances although not to levels that are uncomfortable, and we expect inventories to remain elevated through the end of the calendar year. As Mark pointed out, our inventory carrying values are not excessive relative to replacement cost. And in reality, it's unlikely that domestic suppliers would be able to provide adequate volumes for us to sustain operations during our fourth and first quarters, making offshore supplies indispensable.

In a perfect world, we would not find it necessary to participate to such an extent in the international market, and we would prefer to avoid the working capital implications. Unfortunately, the domestic supply profile does not allow us this luxury. We continue to be optimistic about the impact on our markets of the Infrastructure Investment and Jobs Act we believe that will create significant demand for our products beginning in late 2022 or early 2023. The need for infrastructure investment in the U.S.

has been obvious for decades, but funding has consistently been adequate to address the need. For the first time, it 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 the new funding provided by the Infrastructure Investment and Jobs Act. Anecdotally, there's never been a time when our customer base has enjoyed the level of activity and strength of backlogs that they enjoy today. Many customers have backlogs that extend more than six months out which is practically unprecedented.

Turning to capex. We now project 2022 capex of approximately $20 million based on the timing of shipments from our vendors. The investments in state-of-the-art technology will expand our product capabilities and favorably impact our cash cost of production. We're considering additional projects that would have similar beneficial impact on our market position and our cost profile.

Going forward, we plan to closely monitor market conditions and aggressively pursue the appropriate actions to maximize shipments and optimize our cost, 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. Katy, would you please explain the procedure for asking questions?

Questions & Answers:

Operator

Thank you. [Operator instructions] So we take our first question from Julio Romero from Sidoti. Please go ahead.

Julio Romero -- Sidoti and Company -- Analyst

Hey. Good morning, everyone. Thank you for taking my questions.

Mark Carano -- Senior Vice President, Chief Financial Officer, and Treasurer

Good morning. 

H Woltz -- President and Chief Executive Officer

Good morning.

Julio Romero -- Sidoti and Company -- Analyst

Could you guys maybe just dig into standard welded wire? What percentage of sales does that typically make up of overall sales? And maybe, secondly, what percentage of that standard welded wire usually comes from residential?

H Woltz -- President and Chief Executive Officer

Julio, we don't disclose product line detail like that.

Julio Romero -- Sidoti and Company -- Analyst

OK. Well, I guess maybe asked another way on the residential side, would it be, I think, you guys have typically talked about 15% of your overall sales comes from residential. Does that kind of fall in line with that or deviate too far from that 15%?

H Woltz -- President and Chief Executive Officer

The residential market consumes both standard welded wire reinforcement and PC strand.

Julio Romero -- Sidoti and Company -- Analyst

Got it. OK, I guess maybe any way to rank order what you're seeing in terms of standard welded wire? Any way to rank distribution channel recovery versus slowing new construction as to the impact on to that product line?

H Woltz -- President and Chief Executive Officer

I don't think we have sufficient insight to give you a good answer to that. I think that the -- as I mentioned in my comments, the activity in that market was so frantic for so long that upon the first signs of a retreating residential market environment, I think the buying community just really slammed on the brakes and became ultraconservative. But to give you an answer for exactly the underlying drivers of why that happened, I'm not sure we can do that. We just don't have that information.

Julio Romero -- Sidoti and Company -- Analyst

OK, maybe just thinking about your inventory balance, $192 million, how does that compare to maybe last quarter on a unit basis? And did you guys mention that the average unit cost is on par with current replacement cost?

Mark Carano -- Senior Vice President, Chief Financial Officer, and Treasurer

To your latter question, that's correct. And unit volumes, I would say it's up marginally from where it was last quarter. Obviously, that's a dollar value that you're seeing there, and prices for the product have continued to increase.

H Woltz -- President and Chief Executive Officer

And, Julio, it really was until the latter part of the third quarter that our offshore quantities actually arrived in the volumes that we had ordered.

Julio Romero -- Sidoti and Company -- Analyst

OK. No, that's helpful. I'll turn it over and circle back with any follow-ups. Thanks very much.

H Woltz -- President and Chief Executive Officer

Thank you.

Operator

The next question comes from Tyson Bauer from KC Capital. Please go ahead, Tyson.

Tyson Bauer -- Kansas City Capital Associates -- Analyst

Good morning, gentlemen. 

H Woltz -- President and Chief Executive Officer

Good morning, Tyson.

Tyson Bauer -- Kansas City Capital Associates -- Analyst

I find it interesting that we have a record year that you've reported an earnings in six months and it's viewed negatively, with $4 in EPS for the last six months, but that's how the market goes. Residential 8% -- or 15%, you've made that comment a couple of times already. Infrastructure, I think, typically, historically, has been around 40%. Do we have a little timing issue where we haven't really seen that increase in spending on the infrastructure that should more than offset any current weakness that we may be experiencing on the residential.

That backfill as we get into '23 should be more than adequate to overcome any kind of softness in the housing market.

H Woltz -- President and Chief Executive Officer

Yeah. I mean, we don't view the outlook negatively at all. We view the outlook as extremely bullish for reasons that you cite given the balance of our revenue stream split between res and nonres. And even today, without the incremental spending that should come from the Infrastructure Investment and Jobs Act, business is extremely strong in those sectors.

So I guess, I would have a hard time spinning a negative yarn on this at all.

Tyson Bauer -- Kansas City Capital Associates -- Analyst

Yeah, I mean, when we report -- or you guys report the second highest margin ever and sounds like just because the froth has been taken off, similar to what we saw in the lumber market a year ago, that, all of a sudden, that's viewed as a negative when maybe relatively, it's a little softer. But absolute terms, you're still in a very robust multiyear situation that should be very strong for results and cash flow.

H Woltz -- President and Chief Executive Officer

I agree with the statement.

Tyson Bauer -- Kansas City Capital Associates -- Analyst

The shipments, down 8.2%. You talked about labor. Is that very regional? And are you -- do you have any remedies to solve a regional shortage by overcoming that with -- as freight eases up a little bit from your other facilities or is this just something you have to work your way through?

H Woltz -- President and Chief Executive Officer

It is regional, but I mean -- but every plant location has its own labor market, and they're all in different states, but they're all strong. Nationally, I think unemployment is well under 4%. In our localities, it -- unemployment ranges from a low of around 2% to 4%. And in some respects, it appears that work has become optional in some of these markets, and it's really difficult.

And as I said in my prepared remarks, we've responded by trying to adjust our work schedules to become more flexible and more innovative, and we've had success with that. We can expect to see some more of those activities, but I think we are experiencing the same problems that most manufacturers are experiencing.

Tyson Bauer -- Kansas City Capital Associates -- Analyst

OK. One of the unintended benefits the margin level because of product mix if that standard welded wire had some softness that you have some flexibility and can gear some of that manufacturing toward some of those end customer high-demand items with the better margins?

H Woltz -- President and Chief Executive Officer

There's some opportunity to do that. But in certain respects, the product is unique, and the capacity is may or may not be transferable to other product lines.

Tyson Bauer -- Kansas City Capital Associates -- Analyst

Did the -- was the timing of getting the raw materials in, along with the staffing shortage, does that contribute to just kind of the back-of-the-napkin numbers about $20 million to $30 million of revenue loss that you potentially could have done had you been able to fully staff?

Mark Carano -- Senior Vice President, Chief Financial Officer, and Treasurer

Yeah. It's hard for me to comment, Tyson, on the fly to that exact calculation you've got. I will tell you that we entered -- we kind of mentioned, we entered the third quarter, obviously, with low finished goods inventories. And in a normal operating environment, we would have entered that third and fourth quarter with much, much higher finished goods inventories.

So some of that was driven by the lack of raw materials and the timing of those arriving late in the quarter, if you recall, from the second quarter.

Tyson Bauer -- Kansas City Capital Associates -- Analyst

Typically, at the end of a calendar year, you have a big increase, your fiscal Q1, on your cash balances, just the way the net working capital typically works out. Will we see that again this year? Or are you gearing up to maintain higher inventory levels, so you're well stocked as you enter in or you come out of next year's slower seasonal quarters, so you have that finished inventory available and ready to go. What's the mindset of how you're going to play that cash management and also have adequate inventories?

H Woltz -- President and Chief Executive Officer

Well, let me start by saying we don't want to put ourselves in the position we were in last year this time, that it was -- the operations were extremely ragged because of inadequate raw material supplies. So when you think of the deficiency in units that we experienced last year and the inflation in unit pricing, you can expect to see inventory balances remain higher certainly than they have been driven by a combination of more units and substantially higher values. But as I said, we're not uncomfortable with our inventory levels. And I don't think that we would be able to rely on domestic supplies for the current quarter -- solely domestic supplies for the current quarter or the first quarter of 2023.

So the necessary tactic is to bring it in from offshore. And when you do that, you bring it in, in reasonably large quantities which causes a rather lumpy move in working capital. So inventory balances are going to remain higher, but we would expect to see a working capital release in 2022 calendar.

Tyson Bauer -- Kansas City Capital Associates -- Analyst

And as you walk in your fiscal Q4 with the distribution adjustments from or distributors adjusting some of their inventories, the impact on pricing, obviously, it doesn't show up this quarter. You have a very favorable outlook being provided by one of your competitors, Nucor, this morning is doing well. Are we just talking in relative terms that, yes, we may see some softness as far as not these -- we'll take whatever product at whatever price we can get, but the pricing is still at a level that historically is extremely favorable to Insteel.

H Woltz -- President and Chief Executive Officer

Are you referring to overall, Tyson?

Tyson Bauer -- Kansas City Capital Associates -- Analyst

Right.

H Woltz -- President and Chief Executive Officer

Absolutely.

Tyson Bauer -- Kansas City Capital Associates -- Analyst

I mean, the vast majority of your products, everything, are still at great pricing. We have this one segment that may be experiencing some adjustments on the end markets, but we're going off of an extremely top level that even an adjustment lower is still favorable, especially compared to previous years.

H Woltz -- President and Chief Executive Officer

Yeah, I mean -- and we've made the point for the last several quarters that there has been a FIFO tailwind that we've had although we've not tried to quantify. And inevitably, when pricing begins to level out, the tailwind dissipates. And so if that's where we are, then the tailwind will subside. But the fundamentals of the business now with spreads and volumes, I think, is still extraordinarily favorable.

And as I've said in my comments, our mission is to get our operating hours and to meet the demand that's available to us.

Tyson Bauer -- Kansas City Capital Associates -- Analyst

Got it. Thank you, gentlemen and keep doing it.

H Woltz -- President and Chief Executive Officer

Thanks, Tyson.

Mark Carano -- Senior Vice President, Chief Financial Officer, and Treasurer

Thank you.

Operator

[Operator instructions] We currently have no further questions registered. So H., I will hand it back to you.

H Woltz -- President and Chief Executive Officer

OK. Thank you, Katy. We appreciate your interest in Insteel. We look forward to talking to you next quarter.

And in the meantime, don't hesitate to contact us if you have questions. Thank you.

Operator

[Operator signoff]

Duration: 0 minutes

Call participants:

H Woltz -- President and Chief Executive Officer

Mark Carano -- Senior Vice President, Chief Financial Officer, and Treasurer

Julio Romero -- Sidoti and Company -- Analyst

Tyson Bauer -- Kansas City Capital Associates -- Analyst

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