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Edited Transcript of IIIN earnings conference call or presentation 17-Jan-19 3:00pm GMT

Q1 2019 Insteel Industries Inc Earnings Call

MOUNT AIRY Jan 19, 2019 (Thomson StreetEvents) -- Edited Transcript of Insteel Industries Inc earnings conference call or presentation Thursday, January 17, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Howard Osler Woltz

Insteel Industries, Inc. - Chairman, President & CEO

* Michael C. Gazmarian

Insteel Industries, Inc. - VP, CFO & Treasurer

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Conference Call Participants

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* Adam Robert Thalhimer

Thompson, Davis & Company, Inc., Research Division - Director of Research

* Julio Alberto Romero

Sidoti & Company, LLC - Equity Analyst

* Philip Ross Gibbs

KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst

* Steven F. Marascia

Capitol Securities Management, Inc. - Director of Research

* Tyson Lee Bauer

Kansas City Capital Associates - Senior Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Insteel Industries First Quarter 2019 Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Mr. H. Woltz, President and CEO. Sir, you may begin.

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Howard Osler Woltz, Insteel Industries, Inc. - Chairman, President & CEO [2]

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Good morning. Thank you for your interest in Insteel, and welcome to our first quarter 2019 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'll now turn it over to Mike to review our first quarter financial results and outlook for our construction end markets and then I'll follow up to comment more on business conditions.

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Michael C. Gazmarian, Insteel Industries, Inc. - VP, CFO & Treasurer [3]

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Thank you, H, and good morning to everyone joining us on the call. As we reported earlier today, the first quarter of fiscal 2019 proved to be a challenging period for Insteel as the usual seasonal downturn was exacerbated by the excessively wet weather across many of our largest markets and low-priced import competition, which reduced shipments well below expected levels.

Excluding the nonrecurring gains referenced in our earnings release related to the disposition of fixed assets in the current year and the remeasurement of deferred tax assets and liabilities in the prior year, net earnings came in at $0.19 a share compared with $0.23 a diluted share a year ago.

Shipments for the quarter fell 17.2% from last year and 14.5% sequentially from Q4, primarily due to weather-related construction delays in Texas, our largest market, and across the Southern and Southeastern regions of the country.

Our shipping volumes were also adversely impacted by a continued increase in low-priced imports, particularly in our PC strand business, which has been facilitated by the Section 232 tariff program.

As we've conveyed on previous calls, the tariff has served to provide offshore competitors with a significant cost advantage, relative to the domestic strand producers that are driving U.S. prices for hot-rolled steel wire rod, our primary raw material, substantially above world market levels. As you would expect the drop-off in shipments was the most pronounced in the posttension PC strand market or the commercial segment is subject to import competition.

Average selling prices for the quarter rose slightly from the fourth quarter and were up 28.7% from a year ago, reflecting a series of price increases we've implemented in response to the escalation in our raw material costs.

Gross profit for the quarter fell $0.7 million from a year ago, and gross margin narrowed 140 basis points, driven by the reduction in shipments and higher unit manufacturing costs and lower production volume. On a sequential basis, gross profit was down $8.6 million from the fourth quarter and gross margin decreased 560 basis points due to the same factors compounded by higher raw material costs.

SG&A expense for the quarter increased $0.8 million from a year ago, primarily due to the relative year-over-year changes in the cash surrender value of life insurance policies.

The value of the policies fell $0.5 million this year with a decline in the financial market as compared to a $0.3 million increase last year.

These additional costs were partially offset by lower incentive compensation expense under our return on capital plan driven by the weaker results in the current year. As we indicated in the release, the $0.8 million of other income for the quarter reflects a $0.7 million net gain on the retirement of fixed assets that was nonrecurring in nature and is reflected as an adjustment to operating cash flow on our cash flow statement. Our effective tax rate for the quarter dropped to 23.5% from 24.9% a year ago, excluding the impact of the $3.7 million deferred tax remeasurement gain on the prior year amount.

The lower rate reflects the net effect of the reduction in the statutory rate to 21% from 35% for all of this year versus only 3 quarters last year, plus the elimination of the benefit previously provided by the Section 199 domestic production deduction under the old tax law.

Looking at the fiscal 2019, we currently expect our effective rate to run in the range of 23% to 24%, 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 used $22.8 million of cash in the first quarter due to a working capital bill that was driven by $25.1 million reduction in accounts payable and accrued expenses and a $21.1 million increase in inventories.

You may recall that we had ended the previous quarter with an elevated accounts payable balance of $60 million, largely due to a sharp increase in raw material purchases as we replenish our inventories from the depressed levels of Q3.

Over the course of the first quarter, we scaled back our purchases, particularly during December, reducing payables by $19.6 million. Despite these measures, inventories increased during the quarter, primarily due to the weaker-than-anticipated shipments. Based on our Q2 sales forecast, our quarter-end inventories represented 4.1 months of shipments compared to 3.4 months at the end of the fourth quarter. The average unit cost was higher than our beginning inventory balance in Q1 cost of sales, which implies that we could experience some margin pressure during the second quarter as the higher cost material is consumed.

Capital expenditures totaled $6.2 million for the quarter, up slightly from last year, focused on cost and productivity improvement initiatives in addition to recurring maintenance needs. We ended the quarter with $15.5 million of cash on hand and were debt-free with no borrowings outstanding on our $100 million credit facility.

In allocating our cash flow and managing the cyclical nature of our business, we focus on 3 objectives: reinvesting in the business for growth and to improve our cost and productivity; maintaining adequate financial strength and flexibility; and returning capital to our shareholders in a disciplined manner. Going forward, we will continue to balance these objectives in deploying capital and any excess cash balances.

As we move into the second quarter, our market outlook for the remainder of the year remains positive with the growth in infrastructure construction expected to offset some moderation in nonresidential activity.

We should also benefit from the weather-related deferral of business from the first quarter, although any favorable impact will likely occur over an extended period considering the tightness in the labor markets which makes it difficult for contractors to play catch-up.

The infrastructure-related portion of our business should benefit from higher state and local infrastructure spending in many of our markets as rising tax collections and recent funding initiatives, such as fuel tax increases, bond financings and other valid measures begin to have a greater impact.

The outlook at the federal level, however, is clouded with uncertainty at this time, due to the ongoing shutdown and the lack of a normal appropriation for the entire fiscal year, which could cause state and local officials to become increasingly hesitant to authorize projects.

Federal funding has continued to flow from the DOT during the shutdown since it draws on the user fee supported Highway Trust Fund, not the general fund. However, since the government was operating on a continuing resolution that expired on December 21, state DOTs have only received about 25% of their full 2019 highway allotments. Also, the continuing resolution maintained federal funding at 2018 levels, creating an additional shortfall since Congress has provided increased funding for roads and transit in 2019.

The most recent reports for the Architecture Billings and Dodge Momentum Indexes has been somewhat mixed with the ABI reflecting greater strength. In November, the ABI remained in positive territory for the 14th consecutive month, rising to 54.7 and through the first 11 months of the year, the index has averaged 52.3, up slightly from 52.2 last year.

After getting off to a strong start the Dodge Momentum Index, another leading indicator for nonresidential building construction, has moderated over the second half of the year. For the full year, the overall index was up 4.3% from the end of 2017 with the institutional component of 8.5% and the commercial component rising 1.6%.

Yesterday, the AIA released its semiannual construction forecast for nonresidential building construction for 2019 and 2020, which reflected continued growth for both years. Spending on nonresidential buildings was projected to increase 4.4% this year, driven by stronger gains in the industrial and institutional sectors with the individual firms' forecasts ranging from 3% up to 6.3%. For 2020, the gross rate was projected to slow to 2.4% with the range widening to negative 0.9% up to 4.5% growth.

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

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Howard Osler Woltz, Insteel Industries, Inc. - Chairman, President & CEO [4]

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Thank you, Mike. As Mike indicated, we're disappointed with our first quarter results that were driven by weak shipping and production volumes that we attribute primarily to adverse weather conditions and growing import competition in certain markets. While we aren't happy with the Q1 results, we continue to believe that the underlying market fundamentals are reasonably strong and should support our forecast of another year of growth and demand for our reinforcing products.

As we reported last quarter, our financial performance for 2019 should be viewed in the context of the effects of the Trump administration's Section 232 tariff program, which is increasingly eroding the competitiveness of U.S. producers of downstream steel products that are exposed to foreign competition.

We previously reported that the combination of antidumping duties and the administration's Section 232 tariff regime had caused chaotic conditions in the market for wire rod, our primary raw material, beginning in Q2 of 2018. These factors caused a significant disruption in the availability of imported wire rod, which domestic producers were unable to backfill, resulting in shortages during late Q3 and early Q4. Prices rose substantially, and we were required to purchase imports at premium prices relative to the domestic market to ensure that we could meet customer commitments.

By the end of our fourth quarter, availability concerns had abated as speculative purchasing tapered off and the prospect of additional domestic capacity from the Georgetown, South Carolina Steel Mill became a reality. As we had predicted, in the aftermath of the 232 tariff, U.S. wire rod prices increased to well above the world market level.

Today, according to the indices published by Fastmarkets AMM, an authoritative source for worldwide pricing trends, U.S. wire rod prices are more than $200 per ton higher than the world market price. Since no tariff was applied to most imported downstream products, including PC strand and welded wire reinforcement, U.S. downstream markets have become far more attractive to foreign producers and import volumes have risen considerably, facilitated by substantial underselling, which has compressed margins of domestic producers.

Considering that millions of U.S. jobs at downstream steel users are dependent on the competitive sourcing of hot rolled steel versus less than 100,000 jobs in the steel melting end of the supply chain, it is unclear how the tariff program supports the job-creation objectives of the administration.

If the 232 program continues, as appears likely, it's imperative that the tariff is extended to downstream products derived from wire rod in order to eliminate a harsh penalty that is imposing on downstream producers of steel products, such as Insteel. While we are forcefully making our point with the administration, there's no way to predict whether our efforts to expand tariff coverage to downstream products will be successful.

Turning to CapEx. We reported last quarter that our initial estimate for 2019 was $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 information systems.

During the current quarter, we expect to bring online a new engineered structural mesh production line that will increase capacity for certain niche products as well as contribute to substantial reductions in cash operating costs. Market conditions appear to be favorable and should support our plan ramp-up during this fiscal year.

Notwithstanding our tariff concerns, we'll 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 that 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. Lauren, would you please explain the procedure for asking questions?

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from Julio Romero with Sidoti & Company.

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Julio Alberto Romero, Sidoti & Company, LLC - Equity Analyst [2]

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So my first question is, just given the import pressure, I think you guys are doing outstanding from a pricing standpoint, holding your ASPs here. Can you maybe just give some color on how you're able to hold that pricing? Was it the past price increases that are kind of coming to fruition, or were there any new price increases past? And maybe the full impact of maybe how you see pricing going forward?

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Howard Osler Woltz, Insteel Industries, Inc. - Chairman, President & CEO [3]

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Yes, well, thank you for the compliment, which may or may not be deserved. The reality is that with many of the import sources to quote in our markets, particularly in PC strand are quoting out 3 or 4 months. So the impact on ASP is in our PC strand business and particularly on spreads and margins is likely to be more consequential as we look into Q2 and possibly Q3 than it was in Q1. So our decision was, either we compete with the imports or we curtail operations. And at this point, we've decided that we're going to compete, we're going to stay in the market. And undoubtedly, we'll suffer the consequences of that from a margin point of view.

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Julio Alberto Romero, Sidoti & Company, LLC - Equity Analyst [4]

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Got it. And just as a follow-up to that, I guess, can you maybe talk about the mix in the quarter of welded wire versus PC strand? I assume it was a little bit more weighted to welded wire relative to the historical split?

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Michael C. Gazmarian, Insteel Industries, Inc. - VP, CFO & Treasurer [5]

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Yes, that's accurate. The drop-off in shipments was the most pronounced in that segment of the strand market that's susceptible to import competition. So it was more severe in strand than welded wire.

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Julio Alberto Romero, Sidoti & Company, LLC - Equity Analyst [6]

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Okay. And then maybe just one more before I'll hop back in queue is I appreciate the color you gave on federal funding impact for the shutdown here, would you expect any impact on volumes to become -- is there going to be a ramp-up of it becoming more material if it drags out past maybe the end of January here?

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Michael C. Gazmarian, Insteel Industries, Inc. - VP, CFO & Treasurer [7]

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Yes, I think the longer it drags out, the more downside risk there is, as we move towards, typically, the busiest time of the year from a construction standpoint. So I mean, we're obviously hopeful it gets resolved sooner rather than later. But if it continues out for a few more months, then I think it could begin to have a more severe impact due to the resulting uncertainty.

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Operator [8]

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And our next question comes from Phil Gibbs with KeyBanc Capital Markets.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [9]

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I have just a question on -- around the comment you made on the speculative purchasing tapering off into 2019 for wire rod niche to head yourself with some foreign buys. Are you starting to see with the new mill on the East Coast up now on the rod side, are you starting to see pricing soften up a little bit? Or is that something that you haven't seen yet?

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Howard Osler Woltz, Insteel Industries, Inc. - Chairman, President & CEO [10]

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No, I think maybe there has been some softening. As you know, scrap has tailed off some, which is a primary driver of our suppliers' cost structure. And I think as you saw with Insteel shipments for Q1 softening up considerably, I think that, that trend certainly has not been limited to Insteel. I think it's a trend that has occurred across many of the wire rod consuming markets. And I think that these [PC strands] producers and wire rod producers are feeling that, and it's probably become a little more competitive. But relative to the distinct disadvantage that we have incurred relative to world market, it really hasn't made -- it hasn't made any real change in that circumstance.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [11]

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Just for our education, because I think a lot of the points you're making are very important to manufacturing. Can you give us any sense in terms of how much you think some of these foreign producers have taken share over the last 6 to 12 months? I mean, I don't know your market share -- domestic versus foreign on some of these downstream products, but anyway you could put into perspective how you feel that shifted?

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Howard Osler Woltz, Insteel Industries, Inc. - Chairman, President & CEO [12]

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Well, I guess, first, I would tell you that our data was affected by the government shutdown. So we're not all the way current on exactly what has happened up through the most recent reporting periods. And I would also tell you that I think a lot of the damage is probably prospective not retrospective, because this pressure has been building through the last 6 months. And I think that we'll continue to see imports ramping up going forward and that probably the most significant impact is yet to be seen.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [13]

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That's helpful. And just last question here, if I could, I appreciate what you guys have said. Your volumes are obviously down a staggering amount in the first quarter, and I know that you said that there's some catch up to come over the next several quarters. Just -- what does your crystal ball today tell you in terms of how much volume weakness, I guess, you may see this year? Because it's going to be hard to catch up off of the 17% comp?

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Howard Osler Woltz, Insteel Industries, Inc. - Chairman, President & CEO [14]

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Yes, well, I think if you get back and just look at expectations for the underlying level of demand for our products, that story is positive, that's not negative. And as we have come back from the holiday period after the new year, we've seen shipments reasonably robust coming into the new year. So I think we will make up part of the deficit that we've run through the first quarter. But as Mike pointed out in his comments, I think there is a significant limit to what contractors can do in terms of accelerating their progress on job sites because I believe most are really labor constrained at this point.

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Michael C. Gazmarian, Insteel Industries, Inc. - VP, CFO & Treasurer [15]

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And I think we could see more improvement in the second half of the year, during the busy season, especially from a comp standpoint where we saw some softening in the fourth quarter of '18.

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Operator [16]

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And the next question comes from Tyson Bauer with KC Capital.

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Tyson Lee Bauer, Kansas City Capital Associates - Senior Analyst [17]

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Mike, could you give us a little more color on some of the margin impacts that are -- would be associated with incomplete cost recoveries versus the reduced volume? And which one's easier to get back, depending on how the market plays out as you get into the seasonally stronger quarters?

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Michael C. Gazmarian, Insteel Industries, Inc. - VP, CFO & Treasurer [18]

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Yes, I think from a year-over-year standpoint, I mean, it would primarily a volume issue, which was largely weather related. Our spreads were actually up from last year. We did see some compression from the fourth quarter. But overall, I mean, I would attribute the reduction in gross profit, primarily due to the volume-related impact, both in terms of the contribution effect and then just the impact on our production volumes, which has an unfavorable cost impact as well.

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Tyson Lee Bauer, Kansas City Capital Associates - Senior Analyst [19]

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So all things equal, you'll still have the effect of the imports and those pressures, but as you begin to increase those volume throughputs and like operations efficiencies, that should provide some relief?

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Michael C. Gazmarian, Insteel Industries, Inc. - VP, CFO & Treasurer [20]

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Yes. Yes, definitely. We should see a significant favorable cost impact as the margins move back up.

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Tyson Lee Bauer, Kansas City Capital Associates - Senior Analyst [21]

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Okay. Have you gotten any clarity in your discussions with the administration on Section 232 whether what you're asking would require a new process? Or whether that would just be an expansion of what's on the books, which could be enacted at a quicker time line?

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Howard Osler Woltz, Insteel Industries, Inc. - Chairman, President & CEO [22]

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Well, that's a good question and highly relevant. And the answer is, depending on who you ask, you can find the answer that you want. And it's not clear exactly which path would be most reasonable. So it could be one or it could be the other. I think that's uncertain at this point.

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Tyson Lee Bauer, Kansas City Capital Associates - Senior Analyst [23]

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Okay. One of the schools of thought was the immediate impact was because of the access global capacity was then being diverted to the U.S. on imports, and especially PC strands and others. But as that excess capacity got used up, there would be a finite pressure here in the domestic market. As things slow globally, is that what you're referencing that we could see additional pressure? Or is there a level where we just get to a static point?

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Howard Osler Woltz, Insteel Industries, Inc. - Chairman, President & CEO [24]

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Well, I think the play here is the length of the pipeline for imports where they are quoting -- they're quoting for delivery out 60 to 90 to 120 days. So the margin pressure with respect to import competition will ramp up this quarter. But I don't immediately get the feeling that a global slowdown is going to create significant ramped up volumes of strand in our marketplace. I think that strands going to be here anyway. Just because the pricing is attractive in the market compared to alternatives that they have elsewhere.

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Michael C. Gazmarian, Insteel Industries, Inc. - VP, CFO & Treasurer [25]

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And Tyson, just to provide some added perspective on the import-related impact on the quarterly results, we'd estimate that about 25% of the year-over-year drop-off was occurred in those portions of our business that are susceptible to import competition. Now that business was also affected by the weather, and it's difficult to segregate how much was driven by the weather-related impact, but, I mean, that would be at the high end of that 17% shipment reduction, about 1/4 of it occurred in the import-sensitive part of the business.

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Tyson Lee Bauer, Kansas City Capital Associates - Senior Analyst [26]

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Got it. And the last question for me. You decided to put it in the press release. You discussed the EMS (sic) [ESM] market share growth versus rebar, does that imply that we're finding an easier pathway to get state DOT approvals for your product and states that have been typically more union-driven and labor have soften in that stance that is allowing you to grow your slice of the pie regardless of what the pie itself is doing?

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Howard Osler Woltz, Insteel Industries, Inc. - Chairman, President & CEO [27]

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Well, there are a couple of issues embedded in that question. And first, I would say that from a DOT perspective, there haven't been a whole lot of changes there. And some DOTs are more receptive to the substitution than others, but we are not telegraphing to you, there's been a significant change there one way or the other that the primary area of growth for us with engineered structural mesh will be in the nongovernmental and the private and commercial sector, where we are doing conversions to ESM from rebar. And also, we're not telegraphing to you that, that has come -- become substantially easier. It's still a time-consuming, labor-intensive process to make those conversions. But that is where we expect to see the most significant growth in that private sector and not in the public sector.

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Operator [28]

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(Operator Instructions) And our next question comes from Steve Marascia with Capitol Securities Management.

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Steven F. Marascia, Capitol Securities Management, Inc. - Director of Research [29]

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Just a follow-up on what you're talking about. Just a follow-up on the government shutdown. I know the infrastructure story kind of is apparent. Can you go into a little more detail, if you can, about how it might possibly affect you guys going forward? Say, if this does go on for another 3 or 4 months?

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Michael C. Gazmarian, Insteel Industries, Inc. - VP, CFO & Treasurer [30]

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I think it really boils down to a question of the impact of the continued uncertainty on funding decisions at the state and local level. That will be our primary concern, particularly, as we move closer to the busiest time of the year from a construction standpoint. Because if it gets -- if it moves out too far then there is a potential that you miss the window to begin work on projects during the current season. So I would say that's our primary concern.

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Steven F. Marascia, Capitol Securities Management, Inc. - Director of Research [31]

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Do any of your customers have dealings with federal agencies in terms of permitting in various activities?

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Howard Osler Woltz, Insteel Industries, Inc. - Chairman, President & CEO [32]

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No, typically not.

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Operator [33]

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And our next question comes from Adam Thalhimer with Thompson, Davis.

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Adam Robert Thalhimer, Thompson, Davis & Company, Inc., Research Division - Director of Research [34]

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Just wanted to ask a quick one on what you said on commercial. I think you said may be some moderation or softening late this year. And I was just curious if that's a comment from you looking at the macro data? Or is that more from something you're hearing from your customers?

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Michael C. Gazmarian, Insteel Industries, Inc. - VP, CFO & Treasurer [35]

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Really a combination, I think, where commercial had a long healthy run here just given where we're at in the cycle, likely it is that we could begin to see some softening. And that -- I mean, that's born out in AIA construction forecast that I referenced, where the mix is changing with some softening in commercial and a pickup in industrial and institutional segments as well as infrastructure as well I think there's just more -- the outlook there, it just appears to be more favorable at this time.

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Adam Robert Thalhimer, Thompson, Davis & Company, Inc., Research Division - Director of Research [36]

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On the infrastructure side?

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Michael C. Gazmarian, Insteel Industries, Inc. - VP, CFO & Treasurer [37]

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Yes, yes. Assuming that it's -- again, assuming that this shutdown gets resolved in a timely manner.

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Operator [38]

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And at this time, I'm not showing any further questions. I would now like to turn the call back to our speakers for any closing remarks.

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Howard Osler Woltz, Insteel Industries, Inc. - Chairman, President & CEO [39]

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Okay. Well, we appreciate your interest in the company and we encourage you to follow up with questions if you have them. And we look forward to talking to you next quarter. Thank you.

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Operator [40]

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Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program, and you may all disconnect. Everyone, have a wonderful day.