Insteel Industries Inc (IIIN) Q3 2019 Earnings Call Transcript
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Insteel Industries Inc (NASDAQ: IIIN)
Q3 2019 Earnings Call
Jul 18, 2019, 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 Third 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, Insteel's President and CEO. Sir, you may begin.
H.O. Woltz -- Chairman, President and Chief Executive Officer
Good morning. Thank you for your interest in Insteel and welcome to our third 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 the call over to Mike to review our third quarter financial results and outlook for our markets. Then I'll follow up to comment more on business conditions.
Michael C. Gazmarian -- Vice President, Chief Financial Officer and Treasurer
Thank you, H., and good morning to everyone joining us on the call.
As we reported earlier today, business conditions remained challenging during the third quarter of fiscal 2019 as we continued to contend with low-priced import competition resulting from the Section 232 tariff on imported steel and unusually wet weather in many of our markets, with earnings per share dropping to $0.11 from $0.67 a year ago.
Shipments for the quarter fell 3.9% year-over-year, but were up 17.5% sequentially from the depressed level of Q2 as our usual busy season got off to a slow start. Our PC strand and standard welded wire reinforcement product lines continue to be adversely affected by increased low priced import competition resulting from the Section 232 tariff program and the substantial cost advantage it has provided to offshore producers of these products. The tariffs have driven domestic prices for hot rolled steel wire rod, our primary raw material, substantially higher than world market levels. Foreign competitors have responded with underpricing tactics to capitalize on their lower costs and further penetration of the US market.
The unfavorable impact of the tariffs on our Q3 shipping volumes is apparent, considering that shipments into markets that are susceptible to import competition, which in total represented around a third of our sales for the quarter, were down 20.4% from a year ago, while the volume for the remainder of our business was actually up 7.5%.
In addition to the surge in low-priced imports driven by the tariffs, many of our customers remained in inventory reduction mode during the quarter to the detriment of our order book due to the excessive rainfall and resulting construction delays. The April to June period for the contiguous US was the second wettest on record, impacting a significant portion of our footprint spanning across Texas, the Central and Upper Midwest and into the Northeast. The wet weather for Q3 followed similar conditions during our second fiscal quarter, making the January to June period the wettest on record for the contiguous US. The continued weather related deferral of business should benefit us going forward, although the timing and magnitude of the favorable impact is uncertain.
Average selling prices for the quarter were up 3.7% from a year ago, reflecting the increases we implemented over the course of last year in response to the run-up in our raw material costs, resulting from the tariffs. On a sequential basis, however, ASPs dropped 4% from the second quarter due to pricing pressure driven by the increased imports as well as from domestic competitors, spurred by the weather related softness in demand.
Gross profit for the quarter fell $16 million from a year ago and gross margin dropped from 19.1% to 6.5%, primarily due to the narrowing in spreads between selling prices and raw material costs and, to a much lesser extent, higher manufacturing costs and lower production volume and the reduction in shipments. On a sequential basis, gross profit rose $1.2 million from the second quarter and gross margin increased slightly by 20 basis points as lower manufacturing costs and the increase in shipments offset lower spreads. The ongoing spread compression has been driven by the pricing pressures I alluded to you earlier, with the year-over-year increase in ASPs falling short of recovering the escalation in raw material costs, while the sequential reduction in average selling prices exceeded the decrease in raw material costs.
SG&A expense for the quarter fell $2 million to $5.5 million or 4.4% of net sales from $7.5 million or 6% last year due to lower incentive compensation expense under our return on capital plan, driven by our weaker current year results. Our effective tax rate through the first nine months of the year fell to 22.4% from 24% for the same period last year, excluding the impact of the $3.7 million deferred tax remeasurement gain on the prior amount. The lower rate reflects the net effect of the reduction in the statutory rate under the new tax law to 21% from 35% for all of this year as compared to only three quarters last year, plus the elimination of the Section 199 domestic production deduction, together with changes in book-tax differences. Looking ahead to the remainder of the year, we expect our effective rate for fiscal 2019 will wind up in the range of 22% to 23%, subject to future adjustments related to the level of Q4 earnings, book-tax differences and the other assumptions and estimates entering into our tax provision calculation.
Moving to the balance sheet and cash flow statement. Cash flow from operations for the quarter fell to $14.3 million from $25.3 million last year due to a decrease in earnings and, to a lesser extent, a smaller reduction in net working capital in the current year. Net working capital provided $9.2 million of cash in the current year quarter, driven by a $12.6 million reduction in inventories, which we plan on reducing to an even greater extent during the fourth quarter.
Based on our sales forecast for Q4, our quarter-end inventory position represented 3.4 months of shipments, essentially unchanged from the end of the second quarter and was valued at an average unit cost that was lower than the beginning average as well as the amount reflected in Q3 cost to sales. The lower cost should favorably impact our margins during the fourth quarter unless ASPs fall to the same or a greater extent as was the case in Q3 due to continued pricing pressure. On a pro forma basis, our gross margin for the third quarter would have been around 400 basis points higher than the reported amount if cost to sales was adjusted to reflect the lower carrying value of ending inventory and ASPs were unchanged.
In allocating our cash flow and managing the cyclical nature of our business, we continue to 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. Going forward, we will continue to balance these objectives in deploying capital in any excess cash balances.
Capital expenditures through the first nine months of the year totaled $9.4 million, down $3.1 million from last year, focused on cost and productivity improvement initiatives, in addition to recurring maintenance requirements. And based on our updated forecasts, we now expect outlays to come in at less than $15 million for the year.
We ended the quarter with $7.4 million of cash on hand and no borrowings outstanding on a $100 million revolving credit facility, providing us with substantial financial flexibility and the ability to be opportunistic in pursuing any growth opportunities that may arise in this difficult environment.
During the quarter, we completed an amendment to the facility which, among other favorable changes, extended its maturity date to May 2024 and provided for a $50 million accordion feature that allows us to increase the size of the facility subject to our lender's approval.
As we move into the fourth quarter, the outlook for our construction end markets remains positive, assuming that we finally experience normalized seasonal weather patterns for the time of year. We should also benefit to some extent from the weather related deferral of business from earlier in the year. However, as we've indicated previously, considering the ongoing tightness in the labor market and difficulty for contractors to play catch-up, we suspect that any favorable impact is likely to be gradual and extend out over a protracted period.
We expect the infrastructure related portion of our business will continue to benefit from higher state and local spending than many of our markets, supported by various funding initiatives as well as the FAST Act funding and supplemental measures at the federal level, which is reflected in the most recent construction spending data. Through the first five months of the year, public construction spending was up 11.7% from the prior year as compared to a 3.5% decrease for the private sector, reflecting a 2% increase for nonresidential and an 8.2% decrease for residential. Highway and street construction, which represents close to 30% of total public construction spending and is one of the larger end use applications for our products, was up 18% year-over-year.
The most recent reports for the Architectural Billings and Dodge Momentum indexes, leading indicators for nonresidential building construction, reflect softening activity levels, but relatively stable conditions that are expected to continue for the near term. Following an extended positive run, the ABI has remained relatively flat or declined over the past five months, falling to 49.1 in June from 50.2 the prior month and reducing the year-to-date average to 50.5 from 52.1 for all last year.
The Dodge Momentum Index, another leading indicator for nonresidential building construction, rose 4% in June from the revised May reading but has leveled out since the middle of last year. On a comparable basis, the average for the first half of this year was down 4.3% year-over-year as compared to an 18.3% increase for the first half of 2018 over the prior year level. In its latest report, Dodge indicated that the broader pullback in the index remains gradual and there are still ample projects at the planning stage to maintain stable construction spending in the near term.
I will now turn the call back over to H.
H.O. Woltz -- Chairman, President and Chief Executive Officer
Thank you.
As Mike indicated, our third quarter results continued to reflect disappointing shipping and production volumes that we attribute primarily to growing import competition and adverse weather conditions in certain of our markets. Despite our weak results, we continue to believe that the underlying market fundamentals are reasonably strong and should support a significant rebound in demand as weather patterns normalize.
As we've mentioned on our recent earnings calls, our financial performance for 2019 should be viewed in the context of the administration's Section 232 tariff program initiated in March 2018, which imposed 25% import tariffs on certain steel products, including our primary raw material, hot rolled steel wire rod that did not apply to most downstream steel products, including PC strand and welded wire reinforcement.
Consequently, US prices for hot rolled wire rod continue to be significantly elevated relative to the world market, which has created a highly attractive environment for offshore competitors seeking to capitalize on their tariff related cost advantage or circumvent the tariff by shifting production to products which are not covered. Foreign producers have taken full advantage of these unique circumstances as reflected by the surge in PC strand imports, which through the first five months of the year, were up 55% from a year ago.
Average unit values for imports have fallen to levels that are only marginally above US wire rod prices, creating an unsustainable competitive environment for domestic producers. Similar trends have occurred in the market for standard welded wire reinforcement, where import volumes have surged and average unit values have plummeted, particularly from Mexico.
Unfortunately, we're unaware of any knowledgeable steel trade policy analyst who predicts that the 232 tariff program will be terminated in the near future, with many observers believing the program will persist for the duration of this administration. Assuming the tariff remains in effect, it's imperative that it be extended to include downstream products derived from wire rod in order to eliminate the harsh penalty the current structure is imposing on producers of steel intensive downstream products.
Notably, the 232 tariff has created a competitive environment where even Turkey has shifted production downstream to low value commodity standard welded wire reinforcement, export it into the US markets as a means of circumventing the tariff. This undermines the administration's clear intent in implementing the tariff, which was to shore up the US steel industry. Such blatant examples of gaming the system should provide strong justification to the administration for expanding coverage to downstream steel intensive products. While we plan to continue our dialogue on this matter, it's not possible to predict whether our efforts will be successful.
We'll continue to reassess our manufacturing strategy in response to the unfavorable market changes resulting from the tariff, but our current plans are to continue to compete with low-priced imports, operate our plants and attain additional manufacturing efficiencies while we work toward a satisfactory resolution of the matter with the administration.
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, with investments targeted toward expanding our product capabilities, lowering the cash cost of production and updating technology, including information systems. While we've not canceled any planned investment, it now appears that certain projects will slip into fiscal 2020, resulting in 2019 CapEx coming in closer to $15 million.
During Q3, we continued commissioning activities for a new ESM line in our North Carolina facility that will increase capacity for certain niche products as well as substantially reduce our cash operating costs. Market conditions for ESM are favorable, which should support an orderly ramp-up following additional modifications to the line and the equipment vendors' confirmation that it complies with our performance specifications.
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 we've made in our facilities to lower manufacturing cost, reduce lead times and improve quality.
This concludes our prepared remarks and we'll now take your questions. Joel, would you please explain the procedure for asking questions?
Questions and Answers:
Operator
Thank you. [Operator Instructions] Our first question comes from Julio Romero with Sidoti & Company. Your line is now open.
Julio Romero -- Sidoti & Company -- Analyst
Hi. Good morning, everyone.
H.O. Woltz -- Chairman, President and Chief Executive Officer
Good morning, Julio.
Michael C. Gazmarian -- Vice President, Chief Financial Officer and Treasurer
Good morning, Julio.
Julio Romero -- Sidoti & Company -- Analyst
You had mentioned earlier that your customers remained in inventory reduction mode throughout the quarter. Just curious, if weather aside, are you seeing or hearing any change in the underlying demand from your customers regarding any of your end markets? And if so, where do you think they may or may not be seeing it from?
H.O. Woltz -- Chairman, President and Chief Executive Officer
Yeah. I don't think we're detecting any evidence of a cyclical downturn in demand in our markets. It has been more purely weather related where customers have literally run out of space to store finished goods due to their inability to ship to job sites. And as always, there seem to be those who are doing better than others in certain regional markets. As an overall statement, underlying business conditions appear to be reasonably strong and we would attribute the overwhelming preponderance of low shipments and weak activity to weather at this point.
Julio Romero -- Sidoti & Company -- Analyst
Okay. That's helpful. And when I just think about your last four quarters all being affected by weather and the fact that steel scrap has kind of flattened out from June heading into July, just how should investors think about that backdrop, heading into fiscal '20, of relatively lighter year-over-year comparisons ahead, along with kind of normalizing raw material prices?
H.O. Woltz -- Chairman, President and Chief Executive Officer
Well, as we look out for the next couple of quarters, we certainly aren't forecasting a downturn in demand. We're reasonably optimistic about what we see out there, with the caveat being related to the 232 impact and the ramp-up of imports that we're seeing in a couple critical product lines. But underlying levels of demand, we believe, will be solid. In terms of scrap, there are a lot of things at work in those markets. We're really unable to make any reasonable prediction of where that market is going to go. But clearly, it's not just our spot in the supply chain that's being adversely affected by both 232 and weather related events as we're seeing our supplier base also suffering from low demand, taking production downtime due to just weak underlying conditions that I believe are both 232 and weather related. And of course, when they take downtime, they're not buying scrap. So I think there's been pressure on the scrap market from that perspective, at least in the long products area where we deal.
Julio Romero -- Sidoti & Company -- Analyst
Okay. That makes sense. I'll hop back in the queue. Thank you very much.
Operator
Thank you. And our next question comes from Phil Gibbs with KeyBanc Capital Markets. Your line is now open.
Phil Gibbs -- KeyBanc Capital Markets -- Analyst
Hey, good morning.
H.O. Woltz -- Chairman, President and Chief Executive Officer
Good morning, Phil.
Phil Gibbs -- KeyBanc Capital Markets -- Analyst
You all keep referencing 232 and the duration of that initiative by the administration. But the more we see it, it keeps getting watered down, either through direct country exemptions in the case of Canada and Mexico. And I know they produce some wire rod. And Nucor also mentioned at their Investor Day a couple of weeks ago that there have been a litany of exclusions granted to buyers. And I also see that wire rod prices domestically are down quite a bit; I don't know if it's $100 a ton in the last year, but down a lot from where they were at the highs. So, how do you square that all up with your own gross margins? And seemingly that more favorable or more balanced supply picture on your supplier side probably should shift that tide to you all in terms of the downstream product.
H.O. Woltz -- Chairman, President and Chief Executive Officer
Well, you're absolutely correct that wire rod prices have fallen for a variety of reasons. But the real issue is prices in the US relative to the world market. And as I mentioned in my prepared comments, average unit values of imported PC strand are only marginally higher than the domestic price of US wire rod. So falling prices is not a phenomenon limited to US markets. Prices have fallen worldwide, and I would argue that the delta between US pricing and world market pricing still puts companies such as Insteel at a distinct disadvantage and allows importers to have their way with our markets.
Phil Gibbs -- KeyBanc Capital Markets -- Analyst
Have you -- OK, that makes sense. Have you at all tried to ask for exemptions? Have those been filed and/or denied if you've done so?
H.O. Woltz -- Chairman, President and Chief Executive Officer
Yes. The answer is yes to that, and we're pursuing another round of exclusion request. At this time -- and as is inevitable with any of these programs, there seems to be significant inconsistency in the way that the Department of Commerce has dealt with exclusion requests, with some in our industry -- not directly in our space, but in our industry, some exclusions have been granted strictly based on price effects. And that is the nature of the problem that Insteel has. It's not a supply problem at this point. It's a price problem relative to world markets, and it's just hard to predict the outcome of an exclusion request because there is a clear lack of consistency.
Phil Gibbs -- KeyBanc Capital Markets -- Analyst
Okay. And if I could -- I appreciate that answer. If I could just ask one more on the here and present. You gave some color around the end market dynamics. But as you look into the third quarter -- or the September quarter, are you expecting things to be stable in terms of your shipments or pick up a bit? And then a kind of sub-question is that is that in line with typical seasonality? Or are we still seeing drags from weather? Thanks.
Michael C. Gazmarian -- Vice President, Chief Financial Officer and Treasurer
Yeah. Assuming we get to a period of normalized weather, we would expect a pickup in activities during Q4. Usually, the April to September period is the strongest of the year for us. And as I indicated, we should -- with our end markets remaining relatively strong and assuming the weather normalizes, we should see a pickup and then also benefit to some extent from any push-forward of activity from earlier in the year.
Phil Gibbs -- KeyBanc Capital Markets -- Analyst
Thank you.
Operator
Thank you. [Operator Instructions] Our next question comes from Tyson Bauer with KC Capital. Your line is now open.
Tyson Bauer -- Kansas City Capital Associates -- Analyst
Good morning, gentlemen.
Michael C. Gazmarian -- Vice President, Chief Financial Officer and Treasurer
Good morning.
H.O. Woltz -- Chairman, President and Chief Executive Officer
Hi, Tyson.
Tyson Bauer -- Kansas City Capital Associates -- Analyst
You talked about a potential benefit depending obviously on market prices from the inventories flowing through. Also, if we do see increase in volume, are you able to gauge what kind of improvement in margins you could see just based upon better throughput on volume? Or is that a little hard to gauge at this point?
H.O. Woltz -- Chairman, President and Chief Executive Officer
We should see better throughput in our plants and lower manufacturing costs. I would tell you, though, that the uncertainty, the weather related deferral of business and the delay of the normal seasonal upturn has also apparently made competitors pretty nervous. And there's been significant commercial activity -- pricing activity, in the market due to 232 related import concerns but also just related to the obvious disappointing volumes that have materialized through this supposed seasonal upturn with other domestic sales [Phonetic]. So predicting ASPs is really difficult for us at this time.
Michael C. Gazmarian -- Vice President, Chief Financial Officer and Treasurer
And the factors that H. mentioned -- I mean, that's really what drove the compression in spreads during Q3 where we benefited from a reduction in raw material costs as anticipated. But the drop-off in ASPs exceeded that cost reduction, and that was due to the combination of factors he alluded to, the 232 pressure as well as the soft demand that was primarily weather related. So to the extent that the weather normalizes and we see the usual seasonal pickup in demand, then we could benefit from those lower costs going into Q4.
Tyson Bauer -- Kansas City Capital Associates -- Analyst
H., you've repeated in the last couple of calls that you want to try to protect your market share. You will compete against those imports by matching price or being competitive there. Is there a point where you start to see some pros and cons of changing that philosophy? And if so, what would cause that change at your level?
H.O. Woltz -- Chairman, President and Chief Executive Officer
Well, I think, first we need to come to some conclusion about our view of the likely term that 232 is in place. If we were encouraged by the arguments that we're making with the administration and encouraged that we might see some action there, we're definitely going to hang in and compete and maintain our market share. If we came to a conclusion, though, that we had six more years of these conditions, then we clearly start looking really hard at our cash cost of production and begin to make some longer-term decisions about whether it's in our shareholders' best interest to continue with our current tactics. So, it's just -- we're one tweet away from anything. So, it makes it difficult to plan and to strategize.
Tyson Bauer -- Kansas City Capital Associates -- Analyst
Okay. The SG&A, Mike, coming down, is that a reversal of some accrual that you took in the first half of the year? Or is that a level that you're trying to maintain and just being as lean as possible?
Michael C. Gazmarian -- Vice President, Chief Financial Officer and Treasurer
It's really more a function of a drop-off in incentive comp based on our weaker results. For the current year, there's a pretty substantial variable component to SG&A that's performance driven off our return on capital plan. So this reflects a decrease there. Going into Q4, we should see an increase just due to the timing of equity grants, which occur semiannually. But otherwise, we would expect that to continue to trend at the reduced levels until our performance improves.
Tyson Bauer -- Kansas City Capital Associates -- Analyst
There's been rumblings that Secretary Ross could be on the outs. As you said, it's one tweet away from anything. Given his history with the steel industry, his pushing on 232, would his ouster be viewed favorably by you and those within your industry?
H.O. Woltz -- Chairman, President and Chief Executive Officer
I can't say that that any one person in the administration is going to be a swing factor in what happens here. I think that the error is on at the very top of this administration. I think the error is [Indecipherable] believes strenuously that the tariffs are working, and I don't think the departure of any one or four or five guys would make a big difference to how the program evolves from here.
Tyson Bauer -- Kansas City Capital Associates -- Analyst
Okay. And a last question for me. If we see some of these lower rates from the fed materialize, do you think that's enough to kick start some residential activity and to prolong the cycle on the nonres?
Michael C. Gazmarian -- Vice President, Chief Financial Officer and Treasurer
Yeah. I think, potentially -- I mean, it would certainly have a favorable impact. But at the same time, I think that the recent reductions in nonres fixed investments also being spurred by the uncertainty on the global economic environment as well as just these trading issues and the timeline for when they'll be resolved, I think that kind of uncertainty is working in the other direction to some extent.
Tyson Bauer -- Kansas City Capital Associates -- Analyst
Okay. Thanks.
Michael C. Gazmarian -- Vice President, Chief Financial Officer and Treasurer
Certainly lower rates are positive, though.
Tyson Bauer -- Kansas City Capital Associates -- Analyst
Yes. Thank you, gentlemen.
H.O. Woltz -- Chairman, President and Chief Executive Officer
Thanks, Tyson.
Operator
Thank you. And our next question comes from Julio Romero with Sidoti & Company. Your line is now open.
Julio Romero -- Sidoti & Company -- Analyst
Hey, thank you for taking the follow-up. Can you elaborate at all on how shipments have trended through the first few weeks of July, just relative to the prior year? Thanks.
H.O. Woltz -- Chairman, President and Chief Executive Officer
Yeah, I mean, certainly favorable relative to recent disappointing shipment rates and somewhat favorable to the prior year on -- it's not running away from us at this point. But it's definitely stronger, and we're glad to see that.
Julio Romero -- Sidoti & Company -- Analyst
Thank you. Appreciate it.
Operator
Thank you. I'm not showing any further questions at this time. I would now like to turn the call back over to H. Woltz for any closing remarks.
H.O. Woltz -- Chairman, President and Chief Executive Officer
We appreciate your interest in Insteel. We look forward to talking with you on -- at the end of the current quarter. Thank you.
Operator
[Operator Closing Remarks]
Duration: 33 minutes
Call participants:
H.O. Woltz -- Chairman, President and Chief Executive Officer
Michael C. Gazmarian -- Vice President, Chief Financial Officer and Treasurer
Julio Romero -- Sidoti & Company -- Analyst
Phil Gibbs -- KeyBanc Capital Markets -- Analyst
Tyson Bauer -- Kansas City Capital Associates -- Analyst
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