Good day, ladies and gentlemen, and welcome to the Insteel Industries Second Quarter 2014 Conference Call. [Operator Instructions] Please note that today's conference is being recorded. I would now like to hand the conference over to H. Woltz, President and Chief Executive Officer. Sir, please go ahead. .

Thank you, Karen. Good morning, and thank you for your interest in Insteel. And welcome to our second quarter 2014 conference 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 that 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 second quarter financial results and the macro indicators for our construction end markets. Then I'll follow up to comment more on market conditions and our business outlook. .

Thank you, H. As we reported earlier this morning, Insteel posted solid results for the second quarter of fiscal 2014 with net earnings coming in at $3.5 million or $0.19 a share, compared with $2.7 million or $0.15 a share in our first quarter and $3.7 million or $0.20 a diluted share in the prior year period.

You may recall that our Q2 results for last year wound up representing the high point for the year, which was unusual in that the typical seasonal pattern is for shipments and earnings to peak during our third or fourth quarter. .

Net sales for the second quarter were up 10.3% from last year, driven by a 12.8% increase in shipments, partially offset by a 2.1% reduction in average selling prices. Our shipments have now risen year-over-year for 4 consecutive quarters and in 6 of the previous 7 quarters, reflecting gradual improvement in our construction end markets.

On a sequential basis, net sales were up 4.8% from the first quarter on a 2% increase in shipments and a 2.8% increase in average selling prices, driven by the price increases that were implemented during the quarter.

Gross profit for the quarter improved to $11.6 million from $11.1 million a year ago with gross margins narrowing to 12.7% from 13.3% as the favorable impact from the increase in shipments was partially offset by a slight reduction in spreads between selling prices and raw material costs and higher unit conversion costs relative to the prior year quarter.

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SG&A expense for the quarter rose $0.7 million from a year ago, largely due to the relative changes in the cash surrender value of life insurance policies, together with increases in health insurance and bad debt expense.

Other expense for the second quarter was $0.2 million, primarily due to losses on the disposal of assets that were damaged in the previously reported fire at our Gallatin, Tennessee manufacturing facility. .

Effective income tax rate for the quarter was 34% versus 36.4% in the prior year, primarily due to changes in permanent tax differences, while the 6-month year-to-date rate fell slightly from last year to 35.2% from 35.8%.

Going forward, our effective rate will continue to be subject to fluctuations based upon the level of future earnings, changes in permanent tax differences and adjustments to the other assumptions and estimates entering into our tax provision calculation. .

Moving to the cash flow statement and balance sheet. Operating activities provided $1.6 million of cash for the quarter compared with $2.4 million in the same period a year ago with net working capital using $5.2 million of cash this year versus $5.3 million last year.

Accounts receivable rose $7.4 million, driven by the December to March increase in sales. Inventories rose $1.4 million. And accounts payable and accrued expenses increased $3.5 million, largely due to higher raw material purchases over the latter part of the quarter.

We ended the quarter with $19.2 million of cash and cash equivalents, up $0.2 million from the previous quarter, and no borrowings outstanding on our $100 million revolving credit facility, providing us with plenty of liquidity. .

Looking ahead to the remainder of fiscal 2014, we are encouraged by the recent improvement in the various macro indicators for our construction end markets.

The Architectural Billings Index moved back into positive territory in January and February and has now remained above the 50 growth threshold for 16 of the previous 19 months, its longest positive streak since 2007, implying increased nonres construction spending in the coming months. .

Through the first 2 months of the year, private nonresidential construction spending was up 11.8% from last year. And in February, the seasonally adjusted annual rate rose to its highest level in almost 4.5 years, leaving it 23% under its January 2008 high.

Although public construction spending has remained relatively weak on an overall basis, the highway and street category was up 9.7% through the first 2 months of the year and contract awards for bridge-related construction, one of the larger end-use applications for our products, have surged over the past year.

There are also recent indications that the TIFIA funding provided for in MAP-21 is beginning to have a more meaningful impact as additional projects are approved and move into the bidding phase. .

The outlook for federal transportation infrastructure construction, however, is clouded by the uncertainty surrounding the successor funding bill to MAP-21, which expires in September, and recent forecasts indicating that the Highway Trust Fund could be depleted by the end of August.

With the mid-term elections on the horizon, it's becoming increasingly likely that stop-gap measures will be enacted similar to the 9 short-term extensions that followed the expiration of the previous SAFETEA-LU authorization in September 2009. .

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

Thank you, Mike. As reflected in our release and in Mike's comments, we are encouraged by the continued improvement in market conditions during the second quarter.

Recent industry statistics, as well as most of the leading construction forecasts for 2014, are consistent with our previously stated view that demand for our reinforcing products should gradually improve over the next few quarters.

In addition to the statistics Mike cited, construction employment continues to show modest improvement and the usual seasonal trend should favorably affect demand for our products over the balance of our fiscal year. .

As mentioned in the release, our capacity utilization level improved to 51% for the quarter but remains depressed relative to prerecession levels.

While it's difficult to project capacity utilization for the industry as a whole, we believe it's reasonable to assume that competitors are operating at similar levels and experiencing the same slow growth trends that we're seeing. These factors are largely responsible for the highly competitive pricing environment that prevails in our marketplace.

And we do not expect to see a material change until demand has recovered to.

healthier levels..

Another factor influencing the pricing environment is the high degree of volatility in the steel scrap market, which affects pricing for our principal raw material, hot-rolled wire rod. Sustained upward moment in the scrap and wire rod markets tends to create urgency on the part of our industry to recover higher costs.

As we've seen over the past few months, however, sharp downward moves in these markets tend to alleviate this pressure and potentially undermine the level of support for higher pricing for our products.

Ultimately, improving -- improvement in our margin environment requires more robust demand for reinforcing products that provides additional pricing power to producers. .

With regard to the wire rod market, following the sequential increases in steel scrap pricing that drove wire rod prices higher beginning late in 2013, the market abruptly reversed course during our second quarter.

Scrap prices weakened, coincident with the significant reduction in exports and weak domestic demand, resulting in similar trends in wire rod prices.

Looking out for the next few months, absent recovering exports of scrap or sharply increased domestic demand, we believe it's likely that scrap and wire rod will continue trading within a relatively narrow range. .

On January 31, 2014, a group of domestic wire rod producers filed a trade case against China, which has been the primary source of imported wire rod to the U.S. market for the last 2 years.

We believe that the trade case will be successful and result in significant duties being imposed on Chinese rod exports, causing them to become uncompetitive and resulting in their exit from the U.S. market. Any impact of the case on U.S. supplies would not be evident before our fourth fiscal quarter.

Using history as a guide, we expect transaction prices for foreign wire rod to rise, but we do not expect the trade case to result in shortages. .

Developments related to the trade case have caused us to elevate inventories relative to the prior year to bridge the transition from Chinese sources to other offshore sources for the portion of our material requirement that is imported.

Participation in offshore markets implies higher inventory levels due to the larger order quantities that are required to optimize logistics costs.

In assessing the attractiveness of offshore purchases, we consider the working capital implications as well as the inherent pricing exposure due to the longer order lead times relative to domestic purchases. .

Turning to CapEx. We continue to expect expenditures for 2014 to total less than $12 million and to be focused on opportunities to reduce costs, enhance quality, improve our information systems infrastructure and expand capacity where warranted. .

Finally, I want to comment on the fire that occurred at our Gallatin, Tennessee PC strand facility in January. It appears that the blaze started as a result of maintenance activities being performed by an outside contractor. Fortunately, the incident resulted in no injuries to our employees or to the contractor's employees.

The fire destroyed the process line that cleans raw material at the plant, which is critical to ongoing operations. In response to this disruption, we have ramped up the operations at our other PC strand facility located in Sanderson, Florida and engaged the support outside of tool cleaning providers to meet our requirements.

Our people at these facilities, together with the efforts of our sales and administrative team, have done a tremendous job of minimizing the impact of this event on our customers. And I appreciate the remarkable performance that's been demonstrated.

I'll also extend my thanks to the outside tool providers of cleaning services that have shouldered the balance of the requirement that could not be absorbed by our Florida plant. We've had excellent support from all of these groups. .

As mentioned in the release, the impact of the fire on our financial results for Q2 was immaterial. We expect to bring the rebuilt facility online during the fourth fiscal quarter and currently believe that a startup on this timeline would have a minimal impact on our financial results for Q3 and Q4.

We would cautioned, however, that there are multiple components to our insurance recoveries, and we will not be able to fully quantify the impact until we're closer to completing the reconstruction of the facility. .

To summarize, the recovery in nonres construction markets continues to be gradual and the market environment remains competitive. Favorable reports relative to construction spending and a recovery in nonres markets have translated into a modest uptick in our capacity utilization rates.

Consistent with prior periods, we plan to continue focusing on achieving further improvements in the effectiveness of our manufacturing operations and identifying additional opportunities to broaden our product offering and grow through acquisition. .

This concludes our prepared remarks, and we'll now take your questions.

Karen, would you please explain the procedure for asking questions?.

[Operator Instructions] Our first question comes from the line of Robert Kelly from Sidoti. .

Just a question on spread compression. Compared to a year ago, you called out, I guess, a margin squeeze as well as higher unit conversion costs.

Could you address the latter, the conversion cost issue? What contributed to that? And does that drag on into the second half of the year?.

Bob, we are in the process at several plants of adding some shifts and hourly operating rates are expanding, and there's some inefficiencies related to ramping up that way where we're bringing on new people and have to get them up the learning curve before they're fully productive. We have that going on at 3 or 4 of our facilities. .

That's a good problem to have. And then as far as the raw material cost towards the end of the quarter crimping margins a little bit, are you able to recover the increase once -- I know you work off kind of the FIFO inventory convention.

On a steady state basis, are pricing and raw materials going to drive spreads higher when you enter 3Q?.

It's a difficult question to ask. And you mention on a steady state basis, and there just hasn't been one of those. We saw a rapid escalation in pricing through the last few months of 2013, followed by just an abrupt reversal of course during the early months of 2014.

And you may recall in the last conference call, we had mentioned that we had announced price increases across all of our product lines and actually recovered some of those increased costs through the first part of Q2.

But as scrap prices and wire rod prices seem to reverse course during the quarter, it seems that the commitment on the part of the industry to increase transaction prices waned considerably.

So I think, Bob, I would just have to revert back to the comment that I made in the prepared remarks that our pricing power is weak and is likely to remain relatively weak until we see more robust demand for our products. .

Just one other comment on the spread comparison. I mean, we were down slightly year-over-year. But sequentially, there is a pretty healthy increase. And you may recall that spreads had actually reached a high point last year in Q2, and then dropped off over the remainder of the year. .

Yes.

I mean, what I'm trying to get at is do spreads stabilize at your 2Q level? Will they be within the ballpark of where you were in the second half of last year? And how do we think about spreads as we move into the second half?.

Yes. At this point, we don't see anything -- I mean, it's a dynamic situation. But at this point, I mean, we don't see anything that would imply a dropoff of what we experienced last year. I think last year, we -- for a couple of quarters, we wound up behind the curve. We were in a declining price environment and raw material costs were declining.

But we were negatively impacted by consuming higher cost material from the inventory against lower selling values, so you had that trend over the latter part of the year. I mean, at this point, again it's a fluid situation, but we don't see that for the near term. .

And you would think that with positive seasonal forces working in our favor and with some indication that cyclically we're improving, that the implication for spreads would be positive. But we'll just have to wait and see. .

Okay, great. So as far as the volume outlook, it sounds fairly positive. You had strong results volume-wise in a weather-impacted quarter during 2Q. You talked to the potential cyclicality of the market driving improved activity.

Is there any reason to believe you can sustain low double-digit or mid-teen volume growth in the second half of the year based on what you're hearing from your customers?.

Yes. Although, I would point out that, I mean, there have been a lot of weather-related comments in the media in terms of the impact on this quarter's results, not only Insteel but other companies in our space, and what the impact on construction activity.

But I guess, you also have to keep in mind that the prior year period was also impacted by adverse weather. And in our year-ago call, we made some comments about the impact, the harsh winter weather in the North and excessive rainfall in the South.

So I mean, if you were to normalize both years to exclude that weather-related impact, it really may not have much of an effect on that 12.8% year-over-year change because last year was unfavorably affected as well. .

And Bob, I would tell you that, as we commented in the prepared remarks, that this doesn't -- this is a slow growth market that we're seeing. It doesn't feel like double-digit unit growth to me. .

Okay.

Well, can you just describe the puts and takes of the double-digit unit growth you just did in 2Q, where it came from the end markets of the regions?.

Well, I think it's reasonably widespread between all of our product lines. And as Mike points out, it's a function of both, some growth in the market this year but also comparing against a pretty weak period last year. .

Okay. SG&A line stood out to me in 2Q. Is that kind of $6 million run rate something that we should be thinking about longer term? You've generally been well below that SG&A on a quarterly basis. .

Right, yes. I mean, there's always going to be some variability quarter-to-quarter. If you look at it over, I guess, a longer timeframe, last year, we averaged around $5.2 million this quarter; and then through the first half of this year, we averaged $5.3 million, so it was up year-over-year.

But there are a couple variable components that are going to just cause some fluctuations quarter-to-quarter. And in particular, under our equity incentive comp plan, there are grants made twice a year which affect the Q2 and Q4 SG&A line. And that's split out separately in our cash flow statement.

You can see that it went from 400 -- roughly $400,000 to $800,000 this year. So you'd see a similar dynamic in Q3 and 4, so that causes some fluctuation.

Also the cash surrender value of life insurance policies, and we reference that pretty regularly as being a driver of the changes, and that's just going to be a function of the financial market environment and how the returns on investment compare over the periods.

And then the third item that has an effect is the incentive plan comp expense, where that's obviously going to be driven by our results, an increase or decrease accordingly. So again, if you look at over a longer period, it was up slightly year-over-year.

And I mean, looking forward, you just need to keep these variable components in mind, which can drive it higher or lower. I don't know if that answered your question. .

Yes.

I mean, is that $5.3 million average for the first half a good run rate? Or should we assume it's going to be higher?.

I mean, assuming that our performance continue to improve year-over-year, I mean, that would imply it could go higher if nothing else from the incentive plan comp portion. .

Okay. 2 more questions, and then I'll cede the floor. First off, you guys had talked about the antidumping case with the wire rod producers and the successful outcome of that.

Could you just talk about the potential impact to your pricing if Chinese imports are blocked? I mean, you talked about the urgency and how that affects industry pricing in the reinforcement market.

And then, in recent quarters, you've talked about kind of matching irrational competitors at their sort of low price just to accelerate market consolidation.

Is that still going on during 2Q?.

Well, let me address the wire rod case first. And our guess and our expectation is that the domestic industry will be successful in its case against the Chinese and that the Chinese will exit the market. Typically, what happens is other countries emerge as players in the import segment of the market and typically, transaction prices rise as a result.

We expect that to happen this time. The implication for Insteel and for other companies who are participating in the imported market is that if transaction prices don't rise to recover those higher offshore rod costs, then margins are going to compress. And we don't really expect that to happen.

We think that there will be a resetting of selling prices in those market segments, where import rod is used and that we'll continue with a margin environment that represents a competitive environment but at higher levels. So we don't see a shortage of the product. We don't see that this disadvantages us in any way.

And to the extent that more discipline is exercised in the marketplace by exporting countries, it could actually be good for us. The Chinese have a habit, whether it is PC strand or whether it is wire rod, of just executing a very undisciplined commercial plan in this market.

And the ramification of that is that about all purchasers end up paying the same price and larger purchasers, like Insteel, frequently lose the value of the purchasing power. We would hope that some of this is restored by more disciplined commercial efforts of exporting countries. So that's the way we see the wire rod situation.

In terms of the second part of your question concerning irrational pricing and meeting competitive situations, I'm not sure that I really followed what you were getting at and would ask you maybe to clarify. .

Yes, sure. In a couple of times over the past few quarters, you've made comments along the lines of your competitors were pricing irrationally based on where wire rod costs were and you would meet that low price even though -- if it was uneconomic to you in order to sort of speed up their demise.

Is that still going on? Or is demand strong enough across the board where you're not seeing pockets of irrationality?.

Bob, I don't -- I doubt we implied or stated that it was to speed up the demise. I think it is of any competitor that our reactions are based on where we see the market settling and the commitment that we have to be there for our customers on a regular, consistent basis.

And we believe that our cost structure between our wire rod purchases as well as our internal conversion cost should place us in a very attractive position to compete with competitors who are struggling for volume and pricing irrationally. So we're going to be there. We're going to meet the market and maintain our position in it.

And I think this is a function of just a highly competitive environment that we have described in our prepared remarks and discussed otherwise. I don't think it's any more or less than that. .

Understood. Maybe just one final one. I know I've taken up a lot of time, but it sounds like volumes are accelerating, maybe not in the mid-teen pace that you saw in 2Q but certainly moving up into the right. You have some support from the wire rod trade case to pricing as you enter this seasonally strong period.

And you're going to have better unit conversion cost as your new hires get more efficient.

I mean, is that generally an expectation as to how 2H could play out?.

Yes. I mean, I think each of those points that you stated is correct and should give us some cause for optimism. .

And our next question comes from the line of John Koller from Oppenheimer. .

Quick question on the inventory of raw materials for wire rod.

Would you look to take advantage of lower prices here, given your balance sheet and whatnot? Or do you think that price is still unattractive enough to lay in a significant amount of raw material inventory?.

Are you referring to imports in particular or to... .

Right, exactly. .

Yes. When -- this trade case against the Chinese is the world's worst-kept secret. And we've seen it coming for months and we're prepared for it. And I think I mentioned in my prepared remarks that we have moved inventories up as well as commitments of future deliveries up to take advantage of the last of the Chinese availability.

So yes, that is happening, although we're pretty conservative by nature and haven't -- we haven't gone overboard. .

Okay, great. And then a quick question on ESM, wondering if you could provide some -- maybe figures as far as what percent of that, your business, is ESM versus traditional, that would be helpful. .

We don't disclose the components, John. .

[Operator Instructions] Our next question comes from the line of Tyson Bauer from KC Capital. .

A couple of quick questions here. You talked about the extra shifts at 3 to 4 of your facilities.

Is that completely due to better seasonal -- cyclical outlook? Or is part of that just your normal seasonal pattern that you are building up to supply an increased capacity?.

No, it's due to what we perceive to be an improving underlying level of business. .

Wonderful.

Are you also seeing some activities from your competitors that would reflect the same outlook you have?.

Well, we don't really talk to them too much about that. But I would assume that they are seeing the same thing that we're seeing in the marketplace. And how they react, I really don't know. .

I guess, the implication of that question is are we still expecting some pricing competition as we've seen to be as tight as we go into the second half of this year as we've seen in previous years?.

That's an excellent question, and I wish I could answer it, Tyson. But it's one of those things that will be only be answered week-to-week. .

Okay. Areas of particular strength, obviously you made a comment on the nonresidential construction.

Are you seeing it across the board? Is it more in industrial, office, maybe infrastructure or parking structures, any particular areas, both geographically and also by industry that you're seeing a little pick up?.

Geographically, Texas and Florida have both been strong. From a market segment point of view, we lose clarity on that pretty quickly because we -- our customers compete in the infrastructure segment as well as in the commercial segment, so it's hard to -- it's hard for us to really drill down and be confident about what we're seeing.

But I think as a general statement, we would tell you that there's more strength in the bridge and infrastructure market relatively than in the commercial market. Some customers that are predominantly commercial, nonres, are bullish and busy and others are a little wary of the underlying level of activity. .

Okay.

Are you expecting -- if we look at infrastructure, we saw what, I think, Senator Boxer had recommended, and that is really no increase in the overall federal contribution to infrastructure other than make it an index to inflation and any increases, really just a backfilling of lost funding for that Highway Trust or the fund that they have in place.

Where is the extra money coming from? Is it going to primarily be brought down to the municipality, state levels are going to have to fund more of it? Are we going to see more of this public-private phenomenon that has been suggested, and we're seeing it in Texas and some other areas? Where do see that trend going if we're not going to have support from the federal government?.

No, I think that's exactly what would happen if the federal funding flatlines. You'd tend to see more upside at the state and local level.

And there are already indications of that where a number of the states have elected to move forward in tapping into the alternative revenue sources or increasing their fuel tax because it's gotten to the point to where they can no longer defer the work that's required.

And then I think the TIFIA element, where you get the multiplier effect from that, I wouldn't be surprising to see an increased provision for that. And whatever successor funding authorization comes out, they'll continue to be more moving in the P3 direction, where you can get more bang for the buck. .

Okay. And the last one, John talked about the EMS [ph] as a percentage, what you guys don't give out.

Can you talk in regards to state DOT agencies and maybe building agencies accepting the use of ESM material into these projects? Are there specific states that this is under review that you expect to have greater acceptance? How is that going forward?.

Yes. That's an ongoing source of focus for us, and there have been positive developments. They're incremental in nature. Most recently, we had a real favorable audience with the Arizona DOT people. So that's continued missionary work that we're active in all the time. And it's generally positive in nature for us. .

And I have no further questions from the phone lines. I'd like to turn the conference back to Insteel Industries for any concluding comments. .

Okay. Thank you, Karen. We appreciate your interest in the company and your time today to participate in the call and would encourage you to call us back if you have follow-up questions. Thank you, and have a good day. .

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may now disconnect. Everyone have a good day..