IIIN - Insteel Industries: Strong Fundamentals But May Face More Headwinds

2023-07-06 00:54:27 ET

Summary

• Insteel Industries has been given not more than a "Hold" rating due to tough conditions affecting the non-residential construction sector, on which the company heavily relies.
• Despite the possibility of lower prices, significant declines are unlikely without a shock event like a recession, but actually, the market has already priced this in.
• IIIN has a strong financial position, which should allow it to weather the unfavorable economic cycle, support products offering expansion, increase operational efficiency, and continue to fund dividend payments.

A Hold Rating

This analysis assigns a hold rating to Insteel Industries, Inc. The weak economic outlook continues to weigh on the non-residential sector, where spending fell by 0.3% in June 2023. As the culprits of this situation -- inflationary pressures and elevated debt costs -- persist, shares of Insteel Industries, Inc. (IIIN), whose business is heavily dependent on the non-residential construction sector, will face some headwinds.

There is a possibility of lower prices in the coming weeks, however, according to this analysis, there will be no significant downward movements.

Significant share price declines require a shock, triggered by the expected recession, for example. While there is a 70 percent chance that such a traumatic event for the economy will occur within 10 months, Insteel Industries' shares and the stock market in general have likely already built up enough antibodies against it. Since when has there been talk of a possible recession as a result of the US Federal Reserve's tightening of monetary policy? At least since the central bank started raising interest rates to fight inflation, so for more than a year now. And if the recession leads to a drop in stock prices, Insteel Industries will face less bearish sentiment as indicated by a 24-month beta of 0.73 (scroll this page down to the 'Risk' section).

Shares traded at $30.52 apiece as of this writing, giving it a market cap of $609.09 million. Shares are trading slightly above the 200-day simple moving average line of $28.62, the 100-day simple moving average line of $29.28, and the 50-day simple moving average line of $30.28.

The stock has a 52-week range of $22.39 to $38.27. The stock offers a forward dividend yield of 0.39% as of this writing.

Actually, this stock also has catalysts for a potential increase in its share price, but these are mostly long-term in nature and their positive impact will not be felt immediately. These are the expected boost the non-residential sector will get from the Infrastructure Investment and Jobs Act, or the improvement in the company's sales and margins as a result of the plan to expand product offerings and management's initiatives to reduce operating costs.

The stock has a solid financial position that should allow it to weather this unfavorable economic cycle, support supply expansion, increase operational efficiency and continue to fund dividend payments.

Based on this information and the following analysis, Insteel Industries, Inc., therefore, receives a "Hold" recommendation rating.

Business Outlook of Insteel Industries

Mainly due to suppressed demand, as inflationary pressures and higher interest rates continue to bite and selling prices remain somewhat under competitive pressure, this mix will continue to be unfavorable to Insteel Industries, Inc.'s profit margin.

This is an American manufacturer of steel wire reinforcement products for concrete construction applications, primarily for operators in the private non-residential construction market.

The negative impact of weak demand for the company's products is expected to continue as the economy heads for a possible downturn or even recession. This is the expected outcome of the US Federal Reserve's tightening monetary policy to combat high inflation. This has been known for several months, but what we don't know is when the economy will slide into recession. Meanwhile, uncertainty reigns, forcing companies to postpone investments in the construction of new non-residential infrastructure, as evidenced by the aforementioned decline in spending. Companies are unlikely to embark on a new project to expand or increase their factories, offices, warehouses and other infrastructure until they can predict a recovery.

In addition, the cost of borrowing will remain elevated at least throughout 2023 due to the new interest rate hikes announced by the FED, so corporate investments in non-residential infrastructure will also depend on this aspect as well as a tightening of access conditions to credit. Following the bankruptcy of some regional US banks between March and May this year, it is even more difficult for a company to obtain credit unless it has a very good credit history. However, this may not be the case for Insteel Industries, whose financial position appears to be very healthy, as discussed further on.

The private non-residential construction sector will receive a boost from the Infrastructure Investments and Employment Act, but until demand improves, Insteel Industries customers will continue where possible with the de-stocking that has proven to be so painful for Insteel Industries' margins in recent times . High levels of inventories are the result of a long period of supply chain fears that prompted companies to rush to fund inventory building up. The lack of new orders due to subdued demand stemming from inflationary pressures and higher interest rates is prompting manufacturing companies to continue their efforts to de-stock.

Additionally, a portion of Insteel Industries' revenue comes from sales of welding wire reinforcement products to the housing market, which is showing some signs of recovery, the company noted in its quarterly results for the second quarter of fiscal 2023. However, this analysis warns the retail investor of the real possibility that this recovery could be temporary as it could be affected by a trend that has recently emerged in the real estate market. That said, many families today are choosing to delay moving to a larger home because of costly mortgage refinancing, which impacts the number of existing homes that are actually for sale . So, this recent state of affairs in the US housing market may have helped to stimulate the construction of new homes for those who desperately need a home and can afford higher mortgage rates for their first home purchase. And since this trend is driven by a temporary factor such as rising borrowing costs, it is expected to end with a change in the Fed's monetary policy toward a rate cut. The cost of borrowing should remain high until 2023, but not beyond, as the spike in rates should really be a matter of time now.

How Insteel Industries Performed During the Last Reporting Quarter

For the second quarter of fiscal 2023 ended April 1, 2023, Insteel Industries reported an 87% year-over-year decrease in diluted GAAP earnings to $0.26 per share, falling short of expectations by $0.20.

A reduction in the margin between sales prices and raw material costs weighed on the deterioration in earnings.

Lower sales prices were probably due to price pressure from competitors. Higher inflation and higher borrowing costs have negatively impacted on demand for the company's steel wire reinforcement products in the non-residential sector, which is showing weak growth. Against this background, Insteel Industries' customers, especially concrete manufacturers and concrete contractors who are struggling with a lack of new orders, are reducing their stocks.

And that de-stocking then impacted Insteel Industries, Inc.'s shipment volumes in the second quarter of fiscal 2023.

So, a 14.5% year-on-year decrease in average selling prices coupled with a 12.8% year-on-year decrease in shipments resulted in a 25.4% year-on-year decrease in net sales to $159.1 million in the second quarter of fiscal 2023.

Revenue of $159.1 million missed analysts' median forecast by $11.73 million.

Looking more closely at the company's profitability, gross profit declined 76.7% year over year to $13.3 million and gross margin declined 1,850 basis points year over year to 8.3%primarily due to the consumption of more expensive supplies purchased in earlier periods and competitive pressure on prices.

Operating activities generated a cash flow of $46.6 million in the second quarter of fiscal 2023 versus $6.3 million in the prior year's quarter, but the improvement was driven by the reduction of inventories and receivables.

The Financial Condition Is Solid

As of April 1, 2023, the company's financial position appears to be sound as it has an unencumbered balance sheet with $80.2 million of available cash and the ability to borrow under a $100 million revolving credit facility.

Without the support of cash flow from operations, this financial position is more than sufficient to sustain capital expenditures and dividend payments.

Capital expenditures are expected to be $30 million in 2023 to advance the engineered structural mesh business, which is part of the plan to expand product offerings. In addition, CapEx also includes cost and productivity improvement initiatives and recurring maintenance needs.

The company also pays a quarterly dividend of $0.03 per share, resulting in an annual allocation of $2.33 million for dividend payments, as there are approximately 19.44 million shares outstanding.

There is no reason to believe that the company will not be able to continue funding dividend payments, and even given the outlook, which will still be a bit difficult for Intel Industries' sales and margins, paying a special dividend of $2 per share is still possible.

It is true that the 12-month free cash flow of $2.18 per share as of Q2 of fiscal 2023 is still far below the annual free cash flows of $2.71 in 2021 and $2.55 for the year 2020, but in 2022 when free cash flow was very negative, it was -$0.52 per share, Insteel Industries still paid the dividend even in the special form.

To summarize the company's overall financial health in an index, we can consider the Altman Z-Score of 9.94 (scroll this page down to the 'Risk' section), which signals that Insteel Industries is in a safe zone with a very strong balance sheet and zero probability of bankruptcy.

Conclusion

Insteel Industries, Inc.'s revenue and profit margin will continue to suffer primarily as a result of subdued demand in the private non-residential construction sector as inflationary pressures and higher interest rates continue to have an impact, coupled with continued competitive pressures on selling prices.

As such, shares could face some downward pressure, although this analysis does not predict they can drop significantly lower. Expectations of future lower sales and margins are already factored into valuations, in my opinion, and already for weeks, the market has not considered any other scenario for Insteel Industries given the looming recession.

This stock also has catalysts for a potential increase in the share price, but these are mostly long-term in nature and their positive impact will not be felt immediately. Meanwhile, the formation of more attractive price levels is possible to use in order to increase exposure to this stock given the catalysts of potential upsides. Therefore, it is better to wait and see how events unfold than to make an investment decision now.

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