IIIN - Insteel Industries: Waiting On The Sidelines Till The Bottom Is In Place

Summary

• The company’s revenue should be impacted due to the weakening residential market, inventory destocking in the non-residential market, and lower average selling prices.
• The company’s margin should be impacted in FY23 due to the declining ASPs and volume deleveraging.
• Valuation is cheap.

Investment Thesis

Insteel Industries (IIIN) is experiencing headwinds in its nonresidential market due to inventory destocking at its customers. Additionally, the company is seeing lower demand in its residential markets due to rising interest rates and affordability. The lower demand is resulting in competitive pricing pressure, which is impacting average selling prices. I believe the company's revenue in FY23 should decline due to the weakening residential market, customer inventory destocking in the non-residential market, and decreasing average selling prices. The company's margin should be impacted in FY23 due to declining ASPs and volume deleveraging. While things may improve in FY24, I would like to wait for the next couple of quarters until the bottom is in place before becoming more optimistic on the stock. Hence, I have a neutral rating on IIIN.

Q1 FY23 Earnings

IIIN recently reported lower-than-expected Q1 FY23 financial results. The revenue in the quarter was down ~6.5% Y/Y to $167 mn (vs. the consensus estimate of $177.4 mn). The diluted EPS declined 107% to $0.57 (vs. the consensus estimate of $0.87). The revenue in the quarter declined due to the decrease in shipment volume. The operating margin declined by 1040 bps Y/Y to 6.4% due to higher raw material costs in inventory, and a decline in volumes. This resulted in lower diluted EPS in the quarter.

Revenue Outlook

After seeing good growth in FY21 and FY22, IIIN has started seeing some weakness in its end market of late. The residential market (which contributes ~15% to the IIIN's total revenue) began to weaken in mid-2022 due to rising interest rates and affordability concerns. This continued into the first quarter of FY23. In the non-residential market (which contributes ~85% to the total revenue), the company experienced weakness in Q1 FY23 due to customer inventory management and destocking, resulting from the normalization of lead times. The headwinds in both these markets led to a 10% Y/Y and a 12% sequential decline in the shipment volume in Q1 FY23.

The company increased its selling prices in FY22 and some of its impacts got carried forward in Q1 FY23, which led to a 3.8% Y/Y benefit in revenues. However, the company experienced pressure on its average selling price sequentially and it declined 8.8% from Q4 FY22 due to the moderation in raw material costs and competitive pricing pressures. The majority of the sequential decline in average selling prices was in the products that were exposed to residential markets.

Looking forward, the residential market should continue to experience weakness in FY23 due to rising interest rates and affordability concerns. This should impact the company's revenue in FY23.

The trend in non-residential construction is mixed, with leading indicators for non-residential construction spending showing different readings- the Architectural Billing Index ((ABI)) indicating a decline, and the Dodge Momentum Index (DMI) showing improvement. The ABI in December 2022 improved by 2% m/m to 47.5 but is still below the 50 threshold, which indicates contraction. The DMI improved by 6.6% m/m to 222.2 in December 2022 due to the healthy demand in data centers, warehouses, and labs.

Non-residential looks like a tale of two stories. On the one hand, there is macroeconomic weakness, cost-cutting, and layoffs at corporate, which should reduce demand for non-residential buildings. On the other hand, there is demand from government stimulus from the Infrastructure Investment and Jobs Act (IIJA) and the CHIPS Act, which should aid non-residential construction demand.

However, I believe things will get worse before they get better in non-residential. The project related to the IIJA and CHIPS act should come online later this year and in the following year. Meanwhile, a weakening macroeconomic environment, continued destocking, and a declining ASP due to competitive pressure and moderation in raw material prices should make things worse over the next couple of quarters.

I believe the company's revenue will decline in FY23 given the near-term headwinds in the non-residential and declining residential markets.

Margin Outlook

IIIN's margins saw a nice increase in the initial period post-Covid due to higher average selling prices from strong demand and increased spread between the average selling price and raw material costs. However, margins have been declining over the last couple of quarters due to the decline in shipment volumes and ASP, and higher plant operating costs. In Q1 FY23, the operating margins declined 1040 bps Y/Y to 6.4% due to the deleverage from the reduction in volume, lower spreads between ASP and raw material costs, and higher plant operating costs.

While raw material costs have moderated sequentially, the company's margin hasn't benefited from it, and the margins declined sequentially in Q1 FY23. As the company uses the FIFO accounting method to value its inventory, it has to first consume the higher-cost raw materials in its inventory before its margin benefits from the moderation in raw material costs. Management expects it to be done by the end of the second quarter of FY23. So, I believe 2H FY23 margins will be better than 1H FY23 margins. However, for the full fiscal 2023, margins should still be down, as moderation in raw material prices is unlikely to offset the impact of declining ASPs and volumes.

Valuation & Conclusion

The stock is currently trading at 10.74x P/E FY23 consensus EPS estimate of $2.75. While the stock is no doubt cheap, one should remember that IIIN is in a cyclical business, and its revenues and margins are currently in a downtrend. The company's revenue in FY23 should be impacted by the weakening residential market and customer inventory destocking in the non-residential market. The company's margins should be impacted in FY23 due to higher raw material costs and volume deleveraging. Even though the valuation is cheap, I prefer being on the sidelines at least for the next couple of quarters until there is good visibility that the fundamentals have bottomed. Hence, I have a neutral rating on the stock.

For further details see: