| 2009 | 2010 | ||||||
| Price: | 12.42 | EPS | -$0.28 | $0.82 | |||
| Shares Out. (in M): | 17 | P/E | NA | 15.1x | |||
| Market Cap (in $M): | 218 | P/FCF | 11.1x | 11.5x | |||
| Net Debt (in $M): | 0 | EBIT | -9 | 0 | |||
| TEV (in $M): | 183 | TEV/EBIT | NA | 13.1x | |||
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Insteel Industries, Inc. (Nasdaq: IIIN) is currently trading with roughly 50% upside to my $18 price target. Insteel is a manufacturer of steel wire rod reinforcing products that are used in concrete construction applications. These products are primarily used for non-residential construction (89% of sales) activities in cement reinforcement applications inside the concrete used for large diameter water pipes, driveways, sidewalks, bridges, parking decks, buildings, and many other concrete structures. The balance of the business is used for residential concrete reinforcement applications.
In 2003, Insteel petitioned and won an antidumping (AD) litigation against their competitors from Brazil, India, Korea, Mexico, and Thailand, which essentially eliminated the imported competition. Separately, Insteel petitioned and won a countervailing duty (CVD) litigation against its Indian competitors. Insteel was subsequently able to enter markets that were previously uneconomic for them, raise prices, and bolster margins and profits. The timing of the positive result of the AD/CVD litigations did, however, coincide with an economic period of expansion, coupled with strong steel prices. Since 2003, the Company generated an enormous amount of free cash flow over the past five years, which was used to pay down debt and improve the efficiency of their facilities. In 2001, debt was as high as 50% of total capital, and, today, the Company operates with a $1.99 per share in net cash on the balance sheet. Indeed, protectionism works for the petitioner.
From that period on, the business was quite robust, until the current fiscal year (September fiscal year). Insteel, a cyclical, construction-related steel company, faced a veritable tsunami, composed of a nasty recession, customers with little or no access to credit, and an emboldened base of Chinese competition that was taking the place of the foreign competitors that had previously been eliminated from the market. Revenues have fallen by roughly one-third over the past year, and margins have turned negative. As expected, earnings have been brutalized. Accordingly, the stock has fallen by almost one-half since its July 2008 high.
At the current price, we think the stock is interesting, as the Company has already mapped out a clear path to financial recovery. Having written down its high-cost inventory over the past year, margins should no longer be squeezed by legacy purchasing costs, and a highly variable cost structure should buffer the business during the downturn. A sizable portion of the Federal stimulus package applies to Insteel product applications, which should help to bolster demand over the next several years. In addition, the existing Federal highway funding authorization has been extended for 18 months, so the government plans to keep spending on road construction. Lastly, a favorable mid-2010 final decision on the new industry AD/CVD petitions against the Chinese producers could, once again, stair-step the Company to a new level.
Insteel is either #1 or #2 in its core markets, and after a $45 million capital expansion program over the past three years, the company is the lowest cost producer in the United States. A debt-free balance sheet, combined with a shareholder-friendly management team, just provides further credence to the investment thesis.
The Company
Mount Airy, NC-based Insteel manufactures welded wire reinforcement (WWR) and prestressed concrete strand (PC strand) for a broad range of concrete construction applications. WWR is roughly 55% of the business, and PC strand makes up the balance. The company operates six production plants, all of which are located in the eastern half of the United States (4 WWR plants and 2 PC strand plants). Approximately 95% of sales occur in the United States.
Insteel's products are sold to rebar fabricators (15% of sales), distributors (15% of sales) and concrete product producers (70% of sales). Product demand is primarily driven by construction activity levels. Demand is both cyclical and seasonal. Shipments are usually higher in the spring, summer, and fall (in other words, construction season). Insteel's customer concentration is minimal; it has no customers that account for more than 10% of sales.
In its WWR business, there are three primary product applications:
Insteel is the #2 national player of WWR products, behind Ivy Steel & Wire, a division of CRH America (NYSE: CRH) a $17 billion construction material conglomerate headquartered in Ireland. Other regional competitors in the United States include Nucor, Gerdau Ameristeel, Davis Wire, Keystone/Engineered Wire Products, Oklahoma Steel and Wire, and Concrete Reinforcements, Inc.
PC strand is made by twisting seven strands of steel wire rod together, and it is used to impart compression forces into concrete elements and structures, providing reinforcement for bridges, parking decks, buildings, and other concrete structures. PC strand has high tensile strength, which makes it possible to cast longer concrete spans and thinner sections.
Approximately 50% of the PC strand market is for "precaster" applications, which are typically used in non-residential purposes. Recent import competition has focused on "posttensioners," a lower-end application of standard PC strand products where the concrete is poured at the construction site. Roughly one-half of the posttensioner volume is used on slab-on-grade residential construction applications, primarily to prevent cracking in regions of the country that have expansive soil (e.g., the Gulf Coast). Beginning in Q3 2007, the Company opted to minimize its participation in the slab-on-grade posttension market due to pricing deterioration resulting from low-priced Chinese import competition and ongoing weakness in housing-related demand.
Insteel is the largest producer of PC strand in the United States, representing 2-3x the market share of any other competitor with 40%+ market share. The other competitors in this category include American Spring Wire, Sumiden Wire Products, Strand-Tech Martin, MMIStrandCo (a different division of CRH), and imports. Imported products represent 44% of domestic consumption, with 92% of imports currently sourced from China.
PC strand and WWR production is essentially a metalworking business. The Company purchases steel wire rod from both domestic and foreign sources, which they then convert into the finished products desired. As a result, roughly 90% of cost of sales is variable, which should cushion the business in a severe downturn. The production process is highly automated and therefore has a small labor component. It appears that, assuming Insteel is not carrying high cost inventory on their books, the Company has the capability to remain profitable even at a $200 million revenue base, which is 25% below the currently depressed revenue line.
The Company markets its products through its own sales representatives and through agents. The products are sold nationwide as well as into Canada, Mexico, Central America, and South America. The products are primarily delivered by truck, although rail and boat are also used to deliver product.
The American Recovery and Reinvestment Act (the $787 billion stimulus program) provides for $130 billion for construction spending, which is split between improvements in transportation, energy & technology, water and environmental, and buildings. Of the $49 billion in construction spending for transportation infrastructure, there is ~$28 billion allocated for highways and bridges. Insteel should benefit from this stimulus, as roughly 30% of Insteel's PC strand sales go into public construction projects subject to "Buy America" requirements, which stipulates that the suppliers of these projects must be domestic. Although some of this spending should occur during 2009, there is not likely to be significant impact to Insteel's business until 2010 and 2011. Clearly, Insteel will receive some support from Uncle Sam during this downturn.
Separate from the stimulus package, Federal infrastructure spending will also be impacted by the successor to the $286.4 billion SAFETEA-LU highway funding authorization which expires in September 2009 but has been extended for another 18 months. The successor to this Federal program may reach upwards of $500 billion to maintain U.S. roads, which would have a significant impact on Insteel and its markets.
Insteel has utilized the domestic trade laws to its advantage. In 2003, IIIN won the antidumping (AD) and countervailing duty (CVD) litigations against their PC strand competitors from Brazil, India, Korea, Mexico, and Thailand, which essentially eliminated the imported competition. That is, until the Chinese took their place. The dumping margins imposed under the previous PC strand trade cases are listed below. It should be noted that the 5-year sunset review on this case was finalized last week, and the dumping margins and countervailing duties are scheduled to remain in place for another five years.
Dumping is the act of a manufacturer in one country exporting a product to another country at a price which is either below the price it charges in its home market or is below its cost of production. The U.S. antidumping (AD) laws were written to prevent these actions from harming a domestic industry. In the United States, domestic firms can file an antidumping petition under the regulations determined by the U.S. Department of Commerce (DoC), which determines "less than fair value" and by the U.S. International Trade Commission (ITC), which determines "injury." These proceedings operate on a timetable governed by U.S. law, which normally takes about 14-18 months. The DoC has, more times than not, found that products have been sold at less than fair value in U.S. markets; the larger question is the amount of dumping margin. If the domestic industry is able to establish to the ITC that it is being injured by dumping, then AD duties are imposed on imported goods at a percentage rate calculated to counteract the dumping margin. This process often times results in duties that essentially exclude foreign competitors from the U.S. market - the 2003 PC strand case is a good example of that.
Countervailing duties (CVDs) are imposed when a foreign country subsidizes its exports, hurting domestic producers in the importing country. CVDs in the United States are assessed by the International Trade Administration of the DoC, which determines whether imports in question are being subsidized and, if so, by how much. If there is a determination that there is material injury to the competing domestic industry by the ITC, the DoC has the power to instruct the U.S. Customs Service to levy duties.
On May 27, 2009, Insteel and two other domestic producers of PC strand filed separate AD and CVD petitions alleging that dumped and subsidized imports from China were causing material injury to the U.S. industry. The petitioners are alleging dumping margins ranging from 140% - 315%, with an average margin of 223%. On July 10, 2009, the ITC reached a preliminary determination that imports of PC strand from China threatened to injure the domestic industry. It should be noted that, following a favorable preliminary determination by the DoC, Chinese importers would be required to post cash deposit or bond in an amount based on preliminary duties. . It should be noted that the date for the preliminary determination for the DoC is December 17, 2009, and the stock should react positively from this news.
Before 2007, the DoC did not allow CVD petitions to be filed from non-market economies (NMEs), such as the People's Republic of China. However, since then, there have been 10 decisions, of which 4 of them were in the steel industry; the decisions have been overwhelmingly negative. In the 4 steel cases, the average CVD rate was 98.27%, and the median rate was 36.43%. The data does not bode well for the respondents in the PC strand CVD case, but anything can and will happen.
The Chinese products have caused pricing pressure on both the precast and posttension PC strand markets, although most of their market share gains have been in the posttension market. Beginning in Q3 2007, Insteel opted to extricate itself from the posttension market due to the pricing deterioration resulting from Chinese import competition and ongoing weakness in the construction sector. Shipments to posttensioners fell to 4% of sales in 2008 from 14% in 2006. Roughly 40% of the PC strand consumed in the U.S. market is from imported sources, and ~92% of the imported PC strand is shipped from China.
PC strand is not a labor intensive product, and, according to my sources, the prices that the Chinese charge appear to be well below cost of production. From a subsidy perspective, the Chinese are paying a 15% value-added tax for imports of steel wire rod. For PC strand, the Chinese government provides a 5% rebate, essentially providing a 20% subsidy to Chinese PC Strand producers. Furthermore, in this challenging economy, it should be difficult for the ITC to find a domestic industry that is not being injured by foreign competition. Certainly, the two petitions bode well for Insteel's future ability to take share and grow margins.
As a result of the favorable determination by the DoC and the ITC in the 2003 petition, Insteel and other U.S. suppliers replaced the market vacuum left by the foreign suppliers and increased margins considerably. Since then, the Company has taken the sizable free cash generated and used it to pay down debt and update its facilities. After spending $45.3 million in upgrading projects in its production plants, management does not anticipate significant Capex needs going forward. Annual maintenance Capex going forward should be roughly $3-$5 million.
The Company has an outstanding $25 million share buyback program, which was authorized in November 2008, but the Company appears to be holding onto its war chest. Historically, management has only repurchased shares on an opportunistic basis. Although Insteel pays a modest regular dividend today, the Company paid a special one-time dividend of $0.50 per share in October 2008. Going forward, free cash flow will be utilized, in order of importance, in growing the business organically, dividends, buybacks, and acquisitions. If prices for attractive assets fall enough, they would consider using their cash to buy another company - possible a West coast plant to better service local clients.
Steel product producers generally experience wide variations in pricing. When raw material prices decrease, industry prices for finished goods fall and vice versa. Over the past five years, Insteel has done a good job of passing on its raw material cost increases. From 2003-2008, the Company has raised prices on its customers at an annual rate of ~18%. Accordingly, if the global economy starts to feel the impacts of increased government spending in the form of inflation, Insteel should be able to manage well. Furthermore, two U.S. rod production facilities representing 20% of domestic wire rod capacity have been closed or are in process of closing, thus putting further upward pressure on prices. Rod pricing is already expected to rise next quarter, and Insteel plans to implement price increased to recover these higher raw material costs.
Over the past decade, revenue growth for Insteel had been moderately stunted, resulting from two primary factors. First, the impact of the imports from Brazil, India, Korea, Mexico, and Thailand hampered the top line until FY 2004. Second, the Company was involved in many low margin products that involved manipulating steel wire rod, including nails, industrial wire, galvanized strand, etc. The Company's exit from its industrial wire business, the last in a series of divestitures, in June 2006 served to narrow Insteel's strategic and operational focus to concrete reinforcement products. The elimination of these business lines should unmask the true organic growth of this business. That being said, from 2003-2008, the business was very strong.
However, with the collapse of commodity prices in the second half of 2008 and significant economic weakness, FY 2009 has been far from rosy. Revenues fell 35% during the year, and, in part due to a $26 million inventory write-down, margins collapsed. For the fiscal year, earnings were a negative $0.28.
Going forward, the Company believes that market conditions should remain challenging in view of the macro-environment and lack of credit availability. However, they also stated that financial results should start to demonstrate improvement in the March quarter. Customer inventory destocking, which has clearly negatively impacted order levels this year, appears to be complete.
Further, the Company expects a gradual improvement from the capital projects that were completed during 2007-2008. Insteel anticipates dual benefits in the form of reduced operating costs and additional capacity to support future demand growth, although the near-term impact will be hard to see due to reduced operating levels.
Valuation
I generated a normalized EPS multiple analysis to calculate my valuation for Insteel. This valuation is based on my expectations for revenues and earnings in FY 2011, a period in which I imagine the business will be closer to a mid-cycle level. I believe that FY 2011 revenues will be roughly $310 million, which is still roughly 15% below the peak in revenues in FY 2008. From abnormally low levels in FY 2009, customers should start to restock inventories, which are at very low levels. Plus, wire rod prices are already improving in tandem with the currently increasing price of steel scrap, and I imagine that Insteel price increases are in the queue for next quarter and beyond.
In FY 2010 and FY 2011, I see revenues increasing 25% and 15%, respectively, as the stimulus package takes hold. If a favorable determination from the DoC is provided in the antidumping case, that will just add to the revenue growth in FY 2010 and FY 2011. Assuming that inflationary fears are realized without foreign competition, it is not impossible to see a revenue increase similar to that Insteel generated in FY 2004, when revenues increased 57% and prices increased 48%.
On average, Insteel's operating margin has been ~14% since the dumping case of 2003. I see no reason why this margin will not continue or even improve in the future, given Insteel's capital improvement program over the past three years. Thus, Insteel should earn roughly $1.75/share in FY 2011. Using a modest and appropriate 10x multiple, that gets us to an $18 share price. And this valuation doesn't take into account the $1.99/share in cash on the balance sheet - that is just gravy.
Risks
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Insteel clearly has positioned itself to be a survivor in this economic downturn. Its squeaky-clean balance sheet and low capital needs should allow it to navigate successfully through this recession. The support the Company should be receiving from the Federal government in the form of the stimulus package, highway and bridge spending, and potential protectionist trade barriers should bolster operations through the downturn. And, when inflation starts to flare up (as I believe that it will), the Company has historically demonstrated the ability to raise prices to offset raw material cost increases; it clearly should outperform in an inflationary environment.
Favorable anti-dumping determination from the Department of Commerce, impact from the stimulus package, inflationary fears rising, increase in the highway fund authorization, inventory destocking, and/or an economic turn upwards.
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