This is a challenging time to model non-residential construction investment, particularly in the municipal area, as COVID-19 is likely to hammer local and state budgets. On top of that, federal tariff policy remains inconsistent, protecting some companies and leaving other companies more exposed than before.
I was cautious on Insteel (IIIN) back in January, largely due to questions about end-user demand and pricing, and the latter issue has really been relevant in the past couple of quarters. With the shares down almost 30%, though, I wonder if this under-covered small-cap fabricator isn’t worth another look. While the outlook for the next couple of years is still very foggy, I like how management has run this business and I believe today’s valuation prices in a long-term deterioration of the business that is unlikely to occur.
Tariffs And Pricing Continue To Muddy The Waters
The last two quarters have been up and down for Insteel relative to my expectations, with fiscal second quarter revenue coming in about 4% better than I’d expected and fiscal third quarter revenue coming about 7% worse. In both cases, I underestimated the strength of demand, as non-residential construction activity has remained stronger than expected. On the other hand, the pricing pressures faced by the company due to imbalances created by U.S. tariff policy have only gotten worse, leading to significant pricing pressure.
With significant operating leverage in the model, those revenue shifts have led to a big operating income beat in the second quarter and a sizable miss in the third quarter, but the year-to-date results have been more in line.
Revenue declined about 3% in the fiscal third quarter, with a nearly 10% improvement in volume offset by a steep 12% decline in realized prices. Competition from imports remains the primary problem, as the portion of Insteel’s business exposed to imports saw prices decline 20% while the rest of the business saw 8% price declines (still worse than I’d modeled).
Gross margin still improved, though, as the cost of inputs declined more than the selling prices, and gross margin rose almost six points. Operating income rose 174% on an adjusted basis, with operating margin climbing four points to just over 6%.
Pushing Back On Imports
For years now the company has been hoping that the current administration would fix an important loophole in its current steel tariff policy. While the U.S. has a 25% tariff on imported steel that has largely pushed imports out of the market, that tariff doesn’t extend to finished products like prestressed concrete strand (or PC strand) or wire mesh.
Because of that loophole, companies can take advantage of cheaper steel wire rod sourced from China or Turkey, fabricate it into PC strand or mesh, and export it to the U.S. at a lower price. Insteel has little choice but to follow those prices or lose business, but it’s difficult to compete when rivals can use Turkish wire rod priced around $480 and Insteel has to pay around $580 to $590 per ton to Commercial Metals (CMC) or Nucor (NUE).
Instead of just waiting for the administration to close this loophole, Insteel and some of its peers are taking more direct action, filing anti-dumping petitions on PC strand against countries accounting for around 90% of U.S. imports. The ITC issued an affirmative preliminary determination on June 1, but given the time these things take, it’s unlikely that Insteel will see any benefit until at least mid-2021.
As an aside, I do wonder if Insteel should consider “fighting fire with fire”, depending upon how the November elections go. Given the recent acquisition of Strand-Tech Manufacturing (a PC strand manufacturer) for about $23M (about 0.8x revenue) and the mention that they expect to be able to sell the main facility for around $8 million (moving equipment and personnel to other existing Insteel locations), I wonder if it would make sense for Insteel to establish or acquire an operation outside the United States. I don’t want to assume that the current tariff policy is the “new normal”, but there is demand in Europe and the Mideast for PC strand and wire mesh, and I believe such a plant could serve local demand in normal times but offer access to cheaper steel in times like these.
Navigating Challenging End-Market Trends
Nothing about Insteel’s model is really “settled” right now, and that extends to the demand/volume side of the business. Demand has been stronger than expected this year, as non-residential construction has been stronger than expected. The value of non-resi construction put in place in June rose 0.4% year over year, with highway/street spending up 3.6%, and public non-resi spending was up 6.2%.
Looking ahead, though, the non-residential project funnel is thinning out noticeably. On top of that, I worry about the impact that COVID-19 is going to have on local and state budgets, and what that means for infrastructure projects like roads. I’m not optimistic of any federal action on this until after the election, and that could be setting the stage for a weak 2021.
It’s true that modeling cyclical businesses like Insteel is difficult, and you really can’t hope to be more than “generally right” looking out more than a few quarters. That said, history may not repeat but it does tend to rhyme, and I believe past cycles provide some insight into what Insteel’s future results are likely to be.
I do expect Insteel’s growth to slow from its trailing average (as it’s a bigger company), but I still expect long-term revenue growth around 4%, as I believe the company can continue taking share in its core markets (with underlying market growth around 2% to 3% depending upon stimulus efforts). I believe Insteel can leverage greater scale to modestly improve gross margin, but I expect gross margins on average to remain around the mid-teens with occasional excursions above 20% in the good years and below 10% in the bad years. Over the long term, I expect FCF margins to average out in the mid-single-digits, but again there will be good years (double-digits) and bad years (low single-digits or slightly negative). In any case, the end-result of my DCF approach is an indicated annualized potential shareholder return in the low double-digits.
I also like to use alternative approaches like full-cycle EBITDA for valuing companies like Insteel. With an 8x multiple to my full-cycle estimate, I get a fair value in the mid-$20’s.
The Bottom Line
I don’t want to underplay the risk that demand could fall off noticeably in 2021 and stretch into 2022. Likewise, I don’t want to count on any import competition relief. That said, Insteel has seen tough cycles before (revenue declined almost 40% during the global financial crisis) and I believe they’ll make it through this one. Metal fabrication is a tough business, but Insteel has shown it has staying power and this is an off-the-radar name to consider below $20.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.