Insteel Generating Strong Margins With Robust Demand (NYSE:IIIN)

These are interesting times to be in the steel business, particularly with the market uncertainty unleashed by Russia’s invasion of Ukraine. Insteel Industries, Inc. (NYSE:IIIN) has different exposure than companies like Commercial Metals (CMC) or Nucor (NUE), as it is a steel products producer, taking wire rod and producing prestressed concrete strand and welded wire reinforcing products for the non-residential and infrastructure markets. Nevertheless, navigating the challenges of inadequate domestic supply, strong end-user demand, and rising input costs makes things pretty “interesting” for Insteel as well.

I was more cautious on Insteel at the time of my last article, as I was concerned how the market would react to what looked like some turbulence in the outlook for non-residential construction. The shares have held up better than I expected since, rising almost 10% as the company has done a good job securing better spreads and managing a challenging supply environment.

Given my expectation that non-residential construction will accelerate later this year and into 2023, and that infrastructure and institutional spending will start accelerating in 2023, I like the near-term outlook, but I am still concerned about the risk of peaking financial performance.

Demand Should Accelerate In 2023

Given the typical lag times between new project starts and actual construction starts, I think 2022 could be a choppy year for non-residential construction as the impact of the pandemic works its way through the market. I see stronger activity late this year, though, and expect to continue into 2023 as activity picks up again in areas like offices and retail.

A key “but” to this outlook concerns Insteel’s actual physical footprint. Given that the company is stronger in the Southeast region of the U.S., it may well be the case that the company never really sees much of a lull.

Infrastructure, including roads, bridges, and so on, should start picking up in 2023 on the back of the infrastructure bill, and that strength should extend into institutional construction as well. That uplift should continue for multiple years, and given the labor challenges across the economy, I could see Insteel gaining share with its engineered steel mesh products given that they don’t require the placing and hand-tying of traditional rebar (in other words, it’s a labor-saving alternative).

Securing supply has proven more challenging recently, and I do still see some risk to volumes even in a strong demand environment. With domestic supplies being inadequate to Insteel’s needs over the last couple of quarters, the company has had to turn to foreign markets to secure supply. Unfortunately, not only is foreign supply threatened by their own input/supply challenges (sanctions against Russia, et al), but a meaningful amount of Insteel’s volume is covered under “Buy America” requirements.

Pricing Remains A Key Variable

Predicting steel prices is never easy, let alone Insteel’s spreads, and the current situation clearly creates further challenges. Unlike hot-rolled sheet steel, where the price dropped almost 50% from the late 2021 through to the invasion of Ukraine, wire rod prices have gone even higher on limited excess capacity (corroborated by Insteel needing to buy wire rod from markets outside the U.S. to keep up with demand).

I expect wire rod prices to hold up in 2022 given input cost pressures and limited surplus capacity, but I also expect more capacity to come into the market. I don’t think current prices/spreads are sustainable, with rebar prices about 50% above their five-year average (rebar and wire rod aren’t interchangeable, but rebar prices and wire rod prices do typically move together). For Insteel, I estimate that FQ1’22 realized prices were over 70% higher than the FQ1’20 level, almost 90% above FQ1’17 realized prices, and about 60% higher than the trailing 5-year average.

With prices at this level, I think there will either be increased capacity brought online or pressure from buyers to ease up on some of the tariffs that have been giving domestic wire rod producers so much pricing power.

Although I don’t think Insteel will have a problem keeping its plants running at capacity given the demand I expect from non-residential and infrastructure construction activity, I do expect spreads (and margins) to contract after this fiscal year. The last two quarters have seen two of the three highest gross margin results for the company over the last decade and one of the truths of the industry is that record spreads don’t last.

The Outlook

I continue to have a tremendous amount of respect for Insteel’s management team. Deeply cyclical margins are just part of the business, but the company has only had three years of negative free cash flow since 2005. Moreover, capital intensity is surprisingly low, with the company spending an average of just under 3% of revenue on capex, albeit with some significant year-to-year variations. That, in turn, has allowed the company to pay multiple special dividends over the years, including a $2/share dividend back in December.

This year will be one of those “significant variations”, with management looking to spend up to $25M on new machinery to expand capacity and improve cash costs. Even with that spending, I expect meaningful cash flow and could see another special dividend at the end of this year.

Given strong demand and limited domestic surplus capacity, I expect another strong year of price realizations, though I do think pricing will weaken sequentially after the fiscal second quarter. Volume remains a key unknown for me; the demand is there, but being able to supply it may prove challenging. I think a revenue number of around $750M is possible for this year, along with 20%-plus gross margin, a high-teens operating margin, and an EBITDA margin above 19%. Longer term, I expect mid-single-digit revenue growth with FCF margins in the mid-single-digits.

The Bottom Line

My primary valuation approach to Insteel is a combined 12-month and full-cycle EV/EBITDA approach that tends to level off the peaks and troughs of the cycle. Using a 5x multiple on the 12-month EBITDA (peak EBITDA, in my view) and a 9x multiple on full-cycle EBITDA, I get a fair value of around $43 today, or about 10% above today’s price.

As before, I’m concerned about the challenges of calling a peak in this business and predicting how the market will respond to the various inputs into this business (wire rod prices, Insteel’s pricing power, production costs, etc.). Insteel may well have more pricing power for longer than I expect, but it’s hard for me to see how operating results get much better from here, and I’d be careful about getting too greedy even ahead of strong demand from infrastructure projects.