chinaface/E+ via Getty Images The latest quarter for Insteel Industries, Inc. (NYSE:IIIN) was a very weak fiscal Q1, primarily from the ongoing decline in the residential construction sector and inventory management and destocking measures in non-residential markets that put downward pressure on replacement demand. Consequently, it resulted in a decline in most key metrics, including revenue, gross profit, net earnings, and EPS, among others. The company expects residential markets to remain under pressure until the Federal Reserve eases up on interest rates, while non-residential is expected to grow incrementally, although that’s not likely to happen until inventory levels normalize. In this article we’ll look at its recent earnings numbers, residential construction challenges, and why non-residential business may not be enough to give the stock a sustainable boost in 2023. Some of the numbers While revenue in the first fiscal quarter of 2023 was $167 million, down from $178.5 million in the first fiscal quarter of 2022, it was the other numbers that really hit the company hard in the reporting period. For example, gross profit was $17.79 million in the first fiscal quarter of 2023, compared to gross profit of $42.4 million in the first fiscal quarter of 2022. Gross margin collapsed to 10.7 percent, down from 23.7 percent year-over-year. Net earnings also crashed from $23.1 million in the first fiscal quarter of 2022, or $1.18 per diluted share, to $11.1 million, or $0.57 per diluted share in the first fiscal quarter of 2023. One of the major issues with the bottom line was the company held 4.3 months of inventory on hand, with its value based upon FIFO. As a result, the spread and margins in the reporting period were negatively impacted by the differential between the average selling price of the company’s products, as measured against the increase in the cost of inventory acquired in fiscal 2022. In fiscal 2023, management believes its performance should incrementally improve based upon the decrease in costs from recent purchases of lower-cost materials that are sold from inventory, although that’s based upon the assumption prices will either fall or remain flat. For the most part, the inventory issues of IIIN are centered on residential markets, rather than non-residential markets, and it thinks it should be able to do okay in non-residential in 2023, especially after the first half. Residential market According to management, the residential market started to decline in the third quarter of 2022 in response to rising interest rates. It has continued to be weak through the first fiscal quarter of 2023 and is expected to continue to be weak until there’s a change in the interest rate environment, which I don’t see coming anytime soon. It’s close to certain that the Federal Reserve will raise interest rates at least a couple more times before pausing to see the results of the increases on inflation and the economy, and from there making a decision on what direction to take after that. For that reason, residential construction should remain under pressure for the foreseeable future, which will not only lower demand, but also potentially slow down destocking while keeping stricter inventory measures in place to lower risk. As mentioned above, the company had approximately 4.3 months of inventory on hand it has to work through as of the end of the reporting period and shrinking demand and the probability it’ll take longer to work down inventory in the current environment, suggests to me it’s going to take some time for IIIN to work its way out of the challenges it faces, even if non-residential offsets some of residential’s underperformance. At the time of the earnings report management said it had reduced its inventory position to approximately 3.9 months on a forward-looking basis. That said, the company should be able to modestly improve the bottom line once it gets the benefit of the lower costs from recent acquisitions of raw materials. Non-residential While the company acknowledges the slowdown in its residential was directly related to a decline in demand, it feels the shipping weakness in non-residential during the reporting period was related more to inventory management and destocking rather than a decline in market demand for its products. As its non-residential customers decided that with lead times being normalized, they were able to operate with lower inventory levels that had been built up for about a year in order to have enough on hand to meet their obligations under an environment of tightened supply and extended lead times. For that reason, management believes market demand remains strong, citing its backlog in its non-residential construction market segment. That said, recent mixed reports from ABI and Dodge, leading indicators for non-residential construction spending, suggest there is no certainty the conclusion of IIIN management is reflective of market realities. For example, ABI continues to remain in negative territory for the second month in a row, dropping to 46.6. On the other hand, the Dodge Momentum Index, which has jumped to 222.3 in December 2023, suggests non-residential building construction has been making a recovery. The commercial component of the index was up 51 percent year-over-year, while projects associated with institutions were up 20 percent. With the two indices basically contradicting one another, is seems to me it underscores a non-residential construction market that could go either way in 2023. Last, according to the AIA, it projects spending on non-residential construction to grow at a pace of 5.8 percent in 2023. Conclusion Insteel Industries, Inc. is coming off a very weak performance for the first fiscal quarter of 2023, and I see it continuing to struggle at least through the first half, primarily from the ongoing increase in interest rates which will result in a decrease in demand. That, combined with a labor market that is coming under pressure from an increasing number of workers being laid off or terminated, which is causing consumers to reprioritize their spending habits, and of course not entering into mortgage contracts that they could struggle to pay off if they are let go by their employers. In regard to non-residential, I think that’s still up in the air, even though I do agree it’ll do better than residential. Even so, that’s not a high bar to beat at this time, and a lot of things will have to go right for it to offset the big decline in residential revenue. A major one will be how quickly its non-residential customers work through existing inventory and make new orders to replenish dwindling supply. The pace of that will determine much of its non-residential performance in 2023, especially in the second half. The other thing is, Insteel Industries, Inc. management cited the Infrastructure Investment and Jobs Act as being a positive catalyst for 2023, but I’m suspect of that because of the fact government entities are notoriously late and uneven in deploying capital toward projects that have already been approved. And, of course, that money, when deployed, will have to make to the customers of IIIN in order for it to benefit from it. The bottom line for Insteel Industries, Inc. is that residential will continue to underperform for most, if not of all of 2023 because of elevated interest rates. And with inventory levels connected to non-residential having to be worked down more before significant new orders are made, I think it’s going to be a tough year for Insteel Industries, Inc. I think Insteel Industries, Inc. revenue is likely to remain flat or down, while the bottom line, at best, will slightly improve, but still remain down from the previous year.
