H. Woltz - President and CEO Mike Gazmarian - Vice President, CFO and Treasurer

Michael Conti - Sidoti Tyson Bauer - KC Capital Lance James - RBC Global Asset Management Chris Olin - Rosenblatt Securities

Good day, ladies and gentlemen, and welcome to the Insteel Industries’ Third Quarter 2016 Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this conference call may be recorded. I would now like to turn the conference to Mr. H. Woltz, Insteel President and CEO. Please begin. H. Woltz: Thank you. Good morning. Thank you for your interest in Insteel and welcome to our third quarter 2016 earnings call, which will be conducted by Mike Gazmarian, our Vice President, CFO and Treasurer and me. Before we begin, let me remind you that some of the comments made on today's call are considered to be forward-looking statements, which are subject to various risks and uncertainties that could cause actual results to differ materially from those projected. These risk factors are described in our periodic filings with the SEC. All forward-looking statements are based on our current expectations and information that is currently available. We do not assume any obligation to update these statements in the future, to reflect the occurrence of anticipated or unanticipated events or new information. I'll now turn it over to Mike to review our third quarter financial results and the macro indicators for our constructions markets then follow up to comment more on market conditions and our business outlook.

Thank you, H. As we reported earlier this morning, Insteel's net earnings for the third quarter of fiscal 2016 more than doubled from a year ago to $13.5 million or $0.71 a diluted share rising to the higher level since 2008 driven by widening spreads between selling prices and raw material costs, higher shipments and lower conversion costs. Conditions in our construction end markets remain strong during the quarter with shipments rising 8.8% sequentially from Q2, which benefitted from the relatively mild winter weather and 9.8% from year ago. Both the current and prior year volumes were unfavorably impacted by the heavy rainfall and flooding in the South Central states, particularly in our largest market Texas, which brought customer operations to a standstill for intermittent periods, although to a lesser extent this year. Nova reported that rainfall in Texas for the April to May period was 62% above the historical average this year or the sixth [widest in history or issues] total for the same period represented an all-time high that was more than double the usual level. Average selling prices fell 1.1% and sequentially from the second quarter, largely due to a less favorable product mix, but gradually rose during the period as a result of the price increases that were implemented with June ASPs up 3.5% from the March level. Our Q4 ASP should benefit from the full quarter impact of these increases together with additional adjustments that became effective at the beginning of July. Gross profit for the quarter nearly doubled from a year ago to $27.5 million with gross margin widening to 23.8% from 13.4% due to the higher spreads in shipments and lower conversion cost. Spreads for the quarter benefitted from the consumption of lower cost inventory that was purchased prior to the full impact of the previous price increases for wire rod. Since we're typically carrying around three months of inventory valued on a FIFO basis, there is usually a one quarter lag before our raw material purchases are reflected in cost of sales. On a sequential basis, gross profit was up $8.9 million from Q2 and gross margin rose 650 basis points from 17.3% due to the same factors. Our inventory position at the end of the third quarter represented 94 days of shipments or just over three months calculated off our Q4 forecast and reflected higher average unit cost than the beginning of the period, although we've been able to mitigate the extent of the increase through the purchase of lower priced offshore material. As we move into our fourth fiscal quarter, spreads are likely to narrow from the levels of Q3 as the higher cost inventories consumed. We believe however that the pricing adjustments that were made during the quarter and that will become effective in the fourth quarter are sufficient to recover the net increase in raw material cost that has occurred since the beginning of the year and should maintain margins at improved levels. SG&A expense for the quarter rose $0.4 million from a year ago to $7.6 million primarily due to higher expenses under our return on capital incentive compensation plan driven by our improved results, partially offset by a $0.2 million favorable year-over-year change in the cash to render value of life insurance policies and $0.2 million reduction in employee health insurance costs related to the high dollar claims that were incurred last year. On a sequential basis, SG&A expense was down $0.8 million from Q2 largely due to lower stock-based compensation expense. Equity awards under our plan are typically granted on a semi-annual basis in our second and fourth fiscal quarters, which drives SG&A expense higher in these periods. Our cash flow from operations for the quarter improved to $21.9 million from $18.1 million a year ago largely due to the increase in earnings, leaving us with $53.8 million in cash at the end of the quarter or close to $3 a share and no borrowings outstanding on our $100 million credit facility providing us with plenty of liquidity and financial flexibility. As previously reported, we’re proceeding with the termination of the defined benefit pension plan for the former employees at the Wilmington, Delaware facility to eliminate the ongoing investment risks and administrate costs. Benefits under the plan have been frozen in 2008 and the plan was subsequently closed in 2011 following the [IV] acquisition. We expect to make a contribution sufficient to fully fund the plan and settle the liabilities by the end of September, which will result in an estimated settlement charge of around $1.9 million in Q4. As we move into our fourth quarter, we expect continued strength in our construction end markets. The trends reflected in the monthly construction spending data have been somewhat distorted by the unusually mild winter weather earlier in the year followed by the excessive rainfall and flooding in the South Central states during April and May. On a year-to-date basis, total construction spending through May was up 8.2% from last year with private non-residential up 9.2%, public up 3.8% and private residential up 9.9%. Public spending in highway and street construction which had risen 15.8% year-over-year during the first quarter moderated in April and May leaving the five month year-to-date total up 6.9% from last year. The most recent reports for the Architectural Billings Index and Dodge Momentum Index reflect favorable trends that imply further improvement in non-residential building construction during 2017. Yesterday the American Institute of Architect reported another positive reading for the ABI, which came in at 52.6% for June. It has now remained above the 50 growth threshold for five straight months and 10 of the previous 12 months and the three month average of 52.1% was at its highest level since last August. The Dodge Momentum Index rose for the third straight month in June increasing 11.2% to its highest level since the beginning at 2009 and 18% year-over-year. The three month average, which smoothes out the month to month volatility was up 6.9% from the same period last year, reflecting similar increases in both the commercial and the institutional components. As we move further into the year, we expect the federal highway funding provided for under the recently passed FAST Act will begin to have a favorable impact on infrastructure construction activity and demand for our products. The five-year duration represents a significant improvement over the 36 short term extension since the last long-term bill expired back in September 2009. We continue to believe that the higher degree of funding certainty will benefit Insteel by shifting the project mix toward larger longer term projects that require greater usage of our concrete reinforcing products. I'll now turn the call back over to H. H. Woltz: Thank you, Mike. It’s reflected in our release and Mike’s comments, our third quarter results benefited from higher shipments, lower unit conversion costs and wider spreads resulting from the downturn in wire rod cost earlier in the year. In view of the continuing recovery in our markets, we expect to finish fiscal 2016 with another strong quarter and get off to a good start in fiscal 2017. In our last few earnings calls, we commented on the potential for widening spreads driven by declining prices for steel scrap and our primary raw material steel wire rod, together with stable or more slowly declining selling prices for our products as a result of the continued recovery in the construction sector. Our Q3 2015 results reflected the initial impact of these favorable trends, which became more pronounced with each successive quarter over the last year. Improved volume trends driven by the higher level of construction activity served to amplify the positive impact of widening spreads on our financial results. Over the course of January through May, raw material pricing trends reversed course, which scrapped escalating to levels that were in the range of $120 per ton above the December lows. On wire rod costs generally tracked this upward trend. As we reported on our last call, in April we began pursuing price increases to recover these higher costs. Following our initial increases raw material markets reversed course in June and again in July with scrap price declining over the two-month period. Early indications are that August scrap settlements will be down from the July level, which would imply a further reduction in our raw material costs. With respect to the impact of this volatility on our margins, we believe the cumulative pricing adjustments we have made will be sufficient to recover the net raw material cost increase that we expect to incur. Spreads and margins are expected to moderate from the levels of the third quarter as wire rod that was purchased at the peak of the cycle flows through cost of sales around the end of our fiscal year. Assuming continuing strength in demand for our products, the impact of these higher costs will be alleviated should scrap drift downward in August as appears likely at this time and through the lower priced import purchases that have been made. In any event, we expect margins to remain at attractive levels over the next couple of quarters. We mentioned in our previous call that a PC strand competitor was starting up a new South Carolina manufacturing plant there in our second quarter. Events unfolded substantially as expected and we continue to experience pricing pressure related to their ramp up during the third quarter. We believe that the growth of the PC strand market will be adequate to mitigate the impact of this additional domestic capacity. Turning to CapEx, we previously indicated that outlays would rise to approximately $20 million in 2016, which includes an investment of $9 million in our Houston PC strand facility to upgrade equipment and install a new state-of-the-art wire rod cleaning process comparable to our Gallatin and Sanderson strand points. Based on our current view of equipment delivery schedules and construction progress and then timing of anticipated payments around the end of our fiscal year, it now appears likely that 2016 CapEx will not exceed $18 million with the shortfall rolling into fiscal 2017. The Houston project, which is our largest 2016 investment is well underway and on budget. We continue to expect the first phase of the project to be completed by the end of the first fiscal quarter of 2017 and to generate approximately $5 million of annualized cost savings. Looking forward to 2017, we expect CapEx to remain elevated relative to the recent past as we complete the Houston project and continue upgrading our production technology and information systems to reduce operating costs and improve our manufacturing capabilities and the quality of our products. We will provide more specific CapEx guidance during our Q4 earnings call. To conclude our prepared remarks, we're pleased by the continued strength we're seeing in our markets and are optimistic that the recently passed FAST Act will provide added certainty to infrastructure funding thereby favorably impacting demand for our products during fiscal 2017. Additionally, we should begin to realize the anticipated benefits from several important investment initiatives that are underway. We expect to deliver strong results over the course of the next couple quarters and we'll continue our efforts to further improve the effectiveness of our manufacturing operations, identify additional opportunities to broaden our product offering and to grow through acquisition. This concludes our prepared remarks and we’ll now take your questions. Nicole, would you please explain the procedure for asking questions.

Yes. Thank you. [Operator Instructions] Our first question comes from Michael Conti of Sidoti. Your line is now open.

Good morning, H. good morning, Mike. H. Woltz: Good morning, Mike.

Good morning, Mike.

Yes so obviously huge improvement within the gross margin. Can you just break out how much of the gross margin improvement was due to lower conversion costs leverage from your shipments and then obviously from the consumption of lower priced inventory? H. Woltz: I don't know that we'd be able the precisely quantify it. But the most significant portion would have been driven by the widening in spreads and then to a lesser extent the other -- the other two drivers the increase in shipments and conversion cost I believe. They both had a similar impact on margin for the quarter.

Okay. And then just given the run up in scrap and your corresponding selling price increases, can you just give us an idea on how much of the volume, I know some of those offset by weather, but how much of that volume was due to a pull forward just to beat the selling price increases? H. Woltz: I don’t think it’s a material matter Mike. We haven’t seen hedge buying occurring and nor have we felt the need to try to hedge back.

Okay. And then can you just comment on may be customer inventory levels heading into the September quarter, just compared say inventory levels historically? H. Woltz: Yeah, I just -- first, let me just point out that we don’t have excellent insight into that, but our observations just from the field and anecdotally would be that there has been no -- there has been no unanticipated building customer inventories and we have, as I mentioned before, we’re not seeing any real inclination of customers to feel like they needed to hedge by. So, I think their volumes are running at reasonable levels and they’re buying what they need to make their schedules and things that we’re unaware of any bulge there.

Sure and last one before I hop off queue, just switching over to the infrastructure side, can you just quantify for us your order book or growth on a year-over-year basis specifically related to government backed projects, just to give us an idea on the potential increase in volumes related to the FAST Act. H. Woltz: I’m not so sure we can drill at the level of detail, but I think that as you know, we believe around 35% of our shipments go into the infrastructure sector. I don’t think that that’s changed materially and there could be some upside there as we look at 2017, but for the time being I wouldn’t tell you that there has been any dramatic change.

Okay. Great. I’ll hop back in queue. Thanks. H. Woltz: Thank you.

Thank you and our next question comes from the line of Tyson Bauer of KC Capital. Your line is now open.

Good morning, gentlemen and excellent quarter. H. Woltz: Good morning, Tyson. Thank you.

In regard to your comment on the margins, you just came off a very healthy 23.8%, your comp going from last year's Q4 was 18.5%, is the suggestion that we land somewhere in between that range? H. Woltz: Yeah, I think the expectation is that we'll see some moderation from the 23.8%, but they’ll still remain at attractive level. So I think that would probably be a reasonable assumption.

Okay. The initial price increases that went through and obviously were well received in the marketplace was during the period as you described where you saw increases in scrap prices and on the previous questioner commented that and you may have seen forward buying. We don’t know if that happened or not. Now you are in a reverse situation where you're trying to get in some recent price increases with the underlying raw material softening. Does that make it little more difficult to get those price increases through or is there enough volume demand currently that we haven’t really seen in prior years where you can be a little more sticky on those prices and force them through? H. Woltz: Well, price increases are always difficult in our industry, its highly comparative it is today and it always has been, but certainly the reversal of the trends in the scarp market have had an impact on the intensity with which we're seeing competitors try to raise prices. So the answer is certainly that reversal in course in scrap has had an adverse impact on our ability to raise prices.

Okay. The Texas market, our calculation is probably cost you about 1%, 2% of your revenue. Does that get made up in this fiscal quarter or is it kind of a drawn out period where the next couple quarters will receive that benefit of displaced volumes? H. Woltz: Again it's hard to give you a real accurate answer, but just knowing that at this of year with the seasonal up-trends that all our customers are experiencing, I don’t think they have the capability to ramp up to a significant degree beyond what they had previously planned. So, I think that just implies that that recovery will take place over a longer period than in the same quarter.

Okay. Last question, can you talk about the infrastructure is 35% of business, does that -- are you seeing greater acceptance of your ESM product now that it's been in the marketplace longer and some of these projects are larger in scope and in duration where that may be a more important cost component as far as reducing overall product or project cost, have you seen a pickup in demand and interest and using your ESM product? H. Woltz: Well, certainly our ESM product has continued to grow and we expect it to grow further. I don’t think that ramped up infrastructure spending itself will have a material impact on that. It's more -- it's more an internal job of promoting the product and promoting its acceptance. Certainly there will be more targets to shoot at as the market -- as the market grows and that’s favorable for us, but in and of itself, the infrastructure growth I don’t think is a material impact on us.

Have you received more DOT at the state level acceptance and the qualification to utilize some of those products? H. Woltz: Yeah, we continue to work on that and continue to receive more acceptance yes.

Okay. And on the PC strand, if I’m correct lot of that’s in bridges and some of those that are bigger projects, with the growth from FAST that you mentioned, is that what gives you the confidence that we can observe more industry capacity coming online because we should see greater use in the type of projects that utilize that product? H. Woltz: Certainly that’s an impact Tyson, but I wouldn’t discount the impact of just the continuing recovery in our markets since oil. I think that’s equally important.

And any ideas, obviously this is your opinion for the reversal in I guess scarp that it just get a little ahead of itself and now we’re just trying to get into a more stabilized environment or do you see anything longer term in the trends that could lead to further softening through the end of the year. H. Woltz: In my experience, long term trends in this scrap market are like 30 days. So, we have very little insight into the drivers behind this and when I mentioned that the early indications are that August pricing will trend downward, it's market speculation more than any scientific analysis that we’re privy to.

All right. That was it. Thanks a lot, gentlemen. H. Woltz: Thank you.

Thank you. Our next question comes from the line of Lance James of RBC Global Asset Management. Your line is now open.

Thanks. Number of my questions have been answered, but I will also echo congratulations, not just on a very strong quarter, but really your steadfastness through a number of years to bring the company to this place so, congratulations. My question would be or the remaining question would be, in terms of your capacity utilization of your current existing fiscal plans, any comment on where you are in terms of your own capacity utilization and whether there would be any larger capital outlays necessary in the foreseeable future to have to expand that? H. Woltz: We continue to have ample capacity to grow and to ramp our revenues up. We have stated in our Investor Presentations that we could see between $600 million and $700 million of revenue on annual basis from existing facilities and we continue to believe that that is the case. A lot of the capital investments that we're making in machinery and equipment are to take advantage of lower operating cost and higher quality products and that’s going to continue. So, I think as we stated, CapEx will be elevated in 2017 relative to recent years, but certainly we wouldn’t anticipate it threaten positive free cash flow.

Terrific and again this question is more from my ignorance of just the general -- your general manufacturing process but is there operating leverage there, if your orders go up 10% or so, will the gross margin on those orders typically be similar to the rest of your output or if there some operating leverage that additional dollars would or additional orders would actually help improve your overall gross margins by spreading cost over an existing production base? H. Woltz: There would be some operating leverage benefit when you break out the components of our cost structure and just focus on that conversion cost component at our plants. On an overall basis, probably around half of it would be variable versus fixed. So, we get some leverage benefit there as well as on our SG&A expense where we’re now making that the statement about having the ability to ramp up to $700 million of revenues that could be done without any additional staffing requirements. So, we get an added leverage benefit there as well.

Terrific. Very helpful and congratulations again. Thanks. H. Woltz: Thank you.

Thank you. Our next question comes from the line of [indiscernible]. Your line is now open. Your line is now open.

Sorry. I was on mute. Good morning. Just curious if you haven’t covered this already, what kind of impact did you guys have in weather impacted markets in the quarter? Your shipments were pretty impressive, but what kind of magnitude impact did you guys see due to the weather in the quarter? H. Woltz: It’s difficult to precisely quantify it, but just in terms of order of magnitude, we reference the differences in the rainfall level this year. Last year was an all-time high. The flooding was more severe this year with the sixth widest on history. So, pretty unusual as well, but just in terms of order of magnitude, last year would had more significant impact, but I don’t know that we can precisely quantify it beyond that.

We could have had a better coupe of one or two or three points. H. Woltz: Potentially, the Texas is our largest market. So just depending on the assumed impact that it could amount to that much.

Okay. And you guys are showing some really nice operating leverage. I’m just curious, is it more from some of the efficiency upgrades that you guys have talked about in previous quarters at some of your facilities or are you guys adding lines or maybe a little bit of both. Can you give us a little color on that?

Yes, we’ve added on several highly flexible and efficient production lines in the last few years. We continue to do that. So it’s probably a combination of the factors that you point out. H. Woltz: But more recently we would attribute a larger portion to the widening in spreads. The operating improvement and the conversion cost reduction have had a positive impact as well, but the spreads have been the primary driver here recently. Now when you move into next year and we wrap up this first phase of it, Huston expansion we're expecting to realize another significant reduction relating to that and annualized cost reduction of around $5 million that would begin after its completion beginning in the second quarter. So, that would be the other I guess the other significant reduction that we see on the horizon.

Okay. And I know you guys were talking with a -- on a previous question about utilizations. Are there plans or are you in the process of adding lines in any of the facilities right now just given current market conditions?

Yes, we're constantly underway with additions and there are those in the pipeline right now.

Okay. Great, thanks, congratulations.

Thank you.

Thank you. [Operator Instructions] Our next question comes from the line of Chris Olin of Rosenblatt Securities. Your line is now open.

Hey good morning, guys. H. Woltz: Good morning, Chris.

Just had a couple of quick follow-up questions and wanted to focus first just your steel wire purchases. There has been a lot of talk within the carbon steel industry that the spreads between domestic pricing and imports has gotten to a very wide level and I guess I was curious if you are seeing levels where you could continue to benefit from sourcing from outside the U.S. and are you seeing spreads continue to expand even with kind of your thoughts on scrap going forward? H. Woltz: Suffice it to say Chris, that the spreads are on adequate to justify our continued participation in the offshore market and almost without regard to spreads, we would always participate in that market anyway just to assure ourselves of adequate supplies. But spreads haven’t widened to the point that we would try to ratchet up our participation offshore. It's ample to cover the risk that we perceive from the longer lead times, but it hasn’t varied greatly from its historical level.

Okay. And then just to be clear on your pricing comments, there were two price increases announced, one on the welded wire and then the other on the PC strand and I was on your assumption that it could be more challenging to get the full price increases on PC strand because of some new competition in the marketplace as well as imports now. I was just wondering if you're just as confident on that side as you are on the other side of the business. H. Woltz: Well we really want to speak of it just in terms of the overall impact on our margins across all product lines because they all act differently at certain times. So I think we should just leave it to say that we believe we’re going to cover on average the increases that we expect to have to pay.

Just in terms -- again on an overall basis, in terms of our Q4 expectations, we are expecting an increase in ASPs where we only -- we only realized a portion of the increases that were implemented in Q3 and then there will be another increase that became effective at the beginning of this month. So we are expecting -- we are expecting a net increase sequentially, which should serve to offset the higher raw material cost coming out of inventory.

Okay. That’s all I had. Thank you.

Thank you.

Thank you. [Operator Instructions] And I’m showing no further questions at this time. H. Woltz: Okay. Thank you. We appreciate your participation today and your interest in Insteel and we look forward to speaking with you for the Q4 call. Thank you.

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude today’s program. You may now disconnect. Have a great day everyone.