INSTEEL INDUSTRIES INC (IIIN) FY 2021 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The matters discussed in this section include forward-looking statements that are subject to numerous risks. You should carefully read the “Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors” in this Form 10-K.

Overview

Our operations are entirely focused on the manufacture and marketing of concrete reinforcing products for the concrete construction industry. Our business strategy is focused on: (1) achieving leadership positions in our markets; (2) operating as the lowest cost producer in our industry; and (3) pursuing growth opportunities within our core businesses that further our penetration of the markets we currently serve or expand our footprint.

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On March 16, 2020, we, through our wholly-owned subsidiary, IWP, purchased substantially all of the assets of STM for an adjusted purchase price of $19.4 million, which reflects certain post-closing adjustments. STM was a leading manufacturer of PC strand for concrete construction applications. We acquired, among other assets, STM’s accounts receivable, inventories, production equipment and facility located in Summerville, South Carolina and assumed certain of its accounts payable and accrued liabilities. Subsequent to the acquisition, we elected to consolidate our PC strand operations with the closure of the Summerville facility.

Impact of COVID-19

Despite the significant disruption in the U.S. and global economies, including supply chain challenges and labor market obstacles, COVID-19 has had a limited impact on our operations to date. We have implemented procedures to support the health and safety of our employees and we are following all U.S. Centers for Disease Control and Prevention guidelines. While the U.S. economy appears to be entering a recovery and operating conditions are improving, we continue to closely monitor the impact of the COVID-19 pandemic on all aspects of our business and the potential effect on our financial position, results of operations, and cash flows. There are many uncertainties regarding the future and ultimate impact that COVID-19 will have on all aspects of our business. We will continue to assess and make adjustments as necessary.

Critical Accounting Estimates

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. Our discussion and analysis of our financial condition and results of operations are based on these consolidated financial statements. The preparation of our consolidated financial statements requires the application of these accounting principles in addition to certain estimates and judgments based on current available information, actuarial estimates, historical results and other assumptions believed to be reasonable. These estimates, assumptions and judgments are affected by our application of accounting policies, which are discussed in Note 2, "Summary of Significant Accounting Policies", and elsewhere in the accompanying consolidated financial statements. Estimates are used for, but not limited to, determining the net carrying value of trade accounts receivable, inventories, recording self-insurance liabilities and other accrued liabilities. Estimates are also used in establishing opening balances in relation to purchase accounting. Actual results could differ from these estimates.

Accounting estimates are considered critical if both of the following conditions are met: (1) the nature of the estimates or assumptions is material because of the levels of subjectivity and judgment needed to account for matters that are highly uncertain and susceptible to change and (2) the effect of the estimates and assumptions is material to the financial statements.

We have reviewed our accounting estimates, and none were deemed to be considered critical for the accounting periods presented.

Recent Accounting Pronouncements.

The nature and impact of recent accounting pronouncements is discussed in Note 3 to our consolidated financial statements and incorporated herein by reference.

Results of Operations

The following discussion and analysis of our financial condition and results of operations is for the year ended October 2, 2021 compared with the year ended October 3, 2020. Discussions of our financial condition and results of operations for the year ended October 3, 2020 compared to September 28, 2019 that have been omitted under this item can be found in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the fiscal year ended October 3, 2020, which was filed with the SEC on October 29, 2020.

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The table below presents a summary of our results of operations for fiscal 2021 and fiscal 2020.

Statements of Operations – Selected Data

(Dollars in thousands)

"N/M"= Not meaningful

2021 Compared with 2020

Net Sales

Net sales increased 25.0% to $590.6 million in 2021 from $472.6 million in 2020, reflecting a 25.7% increase in selling prices partially offset by a 0.6% decrease in shipments. The increase in average selling prices was driven by price increases implemented in the current year primarily to recover the escalation in raw material costs together with strong demand for our products. Shipments for the prior year benefited from an extra week based on our fiscal calendar. On a pro forma basis adjusting the prior year to reflect the same 52-week period as 2021, the year-over-year shipment increase was 1.6%. The pro forma increase in shipments was primarily due to improved market conditions, the additional business provided by the STM Acquisition and strengthening demand for our products relative to the prior year, which offset the impact on shipments resulting from sustained tight supply conditions for raw materials. Shipments for both years were not materially impacted by the COVID-19 pandemic.

Gross Profit

Gross profit increased 117.9% to $121.5 million, or 20.6% of net sales, in 2021 from $55.8 million, or 11.8% of net sales, in 2020. The year-over-year increase was primarily due to higher spreads between average selling prices and raw material costs ($73.2 million) partially offset by higher manufacturing costs ($7.0 million) and a decrease in shipments ($436,000). The increase in spreads was driven by higher average selling prices ($122.2 million) partially offset by higher raw material costs ($46.7 million) and freight expense ($2.3 million).

Selling, General and Administrative Expense

Selling, general and administrative expense (“SG&A expense”) increased 3.3% to $32.4 million, or 5.5% of net sales, in 2021 from $31.3 million, or 6.6% of net sales, in 2020 primarily due to higher compensation ($3.5 million) and legal expense ($392,000) offset by the relative year-over-year changes in the cash surrender value of life insurance policies ($1.3 million) and lower earnout expense ($1.4 million). The increase in compensation expense was largely driven by higher incentive plan expense due to our improved financial results in the current year. The increase in legal expense was primarily related to costs associated with trade matters. The decrease in earnout expense was due to the revaluation of a contingent earnout liability in the prior year.

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Restructuring Charges, Net

Net restructuring charges of $2.9 million were incurred in 2021 compared with $1.7 million in the prior year. The net restructuring charges were related to the closure of the Summerville, South Carolina facility, which had been acquired through the STM Acquisition, and consolidation of our PC strand operations. Net restructuring charges in 2021 included asset impairment charges ($1.4 million), facility closure costs ($1.0 million), equipment relocation costs ($423,000) and employee separation costs ($13,000). The net restructuring charges incurred in the prior year were for facility closure costs ($806,000), equipment relocation costs ($482,000), impairment charges related to the decommissioning of equipment ($343,000) and employee separation costs ($182,000). These charges were partially offset by a $118,000 gain from the sale of equipment associated with the Summerville facility.

Acquisition Costs

Acquisition costs of $195,000 were incurred in 2020 for legal, accounting and other professional fees related to the STM Acquisition. There were no acquisition costs incurred in 2021.

Other Expense (Income), Net

Other expense was $114,000 for 2021 compared with other income of $1.3 million in 2020. Other income in the prior year was primarily related to a gain from the disposition of assets held for sale.

Income Taxes

Our effective income tax rate for 2021 increased to 22.6% from 21.4% in 2020 due to a discrete tax benefit recorded in the prior year in connection with the net operating loss carryback provisions of the Coronavirus Aid, Relief and Economic Security Act, which was enacted in March 2020.

Net Earnings

Net earnings increased to $66.6 million ($3.41 per diluted share) in 2021 from $19.0 million ($0.98 per diluted share) in 2020 primarily due to the increase in gross profit partially offset by higher SG&A expense and restructuring charges associated with the consolidation of our PC strand operations.

Liquidity and Capital Resources

Overview

Our sources of liquidity include cash and cash equivalents, cash generated by operating activities and borrowing availability provided under our $100.0 million revolving credit facility (the “Credit Facility”). Our principal capital requirements include funding working capital, capital expenditures, dividends and any share repurchases. As of October 2, 2021, our cash and cash equivalents totaled $89.9 million compared with $68.7 million as of October 3, 2020.

Selected Financial Data

(Dollars in thousands)

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Operating Activities

Operating activities provided $69.9 million of cash in 2021 primarily from net earnings adjusted for non-cash items partially offset by an increase in working capital. Working capital used $12.3 million of cash due to a $14.1 million increase in accounts receivable and a $10.1 million increase in inventories partially offset by an $11.9 million increase in accounts payable and accrued expenses. The increase in accounts receivable and inventories were due to the escalation in raw material costs and average selling prices during 2021. The increase in accounts payable and accrued expenses was primarily related to raw material purchases with higher unit costs near the end of the period and, to a lesser extent, increases in accrued salaries, wages and related expenses and income taxes.

Operating activities provided $56.2 million of cash in 2020 primarily from net earnings adjusted for non-cash items together with decrease in working capital. Working capital provided $19.4 million of cash due to a $20.2 million increase in accounts payable and accrued expenses and a $5.1 million decrease in inventories partially offset by a $5.8 million increase in accounts receivable. The increase in accounts payable and accrued expenses was primarily related to higher raw material purchases near the end of the year together with increases in accrued salaries, wages and related expenses, earnout liability and income taxes. The decrease in inventories was primarily driven by lower unit costs partially offset by higher raw material purchases. The increase in accounts receivable was primarily related to higher shipments partially offset by lower average selling prices.

We may elect to adjust our operating activities as there are changes in the conditions in our construction end-markets, which could materially impact our cash requirements. While a downturn in the level of construction activity affects sales to our customers, it generally reduces our working capital requirements.

Investing Activities

Investing activities used $17.8 million of cash in 2021 primarily due to capital expenditures ($17.5 million) and an increase in the cash surrender value of life insurance policies ($0.4 million). Investing activities used $23.2 million of cash in 2020 primarily due to the STM Acquisition ($18.4 million) and capital expenditures ($7.1 million) partially offset by the receipt of proceeds from the sale of assets held for sale ($2.2 million). Capital expenditures for both years focused on cost and productivity improvement initiatives in addition to recurring maintenance requirements. Capital expenditures are expected to total up to $25.0 million in 2022, which include expenditures primarily to advance the growth of our engineered structural mesh business and to support cost and productivity improvement initiatives as well as recurring maintenance requirements. Our investing activities are largely discretionary, providing us with the ability to significantly curtail outlays should future business conditions warrant that such actions be taken.

Financing Activities

Financing activities used $30.9 million of cash in 2021 and $2.5 million of cash in 2020. In 2021, $31.3 million of cash was used for dividend payments (including a special cash dividend of $29.0 million, or $1.50 per share, and regular cash dividends totaling $2.3 million), which was partially offset by $1.1 million of proceeds from the exercise of stock options. In 2020, $2.3 million of cash was used for dividend payments.

Cash Management

Our cash is principally concentrated at one financial institution, which at times exceeds federally insured limits. We invest excess cash primarily in money market funds, which are highly liquid securities that bear minimal risk.

Credit Facility

We have a Credit Facility that is used to supplement our operating cash flow and fund our working capital, capital expenditure, general corporate and growth requirements. In May 2019, we entered into a new credit agreement, which amended and restated in its entirety the previous agreement pertaining to the revolving credit facility that had been in effect since June 2010. The new credit agreement, among other changes, extended the maturity date of the Credit Facility from May 13, 2020 to May 15, 2024 and provided for an accordion feature whereby its size may be increased by up to $50.0 million, subject to our lender’s approval. Advances under the Credit Facility are limited to the lesser of the revolving loan commitment amount (currently $100.0 million) or a borrowing base amount that is calculated based upon a percentage of eligible receivables and inventories. As of October 2, 2021, no borrowings were outstanding on the Credit Facility, $98.6 million of borrowing capacity was available and outstanding letters of credit totaled $1.4 million (see Note 8 to the consolidated financial statements). As of October 3, 2020, there were no borrowings outstanding on the Credit Facility.

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We believe that, in the absence of significant unanticipated cash demands, cash and cash equivalents, cash generated by operating activities and the borrowing availability provided under the Credit Facility will be sufficient to satisfy our expected requirements for working capital, capital expenditures, dividends and share repurchases, if any. We also expect to have access to the amounts available under our Credit Facility as required. However, should we experience future reductions in our operating cash flows due to weakening conditions in our construction end-markets and reduced demand from our customers, we may need to curtail capital and operating expenditures, delay or restrict share repurchases, cease dividend payments and/or realign our working capital requirements.

Should we determine, at any time, that we require additional short-term liquidity, we would evaluate the alternative sources of financing that were potentially available to provide such funding. There can be no assurance that any such financing, if pursued, would be obtained, or if obtained, would be adequate or on terms acceptable to us. However, we believe that our strong balance sheet, flexible capital structure and borrowing capacity available to us under our Credit Facility position us to meet our anticipated liquidity requirements for the foreseeable future.

Off-Balance Sheet Arrangements

We do not have any material transactions, arrangements, obligations (including contingent obligations), or other relationships with unconsolidated entities or other persons, as defined by Item 303(a)(4) of Regulation S-K of the SEC, that have or are reasonably likely to have a material current or future impact on our financial condition, results of operations, liquidity, capital expenditures, capital resources or significant components of revenues or expenses.

Contractual Obligations

In addition to our discussion and analysis surrounding our liquidity and capital resources, our contractual obligations and commitments as of October 2, 2021, include:

Impact of Inflation

We are subject to inflationary risks arising from fluctuations in the market prices for our primary raw material, hot-rolled carbon steel wire rod, and, to a much lesser extent, labor, freight, energy and other consumables that are used in our manufacturing processes. We have generally been able to adjust our selling prices to pass through increases in these costs or offset them through various cost reduction and productivity improvement initiatives. However, our ability to raise our selling prices depends on market conditions and competitive dynamics, and there may be periods during which we are unable to fully recover increases in our costs.

During 2021, we were successful in implementing price increases sufficient to recover the escalation in our raw material costs that occurred over the course of the year. In 2020, selling prices for our products declined in response to low-priced import competition, which negatively impacted our financial results. The timing and magnitude of any future increases in raw material costs and the impact on selling prices for our products is uncertain at this time.

Outlook

Looking ahead to fiscal 2022, we expect continued robust demand in our construction markets. The economic recovery along with sustained favorable forecasts from widely monitored leading market indicators in private non-residential construction and a resilient public construction market are supporting our optimism in the demand outlook. We also believe there is a possibility that Congress and the Administration will successfully negotiate an infrastructure investment plan that may benefit our markets, although the ultimate size and timing of any improvements are not possible to project.

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The supply shortage and escalating prices for steel wire rod, our primary raw material, remains a key concern. In addition, critically tight labor markets are expected to continue to negatively affect our operations. These challenges may impact our ability to meet fully our customer demand and result in plant operating inefficiencies and customer service delays. We expect to continue passing the rising costs through the supply chain, but we would anticipate margins returning to more normalized levels once the raw materials markets stabilize. Additionally, our markets and operations remain vulnerable to the lingering impact of COVID-19.

Regardless of the market dynamics, we continue to focus on those factors we control: closely managing and controlling our expenses; aligning our production schedules with demand in a proactive manner as there are changes in market conditions to minimize our operating costs; and pursuing further improvements in the productivity and effectiveness of all our manufacturing, selling and administrative activities. We also expect gradually increasing contributions from the substantial investments we have made in our facilities in the form of reduced operating costs and additional capacity to support future growth. Finally, we will continue to pursue acquisitions opportunistically in our existing businesses that expand our penetration of markets we currently serve or expand our footprint.

The statements contained in this section are forward-looking statements. See “Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors”.