Insteel Industries

INSTEEL INDUSTRIES (Nasdaq: IIIN)
Insteel manufacturers and markets steel wire products for various industrial applications. 90% of their products are used in industrial building and road construction. Majority of the remaining sales are made up of wire products used in tire manufacturing. Insteel is considered a market leader in its segment. I believe that this company is worth at least $21.6 which represents 33% upside from current market price of $16.30.

Reasons to Buy:
Since exiting its unprofitable nail business in 2003, company has shown impressive profitability. Attractive valuation at 25% LTM cap rate.
Expected increase in unit shipments due to recovery of commercial real estate market and the passage of highway bill
Company is showing responsible cash management through debt reduction and reinstatement of quarterly dividend
Customers overbought inventory last year which resulted in reduced sales in early quarters. Unit shipments in core business have required in most recently announced results and is expected to continue growing closer to long term average trend (2% annual)
Increase in domestic carbon wire capacity alleviated supply shortages and significantly improved working capital requirements and returns on capital.
22% insider ownership aligns interest of management with shareholders
Expected earnings contribution from Engineered Structural Mesh (ESM) and other upcoming products which so far have only been cost drivers

Risks:
Competitors may chose to compete irrationally reducing gross margins
Engineered Structural Mesh is an unproven product that may end up destroying value for the shareholders

Catalyst:
Valuation gap will start closing as investment community will realize that company’s sustainable earnings power is closer to that of last two years as opposed to earlier figures which included unprofitable businesses.

Insteel Industries was a long time stock market laggard with stock price languishing around at around $1 until early 2004. The company has been able to significantly improve its profitability primarily through divestiture of unprofitable nail business and subsequent recovery of gross margins which resulted in an impressive rise to an all time high of $25 and subsequent pull back to current level of $16 due to temporarily deteriorating business conditions. The fact that Insteel has been able to generate over $4 per share in operating profits in 2005 speaks volumes about its long term profitability potential. FY 2005 represented a period in which its unit sales dropped by 15% yet the company was still able to maintain 17% gross margins and generate a healthy profit as a result of its low cost model.
On normalized basis Insteel’s gross margins should decrease from current levels to a five year average 12%. A portion of an increase in the gross margin is due to higher than normal spread between the price of raw materials and final product. Historically those spreads compressed due to irrational competition within industry. However valuation is supported by upcoming cyclical upswings in commercial and road construction. In order to be conservative, I assumed a 30% reduction in sale over next two years to reflect possible falling steel prices. Even with these conservative assumptions earnings power supports share price up to $21. Despite a significant run up in the last two years, this scenario suggests that the downside for Insteel shares is quiet limited. On the other hand the upside is more than 100% since it is likely that the company would actually be able to keep their EBIT closer to the current level of 40M due to cyclical upswing in demand and earnings contribution from new products.