Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
Friedman Industries, Incorporated is a manufacturer and processor of steel products and operates in two reportable segments; coil products and tubular products.
The coil product segment includes the operation of two hot-roll coil processing facilities; one in Hickman, Arkansas and the other in Decatur, Alabama. Each facility operates a temper mill and a cut-to-length line. The temper mill improves the flatness and surface qualities of the coils and the cut-to-length line levels the steel and cuts the coils into sheet and plate of prescribed lengths. Combined, the facilities are capable of cutting sheet and plate with thicknesses ranging from 14 gauge to ½” thick. The coil product segment sells its prime grade inventory under the Friedman Industries name but also maintains an inventory of non-standard coil products, consisting primarily of mill secondary and excess prime coils, which are sold through the Company’s XSCP division. The coil product segment also processes customer-owned coils on a fee basis. Effective April 1, 2018, the Company changed the inventory valuation method for the coil segment’s prime coil inventory from the LIFO method to the average cost method. The impact of this change in accounting principle to both the current quarter and, as applied retrospectively, to the comparable quarter of the prior fiscal year are disclosed in Note B of this quarterly report on Form 10-Q. Prior period information provided in this Management’s Discussion and Analysis has been updated to reflect the retrospective application of the change in accounting principle.
The tubular product segment consists of the Company’s Texas Tubular Products division (“TTP”) located in Lone Star, Texas. TTP operates two electric resistance welded pipe mills with a combined outside diameter (“OD”) size range of 2 3/8” OD to 8 5/8” OD. Both pipe mills are American Petroleum Institute (“API”) licensed to manufacture line pipe and oil country pipe and also manufacture pipe for structural purposes that meets other recognized industry standards. TTP has a pipe finishing facility that threads and couples oil country tubular goods and performs other services that are customary in the pipe finishing process. The pipe finishing facility is API licensed and focuses on threading semi-premium connections. TTP’s inventory consists of raw materials and finished goods. Raw material inventory consists of hot-rolled steel coils that TTP will manufacture into pipe. Finished goods inventory consists of pipe TTP has manufactured and new mill reject pipe that TTP purchases from U.S. Steel Tubular Products, Inc. (“USS”).
Results of Operations
Three Months Ended June 30, 201
8
Compared to Three Months Ended June 30, 201
7
During the three months ended June 30, 2018, sales, costs of goods sold and gross profit increased $25,110,049, $20,460,881 and $4,649,168, respectively, compared to the amounts recorded during the three months ended June 30, 2017. The increase in sales was related to both an increase in tons sold and an increase in the average per ton selling price. Tons sold increased approximately 81% from approximately 33,500 tons in the 2017 quarter to approximately 60,500 tons in the 2018 quarter. Discussion of the sales improvement is expanded upon at the segment level in the following paragraphs. Gross profit as a percentage of sales increased from approximately 6.7% in the 2017 quarter to approximately 12.8% in the 2018 quarter.
Coil Segment
Coil product segment sales for the 2018 quarter totaled $31,129,200 compared to $18,009,835 for the 2017 quarter, representing a sales increase of $13,119,365 or approximately 73%. For a more complete understanding of the average selling prices of goods sold, it is helpful to isolate sales generated from processing of customer owned material and sales generated from coil segment inventory. Sales generated from processing of customer owned material totaled $242,711 for the 2018 quarter compared to $365,641 for the 2017 quarter. Sales generated from coil segment inventory totaled $30,886,489 for the 2018 quarter compared to $17,644,194 for the 2017 quarter. The increase in coil segment sales was driven by an increase in tons shipped from inventory and an increase in the average selling price per ton for these shipments. Inventory tons sold increased from approximately 26,500 tons in the 2017 quarter to approximately 36,000 tons in the 2018 quarter. The average per ton selling price related to these shipments increased from approximately $670 per ton in the 2017 quarter to approximately $853 per ton in the 2018 quarter. The improved shipping volume for the 2018 quarter is attributable to increased demand among many of the segment’s customers and is also attributable to an increase in the number of customers sold. Coil segment operations recorded operating profits of approximately $3,179,000 and $1,033,000 in the 2018 and 2017 quarters, respectively. Management expects coil segment shipping volume in the second quarter to be similar to the first quarter volume but expects a slight contraction in margins for the second quarter as compared to the first quarter.
The Company’s coil segment purchases its inventory from a limited number of suppliers. Loss of any of these suppliers could have a material adverse effect on the Company’s business.
Tubular Segment
Tubular product segment sales for the 2018 quarter totaled $17,064,118 compared to $5,073,434 for the 2017 quarter, representing a sales increase of $11,990,684 or approximately 236%. For a more complete understanding of the average selling prices of goods sold, it is helpful to isolate sales generated from the finishing of customer owned pipe and sales generated from tubular segment inventory. Sales generated from finishing of customer owned pipe totaled $687,870 for the 2018 quarter compared to $518,064 for the 2017 quarter. Sales generated from tubular segment inventory totaled $16,376,248 for the 2018 quarter compared to $4,555,370 for the 2017 quarter. The increase in tubular segment sales was driven by an increase in tons shipped from inventory and an increase in the average selling price per ton for these shipments. Tons sold increased from approximately 7,000 tons in the 2017 quarter to approximately 24,500 tons in the 2018 quarter. The average per ton selling price related to these shipments increased from approximately $637 per ton in the 2017 quarter to approximately $670 per ton in the 2018 quarter. The tubular segment recorded an operating profit of approximately $2,321,000 for the 2018 quarter compared to an operating loss of approximately $1,000 for the 2017 quarter.
Management believes the improved tubular results are primarily related to the sustained recovery of the U.S. energy industry and the segment’s new product offering of API line pipe. Late in the third quarter of fiscal 2018, TTP began actively producing, marketing and selling line pipe directly to distributors. Shipments of line pipe during the 2018 quarter totaled approximately 6,000 tons, or approximately 34%, of the 17,500 ton increase in tubular sales volume. Management expects line pipe sales to be a significant component of total tubular segment sales moving forward. Management expects second quarter line pipe shipments to slightly exceed the first quarter volume.
Shipments of mill reject pipe during the 2018 quarter totaled approximately 14,000 tons compared to 3,000 tons during the 2017 quarter, accounting for approximately 63% of the 17,500 ton increase in tubular sales volume. The increased shipping volume of mill reject pipe is due to improved demand and a concentrated effort to reduce the level of inventory. Based on current orders and the continued effort to achieve desired inventory levels, management expects shipping volume of mill reject pipe in the second quarter to be similar to the first quarter volume. Management currently expects a decline in volume during the third quarter as desired inventory levels are achieved.
Due to uncertainty in the market and fluctuations in our customers' needs, management expects revenue related to the finishing of customer owned pipe to be reduced in the second quarter as compared to the first quarter revenue.
USS has been the primary supplier of new mill reject pipe to the Company. In March 2016, USS announced it was temporarily idling pipe production at its Lone Star Tubular Operations facility due to weak market conditions. In December 2016, USS announced plans to permanently idle its #1 pipe mill at the Lone Star facility. In May 2017, USS resumed production at its Lone Star facility’s #2 pipe mill. The Company expects the volume and size range of new mill reject pipe supply from USS to be reduced given the permanent idling of the Lone Star facility’s #1 pipe mill. USS is also a significant customer of the tubular segment’s pipe-finishing facility. Loss of USS as a supplier or customer could have a material adverse effect on the Company’s business. The Company can make no assurances as to orders from USS or the amount of supply that will be available from USS in the future. In general, the tubular segment purchases its inventory from a limited number of suppliers. Loss of any of these suppliers could have a material adverse effect on the Company’s business.
General, Selling and Administrative Costs
During the 2018 quarter, general, selling and administrative costs increased $454,346 compared to the 2017 quarter. This increase was related primarily to increases in bonuses and commissions associated with the increased earnings and sales volume.
Income Taxes
Income taxes in the 2018 quarter increased $1,017,659 from the amount recorded in the 2017 quarter. This increase was related primarily to the increase in earnings before taxes for the 2018 quarter compared to the 2017 quarter but partially offset due to effects of the Tax Cuts and Jobs Act (the “Tax Act”) that was enacted by the U.S. government on December 22, 2017. The Tax Act reduced the federal corporate tax rate applicable to the Company from 34% to 21% effective January 1, 2018.
FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES
The Company remained in a strong, liquid position at June 30, 2018. The current ratios were 3.8 at June 30, 2018 and 6.1 at March 31, 2018. Working capital was $59,968,313 at June 30, 2018, and $56,238,771 at March 31, 2018.
During the quarter ended June 30, 2018, the Company maintained assets and liabilities at levels it believed were commensurate with operations. Changes in balance sheet amounts occurred in the ordinary course of business. Cash decreased primarily as a result of an increase in inventory. The balance of accounts payable and inventory rose considerably due to the volume and timing of inventory purchases for both the Company’s coil and tubular segments. The Company expects to continue to monitor, evaluate and manage balance sheet components depending on changes in market conditions and the Company’s operations.
In December 2017, the Company put into place a $7,500,000 revolving line of credit facility (the “Credit Facility”) that expires December 11, 2018. At June 30, 2018, the Company had no borrowings outstanding under the Credit Facility. Subsequent to quarter-end, the Company borrowed funds under the Credit Facility and as of the filing date of this quarterly report on Form 10-Q, the balance under the credit facility is $2,500,000 with an applicable interest rate of 4.45%. The Company was not in violation of any terms or covenants related to the Credit Facility as of the filing date of this quarterly report on Form 10-Q.
The Company believes that its current cash position along with cash flows from operations and borrowing capability due to its financial position are adequate to fund its expected cash requirements for the next 24 months.
CRITICAL ACCOUNTING POLICIES
The preparation of consolidated financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Significant estimates that are subject to the Company’s assumptions include the determination of useful lives for fixed assets and determination of the allowance for doubtful accounts. The determination of useful lives for depreciation of fixed assets requires the Company to make assumptions regarding the future productivity of the Company’s fixed assets. The allowance for doubtful accounts requires the Company to draw conclusions on the future collectability of the Company’s accounts receivable. Actual results could differ from these estimates.
FORWARD-LOOKING STATEMENTS
From time to time, the Company may make certain statements that contain forward-looking information (as defined in the Private Securities Litigation Reform Act of 1996, as amended) and that involve risk and uncertainty. These forward-looking statements may include, but are not limited to, future results of operations, future production capacity, product quality and proposed expansion plans. Forward-looking statements may be made by management orally or in writing including, but not limited to, this Management’s Discussion and Analysis of Financial Condition and Results of Operations and other sections of the Company’s filings with the U.S. Securities and Exchange Commission (the “SEC”) under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Actual results and trends in the future may differ materially depending on a variety of factors including, but not limited to, changes in the demand for and prices of the Company’s products, changes in the demand for steel and steel products in general and the Company’s success in executing its internal operating plans, including any proposed expansion plans.