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 fiscal year periods and, as applied retrospectively, to the comparable periods of the prior fiscal year are disclosed in Note B of the consolidated financial statements. 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
Nine Months Ended December 31, 201
8
Compared to Nine Months Ended December 31, 201
7
During the nine months ended December 31, 2018 (the “2018 period”), sales, costs of goods sold and gross profit increased $67,756,927, $60,457,679 and $7,299,248, respectively, from the comparable amounts recorded during the nine months ended December 31, 2017 (the “2017 period”). 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 53% from approximately 114,500 tons in the 2017 period to approximately 175,500 tons in the 2018 period. 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 6.2% in the 2017 period to approximately 8.3% in the 2018 period.
Coil Segment
Coil product segment sales for the 2018 period totaled $94,688,636 compared to $60,547,245 for the 2017 period, representing a sales increase of $34,141,391 or approximately 56%. 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 $906,209 for the 2018 period compared to $947,651 for the 2017 period. Sales generated from coil segment inventory totaled $93,782,427 for the 2018 period compared to $59,599,594 for the 2017 period. 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 90,000 tons in the 2017 period to approximately 105,500 tons in the 2018 period. The average per ton selling price related to these shipments increased from approximately $661 per ton in the 2017 period to approximately $890 per ton in the 2018 period. The improved shipping volume for the 2018 period is attributable to increased demand among many of the segment’s customers. Management believes the demand improvement was primarily related to the effects of the U.S. government’s Section 232 steel trade actions, sustained improvement of the U.S. energy industry and the steel industry and U.S. economic conditions in general. Coil segment operations recorded operating profits of approximately $5,847,000 and $2,942,000 in the 2018 and 2017 periods, respectively.
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 period totaled $50,262,791 compared to $16,647,255 for the 2017 period, representing a sales increase of $33,615,536 or approximately 202%. 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 $837,000 for the 2018 period compared to $1,664,256 for the 2017 period. Sales generated from tubular segment inventory totaled $49,425,791 for the 2018 period compared to $14,982,999 for the 2017 period. 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 24,500 tons in the 2017 period to approximately 70,000 tons in the 2018 period. The average per ton selling price related to these shipments increased from approximately $616 per ton in the 2017 period to approximately $704 per ton in the 2018 period. Tubular segment operations recorded operating profits of approximately $4,348,000 and $261,000 in the 2018 and 2017 periods, respectively.
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 period totaled approximately 20,500 tons compared to approximately 2,000 tons in the 2017 period, accounting for approximately 41% of the 45,500 ton increase in total tubular sales volume. Management expects line pipe sales to be a significant component of total tubular segment sales moving forward.
Shipments of mill reject pipe during the 2018 period totaled approximately 38,000 tons compared to approximately 11,500 tons during the 2017 period, accounting for approximately 58% of the 45,500 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.
Due to fluctuations in our customers’ needs, revenue related to the finishing of customer owned pipe decreased $827,256 in the 2018 period compared to the 2017 period.
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. In February 2019, USS announced plans to restart its Lone Star facility’s #1 pipe mill early in their third quarter of 2019. The Company expects the volume and size range of new mill reject pipe supply from USS to be reduced while the Lone Star facility’s #1 pipe mill remains idle. 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. 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 period, general, selling and administrative costs increased $874,140 compared to the 2017 period. 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 period increased $1,133,567 from the amount recorded in the 2017 period. This increase was related primarily to the increase in earnings before taxes for the 2018 period compared to the 2017 period 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.
Three Months Ended December 31, 201
8
Compared to Three Months Ended December 31, 201
7
During the three months ended December 31, 2018 (the “2018 quarter”), sales, costs of goods sold and gross profit increased $15,292,559, $15,086,609 and $205,950, respectively, compared to the amounts recorded during the three months ended December 31, 2017 (the “2017 quarter”). 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 23% from approximately 42,000 tons in the 2017 quarter to approximately 51,500 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 decreased from approximately 6.2% in the 2017 quarter to approximately 4.5% in the 2018 quarter.
Coil Segment
Coil product segment sales for the 2018 quarter totaled $28,730,992 compared to $22,409,571 for the 2017 quarter, representing a sales increase of $6,321,421 or approximately 28%. 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 $305,289 for the 2018 quarter compared to $356,643 for the 2017 quarter. Sales generated from coil segment inventory totaled $28,425,703 for the 2018 quarter compared to $22,052,928 for the 2017 quarter. The increase in coil segment sales was driven by an increase in the average selling price per ton of material from inventory partially offset by a decrease in the volume of these shipments. The average per ton selling price related to these shipments increased from approximately $658 per ton in the 2017 quarter to approximately $905 per ton in the 2018 quarter. Inventory tons sold decreased from approximately 33,500 tons in the 2017 quarter to approximately 31,500 tons in the 2018 quarter. Coil segment operations recorded operating profits of approximately $744,000 and $1,233,000 in the 2018 and 2017 quarters, respectively.
The average selling price for the 2018 quarter was significantly higher than the 2017 quarter due to increased hot-rolled steel prices primarily associated with initial speculation and reaction to the U.S. government’s Section 232 steel trade actions and general steel industry and U.S. economic conditions. The price of hot-rolled steel increased steadily and significantly from the 2017 quarter and leading up to October 2018, the start of the 2018 quarter. During the 2018 quarter, hot-rolled steel prices decreased significantly and continued to decline into the Company’s fourth quarter. Management believes the decline in steel prices during the 2018 quarter was primarily associated with market participants managing inventory levels, temporary softness in the U.S. energy industry and uncertainty surrounding the volume and impact of foreign steel products at the start of 2019. As a result of the declining steel prices, the coil product segment experienced downward price pressure from its customers during the 2018 quarter. This downward price pressure combined with higher cost inventory making its way through cost of goods sold resulted in coil product segment margins contracting compared to the second quarter. Management expects further margin pressure in the fourth quarter due to steel prices continuing to decline during the first half of the fourth quarter. Around the start of February 2019, most domestic steel producers announced price increases for their products. Management believes the coil product segment’s margin compression will reverse if these price increases gain traction but the increases will take time to make their way through the supply chain to the consumers of the Company’s products. Management expects fourth quarter sales volume for the coil product segment to slightly exceed the third quarter volume.
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 $14,595,088 compared to $5,623,950 for the 2017 quarter, representing a sales increase of $8,971,138 or approximately 160%. 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 $66,734 for the 2018 quarter. There was no revenue generated from finishing of customer owned pipe during the 2017 quarter. Sales generated from tubular segment inventory totaled $14,528,354 for the 2018 quarter compared to $5,623,950 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 8,500 tons in the 2017 quarter to approximately 20,000 tons in the 2018 quarter. The average per ton selling price related to these shipments increased from approximately $648 per ton in the 2017 quarter to approximately $723 per ton in the 2018 quarter. Tubular segment operations recorded an operating profit of approximately $650,000 in the 2018 quarter and an operating loss of approximately $53,000 in 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 6,500 tons compared to approximately 2,000 tons in the 2017 quarter, accounting for approximately 39% of the 11,500 ton increase in total tubular sales volume. Management expects line pipe sales to be a significant component of total tubular segment sales moving forward.
Shipments of mill reject pipe during the 2018 quarter totaled approximately 10,500 tons compared to 4,000 tons during the 2017 quarter, accounting for approximately 57% of the 11,500 ton increase in total 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.
Revenue related to the finishing of customer owned pipe was $66,734 for the 2018 quarter. No revenue was generated from the finishing of customer owned pipe during the 2017 quarter. For the fourth quarter, management expects a low level of activity similar to that of the third quarter. These revenues are generated at the Company’s pipe finishing facility that commenced operations in May 2017. The facility is designed to function optimally as a high volume processing facility with a small customer base. Operations at the facility have been sporadic as new customer relationships evolve and due to some fluctuation in the energy industry and the steel industry in general. In addition to cultivating existing customer relationships, management continues to seek additional customers that are a strategic fit for the facility. Management will continue to evaluate the long-term operating potential of the facility on a continual basis.
Compared to the second quarter, the tubular segment also experienced margin compression during the third quarter related to the decline in hot-rolled steel prices and higher cost inventory making its way through cost of goods sold. Management expects continued margin compression into the fourth quarter associated with these factors and additional pressure on selling prices due to an increased presence of foreign material associated with Section 232 quotas resetting at the start of 2019.
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. In February 2019, USS announced plans to restart its Lone Star facility’s #1 pipe mill early in their third quarter of 2019. The Company expects the volume and size range of new mill reject pipe supply from USS to be reduced while the Lone Star facility’s #1 pipe mill remains idle. 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. 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.
Income Taxes
Income taxes in the 2018 quarter decreased $343,873 from the amount recorded in the 2017 quarter. This decrease was related primarily to the 2017 quarter containing the impact from re-measuring deferred tax assets and liabilities pursuant to the Tax Act enacted during the 2017 quarter. The decrease is also associated with the Tax Act reducing the federal corporate tax rate applicable to the Company from 34% to 21% effective January 1, 2018. These circumstances contributing to decreased income taxes were partially offset by the increase in earnings before tax for the 2018 quarter.
FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES
We believe the Company remained in a strong, liquid position at December 31, 2018. The ratio of current assets to current liabilities was 4.5 and 6.1 at December 31, 2018 and March 31, 2018, respectively. Working capital was $62,024,110 at December 31, 2018 and $56,238,771 at March 31, 2018.
At December 31, 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 the purchase of inventory, the purchase of property, plant and equipment and the payment of cash dividends partially offset by net earnings and an increase in accounts payable. 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 2018, the Company’s $7,500,000 revolving line of credit facility expired and the Company put into place a new $5,000,000 revolving line of credit facility (the “Credit Facility”) that expires December 12, 2019. Access to funds under the Credit Facility is subject to a borrowing base requirement. The borrowing base is calculated as 80% of eligible tubular segment accounts receivable plus 40% of eligible tubular segment inventory. The total amount contributed to the borrowing base by eligible inventory shall not exceed $3,000,000. At December 31, 2018 and as of the filing date of this quarterly report on Form 10-Q, the borrowing base calculations would allow the Company access to the full $5,000,000 available under the Credit Facility. At December 31, 2018 and as of the filing date of this quarterly report on Form 10-Q, the Company had no borrowings outstanding under the Credit Facility. 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 operating cash flow potential 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 the 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.
CAUTIONARY NOTE REGARDING 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. Such statements may include those risks disclosed in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of this report. These forward-looking statements may include, but are not limited to, future changes in the Company’s financial condition or 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”), including the Company’s Annual Report on Form 10-K and its other Quarterly Reports on Form 10-Q. Forward-looking statements include those preceded by, followed by or including the words “will,” “expect,” “intended,” “anticipated,” “believe,” “project,” “forecast,” “propose,” “plan,” “estimate,” “enable,” and similar expressions, including, for example, statements about our business strategy, our industry, our future profitability, growth in the industry sectors we serve, our expectations, beliefs, plans, strategies, objectives, prospects and assumptions, and estimates and projections of future activity and trends in the oil and natural gas industry. These forward-looking statements are not guarantees of future performance. These statements are based on management’s expectations that involve a number of business risks and uncertainties, any of which could cause actual results to differ materially from those expressed in or implied by the forward-looking statements. Although forward-looking statements reflect our current beliefs, reliance should not be placed on forward-looking statements because they involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance or achievements to differ materially from anticipated future results, performance or achievements expressed or implied by such forward-looking statements. 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. Accordingly, undue reliance should not be placed on our forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events, changed circumstances or otherwise, except to the extent law requires.