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. The Hickman 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. The Hickman facility is capable of cutting sheet and plate with thicknesses ranging from 14 gauge to ½” thick in widths ranging from 36” wide to 72” wide. The Decatur facility previously operated a temper mill and a cut-to-length line but during the quarter ended June 30, 2020, the equipment was removed to allow the foundation to be prepared for a new stretcher leveler line that will be installed. Installation commenced in December 2020 and commercial use is expected to start in March 2021. The estimated total cost of this project is $7,200,000 with approximately $6,479,000 having been spent as of December 31, 2020. The new equipment will expand the coil segment’s processing capabilities to include material up to 96” wide and material of higher grades and will allow the Decatur facility to cut material that is up to ½” thick compared to the previous equipment’s capability of 5/16” thick. In addition, sheet and plate that has been stretcher leveled is preferable to some customers and applications compared to material that has been leveled through the temper mill process. 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.
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 an API licensed 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 currently idled due to market conditions. 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 that TTP has manufactured and new mill reject pipe that TTP purchased from U.S. Steel Tubular Products, Inc.
COVID-19 Update
In March 2020, the World Health Organization declared the novel strain of coronavirus (“COVID-19”) a global pandemic. In addition to the devastating effects on human life, this contagious virus has adversely affected economies globally. It has also disrupted the normal operations of many businesses, including ours and many of our customers. Our facilities have continued to operate during this crisis but we are operating with modifications to our facility practices, employee travel, employee work locations and virtualization or cancellation of company and customer events, among other modifications. We may take further actions that alter our business operations as the situation evolves. There are no comparable events that provide guidance as to the effect the COVID-19 pandemic may have, and, as a result, the ultimate effect of the pandemic is highly uncertain and subject to change. We do not yet know the full extent of the effects on the economy, the markets we serve, our business or our operations.
Results of Operations
Nine Months Ended December 31, 2020 Compared to Nine Months Ended December 31, 2019
During the nine months ended December 31, 2020 (the “2020 period”), sales and costs of goods sold decreased $32,233,388 and $37,335,481, respectively, and gross profit increased $5,102,093 compared to the amounts recorded during the nine months ended December 31, 2019 (the “2019 period”). The decrease in sales was related to both a decline in tons sold and a decrease in the average per ton selling price. Tons sold decreased from approximately 157,500 tons in the 2019 period to approximately 125,000 tons in the 2020 period. The drop in volume was primarily attributable to economic impacts of COVID-19. Discussion of the change in sales is expanded upon at the segment level in the following paragraphs. Gross profit as a percentage of sales increased from approximately 0.7% in the 2019 period to approximately 7.6% in the 2020 period. Our operating results are significantly impacted by the market price of hot-rolled steel coil. The improved results for the 2020 period were driven by increasing steel prices in the back half of the period while the 2019 period was negatively impacted by declining steel prices throughout the period. During August 2020 hot-rolled steel pricing started to rise and as of the end of the 2020 period, pricing had increased approximately 124%. The impact of this rise in steel prices on each of our segments is discussed further in the following paragraphs. Results for the 2020 period also benefitted from gains on hot-rolled steel derivative contracts of approximately $401,000 that were reported as a reduction of costs of goods sold within the coil segment. The use of derivative instruments to manage the commodity price risk inherent in our business is a new practice for the 2020 period. Additional information related to our derivative instruments is provided in Note H. The company did not have any derivative instruments in the 2019 period.
Coil Segment
Coil product segment sales for the 2020 period totaled $55,561,017 compared to $77,603,435 for the 2019 period. 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 $634,894 for the 2020 period compared to $578,891 for the 2019 period. Sales generated from coil segment inventory totaled $54,926,123 for the 2020 period compared to $77,024,544 for the 2019 period. Inventory tons sold decreased from approximately 115,500 tons in the 2019 period to approximately 92,500 tons in the 2020 period. The average per ton selling price related to these shipments decreased from approximately $667 per ton in the 2019 period to approximately $594 per ton in the 2020 period. Coil segment operations recorded operating profits of approximately $3,529,000 and $575,000 for the 2020 and 2019 periods, respectively. Operating results for the 2020 period were negatively impacted during the first six months by a decline in volume primarily related to the impacts of the COVID-19 pandemic and by declining steel prices. In the last three months of the 2020 period, operating results benefitted from steady margin improvement associated with the rapidly increasing steel prices. The 2020 period benefitted additionally from the gains on hot-rolled steel derivative contracts mentioned above. The 2019 period was negatively impacted by a general decline in steel prices throughout the period.
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 2020 period totaled $21,327,312 compared to $31,518,282 for the 2019 period. Sales declined due to both a reduction in the volume sold and a decrease in the average selling price per ton. Tons sold decreased from approximately 42,000 tons in the 2019 period to approximately 32,500 tons in the 2020 period. The average per ton selling price related to these shipments decreased from approximately $750 per ton in the 2019 period to approximately $658 per ton in the 2020 period. The tubular segment operations recorded operating losses of approximately $16,000 and $1,670,000 for the 2020 and 2019 periods, respectively. Operating results for the 2020 period were negatively impacted by the effect of declining steel prices, a decline in volume primarily related to impacts of the COVID-19 pandemic and challenging conditions for the U.S. energy industry. Tubular segment margins do not respond as quickly to changes in steel price when compared to the way coil segment margins respond. Tubular segment margins did not see significant improvement until December 2020 due to the longer manufacturing lead time associated with tubular products and soft energy industry demand. The 2019 period was negatively impacted by a general decline in steel prices throughout the period. Operating results for both the 2020 and 2019 periods were also negatively impacted by inventory write downs related to the segment's manufactured pipe inventory. In the 2020 period there was a write down of $274,093 at June 30, 2020 and in the 2019 period there was a write down of $955,605 at September 30, 2019.
The Company’s 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. In March 2020, U.S. Steel announced the idling of their Lone Star Tubular Operations which is our sole supplier of mill reject pipe. At December 31, 2020, we had approximately 26,000 tons of mill reject inventory which we believe to be approximately two years of inventory. We expect the idling to have a negative impact on our operations as we eventually sell out of inventory.
General, Selling and Administrative Costs
During the 2020 period, general, selling and administrative costs increased $856,155 compared to the 2019 period. The increase was related primarily to increased payroll, professional fees and restricted stock plan compensation expense.
Income Taxes
Income taxes increased from a benefit for the 2019 period of $678,043 to a provision for the 2020 period of $298,668. This increase was related primarily to the shift from a loss before taxes for the 2019 period to having earnings before tax for the 2020 period.
Three Months Ended December 31, 2020 Compared to Three Months Ended December 31, 2019
During the three months ended December 31, 2020 (the “2020 quarter”), sales increased $351,232, costs of goods sold decreased $4,091,684 and gross profit increased $4,442,916 compared to the amounts recorded during the three months ended December 31, 2019 (the “2019 quarter”). The increase in sales was primarily related to an increase in the average selling price of the coil segment's products. This increase was partially offset by a lower average selling price for the tubular segment's products and a slight decline in overall tons sold. Tons sold decreased from approximately 45,500 tons in the 2019 quarter to approximately 43,500 tons in the 2020 quarter. Discussion of the change in sales is expanded upon at the segment level in the following paragraphs. Gross profit as a percentage of sales increased from approximately 0.2% in the 2019 quarter to approximately 15.8% in the 2020 quarter. Our operating results are significantly impacted by the market price of hot-rolled steel coil. The improved results for the 2020 quarter were driven by increasing steel prices prior to and throughout the quarter while the 2019 quarter was negatively impacted by declining steel prices preceding the quarter and during part of the quarter. During August 2020 hot-rolled steel pricing started to rise and as of the end of the 2020 quarter, pricing had increased approximately 124%. The impact of this rise in steel prices on each of our segments is discussed further in the following paragraphs. Results for the 2020 quarter also benefitted from gains on hot-rolled steel derivative contracts of approximately $397,000 that were reported as a reduction of costs of goods sold within the coil segment. Additional information related to our derivative instruments is provided in Note H. The company did not have any derivative instruments in the 2019 quarter.
Coil Segment
Coil product segment sales for the 2020 quarter totaled $21,672,147 compared to $21,001,358 for the 2019 quarter. 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 $244,860 for the 2020 quarter compared to $185,870 for the 2019 quarter. Sales generated from coil segment inventory totaled $21,427,287 for the 2020 quarter compared to $20,815,488 for the 2019 quarter. Inventory tons sold decreased from approximately 34,500 tons in the 2019 quarter to approximately 32,000 tons in the 2020 quarter. The average per ton selling price related to these shipments increased from approximately $600 per ton in the 2019 quarter to approximately $665 per ton in the 2020 quarter. Coil segment operations recorded an operating profit of approximately $3,238,000 for the 2020 quarter compared to an operating loss of approximately $93,000 for the 2019 quarter. Operating results for the 2020 quarter benefitted from a significant increase in steel prices and associated improvement in our margins. The 2020 quarter benefitted additionally from the gains on hot-rolled steel derivative contracts mentioned above. The 2019 quarter was negatively impacted by low margins associated with declines in hot-rolled steel prices.
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 2020 quarter totaled $6,829,902 compared to $7,149,459 for the 2019 quarter. Sales declined due primarily to a decrease in the average selling price per ton. Tons sold was approximately 11,000 tons in both the 2020 quarter and the 2019 quarter. The average per ton selling price related to these shipments decreased from approximately $646 per ton in the 2019 quarter to approximately $616 per ton in the 2020 quarter. The tubular segment operations recorded an operating profit of approximately $269,000 for the 2020 quarter and an operating loss of approximately $468,000 for the 2019 quarter. Even though steel prices increased significantly throughout the 2020 quarter, tubular segment margins did not see significant improvement until December 2020 due to the longer manufacturing lead time associated with tubular products and soft energy industry demand. Operating results for the 2019 quarter were negatively impacted by compressed margins associated with declining steel prices and weak energy industry conditions.
The Company’s 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. In March 2020, U.S. Steel announced the idling of their Lone Star Tubular Operations which is our sole supplier of mill reject pipe. At December 31, 2020, we had approximately 26,000 tons of mill reject inventory which we believe to be approximately two years of inventory. We expect the idling to have a negative impact on our operations as we eventually sell out of inventory.
General, Selling and Administrative Costs
During the 2020 quarter, general, selling and administrative costs increased $524,750 compared to the 2019 quarter. The increase was related primarily to increased payroll, professional fees and restricted stock plan compensation expense.
Income Taxes
Income taxes increased from a benefit for the 2019 quarter of $264,550 to a provision for the 2020 quarter of $639,152. This increase was related primarily to the shift from a loss before taxes for the 2019 quarter to having earnings before tax for the 2020 quarter.
Outlook
During August 2020 hot-rolled steel pricing started to rise and has continued a significant increase of approximately 165% as of the filing date of this Form 10-Q. Our coil segment margins experienced improvement throughout the third quarter and we expect the fourth quarter to have strong margins. Our tubular segment margins do not respond as quickly to the fluctuations in steel price but we did see significant improvement in December 2020 and we expect that margin strength to continue during the fourth quarter. We expect both coil segment and tubular segment sales volumes for the fourth quarter to be slightly higher than the third quarter volumes.
FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES
The Company’s current ratio was 7.5 at December 31, 2020 and 6.8 at March 31, 2020. Working capital was $55,706,092 at December 31, 2020 and $55,566,158 at March 31, 2020.
During the nine months ended December 31, 2020, 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 from the purchase of property, plant and equipment, payment of cash dividends and the repurchase of common stock partially offset by cash provided by operating activities and from Paycheck Protection Program loan proceeds. 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 April 2020, the Company received a $1,690,385 loan (the “PPP Loan”) from JPMorgan Chase Bank, N.A. (the “Bank”), under the Paycheck Protection Program, which was established under the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), as modified by the Paycheck Protection Flexibility Act of 2020 (the “PPP Flexibility Act”). The term of the PPP Loan is two years from the funding date of the PPP Loan. The interest rate on the PPP Loan is 0.98%. Under the terms of the PPP Loan, interest accrues from the funding date of the PPP Loan but payments of both principal and interest payments are deferred for six months. Pursuant to the terms of the CARES Act, the Company can apply for and may be granted forgiveness for all or a portion of the PPP Loan, if and to the extent that the Company satisfies certain requirements. Such forgiveness is subject to use of the PPP Loan proceeds for qualifying purposes and is also subject to maintenance or achievement of certain employee and compensation levels. While the Company plans to apply for forgiveness of the PPP Loan in accordance with the requirements and limitations under the CARES Act, the PPP Flexibility Act and the Small Business Administration ("SBA") regulations and requirements, no assurance can be given that all or any portion of the PPP Loan will be forgiven. Additional deferment of both principal and interest payments has been granted to provide ample time to submit a loan forgiveness application. As of the filing date of this Form 10-Q, the Bank has paused their processing of forgiveness applications while they and the SBA make modifications to their systems and processes based on new provisions. We plan to submit a forgiveness application as soon as allowed.
On June 25, 2020, our Board of Directors authorized a share repurchase program under which the Company may repurchase up to 1,062,067 shares of the Company’s outstanding common stock through June 30, 2023, which equates to 15% of the Company’s outstanding shares of common stock as of June 25, 2020. As of December 31, 2020, we have repurchased 180,200 shares at a total cost of $1,143,356. Repurchases under the program may be made from time to time at the Company’s discretion and may be made in open market transactions, through block trades, in privately negotiated transactions and pursuant to any trading plan that may be adopted by the Company’s management in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934, as amended, or otherwise. The timing and actual number of shares repurchased pursuant to the program will depend on a variety of factors including price, corporate and regulatory requirements, market conditions and other corporate liquidity requirements and priorities. The repurchase program does not obligate the Company to acquire a specific dollar amount or number of shares and may be modified, suspended or discontinued at any time.
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 12 months.
CRITICAL ACCOUNTING ESTIMATES
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Significant estimates that are subject to the Company’s assumptions include the fair value of the pipe-finishing facility, determination of useful lives for fixed assets, determination of the allowance for doubtful accounts and the determination of net realizable value relative to inventory. The fair value determination of the pipe-finishing facility requires assumptions related to future operations of the facility and estimates related to the replacement cost and value in exchange for the assets. 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. The determination of net realizable value when reviewing inventory value requires the Company to make assumptions concerning sales trends, customer demand and steel industry market conditions. 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 government policy regarding steel, changes in the demand for steel and steel products in general and the Company’s success in executing its internal operating plans, changes in and availability of raw materials, unplanned shutdowns of our production facilities due to equipment failures or other issues, increased competition from alternative materials and risks concerning innovation, new technologies, products and increasing customer requirements. 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.