Friedman Industries Inc: Form 10-Q for the period ended Dec 31, 2023

Overview

Friedman Industries, Incorporated is a manufacturer and processor of steel products and operates in two reportable segments; flat-roll products and tubular products. The flat-roll segment was previously referred to as the coil segment. The Company is now using flat-roll to describe the segment due to it being a more common term used in the Company's industry.

The flat-roll product segment consists of the operation of five hot-rolled coil processing facilities located in Hickman, Arkansas; Decatur, Alabama; East Chicago, Indiana; Granite City, Illinois and Sinton, Texas. The facilities in Granite City and East Chicago were acquired on April 30, 2022 from Plateplus, Inc ("Plateplus"). More information about the Plateplus transaction can be found in Note B to the condensed consolidated financial statements. The facility in Sinton is a newly constructed facility that commenced operations during October 2022. The Hickman, Granite City and East Chicago facilities operate temper mills and cut-to-length lines. The Decatur and Sinton facilities operate stretcher leveler cut-to-length lines. The equipment at all locations improve the flatness and surface quality of the coils and cut the coils into sheet and plate of prescribed lengths. On a combined basis, the facilities are capable of cutting sheet and plate with thicknesses ranging from 16 gauge to 1” thick in widths ranging from 36” wide to 96” wide. The vast majority of flat-roll product segment revenue is generated from sales of Company owned inventory but the segment also generates revenue from the processing or storage of 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 a pipe finishing facility capable of applying threads and couplings to oil country tubular goods and performing other services that are customary in the pipe finishing process. The pipe finishing facility is currently idled. All of the tubular segment's revenue is generated from sales of Company owned inventory.

Results of Operations

Nine Months Ended December 31, 2023 Compared to Nine Months Ended December 31, 2022

During the nine months ended December 31, 2023 (the “2023 period”), sales and costs of goods sold decreased approximately $39.3 million and $42.4 million, respectively, and gross profit increased approximately $3.1 million compared to the amounts recorded during the nine months ended December 31, 2022 (the “2022 period”). The decrease in sales was primarily related to a decline in the average selling price per ton partially offset by an increase in sales volume. Sales volume for the 2023 period consisted of approximately 375,000 tons from inventory and another 72,000 tons of toll processing customer owned material compared to the 2022 period volume consisting of approximately 335,000 tons from inventory and 34,000 tons of toll processing. The growth in sales volume was primarily related to the Sinton, TX facility operating for the full 2023 period compared to commencing operations during October 2022 of the 2022 period. Gross profit increased from approximately $29.5 million for the 2022 period to approximately $32.6 million for the 2023 period. Gross profit as a percentage of sales increased from approximately 7.0% for the 2022 period to approximately 8.5% for the 2023period. Gross profit for the 2023 period included a recognized loss of approximately $0.4 million related to hedging activities while gross profit for the 2022 period included a recognized loss of approximately $3.0 million related to hedging activities. Excluding the recognized hedging losses, gross profit related to physical material as a percentage of sales was approximately 8.6% for the 2023 period compared to approximately 7.6% for the 2022 period.

Our operating results are significantly impacted by the market price of hot-rolled steel coil ("HRC"). The Company experienced significant volatility in steel price during both the 2023 period and the 2022 period. Entering the 2022 period, HRC prices experienced a sharp and abrupt increase in reaction to the Russian invasion of Ukraine increasing approximately 60% from March 2022 to April 2022. HRC prices then declined approximately 60% until the middle of December 2022. From late November 2022 until April 2023, domestic steel producers announced several rounds of price increases with HRC prices increasing approximately 95% during this time. From the middle of April 2023 and until early October 2023, HRC prices declined approximately 45%. From early October 2023 through the end of the 2023 period, HRC prices increased approximately 66%. For both the 2023 and 2022 periods, the Company experienced significant increases in steel prices entering the periods with an inflection point in steel price occurring early in each period. As a result both periods experienced similar margin dynamics with stronger margins for the first quarter followed by lower margins for the second quarter and entering the third quarter with margin improvement towards the end of the third quarter.

Flat-roll Segment

Flat-roll product segment sales for the 2023 period totaled approximately $352.1 million compared to approximately $372.8 million for the 2022 period. For a more complete understanding of the average selling prices of goods sold, it is helpful to exclude any hedging related gains or losses that are captured in sales and any sales generated from processing or storage of customer owned material. Flat-roll segment sales for the 2023 period were reduced by approximately $0.4 million for the recognition of hedging related losses. Flat-roll segment sales for the 2022 period were reduced by approximately $3.0 million for the recognition of hedging related losses. Sales generated from processing or storage of customer owned material totaled approximately $3.6 million for the 2023 period compared to approximately $1.0 million for the 2022 period. Sales generated from flat-roll segment inventory, excluding the impact of any hedging related gains or losses, totaled approximately $348.9 million for the 2023 period compared to approximately $374.8 million for the 2022 period. The average per ton selling price related to these shipments decreased from approximately $1,222 per ton in the 2022 period to approximately $995 per ton in the 2023 period. Flat-roll segment sales volume for the 2023 period consisted of approximately 351,000 tons from inventory and another 72,000 tons of toll processing customer owned material compared to the 2022 period volume consisting of approximately 306,500 tons from inventory and 34,000 tons of toll processing. The growth in sales volume was primarily related to the Sinton, TX facility operating for the full 2023 period compared to commencing operations during October 2022 of the 2022 period. Flat-roll segment operations recorded operating profits of approximately $23.6 million and $15.7 million for the 2023 period and 2022 period, respectively. The operating profit for the 2023 period includes a recognized loss on hedging activities of approximately $0.4 million while the 2022 period operating profit included a recognized loss on hedging activities of approximately $3.0 million.

The Company’s flat-roll 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 2023 period totaled approximately $31.9 million compared to approximately $50.5 million for the 2022 period. Tubular segment sales for the 2023 period and 2022 period were not impacted by any hedging related gains or losses. Sales decreased due to a decrease in the average selling price per ton, accompanied by a decline in the volume sold. The average per ton selling price decreased from approximately $1,785 per ton in the 2022 period to approximately $1,319 per ton in the 2023 period. Tons sold decreased from approximately 28,500 tons in the 2022 period to approximately 24,000 tons in the 2023 period. The tubular segment recorded operating profits of approximately $2.2 million and $6.1 million for the 2023 period and 2022 period, respectively.

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 2023 period, selling, general and administrative costs decreased approximately $0.7 million compared to the 2022 period. This decrease is primarily related to the 2022 period containing one-time costs associated with the Plateplus transaction with this decrease being partially offset by increased payroll and benefits expense in the 2023 period associated with a higher employee count.

Income Taxes

Income taxes decreased from a provision for the 2022 period of approximately $4.6 million to a provision for the 2023 period of approximately $3.8 million. This decrease was primarily related to the lower earnings before income tax for the 2023 period. The income tax provision as a percentage of earnings before tax was approximately 23.4% and 23.6% for the 2023 period and 2022 period, respectively. For both periods, the effective tax rate differed from the federal statutory rate due primarily to the inclusion of state income taxes in the provision.

Three Months Ended December 31, 2023 Compared to Three Months Ended December 31, 2022

During the three months ended December 31, 2023 (the “2023 quarter”), sales increased approximately $4.1 million, costs of goods sold decreased approximately $0.2 million, and gross profit increased approximately $4.3 million compared to the amounts recorded during the three months ended December 31, 2022 (the “2022 quarter”). The increase in sales was primarily related to an increase in sales volume partially offset by a decrease in the average selling price per ton. Sales volume for the 2023 quarter consisted of approximately 118,000 tons from inventory and another 22,000 tons of toll processing customer owned material compared to the 2022 quarter volume consisting of approximately 113,000 tons from inventory and 13,000 tons of toll processing. The growth in sales volume was primarily related to the increased production at the Company's Sinton, TX facility which commenced operations in October 2022. Gross profit increased from approximately $6.1 million for the 2022 quarter to approximately $10.4 million for the 2023 quarter. Gross profit as a percentage of sales increased from approximately 5.5% for the 2022 quarter to approximately 9.0% for the 2023 quarter. Gross profit for the 2022 quarter included a recognized loss of approximately $0.9 million related to hedging activities, while the 2023 quarter gross profit was not impacted by any hedging activities. Excluding the recognized hedging losses, gross profit related to physical material as a percentage of sales was approximately 6.2% for the 2022 quarter.

Our operating results are significantly impacted by the market price of HRC. The Company experienced an inflection point in HRC price during the 2023 quarter with prices increasing approximately 66% from early October 2023 and through the end of the 2023 quarter. As a result, the Company experienced considerable physical margin improvement in the second half of the 2023 quarter. In the 2022 quarter, HRC price declined approximately 22% until rising in the second half of December 2022. With the prevailing downward price trend during the 2022 quarter the Company experienced lower physical margins.

Flat-roll Segment

Flat-roll product segment sales for the 2023 quarter totaled approximately $106.4 million compared to approximately $100.2 million for the 2022 quarter. For a more complete understanding of the average selling prices of goods sold, it is helpful to exclude any hedging related gains or losses that are captured in sales and any sales generated from processing or storage of customer owned material. Flat-roll segment sales for the 2022 quarter were reduced by approximately $0.9 million for the recognition of hedging related losses, while 2023 quarter sales were not impacted by any hedging related gains or losses. Sales generated from processing or storage of customer owned material totaled approximately $1.0 million for the 2023 quarter compared to approximately $0.3 million for the 2022 quarter. Sales generated from flat-roll segment inventory, excluding the impact of any hedging related gains or losses, totaled approximately $105.4 million for the 2023 quarter compared to approximately $100.8 million for the 2022 quarter. The average per ton selling price related to these shipments increased from approximately $949 per ton in the 2022 quarter to approximately $960 per ton in the 2023 quarter. Sales volume for the 2023 quarter consisted of approximately 110,000 tons from inventory and another 22,000 tons of toll processing customer owned material compared to the 2022 quarter volume consisting of approximately 106,000 tons from inventory and 13,000 tons of toll processing. The growth in sales volume was primarily related to the increased production at the Company's Sinton, TX facility which commenced operations in October 2022. Flat-roll segment operations recorded operating profits of approximately $8.7 million and $3.3 million for the 2023 quarter and 2022 quarter, respectively. The operating profit for the 2022 quarter included a recognized loss on hedging activities of approximately $0.9 million, while operating profit for the 2023 quarter was not impacted by any hedging related gains or losses.

The Company’s flat-roll 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 2023 quarter totaled approximately $9.5 million compared to approximately $11.6 million for the 2022 quarter. Tubular segment sales for the 2023 quarter and 2022 quarter were not impacted by any hedging related gains or losses. Sales decreased due to a decrease in the average selling price per ton, partially offset by an increase in the volume sold. The average per ton selling price decreased from approximately $1,648 per ton in the 2022 quarter to approximately $1,164 per ton in the 2023 quarter. Tons sold increased from approximately 7,000 tons in the 2022 quarter to approximately 8,000 tons in the 2023 quarter. The tubular segment recorded an operating loss of approximately $0.1 million for the 2023 quarter compared to recording operating profit of approximately $0.7 million for the 2022 quarter.

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 2023 quarter, selling, general and administrative costs decreased approximately $0.4 million compared to the 2022 quarter. This decrease is primarily related to decreased payroll and benefits expense in the 2023 quarter.

Income Taxes

Income taxes decreased from a provision for the 2022 quarter of approximately $0.4 million to a provision for the 2023 quarter of approximately $0.1 million. This decrease was primarily related to lower earnings before taxes for the 2023 quarter and adjustment to interim tax estimates during the 2023 quarter. The income tax provision as a percentage of earnings before tax was approximately 5.9% and 23.9% for the three months ended December 31, 2023 and 2022, respectively. For the 2023 quarter, the effective tax rate differed from the federal statutory rate due primarily to the adjustment of tax estimates mentioned above. For the 2022 quarter, the effective tax rate differed from the federal statutory rate due primarily to the inclusion of state income taxes in the provision.

FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES

The Company’s current ratio was 3.1 at December 31, 2023 and 3.2 at March 31, 2023. Working capital was approximately $116.3 million at December 31, 2023 and $98.6 million at March 31, 2023.

During the nine months ended December 31, 2023, 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 and restricted cash increased due primarily to cash generated from operating activities and cash drawn on the Company's credit facility being greater than cash used for investing activities. The Company expects to continue to monitor, evaluate and manage balance sheet components depending on changes in market conditions and the Company’s operations.

The Company has a $150 million asset-based lending facility ("ABL Facility") which matures on May 19, 2026 and is secured by substantially all of the assets of the Company. The Company can elect borrowings on a floating rate basis or a term basis. Floating rate borrowings accrue interest at a rate equal to the prime rate minus 1% per annum. Term rate borrowings accrue interest at a rate equal to the SOFR rate applicable to the selected term plus 1.8% per annum. Availability of funds under the ABL Facility is subject to a borrowing base calculation determined as the sum of (a) 90% of eligible accounts receivable, plus (b) the product of 85% multiplied by the net orderly liquidating value percentage identified in the most recent inventory appraisal multiplied by eligible inventory. The ABL Facility contains a springing financial covenant whereby the financial covenant is only tested when availability falls below the greater of 15% of the revolving commitment or $22.5 million. The financial covenant restricts the Company from allowing its fixed charge coverage ratio to be, as of the end of any calendar month, less than 1.10 to 1.00 for the trailing twelve month period then ending. The fixed charge coverage ratio is calculated as the ratio of (a) EBITDA, as defined in the ABL Facility, minus unfinanced capital expenditures to (b) cash interest expense plus scheduled principal payments on indebtedness plus taxes paid in cash plus restricted payments paid in cash plus capital lease obligation payments plus cash contributions to any employee pension benefit plans. The ABL Facility contains other representations and warranties and affirmative and negative covenants that are usual and customary. If certain conditions precedent are satisfied, the ABL facility may be increased by up to an aggregate of $25 million, in minimum increments of $5 million. At December 31, 2023, the Company had a balance of approximately $46.0 million under the ABL Facility with an applicable interest rate of 7.5%. At December 31, 2023, the Company's applicable borrowing base calculation supported access to approximately $106.1 million of the ABL Facility. As of the filing date of this Form 10-Q, the Company had borrowings of approximately $49.9 million outstanding under the ABL Facility and the Company's most recent borrowing base calculation provided access to approximately $110.6 million of the ABL Facility.

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.

HEDGING ACTIVITIES

The Company utilizes hot-rolled coil futures to manage price risk on unsold inventory and longer-term fixed price sales agreements. The Company has elected hedge accounting for some of its hedging activities previously but most recently the Company has classified its hedging activities as economic hedges of risk with mark-to-market ("MTM") accounting treatment. Hedging decisions are intended to protect the value of the Company's inventory and produce more consistent financial results over price cycles. The Company recognized a loss related to futures designated for hedge accounting of approximately $0.4 million for the nine months ended December 31, 2023 with all of this recognition occurring during the first fiscal quarter ended June 30, 2023. For the three months ended December 31, 2023, the Company recognized a loss related to economic hedges of risk of approximately $4.1 million. For the nine months ended December 31, 2023, the Company recognized a gain related to economic hedges of risk of approximately $0.7 million. With MTM accounting treatment it is possible that hedging related gains or losses might be recognized in a different fiscal quarter than the corresponding improvement or contraction in our physical margins. The Company experienced an inflection point in steel prices during the quarter ended December 31, 2023 with both HRC price and the futures prices increasing. This resulted in physical margins improving in the second half of the quarter with this margin improvement being partially offset by hedging losses. The Company expects to recognize the appreciation of its inventory value through increased physical margins on fiscal fourth quarter sales. See Note H for additional information related to the Company's hedging activities.

OUTLOOK

The Company expects to conclude fiscal year March 31, 2024 with a strong fourth fiscal quarter characterized by solid margins associated with a considerable increase in HRC price entering the fourth quarter. Sales volume for the fourth quarter of fiscal 2024 is expected to be slightly higher than the third quarter volume.

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. The more significant estimates and judgements for the Company include determining the fair value of assets acquired and liabilities assumed in the business combination discussed in Note B. The determination of fair value requires management to make significant judgments and estimates, including the selection of valuation methodologies, estimates of future revenue and cash flows, discount rates and selection of comparable companies. 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, including the adequacy of cash and expectations as to future sales, prices and margins. 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.

Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) and 15(d)-15(f) promulgated under the Securities Exchange Act of 1934, as amended). We have established disclosure controls and procedures designed to ensure that material information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission and that any material information relating to us is recorded, processed, summarized and reported to our management including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. In designing and evaluating our disclosure controls and procedures, our management recognizes that controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving desired control objectives. In reaching a reasonable level of assurance, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Rule 13a-15(b) under the Exchange Act, we have evaluated, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this quarterly report. Based upon our evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were not effective as of the end of the period covered by this Quarterly Report on Form 10-Q because the Company has not yet completed its remediation of the material weaknesses previously identified and disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2023.

Notwithstanding the identified material weaknesses, the Company's management, including our Chief Executive Officer and Chief Financial Officer, believes that the consolidated financial statements included in this Quarterly Report on Form 10-Q fairly present in all material respects our financial condition and results of operations for the three months ended December 31, 2023 in accordance with U.S. Generally Accepted Accounting Principles.

Material Weakness in Internal Control Over Financial Reporting

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company's annual or interim financial statements will not be prevented or detected on a timely basis.

During the audit process related to our fiscal year ended March 31, 2023, management, in connection with our independent auditors, identified the following material weaknesses:

• The Company did not design relevant control activities necessary to address all identified risks of material misstatement or in some circumstances, controls were designed appropriately but were implemented late in the fiscal year not allowing a sufficient period of time to evidence operating effectiveness.
• The Company did not design and implement control activities to ensure completeness and accuracy of key reports used in the performance of certain controls.
• Management review were not designed to operate at a level of precision sufficient to identify all potential material errors.
• Certain controls were not executed or performed or were performed without sufficient documentation supporting the execution of the controls.
• The Company had inadequate segregation of duties for certain business transactions.

Plan for Remediation of Material Weakness

In the prior year, the Company identified that the number of accounting personnel and the limited utilization of information technology in its control structure were the primary contributing factors to the material weaknesses identified. The Company hired additional personnel during the fiscal year ended March 31, 2023 ("fiscal 2023") and believes it is adequately staffed to execute the remediation plans developed by management. The previously identified material weaknesses have not been remediated due to ongoing post-acquisition integration during fiscal 2023. The operation of the full business in a new enterprise resource planning ("ERP") system is the most significant piece of this integration. All of the Company's flat-roll segment locations were integrated into the new ERP system as of February 2023. The Company's tubular segment went live under the new ERP system at the start of August 2023. The Company expects the new ERP system to allow for many of the Company’s current manual controls and missing controls to be performed by the design and capabilities of the ERP system rather than relying on manual human execution. With most of the post-acquisition integration completed, the Company expects its additional personnel will be able to dedicate the necessary time during the fiscal year ended March 31, 2024 to improve the design, documentation and execution of internal controls. The Company has also engaged a consultant to assist with remediation efforts and to support the Company's design, documentation and testing of internal controls.

We will continue to monitor the design and effectiveness of these procedures and controls and make any further changes the Company determines appropriate. We believe the additional investment in human capital and technology described above will allow the Company to remediate the material weaknesses identified. However, the material weaknesses will not be considered remediated until the applicable remedial actions operate effectively for a sufficient period of time.

Changes in Internal Controls over Financial Reporting

Except as discussed above, there were no changes in the Company's internal control over financial reporting that occurred during the fiscal quarter ended December 31, 2023 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

Three Months Ended December 31, 2023