OLYMPIC STEEL INC - Quarter Report: 2018 June (Form 10-Q)

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

Olympic Steel, Inc.

Consolidated Balance Sheets

 (in thousands)

The accompanying notes are an integral part of these consolidated statements.

Olympic Steel, Inc.

Consolidated Statements of Comprehensive Income

(in thousands, except per share data)

The accompanying notes are an integral part of these consolidated statements.

Olympic Steel, Inc.

Consolidated Statements of Cash Flows

For the Six Months Ended June 30,

(in thousands)

The accompanying notes are an integral part of these consolidated statements.

Olympic Steel, Inc.

Supplemental Disclosures of Cash Flow Information

For the Six Months Ended June 30,

(in thousands)

The accompanying notes are an integral part of these consolidated statements.

Olympic Steel, Inc.

Notes to Unaudited Consolidated Financial Statements

June 30, 2018

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with our unaudited consolidated financial statements and accompanying notes contained herein and our consolidated financial statements, accompanying notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2017. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause a difference include, but are not limited to, those discussed under Item 1A (Risk Factors) in our Annual Report on Form 10-K for the year ended December 31, 2017. The following section is qualified in its entirety by the more detailed information, including our financial statements and the notes thereto, which appear elsewhere in this Quarterly Report on Form 10-Q.

Forward-Looking Information

This Quarterly Report on Form 10-Q and other documents we file with the SEC contain various forward-looking statements that are based on current expectations, estimates, forecasts and projections about our future performance, business, our beliefs and management’s assumptions. In addition, we, or others on our behalf, may make forward-looking statements in press releases or written statements, or in our communications and discussions with investors and analysts in the normal course of business through meetings, conferences, webcasts, phone calls and conference calls. Words such as “may,” “will,” “anticipate,” “should,” “intend,” “expect,” “believe,” “estimate,” “project,” “plan,” “potential,” and “continue,” as well as the negative of these terms or similar expressions, are intended to identify forward-looking statements, which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those implied by such statements including, but not limited to:

Should one or more of these or other risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, intended, expected, believed, estimated, projected or planned. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to republish revised forward-looking statements to reflect the occurrence of unanticipated events or circumstances after the date hereof, except as otherwise required by law.

Overview

We are a leading metals service center that operates in three reportable segments; carbon flat products, specialty metals flat products, and tubular and pipe products.  We provide metals processing and distribution services for a wide range of customers.  Our carbon flat products segment’s focus is on the direct sale and distribution of large volumes of processed carbon and coated flat-rolled sheet, coil and plate products and fabricated parts.  Our specialty metals flat products segment’s focus is on the direct sale and distribution of processed aluminum and stainless flat-rolled sheet and coil products, flat bar products and fabricated parts.  Through the acquisition of Berlin Metals on April 2, 2018, the specialty metals flat products segment expanded its product offerings to include differing types of stainless flat-rolled sheet and coil and prime tin mill products.  In addition, we distribute metal tubing, pipe, bar, valves and fittings and fabricate pressure parts supplied to various industrial markets.  Products that require more value-added processing generally have a higher gross profit.  Accordingly, our overall gross profit is affected by, among other things, product mix, the amount of processing performed, the demand for and availability of metals, and volatility in selling prices and material purchase costs.  We also perform toll processing of customer-owned metals. We sell certain products internationally, primarily in Canada and Mexico.  International sales are immaterial to our consolidated financial results and to the individual segments’ results.

Our results of operations are affected by numerous external factors including, but not limited to: general and global business, economic, financial, banking and political conditions; fluctuations in the value of the U.S. dollar to foreign currencies, competition; metals pricing, demand and availability; transportation and energy costs; pricing and availability of raw materials used in the production of metals; global supply, the level of metals imported into the United States, and inventory held in the supply chain; customers’ ability to manage their credit line availability; and layoffs or work stoppages by our own, our suppliers’ or our customers’ personnel. The metals industry also continues to be affected by the global consolidation of our suppliers, competitors and end-use customers.

Like other metals service centers, we maintain substantial inventories of metals to accommodate the short lead times and just-in-time delivery requirements of our customers.  Accordingly, we purchase metals in an effort to maintain our inventory at levels that we believe to be appropriate to satisfy the anticipated needs of our customers based upon customer forecasts, historic buying practices, supply agreements with customers and market conditions.  Our commitments to purchase metals are generally at prevailing market prices in effect at the time we place our orders.  We have entered into nickel and carbon swaps at the request of our customers in order to mitigate our customers’ risk of volatility in the price of metals, and we have entered into metals hedges to mitigate our risk of volatility in the price of metals.  We have no long-term, fixed-price metals purchase contracts.  When metals prices decline, customer demands for lower prices and our competitors’ responses to those demands could result in lower sale prices and, consequently, lower gross profits and earnings as we use existing metals inventory.  When metals prices increase, competitive conditions will influence how much of the price increase we can pass on to our customers.  To the extent we are unable to pass on future price increases in our raw materials to our customers, the net sales and gross profits of our business could be adversely affected.

At June 30, 2018, we employed approximately 1,780 people.  Approximately 325 of the hourly plant personnel at the facilities listed below are represented by ten separate collective bargaining units.  The table below shows the expiration dates of the collective bargaining agreements.

We have never experienced a work stoppage and we believe that our relationship with employees is good. However, any prolonged work stoppages by our personnel represented by collective bargaining units could have a material adverse impact on our business, financial condition, results of operations and cash flows. 

On April 2, 2018, we acquired all of the net assets of Berlin Metals, based in Hammond, Indiana. Berlin Metals was founded in 1967 and is one of the largest North American service centers processing and distributing prime tin mill products and stainless steel strip in slit coil form. Berlin Metals is also a supplier of galvanized, light gauge cold rolled sheet and strip and other coated metals in coil forms, to customers in the building products, automotive and specialized industrial markets.

The acquisition was accounted for as a business combination and the assets were valued at fair market value. The acquisition is not considered significant and Berlin Metals’ results are included in our specialty metals flat products segment in our second quarter of 2018 financial results. The acquisition is expected to be accretive to 2018 earnings.

Reportable Segments

We operate in three reportable segments; carbon flat products, specialty metals flat products and tubular and pipe products. The carbon flat products segment and the specialty metals flat products segment are at times consolidated and referred to as the flat products segment. Some of the flat products segments’ assets and resources are shared by the carbon and specialty metals segments and both segments’ products are stored in the shared facilities and, in some locations, processed on shared equipment. As such, total assets and capital expenditures are reported in the aggregate for the flat products segments. Due to the shared assets and resources, certain of the flat products segment expenses are allocated between the carbon flat products segment and the specialty metals flat products segment based upon an established allocation methodology.

We follow the accounting guidance that requires the utilization of a “management approach” to define and report the financial results of operating segments. The management approach defines operating segments along the lines used by the chief operating decision maker, or CODM, to assess performance and make operating and resource allocation decisions. Our CODM evaluates performance and allocates resources based primarily on operating income. Our operating segments are based primarily on internal management reporting.

Due to the nature of the products sold in each segment, there are significant differences in the segments’ average selling price and the cost of materials sold. The tubular and pipe products segment generally has the highest average selling price among the three segments followed by the specialty metals flat products and carbon flat products segments. Due to the nature of the tubular and pipe products, we do not report tons sold or per ton information. Gross profit per ton is generally higher in the specialty metals flat products segment than the carbon flat products segment. Gross profit as a percentage of net sales is generally highest in the tubular and pipe products segment, followed by the carbon and specialty metals flat products segments.

Due to the differences in average selling prices, gross profit and gross profit percentage among the segments, a change in the mix of sales could impact total net sales, gross profit, and gross profit percentage. In addition, certain inventory in the tubular and pipe products segment is valued under the LIFO method. Adjustments to the LIFO inventory value are recorded to cost of materials sold and may impact the gross margin and gross margin percentage at the consolidated Company and tubular and pipe products segment levels.

Carbon flat products

The primary focus of our carbon flat products segment is on the direct sale and distribution of large volumes of processed carbon and coated flat-rolled sheet, coil and plate products and fabricated parts. We act as an intermediary between metals producers and manufacturers that require processed metals for their operations. We serve customers in most metals consuming industries, including manufacturers and fabricators of transportation and material handling equipment, construction and farm machinery, storage tanks, environmental and energy generation equipment, automobiles, military vehicles and equipment, as well as general and plate fabricators and metals service centers. We distribute these products primarily through a direct sales force.

Specialty metals flat products

The primary focus of our specialty metals flat products segment is on the direct sale and distribution of processed stainless and aluminum flat-rolled sheet and coil products, flat bar products and fabricated parts. Through its acquisition of Berlin Metals on April 2, 2018, our specialty metals flat products segment expanded its product offerings to include differing types of stainless flat-rolled sheet and coil and prime tin mill products. We act as an intermediary between metals producers and manufacturers that require processed metals for their operations. We serve customers in various industries, including manufacturers of food service and commercial appliances, agriculture equipment, transportation and automotive equipment. We distribute these products primarily through a direct sales force.

Combined, the carbon and specialty metals flat products segments have 21 strategically-located processing and distribution facilities in the United States and one in Monterrey, Mexico. Many of our facilities service both the carbon and the specialty metals flat products segments, and certain assets and resources are shared by the segments. Our geographic footprint allows us to focus on regional customers and larger national and multi-national accounts, primarily located throughout the midwestern, eastern and southern United States.

Tubular and pipe products

The tubular and pipe products segment consists of the Chicago Tube and Iron, or CTI, business, acquired in 2011. Through our tubular and pipe products segment, we distribute metal tubing, pipe, bar, valve and fittings and fabricate pressure parts supplied to various industrial markets. Founded in 1914, CTI operates from nine locations in the midwestern and southeastern United States. The tubular and pipe products segment distributes its products primarily through a direct sales force.

Corporate expenses

Corporate expenses are reported as a separate line item for segment reporting purposes. Corporate expenses include the unallocated expenses related to managing the entire Company (i.e., all three segments), including compensation for certain personnel, expenses related to being a publicly traded entity such as board of directors’ expenses, audit expenses, and various other professional fees.

Results of Operations

Our results of operations are impacted by the market price of metals. During the first half of 2018, metals prices increased significantly and changes to our net sales, cost of materials sold, gross profit, cost of inventory and profitability, are all impacted by industry metals pricing. The pricing increases continued through the first half of 2018 resulting in metals pricing reaching its highest point in 10 years. The increases are driven by both the tariffs initiated by the U.S. government in 2018 under Section 232 of the Trade Expansion Act (section 232 tariffs) of and strong customer demand.

Transactional or “spot” selling prices generally move in tandem with market price changes, while fixed selling prices typically lag and reset quarterly. Similarly, inventory costs (and, therefore, cost of materials sold) tend to move slower than market selling price changes due to mill lead times and inventory turnover impacting the rate of change in average cost. When average selling prices increase, and net sales increase, gross profit and operating expenses as a percentage of net sales will generally decrease. Our net sales and earnings were positively impacted by the price increases and increased customer demand during the first half of 2018, and we expect this trend to continue into the third quarter of 2018. As price increases continue, the gross margins we earn on each sale will lower as higher priced inventory is applied to sales.

Operating results for the second quarter of 2018 include the additional revenues and operating expenses resulting from the acquisition of Berlin Metals on April 2, 2018. Distribution expenses increased in the first half of 2018 across all segments as anticipated. The increase accounted for 37.9% of the consolidated operating expense increase. The increase is related to a shortage of drivers due to the stronger economy and more products moved via truck and limited driver hours per day resulting from the Electronic Log Device mandate by the Federal Motor Carrier Safety Administration issued in 2017.

During the second quarter of 2017, we announced the permanent closure of our carbon flat products segment’s Siler City, North Carolina operation. The facility ceased operations in the third quarter of 2017. The land and building associated with the operation is classified as Assets held for sale on the accompanying Consolidated Balance Sheets, and was subsequently sold in July 2018 at net book value. The operating loss related to the Siler City, North Carolina operation was immaterial in the first half of 2018 compared to $938 thousand for the first half of 2017.

Consolidated Operations

The following table presents consolidated operating results for the periods indicated (dollars are shown in thousands):

Net sales increased $96.7 million, or 27.2%, to $452.9 million in the second quarter of 2018 from $356.2 million in the second quarter of 2017. The increase in net sales was due to a 21.3% increase in average selling prices and a 4.8% increase in sales volume during the second quarter of 2018 compared to the second quarter of 2017. Average selling prices increased sequentially from the first quarter of 2018 by approximately 13.0%. The average selling prices increased in the carbon flat products and tubular and pipe products segments during the second quarter of 2018 compared to the second quarter of 2017 due to the increased market prices discussed above. Sales volumes increased in the specialty metals flat products segment due to the acquisition of Berlin Metals and increased customer demand, and in the tubular and pipe products segment due to increased customer demand. Carbon flat products net sales were 61.7% of total net sales in the second quarter of 2018 compared to 66.6% of total net sales in the second quarter of 2017. Specialty metals flat products net sales were 21.5% of total net sales in the second quarter of 2018 compared to 16.4% of total net sales in the second quarter of 2017. Tubular and pipe products net sales were 16.8% of total net sales in the second quarter of 2018 compared to 17.1% of total net sales in the second quarter of 2017.

Net sales increased $137.4 million, or 19.9%, to $828.5 million during the six months ended June 30, 2018 from $691.1 million during the six months ended June 30, 2017. The increase in net sales was due to a 17.2% increase in average selling prices and a 2.3% increase in sales volume during the six months ended June 30, 2018 compared to the six months ended June 30, 2017. Average selling prices increased in all three operating segments during the first six months of 2018 compared to the first six months of 2017. Sales volumes increased in the specialty metals flat products segment due to the acquisition of Berlin Metals and increased customer demand, and in the tubular and pipe products segment due to increased customer demand. Carbon flat products net sales were 62.7% of total net sales in the first six months of 2018 compared to 65.7% of total net sales in the first six months of 2017. Specialty metals flat products net sales were 19.7% of total net sales in the first six months of 2018 compared to 16.8% of total net sales in the first six months of 2017. Tubular and pipe products net sales were 17.6% of total net sales in the first six months of 2018 compared to 17.5% of total net sales in the first six months of 2017.

Cost of materials sold increased $73.0 million, or 25.8%, to $356.0 million in the second quarter of 2018 from $283.0 million in the second quarter of 2017. Cost of materials sold increased $109.3 million, or 20.2%, to $650.8 million during the six months ended June 30, 2018 from $541.5 million during the six months ended June 30, 2017. The increase in cost of materials sold in the second quarter and first six months of 2018 is related to increased market metals pricing discussed above and increased sales volume.

As a percentage of net sales, gross profit (as defined in footnote (b) in the table above) increased to 21.4% in the second quarter of 2018 compared to 20.5% in the second quarter of 2017. As a percentage of net sales, gross profit decreased to 21.4% in the six months ended June 30, 2018 compared to 21.6% in the six months ended June 30, 2017. The decrease in the gross profit as a percentage of net sales is due to the impact of higher average selling prices, as the average gross profit per ton increased in the first half of 2018 compared to the first half of 2017.

Operating expenses in the second quarter of 2018 increased $9.0 million, or 14.2%, to $72.5 million from $63.5 million in the second quarter of 2017. As a percentage of net sales, operating expenses decreased to 16.0% for the second quarter of 2018 from 17.8% in the comparable 2017 period. Operating expenses in the carbon flat products segment increased $3.7 million, operating expenses in the specialty metals flat products segment increased $3.8 million, operating expenses in the tubular and pipe products segment increased $0.3 million, and Corporate expenses increased $1.3 million. Operating expenses increased in all categories, except for depreciation expense, as reported on the Company’s Consolidated Statements of Comprehensive Income. Operating expenses related to the newly acquired Berlin Metals on April 2, 2018 accounted for $2.3 million, or 25.7%, of the operating expense increase. In addition, distribution expenses increased $2.8 million, or 26.7%, and accounted for 31.3% of the total operating expense increase as discussed above. Selling and administrative and general expenses increased $4.2 million, or 17.4%, primarily as a result of labor expenses and increased variable based incentive compensation.

Operating expenses in the first six months of 2018 increased $12.1 million, or 9.4%, to $141.0 million from $128.9 million in the first six months of 2017. As a percentage of net sales, operating expenses decreased to 17.0% in the first six months of 2018 from 18.6% for the first six months of 2017. Operating expenses in the carbon flat products segment increased $6.3 million, operating expenses in the specialty metals flat products segment increased $4.5 million, operating expenses in the tubular and pipe products segment decreased $0.2 million, and Corporate expenses increased $1.5 million. Operating expenses increased in all categories, except for depreciation expense, as reported on the Company’s Consolidated Statements of Comprehensive Income. Operating expenses related to the newly acquired Berlin Metals on April 2, 2018 accounted for $2.3 million, or 19.1%, of the operating expense increase. In addition, distribution expenses increased $4.6 million, or 21.9%, and accounted for 37.9% of the total operating expense increase as discussed above. Selling and administrative and general expenses increased $5.7 million, or 11.6%, primarily as a result of labor expenses and increased variable based incentive compensation.

Interest and other expense on debt totaled $2.7 million, 0.6% of net sales, for the second quarter of 2018 compared to $1.8 million, or 0.5% of net sales, for the second quarter of 2017. Interest and other expense on debt totaled $4.6 million, or 0.6% of net sales, for the first six months of 2018 compared to $3.4 million, or 0.5% of net sales, for the first six months of 2017. Our effective borrowing rate, exclusive of deferred financing fees and commitment fees, was 3.4% for the first six months of 2018 compared to 2.9% for the first six months of 2017 due to the increase in LIBOR rates since the first half of 2017. Total average borrowings increased $64 million, or 33.4%, from $190.8 million in the first six months of 2017 to $254.6 million in the first six months of 2018, primarily related to increased working capital needs in 2018.

For the second quarter of 2018, income before income taxes totaled $21.6 million compared to $7.8 million in the second quarter of 2017. For the first half of 2018, income before income taxes totaled $31.8 million compared to $17.2 million in the first half of 2017.

An income tax provision of 26.5% was recorded for the second quarter of 2018, compared to 38.6% for the second quarter of 2017. An income tax provision of 26.3% was recorded for the first half of 2018, compared to 27.4% for the first half of 2017. During the quarter ended March 31, 2017, we made an out-of-period adjustment to correct and record previously unrecognized deferred tax assets, and the associated tax benefit, related to the SERP. The adjustment, which accumulated since the inception of the plan in 2005, resulted in an increase to after-tax income of $1.9 million in the first quarter of 2017. 

Our tax provision or benefit for interim periods is determined using an estimate of our annual effective tax rate, adjusted for discrete items that are considered in the relevant period. Each quarter, we update our estimate of the annual effective tax rate, and if our estimated tax rate changes, we make a cumulative adjustment. We expect our operational effective tax rate to approximate 26% to 28% on an annual basis in 2018, which is a decrease from the 2017 operational effective tax rate as a result of the Tax Cuts and Jobs Act signed into law in the fourth quarter of 2017.

Net income for the second quarter of 2018 totaled $15.8 million or $1.39 per basic and diluted share, compared to $4.8 million, or $0.42 per basic and diluted share for the second quarter of 2017. Net income for the first half of 2018 totaled $23.5 million or $2.06 per basic and diluted share, compared to $12.5 million, or $1.10 per basic and diluted share for the first half of 2017.

Segment Operations

Carbon flat products

The following table presents selected operating results for our carbon flat products segment for the periods indicated (dollars are shown in thousands, except for per ton information):

Tons sold by our carbon flat products segment decreased 4 thousand tons, or 1.3%, to 304 thousand in the second quarter of 2018 from 308 thousand in the second quarter of 2017. Tons sold by our carbon flat products segment decreased 10 thousand tons, or 1.7% to 602 thousand in the first half of 2018 from 612 thousand in the first half of 2017. The decrease in tons sold is due to the strategic decision to eliminate low margin international trading sales and the closure of our North Carolina operation in the third quarter of 2017, which accounted for a decrease year-over-year of approximately 28 thousand tons. Excluding these strategic decisions, the carbon flat products segment experienced tonnage increases in 2018 compared to 2017. Customer demand was strong in the first half of 2018, and we expect similar year-over-year growth it to continue into the third quarter of 2018.

Net sales in our carbon flat products segment increased $42.2 million, or 17.8%, to $279.3 million in the second quarter of 2018 from $237.1 million in the second quarter of 2017. The increase in sales was due to a 19.4% increase in average selling prices during the second quarter of 2018 compared to the second quarter of 2017. Average selling prices in the second quarter of 2018 were $918 per ton, compared with $769 per ton in the second quarter of 2017, and $809 per ton in the first quarter of 2018.

Net sales in our carbon flat products segment increased $66.2 million, or 14.6%, to $520.2 million in the first half of 2018 from $454.0 million in the first half of 2017. The increase in sales was due to a 16.5% increase in average selling prices. Average selling prices in the first half of 2018 were $864 per ton, compared with $741 per ton in the first half of 2017.

Cost of materials sold increased $27.4 million, or 14.5%, to $217.1 million in the second quarter of 2018 from $189.7 million in the second quarter of 2017. Cost of materials sold increased $48.1 million, or 13.4%, to $406.9 million in the first half of 2018 from $358.8 million in the first half of 2017. The increase was due to the increased market price for metals discussed above.

As a percentage of net sales, gross profit (as defined in footnote (a) in the table above) increased to 22.3% in the second quarter of 2018 compared to 20.0% in the second quarter of 2017. Gross profit increased $50 per ton to $204 per ton in the second quarter of 2018 from $154 per ton in the second quarter of 2017 and $172 per ton in the first quarter of 2018.

As a percentage of net sales, gross profit increased to 21.8% in the six months ended June 30, 2018 compared to 21.0% in the six months ended June 30, 2017. Gross profit increased $33 per ton to $188 per ton in the six months ended June 30, 2018 from $155 per ton in the six months ended June 30, 2017.

Operating expenses in the second quarter of 2018 increased $3.6 million, or 9.2%, to $43.8 million from $40.2 million in the second quarter of 2017. As a percentage of net sales, operating expenses decreased to 15.7% for the second quarter of 2018 from 16.9% in the comparable 2017 period. Operating expenses in the first half of 2018 increased $6.4 million, or 7.8%, to $86.9 million from $80.5 million in the first half of 2017. As a percentage of net sales, operating expenses decreased to 16.7% for the first half of 2018 from 17.8% in the comparable 2017 period. Variable operating expenses, such as warehouse and processing, increased as a result of increased sales volume at our current operating facilities. Other operating expenses increased as a result of increased distribution expense discussed above, labor expenses and increased variable performance based incentive compensation.

Operating income for the second quarter of 2018 totaled $18.3 million, or 6.6% of net sales, compared to $7.2 million, or 3.1% of net sales for the second quarter of 2017. Operating income for the six months ended June 30, 2018 totaled $26.4 million, or 5.1% of net sales, compared to $14.6 million, or 3.2% of net sales for the six months ended June 30, 2017.

Specialty metals flat products

The following table presents selected operating results for our specialty metals flat products for the periods indicated (dollars are shown in thousands, except for per ton information):

Tons sold by our specialty metals flat products segment increased 16 thousand tons, or 72.2%, to 39 thousand in the second quarter of 2018 from 23 thousand in the second quarter of 2017. Tons sold by our specialty metals flat products segment increased 18 thousand tons, or 39.2%, to 64 thousand in the six months ended June 30, 2018 from 46 thousand in the six months ended June 30, 2017. The increase in tons sold is due to the acquisition of Berlin Metals on April 2, 2018 and improved customer demand in the markets we serve during the second quarter and first six months of 2018. The specialty metals flat products segment increased its market share for stainless and aluminum products in the first half of 2018.

Net sales in our specialty metals flat products segment increased $39.1 million, or 67.0%, to $97.4 million in the second quarter of 2018 from $58.3 million in the second quarter of 2017. The increase in sales was due to the 72.2% volume increase discussed above offset by a 3.0% decrease in the average selling prices during the second quarter of 2018 compared to the second quarter of 2017. Average selling prices in the second quarter of 2018 were $2,509 per ton compared to $2,586 per ton in the second quarter of 2017 and $2,636 per ton in the first quarter of 2018. Some of the products sold by Berlin Metals have a lower average selling price than products historically sold by the specialty metals flat products segment.

Net sales in our specialty metals flat products segment increased $46.6 million, or 40.1%, to $162.9 million in the first half of 2018 from $116.2 million in the first half of 2017. The increase in sales was due to the 39.2% increase in sales volume as discussed above as the average selling prices remained unchanged between the periods. Average selling prices in the first half of 2018 were $2,558 per ton, compared with $2,542 per ton in the first half of 2017.

Cost of materials sold increased $32.7 million, or 65.2%, to $82.7 million in the second quarter of 2018 from $50.0 million in the second quarter of 2017. The increase was due to a 72.2% increase in sales volume, offset by a 4.1% decrease in market metals cost in the second quarter of 2018 compared to the second quarter in 2017.

Cost of materials sold increased $40.5 million, or 41.2%, to $138.8 million in the first half of 2018 from $98.3 million in the first half of 2017. The increase in cost of materials sold was due to a 39.2% increase in sales volume and a 1.4% increase in market metals cost during the six months ended June 30, 2018 compared to the six months ended June 30, 2017.

As a percentage of net sales, gross profit (as defined in footnote (a) in the table above) increased to 15.1% in the second quarter of 2018 from 14.1% in the second quarter of 2017. As a percentage of net sales, gross profit decreased to 14.8% in the six months ended June 30, 2018 from 15.4% in the six months ended June 30, 2017.

Operating expenses in the second quarter of 2018 increased $3.8 million, or 70.5%, to $9.2 million from $5.4 million in the second quarter of 2017. As a percentage of net sales, operating expenses increased to 9.4% of net sales for the second quarter of 2018 compared to 9.2% of net sales for the second quarter of 2017.

Operating expenses in the first six months of 2018 increased $4.4 million, or 40.6%, to $15.5 million from $11.1 million in the first six months of 2017. As a percentage of net sales, operating expenses increased to 9.6% of net sales for the six months ended June 30, 2018 compared to 9.5% for the six months ended June 30, 2017. Operating expenses increased due to the acquisition of Berlin Metals on April 2, 2018. Variable operating expenses, such as distribution and warehouse and processing increased as a result of higher sales volumes. Selling and administrative and general expenses increased primarily as a result of increased variable based incentive compensation related to the increased sales volume, gross profit and operating income.

Operating income for the second quarter of 2018 totaled $5.5 million, or 5.7% of net sales, compared to $2.9 million, or 4.9% of net sales, for the second quarter of 2017. Operating income for the six months ended June 30, 2018 totaled $8.5 million, or 5.2% of net sales, compared to operating income of $6.8 million, or 5.9% of net sales, for the six months ended June 30, 2017.

Tubular and pipe products

The following table presents selected operating results for our tubular and pipe products segment for the periods indicated (dollars are shown in thousands):

Net sales increased $15.4 million, or 25.3%, to $76.3 million in the second quarter of 2018 from $60.9 million in the second quarter of 2017. The increase is a result of a 22.4% increase in sales volume and a 2.4% increase in average selling prices during the second quarter of 2018 compared to the second quarter of 2017.

Net sales increased $24.5 million, or 20.3% to $145.4 million in the six months ended June 30, 2018 from $120.9 million in the six months ended June 30, 2017. The increase in net sales is a result of a 19.5% increase in sales volume as the average selling price remained unchanged between the periods.

Cost of materials sold increased $13.0 million, or 29.8%, to $56.3 million in the second quarter of 2018 from $43.3 million in the second quarter of 2017. During the second quarter of 2018, we recorded LIFO expense of $1.5 million compared to $0.4 million in the second quarter of 2017.

Cost of materials sold increased $20.8 million, or 24.6% to $105.1 million in the first six months of 2018 from $84.3 million in the first six months of 2017. During the first six months of 2018, we recorded $2.0 million of LIFO expense compared to $0.8 million in the first six months of 2017. The increase in cost of materials sold is a result of increased sales volumes, increased market metals cost and increased LIFO expense in 2018 compared to 2017.

As a percentage of net sales, gross profit (as defined in footnote (b) in the table above) decreased to 26.2% in the second quarter of 2018 from 28.8% in the second quarter of 2017. As a percentage of net sales, the $1.5 million LIFO expense decreased gross profit by 2.0% in 2018 compared to the $0.4 million LIFO expense in 2017 that decreased gross profit by 0.7%. As a percentage of net sales, gross profit decreased to 27.7% in the first six months of 2018 compared to 30.2% in the first six months of 2017. As a percentage of net sales, the $2.0 million LIFO expense recorded in the six months ended June 30, 2018 decreased gross profit by 1.4%, compared to the $0.8 million LIFO expense recorded in the six months ended June 30, 2017 that decreased gross profit by 0.6%.

Operating expenses in the second quarter of 2018 increased $0.3 million, or 2.0%, to $15.5 million from $15.2 million in the second quarter of 2017. As a percentage of net sales, operating expenses decreased to 20.3% for the second quarter of 2018 compared to 24.9% for the second quarter of 2017. Operating expenses increased in the second quarter primarily as a result of increased distribution expense discussed above and increased variable incentive compensation related to increased gross profit and operating income.

Operating expenses in the six months ended June 30, 2018 decreased $0.2 million, or 0.6%, to $31.5 million from $31.7 million in the first half of 2017. As a percentage of net sales, operating expenses decreased to 21.7% in the first half of 2018 compared to 26.2% in the first half of 2017. Operating expenses decreased in the first half of 2018 primarily as a result of more labor and overhead capitalization into inventory offset by increased distribution expense.

Operating income for the second quarter of 2018 totaled $4.6 million, or 6.0% of net sales, compared to $2.3 million, or 3.9% of net sales, for the second quarter of 2017. Operating income for the six months ended June 30, 2018 totaled $8.8 million, or 6.1% of net sales, compared to $4.8 million, or 4.0% of net sales, for the six months ended June 30, 2017.

Corporate expenses

Corporate expenses increased $1.3 million to $4.1 million in the second quarter of 2018 compared to $2.8 million in the second quarter of 2017. Corporate expenses increased $1.5 million to $7.1 million in the first half of 2018 compared to $5.6 million in the first half of 2017. The increase in corporate expenses is primarily attributable to increased variable incentive compensation related to increased operating income and the professional fees incurred in connection with the Berlin Metals acquisition on April 2, 2018.

Liquidity, Capital Resources and Cash Flows

Our principal capital requirements include funding working capital needs, purchasing, upgrading and acquiring processing equipment and facilities, making acquisitions and paying dividends. We use cash generated from operations, leasing transactions and borrowings under our credit facility to fund these requirements.

We believe that funds available under our existing asset-based credit facility (the ABL Credit Facility), lease arrangement proceeds and the sale of equity or debt securities, together with funds generated from operations, will be sufficient to provide us with the liquidity necessary to fund anticipated working capital requirements, capital expenditure requirements, our dividend payments and any business acquisitions over at least the next 12 months. In the future, we may, as part of our business strategy, acquire and dispose of assets or other companies in the same or complementary lines of business, or enter into or exit strategic alliances and joint ventures. Accordingly, the timing and size of our capital requirements are subject to change as business conditions warrant and opportunities arise.

Operating Activities

For the six months ended June 30, 2018, we used $61.9 million of net cash for operations, of which $35.7 million was generated from operating activities and $98.6 million was used for working capital investments. Net cash from operations during the six months ended June 30, 2018 consisted primarily of net income of $23.5 million.  For the six months ended June 30, 2017, we used $38.5 million of net cash from operations, of which $21.4 million was generated from operating activities and $59.9 million was used for working capital investments.  Net cash from operations during the six months ended June 30, 2017 consisted primarily of net income of $12.5 million.

Working capital at June 30, 2018 totaled $422.3 million, a $113.3 million increase from December 31, 2017. The increase was primarily attributable to a $65.9 million, or 49.6%, increase in accounts receivable (resulting from higher sales prices and higher sales volumes experienced in the second quarter compared to the fourth quarter) and a $73.5 million, or 27.1%, increase in inventories (resulting from higher inventory levels and higher average inventory costs in the second quarter of 2018 compared to the fourth quarter of 2017) offset by a $35.9 million increase in accounts payable and outstanding checks (related to the increased inventory purchases discussed above).

Investing Activities

Net cash used for investing activities was $35.6 million during the six months ended June 30, 2018, compared to $4.3 million during the six months ended June 30, 2017.  Investment activities in 2018 includes the acquisition of Berlin Metals for $21.9 million and $13.8 million of capital expenditures were primarily attributable to a building expansion and additional processing equipment at our existing facilities.  During 2018, we expect our capital spending to approximate $25 million primarily related to a building expansion and new processing equipment at our existing facilities.

Financing Activities

During the six months ended June 30, 2018, $100.0 million of cash was generated from financing activities, which primarily consisted of $101.4 million of net borrowings under our ABL Credit Facility due to the continued rising metals prices and working capital needs and the acquisition of Berlin Metals on April 2, 2018 offset by the final Industrial Revenue Bond (IRB) payment of $0.9 million and $0.4 million of dividends paid. During the six months ended June 30, 2017, $44.7 million of cash was generated from financing activities, which primarily consisted of $46.1 million of net borrowings under our ABL Credit Facility offset by a $0.9 million IRB repayment.

Dividends paid were $0.4 million for both the six months ended June 30, 2018 and June 30, 2017. In August 2018, our Board of Directors approved a regular quarterly dividend of $0.02 per share, which will be paid on September 17, 2018 to shareholders of record as of September 4, 2018. Regular dividend distributions in the future are subject to the availability of cash, the $5.0 million annual limitation on cash dividends and common stock repurchases under our ABL Credit Facility and continuing determination by our Board of Directors that the payment of dividends remains in the best interest of our shareholders.

Stock Repurchase Program

In 2015, our Board of Directors authorized a stock repurchase program of up to 550,000 shares of our issued and outstanding common stock, which could include open market repurchases, negotiated block transactions, accelerated stock repurchases or open market solicitations for shares, all or some of which may be effected through Rule 10b5-1 plans. Repurchased shares will be held in our treasury, or canceled and retired as our Board may determine from time to time. Any repurchases of common stock are subject to the covenants contained in the ABL Credit Facility. Under the ABL Credit Facility, we may repurchase common stock and pay dividends up to $5.0 million in the aggregate during any trailing twelve months without restrictions. Purchases in excess of $5.0 million require us to (i) maintain availability in excess of 20% of the aggregate revolver commitments ($80.0 million at June 30, 2018) or (ii) to maintain availability equal to or greater than 15% of the aggregate revolver commitments ($60.0 million at June 30, 2018) and we must maintain a pro-forma ratio of EBITDA, minus certain capital expenditures and cash taxes paid to fixed charges of at least 1.00 to 1.00. The timing and amount of any repurchases under the stock repurchase program will depend upon several factors, including market and business conditions, and limitations under the ABL Credit Facility, and repurchases may be discontinued at any time.

No share repurchases were made during the six months ended June 30, 2018.

Debt Arrangements

Our ABL Credit Facility is collateralized by our accounts receivable, inventory and personal property. The ABL Credit Facility consists of (i) a revolving credit facility of $370 million, including a $20 million sub-limit for letters of credit and (ii) a first in, last out revolving credit facility of up to $30 million. Under the terms of the ABL Credit Facility, we may request additional commitments in the aggregate principal amount of up to $200 million to the extent that existing or new lenders agree to provide such additional commitments. Revolver borrowings are limited to the lesser of a borrowing base, comprised of eligible receivables, inventories and personal property, or $400 million in the aggregate. The ABL Credit Facility matures on December 8, 2022.

The ABL Credit Facility contains customary representations and warranties and certain covenants that limit our ability to, among other things: (i) incur or guarantee additional indebtedness; (ii) pay distributions on, redeem or repurchase capital stock or redeem or repurchase subordinated debt; (iii) make investments; (iv) sell assets; (v) enter into agreements that restrict distributions or other payments from restricted subsidiaries to us; (vi) incur liens securing indebtedness; (vii) consolidate, merge or transfer all or substantially all of our assets; and (viii) engage in transactions with affiliates. In addition, the ABL Credit Facility contains a financial covenant which requires: (i) if any commitments or obligations are outstanding and our availability is less than the greater of $30 million or 10.0% of the aggregate amount of revolver commitments ($40.0 million at June 30, 2018), or 10.0% of the aggregate borrowing base ($40.0 million at June 30, 2018) then we must maintain a ratio of EBITDA minus certain capital expenditures and cash taxes paid to fixed charges of at least 1.00 to 1.00 for the most recent twelve fiscal month period.

We have the option to borrow under our revolver based on the agent’s base rate plus a premium ranging from 0.00% to 1.50% or the London Interbank Offered Rate, or LIBOR, plus a premium ranging from 1.25% to 2.75%.

As of June 30, 2018, we were in compliance with our covenants and had approximately $99 million of availability under the ABL Credit Facility.

As of June 30, 2018, $1.7 million of bank financing fees were included in “Prepaid expenses and other” and “Other long-term assets” on the accompanying Consolidated Balance Sheets. The financing fees are being amortized over the five-year term of the ABL Credit Facility and are included in “Interest and other expense on debt” on the accompanying Consolidated Statements of Comprehensive Income.

On March 1, 2018, we made the final $0.9 million payment on our IRB and the letter of credit and fixed interest rate swap associated with the IRB were terminated. 

Critical Accounting Policies

This Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on the consolidated financial statements included in this Quarterly Report on Form 10-Q, which have been prepared in conformity with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements. We monitor and evaluate our estimates and assumptions, based on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions.

We review our financial reporting and disclosure practices and accounting practices quarterly to ensure they provide accurate and transparent information relative to the current economic and business environment. For further information regarding the accounting policies that we believe to be critical accounting policies that affect our more significant judgments and estimates used in preparing our consolidated financial statements, see Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2017.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our principal raw materials are carbon, coated and stainless steel, and aluminum, prime tin mill, pipe and tube, flat rolled coil, sheet and plate that we typically purchase from multiple primary metals producers.  The metals industry as a whole is cyclical and, at times, pricing and availability of metals can be volatile due to numerous factors beyond our control, including general domestic and international economic conditions, the levels of metals imported into the United States, labor costs, sales levels, competition, levels of inventory held by other metals service centers, consolidation of metals producers, new global capacity by metals producers, higher raw material costs for the producers of metals, import duties and tariffs, including the Section 232 tariffs initiated by the U.S. government in 2018, and currency exchange rates. This volatility can significantly affect the availability and cost of raw materials for us.

We, like many other metals service centers, maintain substantial inventories of metals to accommodate the short lead times and just-in-time delivery requirements of our customers. Accordingly, we purchase metals in an effort to maintain our inventory at levels that we believe to be appropriate to satisfy the anticipated needs of our customers based upon historic buying practices, supply agreements with customers and market conditions. Our commitments to purchase metals are generally at prevailing market prices in effect at the time we place our orders. We have no long-term, fixed-price metals purchase contracts. When metals prices increase, competitive conditions will influence how much of the price increase we can pass on to our customers. To the extent we are unable to pass on future price increases in our raw materials to our customers, the net sales and profitability of our business could be adversely affected. When metals prices decline, customer demands for lower prices and our competitors’ responses to those demands could result in lower sale prices and, consequently, lower gross profits and inventory lower of cost or market adjustments as we sell existing inventory. Significant or rapid declines in metals prices or reductions in sales volumes could adversely impact our ability to remain in compliance with certain financial covenants in our credit facility, as well as result in us incurring inventory or intangible asset impairment charges. Changing metals prices therefore could significantly impact our net sales, gross profits, operating income and net income.

Rising metals prices, like we are experiencing in 2018, result in higher working capital requirements for us and our customers. Some customers may not have sufficient credit lines or liquidity to absorb significant increases in the price of metals. While we have generally been successful in the past in passing on producers’ price increases and surcharges to our customers, there is no guarantee that we will be able to pass on price increases to our customers in the future. Declining metals prices have generally adversely affected our net sales and net income, while increasing metals prices have generally favorably affected our net sales and net income.

Approximately 48% and 46% of our consolidated net sales during the first six months of 2018 and 2017, respectively, were directly related to industrial machinery and equipment manufacturers and their fabricators.

Inflation generally affects us by increasing the cost of employee wages and benefits, transportation services, processing equipment, energy and borrowings under our credit facility. General inflation, excluding increases in the price of metals and increased distribution expense, has not had a material effect on our financial results during the past two years. We expect transportation expenses to increase significantly in excess of general inflation in 2018 due to a shortage of truck drivers and the Electronic Log Device mandate by the Federal Motor Carrier Safety Administration issued in 2017.

We are exposed to the impact of fluctuating metals prices and interest rate changes. During 2018 and 2017, we entered into metals swaps at the request of customers. These derivatives have not been designated as hedging instruments. For certain customers, we enter into contractual relationships that entitle us to pass-through the economic effect of trading positions that we take with other third parties on our customers’ behalf.

Our primary interest rate risk exposure results from variable rate debt. We have the option to enter into 30- to 180-day fixed base rate LIBOR loans under the ABL Credit Facility.

Item 4. Controls and Procedures

The evaluation required by Rule 13a-15(e) of the Securities Exchange Act of 1934 of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this Quarterly Report on Form 10-Q has been carried out under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. These disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed in reports that are filed with or submitted to the SEC is: (i) accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures and (ii) recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2018, our disclosure controls and procedures were effective.

There were no changes in our internal control over financial reporting that occurred during the first quarter of 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 

Part II. OTHER INFORMATION

Items 1, 1A, 2, 3, 4 and 5 of this Part II are either inapplicable or are answered in the negative and are omitted pursuant to the instructions to Part II.

Item 6. Exhibits

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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