UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the Quarterly Period Ended June 26, 2004

OR

For the Transition Period From ________ to ________

Commission File Number 1-9929

Insteel Industries, Inc.

Registrant’s telephone number, including area code: (336) 786-2141

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

     The number of shares outstanding of the registrant’s common stock as of August 3, 2004 was 9,066,471.

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

INSTEEL INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands)

     See accompanying notes to consolidated financial statements.

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INSTEEL INDUSTRIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands except for per share data)
(Unaudited)

     See accompanying notes to consolidated financial statements.

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INSTEEL INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

     See accompanying notes to consolidated financial statements.

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INSTEEL INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1)	Basis of Presentation

     The accompanying unaudited interim consolidated financial statements of Insteel Industries, Inc. (the “Company”) have been prepared pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) for quarterly reports on Form 10-Q. Certain information and note disclosures normally included in the audited financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. These financial statements should therefore be read in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended September 27, 2003 included in the Company’s Annual Report on Form 10-K filed with the SEC.

     The accompanying unaudited interim consolidated financial statements included herein reflect all adjustments of a normal recurring nature that the Company considers necessary for a fair presentation of results for these interim periods. The results of operations for the three months and nine months ended June 26, 2004 are not necessarily indicative of the results that may be expected for the fiscal year ending October 2, 2004.

(2)	Recent Accounting Pronouncements

     In December 2003, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 132 (revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” This Statement changes the disclosure requirements for pension plans and other post-retirement benefit plans. It does not change the measurement or recognition of those plans required by SFAS No. 87, “Employers’ Accounting for Pensions,” SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” or SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” This Statement requires additional disclosures to those required in the original SFAS No. 132 about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension plans and other post-retirement benefit plans. SFAS No. 132 requires that information be provided separately for pension plans and for other post-retirement benefit plans and is effective for annual financial statements with fiscal years ending after December 15, 2003, and for interim periods beginning after December 15, 2003. The Company has adopted SFAS No. 132 and provided the interim period disclosure requirements for the three months and nine months ended June 26, 2004 as disclosed in Note 5. The adoption of SFAS No. 132 did not have any impact on the Company’s operating results or financial position.

     In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities — an interpretation of Accounting Research Bulletin (“ARB”) No. 51.” This Interpretation is intended to clarify the application of the majority voting interest requirement of ARB No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The controlling financial interest may be achieved through arrangements that do not involve voting interests.

     Subsequent to issuing FIN 46, the FASB issued FIN 46 (revised) (“FIN 46R”), which replaces FIN 46. Among other things, FIN 46R clarified and changed the definition and application of a number of provisions of FIN 46 including de facto agents, variable interests and variable interest entity (“VIE”). FIN 46R also expanded instances when FIN 46 should not be applied. FIN 46R was issued December 23, 2003 and, for the Company, was effective no later than the end of the second quarter of fiscal 2004. FIN 46R may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. The Company has not identified any significant variable interests that would have a material impact on its financial statements since its adoption of FIN 46 at the end of the second quarter of fiscal 2004.

(3)	Stock-Based Compensation

     The Company accounts for its employee stock option plans under the intrinsic value method prescribed by Accounting Principals Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, and has adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based

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Compensation” and, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment for FASB Statement No. 123.”

     SFAS No. 123, as amended by SFAS No. 148, permits companies to recognize the fair value of all stock-based awards on the grant date as expense over the vesting period. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. Because the Company’s stock-based compensation plans have characteristics significantly different from those of traded options and because changes in subjective input assumptions can materially affect the fair value estimate, the Company believes that the existing option valuation models do not necessarily provide a reliable single measure of the fair value of awards from the plan. Therefore, as permitted, the Company applies the existing accounting rules under APB No. 25 and provides pro forma net earnings and net earnings per share disclosures for stock-based awards made during the indicated periods as if the fair value method defined in SFAS No. 123, as amended, had been applied. Net earnings and net earnings per share for the three months and nine months ended June 26, 2004 and June 28, 2003, respectively, are as follows:

(4) Deferred Tax Assets

     The Company has recorded the following amounts for deferred tax assets, deferred tax liabilities, and accrued income taxes on its consolidated balance sheet as of June 26, 2004: a current deferred asset of $874,000 in prepaid expenses and other, a noncurrent deferred tax asset of $3.1 million (net of valuation allowance) in other assets and accrued income taxes payable of $6.2 million in accrued expenses. The Company has utilized all of its gross federal operating loss carryforwards of $18.0 million and $15.9 million of gross state operating loss carryforwards based on income generated during the current year. The Company has $21.3 million of gross state operating loss carryforwards that begin to expire in eight years, but principally expire in 17 — 20 years. The Company also has utilized all of its federal alternative minimum tax credit carryforwards of $360,000 due to the income generated during the current year.

     The realization of the Company’s deferred tax assets is entirely dependent upon the Company’s ability to generate future taxable income. Generally accepted accounting principles (“GAAP”) require that the Company periodically assess the need to establish a valuation allowance against its deferred tax assets to the extent the Company no longer believes it is more likely than not that the tax assets will be fully utilized. Based on the Company’s expectations with respect to future operations, the Company anticipates that it will generate sufficient taxable income to utilize all of its state net operating loss carryforwards. Under GAAP, however, projected financial performance alone is not sufficient to warrant the recognition of a deferred tax asset to the extent the Company has had cumulative losses in recent years. Rather, the presumption exists that absent recent historical evidence of the Company’s ability to generate taxable income, a valuation reserve against deferred tax assets should be established. Accordingly, in connection with the losses incurred for fiscal years 2001 and 2002, the Company established a valuation allowance of $7.5 million against its deferred tax assets in 2002. The valuation allowance was reduced during the fourth quarter of 2003 from $7.5 million to $1.3 million eliminating the valuation allowance on all federal net operating losses (“NOLs”) due to their anticipated utilization in 2004. The remaining $1.3 million valuation allowance pertains to various state NOLs that are not anticipated to be utilized during 2004. During 2004, this $1.3 million valuation allowance was reduced to $1.0 million based on the income generated during the current year. The valuation allowance established by the Company is subject to periodic review and adjustment based on changes in facts and circumstances.

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(5)	Pension Benefits

     The Company has one defined benefit pension plan, the Insteel Wire Products Company Retirement Income Plan for Hourly Employees, Wilmington, Delaware, (“the Delaware Plan”). The Delaware Plan provides benefits for eligible employees based primarily upon years of service and compensation levels. The Company’s funding policy is to contribute amounts at least equal to those required by law. The Company has contributed $447,000 to the Delaware Plan during the nine-month period ended June 26, 2004 and it expects to contribute $572,000 for the entire fiscal year ending October 2, 2004. The net periodic pension costs and related components for the Delaware Plan for the three months and nine months ended June 26, 2004 and June 28, 2003, respectively are as follows:

(6)	Credit Facilities

     On June 3, 2004, the Company entered into a new $82.0 million senior secured debt facility, consisting of a $60.0 million revolver, a $17.0 million Term Loan A and a $5.0 million Term Loan B, which has a four-year term maturing on June 2, 2008. Proceeds from the financing were used to pay off and terminate the Company’s previous credit facility (approximately $62.4 million outstanding as of the closing date) and will support the Company’s working capital, capital expenditure and general corporate requirements going forward. The new credit facility is secured by all of the Company’s assets.

     Advances under the revolving credit facility are limited to the lesser of the revolving credit commitment or a borrowing base amount that is calculated based upon a percentage of eligible receivables and inventories. As of June 26, 2004, approximately $33.8 million was outstanding on the revolver and excess borrowing availability was $21.1 million, $17.0 million was outstanding on Term Loan A, and $4.4 million was outstanding on Term Loan B. Term Loan A amortizes over 47 months, beginning on July 1, 2004, at $283,000 per month with the remaining principal balance due on June 2, 2008. Term Loan B does not amortize and the entire principal balance is due in a single payment on June 2, 2008. The Credit Agreement also provides for mandatory prepayments equal to 50% of Excess Cash Flow (as defined in the Credit Agreement) and voluntary prepayments of up to $625,000 each year on Term Loan A and B.

     Interest rates on the revolver and Term Loan A are based upon (1) a base rate that is established at the higher of the prime rate or 0.50% plus the federal funds rate, or (2) at the election of the Company, a LIBOR rate, plus in either case, an applicable interest rate margin. Interest rates on the Term Loan B are based upon the higher of the prime rate or 0.50% plus the federal funds rate plus an applicable interest rate margin. The applicable interest rate margins are initially 1.50% for the base rate and 3.00% for the LIBOR rate on the revolver, 2.25% for the base rate and 3.75% for the LIBOR rate on Term Loan A, and 7.00% for the base rate on Term Loan B. Beginning on April 2, 2005, the applicable interest rate margins will be adjusted within the following ranges on a quarterly basis based upon the Company’s leverage ratio: 1.00% - 1.75% for the base rate and 2.50% — 3.25% for the LIBOR rate on the revolver, 1.50% — 2.25% for the base rate and 3.00% — 3.75% for the LIBOR rate on Term Loan A, and 5.00% — 7.00% for the base rate on Term Loan B. In addition, the applicable interest rate margins may be adjusted further based on the amount of excess availability on the revolver and the occurrence of certain events of default provided for under the credit facility. As of June 26, 2004, interest rates on the credit facility were 4.32% on the revolver, 4.96% on Term Loan A and 11.00% on Term Loan B. In connection with the refinancing of the previous credit facility, the Company terminated interest rate swap agreements for payments totaling $2.1 million and recorded a corresponding unrealized loss for hedging instruments in the third quarter of fiscal 2004 which, in accordance with GAAP, will be amortized and recorded as interest expense through the original termination date of January 31, 2005.

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     The Company’s ability to borrow available amounts under the credit facility will be restricted or eliminated in the event of certain covenant breaches, events of default or if the Company is unable to make certain representations and warranties, including that a Material Adverse Change (as defined in the Credit Agreement) has not occurred with respect to the Company.

     Financial Covenants

     The terms of the credit facility require the Company to maintain certain fixed charge coverage and leverage ratios during the term of the credit facility. Commencing with the fiscal quarter ending on October 2, 2004, the Company must have a Fixed Charge Coverage Ratio (as defined in the Credit Agreement) of not less than 1.15 at the end of each fiscal quarter for the twelve-month period then ended (or, for the fiscal quarters ending on or before July 2, 2005, the period commencing on June 1, 2004 and ending on the last day of such fiscal quarter). In addition, the Company must maintain a Leverage Ratio (as defined in the Credit Agreement) of not more than 3.25 as of the last day of each quarter through July 1, 2006, and not more than 3.00 thereafter. The Company is also required to have consolidated EBITDA (as defined in the Credit Agreement) equal to at least $15.0 million for the quarter ending June 26, 2004. The Company was in compliance with all of the financial covenants as of June 26, 2004.

     Negative Covenants

     In addition, the terms of the credit facility restrict the Company’s ability to, among other things: engage in certain business combinations or divestitures; make capital expenditures; make investments in or loans to third parties, unless certain conditions are met with respect to such investments or loans; incur or assume indebtedness; issue securities; enter into certain transactions with affiliates of the Company; or permit liens to encumber the Company’s property and assets.

     The Company is limited to Capital Expenditures (as defined in the Credit Agreement) of not more than $5.0 million for the period beginning on May 30, 2004 and ending on October 2, 2004, and not more than $7.0 million for each fiscal year thereafter through the year ending September 29, 2007, and for the period beginning on September 30, 2007 and ending on June 2, 2008, plus for any of these periods, up to a $2.0 million carryover of the amount by which actual Capital Expenditures are less than the applicable limitation for the prior period.

     Events of Default

     Under the terms of the credit facility, an event of default will occur with respect to the Company upon the occurrence of, among other things: a default or breach by the Company or any of its subsidiaries under any agreement resulting in the acceleration of amounts due in excess of $500,000 under such other agreement; certain payment defaults by the Company or any of its subsidiaries in excess of $500,000; certain events of bankruptcy or insolvency with respect to the Company; an entry of judgment against the Company or any of its subsidiaries for greater than $500,000, which amount is not covered by insurance; or a change of control of the Company.

(7)	Earnings Per Share

     The reconciliation of basic and diluted earnings per share (“EPS”) is as follows:

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     Options to purchase 354,000 shares and 566,000 shares for the three months ended June 26, 2004 and June 28, 2003, respectively, were antidilutive and were not included in the diluted EPS computation. Options to purchase 519,000 shares and 686,000 shares for the nine months ended June 26, 2004 and June 28, 2003, respectively, were antidilutive and were not included in the diluted EPS computation. Options to purchase 321,000 shares were exercised during the nine months ended June 26, 2004, resulting in an increase to common stock of $643,000 and a reduction to additional paid-in capital of $310,000.

(8)	Comprehensive Income (Loss)

     The components of comprehensive income (loss), net of tax, for the three months and nine months ended June 26, 2004 and June 28, 2003, respectively, are as follows:

     The change in the accumulated other comprehensive loss for the nine months ended June 26, 2004 is as follows:

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(9)	Other Financial Data

     Balance sheet information:

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

Cautionary Note Regarding Forward-Looking Statements

     This report contains forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. When used in this report, the words “believes,” “anticipates,” “expects,” “plans” and similar expressions are intended to identify forward-looking statements. Although the Company believes that its plans, intentions and expectations reflected in or suggested by such forward-looking statements are reasonable, such forward-looking statements are subject to a number of risks and uncertainties, and the Company can provide no assurances that such plans, intentions or expectations will be achieved. Many of these risks are discussed in detail in the Company’s periodic reports, in particular in its report on Form 10-K for the year ended September 27, 2003, filed with the U.S. Securities and Exchange Commission. You should carefully read these risk factors.

     All forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by these cautionary statements. All forward-looking statements speak only to the respective dates on which such statements are made and the Company does not undertake and specifically declines any obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect any future events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

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     It is not possible to anticipate and list all risks and uncertainties that may affect the future operations or financial performance of the Company; however, they include, but are not limited to, the following:

	•		general economic and competitive conditions in the markets in which the Company operates;
	•		the cyclical nature of the steel industry;
	•		changes in U.S. or foreign trade policy affecting steel imports or exports;
	•		fluctuations in the cost and availability of the Company’s primary raw material, hot-rolled steel wire rod from domestic and foreign suppliers;
	•		the Company’s ability to raise selling prices in order to recover increases in wire rod prices;
	•		interest rate volatility;
	•		unanticipated changes in customer demand, order patterns and inventory levels;
	•		the Company’s ability to successfully develop niche products, such as its engineered structural mesh products;
	•		legal, environmental or regulatory developments that significantly impact the Company’s operating costs;
	•		unanticipated plant outages, equipment failures or labor difficulties; and
	•		continuing escalation in medical costs that affect employee benefit expenses.

Results of Operations

Statements of Operations – Selected Data
($ in thousands)