Small Cap Watch List (Track at Marketocracy) member Insteel (IIIN) reported disappointing earnings this morning:

Earnings from continuing operations for the quarter were $4.9 million, or $0.27 per diluted share compared with $7.8 million, or $0.42 per diluted share for the same period last year. Including the results of discontinued operations, net earnings were $4.9 million, or $0.27 per diluted share compared with $7.4 million, or $0.40 per diluted share in the prior year. Net sales for the second quarter decreased 6.3% to $74.8 million from $79.8 million last year. Shipments decreased 6.4% while average selling prices increased 0.2%.

The consensus earnings estimate was for $0.29, though only two analysts were in the consensus – one hit $0.27 on the nose and the other was way off at $0.31. For small cap companies like this the second estimate could have been quite stale. Management put things in the best light possible:

“Considering the continued weakness in housing-related demand, escalating raw material costs and adverse weather conditions that we experienced in certain of our markets, we are pleased with Insteel’s financial results for the second quarter,” said H.O. Woltz III, Insteel’s president and chief executive officer. “We also faced difficult year-over-year comparisons in view of the exceptionally strong prior year results, which represented record sales and earnings for our second fiscal quarter facilitated by the unusually mild weather and extended construction season.

Looking over the financials, we were a bit concerned by the fact that the company burned through $6 million in cash during the first six months of its fiscal year despite reporting more than $10 million in earnings. Given that the company ended the quarter with just $9,000 in cash (thousands, not millions) they may have to tap into borrowings to fund operations this quarter.

The cash burn related mostly to paying off accounts payable from suppliers. When business is growing new accounts payable are generated at a faster rate than older ones are paid, so in aggregate suppliers provide more services than is paid in to them in cash during the period. When business slows, accounts payable come due at a faster rate than new payables are generated and more cash is paid than services received. This is what has happened to Insteel. The good news is that the payables balance now reflects the lower sales pace and the cash burn (from operations) should begin to ease.

Still draining cash in the months ahead, however, is an unusual level of capacity expansion:

Capital expenditures for 2007 are currently expected to total $18.0 million and decline to a range of $3.0 to $5.0 million per year beginning in 2008 following the completion of the expansions and equipment upgrades in the Company’s PC strand and ESM businesses. The actual timing of these expenditures as well as the amounts are subject to change based on adjustments in the project timelines, future market conditions, the Company’s financial performance and additional growth opportunities that may arise.

“We expect to start up the new ESM production line in our Texas facility during the fourth fiscal quarter of 2007, following the anticipated receipt of the equipment this quarter,” commented Woltz. “With ESM overwhelmingly used in nonresidential construction applications, the timing of the ramp-up appears to be favorable and should be unaffected by the weakness in the housing market.”

“Business conditions improved as we progressed through the quarter with March shipments rising 7% from the prior year level — the first month this fiscal year that we’ve posted a year-over-year increase. With the demand outlook more favorable heading into our busy season, we recently announced price increases across all of our product lines to offset the recent upward trend in raw material costs which should favorably impact our third-quarter results.”

The improvement would be coming in the nick of time.

With the end of the first quarter approaching, it is time to adjust the names in our Watch Lists. We will price all the new lists as of the close on Friday, March 30. Today we present our planned updates to the Small Cap Watch List (Track at Marketocracy).

Frankly, we were surprised at the amount of turnover in our screens. Only 9 of the original 29 names made the cut for the new list (which comes in at only 24 names.) Still, given the level of outperformance we saw in the first quarter (actually just two months) and the fact that much of those gains were achieved early, perhaps the turnover is warranted.

So without further ado, the names on the chopping block from the previous list are:

Silgan Holdings (SLGN - Annual Report); Steel Dynamics (STLD - Annual Report); NVR (NVR - Annual report); Middleby (MIDD); Vector Group (VCG); Sanderson Farms (SAFM); Downey Financial (DSL); Waddell & Reed (WDR); Wilshire Bancorp (WIBC); Harrington West (HWFG); Gamco Investors (GBL); Apria Healthcare (AHG); Papa John’s (PZZA); Cato Corporation (CTR); Meredith Corporation (MDP); CSG Systems (CSGS); Energy East (EAS); Dynamics Research (DRCO); Ingram Micro (IM); and Dade Behring (DADE).

The new watch list will be:

We asked, but no one answered. So we are taking our own counsel and breaking our Watch List into three portfolios: Small Cap, Mid Cap and Large Cap. Each will be tracked against the relevant S&P index going forward from their collective inception date of January 31 (priced at the close of market trading that day.)

For your viewing pleasure, the Small Cap Watch List (Track at Marketocracy) (to be measured against the S&P 600) follows.

In addition, we will provide a “quick and dirty” analysis of each name, with a goal of one such analysis per day. As the name implies, the quick and dirty analysis will be incomplete. We are hoping you will join in the debate and fill the gaps in our analysis.