Few Charts And Figures Showing The Superiority Of Trex Company (NYSE:TREX)


Editor’s note: Seeking Alpha is proud to welcome Steady Growing Wealth as a new contributor. It’s easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA PREMIUM. Click here to find out more »

Editor’s note: Seeking Alpha is proud to welcome Steady Growing Wealth as a new contributor. It’s easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA PREMIUM. Click here to find out more »

Introduction

As a private investor focused on multi-year family capital growth, I select outstanding, long-lived companies. Trex Company, Inc. (NYSE: TREX) has been engaged in its core business (production of composite decking) for more than 2 decades (or 3, if we count from the date of foundation of Rivenite Corporation, the predecessor of Trex).

These are my 3 arguments that Trex is still worthy of long-term investors’ money:

  • Trex is an outstanding company with strong fundamentals;
  • Trex is run by a competent and trustworthy management;
  • Trex has a long-term competitive edge (“moat”).

I owe this set of 3 criteria to the great investor Warren Buffett, who popularized the term “moat” among investors as a metaphor for a long-term competitive edge that protects excellent returns on invested capital made by great businesses from future repeated assaults by competitors (Warren Buffett’s letters to Berkshire shareholders: 2005, p.14; 2007, p.6; 2012, p.19).

Before I elaborate on my arguments, let me remind what Trex Company, Inc. today is the world’s largest manufacturer of composite decking whose sources of raw materials, manufacturing facilities and end market (residential housing) are located in the U.S.

Trex is built on a unique recycling business model – its composite decking is 95% comprised of reclaimed wood sawdust plus recycled polyethylene film and bags. The company is also developing other products to achieve synergy, but their share in sales is not so significant so let me not dwell on them.

Well, here we go.

1. Trex is an outstanding company with strong fundamentals

Free cash flow

For the last 12 years Trex has been generating positive free cash flow (FCF) every year. Moreover, FCF is in a growing trend (see chart).

Data source: SEC 10-K filings, my calculations

Yes, starting from 2019FY and in the next 1-2 years, FCF will sink due to significant capital expenditures ($67.3 mln in 2019, $140-160 mln planned for 2020) required for expansion of production capacities that are expected to increase by at least 70% as demand for the company’s main product – composite decking – is steadily growing and available capacities are already 100% loaded.

FCF is likely to remain positive as further growth of cash provided by operating activities is expected.

Income from operations

Income from operations has been growing continuously for the last 8 years (see chart), with CAGR 22.6% for the last 5 years.

Trex Company: Income from operations 1998 - 2019

Data source: SEC 10-K filings

Operating margin

Operating margin for the last 8 years shows a growing trend reflecting the healthy growth of the company, and for the last few years it has been keeping stable at 25-26% (see chart).

Trex Company: Operating margin 1998 - 2019

Data source: SEC 10-K filings, my calculations

Debt

As of March 31, 2020, the company’s outstanding debt consists of $28.5 mln in outstanding borrowings under its revolving credit facility with the limit of $250 mln for annual seasonal working capital financing.

The company has no long-term debt.

Operating lease liabilities were $32.4 mln for office space, storage warehouses and certain plant equipment. Rental expenses for the last 3 years amounted to $9.1 mln, $10.0 mln, $8.4 mln in 2017, 2018, 2019, respectively.

Return on equity

Let’s look at the return on equity which I prefer to calculate using Income from operations instead of Net Income, as I believe it reflects the efficiency of the company’s business better.

Operating ROE = Income from operations / Total stockholders’ Equity average for the financial year. Something interesting awaits us here.

The change of the management team at the beginning of 2008 broke the trend, replacing the nosedive with a new take-off. Starting from 2012, the period of rapid income growth begins, accompanied by an amazing surge of Operating ROE from 2% in 2011 to 83% in 2016 (see chart).

Trex Company: Operating ROE 1998 - 2019

Data source: SEC 10-K filings, my calculations

But then Operating ROE drops continuously: 78%, 62%, 48% in 2017, 2018, 2019, respectively. Does this decline mean the company’s business has gone worse? I don’t think so. It is worth digging deeper to see: ROE trend has changed because the company has started saving money for large investments (and now I’m going to prove it).

Buybacks & Cash

During the first 4 years of strong profit growth (2013, 2014, 2015, 2016) most of the annual net income returned to stockholders in the form of buyback (72%, 120%, 94%, 79% of net income, respectively) which constrained the growth of total stockholders’ equity, pushing Operating ROE to new heights (see chart).

Trex Company: Operating ROE and Buyback 2011 - 2019

Data source: SEC 10-K filings, my calculations

At the same time cash was kept at a low level, both in absolute values and in relation to working capital: 15%, 21%, 21%, 27% of working capital in 2013, 2014, 2015, 2016, respectively (see chart).

Trex Company: Operating ROE and Cash & Cash equivalents 2013 - 2019

Data source: SEC 10-K filings, my calculations

The period after 2016 is characterized by a different financial policy. Against the backdrop of continued revenue and profit growth the company sharply reduced its buyback volume (0%, 19%, 27% of net income in 2017, 2018, 2019, respectively) and focused on the accumulation of cash instead, which began to grow rapidly reaching 63% of working capital for 2019 (see chart). Accumulation of assets (сash) owned by shareholders but temporarily not engaged in business reversed the trend of Operating ROE and the indicator started to decline.

I see the following explanation: the company’s development has come to a point where to maintain further growth of sales and profits against the background of steady growth of demand it is necessary to significantly increase production capacity, which requires serious investments.

My guess is the management has decided to accumulate funds, anticipating the need for future expansion of production. The company spent $3.2 mln in 2015 and $5.6 mln in 2016 on purchase of land adjacent to company’s facility in Winchester, Virginia, “to support potential future expansion.”

In June 2019 announced a $200 mln multi-year capacity expansion program between 2019 and 2021 to increase capacity at Nevada and Virginia facilities by at least 70%. Under this program, out of $67.3 mln CapEx in 2019 (see chart) $59.8 mln was spent on capacity expansion alone. Construction of a new building has already begun on the acquired land in Winchester, Virginia.

Trex Company: Capital Expenditures 2012 - 2019

Data source: SEC 10-K filings

Also, all previous years the company methodically worked on process and productivity improvements and implemented cost reduction initiatives at existing facilities.

So I believe that the company shows a strong position on the fundamental indicators, which I tend to consider as the most important in the long term:

  • positive and growing free cash flow,
  • growing income from operations,
  • growing or stable operating margin,
  • zero long-term debt,
  • high operating ROE,
  • growing cash and cash equivalents,
  • growing capital expenditures.

With these outstanding results, Trex owes much to the current management team.

2. Trex is run by a competent and trustworthy management

To confirm my thesis about the current management of Trex, I’d like to recall some details from the company history in relation to specific people and their actions.

Until the end of 2007, Trex was managed by a team of top founding managers, initially consisting of 4 persons, including Roger A. Wittenberg, who is considered to be the inventor of the wood-plastic composite deck manufacturing technology from the mixture of shredded plastic bags with sawdust (and who left the company in May 2003). If you are interested, I have collected some details about Trex management before 2008 in this short post.

Since 2008, a new era in Trex’s history has begun and continues to this day. The charts above reflect well the “turnaround” made by the new management team.

Ronald W. Kaplan (68 y.o. now) headed Trex from January 2008 to August 2015 as President and CEO. He served as Chairman from May 2010 to April 29, 2020, also and currently serves as Vice Chairman.

Mr. Kaplan has solid professional experience as CEO of manufacturing companies, including experience leading companies through financial and operational “turnarounds.”

In 2008, he changed the motivation system for managers and factory workers, cutting about 30 people among the former and 30% among the latter. In 2009, he launched Transcend, a new coated decking with 25-year warranty which still heads Trex product line. In 2012, Trex paid off remaining $91.9 mln debts inherited from its previous management team.

James E. Cline (68 y.o. now) was always the man Mr. Kaplan could rely on for financial management. He served as CFO from March 2008 and succeeded Ronald W. Kaplan as President and CEO in August 2015 as well as Chairman from April 29, 2020 to the present time.

Here are a couple of quotations reflecting Ronald W. Kaplan’s views on working with James E. Cline at Trex:

… Jim Cline … was key to our successful turnaround and has been instrumental in our recent successes. … he brings … an extensive knowledge of the industry and the proven ability to lead.

Jim Cline has done an outstanding job as CEO of Trex, driving strong growth, building shareholder value and positioning the Company for continued success. In addition to significantly expanding the Company’s business and addressable market, Jim has been an excellent mentor to Trex executives.

Bryan H. Fairbanks, Christopher P. Gerhard and Adam D. Zambanini joined Trex earlier than 2008, passed the rigid Mr. Kaplan’s personnel filter, consistently occupied more and more senior and responsible positions at Trex. These seem to be the managers that James Cline mentioned:

When I first came onboard, after we got rid of that top level of management, I was able to talk to a wide variety of our people and found that they were turned on and focused. They knew what the problems were – they just needed some help in driving the change that needed to take place within the organization. It was a great talent pool that just needed a different direction.

Bryan H. Fairbanks (50 y.o. now) served at Trex as Director, Financial Planning and Analysis from May 2004 to March 2006, then as Senior Director, Supply Chain to August 2015, then as CFO until recently. From April 29, 2020, he holds the position of President and CEO. Also from September 2012 to August 2015, he concurrently served as Executive Director, International Business Development.

Here are a couple of quotations reflecting James E. Cline’s views on working with Bryan H. Fairbanks at Trex:

Bryan has more than a decade of business, operational and financial experience with Trex, and has done an outstanding job in each of the roles he has held. With his diverse background and successful track record, he is perfectly positioned to become Trex’s chief financial officer.

Bryan and I have worked together closely for more than four years on developing strategies to strengthen the Trex brand, consolidate our market leadership in composites and accelerate conversion from the dominant wood market, while delivering strong financial results. I am confident that Bryan’s leadership skills and dedication to excellence will foster the Company’s continued growth.

Christopher P. Gerhard (47 y.o. now) served at Trex from May 2006 in a number of capacities, including as Director, Field Sales. From June 2012 Mr. Gerhard has served as Vice President, Sales.

Adam D. Zambanini (43 y.o. now) served at Trex from September 2005 in a number of capacities, including as Director, Marketing. From January 2011 to July 2018 he served as Vice President, Marketing. Mr. Zambanini currently holds the position of President of Trex Residential Products, the core of the company’s two business segments.

Dennis Schemm (54 y.o.), a new member of the team as Vice President and CFO joined Trex on April 29, 2020. Prior to that, he had a brilliant career in finance, at such companies as Monsanto, Danaher (NYSE:DHR), Armstrong Flooring (NYSE:AFI) and Continental Building Products (NYSE:CBPX).

Commenting on this appointment, Bryan Fairbanks noted:

Dennis brings extensive industry knowledge, financial acumen and the proven ability to lead. His background and continuous improvement mindset make him an excellent business and cultural fit for Trex.

Thus, from April 29, 2020, Trex has:

  1. A team of mature (43-54 y.o.) and experienced top managers represented by Bryan H. Fairbanks as President and CEO, Dennis Schemm as Vice President and CFO, Christopher P. Gerhard as Vice President, Sales and Adam D. Zambanini as President of Trex Residential Products, each of whom (except for the newly appointed Dennis Schemm) has served at Trex for at least 14 years and has successfully passed through all the stages of “turnaround” (since 2008);
  2. Elders represented by Ronald W. Kaplan (68 y.o.) and James E. Cline (68 y.o.) in the Board of Directors, whose experience in managing and exiting crisis at production enterprises (including Trex) cannot be overestimated.

Given the fact Ronald W. Kaplan is known for his “take-no-prisoners” approach showing a certain coldheartedness, culling employees as needed, it can be concluded Bryan H. Fairbanks, Christopher P. Gerhard and Adam D. Zambanini have proven to be effective as they continue to serve at Trex so far.

Warren Buffett’s arsenal has a simple test that allows to evaluate how effectively management uses the company’s profits: each dollar of retained earnings growth should bring at least one dollar of the company market value growth in an interval of 4-5 years.

Let’s see: from 2012 to 2019, Trex’s retained earnings (net of buyback) increased by $332 mln, and market capitalization increased from $357 mln to $5.2 bln (as of December 31, 2019). That is, every dollar of retained earnings growth brought $14.7 in capitalization growth. It’s hard to deny that this is the merit of the current management.

3. Trex has a long-term competitive edge (“moat”)

The main long-term competitive edge of Trex (“moat” according to Warren Buffett), I believe, is the steady adherence to the key business idea inherited from its founder Roger A. Wittenberg: “recycling used products into useful products,” combined with the continuous improvement of the ways of its implementation. Trex decking contains 95% recycled material – an absolute record among competitors.

Over several decades, this business idea has generated long-term competitive advantages in the decking market, such as the most famous brand and unique “eco-friendly” reputation (“greenest product,” “company – eco-leader“). I’m not going to list the awards Trex has received – they are easy to google if you want.

The company regards wood decking as its primary competitor and is constantly striving to convert demand for wood products into demand for composite products. Although the most affordable deck in the Trex product line – Enhance Basic – is 2 times more expensive in retail than conventional wood decking, Trex seeks to convey to consumer the idea that composite decking requires substantially lower life-cycle costs compared to conventional wood. Emphasis is placed on a longer service life (25 years vs. 10 years) and the minimum annual care required (only water and soap).

Among other manufacturers of wood-alternative products, Trex names The Azek Building Products, Inc. (private but about to become a public company), and Fiberon (a division of Fortune Brands (FBHS) since September 2018) as its closest competitors.

Other competitive advantages at the moment:

  1. The highest market share. At 2019FY the company estimated the entire market for decking at $5 billion, including $1 billion of composite decking plus $4 billion of conventional wood decking. At sales $694 mln in Trex Residential business segment it means market share ~ 70% across composite decking and ~ 14% across “composite + wood” decking.
  2. Strong supply chain. Reclaimed wood fiber comes in as a byproduct of local сabinet and flooring manufacturers. A scrap polyethylene film and plastic bags come from both commercial partners and through the donation collection programs:
    1. NexTrex Recycling Program. Approx. 32,000 partner retailer stores incl. Kohl’s (NYSE:KSS) and Target (NYSE:TGT) in all 50 states.
    2. Trex Plastic Film Recycling Challenge. In the season 2019/2020 over 700 schools nationwide have collected 362,556 pounds of polyethylene plastic, contributing to the more than 400 million pounds of plastic film, bags and wrap that Trex diverts from landfills each year.
  3. Strong distribution network: 6,700 stocking locations incl. Home Depot (NYSE:HD) and Lowe’s (NYSE:LOW).
  4. Bi-coastal manufacturing facilities & storage: Winchester, Virginia and Fernley, Nevada.
  5. Six Sigma and Lean Manufacturing methodologies are guardians of quality and product value to consumers.
  6. Powerful company culture. Leadership training program, regular semi-annual performance reviews for all salaried employees, competitive benefits output voluntary turnover rate for employees with more than one year of service less than 7%.

Conclusion

As Warren Buffett said:

Time is the friend of the wonderful business, the enemy of the mediocre.

As long as Trex’s business remains “wonderful” according to the 3 criteria disclosed in this article, I will hold its shares and enjoy a smooth growth in their value over the long term.

In case of a sharp price decline, not caused by the problems of the company’s core business, I will buy more shares. For example, that’s what I did in March this year.

Quick note on the COVID-19: I tend to see the impact of COVID-19 as a very strong but relatively short-term shock to the economy.

I’m also encouraged that although management has rescinded guidance metrics previously provided for full-year 2020 until second-half visibility improves, at the same time “order flow remains in line with expectations over the past four months of the year,” the company “is set to continue operating at 100% capacity utilization and sees no need to modify its current capital expansion program,” as stated in early May by Bryan Fairbanks, President and CEO of the company, during a conference call for the first quarter.

Disclosure: I am/we are long TREX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Be the first to comment

Leave a Reply

Your email address will not be published.


*