TREX - Trex Company: Tougher 2022 Than Previously Thought

Summary

• Trex Company, Inc. has seen a big pullback in the second half 2022 results, after a strong start to the year.
• Cash flow conversion has been hurt by large capital investment requirements and lower earnings.
• Fortunately, Trex Company, Inc. entered this uncertain period with a strong balance sheet.
• Long term secular trends remain intact, leaving me upbeat on Trex Company, Inc. in the long run.

In April of last year, I believed it was becoming time to take a bite out of Trex Company, Inc. ( TREX ). I called it a secular growth story in the outdoor living space as its composite products are gaining long-term market share over wood. Seen as a key Covid-19 beneficiary, most evident in the 2020 and 2021 results, I was a bit fearful of a reversal of current momentum, yet at the same time believed that the valuation reset has been sufficient to reveal appeal.

The Trex Business

Trex is an outdoor living play, providing decks for outdoor spaces to replace wood because of its superior quality, sustainability and price (over the lifetime, as the benefits have to come from longer durability and less maintenance). This is evident in the qualitative features which includes no rotting, no color fading, no painting, and no fertile grounds for termites.

Besides the core decking, other product features includes rails, but even kitchens and cladding as well. The nature of the business made the company a prime Covid-19 beneficiary as consumers remodeled their homes en masse, but certainly the outdoor parts of it. Products are found with contractors, builders, and notably Home Depot ( HD ) and Lowe's ( LOW ) , creating thousands of well-known distribution points.

It is important to note that the business saw strong growth ahead of the pandemic, as sales had risen from half a billion dollars in 2016 to three quarters of a billion in 2019. Revenues rose to nearly $900 million in the pandemic year 2020, to come in at $1.2 billion in 2021. EBITDA margins have been quite stable, around 30%, with operating margins trailing that number by a few points. To meet demand, the company started a huge new production facility in Arkansas in 2022, with completion set to take $400 million and to take more than 2-years time. This is a huge investment, with depreciation charges seen at just $40 million a year.

A $10 stock in 2016 traded at $50 pre-pandemic, peaked at $140 in December 2021, having retraced to $65 when I last looked at the shares in April. At the time, the company had just posted its 2020 results, with sales and adjusted earnings both up 36% to respectively $1.2 billion and $2.10 per share, with net cash reported at $141 million. Guiding for double digit growth in 2022, earnings likely would come in around $2.50 per share while free cash flow conversion was likely poor due to the Arkansas expansion project, albeit that net cash was strong.

While a forward 25 times multiple was still not dirt cheap, I liked the secular growth and quality of the business, as I was dipping my toes into the shares, planning to average down. After taking an initial position at $65, I have averaged down to $52, with shares now trading at $47, after trading as low as $39 per share.

2022 - Worse Than Thought

The reason for the softer share price performance has everything to do with the outside environment, as notably inflation hurts the business somewhat, but more so because higher interest rates depress valuations at large. They hurt demand for the housing business, notably for discretionary and expensive product categories, like the one served by Trex Company, Inc.

In May, the company still posted very strong first quarter results with revenues up 38% to $339 million as earnings rose in a faster manner to $0.62 per share. The company confirmed the double-digit revenue growth expectation for 2022 and 30-35% EBITDA margins. Second quarter sales rose 24% to $386 million, with earnings rising again in a spectacular fashion to $0.79 per share.

That was about the good news, with earnings so far topping $1.40 per share as the company has seen inventory cuts in the channel in June, and with customers reducing inventory levels, Trex Company, Inc. has taken measures as well. On the bright side, the midpoint of the capital spending guidance is now seen at $175 million, down from a previous $210 million guidance, as the company has slowed down the pace of the Arkansas project.

Third quarter sales were now seen at just $190 million and fourth quarter sales at $185 million, with the combined revenues in the second half of the year pretty much matching the second quarter revenue number. This means that full year sales were now seen at just $1.1 billion, which reveals a high single-digit revenue decline, standing in sharp contrast to a previous guidance calling for double digit growth. Moreover, full year EBITDA margins were seen at 28%, or just over $300 million. With EBITDA posted at $235 million the first half of the year, and the D&A component being pretty fixed, that reveals minimal earnings in the second half of the year.

Following some buybacks and capital spending, net cash balances are down to $16 million, yet the issue is that capital spending so far only totaled $66 million. This revealed that amidst hardly any profits in the second half of the year, the company would still invest more than $100 million into capital spending, resulting in a net debt position, but this is likely very manageable.

In October, Trex posted third quarter sales of $188 million, in line with the revised outlook, with EBITDA seen at $32 million and net earnings coming in at $15 million, all quite in line with the revised guidance. With capital spending so far totaling $108 million and some poor working capital cash flow conversion, the company has taken on some loans, operating with $70 million in net debt.

And Now?

Right now, Trex Company, Inc. has been able to cut the share count by approximately 5% to 110 million shares, which at $47 per share works down to a $5.2 billion equity valuation. To streamline the operations, the company announced a small sale towards the end of the year, as the company sold the Commercial Products business at an undisclosed price. The activities generated $35 million in revenues in the first nine months of 2022, generating a loss of $2 million in the process.

Obviously, 2022 was much tougher than thought amidst falling sales, falling margins, and huge capital spending requirements. The leverage position seems far from an issue, as we might see a couple more quarters of higher capital spending, but then it should pretty much end. The question is at which levels sales activities will stabilize, as quite frankly sales levels now come in below 2019, so below any pre-pandemic level as this does not yet account for the impact of inflation as well.

Hence, the anticipated $2.50 per share earnings number seen in 2020 has moved lower to roughly $1.50 per share, and while the 2023 outlook is rather murky in likelihood, there is real potential for earnings to recover to $2 per share, or even higher in the coming years. This still makes Trex Company, Inc. probably a decent long-term investment, albeit that the pullback has been a bit steeper than I feared in spring of 2022.

For that, I am holding on to my current position, but am not actively looking to add Trex Company, Inc. here at current levels.

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