Trex Company, Inc. (TREX) Q2 2012 Earnings Report, Transcript and Summary

Welcome to the Trex Company Second Quarter 2012 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded today, July 26, 2012. I would now like to turn the conference over to Harriet Fried of LHA. Please go ahead, ma'am.

Thank you, everyone, for joining us today. With us on the call are Ron Kaplan, Chairman, President and Chief Executive Officer; and Jim Cline, Chief Financial Officer. Joining Ron and Jim are Brad McDonald, Controller; Ryan Bertaux, Director of Financial Planning and Analysis; and Bill Gupp, General Counsel. The company issued a press release this morning containing financial results for the second quarter of 2012. This release is available on the company's website, as well as on various financial websites. The call is also being webcast on the Investor Relations page of the company's website, where it will be available for 30 days. I'd now like to turn the call over to Bill Gupp, Trex's General Counsel. Bill?

Thank you, Harriet. Before we begin, let me remind everyone that statements on this call regarding the company's expected future performance and condition constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements are subject to risks and uncertainties that could cause the Company's actual operating results to differ materially. Such risks and uncertainties include the extent of market acceptance of the company's products, the cost associated with the development and launch of new products and the market acceptance of such new products, the sensitivity of the company's business to general economic conditions, the company's ability to obtain raw materials at acceptable prices, company's ability to maintain product quality and product performance at an acceptable cost, the level of expenses associated with product replacement and consumer relations expenses related to product quality, and the highly competitive markets in which the company operates. Documents filed with the Securities and Exchange Commission by the company, including in particular, its latest annual report on Form 10-K and quarterly reports on Form 10-Q discuss some of the important factors that could cause the company's actual results to differ materially from those expressed or implied in these forward-looking statements. The company expressly disclaims any obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise. To supplement the company's consolidated financial statements, the company is using certain non-GAAP financial measures in today's conference call. A reconciliation of these financial measures to GAAP is attached at the end of the company's press release in 2 tables entitled "Reconciliations of Pro Forma Results of Operations Measures to the Nearest Comparable GAAP Measures, 3 Months Ended June 30, 2012", and "Reconciliations of Pro Forma Results of Operations Measures to the Nearest Comparable GAAP Measures 6 Months Ended June 30, 2012". With that introduction, I'll turn the call over to Ron Kaplan.

Good morning, everyone, and thanks for joining our second quarter update. Our 20% of revenue growth and $6.2 million increase in net income reflect the successful execution of our comprehensive growth strategy, even though the economy continues to present challenges, we exceeded our revenue target and continued to advance our industry-leading market share. Today, it is even more evident that Trex is leading the market's transition to ultralow maintenance products, offering great aesthetics and superior performance. In 2010, we engineered the -- we pioneered the shelf composite deck board with the launch of Trex Transcend, which continues to be a significant driver of our sales. It's complemented by Accents and Enhance, which together, fuels a full range in decking boards and make up our good, better, best decking platform strategy. We have utilized the Transcend technology to expand our ultralow maintenance product offering, which also includes Trex Porch. These products combined with our railing platform, TrexTrim, and accessory products like Lighting and Trex Elevations steel substructure have put us at the forefront of redefining what it means to create the outdoor ultimate living space. In past calls, I've talked about our emphasis on improving profitability through manufacturing and productivity initiatives. We continued to make strides in this area, reaching an underlying gross margin of 37% in the second quarter. This represents a 680 basis point year-over-year increase. I'm proud to say we've increased productivity 30% in the last 4.5 years. And we continue to expand our international presence. Including North America, Trex's global footprint now encompasses 26 countries. Despite the global economic headwinds, we have seen growth in sales and believe this is a very promising platform for continued development. We just hired another International Sales Manager, who lives in Germany, and we'll focus on developing a pro channel network of dealers and contractors in Europe, in the Middle East, with important elements for increasing our presence overseas. We recently paid off $92 million principal balance on our convertible notes, using $67 million of existing cash and $25 million from our revolving credit facility. In total, we've reduced the company's debt by $109 million since 2008, dramatically strengthening the company's financial position. Our net debt-to-capital ratio stands at 15%, and our cash conversion cycle this year has decreased by 25 days, a testament to our focus on cash management. Obviously, the stronger balance sheet gives us more flexibly to manage our business and pursue our growth strategy. We continue to invest in R&D, to broaden our product platform and appeal to an even wider range of buyers. As an example, our newest Transcend color, Rope Swing, was designed for hot weather markets like Florida and Texas, where people prefer lighter colors. It's been a big hit in those areas, and the coordinating Railing has also been very successful. We think that Railing provides additional opportunities to increase sales, and we want to continue leading the innovation in this category. And we want to give people as many design options as possible so that they can think outside of the rectangle, and use Trex to design customized outdoor living spaces. To that end, we recently introduced an iPad application that provides a deck color visualizer tool to help homeowners plan their outdoor living spaces. The app allows people to experiment with color combinations, save their design ideas and email them to family friends and contractors. So it's a great way to make it easier for our customers to create their ideal outdoor living space. Brand equity is one of our most vital assets, and we continue to look at ways to expand our reach efficiently. In preparation for next year's building season, we've conducted an extensive review of our branding activities. We recently completed a customer segmentation study that provided a lot of insightful information to help guide our marketing efforts for 2013 and beyond. Our goal is to get even smarter about our audience and market dynamics, and engage customers as they go through the decision-making process. In summary, it's been a very productive quarter and year for Trex. In the last 6 months underlying gross margin was 37%,while capacity utilization has been under 40%. Inventory has been reduced $15 million and free cash flow exceeded $33 million. Our plants are operating efficiently, we continue to execute well on our market share initiatives and our new product development continues to be robust. For the third quarter, we expect sales to continue to be strong and are projecting net sales of approximately $70 million. With that, I'll turn the call over to Jim Cline to provide more details on our financial results. Jim?

Thank you, Ron. Good morning, everyone. As you know, the press release with Trex's second quarter and year-to-date financial results was issued this morning. First, I'd like to review our second quarter financial results. The company recognized net sales of $94.3 million in the second quarter of 2012, a 20% increase compared to 2011. The increase in net sales was driven by a 23% increase in sales volume. We continue to advance our market share due in part to our expanding product portfolio. Weather conditions in 2012 have been significantly better than 2011, and has resulted in a more normal beginning to the deck building season. The company recorded net income of $8.3 million or $0.48 per share in the second quarter of 2012. The company's results for the second quarter of 2012 include $1.8 million of charges consisting of $1.1 million increase to the warranty reserve and a $700,000 increase for severance charges. Before giving effect to these charges, net income was $10.1 million or $0.59 per share, compared to net income of $2.1 million or $0.12 per share in 2011. Gross margin was 35.6% in the second quarter of 2012, a 560 basis point improvement from 2011. The gross profit in the quarter was adversely affected by the warranty charge. Excluding this charge, the underlying gross margin increased by 680 basis points. Increase in gross margin was primarily due to continued improvements in manufacturing efficiencies, and to a lesser extent, reduced discounts and a shift in sales mix towards our ultralow maintenance shelled products. This improvement was offset the by start-up cost associated with our shelled products of $800,000. SG&A for the second quarter of 2012 was $20.9 million compared to the $17.4 million in 2011. The second quarter of 2012 included the severance charge previously mentioned. Excluding this charge, the increase of $2.8 million in SG&A expense was primarily related to an increase in personnel related expenses, including incentive compensation and sales commissions. Net interest was $4.3 million in the quarter, a $300,000 increase from 2011. The company's results in the second quarter of 2012 and 2011 included $2.7 million and $2.3 million of non-cash interest, respectively, related to the convertible bonds. For the first 6 months of 2012, net sales were $190.4 million compared to net sales of $147.4 million for 2011, an increase of 29%. The increase in net sales was attributable to a 29% increase in sales volume. The same factors that influenced our second quarter sales volume favorably impacted our 6-month sales. In addition, we have explained in past calls, sales volumes in the first 6 months of 2011 were depressed as a result of customers purchasing product in late 2010 to avoid an announced 2011 Transcend price increase. The company recorded net income of $20.7 million or $1.22 per share in the first 6 months of 2012 compared to net income of $7.2 million or $0.42 per share in 2011. The company's results in the first 6 months of 2012 include $2.2 million of charges, consisting of $1.5 million related to an increase to the warranty reserve and $700,000 of severance charges. The company's results for the first 6 months of 2011 included a favorable resolution of uncertain tax positions in the first quarter that positively impacted income taxes by $2.6 million. Before giving an effect to these items, net income for 2012 was $22.8 million or $1.34 per share, compared to net income for the first 6 months of 2011 of $4.6 million or $0.27 per share. Gross profit was 36.2% in the first 6 months of 2012, a 460 basis point improvement from 2011. Gross profit in the first 6 months of 2012 was adversely affected by the warranty charge. Excluding the warranty charge, underlying gross margin increased by 540 basis points to 37%. The increase in gross margin was primarily due to manufacturing efficiency improvements and to a lesser extent, a shift in sales mix towards our ultralow maintenance shelled products. SG&A for the first 6 months of 2012 was $39.5 million compared to $34 million in 2011. SG&A in 2012 included the severance charge previously mentioned. Excluding this charge, the increase of $4.8 million in SG&A expenses was primarily related to an increase in personnel-related expenses, including incentive compensation and sales commissions. Net interest was $8.7 million for the first 6 months of 2012, a $700,000 increase from 2011. The company's results for the first 6 months of 2012 and 2011 include $5.5 million and $4.6 million of non-cash interest related to the convertible bonds. The effective income tax rate for the first 6 months of 2012 remain low as a result of the valuation allowance against the deferred tax asset. In 2011, it included $2.6 million of favorable non-cash adjustments to taxes that was previously mentioned. At June 30, 2012, the company had $96.5 million of cash on hand. Our debt at June 30 was $116.9 million, consisting of our revolver borrowing of $25 million and $91.9 million of convertible notes that were repaid on July 2 of 2012. Net debt to total capitalization at June 30 of 2012 was 15% compared to 38% at June 30, 2011. Since January of 2008, we have reduced our debt by $109 million. Inventory was $13.4 million at June 30, 2012, a $25.6 million year-over-year decrease. Cash flow from operating activities for the first 6 months of 2012 was $35.9 million, compared to $3.3 million for 2011. The $32.7 million increase in cash flow from operating activities was primarily related to higher net income and the reduction in working capital. Cash used in investing activities totaled $2.9 million in 2012, compared to cash used in investing activities of $6.8 million in 2011. Free cash flow of $33 million was $36.6 million higher than the first half of 2011. Finally, turning to our guidance for the third quarter, we believe that the start-up cost associated with our cap products are now behind us and our inventory is now at a seasonally normal level. We expect capacity utilization will be similar to the third quarter of 2011. SG&A expenses are expected to be approximately $3 million lower than the second quarter of 2012. The impact of paying off to convertible debt will be to significantly reduce our interest expense beginning in the second half of 2012. We expect the reduction in interest expense to be over $7.6 million compared to the second half of 2011. Operator, we would now like to open the call up for questions, after which, Ron will provide his closing statement.

[Operator Instructions] Your first question comes from the line of Trey Grooms with Stephens Inc.

First, Jim, just on the comment just, from just a few minutes ago, so 3Q utilization's similar to last year's 3Q, could you remind us what that was?

Yes, the third quarter of last year was roughly 21%.

Okay, so we're going to be about that same level, is that what you said?

That's correct.

Okay. And then also, on the SG&A, so that implies SG&A's going to be up quite a bit, I guess from the 3Q '11 period. Is that all kind of related to those personnel expenses that you were talking about, or is there anything else going on there?

It's primarily personnel-related expense, plus branding.

Okay, so you guys had some branding expense or ad spend that you guided to in the second quarter, so did some of that kind of leak in, I guess, into the third quarter. Or is this just kind of typical?

Some of it moved into the third quarter. Our overall branding spend will be up year-over-year.

Okay. And since we're on the financials here, so this, the non-cash interest that's going to be going away with the elimination of the convert, the debt discount amortization there, you said, I think was about $2.7 million in the second quarter, was that correct?

Yes.

Okay, so going forward, we would expect D&A then should be running kind of in the $4.3 million to $4.4 million arrange per quarter I guess, maybe $17 billion to $17.5 million annually?

That's correct.

Okay, perfect. And then also, just on -- could you give us, Ron, maybe the initial kind of acceptance of the Enhance line, what that's been, here kind of in the early stages?

Yes, we've been pleased with it so far. We are in the early stages, but the adoption rate has been consistent with our expectations. So we -- clearly, we're moving toward a shell technology world.

Your next question comes from the line of Keith Hughes with SunTrust.

Your comments on the capacity utilization in the third quarter, low '20s, and that's a pretty big deceleration from I think we saw here in the second. Are you seeing orders slow down, I mean your inventory was historically very low, I mean I could have the second.

Well, we're exceptionally good now at -- we're at a rate at which we can change over our production lines from -- between colors and products. So our efficiency enables us to operate very -- in a very lean fashion. Our orders are adequate enough to support our $70 million forecast, so there's a lot of different variables are going to our forecast, but we're comfortable with our forecast as we sit here today.

If you look towards next year, would we be seeing a significant product introduction next year?

Well, we'll make that decision in October. We do have some things under consideration and we won't make final decisions about major product introductions until October.

I guess finally, as you head into next year, it appears you'll be debt-free or close to debt-free. Future uses of cash flow, where do you think those would go?

Well we have a number of options available to us. These not net -- are not necessarily in orders of preference or sequence, but R&D is something that has proven to be very worthwhile for us. I don't have any big capital expansion programs in mind, but clearly, stock buybacks or dividends are options as well. As well as an enhanced, more aggressive view of acquisitions.

Your next question comes from the line of John Baugh with Stifel, Nicolaus.

Could you give some color around your mix of sales, how much is deck board, how much is a Railing, how much is trend, just any kind of trends in those businesses, et cetera?

Well, it is mostly deck boards. Our Railing is a -- as a percentage of sales is higher now than it was 4 years ago. We've introduced Elevations, which is, obviously was 0 a couple of years ago. We're not going to give numbers. We can tell you that obviously Elevations is increasing as a percentage of sales. I can tell you that International is increasing as a percentage of sales. I can tell you that Railing and lighting have increased as a percentage of sales, but deck boards is still predominant. I can tell you that within our decking, shelled product has grown extraordinarily rapidly as a percentage of our total decking sales, and that Trim continues to grow as a percentage of our sales. That's about as much color -- I know you'd like more granularity, John, I know you're frustrated.

That's okay. Would you comment on all of these other products you've touched on in terms of the influence on positively or negatively on gross margin or EBIT margin?

No. I'm an operations guy, I use short sentences.

You mentioned this brand review, and then you've mentioned branding is going to be up. I guess I'm curious, I think the branding, that being up, was decided earlier in the year. Maybe I'm wrong on that. And then what have you learned from the brand review? And what are your thoughts about spending in that area? Not just the balance of this year, but next year?

Well, I would say that branding is going to be a little bit more than it has been in the past because we're prosecuting new markets and new products. So when you prosecute a new market, new product, you've got put some bread on the water to get it launched. But it's proven to have a pretty good payback so far. We have performed this market study that I've referenced. I'm not going to tell you exactly what it says, but I can tell you that helped us modify our view of who our customers really are. There were some revelations in there. I'm not going to describe what they were, but it will more -- it will help us more accurately use a rifle shot to target our market than we have in the past. But I think I was very impressed with the level of science, data collection and statistical analysis that went into the study. And I'm very satisfied that the study and the resulting learnings that coming out of the study will more accurately define how we spend that brand money.

And Ron, on that topic, I mean that, you have sort of multiple customers. You've got a distributor, you've got the dealer and you got a consumer and a contractor, really. Any thoughts on when you talk about targeting your customer -- of those 4 choices, it would seem like if you're going to increase in branding, you're going more at the consumer? Or am I misreading that?

Well, there's only a one real customer at the end of the day, that's the customer is the homeowner. Everybody else in the food chain makes money off the Trex transaction, the only person that doesn't make money is the homeowner, who parts with his money and ends up with a beautiful Trex deck. So clearly, one thing that remains unchanged, is we want every consumer in America asking for Trex, and we want every contractor recommending Trex. The battle is fought and won or lost at the kitchen table, but that remains integral to our focus.

Okay, and then last my question is back to the wonderful topic of the warranty, over $400,000 in Q1. Now we go to $1.1 million in Q2. Refresh my memory again, on the methodology of estimate? Or what are the accountants making you do? Or that number just keeps coming and keeps coming and it's hard for us to get our arms around where that process is.

Well, I'm not -- you've got a lot of editorial remarks in there, John. I'm going to let our remarks stand by themselves. Jim is, lives and breathes this analysis on a quarterly basis, I'll let him respond to some of your questions.

Yes, John, basically, we look at the statistics of claims and the cash being paid out. As we mentioned last year, we're going to look at this on a quarterly basis, we'll make adjustments where we see it's appropriate, claims continue to decline. We anticipate the cash payments for the year will be lower than we anticipated. But based on the way the claims came in, we felt it was appropriate to make both of those adjustments to the warranty reserve.

And where will that cash number be for '12, Jim?

I'm not prepared to release that number, other than to say we anticipate it will be lower than the $8 million we had last year.

Your next question comes from the line of Morris Ajzenman with Griffin Securities.

Question for Ron. Normally, referencing market share and in your slide presentation that you have online here go through 2010 showing your market share, 35% relative to all the others here, and that's kind of trended down a little, except for Fiberon. But anyhow, I think you all also said in the past calls, you have a target, and correct me if I'm wrong, exiting 2012, I think you had said 50% market share, maybe I'm misquoting you, but can you give us any updates to that slide that goes to 2010, where you think your market share is currently?

Yes, there's a couple of points in your -- it's a good question, Morris, and let me hit a few of the different points. I did say that it was our internal goal of achieving 50% market share by the end of 2012. We certainly have moved north. We don't have firm numbers yet for 2011. We expect that they'll be published sometime in Q4 by Principia. We'll wait and see what they have to show, but my personal guess is that they're somewhere between 35% and 40%, so they continue to move north. Whether we hit our 40% internal goal by the end of 2012, history will -- 50% goal by the end of 2012, history will tell us what we've done. But we continue to move north in that regard. Now what else, Morris, did you have in your question?

Yes, just some questions, this time for Jim. In your remarks, I was scribbling a lot of numbers here, you gave us some sort of guidance for some items for third quarter, capacity, utilization, SG&A has just -- has been down. Did you touch on gross margins at all, for third quarter?

I didn't describe the gross margins, Morris. The relative information on gross margin is, one, we believe that the $800,000 of start-up cost associated with cap products that occurred in the second quarter will not continue into the third. Typically, the calculation we use internally is for every change in sales dollar up or down, it'd be a $0.50 change to the gross profit line. In addition for every change of 1% of capacity utilization on a quarterly basis, up or down, that would be about a $200,000 impact on gross profit. So I think, with that information, you can very closely estimate at what we anticipate the gross profit to be.

And I will run through those calculations, but last year, you had $68 million of revenues, 25.4% gross margin. You're going to $70 million, but we can run on those little numbers here, but should we be north of 25.4?%.

I would certainly expect that.

Okay, and very last question. Going forward, it would -- looks like your interest expenses are going to virtually nil, $1,000 to $20,000, per quarter, is that correct?

Exactly right.

And actually, one last question. And what are your shares outstanding, going forward, 17 million, 17.2 million?

17.1 million, roughly.

[Operator Instructions] Your next question comes from the line of Robert Kelly with Sidoti.

Could you just -- I missed the capacity utilization during 2Q. We got the first half roundabout, what was the number for Q2?

39%, which is roughly the same as last year.

Okay. As far as your cash balances, post the convertible path? Can you just give us an update, where you are with your cash reserve?

Cash on hand has expanded since the end of June, roughly at $10 million.

So that's what you have post the convert path?

Yes.

And then you still have the revolver borrowings?

25. I'm sorry, correction, 18.

18. So just based on the first half cash fall and I know things slowed down seasonally in the second half of the year here, but it's going to be a big free cash flow year. Do you end the year with like a net cash position?

We anticipate it will be a net debt. You'll see an improvement. We expect an improvement in the third quarter, and then as we start the building inventory for the first quarter, we'll have cash out occurring at that point.

Got you. In past quarters, you talked about CapEx being midteens million for 2012. Is that still the goal?

$10 million to $15 million will be the range.

So what will you be spending on in the second half to get to that $10 million to $15 million range?

The focus of our capital spend is retrofitting certain of our lines to expand our shelled product capacity, new product introduction and cost-reductions. There's no bricks and mortar in there, it is all focused on profit enhancement.

Understood. And then, just someone asked about the market share. Could you just talk about the competitive landscape at this point?

Well, the competitive landscape, we've -- Trex has more than double the market share of its next closest competitor. There's 3 companies that really sort of tied for #2, between Fiberon, AZEK and Timbertech. And then below that, there's another half-dozen or so competitors that sort of nibble around the edges with single-digit, low single-digit market shares. So no real blockbuster changes in the competitive landscape. There's no international penetration of our domestic markets to speak of. That would be a 10,000-foot view.

If you could, I mean, 30% growth in the first half is beyond what the market's doing. Is my guess, where is the share shift happening?

Well, as I said earlier, I think we're gaining some market share.

Is it coming from your #2, that 3 folks tied for #2, or is that, from that, the bottom tier?

We think it's coming from all of the above. And there may be a couple of folks in there that are moving ahead, and the summer moving behind, but I can't really speak incisively about with a lot of granularity about which guys are moving ahead, which are falling behind. We think we're -- we're taking it across the board from what we can tell.

Your next question comes from the line of Paul Betts with BB&T Capital Markets.

You said utilization rates were similar during the quarter to last year and you kind of expect Q3 to be similar to last year's Q3, then you have that formula about 1% capacity, but I guess other things are involved, like your manufacturing and productivity initiatives that made you have a -- almost 680 basis points increase in gross margin. So I guess that 680 did come all from the initiatives that you guys did?

Not all of it. One of the things that you need to look at is the sales in 2011 for the second quarter is only $78 million. So the increase in sales revenue for the quarter of roughly $16 million would've put $8 million of additional profit into the quarter, 2012. And that would be a large piece of it. But the productivity would've been the addition -- the additional primary driver.

And you've done a good job of reducing your inventory levels, do have any feel of what your distributor inventory levels are?

Yes. 6 out of the 9 major distributors have lower inventory now than they did a year ago.

And has that attributed to your quick turnaround time or...?

No, it's attributable to the fact that the sell-through rate has been brisk.

That is all the time we have today. Mr. Kaplan, please proceed with your presentation or any closing remarks.

Thank you. Couple of points I'd like to make. It's always a little bit challenging to balance the -- the desire that I have got to be responsive to the folks who asking questions versus the fact that I've got competitors listening into this call. So I wish I could be more responsive, and not give short answers to very thoughtful questions that you guys pose to us, but I'm reminded that looking at my screen, that I got competitors listening, and I, and so I'm -- that's the reason that I'm a little bit brief sometimes in the responses that I give. Secondly, these last few weeks have been extraordinarily gratifying to us here at Trex, and me personally. When we paid off that convertible debt, that was an extraordinary pivot point for Trex. If you look at where we were 4.5 years ago, to where we were, where we are now, we've vastly reduced the inventory, we transformed the technology and the industry. We generated over $100 million of cash flow. We had game-changing products and technology. We've expanded our markets internationally. And the last major hurdle to deal with issues of the past was to pay off that debt. This really gives Trex some running room and all of these things didn't happen because of 1 or 2 smart people. They happened because this organization is filled with smart, motivated people from the top floor to the shop floor, and I know a lot of them are listening to me right now, and I wanted to make them aware that their work is appreciated, and to make sure that you guys in the analyst community appreciate the fact that this company does have a strategic advantage, and that's its people. I'm very proud of them. Well, thanks very much for joining us this morning. It's been a productive period for Trex, with our improvement in sales margins and cash management. We're going to continue to execute on our market share initiatives and new product development efforts, so enjoy the rest of the summer and I look forward to talking to you soon. Goodbye.

Ladies and gentlemen, that concludes your conference call for today. We thank you for your participation and ask that you please disconnect your lines.