Trex Company, Inc. (TREX) Q2 2013 Earnings Report, Transcript and Summary

Welcome to the Trex Second Quarter 2013 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded today, Tuesday, August 6, 2013. 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; and Brian Bertaux, Director of Financial Planning and Analysis. The company issued a press release this morning containing financial results for the second quarter of 2013. The release is also 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. Before we begin, let me remind everyone that statements on this call regarding the company's expected future performance and conditions constitute forward-looking statements within the meaning of the federal securities law. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. For a discussion of such risk and uncertainties, please see the company's most recent Form 10-K and Form 10-Q, as well as its '33 and other '34 Act filings with the SEC. 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 provided in the tables at the end of this morning's release. With that introduction, I'd like to turn the call over to Ron Kaplan. Go ahead, please, Ron.

Good morning. I'll start with an overview of this quarter's results, and we'll then give you an update on our strategic initiatives. As a reminder, we had a strong start to the year. We exceeded our sales guidance for the first quarter and had the right amount of inventory in the channel to support the start of the building season. The wet spring, specifically in June, adversely impacted our second quarter sales. Despite the weather conditions, we delivered a strong financial performance. Sales were up almost 5%. Gross margin rose nicely, and our profitability was strong. The steady operational progress we've made over the past 5 years contributed to the good bottom line. We also generated a significant amount of cash during the quarter, further improving our liquidity. The share repurchase program that we announced this morning is a testament to that. With the great balance sheet we've built, this is just the first step in optimizing our capital structure to continue enhancing shareholder value. Our strategy for 2013 of offering a full lineup of best-in-class, high-performance decking and railing products has been effective. These products offer a higher level of fade, scratch, and stain resistance than our predecessors. Consumers like our value proposition, and we continue to see a shift in sales mix toward these higher-priced products. Our expanded array of best-in-class products is also helping us build stronger relationships with our dealers and distributors. Our product strategy has strengthened loyalty in the marketplace. This is demonstrated by our increased sales in what continues to be a slowly improving but still challenging economic environment. In addition, with our expanded high-performing platforms, we're able to appeal to a broader range of consumers. Our decision to go beyond the WPC market and offer products that compete in the PVC and aluminum railing segments is showing early signs of success. As I mentioned last quarter, by offering Trex Select and Trex Reveal railing, we have access to $325 million of market opportunity not previously served by Trex. In total, Trex now offers an unparalleled portfolio of 1,200 different decking and railing combinations for contractors and consumers. We also offer a number of design tools to help contractors and consumers visualize their decking and railing options. On the international front, we're continuing to bring Trex products to new countries. Trex now services 35 countries across the globe. Our strategy is beginning to take effect. I'll close my section as usual with the outlook for the coming quarter. For this year's third quarter, we're expecting net sales of approximately $72 million, which is a gain of nearly 2% over last year's period. Jim?

Thank you, Ron. Good morning. As you know, the press release with the Trex second quarter financial results was issued this morning. The company recognized net sales of $99 million in the second quarter of 2013, a 5% increase compared to 2012. The increase was primarily due to a shift in sales mix towards our higher -- high-performance decking and railing products, including our recently launched Reveal aluminum and Select railing products. Heavier precipitation in June tempered the demand in the quarter for outdoor living products. The company recorded net income of $13 million or $0.76 per share in the second quarter of 2013 compared to net income of $8 million or $0.48 a share in 2012. The company's results for the second quarter included $1.7 million charge related to the mold class action. The company's results for the second quarter of 2012 included $1.8 million of charges consisting of $1.1 million increase to the warranty reserve and a $700,000 severance charge. Before giving effect to these charges, the 2013 net income was $15 million or $0.86 a share, and the 2012 net income was $10 million or $0.59 a share. Gross margin was 37.5% in the second quarter of 2013, a 70-basis-point improvement from the pro forma 2012 quarter. Lower sales-related cost reduced startup cost in our high-performance products, and a favorable capacity utilization contributed to the increase in gross margin. SG&A was $23 million in the second quarter of 2013 compared to $21 million in 2012. The SG&A increased $1.5 million on a pro forma basis, which was primarily related to an increase in branding. As a percent of net sales, pro forma SG&A expense for the quarter was 22% in 2013 compared to 21% in 2012. Net interest was $200,000 in the second quarter of 2013, a $4 million decrease from 2012. The decrease was a direct result of the midyear 2012 retirement of our convertible notes. Our 2013 year-to-date financial performance showed considerable improvement compared to the first 6 months of 2012. The 2013 year-to-date net sales were $206 million, an 8% increase year-over-year. The 2013 sales were positively influenced by the launch of 3 new products during 2013 that rounded out our good, better, best high-performance decking and railing product platforms. Our gross margin of 38.2% was 110 basis points better than the year-to-date 2012 pro forma gross margin. The key drivers were consistent with those previously communicated for the second quarter. Pro forma net income also showed significant improvement. Year-to-date pro forma net income was $37 million or $2.12 a share. This compares favorably to the pro forma net income of $23 million or $1.34 per share for the first half of 2012. We generated $18 million of free cash flow for the first 6 months of 2013 compared to $33 million in 2012. The $15 million variance in free cash flow was primarily driven by timing of accounts receivable collections and a lower reduction in inventory in 2013. Capital expenditures for the first 6 months of 2013 were $5 million, a $2 million increase compared to the prior year. A considerable portion of this year's capital expenditure is committed to cost reduction initiatives, as well as our new product launches. At June 30, 2013, the company had no outstanding debt and $16 million of cash on hand. Our guidance for the third quarter sales is $72 million, an increase of 2% over 2012. The reduction in capacity utilization from the second to third quarter will be greater than the prior year and will pull third quarter gross margin below last year's level. SG&A spending will be down over $1 million in the quarter compared to the prior year. As Ron mentioned earlier, the company has initiated a stock repurchase program. This is the first time in the company's history that such a program has been implemented. A share program is the first step in a comprehensive review of our capital structure and demonstrates our board's confidence in the company's strategy and long-term prospects. Operator, we would now like to open the call up for questions. After which, Ron will provide his closing statements.

[Operator Instructions] Our first question is from Keith Hughes with SunTrust.

A couple. I guess number one, can you give us any sort of field [ph] capacity utilization in the third quarter? How much is it going to be down versus the third quarter of last year?

A couple of points.

A couple -- okay, I'm sorry, a couple of points?

Yes.

And as you look out into the market, and obviously, the wet weather had an impact, where do you feel like distributor inventories are as we end July?

We think they are probably a little heavier than they were at the same period last year. We think that's largely due to the number of products we've introduced, slower sales than may have been expected in some quarters. So it's a little bit heavier.

And final question, you had called out railings as being positive. Is the -- will next year be the year we hit a faster growth rate on railings? I know some of these products are still fairly new in the market.

Well, I can tell you that it's increasing several percentage points as the percentage of our total sales quite significantly from year to year. So it is -- we're quite pleased with what's happening with railing this past year.

Yes, I think you're right, Keith. To fully commercialize any new product, it takes somewhere between 2 to 3 years. So we will see a faster growth in the next 2 years on the railing.

And so this is really the first season for many of the railing products here on '13, correct?

That's right.

Our next question is from Trey Grooms with Stephens.

Jim, on your commentary about 3Q gross margins are going to be a little bit lower than the 3Q in '12, if I remember correctly, there were a few things that's going on in the 3Q '12 that impacted margins. Can you give us an idea what the true kind of apples-to-apples margin number we should be looking at for the prior year period would have been?

Yes, I think the pro forma last year was around 30%, 31%. So that would be the comp that you ought to be measuring against.

Okay, that's helpful. Again, looking at the quarter, you mentioned weather and that sort of thing. So is it reasonable to think that you really had a big dropoff in June as we progress through the quarter? And you pointed to weather and a few other things, but I'm assuming that there was a big dropoff in June. And then as we kind of get into July, can you just talk about kind of how things have trended since, I guess, beginning of June?

Well, June did experience a significant impact from the weather. And it wasn't a falloff in demand in June. This morning, I drove to work and went through a monsoon. It has been a wet summer in much of the country. I don't want to blame everything on the weather. Weather has been a part of the story. I mean, clearly, part of the story is that the recovery and repair and remodeling is just not as aggressive as the resurgence of new housing construction. We think it will follow, but it's a little bit of a slower rate of increase. So we're managing our balance sheet extremely carefully. When demand is off, we cut our production and you see the impact of it. But the reverse is also true. So as soon as demand picks up, we'll increase production and we'll get the benefit of that. So I think it's a -- there's a couple of stories involved. One is the weather and the other one is the underlying demand. We certainly haven't lost any market position. Our market position is strong and getting stronger. We've added 230 stores within the big-box category we didn't have last year is an example. We've got a strong product pipeline. And so for those of you who followed Trex for years know that it gets lumpy from quarter to quarter. But on the whole, the future -- we're confident in the future.

All right, okay. And then on the timing of the pre-buy as we look into next spring, I guess the pre-buy for this year actually occurred in the first quarter given the timing of your rollout of new products. Can you give us kind of some color on your expectations for pre-buy going into next year? Would it typically be more in the 4Q? Or how do you stand on that?

Well, I can tell you a couple of things. Number one, I've got competitors listening to this phone call. So I've got to be very careful. The second thing I'll tell you is we haven't decided yet as to how the pre-buy is going to work. We'll make that decision in October. That decision we made -- we do have some important meetings to be held in late August, and we'll be developing input from our partners across the country. So I'm not going to give any more color than that other than to say that we'll make this decision about the timing and the extent and the flavor of the early buy and we'll do that in Q4.

Our next question is from John Baugh with Stifel. John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division: Just a couple of things. Did I hear you right? Did say your higher-end deck sales are performing -- outperforming your lower end? And just curious as to how your experimentation with a little lower pricing at the entry level has occurred in select markets.

Sure. One of the things we announced earlier this year is that we were going to be discontinuing the manufacturing of the Accent-branded product. And as consequence, people are looking towards the new high-performance products. They also look at the features. So we have seen a migration to that. But we see strong sales across each -- the good, better, best platforms. This is the second year for Enhance. Volume has built nicely with the Enhance. This is the third year for Transcend. And again, we see good strength in the Transcend. The opening price point that replaces Accents, the Select product, is showing strong support across the whole United States. The test pricing we did on that, we've seen results consistent with our expectations. And we will continue to monitor that as we go through the rest of this year. John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division: Any color between channels, big box versus the 2 steppers? And did you add a big box or did you get more store space in an existing customer?

We got more store space -- well, we added more stores. So I guess that's more store space with existing customers, although the ratios are relatively static. We're -- about 1/3 of our sales go through the big boxes. But now with the addition of 230 stores, it's possible that could change. John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division: And then last one, just quickly on the tax rate, any color there, Jim, remaining '13 as well as '14 in terms of rate?

Well, the GAAP rate for 2013 will be basically, sub-5%. For next year, assume a GAAP rate of 39%. Actual taxes paid, probably average next year in the 20% to 25% rate.

Our next question is from Robert Marshall with Davenport. Robert R. Marshall - Davenport & Company, LLC, Research Division: I just wanted to see if I can get any more granularity on what's going on in the 2-step channel. Are you seeing sort of discounting from your competitors? And do you think we're seeing an impact from higher rates here?

You mean higher interest rates? Robert R. Marshall - Davenport & Company, LLC, Research Division: Higher interest rates, yes.

Well, it's hard for me to tell what's attributable to what. I'm not an economist, so I can't really opine on effective interest rates on the market. I can tell you that because of the recent merger between 2 of our competitors, there's a lot of what I'll call discombobulation within the distribution marketplace. We certainly have not been adversely affected by it. But I do think a lot of things are going to play out. We could be the recipient of some increases in the market share as a result of that merger. I think the people who are going to lose are the smaller players. It's really sort of consolidating now into the big 3, the big 3 being Trex and AZEK/TimberTech and Fiberon. And there's about a dozen competitors after that, that are, I think, are in jeopardy. That's about the best granularity that I can give you without giving away competitive information.

A couple of additional points for you on that. With regard to pricing, we really haven't seen much in the way of anybody discounting. But we did take note that one of our competitors increased their pricing across the board, pretty much on the deck boards, by roughly 5%. So there appears to be some upward momentum on prices from one of our key competitors. The other thing I'll note is that we did introduce a financing program early in the year. It is a nonrecourse program to Trex, but it does assist homeowners in being able to finance their decking projects where they may not be able to tap into their home equity lines in the way they had in prior years. We see this as a growing opportunity but a relatively small impact for this year. Robert R. Marshall - Davenport & Company, LLC, Research Division: And Jim, we've discussed attach rates for railings before. Is that metric kind of moving in a positive direction at this point? And is that kind of a metric we could get on an ongoing basis?

Did you say the attachment rate? Robert R. Marshall - Davenport & Company, LLC, Research Division: Attachment rate, decks, yes.

The attachment rate is increasing. As I mentioned a little bit earlier in my commentary, it's several percentage points higher than it was prior year.

Our next question comes from the line of Robert Kelly with Sidoti. Robert J. Kelly - Sidoti & Company, LLC: Point of clarification, the mold class action charge, what was that in relation to?

We had a litigation filed against Trex, a class action related to a claim that our boards are susceptible to mold and mildew. And even though we do not have a warranty against mold and mildew, we specifically called that out as not being valid. We have been in negotiations with the plaintiff and have submitted a proposal to the court. And based on a series of requests from the court, we have modified our offer to settle that litigation, and that required us to expand our reserve from the $1.7 million we had at the end of the first quarter to $3.4 million. So it's a $1.7 million charge. As we mentioned in our last 10-K, as well as the Q from the first quarter, we anticipate that the total cost of this litigation will be less than $10 million. Robert J. Kelly - Sidoti & Company, LLC: Okay. And so that's not settled, it's ongoing, but it sounds like you're moving in that direction, to settle it?

We're hopeful that we can resolve this amicably. But until the court rules, it is up in the air. Robert J. Kelly - Sidoti & Company, LLC: Okay, thanks. Exiting 1Q, you kind of talked about remodel demand strengthening. I know weather kind of sidetracked you, specifically in June. Is that still the case, that you see some acceleration in remodel demand or is the guide for 3Q kind of telling us remodel growth is still pretty tepid?

Well, if you talk to our contractors, they're busy, they're quoting longer lead times than they did last year. But this recovery in the general economy is still not completely rock solid. We do see an increase in activity. There's an increase in demand. Our sales were going up, as you can see. But we think that based on what we read and what we see, the remodeling activity is just following housing demand but not at the same rate of increase. Robert J. Kelly - Sidoti & Company, LLC: On the buyback, the release talks about a 6-month period. I mean, should we assume that you are aggressively repurchasing over the next 6 months or you'll all kind of revisit the situation after 6 months has passed?

Well, we've got internal price targets. We're going to buy -- we're authorized to buy up to $25 million in stock. The plan ends in 6 months. But we will do what's in our shareholders' interest. We've got the cash do it. The cash is building. The balance sheet is in fine shape, and we think this is the right to do at this time. When the buyback period expires, we'll revisit that. In the meantime, there are other capital allocation restructuring options that are under aggressive review. Robert J. Kelly - Sidoti & Company, LLC: Okay. And then just one more on the -- you kind of talked about the merger of your competitors, the discombobulation. It seems like the parent company now of that merged competitors now is rumored to be on the block. What is the take from your customers as far as another owner for that business and potentially the next year?

Well, I guess I'll revert back to the same adjective I used before. There's discombobulation. There's a lot of concern as to what effect that it will have on relationships, behavior and so on. It's causing a lot of cautious outlook on the part of the 2-step distribution and the big boxes. Nobody knows how it's quite going to play out. And of course, the market swirls with rumors, and I think you'll just let the facts play out and we'll see what the future brings. I can't be more incisive than that without knowing more than that. Robert J. Kelly - Sidoti & Company, LLC: Right. I guess if it were to swing your way in a positive -- be a positive benefit, it would show up during the October timeframe, when you set up for '14. Is that kind of the way to think about it?

No, no, it would be Q1 or Q2 next year.

[Operator Instructions] Our next question comes from the line of Keith Hughes with SunTrust.

My follow-up has been answered.

Our next question comes from the line of Kenneth Smith with Lenox Equity Research.

You mentioned the credit program that seemed to be going reasonably well, but you also said you expect it to perform better next year. Can you sort of elaborate on that? Is it, in fact, performing well this year? And why would it be better -- be stronger next year?

It will be stronger next year for the same reason that Jim gave on new product development. It takes a couple of years for the commercialization of a new program. And we've gotten, I'm not going to put a number on it, but several dealers and contractors who registered for the program. They are certain to sell decks under the program, but it takes a while for it to catch on. So we know that as long as we keep getting dealers and contractors to sign up for the program, by definition, the sales are going to increase under the program. So we've also talked to the people who offered their financing, and they've told us what the experience is of other people in the remodeling industry, and if our growth pattern follows, others who have been preceding to us, we should expect a rapidly rising level of participation in the program.

And then another question, on the capital structure review, if I'm phrasing it correctly, is there some timeframe that you can share with us when we might hear more about that?

We could, but we've elected not to. There's too many moving pieces to this. But as I've said, it's under aggressive and active review, and I'll just leave it at that.

Okay. And then finally, on the new product pipeline, as you look through the balance of the year going into 2014, are new products more likely to be extensions of what you have now or could there be something more significant coming in 2014?

There could be something more significant.

So we would hear about that in the fall when you do your product introductions for the following year?

No, the thing that might be more significant will be towards the end of 2014.

Okay. And then -- and one other thing. On the international, you said you were up to 35 countries. Where were you a year ago versus start of this year? And are you getting growth in those countries where you've been the longest?

Well, probably if you went back a year ago, we were probably somewhere between the mid and upper 20s, something like that. The growth rate during the first year was 147%. I remember that year. And for this year, we're expecting it won't be a 3-digit increase, but it will certainly be a mid to high 2-digit increase.

That's in total international sales?

Correct.

Our next question is from Trey Grooms with Stephens.

Just a follow-up. Jim, I just want to make sure I'm understanding this correctly. On SG&A, you guided to 3Q SG&A being down $1 million, if I heard that right. Were you referring to sequentially or year-over-year? Just to be clear.

Year-over-year.

Okay. And then -- so I guess your kind of guidance for the full year that you've mentioned in the past for SG&A being down from 2012, that still holds then?

That's right. Basically, what I said is, if you go back and look at the 2011, 2012, they represent kind of the low and the high. So the starting point is probably the average of those 2 and add inflation to it.

Right, okay. And your returns on capital are very strong. You mentioned that -- you announced this buyback here, but Ron, you did say that this was the first step because you guys are going to be generating a tremendous amount of free cash over the foreseeable future, I would expect. Can you kind of give us maybe a few other options that you guys -- I know you're working hard on looking at all those things now and nothing's definitive, but can you give us kind of some -- as we look past this first buyback, kind of, what other things are on the list that you're considering there?

Well, I can give a list, but understand, they're just options. Nothing's been agreed to yet, but options would include dividends, special dividends, recurring dividends. It would include borrowing money and adjusting the debt-to-capital ratio. It would include an extension of the repurchase agreement or an expansion of it. It would include an array of standard financing options. So we're looking at all the options carefully and doing certain modeling and watching interest rates and so on, and we'll make decisions over the next several months.

Yes. The one other thing I'll mention, Trey, it also includes the opportunity for internally-developed products that may be more capital-intensive than some of the introductions we've had in the past.

And so with that in mind, I mean, could you give us -- and you may have touched on it earlier, I may have missed it, but a guidance for CapEx this year?

The guidance for CapEx this year was around $15 million.

There are no further questions at this time. Please proceed with your presentation or any closing remarks.

As you've seen, we've made real progress with our sales programs, branding strategy and operational excellence. These efforts are reflected in our bottom line financial results and our balance sheet. Our general view of this market potential and our long-term growth remains intact. So thank you, everybody, for joining us, and I'll say 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.