Trex Company, Inc.
Q3 2013 Earnings Call Transcript

Published: 25 Oct 2013

[Operator:]

Welcome to the Trex Third Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded, October 25, 2013. I would now like to turn the conference over to Harriet Fried of LHA. Please go ahead, ma'am.

[Harriet C. Fried:]

Thank you, everyone, for joining us today. With us on the call are Ron Kaplan, Chairman, President and Chief Executive Officer; and Jim Cline, Senior Vice President and Chief Financial Officer. Joining Ron and Jim are Brad McDonald, Controller; Brian Bertaux's, Director of Financial Planning and Analysis; and Bill Gupp, Chief Administrative Officer, General Counsel, and Secretary. The company issued a press release this morning containing financial results for the third quarter of 2013. 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. Bill?

[William R. Gupp:]

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 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 risks and uncertainties, please see our most recent Form 10-K and Form 10-Qs as well as our '33 and other '34 Act filings on file 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 press release. With that introduction, I'll turn the call over to Ron Kaplan.

[Ronald W. Kaplan:]

Good morning. I'll start with an overview of our third quarter financial results, and then give you an update on our strategic initiatives. We've taken significant steps in the past few months to grow our sales. Some of these steps required noncash charges to be recognized in the third quarter, the sales growth will be clearly evident next year. Consumers continue to be enthusiastic with our recent product launches. This enthusiasm resulted in exceeding our sales guidance in prior year for the third quarter on an underlying basis. In 2010, we launched our innovative high-performance Transcend deck and railing product lines. This innovation elevated homeowners' expectations with regards to the performance and design of wood alternative products. We pride ourselves on being responsive to changes in the marketplace. Accordingly, we introduced a full platform of high performing products with the highest level of combined fade, scratch and stain resistance ever seen in the industry. This year, we also expanded our product offering to include entrance into the combined $315 million hollow vinyl and aluminum railing markets. Moving forward, we'll only offer our comprehensive and innovative high-performance decking and railing products. We have also adjusted our pricing to optimize our value opposition. As a result, we will start to move the needle on achieving our market share goals. In just the last month, we added 3 major East Coast distributors, significantly increasing our presence in this strategically important region. We continue to expand share in all of our markets. Consumers are viewing Trex as the premier manufacturer of wood-alternative outdoor living products as the market continues to consolidate. Now I realize that all of you would like to more fully understand the specifics related to each of the changes that are occurring within our distribution footprint. I am also sure that you understand our need to be mindful of the competitive nature of this information, and our commitment to confidentiality precludes a more detailed point-by-point breakdown. Based on the recent market share wins, we expect this element of our strategy to grow sales in 2014 by $40 million to $60 million. As with all major changes of this kind, a maximum benefit usually takes 2 to 3 years to be fully realized. Therefore, we expect market expansion from these recent initiatives to continue over the next 3 years. We started utilizing our excess cash to return capital to our shareholders. During the third quarter, we completed the first share repurchase program in the company's history, providing a $25 million return to shareholders. As we announced this morning, we're moving forth with a new $30 million share repurchase program. We will continue to evaluate other options to optimize our capital structure and reward shareholders for their investment in Trex. I'll close my section with our outlook for the fourth quarter. We're expecting net sales for the fourth quarter to be approximately $50 million, which represents a gain of nearly 9% over last year's period. Jim?

[James E. Cline:]

Thank you, Ron. Good morning. The press release containing our third quarter financial results was issued this morning. The company recognized net sales of $72 million in the second quarter of 2013, a 2% increase compared to 2012. The increase in sales in the quarter was primarily due to a shift in sales mix towards our high-performance decking and railing products, including our recently launched Reveal aluminum and Select railing products. This was partially offset by a decrease in sales volume and a $1.8 million charge related to market share expansion and the reset of certain -- the prices for certain products as we transition to our second generation product offering. The company recorded a net loss of $15.3 million or $0.91 per share in the third quarter of 2013 compared to a net loss of $14.3 million or $0.86 per share in 2012. The company's results for the 2013 quarter included $22.9 million of charges, consisting of the $1.8 million charge against net sales or sales expansion opportunities, a $20 million increase to the warranty reserve and a $1.1 million charge for a sublease exposure related to the 2005 planned relocation of our headquarters to Dulles, Virginia. The company's results for the third quarter of 2012 included a $20 million increase to the warranty reserve. Before giving effect to these charges, the 2013 net income was $7.7 million or $0.45 per share and the 2012 net income was $6.1 million or $0.36 per share. Excluding the charges just mentioned, gross margin was 29.6% in the third quarter of 2013, a 170 basis point decrease from the 2012 quarter. Favorable inventory adjustments in the 2012 quarter included the recognition of a LIFO inventory liquidation benefit which contributed 140 basis points to the underlying gross margin. SG&A, excluding the $1.1 million sublease exposure identified previously, was $14.2 million in the third quarter of 2013 compared to $15.8 million in the 2012 quarter. The decrease was primarily due to lower incentive compensation. As a percentage of net sales, underlying SG&A expense for the 2013 quarter was 19% compared to 22% in 2012. Our 2013 year-to-date financial performance showed considerable improvement compared to the first 9 months of 2012. Net sales for the 2013 9-month period was $279 million, a 7% increase. Our sales were positively influenced by the launch of 3 new product lines during the year, that rounded out our "good, better, best" high-performance decking and railing platforms. Our gross margin, excluding the charges previously discussed of 35.9%, was 40 basis points better than the year-to-date 2012 gross margin. Lower sales-related cost in 2013 were partially offset by favorable inventory adjustments including the recognition of the LIFO inventory liquidation benefit in the 2012 9-month period. Excluding the charges just noted, net income for the 9-month period also showed significant improvement. Year-to-date net income was $45 million or $2.57 per share. This compares favorably to the 2012 net income of $29 million or $1.70 per share for the first 9 months of 2012. We generated $44 million of free cash flow in the first 9 months of 2013 compared to $55 million in 2012. The $10 million reduction of free cash flow was primarily driven by increased capital expenditures to support our cost reduction and growth strategies and a lower reduction in inventory in 2013 compared to 2012. This was partially offset by a favorable timing of accounts receivable collections in 2013. At September 30, 2013, the company had no outstanding debt and $20 million of cash on hand. As Ron mentioned, our guidance for the fourth quarter is for sales of $50 million, an increase of 9% over 2012. SG&A expenses will be down about $2 million compared to the fourth quarter of 2012 due primarily to reduced incentive compensation. As Ron mentioned previously, we expect sales in all markets will grow significantly in 2014 over 2013. This market share growth is in addition to market share growth from improving market conditions, normal market share growth as we have experienced over the last couple of years, the impact of changing prices and international sales growth. To assist you on modeling for 2014, we estimate that the variable margin that we expect to realize on increased sales will be approximately 45%. SG&A should be no more than the SG&A expenses in 2013. Operator, we would now like to open the call up for questions. After which, Ron will provide his closing statement.

[Operator:]

[Operator Instructions] Our first question is from John Kasprzak from BB&T.

[John F. Kasprzak:]

With regard to the comment on pricing for next year, how should we think about that? Is that coming about from the new products that are higher prices, on a comparison basis, you're getting that benefit? Is -- or is there -- are there same on -- same price increases are a way to break that down?

[Ronald W. Kaplan:]

Well, I can only tell you that due to a very careful market research, some prices we decided to go up and some to go down. Some of it attributable to existing products and some to new products. So it -- all the products in our portfolio were analyzed or there are lots of changes, but they go in both directions.

[John F. Kasprzak:]

Okay. And the new distribution relationships or agreements and the comment on the $40 million to $60 million of incremental revenue, I mean I think that's the first time you guys have quantified it and it's obviously material. What's happening out there? Are these bigger companies that you're forging relationships with now who because of the revamp of the product line, and it's just more desirable to them? And how many of these types of announcements are potentially out there?

[Ronald W. Kaplan:]

Well, I'm not going to put a number on how many are out there. I will tell that the probability is greater than 0 that there'll be more. But that's as far as I'm going to go with that. The people making the changes are largely coming to us because of what we've done with Trex over the past several years. They like what they see, they compare the alternatives. And if we come to -- if we find it's in our mutual interest to make this change, it's good for the distributor and it's good for us, we'll make the change, but it's a very rigorous analysis, because we don't believe in change for the sake of change. It's got to be a wealth-creating venture for all parties involved.

[John F. Kasprzak:]

Fair enough. But again, Ron, the sales value here is, obviously, material. Are they just your more -- are you impacting bigger potential customers here or, with the new product launch, is that something else happening in the marketplace or is this...

[Ronald W. Kaplan:]

I would say it's wider and deeper market coverage.

[Operator:]

Our next question is from Keith Hughes with SunTrust.

[Keith B. Hughes:]

Yes. My question, talking about '14 and with that revenue growth, are you saying that the SG&A dollars will be flat year-over-year associated with these or just as a percentage of sales?

[James E. Cline:]

The dollars.

[Keith B. Hughes:]

The dollars will be flat. With adding this much in terms of revenue just from effectively market share gains, why isn't there any sort of SG&A add to that?

[James E. Cline:]

Typically, the SG&A, we would normally see about a 5% growth for increased sales. We -- also, each year the board resets objectives for management and the reset for management will reduce our anticipated incentive compensation expense for next year. We have also identified cost reduction opportunities that we're going to avail ourselves of.

[Keith B. Hughes:]

And the gross margin for this additional revenue, is it roughly similar to what we've seen from Trex historically?

[James E. Cline:]

What we've communicated is for the incremental sales that you build in your model for next year, you ought to assume that the variable contribution from those sales would be about 45%.

[Keith B. Hughes:]

And final question, we've seen the public announcement of the distributor adds over the last several weeks. In addition to those, is there something else helping to drive this $40 million to $60 million incremental advantage?

[Ronald W. Kaplan:]

Well, I'll just say that if you go back to my earlier comments, that we continue to prosecute a strategy of market share penetration across all market categories. And beyond that, I'm not going to comment.

[Operator:]

Our next question is from Trey Grooms with Stephens Inc.

[Trey Grooms:]

I guess one other -- maybe way to ask this, surrounding these expansion strategies that you're laying out here, and I understand the need to be careful, I totally understand that, but you mentioned wider and deeper in all market categories, with the, obviously, the few distributors you guys won through the quarter, that was -- I mean we can see that. But in addition to that, is there any -- does this include any new distribution channels for Trex or is it kind of just going wider and deeper into your existing type of distribution that you historically have had?

[Ronald W. Kaplan:]

I would say that it's wider and deeper in the historical channels that we've had. There are -- I mean, there are no channels out there that we don't participate into some degree or another.

[Trey Grooms:]

Yes. I guess maybe another way to put it would be to -- are you expanding into a new channel, I guess not necessarily new, but getting deeper and wider into one particular channel that you're in or is it spread against or amongst everything you're currently in, I guess is the way to ask it.

[Ronald W. Kaplan:]

Yes. You guys can keep asking me the same question as many different ways as you want, and I don't have anything further to say.

[Trey Grooms:]

Okay. All right, fair enough. All right. And looking at the expanded support for business partners, what do you mean by that exactly, Ron? You mentioned that in the press release as one of the things that were kind of going hand-in-hand with the revamped pricing strategy, I believe?

[Ronald W. Kaplan:]

Certainly. As we're introducing new products, certainly the requirement to properly merchandise those products across our spectrum with our new distribution partners, obviously, we need to supply them the tools to be able to effectively sell the new products we've introduced. So it really goes across all of the new customers plus most of our existing. We need to push deeper into the dealer channel and make sure both dealers as well as the contractors have the right tools to be able to support the product offering.

[Trey Grooms:]

Got you, okay. And then the incremental gross margin guidance that you gave, Jim, what's the -- because we were kind of at the 50% kind of range and now we're at the 45% kind of range which is still, obviously, very, very good. But just -- is it more kind of a product mix shift that's changing that and your kind of expectations going forward? Is it more kind of going -- one going through -- more product going through one channel as opposed to the other? What's the difference there in what we have been seeing or your -- kind of your historic guidance on that versus kind of now what we're looking at in '14?

[James E. Cline:]

, Trey, we've made some significant changes in the pricing on various classes of products. Some of them down, some of them up. Trex is committed to participating in all the markets on a very active basis. Some of those changes will put pressure on margins. But with that pressure on margins...

[Ronald W. Kaplan:]

Margin percent.

[James E. Cline:]

Margin percent, sorry. But also with that, comes growth opportunity. So we gave you the 45% in recognition of those pricing change implications so that, as you go forward, you are clearly recognizing we are making a change in that regard.

[Trey Grooms:]

Okay. And my last question is with all these changes that you're making, looking at customer concentration, do you guys foresee having to disclose a major customer that's -- that would be new in over 10% of your total sales?

[James E. Cline:]

We don't at this point.

[Operator:]

Our next question is from John Baugh with Stifel.

[John A. Baugh:]

Quickly, I'll just get right -- more direct. Is there a home center channel assumption in this $40 million to $60 million for next year?

[Ronald W. Kaplan:]

Well, I'm not going to waiver from the position I've taken, which is we're just not going to get into more details about which channels of distributions we're winning in. But we're -- just to say, I don't mean to be glib or smart with you, John, I know the nature of your question, I know why you want to know it. We're in a very competitive environment, a lot of sensitivities, and we're just not going to get into it.

[John A. Baugh:]

Okay. On the 3 distributors you've announced in Northeast, you've obviously got coverage in the Northeast already, I know you've said you're going to go wider and deeper. Is there any sense though how much of the $40 million to $60 million relates to these 3 or any kind of help on how meaningful these 3 might be for next year?

[James E. Cline:]

John, we know exactly what we believe the implications are going to be. But as Ron mentioned, we aren't going to bifurcate this down into an individual accumulation of each company sales. They are all significant in their markets. They're all strong players in their market. And we're happy to have them as part of the Trex distribution team.

[John A. Baugh:]

Okay. And then historically, you've only given 1 quarter out of revenue, now you give out, basically, a full year. Is the assumption, Jim or Ron, that the environment, the macro or the weather or whatever is exactly the same, so the $40 million to $60 million is just a sheer gain, or is there some other assumption embedded in that?

[James E. Cline:]

Yes. If you reflect back on what I communicated, John, this is a -- what we believe to be a significant market share gain. We believe we have an obligation to give guidance of the impact of this gain to the marketplace. It does not include any implications from any other change related to either weather conditions, improving market conditions beyond where we are today, it doesn't include international growth, it doesn't include the impact of the changing prices. So I know you'd like to have more detail on it but, unfortunately, this is where we are.

[John A. Baugh:]

Okay. And then have you communicated, I think you have with your distributors, the new products for the coming year? Is there any color you can give us on new product launches, Ron?

[Ronald W. Kaplan:]

This is a modest year in terms of total product launches. There are some new products. We're not going to give any further granularity in terms of what we expect from each product. But the product launches, as compared to, say, 2010 or 2013, are modest in comparison with those years. This is the year of commercialization.

[John A. Baugh:]

Okay. Got it. And then 2 final ones, quickly, any sense of where channel inventories sit for both the distributors and the lumberyards, and then tax rate for Q4 and '14?

[Ronald W. Kaplan:]

They're flat, about the same as last year.

[John A. Baugh:]

Okay. And then tax rate?

[James E. Cline:]

Tax rate for next year, as we've mentioned before, should be a full 39% rate. Based on the trajectory we're at, we anticipate that we will be coming out of the valuation allowance in the fourth quarter, barring any unforeseen change. From a case standpoint, next year, we would expect something in the 25% range for cash taxes.

[Operator:]

Our next question is from Morris Ajzenman with Griffin securities.

[Morris Ajzenman:]

It sounds like -- and again, I'm just listening to the nuance in the questions and your answers, but the $40 million to $60 million revenue increase for next year is -- there's no upside to that because you're not talking about what happens with price changes. You're not incorporating international or other things. Is that a fair summary of what's been going on that, that's a minimum expectation?

[James E. Cline:]

That is fair, Morris.

[Morris Ajzenman:]

Okay. And international, is 2014 going to be anything material? And I know it's percentages, big increases, but still small. But will '14 start becoming some sort of visual appealing number from an absolute basis?

[Ronald W. Kaplan:]

It continues to grow. We continue to be happy with the rate of growth. We start from a base of 0 on 2009 or '10, so it's growing. It's still a relatively small number in the grand scheme of things but soon, relatively soon, it'll be -- within a couple of years, it will be a meaningful number.

[Morris Ajzenman:]

Okay. And last question, Jim, on cash flow, looking out to 2014, I think you gave us the number of $45 million for the first 9 months? But for next year, should we expect a meaningful increase in free cash flow based on just improving results and maybe not that much necessitated increase in working capital excess? How does that play out? Do we have a big bump in free cash flow for next year?

[James E. Cline:]

Yes. Free cash flow for next year should be considerably stronger than this year.

[Operator:]

Our next question is from Alex Rygiel with FBR Capital Markets.

[Alexander J. Rygiel:]

As it relates to the $40 million to $60 million, is there any chance that over the next year or 2, we hear sort of a similar positive success story?

[Ronald W. Kaplan:]

Possible, I suppose. We've crafted the question. I wouldn't rule it out.

[James E. Cline:]

And certainly, as we indicated in the press release, when you make changes in distribution, not all of the benefit comes in the first year. It takes time to complete conversions on a number of the dealers. And so, we anticipate there will be favorable implications for future years, 2015 and probably 2016.

[Alexander J. Rygiel:]

That's helpful. And where was capacity utilization in the third quarter? And where might you think you could get to in 2014?

[James E. Cline:]

Some time ago, we made the determination, we were -- we're not going to be conveying capacity utilization information. It suffices to say, I think, that the company has significant capacity available. We could substantially increase the sales and not require to put additional production lines build -- additional production lines.

[Alexander J. Rygiel:]

And lastly, you've talked in the past about possibly considering alternatives to balance sheet recapitalization and what not. I think you've suggested that maybe early in 2014, you'd take a more serious look, but is there any update towards that timeline?

[James E. Cline:]

You've seen in the first 2 movements that we've elected to make and the buyback that was completed in the third quarter for $25 million and the $30 million buyback that we announced just this quarter, we will continue to evaluate that and work with our board on determining the proper balance sheet for the company. I would not anticipate any significant changes taking place prior to our next call.

[Operator:]

Our next question comes from Bob Kelly with Sidoti.

[Robert J. Kelly:]

Just a question on the gross margin guidance for modeling next year, are we incorporating the potential benefits to utilization in that 45% guideline?

[James E. Cline:]

Yes.

[Robert J. Kelly:]

Okay. So there wouldn't be an added benefit on top of that from utilization?

[James E. Cline:]

There would not.

[Robert J. Kelly:]

Okay, great. And as far as 4Q, is that a down sequential utilization quarter?

[Ronald W. Kaplan:]

No, it's an up quarter.

[Robert J. Kelly:]

So inventories, year end, are going to be in line with slightly above where you ended at 2012?

[James E. Cline:]

I'd say they're going to be above. We've got a -- as we've indicated, a lot of new business. We're going to prepare for that business, so that we hit the market with the right mix of inventory from the early part of the year, which is consistent with what we've done in prior years.

[Robert J. Kelly:]

That leads to my next question. The phasing of the $40 million to $60 million, is that front-weighted towards 1H?

[James E. Cline:]

Maybe slightly. But you could pretty much take where we were across 2013 and -- but for a slight elevation in the first quarter, I think it would be pretty consistent.

[Robert J. Kelly:]

Okay, fair enough. And then just as far as -- you have a lot of irons in the fire with respect to share gains. Market growth for 2014, are we still thinking like mid single-digit kind of market recovery? Has your thoughts changed on that?

[Ronald W. Kaplan:]

That would be my thinking. Mid to upper single-digits. It's hard for me to guess, I'm not an economist. But it would seem to be a reasonable guesstimate.

[Operator:]

Our next question is from -- I guess, a follow-up from Morris Ajzenman with Griffin.

[Morris Ajzenman:]

If we look out to an optimal environment 3, 4 years down the road, things are really going well, things are buzzing. Based on your current capacity, based on increasing utilization, you're getting more lines run, what sort of revenue capacity could you generate out of your existing infrastructure?

[Ronald W. Kaplan:]

Well, we've previously stated, Morris, that we could more than double the size of Trex with the existing footprint.

[Morris Ajzenman:]

Okay, okay. So you'll stick with that, more than double. Okay. Fair enough.

[James E. Cline:]

Just a follow up on that. We continue to make improvements in our manufacturing environment on throughput and yields. So it is a moving target. It's a growing capacity that we have. Because of the improvements we make, the products that we've introduced have enabled us to make further progress on those yields and throughput. So we anticipate over time that will continue to be an improving number for us.

[Morris Ajzenman:]

All right. And one last question. Market share, do you have any recent data we can get -- gives us some sort of better idea of what your market share is and what you think it can improve to next year?

[Ronald W. Kaplan:]

Well, we probably stated that our long-term goal was the 50% domestic market share. The recent achievements move us significantly toward that goal. We're not at that goal, but we're certainly moving toward it from where we were, which is about 1/3 of the market.

[Operator:]

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

[Ronald W. Kaplan:]

Well, thanks for joining us today. As you've heard, our employees are not resting on the laurels of our industry leadership. We continue to work fervently on increasing our market share in current markets and our new markets and reward shareholders. We are putting initiatives in motion for 2014 and expect it to be an exciting year. We look forward to giving you more details in the coming months. Thank you, and goodbye.

[Operator:]

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