Trex Company, Inc. (TREX) Q3 2012 Earnings Report, Transcript and Summary

Welcome to the Trex Third Quarter 2012 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded today, November 1, 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 third 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. Go ahead please, Bill.

Thank you, Harriet. 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 Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements are subject to risk and uncertainties that could cause the company's actual operating results to differ materially. Such risk and uncertainties include the extent of market acceptance of the company's products, the costs 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, the company's ability to maintain product quality and product performance at an acceptable cost, the level of expenses associated with product replacement and consumer relation expenses related to product quality in 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 results 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 the 2 tables titled, Reconciliations of Pro Forma Results of Operation Measures to the Nearest Comparable GAAP Measures, 3 Months Ended September 30, 2012, and Reconciliations of Pro Forma Results of Operation Measures to the Nearest Comparable GAAP Measures, 9 Months Ended September 30, 2012. With that introduction, I'll turn the call over to Ron Kaplan.

Good morning, everyone. Thanks for joining today's call. As you've seen from this morning's press release, we turned in another strong operating performance in the third quarter. Sales rose 4%, topping the guidance we provided in July. On an underlying basis, gross margin was more than 31%, and we delivered robust underlying earnings of $0.36 a share. Year-to-date, we've achieved underlying gross margin of 35.5% despite operating at low capacity utilization levels. We've reduced inventory by more than $20 million, and we've generated $55 million of free cash flow. These are impressive results, especially given the uneven economy. We're also executing well on our market share initiatives, and we announced the launch of several exciting new products this week in our Annual Distributor Meeting. As described in this morning's release, we increased the warranty reserve for the legacy quality issue by $20 million. I want to emphasize that the number of claims in 2012 have declined compared to 2011. However, we had expected a greater reduction. Given the additional visibility gained during the quarter, which in turn affects our view on subsequent periods, it was prudent that we increase the reserve. We believe this increase should end the need for future reserve adjustments. Now let's turn to the strategy we've developed for 2013, and why we feel great about our prospects. Earlier this week, we had our Annual Distributor Meeting. Everybody came away from the strategic conference very upbeat. Since we introduced Trex Transcend in 2010, our brand strategy has been to elevate our entire portfolio with high-performance decking and railing products. Our ultralow maintenance product platform offers great aesthetics and unparalleled resistance to scratching, staining and fading. By early in 2013, we’ll have launched a series of new products that will contribute the most encompassing product platform in Trex's…

Thank you, Ron. Good morning, everyone. As you know, the press release with Trex's third quarter and year-to-date financial results was issued this morning. First, I would like to review our third quarter financial results. The company recognized net sales of $70.8 million in the third quarter of 2012, a 4.3% increase compared to 2011. The increase in net sales was driven by sales volume. The company recorded a net loss of $14.3 million or $0.86 per share in the third quarter of 2012, compared to a net loss of $500,000 or $0.03 per share in 2011. The company's results for the third quarter of 2012 include $20.5 million in charges consisting of a $20 million increase to the warranty reserve and a related $500,000 income tax adjustment. The company's results for the third quarter of 2011 included a $500,000 noncash charge related to the extinguishment of $5.6 million of convertible notes. Before giving effect to these charges, net income was $6.2 million or $0.36 per share for the third quarter of 2012 and $28,000 in the third quarter of 2011. Gross margin, which includes the increase to the warranty reserve, was 3% in the third quarter of 2012, a significant decline from 2011. Excluding this warranty charge, underlying gross margin increased by 580 basis points to 31.3%. The increase in gross margin was primarily due to continued manufacturing efficiency improvements and increased capacity utilization. SG&A for the third quarter was $15.8 million compared to $13 million in 2011. The $2.8 million increase in selling, general and administrative expenses in 2012 was primarily related to an increase in branding and personnel-related expenses driven by incentive compensation and sales commissions. Net interest was $200,000 in the quarter, a $4.6 million decrease from 2011. The decrease was primarily the result of a…

[Operator Instructions] Our first question is from the lines of Jack Kasprzak with BB&T.

Just real quick. The first question for Jim. I think I just missed the capacity utilization number in Q3.

The Q3 capacity utilization was 25% this year.

Okay. And regarding the hurricane, I realize it's very early. But the question on everyone's mind regarding building product stocks in general, I think. Do you guys have any thoughts on the potential impact there, with all the boardwalks and piers that have been destroyed in terms of whether Trex product will be part of the rebuilding?

We think it will be part of the rebuilding, as much for homes as it will be for piers and boardwalks. Piers and boardwalks, depending upon the locality, have different specifications. We do expect there will be some demand that it’s created. It won't happen overnight. The decks won't be the first thing that's put on, but it will be part of the rebuilding program. So we do look for some uplift resulting from that.

Okay. And stepping back just real -- on your stated goal to the investor presentation, and obviously, you've talked about it on previously calls, of getting to a 50% market share. And I think the most recent number that we're still using is 35%, but that's a little dated. Do have any thoughts on progress toward that goal, where you are now and how long it might take to get there?

Yes, we think we're approaching 40%. When we started this working together, we were at 30%. The numbers were published at 35%. We think we're approaching somewhere between 37% and 40% now. We'll continue to work toward our effort. I had our distributor meeting in -- literally 48 hours ago, I was giving a speech to our distributors, and we continue our march toward the goal that we've stated. So I'm not going to put a timeline on it, but we continue to move in the right direction.

Our next question comes from Trey Grooms with Stephens.

First off, for Jim. You guys had very nice incremental margins in the quarter, better than your kind of historical guidance for incremental margins would imply, I guess given the increased manufacturing efficiencies. Does that math or the kind of incremental margins you've given us in the past still hold or should we be thinking about it differently going forward? Also, do you see some longer-time -- or longer-term upside to that kind of 50% incremental margin? Is there more room for -- to increase these manufacturing efficiencies going forward?

Yes, Trey. I would stay with the current formula that everyone is working with. Again, as you model the future, I would go from the third quarter in your modeling. Do not go back to the prior fourth quarter to model from that. I don't think you'll get the right kind of results you'd be looking for. We do see improvements in manufacturing efficiencies and cost reduction activities. This is an ongoing process as with any company. The operations people have been very successful in delivering solid results for us, and we anticipate we'll continue to see that in the future.

Okay, great. And then, on the new product line, the entry-level lines, I think it's Select. Where does this pricing kind of fall relative to your other products?

Well, it's -- it will be about 5% higher than the pricing on Accents.

Okay. And then, would you expect this to take share from some of the other noncapped, I guess, lower kind of entry-level products there?

Yes, that's exactly what it's going to do. This is designed to take market share. It's going to take it primarily, in our case, from Accents. But this is a superior product with Transcend technology that will enable us to have an opening price point and products. So now we essentially cover the spectrum.

Okay, that's helpful. And then on inventory levels, the inventory levels here are the lowest we've seen. Can you talk about kind of, number one, how you're able to pull that off and what's different there than what we've seen in the past? And then also, is this about where you want to be going into the end of the year? And then lastly on that, can you talk about your sense of kind of inventory levels in the channel kind of heading into '13?

Inventory in the channel, we believe, is very thin. That's our general observation. In terms of how we do it, I have spoken to this before. But, a lot of it has to do with our ability to do changeovers. When you think of a Trex changing over a line, think of a NASCAR pit crew. We’ve vastly reduced the amount it takes to do a changeover. The manufacturing team here is galvanized on the speed and quality of production. That has been our mantra since we started. And we continue to work in that direction and the numbers speak for themselves. There's nothing that I can say that's going to put more light on it than the actual numbers that we're showing you. That enables us to keep very low inventory. We can turn the factory pretty much on a dime. And so inventory will rise in the fourth quarter as we get ready for the early buy in Q1. But you can expect the inventory turns in the coming year to be higher than they historically have been on average.

And, I'm sorry, I do have one last question. On SG&A, Jim, this year, early -- earlier in the year especially, SG&A costs were a bit higher than what we've seen, especially in 2011 and I guess in 2010 as well. Can you kind of give us some idea of kind of what we should be expecting? I know you gave us a little bit of color on fourth quarter. But just kind of as a run rate as we look into '13, directionally, could you give us any kind of color there?

Sure. If you looked at, for example 2011 and 2012 average, or if you went back and looked at 2010, you'd see the average run rate is in the $65 million, $68 million level. And those are pretty much the average run rate I would expect to see at those levels, maybe a slight increase for inflation. But in general terms, that's what we ought to be running at.

Our next question is from the line of Richard Paget with Imperial Capital.

So with the potential of Select maybe cannibalizing some of the Accent line, how should we think about the margins on Select versus Accents? Or is it this just a move that you need to evolve with the industry regardless of what the profitability profile looks like?

Well, the introduction of Select has been a project that we've been working on for several years. It was a natural move to provide the ultralow maintenance characteristics. And with this introduction, we see essentially no difference in the margins between our Accent products and our Select products.

Okay. So this is just a better value proposition.

Better value proposition for the consumer.

Okay. And then, Jim, on the capacity utilization. I think last year's third quarter it was around 21%. Guidance for revenues came in a little bit higher than you guys had expected, but capacity utilization seemed to come in much higher. What -- did anything change or just -- from what your outlook was during the third quarter?

I think our guidance that we gave on the capacity utilization was approximately the same as last year. We did bring it up a couple of percentage points from what we were planning. And that was just based on what we saw coming up for the month of October. October demand indicated we needed to put a little bit more finished goods on the ground, and we did that. Overall inventories were very good. It just moved in character from raw materials to a little bit more finished goods than what we planned.

Okay. And then, finally, I know you guys just kind of ended the deleveraging process. But going forward, if the right opportunities came up, what would be a comfortable level of leverage that we should think about for you guys?

Well, we don't have any of those opportunities that are imminent. But Jim and I, I think, would both be comfortable with a 35% debt-to-cap ratio, somewhere in that range. But in the meantime, we're not going to borrow any money until we can figure out a good way to put it to use. Right now, the cash being generated by our business is sufficient to cover our internal organic needs. And our internal organic initiatives that we've got underway seem to provide us with the biggest bang for the buck.

Our next question is from Bob Wetenhall with RBC.

It looks like you're getting increased capacity utilization in the fourth quarter. Could you help quantify or give us directionally the impact of that on gross margin performance?

Well, for every point of capacity utilization, you basically get about a $200,000 quarterly improvement to income. Now, if capacity utilization were to go down, you'd see the reverse; it would be $200,000 negative. So we guided a few points up. If you pick 3 points, that would be about a $600,000 impact, favorable.

Got it. So it's not dramatic, but it still is certainly positive. The other thing is, you guys are generating a ton of free cash flow and it doesn't sound like you're looking to do any acquisitions or squander the money. Have you guys considered implementing a dividend or paying a onetime special dividend? And as you go forward and continue to generate free cash flow, what should shareholders expect?

Well, I'm not prepared to tell our shareholders what they should expect yet in terms of what we do with the money. But I will tell you that my bias is to have a dividend, a regular dividend, but we're not at that point yet. I look forward to being at that point at some point in time. That is my bias. Of course, there are several options available to us. It would include a special dividend. It would include a stock buyback. But my personal bias is to position the company to pay a regular dividend, but that's a ways off. I think we'd like to get a few more quarters under our belt, and we'll constantly evaluate the situation.

Good. And just, if I could sneak a final one in. What do you think the revenue potential is of the below-deck products that you guys are rolling out for ‘13?

You mean the substructure?

Yes.

Well, we know that it's a $2 billion market. We're starting from ground 0 2 years ago, so it's moving north where the sales are expanding exponentially. But I'm not prepared to give a specific number to that. I can tell you that we've got special initiatives as we continue to enhance our penetration of that market. We've got new design options. We've got additional SKUs that flesh out the product line. And in fact, we take note of the fact that there is more press being given to other manufacturers in the business considering metal substructures. So it's starting to move just like Trex itself did 20 years ago.

Our next question is from John Baugh with Stifel, Nicolaus.

Let's see. First, were there any pricing changes for this coming year?

Yes, there were several. Some products are going up; some products are coming down; some products are going to stay the same. On a net-net basis, pricing will probably go up about 2%.

Okay. And could you just kind of quickly walk through the key product price points by -- starting with, I guess, with Select or maybe Accents, I guess, is the lowest. Roughly, where that pricing will be for this coming year?

You're looking at something from a retail standpoint?

Yes.

Okay. Well, Select would be between $2.60 and $2.70 a foot at retail, which would be about the same as Accents. Let me think through a couple of these other numbers here. Enhance would be somewhere between $2.81 and $2.90 a foot, and Transcend would be between $3.25 and $3.50 a foot.

And then is the Select product going to utilize your existing capacity? Or is there some element that's outside or some process change in the lines?

It's existing assets.

And obviously, aluminum railing doesn't use the existing. But the other railing product, will that use existing capacity?

Yes.

And could you discuss quickly what the key changes year-over-year are to the early buy program?

My early buy program is not even 48 hours old. Our distributors haven't gotten a chance to discuss it with their dealers. I got competitors sitting on the telephone line. So I'm just going to politely defer answering that question, John.

Okay. I assume that given the shift in timing you alluded to that there's some change in the early buy that would cause that, correct?

Well, you're right. I mean, our distribution and dealers are going to need a little extra time to figure out the proper product mix in their initial orders, because we've got so many new products that we're unveiling at once, primarily Select decking and our new railing lines. So they're trying to absorb all of this and they’ve asked for a little extra time to get this into the system. So I wouldn't -- I'd look at it as a positive; not as a negative. I really feel quite upbeat about the fact that they're more engaged, and this is more strategic than anything we've done probably including Transcend.

Great. And then my last question or questions is around the warranty. I guess the first one simply is will that increase warranty reserve impact incentive comp or is your incentive comp more tied cash flow, Number one. And then you mentioned that you really think this is the end. I forget the cumulative number, but are you saying that because you basically will -- written down everything or reserved almost everything you’ve produced at this point? Or is there some level of incoming claims that, as you mentioned it's down, that it's just almost got to go to a number that can't be more than this $20 million? Or any kind of color on that.

John, your first question, could you repeat that?

Just as it relates to executive bonuses and/or overall personnel compensation. Obviously, it's a $20 million hit to the income statement with the reserve. Just wondering, is that irrelevant as it relates to compensation? Because you're going to -- you compensate more on cash flow or earnings excluding these charges.

John, as you recall, the warranty reserve relates to production that was made from 2006 and prior. And this has been an issue that the board has considered some time ago, and it is something that is excluded from the calculations. Having said that, the calculation of the reserve doesn't mean the cash out spending for each year that we have, for example for 2013, is going to be significantly increased from what we had before. What it does mean is our current view includes a reserve that covers a much longer period of time and does not decline as quickly as what we had planned.

You may recall, John, that when I came onboard in 2008, I think in my very first conference call, I'd been onboard 8 or 10 weeks, I said there's nothing worse than death by a thousand cuts. We got a lot more information at our fingertips now than we had then or in between then and now. Clearly, we don't like having to expand that reserve. But when we looked at the activity, it was just prudent for us to increase the reserve. After reviewing the issue with Jim, we agreed that our best estimate should reflect a minor rate of decline in terms of the claims activity, because we don't want to be doing this again and again. At the end of the day, we're going to be governed by generally accepted accounting principles. But we don't intend to have to increase this reserve.

Could you remind me, Jim, of what that rough cash out number will be in 2012, and then maybe a guess at '13? That would be great.

Yes, 2012 will probably be in the $7 million to $7.5 million, and we would expect that to decline between 10% and 20% in 2013.

Our next question is from Keith Hughes with SunTrust.

…are you going to be -- running the company just production as orders come in? Is that what we're getting to at this point?

The first part of your question was cut off. Can I ask you to repeat your whole question? I'm sorry.

With inventory levels so low, are we now at a point at Trex where you can just match production to the incoming order flow and we don't have to have the seasonal up and down of inventories like we've seen in the past?

There will be some seasonal up and downs. I mean clearly, when we started in 2008, we had $70 million to $80 million worth of inventory and 150 SKUs, and we had 60% on-time delivery. Now we've got about 650 SKUs; we've got $8 million or $10 million worth of inventory; and we're operating at 95% on-time delivery. So clearly, we're in a much better position to respond immediately to rising and falling customer demand. But there is going to be some seasonality to our inventory levels. They won't be completely smooth.

We're not going back to the $70 million to $80 million of inventory that we've seen in the past?

Not in my lifetime.

And if you look at what's occurred over the last 12 months, you've seen the inventory come down pretty consistently quarter-over-quarter. And I think what you saw in the second quarter is the seasonal size of inventory, same thing in the third. The fourth quarter still had a little bit of extra inventory, so I'd expect it would come down a little bit from that. But the first quarter was probably a pretty good representation of where the inventory would be. So I think you've got basically 3 data points you can model the inventory as relative to the sales level. So if sales were to go up dramatically, the inventory would go up proportionately with that.

Second question. You're announcing your new product launch and expansion of TrexTrim, I think you have a new supplier. Can you give us any details on what you're doing there?

Well, again, I've got a competitive situation here. But we wanted a supplier that was better able to keep pace with our level of demand. It was primarily a demand issue. There are some quality aspects to it as well, but we just needed somebody to keep up with us. And we have significantly more capacity with the new supplier. It enables us to grow the category quite significantly.

Our next question is from Morris Ajzenman with Griffin Securities.

But just a couple of little things here. Geographically, any areas where you're seeing a lot of strength, and conversely, any areas you're seeing weakness?

This is a national company. We find the pickup to be -- I mean the biggest market for us clearly is still the Northeast. But we -- our sales -- about 40% of our sales are west of the Rockies. And we cover this country and it sort of goes up and down pretty much together. We don't notice any area of a particular strength or particular weakness.

And the last question, just as a follow-up to the inventory turns you're implying are pushed on increasingly going forward. Can you kind of give us some sort of where you'd like to see that versus what it is now?

Could you repeat that, Morris?

The inventory turns. You said that you'd like to see ultimately it will be moving even higher. Any sort of guidance where you think the inventory turns can move to, from what level they were at this past quarter, ultimately?

Well, what we're trying target, and we haven't been totally successful but we've come pretty close over last few quarters, is 5.5 turns on a FIFO basis looking forward. So we're always looking forward with our inventory. We don't base what we're going to build on history. We're looking at what we need to build. So we try and turn that inventory -- basically have about 2 months, a little bit less than 2 months of inventory on hand is what would be optimal for us.

And one question I'm not sure you guys will want to answer. But capacity utilization, without tipping your hand on what you see for '13 because what you give is guidance for the next quarter revenues. But again, your capacity utilization has been running very low over the last number of years and you're still turning profits. Where -- what do you think within another year or so, without tipping your hand, how much can you increase capacity utilization? What's -- we know what the ultimate goal is, you've said in the past, getting it well north of 50%, I think that's what you said. But on the next 12 months or so, where do you think we can get capacity utilization to?

Morris, I don't know how to answer it without tipping my hand. I mean, I understand the question and I understand why you want to know the answer. But I just don't know how to answer it and not violate other principles that I've laid out. So I'm going to politely and respectfully decline.

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

Well, I want to thank everybody for joining us. As you can see, something is going on here, that I'm extreme extremely proud of. The improvements in our manufacturing operation continue to be quite stellar and very notable. And really are very gratifying to see at this point in my career. But what's more gratifying is the coordination between our various departments. Our marketing effort has been superlative in terms of anticipating changes in the market. Our sales folks are effectively deployed, enthusiastic and sharp and upbeat. The engineering continues to be spot on. And the coordination between departments is extraordinary. So there's a very high sense of unit cohesion here. We’ve all got back from the distributor meeting. It went very, very well and the coordinating, and we've also unveiled a consumer finance program that we didn't really talk about, but I will tell you that it's a nonrecourse consumer finance program. There are things going on, on all fronts within Trex, and I'm very, very upbeat about the coming year. So I want to thank everybody for joining us today, and that concludes our call. Thank you.

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