Trex Company, Inc. (TREX) Q1 2019 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the Trex Company First Quarter 2019 Earnings Conference Call. [Operator instructions] Please note this event is being recorded. I would now like to turn the conference over to Viktoriia Nakhla. Please go ahead.

Thank you all for joining us today. With us on the call are Jim Cline, President and Chief Executive Officer; and Bryan Fairbanks, Executive Vice President and Chief Financial Officer. Joining Jim and Bryan is Bill Gupp, Senior Vice President, General Counsel and Secretary as well as other members of Trex management. The company issued a press release today after the market close containing financial results for the first quarter of 2019. This release is available on the company's website. This conference call is also being webcast and will be available on the Investor Relations page of the company's website for 30 days. I would now like to turn the call over to Bill Gupp. Bill?

Thank you, Viktoriia. 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 federal securities laws. 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 1933 and other 1934 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. With that introduction, I will turn the call over to Jim Cline.

Thank you, Bill. Thank you all for joining us this afternoon to review our first quarter results and discuss our business outlook. First quarter revenue and product mix was consistent with our expectations. Our standard margin was stronger than last year due mainly to product mix. Demand was strong for the quarter, where shipments constrained by production throughput as a result of start-up challenges associated with our new enhanced products. Our gross margin was pressured by start-up costs and manufacturing inefficiencies related to the production of our new Enhance products. In addition, 2 equipment failures at our Nevada operation and the first quarter resulted in the loss of 2 production lines for 30 days during the quarter. These costs adversely impacted our first quarter by $10 million. While start-up costs are to be expected, this has been a challenging ramp up and the magnitude of these associated costs was greater than we had anticipated. Bryan Fairbanks will further review these costs in his financial commentary. During the month, we made a number of changes to improve throughput, including the modification of the Enhance decking profile. For those of you who have seen the product, the new profile has less pronounced scallops. These actions were taken in mid-March at our largest operation located in Virginia. Our production rates have come up to planned levels and associated operating inefficiencies have been reduced dramatically. Our Nevada team has taken similar actions, which we expect will have a similar positive outcome by the middle of second quarter. Also, equipment that failed at our Nevada operations in the first quarter are back in production. While we'll still have start-up costs in the second quarter, the dollar amount will be significantly lower. This should result in a 300 basis point improvement in the second quarter's gross margin compared to the first and gross margin expansion beginning in the third quarter of 2019. Demand for residential products remained strong. The slower-than-expected production build of the new Enhance products and the manufacturing efficiencies that ensued have caused capacity constraints at our Virginia operations, where lead times have increased beyond our normal 2 weeks. In Nevada, we have also extended lead times and have moved to an allocation program through the end of July to ensure a more balanced distribution of our products in the western footprint. We have been in close contact with our channel partners, keeping them updated on our progress. The Trex brand continues to gain recognition in the industry and attract considerable consumer attention. A number of recent awards are noted in today's earnings release. In addition, we continue to experience high levels of web traffic at both trex.com and decks.com. The initial response to the launch of our Enhance Basics and Naturals products continues to be very positive at both pro and retail channels, and consumer feedback has been encouraging. This supports our conviction that the new Enhance products will significantly increase our addressable market and accelerate conversion from the dominant wood market. With respect to commercial products, revenue results were consistent with our expectations following a very strong 2018. Margin improved both sequentially and year-on-year, but there's still work to be done to increase efficiencies. In the meantime, the development of further synergies between our residential and commercial operations are proceeding well. We introduced 2 new railing products for the residential market that were engineered and designed with significant input from Trex Commercial. Operator, at this point, I would now like to turn the call over to our Executive Vice President and CFO Bryan Fairbanks for a more detailed financial overview of the quarter. Bryan?

Thank you, Jim. Good afternoon, everyone. I'll provide an overview of Trex's financial performance in the first quarter of 2019. Consolidated net sales increased by 5% year-over-year in the first quarter, mainly driven by 7% year-over-year revenue growth from residential products. This performance, which came on the heels of 11% Residential Products growth at last year's fourth quarter, demonstrated continuing strong demand for our decking and railing products. Sales from Trex Commercial Products declined by $2 million year-over-year in line with our expectations. Jim mentioned the $10 million in start-up costs and manufacturing inefficiencies that reduced this year's first quarter gross margin. While we had anticipated a certain level of cost associated with the initial production of our Enhance products, the operating efficiencies from lower run rates at our manufacturing facilities and the equipment failures at our Nevada plant increased these costs considerably. The inefficiencies included reduced line rates, increased material usage and lower manufacturing yields. In Trex Commercial, we made improvements to positively impact design, manufacturing, flexibility and installation of our commercial railing solutions. These actions as well as the runoff of several legacy projects, which we expect to be completed by the end of the third quarter, led to sequential and year-over-year gross margin expansion of 280 and 210 basis points, respectively. SG&A increased $1.2 million or 4.2% due to higher R&D expense this quarter, but expenses as a percentage of sales remained relatively flat year-over-year. Last year's SG&A included $1.2 million of amortization expense associated with the acquisition of Trex Commercial Products. Our first quarter tax rate decreased by 230 basis points compared to the year ago quarter, primarily due to a current year increase in excess tax benefits. Net income amounted to $32 million or $0.54 per diluted share compared to $37 million or $0.63 per diluted share reported in the first quarter of 2018. Overall, inventory levels were similar to last year's level, but finished goods inventory at the end of the first quarter were significantly below our plan, which will limit our ability to meet demand in the second quarter. Consistent with prior years, we used the balance sheet to fund our Early Buy program. At quarter end, we used $110 million of cash for operating activities, 12% of prior year. Capital expenditures increased to $9 million, primarily allocated to production improvements, supporting increased line throughput. Net debt at the end of the quarter was $27 million, down substantially from the $82 million from the prior year's first quarter. In the first quarter, we repurchased approximately 125,000 shares of our outstanding common stock under our stock repurchase program for a total outlay of $8.7 million. Under the program to date, we've repurchased approximately 580,000 shares in a 5.2 million shares available for repurchase left under our program. Also, please note that our balance sheet has been adjusted for the new FASB standard on lease accounting, which resulted in approximately $44 million in operating lease assets and liabilities being added to our 2019 balance sheet. For financial modeling purposes, please note the following items: incremental margin guidance to be approximately 40% for full year 2019; second quarter margin is expected to improve sequentially by approximately 300 basis points; we expect our 2019 tax rate to be approximately 25%; and we expect our capital spending in 2019 to be approximately $45 million as we continue to invest in increasing throughput at our plants and in equipment upgrades. Now I'll turn the call back to Jim for his closing remarks.

Thanks, Bryan. As noted in today's release, our guidance for the second quarter 2019 consolidated sales is $195 million to $205 million, which is a decline from last year's second quarter levels. This reflects the first quarter impact of operating inefficiencies and lower-than-planned finished goods inventory at the end of March, as well as suboptimal second quarter production level at our Nevada manufacturing operations. We continue to dedicate significant resources to increase production throughput. In essence, 2019 will bear the cost of the investment in the Trex Company's long-term growth, with the highest cost behind us and progressive improvement expected as we move through the year. Operator, I'd now like to open the call up to questions.

[Operator instructions] Our first question today will come from John Baugh of Stifel.

Jim, if you could take a stab at or give us some guidance on where you wanted inventories to be -- finished goods inventory to be at the end of the first quarter? And then roughly, what do you think the combination of that and the going production challenges, it sounds like in both locations, what that's going to either leave you behind in terms of revenue opportunity for the second quarter and/or year?

John, as I look at the demand for the product, as we ran through the first quarter, the demand for products clearly came on stronger than what we anticipated. We had anticipated the levels that we essentially ended up reporting at, but we left a lot of demand on the books that could not be satisfied. That is now rolling into Q2. We basically needed over $10 million of additional inventory on the books to be able to support even a portion of that. Demand continues to be strong in Q2. And unfortunately, as we've talked about in our release, we are not going to be able to fully satisfy all of our good customers. And it is unfortune that we're there, but we're doing everything we can to make sure we're able to do that. One of the changes that we did make was the change that profile on the scallops. That was not without considerable expense, but it did enable us to get to the kind of throughput that would help our customers get through this season in a more orderly fashion. With regard to the full year sales miss, that I think we probably have -- it's measured in tens of millions of dollars. The most of it would have occurred in the first and second quarter. It's hard to put an exact number on it because as you can imagine, when you're not able to ship with the consumer and the dealers demand, you're going to lose future sales on that. And we're going do everything we can to get back on target in the third quarter and get the product out there that people need to run their businesses.

And will the profile change? I mean, there's more raw material in this product and does that change the margin profile of the Enhance?

Yes. There's absolutely more material in it. It does change the margin profile of both the Enhance products that is embedded in the guidance information that we gave you both for Q2 and beyond. We believe that we will make progress on reducing costs into the future, but getting the volume out to our customers is more important than addressing a few million dollars of costs that we're being impacted by.

That makes sense. And the Nevada plant challenges, they're making -- they're not making any of Enhance products, is that correct? And what precisely went wrong there, if you care to share? And I want to clear on when the fix was fully implemented, whether it was mid-quarter or it will be end of June?

The Nevada operations started running in early April with the new dies and the new scallop, but it is a learning curve. Their operation runs a little bit different than the operation in Virginia. So it's a little bit of a challenge. And we believe that by the middle of May, we will be on target with the throughput that we had originally had envisioned. Having said that, the demand in our western footprint has been robust. And it certainly would be a challenge to be able to meet all that even if we had not had the equipment failures that we had. Basically what happened on the equipment failures, we had 2 key pieces of equipment on 2 separate lines that failed. And without those pieces of equipment, you cannot produce the product on those production lines. The replacement of that equipment takes roughly 30 days to put in place. Fortunately, we did have standby equipment available. It's unusual that, that type of thing would happen, but we were able to get back them up and running within roughly 30 days.

So those Nevada, Jim, was making Enhance as well or just Select and Transcend?

No. They're making Enhance Naturals and Basics also.

The next question will come from Phil Ng of Jefferies.

I appreciate you having some challenging -- challenges in the first half, which sounds like you have that under control, but should we expect 3Q kind of get back on track from a production and margin standpoint as planned coming into the year? And do you have some flexibility kind of play catch up in the second half to meet demand? And does that potentially provide a lift on fixed costs absorption if you're running kind of full out?

Well, if you go back to the statement I made before, we do believe that in Q3 we will see expanded margins. We do believe that we will see expanded sales beyond what we normally would have expected, part of that is catch up. But because the demand has been so strong for the Enhance and Basics, I'm reluctant to say that it's all catch up because I think that the demand will continue further into the year than what we experienced in the past. And certainly, as we increase that production, the absorption does come along with it. That was included in that guidance that we would see expanded margins beginning in Q2 -- or Q3.

Got it. And then from a demand perspective, I mean everything you're saying sounds great. It's coming in stronger than you expected. Is the upside actually to Enhance? Or are you seeing a pretty broad base across the Board? And it's still pretty early days but just curious will you able to triangulate consumers that have kind of where this Enhance product has resonated with the consumer? Is it kind of coming from the demographic that you were targeting? Or have you seen any impact from the high end of the market as well?

The demand has been fairly strong in the Enhance, Basics as well as the Naturals. That was to be expected because we had load in that needed to take place with all of our distribution partners. So very important to get that product on to their shelves so they had it available to move to the sale point. We also saw a good demand for the Transcend product, a portion of which came into try and beat the price increase back in December of 2018. But even when we look at what occurred in the first quarter, the demand was up to our expectations there also for both Select and Transcend.

Got it. And just one last question on Enhance, just given the momentum that you've seen, do you have a sense what the run rate is as you exited April in terms of the sell-through for Enhance?

Yes. The sell-through is kind of difficult. It's very early in the season. I cannot tell you that what we're seeing in the south has been a very strong conversion story with the basics. We're definitely seeing conversions for wood. We have received a number of pictures of decks that have been completed by Trex pros in the field that work with both composites and pressure-treated lumber and they're being very effective on those conversions. So we do see that taking place. Really aren't seeing any evidence that we're losing on the top end of the products, the people that would be in the 100,000 to 150,000 year income levels, really aren't seeing that many instances where people are trading down. We expect at a certain level. And I would say at this point, it has materialized to the level we had thought it would.

The next question will come from Alex Rygiel of B. Riley FBR.

The CapEx guidance, looks like it's up about $10 million from the last guide. Any thoughts on the increase there?

Our CapEx spending guidance is same as we were last time, so that's unchanged at this point. And we've talked about investing an additional throughput actions and upgrades in our facilities to gain more end product.

Comment on the cost of the equipment failure in the Nevada plant as it relates to CapEx needs?

It doesn't change our CapEx needs. As Jim mentioned, we had a number of those assets already on the ground, which had gone through CapEx and it was included within the guidance that we already had provided.

And is there any way for you to qualify the demand for Enhance, Basics or Naturals?

Yes. I think it's too early at this point to put a number on that. And in addition, we don't break down our sales by individual products. I can say that the demand has been stronger than what we had anticipated. And we're happy to see that. It affirms what our business valuation told us that by introducing those products, we would touch a new category of consumers and drive additional sales through our business partners.

And in March, you made a change to the profile the Enhance deck board. Why exactly did you do that?

What we found was the throughput that we were achieving with the original design was not allowing us to put as many lineal feet through our production lines as what we needed to put through to be able to try and support our customers. So in reducing the scallop size, we were able to have a more stable production environment, which enabled us to put significantly more product through the production lines, so we can better serve our customers.

The next question will come from Frank Camma of Sidoti.

I just have one question, just a clarification. So when you look at the quarter and you add back -- and maybe I'm doing this wrong, but if I were to add back the $10 million, I get a normalized gross margin about 44.2%, which technically would still be down year-over-year. Is there a problem with looking it that way because it's about 60 basis point decline even though revenue was up fairly nicely year-over-year. So what would be the problem with looking at that way when you normalize it?

Yes. The numbers that you're calling out are absolutely correct. When we gave the guidance for the 45% incremental margin that, of course, is over the course of the full year. We had planned on some level of start-up inefficiencies. Those inefficiencies have been much greater than anything we expected. But also, when you look on a year-over-year basis, we did talk about this a little bit last year, higher cost of labor, increased inbound freight expenses. Jim talked a little bit about the increased material in Enhance. That's mostly picked up in the start-up cost. And there are some higher repair and maintenance spending as well too. So it's more just a timing than anything else. If you would have normalized for the quarter, we would have seen that anyways in the first quarter and then that would offset through the rest of the year.

Okay. Just related to that then, was there any impact from pricing because I know you took pricing a little, so did that help all 70 of those items?

Very little impact from pricing. We had mentioned that in the fourth quarter call that extremely heavy demand on the Transcend product line to get ahead of that pricing. We shipped a lot in the fourth quarter, but a good number of those orders carried over to the first quarter as well. And so we didn't see much benefit from the pricing. We expect it will start to pick that up as we get into the second quarter.

The next question will come from Keith Hughes of SunTrust.

So on Enhance, in terms of getting the kind of the inventory stock out to customers, is that fully completed for those that want to hear at the end of April? Or is there still work to be done?

There's still work to be done. Because of the demand level we've got, it certainly does require that we have a higher level of stocking at our customers. We're working to try and get those levels up. And that is the challenge that we're working under today to try and get as much product out to those customers as we can.

And do you know when they'll have the full allotment by the end of this quarter perhaps?

I think that because we're chasing such a significantly increased demand from what we had planned for, I would say it's going to move into the third quarter.

Okay. And in terms of the new profile, can you comingle what you manufactured before with the new profile and the distribution location?

We can. If you looked at it when you're standing on the deck, you've noticed zero difference. All the scallops are underneath the Board. So the consumer doesn't look at it from that standpoint. They are slightly different, certainly different than the plan that we had. But at this point, virtually all of our customers are more interested in getting product that they can move through the retail channel as quickly as they can.

Our next question will come from Kurt Yinger of D.A. Davidson.

On the profile change, the Enhance products, could you maybe just give a little bit color given the scalloped bottom is somewhat new for you as far as contractor adoption or any feedback you've gotten there from customers as far as ease of use or installation?

Thus far, we have had no issues with installers or consumers with regard to installation. It's pretty straightforward. We offer the same type of product installation that we offer in other products. You can through screw it or surface screw it I should say or you can use hidden fasteners, we supply both boards. So does not seem to be any issue there. As I mentioned, when we looked at the southeast market, the conversion from pressure-treated seems to be going fairly well in that region.

Great. And then I was hoping you could talk a little bit about the timing of the wins within the retail channel that you've disclosed. Is that part of the push out just given the production constraints? Or is that something that you wouldn't have necessarily expected to hit in the first or second quarters anyways?

But we had demand across all of our customer base beginning in the late fourth quarter of this year and we're servicing all of those customers with the production that we had from that time period. Unfortunately, we don't get into discussing individual customers. Just something we've never done. I think our customers appreciate that we maintain a sense of confidentiality with regard to their businesses.

Okay. And then you referenced having perhaps a tough time satisfying demand even if you didn't have the equipment sort of issues that you experienced in the quarter. As you look at the investments that you plan to make this year, do you think you're going to be well positioned to satisfy that demand in 2020? Or are there any thoughts given to sort of accelerating investments in capacity or adding lines or anything of that nature?

We believe with the changes that we have made and some additional improvements in production, we think we're well positioned to be able to service the market for 2020. We are, in fact, looking at other alternatives to move additional production capacity in place. But at this point, we have made no commitments to do so. But as we take a look at the takeaway by the consumers during the second and early part of the third quarter, that will be the driver for us to make the decision on when we make that decision to invest in the next step, which is primarily expanded bricks and mortar as well as equipment.

Okay. That's helpful. And on the raw material front, I've seen some announcements from India and several other countries in Asia about at least intentions of some similar scrap plastic import restrictions as China. Is that something that you think can be a continued gross margin tailwind? Or would it be more from benefits related to your ability to expand the types and sources of scrap polyethylene you use?

Probably the latter that you mentioned on the various types of opportunities that are out there. We will not see anything like we saw back in the 2016-'17 time frame, but there will be likely a gradual decline in that price and the type of the mix of material that we use in the marketplace. The fact that more countries are moving away from it allows there be more supply, but you just don't see the sort of percentage drops that we saw back in the early years when China backed away from the market.

Right. Okay. And then lastly, I was hoping you could maybe touch on the competitive environment a bit within the retail and pro channels, I mean, some of your -- there's obviously been a shake up on the home improvement front and at least under Fortune Brands ownership, it seems like they're trying to leverage the distribution for fiber on a bit. And so I'm curious if the competitive environment is about as you'd expect or anything noteworthy there?

Yes. I think the competitive environment is very consistent with what we expected to see this year. Don't see anything significantly changing there one way or the other.

Our next question will come from Matt McCall of Seaport Global Securities.

Sorry if this has been asked, but I know you broke out -- I think you said to an earlier question that the impact from this item mostly from -- mostly in Q1 and Q2 would be in the tens of millions. Can you quantify what you think Q2 guide would have looked like? Or how much of an impact you've seen from these items? And just how much it impacted, what you're telling us about Q2 top line?

So you're asking me what our top line would have been in Q1 and Q2 had we been able to service the market fully?

Yes.

Matt, I really don't want to start speculating on what the numbers would have -- could have been. I think the numbers speak for themselves. They are not where we wanted to be. I think when I spoke to you before, I said, it's probably measured in tens of millions of dollars that we could have had in the calendar year, most of that would have been impacted in the first and second quarter.

Okay. That's fair. So maybe I'll have more luck with this one. You talked about $10 million of pressures in Q1. I guess, the first part of the question, did that fully encompass all of the pressures? I had a separate comment I thought about throughput, was that included in the $10 million? And then do you have an estimate of what the impact from the continuation of these items is going to be in Q2 on the gross margin line?

Yes, Matt, so that $10 million is inclusive of the Enhance-specific start-up as well throughput issues that we saw within both of our manufacturing facilities as well as the equipment downtime that we had in the friendly plants. As it relates to Q2, that's inclusive in the guidance, the 40% incremental for the full year as well as the second quarter guiding to be 300 basis points better than the first quarter on a sequential basis.

Yes, Matt. Yes, the way I like to look at this is if you take the $10 million aside, what we saw were inflationary costs, inbound transportation, labor in particular, some raw materials. We also had a price increase that we put in effect December 31. We had a lot of customers that took product ahead of that price increase. So a lot of what we shipped out in the first quarter did not get impacted by that price increase. Had we had that price increase, I don't think we would have seen the margin deterioration that you saw absent the $10 million.

Okay. So -- no, how do I think about that in terms of the second quarter when I put all those together, so you'll have more product at the new price, I'm assuming labor, freight and some raws will still be there, some inefficiencies. How do we -- maybe in relative terms versus that $10 million of pressure in Q1 and what does it look like in Q2?

Yes. I think a slightly better way to look at that is the guide we give is that compared to Q1, you see about a 300 basis point improvement in margins.

[Operator instructions] Our next question will come from Alex Maroccia of Berenberg.

I know you previously mentioned staggered results in Trex Commercial throughout the year, making forecasting difficult for. However, did you see anything in particular that caused lower revenue in Q1 '19 versus Q1 '18? And then additionally, when do you believe these order contracts are going to fully roll off?

The revenue for Trex Commercial came in right in line with what we expected for the first quarter. We know it can be lumpy from quarter-to-quarter over the course of the year, and especially coming off of an extremely strong growth year that we saw in 2018. Then relates to the older legacy contracts, those do continue to run off, most of them will be gone by the end of the second quarter, but there'll be a few that carry out through Q3 of this year.

Okay. Great. And then my second set is about the sales channels, so in which region did you see your strong pull through of products in recovers trove? And then in which channel, do you see the most -- the biggest effect from the Nevada equipment issues?

The pull through that we've seen thus far, we would look to the southeast because obviously the consumers buying earlier in the southeast than what we see in the rest of the regions. With regard to where it's coming from, it's pretty widespread. We really don't identify separate channels in that way, so not able to give you more color on that.

Ladies and gentlemen, this will conclude our question-and-answer session. At this time, I'd like to turn the conference back over to Jim Cline for any closing remarks.

I'd like to thank everyone for participating in today's call. I know this last minute, we appreciate you joining in. We wanted to make sure that the full content of our earnings release and earnings call was made available to all the investors at onetime and that way they had the complete story, so thank you for participating. We look forward to meeting with you in the next quarter on a number of conferences we participate in and look forward to our next earnings call with you. Thank you very much. Good day.

The conference is now concluded. We thank you for attending today's presentation. You may now disconnect your lines.