Trex Outdoor Living
Disclaimer
Black Opal Research is a financial newsletter that provides our take on different publicly traded businesses in order to obtain feedback and test our own thesis. We find this process keeps us accountable to make educated investment decisions with our own money and no one else's. Nothing in our articles should be taken as financial advice. We will always ask our readers to seek qualified financial advice before investing in any of the companies that we complete analysis on. Do your own research, fact check, and evaluate.
Summary
Management
CEO Bryan H. Fairbanks
Employed at the company since 2004 with increasingly more senior roles
Previously CFO
Competitive Advantage
Worlds Largest producer of composite decking
Creators of Composite decking
Brand Moat
Margin of Safety price point
Ten Cap - $26.87
DCF Entry - $38
Intrinsic Value (DCF)- $76
Current stock price - $59.48
The Company
Trex is the worlds leading manufacturer and inventor of wood alternative composite decking. Their products are composed of 95% recycled and reclaimed plastics and wood making them an ideal choice for ESG focused mutual and pension funds. Trex also manufactures other outdoor products like railings, fencing, lighting, cladding, and outdoor furniture.
The company came public in 1998 and their original S1 spoke of the same advantages they had over wood products that they have today namely longevity and low maintenance. At the time they were in their early years of brand development, and were working to expand their network and increase their production capacity to keep up with demand. Until last year this was a similar theme for the business.
In 1998 Trex stated that 97% of the decking market was made up of wood based products. At the time they had five competitors and sold approximately 75% of all wood/plastic composites to the decking market. In 2021 Trex estimated that the size of the decking market is ~$8B and that $2.0B (25%) was made up of composite material. Reviewing Trex competitors, (UFPI Industries and AZECK) it looks like they generate almost 2x revenue of the next largest manufacturer in the composite decking market.
The Event
Trex is a business that was favorably impacted by the pandemic. They saw significant demand for their decking, railing and outdoor living products as consumers looked for stay at home leisure. They struggled to keep up with demand through 2021 and the early part of 2022 and have started construction on a new facility 300 acre facility.
In the third quarter of 2022, with inflation rampant, the federal reserve started raising interest rates. This had an impact on the three largest customers that Trex sells product to. While they continued to purchase product, they did reduce order quantities significantly. This combined with a production facility operating at 100% capacity created an oversupply of product which compounded the issue. Third quarter sales fell 43.9% vs 2022. Volume declined by 48.2% Year over year for the quarter and for the year end 2022 sales fell around 7%.
Trex took action to reduce staffing levels and output as they adjusted to their distributors new product volumes. They are now producing to a sales level in line with $1B. They also provided guidance that earnings/margins will take a hit because they are not operating at full capacity for the rest of 2023.
The Evaluation
10 Cap Evaluation
At Black Opal Research we value businesses as if we were going to buy the entire thing. Our Ten Cap analysis is very simple. It ensures that if we purchased the whole business, we would get a return of our entire initial investment over a ten year period. This analysis does not include any growth metrics and assumes that the business will be steady and constant throughout time.
For our analysis of Trex, we will utilize their 2019 operating earnings and will adjust it at a compound annual rate of 15%. For reference the average Owner Earnings growth rate as we calculate it from 2015 - 2019 was ~22%.
In 2019 Trex generated $156m in cashflow from operating activities. The company spent a total of $67m investing in the business of which only a portion is considered maintenance capital expenditures. The details are clearly spelt out in the annual report. Trex spent $60 on expansion of production facilities as well as general efficiency upgrades. They spent 4.9m in production improvements and only 2.2m on general support initiatives. Giving management some leash on what they consider maintenance vs. efficiency upgrades, we would classify only the 2.2m spent on general support initiatives to qualify as maintenance capital expenditures.
In order to get the owner earnings number we use the Operating Cashflow, then subtract the Maintenance Capex, and add in the taxes. This will represent the pre tax free cash flow of the business as if we owned it in its entirety. $156-$2.2+$45=$198.8m
Adjusting the 2019 owner earnings at 15% gives us a total owner earnings at the end of 2022 of $301m. Today, Trex has 112m share's outstanding giving us an adjusted owner earnings per share of 301/112=$2.6875. If we are looking to recover our investment over a ten year period, then our 10 cap entry price per would be $26.87/share.
DCF Evaluation
Trex is focused on growing their business by taking market share from the largely wood decking, railing and outdoor living market. They have been growing their business since it first came public over 20 years ago. Earnings grew at an average of 25% from 2015-2019.
While we don’t think that Trex can continue to grow earnings at that average over the next ten years, we do think they will continue to successfully grow earnings and continue to capture additional market share. We think that the addition of their new facility will significantly increase their ability to ramp up production of their products. This will allow them to adjust to increased market demand for Trex decking products as they continue to obtain market share from the wood decking market. Additionally, once they are operating near full capacity we should see their margins improve as management has suggested in 2026-2028.
Trex has been focused on innovation and improving their decking and railing products. Their new product lines look more like wood than ever before and have been designed to remove some of the negative effects that composite decking materials may have over wood. These innovation will lead to more conversions from wood to composite and should position Trex well for acquiring those new consumers.
Overall we think Trex will grow earnings between 12-18% a year over the next 10 years. This will be due to a combination of an increased market share from wood products, margin expansion due to more efficient utilization at full production, as well as inflationary price increases for products.
We do see some headwinds in the short term. We expect a larger consumer pullback in discretionary spending, a higher inflationary market, a slowdown of new home construction, and increased competition in the composite decking market. Our current view is that these hurdles will be easily overcome by management and may provide opportunities for a margin of saftey entry price in the short term.
Assumptions for DCF
Discount rate - 15%
Earnings Growth - 18%
2022 EPS - $1.65
Future PE - 36
Intrinsic Value - $76.00
Margin of safety @ 50% - $38.42
Conclusion
We believe that Trex is a great simple and well managed business. The management team is focused on what they do best, and has been successful in gaining market share from wood as well as maintaining their advantage as the largest manufacturer of composite decking in the industry. They continue to innovate, maintain a conservative debt ratio and plan appropriately for their future growth even if that means some pain in the short term.
We think that Trex is more aligned with the renovation market which we expect to see less of a demand slump than those companies aligned with the new home construction industry. Additionally we believe that consumers are focused on efficiencies in all aspects of their lives and will continue to transition to a less maintenance intensive product for their outdoor living spaces than pressure treated wood products. Even if it costs them more up front.
While we like the business, we only invest in businesses when we have a margin of safety. With Trex trading at $59.48 we do not have an entry point with the margin of safety we are looking for. We will put this one on our watch list to see how things unfold over the next few months.