Trex Company Inc (TREX) 2006 Q3 法說會逐字稿

Welcome to the Trex Company Third Quarter 2006 Conference Call.

[OPERATOR INSTRUCTIONS]

As a reminder, this conference is being recorded November 1, 2006. I would now like to turn the conference over to Ms. Harriet Fried from LHA. Please go ahead, ma'am.

Thank you, everyone, for joining us today. With us on the call are Tony Cavanna, Chairman and Chief Executive Officer of Trex Company, and Paul Fletcher, Chief Financial Officer. The company issued a press release this morning containing financial results for the third quarter. This release is available on the company's website, as well as on various financial websites.

A replay of this conference call will be available through Thursday, November 8. The call is also being webcast on the investor relations page of the company's website, where it will be available for 30 days. Before we begin, let me remind you that statements on this call regarding expected sales performance and operating results, projections of net sales and earnings per share, and anticipated financial conditions constitute forward-looking statements and are subject to risks and uncertainties that could cause the actual results to differ materially.

Such risks and uncertainties include the extent of market acceptance of the company's products, sensitivity to general economic conditions, and the highly competitive markets in which the company operates. The company's report on 10-K filed with the SEC in March 2006 and its subsequent filings on Form 10-Q discuss some of the important risk factors that could cause actual results to differ from those expressed or implied on this call. The company disclaims any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

With that introduction, I'd like to turn the call over to Mr. Cavanna. Go ahead, please, Tony.

Thank you, Harriet, and good morning. A few hours ago, we released the Trex Company financial results for the third quarter ending September 30, 2006. Revenue of $78.1 million for the third quarter of 2006 is slightly higher than the $77.4 million revenue recorded in the third quarter of 2005. Year-to-date revenue through three quarters is $304.8 million, which exceeds 2005's nine-month revenue of $250.1 million by 22%. Trex's net income for the third quarter was $4.7 million or $0.31 per diluted share, which is lower than the 2005 third quarter income of $0.35 per diluted share. Nine months income of $1.06 per share is 26% higher than the $0.84 per share earned during the first nine months of 2005.

Now, I'd like to turn the call over to Paul Fletcher, our Chief Financial Officer, who will describe our financial performance and financial status in more detail. Paul?

Thank you, Tony. As you are aware, our press release was issued this morning and the numbers I will reference are contained on the last few pages of the release, headed "Condensed Consolidated Statement of Operations," "Condensed Consolidated Balance Sheet," and "Condensed Consolidated Statement of Cash Flow."

At third quarter 2006, sales were $78.1 million, compared to 2005's third quarter net sales of $77.4 million, an increase of approximately 1%. The impact of higher 2006 pricing was offset by 4.8% lower sales volume in the third quarter and price discounts offered through a third quarter sales promotion. Net income in the third quarter of 2007 was $4.6 million or $0.31 per diluted share, compared to net income of $5.2 million or $0.35 per diluted share for the third quarter of 2005.

Third quarter earnings before taxes increased 2.4% from $7.1 million in 2005 to $7.2 million in 2006. Net income for the nine months ended September 30, 2006 was $15.9 million or $1.06 per diluted share, compared to $12.6 million or $0.84 per diluted share for the nine months ended September 30, 2005. Gross profit for the 2006 third quarter represented 29% of sales, approximately 220 basis points less than the third quarter 2005 gross margin of 31%. Favorable pricing and improved capacity utilization during the third quarter of 2006 were negated by sales discounts, higher average purchase poly costs, and incremental labor expenses associated with the quality initiatives implemented at the start of 2006.

The price of PE material in the 2006 third quarter increased approximately 11% over the third quarter of 2005. Since the first quarter of 2006, however, the price of purchased poly has declined 10%. Total plant capacity utilization was approximately 90% during third quarter of 2006, which compared to 71% in the third quarter of 2005. In the third quarter of 2006, SG&A expenses totaled $15.5 million, compared to $17 million in the third quarter of 2005. The decline in total SG&A expenses was driven by the reversal of $3.2 million in cash incentive-based compensation, which had been accrued in the first six months of 2006.

Branding related expenses for the 2006 third quarter was $4.3 million as compared to $3.6 million in the third quarter last year. For the nine months in 2006, SG&A expenses were approximately 8% less than 2005 and represented 19% of net sales, compared to 25% of net sales for the comparable period last year. The SG&A expenses for the nine months of 2005 also did not include cash incentive compensation. Debt to total capitalization was 26% at September 30, 2006, a 300 basis point improvement compared to September 30, 2005.

Debt to trailing 12-months EBITDA was 2.2 at September 30, 2006, compared to 2.1 at September 30, 2005. At September 30, 2006, total debt amounted to $64.8 million, down $6.2 million from September 30, 2005. Net accounts receivable declined from $38.2 million at June 30, 2006 to $23.2 million at September 30, 2006. However, the receivable balance at the September quarter end was impacted by the third quarter product promotion, which carried extended payment terms to December 1 of this year, 2006.

Total inventories, including raw materials and finished goods, increased from $51.4 million at June 30 to $78 million at September 30, 2006. Finished goods inventories increased by approximately $24 million during the third quarter, as we prepared for the 2007 early buy and the introduction of a significant new product slate in 2007. Operating cash flow through the nine months ended September 30 amounted to $24.5 million, which is slightly lower than the first nine months of 2005.

Capital expenditures amounted to $14 million during the 2006 nine month period compared to $27 million for the 2005 nine month period. The primary areas of investment in 2006 have included poly processing, inhalant equipment, production related equipment, and information technology. Tony?

Thanks, Paul. During the last part of 2005 and the early months of 2006, our people worked hard at evaluating the quality and consistency of our products that we deliver to our customers, the manufacturing efficiencies we were experiencing at our three manufacturing sites and the competitiveness of our product line offering.

During the remainder of 2006, our organization has been focused on optimization engineering. What I mean by optimization engineering is, how can we improve our overall manufacturing process to reduce raw material costs, increase manufacturing rates, and increase material yield. How can we deliver product with high quality standards without needing to adhere to the selection and rejection process of quality control, and, finally, what additions or redesigns of our product line will enhance our relationship to our customers?

We have reengineered a significant portion of our manufacturing process and are designing and installing manufacturing upgrades that will allow us to do away with the selection and rejection process of quality control. During 2006 and 2007, we will spend about $25 million on these manufacturing upgrades. During the latter part of 2007, we expect to realize significant benefits from these investments, while full implementation and reward will not be realized until 2008.

As I commented during the July 2006 conference call, we are receiving favorable comments from the improved quality and consistency of the Trex products we are delivering. That trend is continuing and I am pleased about the progress we have made. Our product quality has improved through the selection and rejection process of quality control, albeit at a significant cost to Trex.

Also during the July conference call, I informed you of our plans for a poly processing facility at the Winchester plant location. The extrusion portion of the facility is in the startup stage today as we speak, whereas the entire poly selection process will be operational in the first quarter of 2007. We have broken down our manufacturing process into six distinct operations. Each unit operation has been thoroughly analyzed and opportunities for improvement related to cost and quality have been identified and, more importantly, addressed.

Upon full implementation of the identified enhancements, much of which will be implemented by the second half of 2007, we expect to be producing higher quality Trex at lower cost. As we announced to our distributors last month in Dallas, three changes will be made to our product offering or presentation. We will introduce our new contours deck board. This deck board broadens our product line by presenting an item that has a deeper embossed grain, while providing product that will address the needs of the value buyer.

We will reintroduce Brazilia to satisfy the requirements of the upscale customer, who is looking for a substitute for a rain forest decking board. The colors of our new Brazilia will still be burnished amber and cayenne. However, the variegation will be more visible through greater prominence of the variegation or grain contrast.

To give a shot in the arm to our deck railing sales, we are introducing a four-by-four post sleeve, a product requested by our contractor partners to reduce the total railing costs and makes the Trex designer railing easier to install.

Finally, to enhance the process of buying a Trex designer railing for a Trex deck, we are developing boxed railing kits. These boxed kits will be available in the early part of 2007. Repeating the words I used during the July conference call, new products and product enhancements are critical to our long-term success. Our Home Depot relationship continues to grow. At year end 2005, Trex was stocked at 320 stores. Today, Trex is stocked at more than 800 stores and we expect that Trex will be stocked at over 900 stores by year end 2006.

Our sales of Home Depot are approaching an important level of significance in Trex's overall business. Although still not significant from a volume standpoint, I am pleased to report that our product and market development efforts for Trex's new privacy fencing product, Seclusion, is progressing nicely. While the volume is small in the overall Trex total, the product continues to receive laudatory comments as it relates to its esthetics, product functionality, and ease of installation. We have hired several new salespeople and expect that 2007 will be a kickoff year for raising the importance of Trex's Seclusion to the Trex Company.

As you have read in the press release issued earlier this morning, we have changed our forecast for 2006's revenue and earnings. Because of the overall reduced activities in the home building sector, the high overall inventories carried by our distributor partners for all their product offerings and the pricing strategy we have chosen to follow, we expect Trex's fourth quarter results will be adversely affected.

We are projecting Trex's full year revenues to be between $320 and $330 million and earnings per diluted share to be in the range of $0.35 to $0.45. Based on a strong franchise which excludes our distribution channel, the Trex brand name, and breadth and quality of product offering, we expect a strong increase in results in 2008. I am forecasting that 2007's revenue will increase about 17% to between $375 and $390 million, resulting in earnings per diluted share of $1.05 to $1.25.

This concludes our prepared remarks and we are ready to answer any questions. Harriet?

[OPERATOR INSTRUCTIONS]

The first question comes from Joel Havard, with BB&T Capital Marketing.

Thank you. Good morning, everybody. Tony, if we can, let's start with this Contours. Is this replacing the current wood grain, I think that's Accents, or is this an entirely new family? I caught the word "value" in the commentary, in the press release, and I'm wondering what that implies to sort of price mix, as well. Could you elaborate?

Yes. It's not a replacement for Accents. As a matter of fact, Accents represents more than 70% of our product mix, Joel. It's a step down from the Accents and if it will replace anything in our product line, it will probably be our Origins product, however, at a lower price point and with grain, where Origins does not have a grain.

So that's the look consumers want. Can you give us any insight into how it's going to be a better value? Is this an engineering feat or are you just willing to take a lower --

Our margin is projected to be equal to the rest of our product line and that's usually the way we try to develop our pricing, provided the market will bear it.

The word "contours" means that we're taking -- if you look at the bottom of the board, it's not flat, so it's not reversible from side to side, and we're taking material out of the board so that it will be at a price point similar to some of the lower priced products either in the professional channel or in the big box channel.

I know what you're talking about. Okay. Paul, you all talked about the number of Depots or, Tony, you made that reference. What about -- and you made sort of an oblique reference to the contribution. You've spoken in the past in approximate terms about its revenue contribution. Can you all do that again yet?

Yes. It's about 10% of our total revenue.

It's reaching 10%, Joel.

That's encouraging. Good.

And it's growing rapidly, because I think if you go back to about a year and a half, the stocking rate at the stores is picking up rapidly. Like the last time I spoke, we didn't expect to be at 800 until the end of this year and we're already there and now we expect to be at over 900 by the end of the year.

That is good progress. Progress on the Virginia poly plant, now, I haven't been in that building yet. I wonder if you could tell us exactly how it differs from the wash line, what it's going to do to the overall system.

It's totally separate from the wash line, inasmuch as it contains extrusion, which means it allows us to do melt filtration to take out contaminants, while we -- after we pick the contaminants out, most of it manually, we will then submit the product, the material to extrusion, where we'll subject it to final melt filtration. That will allow us to make a relatively clean plastic. And this will not only give us clean plastic, but will also allow us to reduce our costs in some of the outside work we are now paying for, for people to do this melt filtration for us.

Tony, does that mean that it's widening the net of available raw material?

Without a doubt, Joel. Our overall material costs somewhere around $0.31, $0.32, and I've told you in the past, that means we're buying some material for $0.05 or $0.06, some material at $0.40, there's no one material at $0.31, $0.32. Now we'll be able to go down into lower cost material, in the teens or even below the teens, that will allow us to now spend some money to upgrade it and still have a lower cost for our overall raw material input.

Okay. Just a couple more questions, guys. Thanks for bearing with me. I guess the multi-million question this morning is your 95 or more percent remodeling and home improvement oriented, this forecast, however, sure looks a whole lot like what the builders are saying.

What's your experience with the thought process at the distributor level. Are you just kind of being dragged along with their sort of de-stocking mentality right now or are you seeing all the way downstream that home improvement is starting to really pull on the brakes, too?

I think there's a couple of facets to that answer. One, we are -- well, let's go back. If you go back to the early '90s, when we had a mild recession, and home building declined, actually, remodeling expenses, including decking, actually increased.

Today, our distributors have inventory levels that are higher and they are comfortable with. Some of that is Trex, because I didn't say in my remarks, some of our inventory of Trex at the distributor level has come down since we talked in July, but it's still higher than we'd like it to be at this time of the year.

However, the major impact of their commitment of working capital comes from the back, that all their other products that they're carrying are at inventory levels that they're not comfortable with. So everybody's being painted with the same brush in terms of committing to inventory for the latter part of this year and early part of 2007.

That makes sense. Last question. Tony, now that you're not going to get that $3.2 million bonus accrual, what's the thought process for you and the board on the permanent CEO replacement search?

I've never indicated to you how long I'd be here and I still can't do that, Joel. When I know the answer, I'll give it to you and the other folks.

Fair enough. Thanks, guys. Good luck.

I do not have a termination date yet.

Okay. Good.

Your next question comes from Ryan Thibodeaux with Maple Leaf Partners.

Good morning. Could you guys talk a little bit about the drivers for the '06 guidance and I guess what you were expecting earlier in the year? Really, what's the major driving factor that's causing you to lower that guidance today?

There's really two factors that are new to our projection. It all involves the last 90 days of the year here, the fourth quarter. And the first is volume, we're expecting to have volume and revenue be about half of what it was last year. Remember, last year, we had a price increase at the start of the year, which incented a lot of volume into the fourth quarter. We don't have that this year. That's one reason why we're anticipating a slower fourth quarter.

The other is our decision to shut down or temporarily suspend manufacturing lines, which causes the negative or unfavorable absorption of fixed cost. So those together, they're about equally weighted, drive the EPS guidance from what it was to our new guidance of what it is today.

So does that imply that gross margins for Q4 will be similar to what they were last year's Q4?

They'll be higher, but they'll be in the 8% to 10% range. I think last year it was a breakeven margin.

Will there be any more, I guess, reversals of accruals in SG&A next quarter or was that taken care of?

No. Those were incentives based on financial performance that it was determined we were not going to meet and these were cash incentives. It was not stock-based incentives. They were cash. So those accruals were reversed.

Then looking forward to 2007, then, I guess you're assuming you're not going to have the same problem you've had the last two years now, which would imply a higher gross margin percentage next year. Is that accurate?

I think so. What it amounts to is in 2004, we earned a $1.83 a share. In 2005, we earned $0.17 a share. And we don't like the number we're projecting for 2006, but it's better than in 2005. And in 2007, we're not anticipating the rapid rise in raw materials or poly costs that hit us in that downswing in 2005, as well as other things.

So right now, as we try to implement some of these -- not try, but as we implement some of these cost reduction efforts for raw material, just to talk about raw material yields on our extrusion process, the yields we're operating at today versus what we want to be operating at is costing us somewhere between $10 million and $12 million a year. So what it amounts to is I don't think we'll get it all back in 2007, but we'll get a big part of that back.

And then just one kind of housekeeping question. I noticed in Q3 your interest expense was $133,000. Last year it was a $187,000 per the 10-Q, but it looks like you guys have a different number in the press release for last year. Can you talk about what the fluctuation there is?

The interest expense is offset by interest capitalization and interest income, as well as we have a receivable from our Dimplex partnership that accrues interest. So those are the offsets to the cash interest. There was a reclass of the 2005 foreign exchange transaction that belonged in SG&A and not interest expense.

Okay. So should we expect interest expense to go back up to a normalized level in Q4?

Yes. You would expect that to be normalized.

So just to understand, you're basically just capitalizing that interest, since you plan on taking down some of the lines.

No. As we invest in capital and before it is put into service, we're capitalizing interest during that construction process. So in those, it can be a line, it can be a plant. As the equipment is being put into service, we're capitalizing interest along the way. Once it's put into service and capitalized, then that interest capitalization stops and the depreciation will start from that point forward.

Okay. Thank you.

Your next question comes from Kenneth Hugh, with SunTrust.

Thank you. I wanted to ask about the Brazilia relaunch or reintroduction, I guess. What exactly does that mean when you say reintroduction?

Well, what it amounts to is I believe and I think our company believes that Brazilia is going to be the flagship of our product offering. It doesn't necessarily mean it'll be the highest volume part of our product mix, but it'll be something that relates to Trex and Trex relates to Brazilia.

And we introduced the product sometime in the -- call it late 2004, early 2005, and what it amounts to is the esthetics of the product are extremely attractive. But we also did not do all the job of making sure we could produce the product consistently from a standpoint of what it looks like and its attractiveness, as well from a cost standpoint.

So we've pulled back in 2006 on Brazilia. We kept selling it up until about a month ago, 60 days ago, and, basically, we're selling out of inventory, but not making anymore product and that was for purposes of making sure that we then make the product in such a way that it will have the variegation that is very visible and have the esthetics that the people are looking for. And in addition to that, we've optimized the process such that when we do produce it full out, we will be able to produce it with good economics. So that's what we mean about the reintroduction of Brazilia.

Will the colors and the styles be the same?

The colors will be the same and the styles will be the same, with the exception that the variegation will be much more visible on a consistent basis.

And just looking across the industry, you're not the only ones having problems here, do you expect to see just wholesale discounting across the board over the next quarter or two, as people just struggle with volume at this point? Have you seen it, I guess?

We have not seen discounting as of now. Certainly, our pricing strategy is different this year, such that -- well, to answer your question, we do not expect to see discounting of any major consequence, with the exception maybe of promotions on a monthly or quarterly basis that will comprehend some discounting in a form of reduced price or extended terms.

But what we've done in our pricing this year, to maybe address the price elasticity curve and demand for composites, is that we have chosen not to have a price increase in the first nine months of the year. If anything, we'll have a price increase in September. So, basically, we're trying to keep the price down as it relates to wood and, also, reduce the opportunity for price competition within composites.

Is that part of the reason for the Contours introduction, as well?

That is part of the reason, but the main reason for the Contours is to fill out our product line for the value buyer.

And will you be running, in the first four months of next year, the usual type of early buy-in?

We will, yes.

And, finally, I missed the beginning of the call, Paul, you referred to some type of reversal on a compensation accrual. What was that, again?

It was cash bonus, cash incentives that are tied to financial performance that accrue through the first six months that were reversed based on the evaluation of not meeting the financial target.

And how much was that?

$3.2 million.

That will be in SG&A, correct?

Correct.

Okay. Thank you.

Your next question comes from John Baugh, with Stifel Nicolaus.

Good morning. Two questions. Where will capacity utilization be in the fourth quarter year over year and what kind of assumption in your $1.05 to $1.25, I think it was, for '07, what kind of capacity utilization are you assuming?

John, the fourth quarter, we're looking at, right now, 70% to 75% utilization this year, which compares to 56%-57% a year ago.

So you're going to build, relative to a year ago, more inventory, because you're not going to ship much.

Correct.

And that is because of the new product?

John, that's exactly right. One of the biggest mistakes we made long ago was to create demand for products that then we couldn't supply because we didn't have enough capacity. What it amounts to is since we are making some significant changes in our product mix, whether it be railing, whether it be Contours, whether it be Brazilia, because we stopped selling Brazilia, stopped making it for a while, and then we also have our fencing, Seclusion.

We want to make sure that we over-invest, if anything, on the side of making sure we have the inventory to satisfy the demand we're creating with our programs as we go forward.

Okay. And then can you give some -- obviously, it's conjecture, Tony, but with Contours coming in, how does that impact Origins? How does that impact Accents? And I guess the two questions are do distributors want to stop carrying Origins and, yet, they've got inventory of Origins they need to work through first before they order Contours?

And then does Accents get cannibalized by Contours if the only difference is you can't flip to the other side of the board, but if it's got an even better embossing on it, might it not drive a lot of volume? And I guess if your margin's the same, you're relatively indifferent, although I'm sure it carries a lower gross dollar margin. If you can address those.

Yes. Well, what it amounts to is -- I think you said it well on your last part of your statement. If anything is going to cannibalize our current product line, we'd like it to be ourselves. And the other reason and really the main reason we're introducing this product is we're trying to make the decision difficult for the dealer who is carrying multiple product lines today.

And what it amounts to is if he's carrying one of our competitor's product line, of course, our competitor has a product that's similar to Contours in the pricing range of the overall scheme of the hierarchy, we're trying to make it difficult for him to believe that he needs to carry someone else's product in addition to carrying Trex as his main product.

So you think whatever you may see in trade down within your existing customers will be offset by picking up this price point from a competitor.

That's exactly right.

The other element, John, is that Contours will not be produced in the saddle color. So that won't conflict between Accents and Contours.

Okay. And then how do you gauge poly costs going forward? You've got market dynamics of what virgin polyethylene is doing and then you've got all these cost initiatives to take plastic out or get more efficient. If you're $0.31 to $0.32 today, what are the assumptions in that $1.00 to $1.25 that you're using for poly costs in '07?

We're basically anticipating it will be flat for the whole year. In fact, as we speak today, it's coming down a little bit.

And my last question is where are prices today? Gross prices, are they up 11%, but you discounted off of that and now you're going to stop discounting, so we're really still at a wholesale price that's 11% higher and we're going to hold that price for '07?

That's exactly right, John. The promotions we referred to -- and we had some promotions in the third quarter and we did them specifically in the third quarter, with some pricing concession, rather than the fourth quarter, not to cannibalize from 2007 and try to put our sales base on a quarterly basis back to what the market equilibrium wants to be rather than try to force it one way or another.

So you're not going to be doing most likely a lot of promoting in the fourth quarter.

That's right.

Good luck. Thank you.

Your next question comes from Keith Johnson, with Morgan, Keegan.

Good morning, guys. Just a couple quick questions. I think we've covered most everything that I had on the list. You said Accents was how much percentage of sales?

About 70.

And the railing accounted for how much, as well?

Our railing is well under 10%.

And then you sold a little bit of Brazilia this year, a few percent. I was just trying to get back to how much -- where Origins is going to sell out. Can you give a little bit more color on the current demand environment you're seeing today, how it maybe compares back to what you experienced in kind of the 2000 to 2001 time period?

The 2001 time period?

Right. Well, I guess the last kind of downturn or recession.

I'm not sure I can answer that with any degree of accuracy, Keith.

Your guidance, I guess, for 2007, I guess based on kind of the way I understand the seasonality and buying trends go, it seems a little early in that you could get to the end of December and distributors have a different view of what the 2007 demand patterns will look like?

Right now we're looking at -- the first quarter and second quarter of our business is always high and we're anticipating that that will be the case, because the inventories of our distributors are higher than we would like them to be at this time of year, but they're not exorbitantly higher.

They've come down from where they were in July. So we're -- and not incenting people to buy in December like we did last year with a 4% price increase effective January 1. We're expecting to get back to this norm of equilibrium where maybe the first quarter is about 31, 32% of our sales and the first half is somewhere around 65% of our sales. So that's what we're looking at, Keith.

All right. Thanks a lot.

Your next question comes from [Thomas Haines], with [Empirical Capital].

I just wondered if you could give a little more color on where you are with the fencing product, how you see that market shaping up and what you expect to spend on promotion and that sort of thing.

Well, we're not in a promotion stage of the introduction yet. I said it will be a kickoff year for us, but we probably won't introduce it from a standpoint of a full blown introduction until the latter part of the year.

Our sales this year, without telling you exactly what they are, because I don't feel it's appropriate, are very, very encouraging. It's certainly more -- let me put it this way. It's more than $1 million and what it amounts to, it's growing nicely and what it amounts to is we are still making some changes, minor ones, but changes to the product design, as well as the process design. We expect a very significant increase in sales in 2007. However, it'll still be a number that is not overly significant to our overall business.

And then margin-wise, how do you see that product -- ?

Margin-wise, as we improve the process, we expect it to be in the same range as our decking. As a matter of fact, when we had decking margins in excess of 40%, our goals are to get the fencing business to be in that category, as well as the decking business, but what it amounts to is starting anew.

I think we have a better chance to exceed the 30s in fencing faster than we can get back to those numbers with decking.

Great. Thanks.

Your next question comes from [Greg Powell], with AllianceBernstein.

I've got a few questions. First, did I understand right, you're not going to have a price increase until September of '07?

Yes. I was trying to shy away from the mechanics, but let me just describe the mechanics to you. We are working with our distributors in such a way that we're going to agree on a goal for every one of our distributor customers in the form of a goal of what they should buy during the early buy.

If they meet those numbers, there will be absolutely no price increase until September. If they don't meet the numbers, then there will be a price increase that will go back to January, but we don't expect that to happen. So, therefore, we haven't comprehended it.

So they have until September to meet the goal.

They have until May 1, which is the early buy program, to meet the goal.

And then are you going to offer extended terms?

During early buy, yes.

It will be a similar package that we've offered in the past.

And you offered extended terms this quarter, as well, in Q3?

As a part of the promotion, we did.

Are you taking a higher provision for bad debt? You're selling to distributors that are stretched on working capital and you're offering them extended terms at this time.

We have only had one bad debt in our history of our company, and the nice part of the fact that on our customer slate is that we have only 23 customers and we know the financial status of all of them. I mean, I'm not trying to be naive about this, but I don't think bad debts are something we should be worrying about, as well as our accountants agree with that.

Well, I guess you could say if they're so well capitalized, they wouldn't need extended terms.

We give them the option of a discount or extended terms and so in early buy, actually, the majority of the customers in the past have taken the discount, which reflects their capitalization. So the majority of customers actually take a discount.

In this Q3 program, did more take the extended terms than in the past?

There wasn't a choice. It was a part of the program.

And then the last question, you're going to run at 70% to 75% capacity in Q4. What do you expect to exit the year with in terms of inventories?

Finished goods inventory --?

Total.

Finished goods inventory, $75 to $80 million, and raw materials in the range of $30 million.

Okay. Thanks.

Your next question comes from Robert Kelly with Sidoti & Company.

Good morning. A quick question on the polyethylene costs. You said that they're down about 10% from the beginning of the year. What have they done quarter to quarter?

From Q1 to today, our purchased poly costs are down through Q3.

Quarter to quarter, flat?

No. It's come down sequentially each quarter, first, second, third have come down.

And that's your assumption for the guidance for next year, it's just level, flat.

Flat, right. Stable from here.

Capacity utilization for 4Q, is that any different from what you guys would run? Obviously, last year was a special event. Would Q4 '04 be in that 70% to 75% range?

It would be. We have run in that level. That's not our optimal level, obviously. So we would rather run in the 90%, everything being equal. It's always an inventory type decision of how much to carry going into the early buy.

Usually, we try to get a volume such that we're ready for the early buy and usually the inventory for -- our inventory is lower than this. So on a year when things are going very well, we're running all our capacity to build inventory.

We already have inventory at a little higher level than is totally comfortable, so we're cutting back in the fourth quarter.

Okay. Thanks. Now, you have Contours coming out in '07. You have the fencing now. Brazilia, I guess, is being relaunched. Now, have you covered the spectrum as far as what your competitors carry? Do you have kind of an answer for everything now at this point?

I believe we do, and have some that they don't have.

Right. As far as the slowdown in demand has kind of been industry-wide, I know you can't predict the future, but if the trends were to continue, is it possible you would pull back further on the utilization?

If we don't sell at the rates we expect to, of course, we're not going to continue to grow inventory.

Thank you, very much.

Your next question comes from Bill Gibson, with Nollenberger Capital.

You've been pretty thorough here, but I just want to understand the implied gross margin guidance for next year is lower than I would have imagined, given flat poly costs and your utilization estimate. It must be labor. Is it just the added labor on these quality programs?

It's the labor in the form of -- wasting labor in the form of lower material yields. The value added is labor and manufacturing overhead and if you're operating at 85% yield instead of 95%, that's a big bill to absorb.

So it's just not physical inspection of the boards. It's what you talked about of breaking out the manufacturing and the processes and steps and improving it at each step.

Yes, but there's still some labor, too, Bill, from the standpoint of this inspection and rejection process, until we get all our capital installed to do that automatically.

Thank you. And I think you went over everything on the first quarter. I was thinking maybe the first quarter could be light without the price hike. But essentially you're giving an incentive for someone to take product early.

Yes.

Thanks.

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The next question comes from [Joseph Perrone] with Forest Hill Capital.

Good morning. I'm just curious, in this difficult environment, as you've seen the prices of lumber fall and the spread between composite and lumber stay fairly wide, are you seeing any discounting from your competitors? I know you guys aren't taking any price hikes next year until September, but have you experienced any price cutting from any of the other players in the market?

I'm sure there are some out there, but there's no wholesale price discounting and it would be difficult to identify any significant discounting at all.

And as a follow-up, just kind of go back to what another question was earlier on the call. So the interest expense this quarter was $1 million lower than it normally would have been, because of --

Normally, it runs about 800,000. Again, it was lower than normal, the third quarter, the interest income from cash and the receivable, as well as interest capitalization was higher than usual. So it will return to a more normal rate.

Was cash interest like $800,000 this quarter?

It was not that high. It was about $300,000.

I just knew last year you guys had like some -- you were working on some plants and you had some closures that you were able to capitalize. I wasn't aware that there was a large amount of that going on this year, this quarter.

We have significant construction in progress with the investments from last year and this year that are not capacity related, but as I said, the poly processing and handling equipment, as it's being constructed, interest is capitalized.

That's all I have for now. Thank you.

Your next question comes from [Simian Wallace], with Evercore Asset Management.

My questions have been answered. Thanks.

Your next question comes from Steve Sharkey, with Flat Creek Investors.

Tony, in the press release, you indicate that you think you gained some share in both the professional and retail channels.

Do you have an estimate of Trex sales at retail in Q3?

We don't have it in Q3, Steve. That's part of our problem. We contract with a marketing research firm that does all this for us and through July, we have gained a couple of share points in the professional channel and we know what our sales are at the Home Depot and we know what our competitors' sales to Lowe's are, and combining those two, it's obvious that we've gained a couple of share points.

Okay. Do you have a view on whether it's low wood prices or a slowdown in overall decking sales that's having the biggest impact on composite decking?

Say that again, Steve.

What do you think is causing the overall industry slowdown, at the retail level? Is it lower wood prices right now, or just a slowdown in decking, overall decking sales?

It's probably a combination of both, but one of the things that we're concerned about, and that's why we've got the pricing strategy for 2007 that we described, low wood prices -- prices for wood have come down so dramatically that the spread between composites and wood has become -- when I used to tell you we would double the price board for board, we're about three times price now.

I see.

That's part of our pricing strategy.

Okay. That makes sense. That's got to be having a short-term impact. Okay. Thanks.

Your next question comes from Chris Blackman, with Empirical Capital.

Thank you. Most of my questions have been answered. But I did want to ask, in the past, it seems like you may have been at somewhat of a pricing competitive disadvantage at the retail level. Can you quantify, maybe, on Contours, if you are no longer at a pricing disadvantage, what kind of ultimate impact that can have for you?

I'm glad you gave me an opportunity to talk about Contours again, because there was a question before about cannibalizing our Accents product. The grain on this board is different, much different than the grain on our Accents from the standpoint -- our Accents is a board that gives a very soft look and gives a beautiful, I believe, presentation of a deck, not that the Contours does not, but it is different and it's a much more -- if someone wants to see a deeper impression of the grain, that will have that with Accents.

The other side of the coin is that there are some of our competitors who have our product out there at the lower price point and our desire was to make a full offering available to the marketplace. And I said it before, enough of our dealers are carrying our competitor's board because they wanted to have this lower value product, a value board, shall I call it, available that was not available from Trex.

What kind of volume would you expect initially for your dealers to stock on that product?

I can't answer that question mainly because I don't really know, but I know we have some projections that indicate that it will be significant.

All right.

It's not going to be just bled out. It's going to be part of the early buy.

As we exit '07 and go into '08, I mean, obviously, there's a lot of strategies that you're implementing or have been implementing that you admittedly really won't feel the full benefit to those until the end of '07 and starting of '08. Can you give us a longer term view, beyond '07, what you expect performance-wise?

I'd rather not quantify it. I'd like you to -- I'll repeat it, if you'd like, but I don't think I need to. But we are doing a lot of things both on a product offering and the product, breadth of product that we've probably let ourselves fall behind on for a number of years. But certainly, on the manufacturing side, we didn't keep up with what we should have been doing as it relates to product quality and product cost, because they're related. You have to meet higher quality standards and you have to do it by the rejection process, the inspection-rejection, that becomes very costly.

So all the things we're doing, we're spending that $25 million, I indicated, over the 2006-2007 timeframe, we will address all the areas that we think need to be addressed, as well as the overall economics of the process.

And do you expect to be caught up on all that? At what point in '07 do you expect to be caught up on --

As I said in my prepared comments, we should be caught up by 2008 fully.

And with that being said, at one point, you all were hoping, obviously, to get back to the margin levels that you were several years ago, gross margin level of 40%. When you're fully operational, is that still a goal that you can achieve?

It's still a goal. I can't predict whether we're going to achieve it or not, but the calculations we're making on these investments indicate a very significant improvement on the margins from the 29%-30% where we are now.

Okay. Thank you.

Your next question comes from Simeon Wallis, with Evercore Asset Management.

Hi, guys. Thanks for taking my question. If you look at the change in revenues and earnings from third quarter of '05 to the fourth quarter of '05, you get a contribution margin of about 68%. And if I look at what your guidance is implying for the fourth quarter of this year, you're probably going to lose around $23 million in operating income, as a change, using an operating income, and about $60 million change in revenue, which is about a 40% contribution margin.

I'm just wondering if you could give a little bit of insight into the difference between that 40% that you are implying for this year versus nearly 70% for last year.

Last year, again, I talked about the differences between the two quarters. There's clearly a -- on the plus side, there's pricing in our favor, but on the downside, plastic year over year is running 10% to 12% higher. That we expect to be a negative comparable to the fourth quarter.

How much does pricing increase on average year over year then that you're expecting for fourth quarter?

Pricing on a per unit basis is 11%.

And you're saying that will remain for the fourth quarter.

Right.

Is there anything else in there?

Well, remember, too, this quality, the labor, the incremental labor is significant that we spoke of in terms of quality standards, which didn't start until the beginning of 2006. So that incremental labor is in the Q4 guidance and was not a part of the 2005 quarter that Tony spoke of.

Thanks.

Your next question comes from Robert Kelly, with Sidoti & Company.

Hey, guys, a quick follow-up. During the Q2 call, you said you would be selling out, adding some new lines. Is that still on track?

We said we were going to add two lines during the July quarter. We're going to hold back on one of them. As we speak, we've already started holding back on one and delayed it. But the other one, and some of the things that we're doing with some of our excess capacity, will allow us to make the modifications to the lines that we want to make, while not interfering with our ability to satisfy demand.

And you talked some CapEx spend in the first half of '07. Do you have a target yet for the full year '07?

I didn't talk about a CapEx spend in '07. I talked about, I said the cost reduction in productivity capital between 2006 and 2007 would be $25 million.

And I guess if you include the one line that you put in and -- what is your total capacity at this point?

Somewhere in the area of about $450, $460 million.

Great. Thank you.

And let me just add one more thing to that comment. As we do more and more fencing, more of the lines will be devoted to fencing, of course, and even though the margin is what I indicated, we're trying to achieve between 35% and 40%, some of the outputs on the thinner products are not as great as they are with the decking products.

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

The only closing remarks I have is that we believe that the company overall, even though the income doesn't show it, is a lot stronger than it was at this time last year. We've identified some things that needed to be improved, whether it be from the manufacturing standpoint, whether it be from the material handling, material yield standpoint, and from the product offerings, the breadth of the product offerings standpoint, and those things will allow us to improve our earnings in 2007 and beyond. And I thank you for your participation.

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