Trex Company Inc (TREX) 2008 Q3 法說會逐字稿

Welcome to the Trex Company Third Quarter Earnings Report Conference Call. At this time, all participants are in a listen-only mode. Following management's prepared remarks, we'll hold a Q&A session. (OPERATOR INSTRUCTIONS).

As a reminder, this conference is being recorded today, Wednesday, October 29, 2008.

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, President and Chief Executive Officer, and Jim Cline, Chief Financial Officer. Joining Ron and Jim are Brad McDonald, Controller; Brian Berteau, 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 2008. 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.

With that introduction, I'd like to turn the call over to Bill Gupp, Trex's General Counsel. Bill?

Thank you, Harriet.

Before we begin, let me remind everyone that statements on this call regarding the Company's expected sales performance and operating results, projections of net sales, net income, earnings per share and costs, its anticipated financial condition, and its business strategy constitute forward-looking statements within the meanings of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

These statements are subject to risks and uncertainties that could cause the Company's actual operating results to differ materially. Such risks and uncertainties include the extent of market acceptance of the Company's 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 relations expenses related to product quality in the highly competitive market in which the Company operates.

The Company's report on 10-K filed with the SEC in March 2008 and its subsequent reports on Form 10-Q filed on May 9, 2008 and August 6, 2008 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 uses certain measures defined as non-GAAP financial measures by the SEC. A reconciliation of these results to GAAP is attached to today's earnings release.

With that introduction, I will turn the call over to Ron Kaplan.

Thank you, Bill.

Good morning, everyone. As you know, this morning, we released Trex Company's financial results for the 2008 third quarter.

Net sales totaled $85.4 million, a slight increase over pro forma net sales for the 2007 third quarter. In the toughest market most of us have ever experienced, we are pleased with this performance.

More importantly, for the third quarter of 2008, Trex recorded net income of $6.7 million, or $0.44 per diluted share, compared to a net loss of $41.2 million, or $2.77 per diluted share, for the 2007 period when the Company's results were negatively impacted by $65.8 million in charges.

For the first nine months of 2008, our net sales of $299.9 million were 7.4% lower than pro forma 2007 net sales for the same period, but we generated net income of $23.5 million, or $1.56 per diluted share, compared to a substantial net loss in the 2007 period.

At this point, I'll turn the call over to our Chief Financial Officer, Jim Cline, who will provide more detail on our numbers, as well as the substantial improvement in gross margin and free cash flow we achieved for the quarter and full year to date. After that, I'll come back on to give you more color on the actions we've taken and the strategy we've developed for 2009.

Thank you, Ron.

Good morning. As Ron mentioned, our press release was issued this morning, and the numbers I will reference are contained in the tables headed Condensed Consolidated Statements of Operations, Balance Sheets, and Statements of Cash Flow.

In addition, due to the magnitude of the non-recurring charges recognized in the 2007 and 2008 results, we have included pro forma profit and loss statements to provide greater transparency to the Company's underlying financial performance.

In the third quarter of 2008, net sales were $85.4 million, compared to net sales of $64 million in the third quarter of 2007, an increase of 33%.

The Company's third quarter 2007 sales were adversely affected by $20.8 million in charges primarily related to the West Coast production that exhibited surface flaking characteristics. Before giving effect to these charges, net sales for the third quarter of 2007 totaled $84.8 million.

Volume shift during the third quarter of 2008 decreased by 4% compared to the third quarter of 2007, but net sales were favorably impacted by a 7% price increase implemented in January of 2008 and improved sales mix. The favorable sales mix resulted from our two new product introductions for 2008, Trex Escapes and Trex Trim.

For the nine months ended September 30, 2008, net sales were $299.9 million compared to $298.7 million in the first nine months of 2007. The Company's nine-month 2007 sales were adversely affected by charges totaling $25.4 million primarily related to the West Coast surface flaking. Before giving effect to these charges, net sales for 2007 nine-month period totaled $324 million.

Volume for the first nine months of 2008 was 12% lower than in the 2007 period, but the decline in sales volume was partially offset by the effect of our 7% price increase and improved sales mix.

Net income in the third quarter of 2008 was $6.7 million, or $0.44 per diluted share, compared to a net loss of $41.2 million, or $2.77 per diluted share, for the third quarter of 2007.

Net income for the nine months ended September 30, 2008 was $23.5 million, or $1.56 per diluted share, compared to a net loss of $34.9 million, or $2.35 per diluted share, for the nine months ended September 30, 2007.

The Company recognized charges for West Coast production that exhibited surface flaking characteristics of $56 million and $65.7 million for the three-month and nine-month 2007 periods, respectively.

Gross profit for the 2008 third quarter was 28% of sales, compared to the third quarter of 2007 gross margin of a negative 15%. The third quarter 2008 pro forma gross margin was 30.3%, a 600-basis-point improvement compared to the pro forma margin for the 2007 period.

We continue to enhance gross margins on a year-over-year basis through a combination of process and productivity improvements and reduced cost despite operating at reduced levels of capacity utilization. The lower capacity utilization was a result of increased productivity, reduced sales volume, coupled with inventory reductions as part of our ongoing initiative to increase free cash flow.

During the quarter, we continued to optimize our proprietary manufacturing process. As a result, the cost of our polyethylene material in the third quarter of 2008 was lower than the third quarter of 2007.

In the third quarter of 2008, SG&A expenses totaled $15.1 million, compared to $52.1 million in the third quarter of 2007.

Surface flaking cost recognized in SG&A from West Coast production was $35.5 million in the 2007 quarter. These costs have been recognized against the warranty reserve since October 1, 2007.

In addition, the Company reduced branding expenses and staffing costs in the 2008 third quarter compared to 2007. The Company's lower staffing-related expenses were primarily due to a reduction in force we implemented in the first quarter of 2008.

The positive factors I just mentioned were partially offset by the carrying costs of our idled Olive Branch, Mississippi facility.

On a pro forma basis, SG&A expenses represented 17.2% of revenue, which is a 230-basis-point reduction compared to the pro forma 2007 period.

The third quarter 2008 pro forma operating income was $11.2 million, or 13.1% of net sales. This represents a $7.1 million increase over the third quarter of 2007 pro forma operating income.

Net interest expense in the third quarter of 2008 amounted to $2 million and was comparable to the third quarter of 2007.

Our Company recognized an income tax benefit of $300,000 and $200,000 for the third -- 2008 third quarter and year-to-date results, respectively. As a result of recognizing a decrease in the valuation allowance against the deferred tax asset and other favorable tax adjustments, the combined effect of these tax matters accounted for $0.17 and $0.56 of the increase in earnings per share for the 2008 third quarter and year-to-date financial results, respectively.

As of September 30, 2008, total net debt amounted to $90 million, which represents a $44 million reduction from December 31 of 2007.

Total net debt to total capitalization at September 30, 2008 was 43%, compared to 59% at December 31, 2007.

Total inventories were $49 million at September 30, 2008, a $25 million year-over-year reduction.

Free cash flow was $25.4 million for the 2008 third quarter compared to $1.7 million for 2007, a $24 million improvement.

The year-to-date free cash flow was $49.5 million favorable to 2007. The improvement was primarily a result of improved earnings and reduced capital spend.

Capital expenditures during the third quarter of 2008 were $1.3 million, a $2.5 million reduction compared to last year's third quarter.

Our 2008 investment strategy was primarily focused on lower-spend projects that support our process and productivity improvements and cost-reduction initiatives while improving our return on invested capital. We expect capital expenditures for the full-year 2008 to be approximately $10 million, which is $15 million lower than 2007.

Ron?

Thanks, Jim.

As Jim's commentary clearly shows, Trex's financial results for the third quarter represent another very strong step forward for the Company.

Despite today's extraordinarily difficult economic climate, we delivered another solid financial performance by following the strategy we outlined for you at the beginning of the year, implementing a wide array of manufacturing process improvements and cost controls throughout the organization. I think it's now safe to say that our efforts have been successful and that we've resolved the operational and manufacturing issues that weighed Trex down in 2006 and 2007.

That's not to say we aren't continuing to identify new opportunities for process and productivity improvements. We are currently utilizing lean Six Sigma manufacturing principles to tap into further cost-reduction opportunities. At the same time, we've demonstrated the effectiveness of our approach to growing shareholder value based on four fundamental principals -- providing best-in-class product offering; expanding our distribution presence; increasing our brand leadership; and advancing our low-cost competitive advantage. I'd like to give you an update on each of these.

First, taking a look at our product offering, our full decking, railing, and fencing platform has delivered solid results in light of the economic conditions, which speaks to the power of the Trex brand. We are in the process of repositioning our railing process category to deliver unrivaled flexibility and choice through modular design.

Demand for Escapes has exceeded supply throughout 2008, but we have taken action and are now positioned to meet demand for this new decking product in 2009.

Trex Trim, our ultra-low-maintenance trim product, has been impacted by the housing downturn, but we continue to think it's an area that has a lot of promise, as I will discuss further in a moment.

On the distribution side, we -- I have a number of new opportunities that we've either put in place or are in the final stages of pursuing.

First, in September, we formed a partnership with one of our major distributors of building materials. This distributor will serve as a full-line stocking distributor of Trex Trim. This partnership will be a significant platform for growth in the Trex Trim product line.

Second, we parted ways with a distributor in the Pacific Northwest in California in the fall. The overwhelming response and enthusiasm of current distributors and potential new Trex product distributors to fill this open distribution footprint has been encouraging and again speaks to the power of the Trex brand. We are on track to complete the process of replacing all open distributor locations in the Pacific Northwest, in California, by the end of the year.

Finally, we had a very positive distributor meeting this month that, amongst other things, focused on the programs we have developed for 2009. Our distributor partners are very enthusiastic about the '09 programs and prospects for the year despite today's difficult economic conditions.

With respect to brand leadership, we have a number of plans underway to support our position as the most well-known and trusted name in high-performance wood-alternative products.

We've partnered with a new advertising agency, the [Neiman Group], this year and have developed a new ad campaign that we feel will be extremely effective across the trade and consumer spectrum. To support the new advertising campaign, we will increase branding spend in 2009, as we previously communicated. We will pursue an efficient branding campaign that will continue driving awareness and pull-through demand for our industry-leading product offering. I will personally participate in several high-impact promotional activities directed at the trade.

We will take assertive new steps in our relationships with the trade to make certain our commitments to quality and accountability are clearly understood and to tackle head-on any lingering questions. This is a personal priority for me, as well as a Company priority.

As for advancing our low-cost competitive advantage, that's a very important factor in this time of increased cost pressures and industry competition. In a period of escalating costs, including petrochemicals, our Q3 materials expenses were favorable to last year. We have continued to benefit from our cost-containment initiatives while improving the quality of our product. Our ecofriendly capability to utilize a wide stream of recycled poly sources have further strengthened our low-cost advantage. Most of our competitors are not able to use lower-cost plastic sources due to the constraints of their manufacturing process.

We've produced a gross margin of 28% even though we are operating at less than 50% of our capacity utilization in the third quarter.

So, overall, we are very pleased with our financial performance for the first nine months of 2008, especially considering the challenging macroeconomic environment.

The deck-building season is now winding to a close, but we're determined to keep up the good performance.

Based on the orders we currently have on hand for the fourth quarter and the outlook for the remainder of the period, we project Q4 2008 revenue to be about $30 million. This is equal to the 2007 fourth quarter.

We believe that we now have Trex on sound financial footing, and we'll continue to strengthen the Company's financial performance.

In prior earnings releases, I told you that our primary focus was the turnaround. We will continue to stick to our knitting and stay focused on improving our operational and financial performance, but we are also now focusing on capitalizing our new position of strength through the creation of new opportunities to assert and exploit the Company's leadership, expertise, and competitive advantages.

On a personal note, I want to recognize the contribution to this successful turnaround of two groups -- the employees and the Board of Directors.

The employees of Trex have been committed to success from the day I got here. They've been receptive to new ideas. Their energy, support, and technical competency have been the engine that drove us here.

The Board of Directors has been supportive at every turn. Revolutionary ideas and challenges to the status quo have been received with collegiality and intellectual rigor.

Without the support of these two constituencies, this turnaround would not have been successful.

Operator, we are now ready to take questions.

(OPERATOR INSTRUCTIONS)

John Baugh, Stifel Nicolaus.

A great quarter. A couple of questions. I was wondering if you could give us an update on inventories. Obviously, it's seasonal, but have you worked them down to the level where productivity or production's going to match your sales, or are we still in a down mode there? And I'm really more thinking about 2009 in the fourth quarter.

And then the second question would relate to plastics. What's the outlook for '09 if we assume that we're buying plastic at more or less the same price that you're buying right now? Do we see further reductions in plastic costs year over year or flat if, again, we assume pricing is about the same as you're currently buying plastic at right now?

Well, with respect to the first answer, John, we are not finished drawing down inventory, and we will continue to do so for at least another quarter or two, possibly more, but we're not yet happy with the inventory level. It's moving in the right direction. Our efforts are meeting with success, as evidenced by the numbers, but we think we can continue to drain the swamp.

With respect to plastic prices, I'm going to decline to answer that question right now, again because I'm very sensitive to competitive implications.

I'll follow up on the inventory. So as we think about next year, the year, will you be closer, though, to -- will your capacity utilization increase if your volumes are flat in terms of sales next year, or would you still see further utilization declines because you're working down inventory?

We don't see further utilization declines, but we do continue to see inventory reductions.

Okay. And you mentioned branding, increasing branding expense. Can you give us some guidance on kind of where '08's going to fall out and then where '09 would fall out?

Well, I can tell you that '09 will be higher than '08. One of you guys want to help me in terms of '08 versus '07? [Inaudible], do you have that?

Yes, the level of branding spend that we've shown reduction '08 versus '07 thus far will continue for the remainder of the year, will be a couple million dollars lower for '08 compared to '07.

But '09 will be higher than '08, but I'm not going to say how much.

And I guess, last but not least, in your distributor meeting, did you discuss pricing at all? Or when will you address that? How do we think about price per unit next year?

We discussed the format and the formula for our 2009 pricing program, but we did not reveal price increases per se. I don't want my customers to hear about price increases on this conference call, so it'll be revealed very shortly.

And let me -- if I can go back earlier to your comment about -- or your question about branding, I just want to add one thing, which is to state the obvious. While branding expenses will go up, this management team remains focused like a laser on shareholder value. I'll just leave it at that.

Perfect job, and congratulations. Thanks.

Thank you.

Jack Kasprzak, BB&T Capital Markets.

I just wanted to ask about gross margin, which has obviously been a bright spot all year, and you guys have done a tremendous turnaround on that line item. Excluding whether utilization goes up or goes down due to an improved volume, how much more, as we sit here today, do you think you can squeeze out of gross margin?

We really aren't going to be projecting gross margin numbers for the future. I think that what we've said in the past is we believe that the benefits we've seen are sustainable, and we're very focused on that area, as we have been since the first of the year.

We also indicated, in my comments, that we continue to prosecute lean manufacturing and Six Sigma principles on an ongoing basis. So I think there's enough there for you to draw your own conclusions.

Right. So without quantifying it, there's ongoing efforts to improve gross margin even without utilization rates going up?

For sure.

Okay. And, obviously, a lot's changed in the whole economy in the last six weeks, and I was just -- you mentioned a tough sales environment, speaking of stating the obvious. I mean we know that things generally have gotten tougher in the last six weeks or so, I guess, but I mean how quickly did things change? If you could just talk about the environment over the last number of weeks that's impacting your sales guidance.

Well, it's a little difficult to answer that question because of the inherent seasonality of this business. I mean if you look back historically, I mean the fourth quarter usually is significantly depressed from the other quarters.

So it's a little bit to say, well, how much of the falloff in orders is due to the economy, and how much is due to the seasonality. I mean I will tell you that the slope of the curve is a little bit steeper than it was in the prior year but not as steep as I perceive the general economy is going.

Okay. That's fair enough. Good commentary there. Thanks.

And, last, I just wanted to ask about competition. Given the slower economy, more uncertainty, are you seeing any more shakeout with regard to competitors?

Yes, and I'm not going to mention any names, but I mean as recently as this week, I got a phone call asking me to buy out one of my competitors.

Okay, great. Thanks, guys. Great quarter.

Thank you.

Robert Kelly, Sidoti.

Thanks for taking my question. If you would, could you quantify the driver of the margin you posted at 3Q '08 versus 1Q '08, which was essentially flat gross margin despite a pretty heavy reduction in sales? Is that all raw materials?

I'm looking at my colleagues here. That's a --

We had the increased pricing. That took full effect coming out of our four-month early-buy program January through April. Improved productivity. Those [were] two of the primary drivers.

Within the third quarter, the capacity utilization was lower than in the first quarter.

So that's offsetting the mix?

Yes.

And productivity? Okay, great.

And then, if you would, maybe comment on kind of the inventory level that your distributor or partners are seeing. You had talked about in the Q2 call inventories were pretty thin. Any change to that at this point?

No, I don't see a change to that at this point. These distributors have been pretty -- have played heads-up ball for at least the last year, and so I don't see any evidence that the channel is jammed.

And then, finally, with the Northwest distribution partner kind of falling off here, is that part of the pressure that you're seeing in 4Q orders? And if you were to replace them, do you see upside?

Well, there's going to be some offsetting forces in play here. Clearly, the distributor that was buying inventory is not buying inventory now, but the new distributors that will be buying -- that we're going to replace them with are going to have to fill up their shelves. So at the end of the day, I think it will probably pretty much be a wash.

You've lined up the new distributors at this point?

It's in the process of being done. It's not all being done. A lot of moving parts in motion right now.

Okay, great. And then just on the tax rates, should we expect a low tax rate again in '09?

Well, if we told you that, we'd be giving you guidance.

All right. I got you. Thank you.

Keith Johnson, Morgan Keegan.

Just, I guess, a couple questions. [I've] kind of covered most of them. Let me just revisit that tax rate question that just came across. The 1% tax rate this year was due to some valuation adjustment taken in '07. Not necessarily giving us earnings guidance, but does that roll off at the end of this year so theoretically you'd move back up in '09 to a higher tax rate or consistent with past years?

One second. At this point, we're just going to decline to identify what that change will be. The principles basically are that we have to prove that the earnings are more likely than not to offset that, and it's questionable when that roll-off will occur.

Okay. Let me make sure I heard your comment on operating rates correctly. In the third quarter, you said you were around 50%? Is that the number? I guess utilization rate?

Under 50.

Under 50. Under 50.

Okay. And then as we kind of look into the fourth quarter, do you expect to kind of be able to hold that? Or if I was understanding a comment to an earlier question, you'd still pull inventories down but not necessarily have to effect utilization rates where you are?

I don't expect utilization rates to substantially change over the near term.

Okay.

Remember that we do build inventory for the early-buy season so that absolute dollars in inventory are not necessarily going to go down, but year over year, we should see an improvement.

Okay. Is there any way that you could give us a little color on kind of a third quarter '08 versus third quarter '07? How much did the lower utilization rate affect gross margin?

Well, the third quarter of '07 basically was slightly greater than 70% capacity utilization. We're down under 50, so it's a fairly sizable impact related to that. Roughly something north of 300 basis points would probably be a good estimate.

And then I guess kind of a question just kind of along the lines of the current credit situation and economic trends that we're facing. Have you picked up, I guess, in the marketplace, is there a greater concern not at maybe your initial distributor but potentially their customer level, the lumberyards out there, that this credit situation may potentially affect the way that they're going to be able to manage their working capital and inventory needs over the coming months?

I'll answer that question. The credit situation does not appear to really affect our distributors. Most of our distributors are well-capitalized family businesses with low debt-to-cap ratios. That's my general impression. I think if there were credit concerns affecting Trex, it would be more at the consumer level and the availability of home equity loans, and so on, although Trex customers are usually at the higher end of the income stream, are a little less reliant on debt than I think many of our competitors' market.

Okay. All right. Thanks a lot.

Sure.

Eric Glover, Canaccord.

Just wondering if you could comment about where you think your market share is currently in the composite wood market? Also, do you think the composite wood market overall is gaining or losing share versus traditional wood currently?

I can answer that. If you rely on some well-known third party sources of information, it would indicate that the composite market continues to incrementally grow market share every year against the wood market, and it would indicate that Trex continues to inch upward in terms of its share within the composite category. I don't want to quote a specific number. You can look it up for yourselves, but I'd just say that it's in the mid to high 30s.

Okay. Thank you very much.

[Kenneth Smith], [Lenox Equity].

Ron, you mentioned that the Escapes product was -- the availability of that was less than demand all year but you've taken steps to correct that. How significant has that shortfall been?

The shortfall against the demand as a percentage of demand has been very significant, and so we're looking to solve that mid-first quarter.

And then can you talk about the fencing product? I don't think you said much about how that's doing relative to your expectations and in actuality.

Fencing is a relatively small portion of Trex's overall business. We're pushing it very hard. There is some traction. There is a wider distribution footprint for it now, but as a percentage of sales, it is higher than it was last year, and we do have a wider retail distribution footprint for the coming year.

Do you think it's being well received by the marketplace?

Yes, it is, and we'll be having another lower price point product that we're going to be introducing, as well, which I think will facilitate the whole category.

I see. Okay. Congratulations on an excellent performance.

Thank you.

(OPERATOR INSTRUCTIONS)

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

Well, thanks very much, everyone, for participating in our call in these very turbulent times. Although they're especially challenging in the homebuilding and remodeling industry, we think Trex stands out for the solid execution of our business turnaround strategy. We now have a very solid financial base and are well positioned to continue our mission of turning the back yard into the next great room. Thank you, everyone, and goodbye.

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