Trex Company Inc (TREX) 2010 Q2 法說會逐字稿

Welcome to the Trex Company second-quarter 2010 earnings conference call. At this time, all participants are in a listen-only mode. Following management's prepared remarks, we will hold a Q&A session. (Operator Instructions) I would now like to turn today's conference over to Ms. Harriet Fried. Please go ahead, ma'am.

Thank you everyone for joining us today. With us on the call are Ron Kaplan, Chairman, President and Chief Executive Officer; and Jim Cline, Chief Financial Officer. Joining Ron and Jim are Brad McDonald, Controller; Brian Bertaux, Director of Financial Planning and Analysis; and Bill Gupp, General Counsel.

The company issued a press release this morning containing financial results for the second quarter of 2010. 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 would 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 future performance and condition, constitutes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

These statements are subject to 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 costs associated with the development and launch of new products and the market acceptance of such new products; the sensitivity of the company's business to general economic conditions; the company's ability to obtain raw materials at acceptable prices; the company's ability to maintain product quality and product performance at an acceptable cost; the level of expenses associated with product replacement and consumer relation expenses related to product quality in the highly competitive markets in which the Company operates.

The Company's report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2009, and its report on Form 10-Q filed on May 6, 2010, 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.

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

Thanks Bill, and welcome to all of you joining us today. We delivered a strong second-quarter operating performance. Second-quarter sales were up 26% year over year to $115 million. Sales for the six months-- for the first six months of the year were $182 million, were up 14% over the prior year.

The launch of Trex Transcend, along with other enhancements we've made to our decking and railing platform, are opening sales opportunities and contributing to our objective of taking market share. During our first-quarter conference call I had mentioned that we had so much demand for Transcend, which we just began shipping in January, that we had to substantially increase the number of existing manufacturing lines we were retrofitting to produce it.

We completed that process during the second quarter, enabling us to catch up on open orders. Just as important, we have continued to make progress in the rates and yields in which we're manufacturing Transcend. The category of ultra-low maintenance decking and railing is growing fast, so it was important for Trex to be first to market with our protective shell technology, and to establish a strong market position. Transcend's great looks, easy installation and maintenance, industry-leading warranty and use of recycled materials have been a big hit with both contractors and consumers alike.

Our complementary railing system has also been a big sales driver. In fact, our railing sales hit an all-time high in June and we're expecting them to continue at a very strong pace. I don't want to overlook the contribution of-- our other product lines have been making to our growth. Enhancements we've made to our traditional decking platform last fall also helped drive second-quarter sales and Trex trim gained momentum.

New stocking dealers as well as increased focus on Trex trim by key dealers have been driving this momentum. During the past several months, we continued to pick up dealers in key decking markets and have converted a significant number of contractors. Others have upgraded their level of support.

In 2010, we created a new contractor designation, Trex Pro Platinum, for those who represent Trex exclusively. We are pleased with the number of contractors who have already earned this new designation and we are adding contractors to this notable list. These efforts create an ongoing infrastructure for growth. We had two legacy issues that resulted in recognizing $11.4 million of non-cash charges which include a $9 million increase to the Company's warrant reserve for product that exhibits surface flaking manufactured through two-- mid-2006, at our Fernley plant, and a $2.4 million charge for our recycling joint venture in Spain. Jim will provide further details when he discusses the financial results for the quarter.

We are pleased with the progress we are making in taking market share. During this uneven economic recovery, we have accelerated our branding efforts with consumers and the trade, positioning ourselves not only to take market share now but also to take more when the economy fully rebounds. We want every consumer in America asking for Trex and every contractor in America recommending us. We're-- and we're continuing our R&D efforts with a focus on developing additional products and categories. We'll be sharing more information on those in the future.

I want to emphasize our continued growth in sales and adjusted gross profit. So far this year our sales were up 14% and adjusted gross profit is up 23%. And the Company is generating strong cash flow. This management team is focused on increasing shareholder value and these benchmarks demonstrate that.

Finally, our third-quarter guidance. We are projecting sales of approximately $72 million, an increase of 16% from last year's period. Jim?

Thank you, Ron. Good morning everyone. The press release with Trex's second-quarter and year-to-date financial results for 2010 was issued this morning. First, I'd like to review our second-quarter financial results. The Company recognized net sales of $115.5 million in the second quarter of 2010, a 26% increase compared to the second quarter of 2009. The second-quarter sales volume was approximately 22% higher than 2009.

In addition, net sales were favorably impacted by a shift in sales mix towards higher-priced products, specifically our new high-performance Transcend deck boards and strong sales of railing products, which carry higher prices per linear foot than our core Accent branded products. The Company recorded net income of $5.6 million or $0.35 per share in the second quarter of 2010 compared to net income of $7.4 million or $0.49 per share in 2009.

The Company's results for the second quarter of 2010 include $11.4 million of non-cash charges, including $9 million related to the increase to the warranty reserve and $2.4 million related to our joint venture in Spain that recycles waste polyethylene. Before giving effect to these charges, our second-quarter net income was $17 million or $1.07 per share.

I'd like to provide further details related to the 2009 cash charges that were recognized in this quarter's results. First, those of you who have been following Trex for some time will recall that the Company increased it's warranty reserve in 2007 related to product replacement cost due to surface flaking of a limited amount of production at our Fernley, Nevada, facility, prior to mid-2006. In 2009, a class action suit related to surface flaking was filed against Trex. As a result of the suit, related public announcements in several national periodicals and the subsequent announcement of the settlement in March of 2010, there was an influx of claims. In addition, after completing our review of the claims that have been submitted under the class action suit, we now estimate the cost to resolve claims will be greater than anticipated. Accordingly, we recorded an additional $9 million to the reserve-- warranty reserve in the second quarter.

In 2000, Trex entered into a joint venture operating in Spain to recycle waste polyethylene. During the first half of 2010, the joint venture provided about 6% of our need for recycled plastic. The joint venture has recently been unable to supply material in the quantity or cost we require. We developed and have begun to transition to domestic sources of higher-quality, recycled material at lower cost than was supplied by the joint venture.

The $2 million charge in the second quarter is equal to our entire equity and note-receivable balance with the joint venture. The $9 million increase in warranty reserve was recognized in cost of goods sold. Excluding this charge, the gross margin was 34.4%, a 320 basis point improvement from 2009. Our capacity utilization of 62% was up significantly over 2009 and positively impacted gross margin by approximately 700 basis points.

Our financial results reflect the start-up costs associated with our 2010 introduction of Transcend, which partially offset the positive impact of increased capacity utilization. SG&A for the second quarter was $21.2 million compared to $17.4 million in 2009. The second-quarter non-cash charge of $2.4 million, related to the joint venture in Spain, was recognized in SG&A. Excluding this charge, SG&A was $18.8 million, a $1.4 million increase compared to 2009.

The increase in SG&A was primarily driven by branding initiatives. Our 2010 branding efforts with their focus on new products have been extremely effective.

Net interest was $3.9 million in 2010, a $200,000 increase from 2009, due primarily to the non-cash impact of APB14-1. For the first six months of 2010, net sales were $181.8 million compared to the net sales of $159.1 million for 2009, an increase of 14%. First-half sales volume was approximately 7% higher than 2009. Net income was $1 million or $0.06 per share for the six months ended June 30, 2010, as compared to net income of $4.3 million or $0.28 per share for 2009.

The 2010 net income excluded the previously-- excluding the previously mentioned $11.4 million of non-cash charges was $12.4 million or $0.79 per share. Excluding the warranty reserve charge, gross margin was 30.7%, a 220 basis point improvement from 2009. Our capacity utilization of 54% was up considerably over 2009 and positively impacted gross margin by approximately 510 basis points.

The start-up costs associated with our 2010 introduction of Transcend partially offset the positive impact of capacity utilization. SG&A for the six months ended June 30, 2010, was $38.3 million compared to $34 million in 2009. Excluding the previously mentioned joint venture charge, SG&A was $35.9 million, a $1.9 million increase compared to 2009. The increase in SG&A was primarily driven by branding initiatives and personnel-related costs, which were partially offset by the reduced carrying costs related to the Olive Branch facility.

Net interest was $7.7 million for the six months ended June 30, 2010, a $600,000 increase from 2009. The Company's results for the first six months of 2010 and 2009 included $3.9 million and $3.3 million of non-cash interest related to the accounting treatment for the convertible bonds under APB14-1.

At June 30, 2010, the Company had $22.3 million of cash on hand and no borrowing on our revolving line of credit. Total net debt amounted to $59 million, which is comparable to our net debt at June 30, 2009. Total net debt to total capitalization at June 30, 2010, was 32% compared to 29% at June 30, 2009.

Inventory was $51 million at June 30, 2010, an $11 million year-over-year increase. We held inventory at higher levels at the end of the quarter due to our increased sales volume and given our expanded product platform to ensure an adequate mix of inventory was on hand to service our customers. We anticipate reducing inventory by year-end. We have begun reducing production to bring inventory in line with our anticipated future requirements.

The Company had free cash flow of $4 million in the first six months of 2010, which was $20 million lower than in 2009. The reduced free cash flow was primarily driven by carrying higher inventory to ensure we were able to service the increased sales activity. As of July 31, our cash balance exceeded $35 million and is growing consistent with our plan.

By the end of 2010, we expect the growth in free cash flow will be at least consistent with the sales growth. Capital expenditures for the first six months of 2010 were $4.3 million, a $200,000 increase compared to 2009. Our full-year 2010 investment strategy will be at a spend level several million dollars higher than 2009 and 2008.

Operator, we are now-- we would now like to open the call for-- up for questions, after which Ron will provide his closing statement.

(Operator Instructions). One moment for the first question. Your first question comes from the line of Trey Grooms with Stephens.

Good morning, Ron and Jim.

Good morning.

Hi, Trey.

Just a couple of questions here on the-- the-- Jim, are the roll-out costs associated with Transcend-- you mentioned that the-- increasing the number of lines was complete, but are the costs associated with that complete as of the end of the second quarter?

There are still some costs that will impact us from a capital expenditure standpoint in the third-- early part of the third quarter.

Okay. As far as margin impact though, is that pretty much behind us?

No, we'll continue to see a drag on margin for the next couple of quarters.

Okay. And could you give us a-- an idea of how much that impacted the second quarter?

We-- we really will have to decline on getting into the details of the individual product category margins.

Okay, that's fair enough. Looking at Transcend, looks like you guys are getting, you know, a lot of traction there. What's the expected mix of I guess total sales that you guys think you can see from [Transcends] in 2010? Could you give us--

Well, I can--

-- some color on that?

I can give you some historical context. It-- five years ago, Accents didn't even exist, and last year it was, you know, well over half of our-- of our sales. The growth of Transcend, in relationship to the remainder of our product line, has outpaced that of Accents. So it-- it's a-- I'm not going to get into the specific percentages of sales by product line, but I can tell you that it's been a fairly rapid transition.

Okay. And if you're looking at the-- just on Trancends, there again, you know, when-- when you think about kind of inventory at the distributor level, I mean, I'm assuming that-- or even at the dealer level, for that matter, I'm assuming that there's a fair amount of cannibalization there with Accents. Is that-- I know you had mentioned in the past it was a little bit more than you had expected. Is that kind of continuing or is it starting to kind of level off?

It is-- it is leveling off. I mean, the-- the mix of Transcend shipments versus Accent shipments was highest in the first quarter, began to level off in the second quarter when we-- as our production ramped up and they had gotten their shelves pretty well filled. Now we-- we think it's more normalized right now. It's-- so it has moderated, but we do expect it to continue.

Okay. And then, Ron, you speak-- you've spoken quite a bit about market share gains and your expectations to continue that. Can you give us an idea of kind of where you guys stand right now and then also kind of looking through the next cycle where you kind of expect to-- expect that to go or where it could go?

Well, all I can-- all I can tell you is we've added several hundred dealers. We've had well over 100 dealers that have dropped a competitive line; several dealers have gone exclusive with Trex. It-- I really can't give you numerical-specific information on market share. There's only one company that measures it, they only do it annually in arrears, several months in arrears. So I could give you an educated guess, but I'm not going to do that. I'd just say-- say that we're comfortable with the market share that we're achieving.

Okay.

And clearly-- clearly our sales and the growth of our sales are outpacing what's going on in the general economy.

Yeah, absolutely. All right. Well, great job in the quarter and keep it up. Thanks a lot.

Thank you.

Your next question comes from the line of John Baugh with Stifel.

Good morning, Ron. Good morning, Jim.

Hi, John.

Good morning, John.

Terrific leverage on those revenues, and I'm curious, how many lines do we have converted now? You mentioned a little more CapEx in Q3. Is that going to additional Transcend lines? And I know you don't want to talk rates of production and yields and all those things but some kind of-- the first quarter we were in the first inning, the second quarter we got to the fifth inning and the third quarter will be in the eighth inning, some kind of feel for how that rate and yield is progressing, and a long-winded way of asking, when do you think your margins are full gross margins all in Transcend, is it the first quarter of 2011?

Well, you've got about four questions wrapped up in there but let me-- let me tell you that for the time being-- when I say the time being, for this year, we now have all the lines installed that we want for this year. We do have more lines in the pipeline for the future and I've been reviewing the CapEx request for that. The number of lines we have in production for Transcend, of course, are proprietary, but I can tell you this, that when I stood before the distributors in October, I envisioned a certain number of lines. We actually had to expand that by over 200% above our original expectation last October. So we really underestimated how-- how fast this product was going to be absorbed into the marketplace.

So an awful lot of our time and effort-- and my hats are off to the guys in our engineering and manufacturing group, they had to move heaven and earth to get this number of production lines on-stream. That process has now settled down and our engineers can now focus on rates and yields as opposed to installation. But there's one bunch of exhausted engineers and manufacturing folks at this company.

But we're going to continue to-- based on what we see, we're going to have to expand our lines again for 2011 and I'm not going to speak to what impact that has on margins or CapEx, so I'll let Jim speak to that. John, I hit two or three of your questions, did I-- did I leave anything out?

Well, just curious on, say, your first couple of lines that you started up in Transcend. Are those running at the speed you want them to run with the yield or is there still room to imp-- expand the margin there? In other words, how much of the pressure year to date has just been the obvious expense of start-up (multiple speakers).

Well, we-- all right, to answer your questions, no, they're not where we want them to be yet. They continue to improve and you'll never get me to say that we're satisfied with where they are. But-- but in-- more in practical terms, we-- we've got a ways to go yet. So we're-- the lion's share of the improvement for the early lines is behind us but we still have a significant way to go.

Okay.

John, one other thing. We-- we did have, in the first quarter, I think we mentioned, frequent changeovers to try and get the product out to the distributors and into the channel. We saw that early in the-- early in the second quarter also, and then it really kind of stabilized about midway through the quarter and we're really out of that now. We've got the production up to the level where we don't have those frequent changeovers.

To add further to that, in the first half of 2010, our sales were limited only by production, not by demand.

Got it. And then you mentioned inventories, higher than where you would I guess ideally like them, and you mentioned somewhere in your comments SKU complexity or the amount of SKUs. Is there a plan in the second half of the year to reduce the SKUs at all or do you just sell through inventory normally seasonally, what-- I know your inventory will go down, but just curious as to why?

Yes, let me say a couple of things. First of all, the inventory will go down by the end of the year. We had to build the inventory to accommodate the demand. And secondly, I can tell you is that our SKU count is going to go down dramatically in-- by the end of the year. We've already announced to our distributors a significant reduction in SKUs. It's a-- it's well into a double-digit percentage number and so I think you'll see some benefits from that.

Great. And then my last question is on the-- on the-- and it's not your issue inherited, I realize, but the never-ending flaking, so thought we'd put to bed with the settlement, which I'm sure you thought as well. But the question is essentially what will be the cash settlements out of-- or to settle the claims out of Trex if you had to guess, Jim, for 2010 and 2011 in light of this new $9 million reserve?

Well, I think what you'll see for the next couple of quarters is going to be cash out, something less than $3 million, and then it's going to taper down quickly after that. That's what we anticipate.

Okay. And is this a number that your accountants-- did you-- did you try to guess high so that we might be booking income in the future and not another reserve or any color on that if you could?

Well, let me give the color to that-- the response to that. I think in my very first conference call, you may remember that I said there is nothing worse than death by a thousand cuts. And booking an additional reserve for this issue was anathema to me, but we are governed by Generally Accepted Accounting Principles, which require that we use the best available science to determine what's probable. That's exactly what we've done. So I-- that-- that's the best way I can answer that question.

Right. Thanks, Ron.

Your next question comes from the line of Keith Hughes with SunTrust.

Thank you. I have really two questions. One on revenues, was the pace of revenues and orders in the quarter consistent, and if you could provide any color particularly on business in the last 30 days, has there been any change for that? That's number one. And then number two, as you look at where you are in inventory and your outlook on demand, will we still see substantial increase in production rates in the second half of the year?

Production in the second half of the year is going to have to moderate somewhat to accommodate the reduction in inventory that we envision. What was your first question again?

The-- the pacing on revenue in the quarter was--

Well, and the--

-- it fairly consistent?

In the second--

Particularly July, that's what people want to know.

Well, in the second quarter, we did have to sort of play catch-up ball with all the orders that we'd received in the first quarter. So the second quarter really reflected a-- just meeting the orders that were on the books. I think what you see in the third quarter is-- is that the level of demand, or the-- our forecast really reflects a-- what's being sold out into the-- into the chain, or out of the chain, I should say, out of our distributors. The sell outward. The outbound sales. So I'm not going to speak to the last 30 days. I'm going to leave my forecast as it stands.

Keith, the one thing to remember is in-- in the third quarter this is very typical that the distributors and also the dealers are reducing inventory prior to the fourth quarter. And certainly we expect that we will see that occur in 2010.

Okay. And just-- just question on overall demand. As you talk to contractors and talk to distributors, what is their outlook of business look like at this point, are they less confident, neutral? Just any kind of subjective comment would be helpful.

Yes, I can tell you this. If you talk to our contractors, they'll tell you that they've got more jobs signed up and in front of them than they've had for the last several years. The distributors I've just-- I just met with 10 CEOs in Chicago about two weeks ago. It's a fairly robust attitude. And I guess our general feeling is the same as I've expressed before, which is if you folks can straighten out the economy, we'll take care of production.

But I-- I'm gratified that our strategy of market share has been an appropriate strategy, because we're simply not going to wait around for the economy to get better. The economy is certainly stronger now than it was a year ago, but the sales increases that you've seen from Trex have been equally a function of market share as it has overall economy. But, in summary, our contractors and our distributors and dealers seem to be fairly confident about what's going on out there.

All right. Thank you.

Your next question comes from the line of Jack Kasprzak of BB&T Capital Markets.

Thanks. Good morning, everyone.

Morning, Jack.

Morning, Jack.

Hi. Given the comment about reducing inventory and so, therefore, you might-- production levels might go down a bit in the second half, do you think the gross margin in the second quarter will be the highest gross margin you'll see this year?

Yes. I would expect that it would be.

Okay. Thank you. You made a comment too, I think, Ron, in your remarks about new products and you referenced some R&D, so in-house development, I guess, but would you guys consider an acquisition of any sort regarding a new product add-on, would that be a potential?

Well, it-- it's a potential. Yes, it is a potential. I would tell that one of the strategic issues that's going to emerge for Trex will be what we do with our cash. We have used our balance sheet as an offensive weapon in 2010, and so the basic program that we offered distributors was different in 2010 than it was in 2009. That's why cash flow hasn't quite caught up yet with 2009, but it will surpass that over the next quarter as the money begins to roll in.

And so to some extent, we're going to be-- well, we're not going to be compelled to look at anything we don't want to look at, but I will tell you that acquisitions now is higher up on-- on the radar screen than it was the last time we talked.

Well, given that comment, Ron, would you care to prioritize potential uses of cash?

The number one potential use of cash will be for-- to fund our ongoing research and development, as I expressed earlier. It will be to fund our CapEx requirements, which are still not very high in the grand scheme of things. After that, we're-- the cash will be available should value-added acquisitions come along. If they're not value-added, that money is just going to stay right where it is because cash is not a bad thing to have with the economic outlook that exists.

And in addition, we do have the $97.5 million convertibles due mid-2012, and we're focused on ensuring that we have a plan in place to deal with those notes when they're due.

Okay, great. Thank you very much.

Your next question comes from the line of Morris Ajzenman with Griffin Securities.

Hey, guys.

Morning.

Morning, Morris.

Morning. Hey, just to touch on the follow-up. You-- you spoke about the dealers and distributors and their heightened-- their happiness with the new Trex Transcend, and you touched on their (inaudible) to have sort of good sort of feedback from the consumer. What I'm trying to really get a handle on, which I haven't been really to, making a lot of calls, is-- is what are we hearing from the consumer? Is it too early? Do we have any sort of data points where the consumer has become (inaudible) about this or not so that we can get some feel for it? Is there, beyond just initial inventory feel of-- of the (inaudible) by the dealers and distributors that there's more add-on coming, more ordering based on the sell through? Have we gotten enough time and re-- and history out there to get some sort of feel on the consumer acceptance?

Well, we've got some data and some of it is specific and some of it is anecdotal. We know that our distributors are selling more Trex this year than they did last year, out to their dealers. We know that the dealers that we speak to seem to be quite pleased with the market acceptance of Transcend. We know that there are more contractors recommending it.

What I do not have, what I cannot tell you is, specifically, how many more actual consumers are buying Transcend versus buying something else. We don't get to that level of detail. The supply chain is too long. But we're quite satisfied with the overall reception. There's some static on the phone. I hope we're all still connected.

I'm here.

That-- that's-- that's about all I can say about it. We're selling this-- the orders keep coming in, keep making it, keep selling it. The people keep paying us for it.

Fair enough. Well, one of the follow-up-- another question, your guidance for $72 million in revenues for the third quarter, up from $62 million in previous year, just-- was there any pull-through into the second quarter of revenues from potentially the third quarter, was any-- anything like that going on?

There's nothing like that. We just-- we fill orders as we get them, and we will them as fast as we can.

Okay. And on the cash flow number, besides inventories, accounts receivable, up pretty meaningful, which is no surprise based on the topline expanding, do-- can we expect by year-end receivables being down materially also as well as inventories?

Well, Morris, what you'll see in the third quarter, there will be a significant reduction in receivables during the third quarter as much of those receivables are brought in. I would anticipate that, compared to where we are at the end of June, you would see a reduction in receivables by year-end.

And lastly, that cash provided by operating activities, should we expect when the year comes to a close that will be above 2009 (multiple speakers).

I would certainly expect it to exceed 2009.

Thank you.

Your next question comes from the line of Robert Kelly with Sidoti.

Good morning.

Morning.

Morning.

Just had a question on the-- what you've referred to in the past as ASAP orders. Has that business been picking up, more of a percent of your revenue becoming the ASAP order, and is the dealer channel still fairly thin on inventory?

That's a good question and I wish I had that specific statistic. I think now that we've pretty much caught up with production and demand equaling each other. So I would say that the ASAP orders have probably declined as the channel has been-- gotten more full.

And as far as, and I don't know if you have visibility this far out, but has the channel started to assess your ability to provide Transcend for next year, for the big selling season?

Yes, that's one of the reasons that we had the meeting in Chicago. They are very cognizant of production levels. They get reports from us very frequently, more than monthly if they want it. It enables them to determine exactly what we produced and what the backlog is by SKU.

So are they all positioning themselves already for '11?

No, I don't think they're positioning themselves yet for '11, but they want to make sure that we've got production capacity in place to satisfy them. But they're going to wait to see-- we-- our distributor meeting is already scheduled in October, and by the time that meeting occurs, that's when their view will really begin to gel.

Thank you.

Your next question comes from the line of Eric Prouty with Canaccord.

Thanks. Just a couple of P&L questions. First, just on the D&A, the higher levels we're seeing, that's just commensurate with a higher level of production and some of the switchover in the lines you're doing?

Yeah, when you look at the amortization line, it includes the convertible debt. Convertible debt increased considerably from the prior year and that's what you're seeing there is the increase there. But the normal D&A would not be increasing.

Got you, okay. So kind of the D&A associated-- or the D associated with your production is staying at a fairly constant level?

Yes.

Great. Okay. And then, second, with the warranty reserve that you've taking for the past product, could you just talk about if you take Transcends, what are you reserving as a percent of revenue for some of the newer product lines with the extended warranty periods, et cetera, how are you accruing for warranties for some of these new product lines?

Well, number one, if you look at Trex's experience in the past, the only issue of any significance they've had has been an issue-- has been related to the surface flaking activities, outside of that--

Surface flaking activities, 2003 to 2006 at the one Fernley plant.

Right. Right, sorry. And absent that, our claims are almost nonexistent on other products. And based on that, the accounting guidance would tell us that we would reserve based on the experience and expectations we have on that, so our reserves are minimal related to Transcend, as it is on the Accent-related products, produced outside of that Fernley window that we took the major reserve on.

Okay. Un-- understood on that, great, thank you.

Your next question comes from the line of [Louie Toma] with Delta Partners.

Nice quarter. Just had a couple questions. I know you talked a little bit about this, but just wanted to get a better understanding for the gross margins and how that's going to play out in the September quarter. And I guess if we look at last year, you guys have so many different things affecting this, but if you look at last year, we had a 32% decline sequentially in revenues and then the impact to gross margins was negative 140 basis points, and based on what you're guiding, you're looking at a 38% sequential decline and here we are at 36.5%, so I'm just trying to understand if-- can we expect the same kind of relationship and is that the right way to look at it? I mean, there are so many different things impacting. I'm just trying to get a better sense of how we should look at this.

Basically, going forward, we've determined that we're going to be moving back to the approach of not providing guidance on gross margin. Certainly, as we reduce production, consistent with the reduction in sales, it will have an adverse impact on margin. There-- this has always been a very seasonal business and you all-- you have to look at the seasonality, and I think you can determine if you do your own arithmetic, you can figure out how much money drops to the bottom line based on volume. But, to Jim's point, we're just not going to give guidance. We're going to stick to our knitting, which is we give a quarter of sales guidance, we try to give as much light and transparency to out existing financial statements, but we don't give guidance on revenue by product line or margins.

Is last year's impact the right way to think about it? Is that-- or is there distortion there that makes that not a reasonable way to look at the relationship between volume and margins?

I think if you looked at the third quarter of last year, I think that would be a reasonable guide, recognizing that we did give guidance that we were still going to have an impact of the start-up of Transcends in the third quarter, so there is going to be a drag associated with that.

Okay. And what was the utilization for the quarter?

62%.

Great. Okay, thank you.

Your next question comes from the line of Kenneth Smith with Lenox Equity Research.

Thanks. Ron, going back to the market share, do you have any sense of how you're doing, in terms of the share versus looking at it from-- by product? In other words are you doing better against PVC now with Transcend or is it just more composite or getting-- making any gains against wood? Could you give a little flavor--

Well, actually it's all three, but we're probably getting the most market share from standard [WPC]. Second would probably be PVC, and third would be wood. There-- we do have some evidence that the Transcend value proposition is actually attracting some bus-- some demand from wood, even though it's at a much higher price.

And then on the branding spend, will that be falling off here in the second half of the year significantly?

Branding will actually be a little bit higher compared to prior-year in the third quarter, as we've continued our branding spend in the early part of the quarter.

I can tell you this, that we really stuck our chin out with branding spend, but all evidence suggests that it worked. We've got a lot of different statistics where we measure unaided brand awareness, clicks to our website, follow-through clicks to the website, the number of people who will see our advertisements will ultimately purchase the product. By any way in which we can measure it and we do measure very carefully, we did get the bang for the buck.

Okay. Thanks very much.

Your next question comes from the line of Nick Phillips with Holden Asset Management.

All right. Thanks. Do you guys outsource your PVC product, manufacturing of it?

Yes.

What happens if PVC really becomes a real driver of growth in the category-- or in-- in the industry? I mean, do you guys foresee creating your own lines?

I do not see creating our own lines, but I also do not see tremendous growth in PVC.

Why is that?

Why is that? Well, because we're able to offer a 25-year guarantee for stain and fade on Transcend that we could not do on PVC. And secondly, PVC is not a green product as compared to Transcend, which is still a 95%, recycled product and has some clear buyer preference behind it.

Okay, great. Thanks.

Your next question comes from the line of Alan Mitrani with Sylvan Lake Asset Management.

Hi. Thank you for your guidance for the second-- for the third quarter. I just want to talk a bit about the fourth quarter. I know it's a couple quarters out, but you were-- talked about seasonality and dropping off of some of the manufacturing utilization as you work through some inventories, and normally it seems as if I go back since you first came public, your fourth quarter normally sees a very significant drop.

As you said, Ron, it's a seasonal business. Normally the drop average is somewhere around 40-something-% or so, sequentially third quarter to the fourth quarter. I guess the question is, last year's fourth quarter had $51 million of sales and you had said there was some pre-buys or orders for Transcend in there. I just want to be able to get a sense as to where I should look for the fourth quarter this year, year-over-year comparisons or others, given that last year had some Transcend in it?

Well, this year, they said it would be-- dealer-- the distributors are very, very sensitive to making sure they've got enough on the shelf, of Transcend. So I wouldn't be surprised if there was Transcend orders in the fourth quarter of this year as well. That's about as far as I'll take the answer to that question.

Okay. I think that's-- that's fair. Also, SG&A, it seems like only was up $1 million and cha-- once I've X'd out all the charges, on the first half of 2010 versus 2009 was only up $1 million and change, and you had pretty decent sales growth on that, you were able to grow sales $20-something million. For the second half of 2010, are we going to see similar flattish-type SG&A? I mean are you going to try to hold the cost, basically, steady as you get these market share gains?

Yes, I think one of the things that you're seeing, for example, in the first six months, was the reduction in our depreciation expense related to Olive Branch, which was, in rough numbers, about a million-- a little bit less than $1 million a quarter. That certainly would continue in through the third and fourth quarter. Certainly the branding spend, while it will be up over 2009 in the third quarter, compared to the first and second, it is not as strong. So I think looking to the past for guidance is fair.

Great. And then on the tax rate, can you just give us a little sense as to where you expect the tax rate to be this year, are we looking at a zero tax rate and maybe where do you see it going out next year?

We view the tax rate for the 2010 to be basically de minimis. With regard to 2011, we'll certainly have to evaluate that after we complete 2009. But remember, from a cash out standpoint, we have $50-plus million of loss carryforwards. So from a cash standpoint, we don't anticipate paying tax in 2011. But from a GAAP standpoint, depending on the numbers, we may need to report tax in 2011. That has not been determined yet.

Great. Thank you.

Your next question comes from the line of John Baugh with Stifel.

Just a quick follow-up. You made a comment somewhere in your prepared remarks about free cash flow being in line with sales growth. I may have heard that wrong, just-- what-- what kind of are you guiding, you only have $4 million, I know, year to date. I know it's going to improve in the second half. Just clarify or give us a number. Thank you.

Yes, basically the guidance I was trying to provide is if you look at cash flow from last year, we'll exceed that at least by the percentage increase in sales. So whatever you're modeling on sales, if you take that percentage, we'll at least achieve that.

So the percentage growth in free cash flow will at least match the percentage growth of sales--

Correct.

-- versus last year. Great. Thank you for the clarity.

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

Thank you. Before I continue with my remarks, let me remind everybody that there's no "S" on the end of Transcend. We worked very hard on developing that name. We spent a lot of marketing resources and had a lot of outside advertising agency help, and we want to make sure we get our money's worth. So it's Transcend not Transcends.

But thank you everyone for joining us today. We're pleased with our sales and earnings growth. But for the effect of the non-cash charges related to the two legacy issues, especially in an economic environment that's still so uncertain, we are pleased with the progress that we're making in taking market share, and I want to publicly thank all the men and women of Trex whose hard work drives these achievements and look forward to giving you an update on our initiatives after the third quarter. Thank you, everybody. Bye bye.

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