From Wood to Composite: Trex's Growth and Success in the Decking Industry

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1. Key Facts

Description: Trex Company, Inc. (“TREX”, “Trex”, and “Company”) is the world’s largest manufacturer of composite decking and railing products marketed under the brand Trex. Trex outdoor products are manufactured in the US and are sold through a network of distributors and through the two large DIY retailers, Home Depot and Lowe’s.

Key Financials: Over the period FY13 to Q3’FY22, the Company depicted a revenue and operating income Compound Annual Growth Rate (“CAGR”) of 15.6% and 32.7%, respectively, reaching a Trailing Twelve Month (“TTM”) revenue of c. $1,218 million and operating income excluding unusual items of $314 million (operating margin of 25.7%). Trex has Cash and cash equivalents of $6 million compared to borrowings and lease liabilities amounting to $112 million while its available borrowing facility as of Q3’FY22 stands at $324 million.

Price & Market Cap (as of 7th February 2023): Its market cap is $6.1 billion with a 52-week high of $94.7 and a 52-week low of $38.7, whereas it currently trades at $55.6.

Valuation: TREX trades at a TTM EV/EBITDA of 17 (10 Year average of 24.3) and at a TTM P/E of 31.7 (10 Year average of 39.7).

The rest of the write-up includes the following sections:

2. Business Overview

3. Management & Culture

4. Industry

5. Financial Analysis

6. Competitive Advantages, Opportunities and Risks

7. Valuation

8. Concluding Remarks

2. Business Overview

What is composite decking?

Composite decking is a low-maintenance alternative to traditional wood decking and it is made from plastics and wood fibers. Trex decking is made from a mixture of 95% recycled materials, including reclaimed wood fibers and recycled polyethylene film which is composed of scrapped plastic film and plastic bags. This makes composite decking more environmentally friendly and also offers a number of benefits over traditional wood decking.

While composite decking may have a higher initial installation cost compared to wood decking, it is argued that it is less costly over the long run due to its longer lifespan and reduced maintenance needs. For example, its resistance to rot, insects, and mold, eliminate the need for seasonal maintenance such as painting and sealing.

This is justified by the below example shared by Trex, where it is shown that decking can cost from 2x to 6x the cost of wood decking while the payback period can range from 1 to 3 years, making it appealing to homeowners.

Source: Investor Presentation FY22 Q3_ Jan 2023 Date Update

Composite decking has been growing in popularity over the past two decades, gaining market share against wood. This trend is expected to continue, driven by factors such as innovation in the composite decking category which improves durability and appearance, an increasing learning curve among contractors, and improved awareness among end customers.

The story of Trex

Trex is the leading manufacturer of composite decking and is credited with inventing and defining the composite decking category. The technology behind Trex was developed by Roger Wittenbergur in the late 1980s and was later acquired by Mobil Oil in 1992. In 1996, Trex Company was formed through a leverage buyout of the assets of Mobil’s composite decking division by four Mobil executives.

Three years later, Trex went public to raise the funds needed to expand its operations and meet the increasing demand. Since then, Trex continued to innovate and improve its composite decking products while expanding its product line to include railing, lighting, and other outdoor living products.

Nonetheless, there have been challenges along the way. During 2008-2010, Trex faced significant losses due to surface flaking issues with products manufactured prior to 2007 and due to the aftermath of the financial crisis. In 2007 alone, the company made provisions to its product warranty of $65 million compared to 2021 provisions of $3.8 million (meanwhile sales almost quadrupled).

In 2008, Ron Kaplan who was appointed as the CEO, led the Company to a successful turnaround by restructuring the executive team, negotiating with lenders, and increasing focus on manufacturing operations, therefore achieving a return to profitability and growth.

Quote from a Barrons article back in 2015:

“Together, Kaplan and Cline overhauled the bonus system for Trex’s factory workers. Plant employees previously had been compensated based on earnings per share, but “they didn’t know what EPS was,” says Cline. The new bonus metric was based on improvement in cost per pound at the factory, a move that attacked efficiency head on.”

Even though Kaplan and Cline retired, they both serve at the Board of Directors until this day, as non-executive directors.

Segments

As of Q3’ FY22, Trex operated under two segments, Trex Residential and Trex Commercial. Trex Residential includes the sale of decking, railing, and fencing products for residential use. Trex Commercial includes the sale of custom-made railing and staging systems for professional and sport facilities, as well as portable staging equipment for events and shows.

Trex Residential is the key segment (and currently the only one) of Trex, accounting for 96.2% of sales and virtually all profits. The key product category is decking which accounts for the majority of sales and is offered in three price tiers (premium, middle and low-cost) effectively providing choices to different type of customers.

In December 2022, Trex Commercial was sold for $8.25 million. Trex Commercial revenues for the nine months ending September 30, 2022 were $35.1 million, i.e., 3.8% of total sales and incurred a net loss of $2.4 million. The Company acquired Trex Commercial in 2017 for a total consideration of $71.8 million whereas the allocated goodwill was fully impaired in FY21, resulting to impairment charges of $54 million. The reasoning behind the disposal was to focus on the most profitable segment of the Company, i.e. Trex Residential.

The acquisition of Trex Commercial was not a good decision considering its stagnant growth and its low margins relative to Trex Residential thus the decision to dispose Trex Commercial makes sense.

Distribution Network

Trex products are sold through two main channels:

1) Wholesale distributors - The Company sells its products to wholesale distributors who in turn sell their products to lumber retailers and to DIY retail locations. The lumber retailers sell directly to homeowners, contractors, remodellers and homebuilders. The Company typically appoints two distributors within a specified area to sell Trex decking products on an exclusive basis.

2) DIY retailers – Direct sales to Home Depot and Lowe’s distribution centers (and subsequently to their retail locations) who serve both contractors and the DIY market. With DIY retailers, the inventory is managed on a Vendor-managed inventory (“VMI”) basis, which means that retailers receive inventory only when they need it, thus reducing the risk of stocking unwanted inventory. This policy does not apply to wholesale distributors.

“The DIY, there never really was an issue with inventory for the Trex Company. We manage that inventory on a VMI basis, we ship into their distribution centers and then from there, we record revenue when it moves out of the distribution center. Because we manage that inventory, we are getting them what they need when they need it, so we didn’t see any inventory issues there and I don’t expect to see any inventory issues there.” Bryan Fairbanks, CEO

Source: Investor Presentation FY22 Q3_ Jan 2023 Date Update

Trex’s scale is remarkable as its products are stocked in more than 6,700 retail locations worldwide. While Trex does not disclose sales by region, it is assumed that the majority of its sales are generated in North America given the DIY retailers and partner distributors. This provides an opportunity for international sales where penetration of composite decking is lower.

“Composites have lower market penetration outside of North America and we believe our international growth can exceed our domestic market expansion pace on a long-term basis.” Bryan Fairbanks, CEO

Customer concentration

As of 2021, three of Trex’s residential customers accounted for 61% of total sales compared to 56% in 2020, thus, there is significant customer concentration. We assume that Home Depot and Lowe’s make the majority of those sales.

However, being the most popular brand in composite decking, having the capacity (see next section) to meet demand for its large customers and the longstanding relationships mitigate the customer concentration risk.

Expanding the manufacturing capacity

As of 31 December 2021, Trex residential operated through two manufacturing facilities, one in Virginia and one in Nevada. In 2019, the Company announced a Capital Expenditure (“CAPEX”) program to increase capacity in the two facilities and it managed to increase it by 70% compared to 2019 volume levels. This CAPEX program led to an increase in spending during 2019 to 2021, as Trex spent a total of $396 million compared to $108 million for the period 2013 to 2018. It's worth noting that during 2019-2021, CAPEX as a percentage of sales averaged at 13.9%, compared to 3.7% for the period 2013-2018.

Source: Koyfin, StockOpine Analysis

In October 2021, the Company announced plans to further increase capacity through the construction of a new facility in Arkansas. The construction started in 2022 and it is planned to start operations in 2024.  Trex expects to spend approximately $400 million over a five year period for the development of the facility in Arkansas. This expansion will help the Company to meet the increasing demand of its products and to increase its market share.

“Arkansas remains a key aspect of our growth strategy due to its strategic advantages, including increased proximity to central raw materials, a strong pool of qualified and skilled labor, adjacency to major transportation hubs and is situated near key growth markets for wood conversion.” Bryan Fairbanks, CEO

Though, if demand for Trex's products takes a hit (at least in the short to medium term) due to macroeconomic factors, which affect the homebuilding and remodeling market, it could result in significant margin contraction as higher fixed costs would be absorbed by a lower output.

Strategic wise, having adequate capacity to meet long term demand could prove to be a winning move to increase market share.

Trex raw materials

Trex decking is made up of approximately 50% wood fiber and 50% scrap polyethylene. Trex sources reclaimed wood fibers mainly from cabinet and flooring manufacturers which create wood fiber as a by-product of their manufacturing process. Scrap polyethylene is derived from plastic scrap bags and plastic film, making Trex one of the largest recyclers of plastic film in North America.

Concerns about the availability of materials due to plastic bag bans in certain regions may arise, however, according to Bryan Fairbanks only 5% of polyethylene is in the form of plastic bags, with the rest being post-industrial protective film from distribution centers.

Those recycled plastics would otherwise end up in a landfill creating a disposal cost for organisations. Instead, Trex pays those organizations to collect the recycling material and takes it to own locations where it transforms them to Trex Products.

It's important to note that recycled plastics are secondary materials with volatile prices that trade like commodities. This means that gross margins may be affected, such as during the COVID-19 pandemic when prices were rising.

Quotes from earnings transcripts (emphasis ours):

“The year-over-year decrease in 2021 fourth quarter gross margins was primarily due to increased raw material costs and higher transportation costs that more than offset increased efficiencies from higher capacity utilization and previous pricing actions.” Q4 2021, Dennis Schemm, CFO

“Trex Residential gross margin was 40.9%, reflecting price realization and production efficiencies that more than offset inflationary pressures on raw material, labor and logistics. We also benefited from a more stable labor situation, allowing us to reliably hire and train our workforce to support our expanded capacity.” Q1 2022, Dennis Schemm, CFO

Brand awareness

Decks.com and Trex.com

Trex owns two websites which uses as part of its strategy to improve brand awareness, educate customers, and increase penetration in composites. According to management, Trex.com and Decks.com drive 64% of the traffic in the decking category.  Through those sites, Trex generates leads and brings together customers and contractors (TrexPros).

Source: Investor Presentation FY22 Q3_ Jan 2023 Date Update

TrexPros

TrexPros is another part of the Company’s strategy to increase brand awareness and educate the industry.  These are contractors trained on the installation of Trex products and have obtained the TrexPro designation. Trex connects those contractors with end consumers and generates customer leads by showcasing their profile and their work in Trex website.  

3. Management & Culture

Management execution to date is considered successful. Since FY19, given that the CEO was appointed in April 2020, TREX revenue increased from $745M to $1.2B (CAGR of 19.6%) on a TTM basis and operating income excluding unusual items from $188M to $314M (CAGR of 20.4%), meanwhile missing revenue and non-GAAP EPS estimates on one occasion (in the latest quarter).