Earl in 2023, I believed that Trex Company, Inc. (NYSE:TREX) had seen a tougher 2022 than it previously thought. Despite these concerns, driven by tough comparables, higher interest rates, and a resulting softening housing market, I was upbeat on the long term secular growth story, with its composite products gaining market share compared to wood.
After a difficult 2023, which came in better than initially expected, I am mindful of the fact that shares have re-rated a lot and trade at very demanding multiples, as investors are extrapolating continued growth, perhaps a bit too much here.
A Long-Term Growth Player
Trex is a play out outdoor living, as it provides decks which typically replace wooden decks, resulting in superior quality, sustainable and price (at least in terms of total cost of ownership) as these products have greater durability and require less maintenance. These economics really work over time, as the premium in deck materials is outdone by labor costs typically being higher than materials, while wood requires maintenance and a greater frequency of replacement.
No rotting, no color fading, no termites and no need to paint, are all reasons why its decks are superior compared to the wooden alternative in this cost-benefit analysis. Besides decking, Trex provides adjacent products such as rails, kitchens and cladding. The company is even moving to expand its range of offerings further, with furniture, fencing, lighting, pergolas and lattice, among others.
The company enjoys the fact that its eco-friendly alternatives can be found at some 6,700 retail locations across the globe, including large retailers such as The Home Depot (HD) as well as Lowe’s (LOW). Despite the benefits of composites, it is still the wood market which is responsible for about three quarters of the total market, but the trend of a greater market share for composite is evident.
A Pandemic Boom – And Retreat
Important to note is that Trex is a long-term secular growth play, and this was happening pre-pandemic already. A half a billion dollar business in 2016 grew sales to three quarters of a billion in 2019, and to $900 million in the pandemic year 2020.
Revenues rose to $1.2 billion in 2021, with EBITDA margins reported around 30%, as operating margins trail these margins by just a few points. This massive growth and fuel provided by the pandemic made that shares rose from the $10 mark in 2016 to a peak of $140 by year-end 2021. This resulted in nosebleed valuations, as peak sales of $1.2 billion that year were accompanied by earnings just north of $2 per share, resulting in sky-high valuations.
That being said, the long-term secular growth play meant that some premium was deserved, as I averaged a position at $52 per share late in 2022 and early into 2023. This dip was clearly a response to very strong demand trends during the pandemic, which reversed in 2022 as higher interest rates hurt the housing business, and certainly spending on discretionary and expensive product categories, such as the ones served by Trex.
All this meant that sales and margins were coming down with inflationary trends, as a retreat in demand hurt earnings. At the same time, the company was investing massively into the business, as large capital expenditure requirements meant that the cash flow picture looked a bit challenging.
With shares trading at $47 per share early in 2023, the company was valued at an equity valuation of $5.2 billion. Believing that earnings power was running at $1.50 per share early in 2023, I was a happy holder in the mid-fifties. While this was not a cheap multiple, it was the long-term quality of the business which made me compelled to the shares.
A Big Re-Rating
Still just a $55 stock in October of last year, shares of Trex have seen strong gains over the past half a year, with shares having gradually risen to the $96 mark, after even trading in the triple-digit territory in recent weeks.
In February of last year, Trex posted a 7% fall in 2022 sales to $1.11 billion, with earnings down more than 11% to still a very respectable net $185 million profit number, which was equal to GAAP earnings of $1.65 per share, with adjusted earnings down to thirty cents to $1.80 per share. Note that the full-year results were a lot better than more recent trends, with fourth quarter sales down 37%, accompanied by even greater earnings declines.
The guidance for 2023 was underwhelming, as EBITDA margins were seen between 26% and 27% of sales, down from margins around 28% in 2022. The company furthermore indicated that its factories were building for annual revenues around a billion, but that it would deviate if demand would be different. This suggested both sales and margins declines for 2023, not boding too well for earnings.
Forwarding to February of this year, Trex posted relatively resilient 2023 results, with revenues reported down a percent to $1.09 billion. Moreover, adjusted EBITDA of $326 million worked down to margins just basis points shy of 30%, stronger than guided for. Net earnings actually rose to $205 million, with GAAP earnings up twenty-four cents to $1.89 per share. This looks better than it is, as adjusted earnings were up just six cents to $1.80 per share.
It is these results that provide comfort to investors, as greater earnings power and reduced capital expenditure needs have eliminated the net debt load to just $3 million.
Moreover, the guidance for 2024 was solid, with sales seen up 12% to a midpoint of $1.225 billion, and EBITDA margins seen between 30.0 and 30.5% of sales. The guidance implicitly calls for EBITDA at $370 million this year, up $44 million from 2023.
That improvement would be equal to $0.40 per share on a pre-tax basis, assuming that depreciation expenses do not increase, which is not too realistic. Amidst all this, realistic adjusted earnings likely trend and improve towards $2.00 per share here, as capital spending is set to continue to outpace depreciation expenses, thereby pressuring cash flows.
What Now?
While the 2023 performance has been a bit stronger than initially seen, the share price momentum has been evident as well, with shares up 75% from October lows, as this now is a >$10 billion (valued) business again, trading at nosebleed valuations near 50 times earnings (even based on the 2024 outlook).
On the subject of the guidance. While sales growth is expected to return in 2024, it is a shift in the early buy program which is expected to boost 2024 sales by a midpoint of $70 million (out of 2023), which once adjusted for makes growth look much less impressive.
Clearly, investors believe in the long term secular growth story, as the company thinks that it can grow 2028 margins by 5 points from current levels. If achieved, this could boost pre-tax earnings by another half a dollar per share on this revenue base, but even in such case, valuations remain demanding.
Of course, if this is met with 12% compounded annual revenue growth, the story changes. In such a case, the business could grow towards $2 billion in sales, $700 million in EBITDA, and earnings to the tune of $4-$5 per share seems to be the realm of possibilities.
That, however, requires some time and execution, and thus uncertainty. I am perfectly happy to take profits on a modest Trex Company, Inc. position here, as future growth expectations have been aggressively priced into the shares.
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