Business Context and Reporting Period
Trex Company, Inc. manufactures wood-alternative decking, railing, fencing, outdoor trim and related products under the Trex brand. The filing reports unaudited results for the three and six months ended June 30, 2012, compared with the corresponding 2011 periods. Trex operates in one business segment.
Financial Performance and Position
| Metric | Q2 2012 | Q2 2011 | Six Months 2012 | Six Months 2011 |
|---|---|---|---|---|
| Net sales | $94.3 million | $78.4 million | $190.4 million | $147.4 million |
| Gross profit | $33.6 million | $23.5 million | $69.0 million | $46.6 million |
| Gross margin | 35.6% | 30.0% | 36.2% | 31.6% |
| Income from operations | $12.7 million | $6.2 million | $29.5 million | $12.6 million |
| Net income | $8.3 million | $2.1 million | $20.7 million | $7.2 million |
| Diluted EPS | $0.48 | $0.12 | $1.22 | $0.42 |
| Operating cash flow | Not separately provided | Not separately provided | $35.9 million | $3.3 million |
Q2 net sales increased 20.2%, primarily from a 22.6% increase in sales volume. Six-month sales increased 29.1%, primarily from a 28.5% volume increase. Management attributed volume growth to favorable weather, increased market share and, for the six-month comparison, depressed 2011 demand following customer purchases ahead of a 2011 Transcend price increase.
Q2 operating margin was 13.5%, compared with 7.9% in the prior-year quarter. Six-month operating margin was 15.5%, compared with 8.5%. Selling, general and administrative expense increased 20.2% in Q2 and 16.0% for the six-month period, driven principally by higher incentive compensation, sales commissions and severance costs.
Cash and cash equivalents were $50.6 million at June 30, 2012, with an additional $45.9 million of restricted cash reserved for repayment of the convertible notes. Total cash on hand, including restricted cash, was $96.5 million. Accounts receivable were $48.9 million and inventories were $13.4 million, compared with $29.2 million and $28.9 million, respectively, at December 31, 2011.
At June 30, total indebtedness was $116.9 million, consisting of $91.9 million of convertible notes and $25.0 million drawn under the revolving credit facility. Revolver capacity was approximately $55.8 million. The company was in compliance with its debt covenants.
Material Changes Versus Prior Comparable Period
- Revenue, gross profit and net income increased substantially in both the quarter and year-to-date period.
- Gross margin expanded by 5.6 percentage points in Q2 and 4.6 percentage points for the six-month period, reflecting manufacturing efficiencies and a favorable shift toward shelled products.
- Six-month operating cash flow increased by $32.7 million, aided by higher earnings and a $15.5 million decrease in inventories, partly offset by a $19.7 million increase in accounts receivable.
- Net interest expense increased to $4.3 million in Q2 and $8.7 million year-to-date, although interest expense as a percentage of sales declined.
- The effective tax rate was 0.9% for the six-month period, compared with a 56.5% benefit rate in 2011. The 2011 benefit primarily reflected a favorable resolution of uncertain tax positions.
- Warranty reserves increased by $1.5 million during the first six months to $13.9 million, reflecting settlements of legacy claims above prior estimates.
Guidance, Outlook, Risks and Unusual Items
Management estimated 2012 capital expenditures of approximately $10 million to $15 million; $2.9 million had been spent through June 30, primarily on manufacturing equipment and productivity improvements. Management expected cash from operations, available revolver borrowings and cash on hand to fund capital expenditures, scheduled obligations and warranty requirements.
On July 2, 2012, after quarter-end, Trex repaid the $91.9 million principal balance of its convertible notes using cash on hand, including restricted cash, and issued 1,061,745 common shares under the notes’ conversion feature. The filing therefore reflects a significant post-quarter-end reduction in note debt and an increase in shares outstanding.
Key risks include seasonal demand, general economic conditions, competitive markets, raw-material availability and pricing, product quality, customer acceptance of new products and distribution-channel inventory changes. The company continues to face legacy warranty claims involving pre-2007 Nevada-produced material and several purported class actions alleging product defects and mold-related misrepresentations. Management believes the lawsuits are without merit, but acknowledges that warranty estimates could materially affect earnings, liquidity and cash flow if claim activity does not decline as expected.
The company also remains obligated under a corporate relocation lease through June 2019. The related contract-termination liability was $0.5 million at June 30, 2012, and future charges could increase if sublease assumptions deteriorate.
On July 24, 2012, the company increased compensation arrangements for outside directors and entered retention agreements with four executive officers. Each executive’s potential award consisted of restricted stock and a cash payment, with vesting or payment subject to specified retention conditions.
Investor Verification Points
- Verify the July 2, 2012 repayment of the convertible notes, the 1,061,745 shares issued on conversion and the resulting post-quarter-end debt and share count.
- Assess whether the 2012 sales and margin improvement reflects sustainable market-share gains or temporary effects from weather, prior-year purchasing patterns and favorable product mix.
- Monitor accounts receivable collections, distribution-channel inventory and the seasonal second-half demand pattern.
- Review the adequacy of the $13.9 million warranty reserve and sensitivity to the company’s estimate that a 10% change in remaining claims or settlement cost would change the reserve by approximately $1.4 million.
- Evaluate liquidity after the convertible-note repayment, including revolver availability, covenant compliance and planned capital expenditures.
- Review the pending product-defect and mold-related litigation and the potential for additional warranty, legal or settlement costs.