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Good afternoon and welcome to the Trex Company Second Quarter 2019 Earnings Conference Call. [Operator instructions] Please note this event is being recorded. I would now like to turn the conference over to Viktoriia Nakhla. Please go ahead.
Thank you all for joining us today. With us on the call are Jim Cline, President and Chief Executive Officer and Bryan Fairbanks, Executive Vice President and Chief Financial Officer. Joining Jim and Bryan is Bill Gupp, Senior Vice President, General Counsel and Secretary as well as other members of Trex management.
The company issued a press release today after market close containing financial results for the second quarter of 2019. This release is available on the company’s website. This conference call is also being webcast and will be available on the Investor Relations page of the company’s website for 30 days.
I would now like to turn the call over to Bill Gupp. Bill?
Thank you, Viktoriia. Before we begin, let me remind everyone that statements on this call regarding the company’s expected future performance and conditions constitute forward-looking statements within the meaning of federal securities laws. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. For a discussion of such risks and uncertainties, please see our most recent Form 10-K and Form 10-Qs as well as our 1933 and other 1934 Act filings with the SEC. 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 will turn the call over to Jim Cline.
Thank you, Bill and thank you all for joining our call this afternoon to review our second quarter results and discuss our business outlook. I would like to open the call by expressing my thanks and deep appreciation to our channel partners and our field sales team who have shown great flexibility through our residential supply issues. Our highest priority is to continue to expand production throughput to meet the strong market demand for our products.
Second quarter sales were in line with our expectations coming out at the higher end of our guidance as we continue to make progress on increasing throughput. Demand for Trex residential decking and railing products from all channels have been robust benefiting from favorable macroeconomic factors, including high consumer confidence levels, stronger and fairer remodeling sector and from our initiatives to accelerate conversion from wood.
Consolidated gross margin increased 180 basis points sequentially, which was an important achievement that was below our 300 basis point target. This was due primarily to higher than expected startup cost related to our new Trex Enhance product lines. The good news is that the startup costs continue to decline and we project continued sequential gross margin improvement in the third and fourth quarters of this year.
Based on anecdotal evidence from distributors and dealers, the strength of demand across all of our product offering at all sales channels, we are confident that Trex is taking share from wood which is a core element of our growth strategy. Sell-through data for our premier Transcend products indicate consumers continue to demand a decking alternative with high performance durability and excellent aesthetics. The new Trex Enhance Basics and Naturals lineup which we introduced earlier this year offers a high-quality low maintenance decking option for the budget minded homeowners who may have previously eliminated composites from consideration due to price. With this rollout, we have made our decking product successful to an even broader audience significantly increasing our addressable market as this product substantially narrows the price gap between composites and wood.
In mid-March, we modified the Enhance decking profile, our largest manufacturing location in Virginia. We made the same change to our Nevada facility in the second quarter. In the second quarter of 2019, our production rate improvements lagged our plan a bit in Nevada, but now meet or exceed our expectations. This change has enabled us to continue to improve our throughput at both facilities. The expansion or a throughput is our primary objective and will enable us to increase product availability in the market.
The Trex team will pursue margin improvements across our decking product lines to achieve our original portfolio of cost targets beginning in the second half of 2019 and into 2020. The timing has been pushed out to avoid any potential disruption to our throughput expansion efforts.
To better meet the demand for our products now and in the future, we recently announced a new multi-year capital expenditure program of approximately $200 million that involves the construction of a new decking facility at our existing Virginia site and the installation of additional production lines at our Nevada site. These investments will provide significant runway and the ability to better capture, share what we believe is an expanding addressable market. All decking production lines are able to run both the new Enhance product as well as Transcend and Select products.
In addition to our expanding throughput, 2 additional production lines in our Nevada facility are coming online this quarter. In addition, 3 lines will begin ramping up in the second quarter of 2020. This will greatly improve Trex’s ability to serve customers in the Western United States. The additional capacity at Virginia will start with one new line early in the first quarter of 2020. Our third decking building in Virginia is expected to be operational in early 2021. Once completed, this expansion program will increase our capacity by approximately 70%. Keep in mind that the program is modular in nature, which enables us the option to postpone the full build out should we encounter less favorable market conditions.
Pushing gears to Trex Commercial, revenue performance this quarter was lower due mainly to reduce sales related to fewer large projects. You may recall last year was a very strong year for stadium, arena and performing arts projects. Gross margin improved sequentially during the quarter and we are focused on continuing to drive the margin expansion through cost reduction and process improvement initiatives. We also continue to see synergies with Trex Residential as well as opportunities for cross-selling. To date we have introduced 3 railing projects that were developed with the design expertise of the Commercial engineers, as well as a new product line of Commercial Railing that will primarily be manufactured at Trex Residential and taken to the market by Trex Commercial. We’ve begun selling those products into both markets in the first half of 2019. With many of our production issues behind us an additional capacity coming online, we are looking ahead to a much improved second half in 2019.
Now I’d like to turn the call over to CFO, Bryan Fairbanks for the second quarter financial review. Bryan?
Thank you, Jim. Good evening, everyone. I will provide a review of our financial performance for the second quarter and year-to-date 2019. Consolidated net sales for the quarter were $206 million at the high end of our guidance range and similar to last year’s second quarter. Trex Residential products net sales increased 2% year-over-year to $193 million. Trex Commercial products contributed $13 million in revenues in the second quarter comparable to first quarter levels, but below the $18 million reported last year, when we benefited from a period of strong, large project completions.
Consolidated gross margin in the second quarter was 40.4%, up 180 basis points from the 38.6% reported in the first quarter of 2019, due to higher sales, throughput improvements and lower startup costs. The 40.4% consolidated figure includes startup expenses and the cost of added material of approximately 370 basis points. While the startup costs are largely behind us, the impact of added material cost, which was down to improve throughput on the Enhance product will continue into 2020 at a declining rate. In the year ago quarter consolidated margin was 44.1%.
Trex Residential products gross margin were 41.7%, representing a 150 basis points of sequential expansion, but below last year’s gross margin of 45.9%. Trex Commercial products gross margin was 21.4%, down from 24.6% in the 2018 second quarter, which was a very strong quarter for the segment. Commercial margin increased 90 basis points from first quarter level, thanks to operational changes and the continued runoff of legacy projects, which we expect will be mostly complete by the end of the third quarter. We continue to work towards achieving greater operating leverage by implementing additional design, manufacturing and procurement improvements.
SG&A was $36 million, or 17.3% of sales, compared to $34 million, or 16.2% of sales in the comparable period in 2018. This quarter’s increase was due to higher marketing and branding spend focused on our continued program to drive consumer conversion from wood composites and a one-time severance expense. Our second quarter tax rate was flat year-over-year at 25.2%. Net income was $36 million, or $0.61 per diluted share, excluding the severance expense of $2 million, earnings per share would have been $0.64 per diluted share. This compares with $43 million, or $0.73 per diluted share last year.
To briefly sum up our first half performance, we reported 2% increase in consolidated net sales to $386 million. Trex Residential products sales were up 4% to $359 million and net income was $67 million, or $1.14 diluted earnings per share. Operating cash flow was $43 million and first half capital expenditures were $19 million, considering primarily of equipment purchases to support increased throughput and cost reduction. In the second quarter, we repurchased approximately 125,000 shares of our outstanding common stock under our stock repurchase program for a total outlay of $8.5 million. Under the program to-date, we’ve repurchased approximately 710,000 shares and have 5.1 million shares available for repurchase left under our program.
For financial modeling purposes, please note the following items. Taking into account our first half results and continued startup costs in the second quarter, we expect incremental gross margin for the second half of the year to be approximately 45%. Our consolidated gross margin for full year 2019 is expected to be below 2018 levels as we continue to prioritize throughput over cost reduction, but we expect to see continued sequential gross margin improvement as we move through the second half of this year. We expect our 2019 tax rate to be approximately 25% and due to a recently announced capacity investment program, we revised our capital expenditure guidance for 2019 to $75 million to $80 million.
Now I will turn the call back to Jim for his closing remarks.
Thanks, Bryan. As noted in today’s release, our consolidated sales guidance for the third quarter of 2019 is $205 million to $210 million, significantly ahead of last year’s third quarter, thanks to strong demand and improved execution. We appreciate the patience of our customers and the tremendous loyalty that they have shown to the Trex brand. We are dedicating significant resources to increasing production throughput and decreasing our lead times. And we are looking ahead to progressive improvements in both of those areas and we’ve moved through the second half of 2019. Operator, I would now like to open the call up to questions.
Thank you. And we will now begin the question-and-answer session. [Operator Instructions] Our first question will come from Frank Camma with Sidoti. Please go ahead.
Hey, guys. Good afternoon.
Good afternoon, Frank.
Jim and Bryan, you guys gave a lot of color on this, but I am just trying to figure out as you gave the comment about how the additional output or factory could be – you could be flexible on it. But can you talk about how you are taking into account as you open the new capacity, how that affects the margin? Is that part of that incremental guidance? No, I assume at first it’s got a weigh on the margins right as you open this capacity since you are not fully utilized?
As Jim mentioned, we do have some capacity coming on in both facilities – I am sorry in our Fernley facility later on this year and add some capacity early next year at our Virginia facility. That capacity we are talking about in our Nevada facility is included in the margin guidance that we provided.
Okay, good. So, because it’s pretty – it’s obviously from the implication, it’s pretty good rebound from the first half. The other question that I had really was on the commercial side, how should we think about that going forward? I know it’s harder for you to assume even internally to model given the lumpiness of the business. How do we think about what drives that business? To me, the consumer side is kind of easier to kind of get your hands around, but what really do we look for there, as it mean a simple spending, new stadiums, I mean how do we think about that given it’s kind of ups and downs?
Yes. If you look at last year, we had a significant increase in the number of large stadium projects that were worked on and in many cases completed during the year. And that clearly is a big driver of the significant growth that occurred last year. When those projects are reduced, obviously what you see is a lower sales number, because you get into more of the ongoing projects for things like hotels, businesses, professional businesses etcetera. So, if you identify major projects that are going in that Trex is participating in, we typically do announcements when we have one of those that will be an indicator to you that good things will be happening in that year.
Okay. And I guess as a follow-up to that is, are you through most of the projects that you inherited that were lower margin or are they still rolling off as in the future?
There are fair amount that we are rolling off in the first quarter and also in the second quarter. Bryan, why don’t you give him a little color on the third?
Yes, we do have some additional projects, some of these were long range projects that will continue through, but the lowest margin projects they will be virtually all rolled off at the end of the third quarter. It looked to be just a little bit of flow through after that.
Great. That’s very helpful. Thanks.
Thank you.
Our next question comes from Phil Ng with Jefferies. Please go ahead.
Hey guys. Appreciating there is definitely some puts and takes. When we look out at 2020 and maybe even 2021 since you are lapping easier comps in the first half, but obviously higher startup costs and margins for Enhance I seem is a little lower. Would you be able to sustain that historical 45% type incremental margins going forward or we will take a step back?
We have not put any guidance out on 2020 as of yet. We have talked in the past that this is a management team that operates by gross margin and will continue to focus on that next year as we move forward in spite of additional capacity and spending that will start coming out as next year. We will provide additional color on that as we get later into the year.
Got it. But since you are seeing lot of growth coming from the Enhance and it sounds like Transcend still seeing decent growth. Does this structurally change your gross margin profile in the medium-term? I don’t want you to guide at anything, but structurally, do you think it’s from a margin profile standpoint, is it flat, up, down, how should we think about it in medium term?
I think in the medium-term, this company has always been resilient in identifying cost reduction initiatives as well as process improvements and we have been able to drive expanded margins. This year has been certainly not the anomaly we would have liked to have seen as we move forward and work our way through these margin challenges. I think you will continue to see the same type of activity occurring as we go forward.
Okay, great. And then just one last one for me, the 25% sales growth you got in 3Q is obviously very impressive. Some of that is working through your backlog in rebuilding inventory and helping your channel partners meet some of that demand. So be helpful, if you could parse out what do you think real sell-through demand would have looked like this year if you didn’t have some of these operational issues? That would be great. Thanks.
The sell-through demand if we would have started the year with the production levels we had anticipated would have been a strong double-digit year.
Okay. Like high double, like high-teens or 20s or anymore color on that would be really helpful?
We said coming out of the first quarter that we left tens of millions on the table and that’s still fair as we look through the second quarter. So, the growth could have been significantly higher, the total revenue significantly higher than what we have booked along the way. We see some of that coming back in the third quarter. Again, we expect to see a strong fourth quarter as well. But yes that will create some of the seasonal differences as we move out to next year I would expect.
Okay. Thanks a lot.
And certainly as you compare the growth we have had over the last several years that, that growth would have been considerably higher than that.
Our next question comes from Keith Hughes with SunTrust. Please go ahead.
Thank you. Regarding the capacity adds that you are coming in the third quarter, when do you anticipate those will be at its full production, is that something we will see relatively shortly afterwards given the demand for Enhance?
Yes, the lines that are going up in the third quarter, we would start to see the impact of those very quickly. Now just as a reminder, the lines coming up in the third quarter are at our Fernley, Nevada site. We have already communicated expanded availability of product to our business partners and they have already anticipated that in their planning and have certainly begun placing orders with that expanded availability of product.
And are you anticipating in the fourth quarter to run more aggressively during that off season quarter that again with the catch up – the catch up is that why the incremental margins will ramp up in the second half of the year?
Yes, we have mentioned in the past that given some of the supply issues early in the year that we will run all of our capacity in the back half of the year. You have known historically coming out of the August timeframe start bringing down capacity and then bring it up in mid-October. Again, this year will be a little bit different. We will continue running all of that capacity to make sure that we can build the material that’s needed to service the marketplace.
Okay. And then final question back on the margins, are you seeing any throughput differences right now producing Enhance versus Transcend, when you produced Transcend, for example, faster, can you go any longer?
Well, the different product lines add different designs to the product. We look at our throughput on an overall portfolio basis based off of the mix that we are selling. The product is running at the expected rates at this point as our other product lines. That wasn’t the case in the first quarter and the part of the second quarter.
But you are hitting your stride during the third, is that a fair statement?
Yes.
Okay. Thank you very much.
Our next question comes from Matt McCall with Seaport Global Securities. Please go ahead.
Thank you. Good afternoon, guys. Maybe, which one to start with here, the gross margin, so the outlook changed in the back half and then – since you’ve last guided, you made the capacity announcements. Was there anything else that took the second half growth contribution margin outlook down? Was there additional material – that you have to running additional material, I want to understand the same – that the impact, what took that number lower?
Yes, the performance that we had in the second quarter was part of that driver not being able to overcome that still drive the incrementals on a full year basis. Also additional insight to where the channel was going to be in the back half of the year. The capacity that we would have available to us just allows us to be more accurate in our forecasting and we believe that 45% incremental in the back half of the year is more reflective of the performance that will show.
Okay. Thank you. Yes.
To a certain degree we’ve also pushed our cost reduction initiatives to ensure that they don’t interfere with increasing throughput. We need to get to our business partners as much product as we can and regardless of cost to the organization we’re better off making sure that we’re servicing their needs as best as we can as opposed trying and getting a little bit of additional cost savings.
Okay. Thanks, Jim. And so I think you quantified 370 basis points in the quarter start up an additional material. What’s the number for those two buckets with the combined buckets going to be for the year or what’s assumed in the guidance?
We’ve not broken out the material or the inefficiency piece of it for competitive reasons. We did state that the startup piece of it is behind us, but the material piece of it will continue to be a drag on margins, but at a declining rate as we move forward.
Okay, okay. And then one more, Jim, you referenced – I think it was June, you referenced seasonal patterns, all parts of seasonal patterns I can remember how you said it. But can you maybe just talk about normal seasonality given some of the mix shifts, channel shifts that you’ve seen? What does it look like relative to what we’ve seen historically?
Yes, Matt, I brought up the altered seasons. As we look out to next year, I would expect that you’ll see our seasons look similar to what you’ve seen historically. Usually third quarter you’re seeing a fairly significant fall off from the second quarter. This year you’re seeing with what we’ve provided as well as the guidance, the two quarters being very similar. I don’t see any reason why we would go to a very different calendar next year. I think we go back to more of historical type seasonality in the business.
Okay, thank you.
Our next question comes from Kurt Yinger with D.A. Davidson. Please go ahead.
Yes. Good afternoon and thanks for taking my question. Just on the additional materials burden declining does that imply you’re kind of gradually moving back towards the original Enhance design, or is it a mix issue, or how should we kind of think about why that would happen?
It implies a couple of things. Number one, it implies that we have identified ways that we can, without disrupting our production a way to reduce cost. We won’t get into what specifically those are, but we see opportunities in the next 6 months to do that as well as into 2020. If you looked at our cost profile right now, it is not what we originally planned for. You saw the effect of that in the first half and we’re committed to putting that behind as quickly as we can, as long as it does not adversely impact our throughput capabilities.
Got it. Thanks, Jim. And could you maybe talk a little bit about how lead times have progressed through the quarter and where you set kind of on finished goods inventory versus where you’d normally like to be with the kind of demand you’re seeing in the third quarter?
Yes, I’d say that we are putting more product out in the western part of our footprint as we bring additional capacity on. So, we’ve been able to provide a greater level of allocation than what we were providing in the second quarter. We continue to see very strong demand in the eastern part of the footprint and we are working to minimize that disruption with our business partners who have done an excellent job of serving the market through their inventories and helping minimize to the greatest extent possible impact on the professional [indiscernible].
Got it. And just lastly on Transcend is embedded in the third quarter outlook? Is there any benefit from the proposed price increase for 2019?
Well, we didn’t take the price increase into 2019, and there is some benefit that’s coming through, it’s not particularly material in the whole scheme of things in the income statement, but it is there.
Okay, great. Thanks very much and good luck in the third quarter.
Thank you.
Our next question comes from Alex Rygiel with B. Riley FBR. Please go ahead.
Thank you. Can I have a two-part question? First, is there any way to kind of quantify or estimate the one-time sales to fill sort of 3 out there in the marketplace for in 2019? And then historically, if you looked at your organic growth rate in last year, low to low teens, how should we think about that organic growth rate with this new capacity coming on stream for the next 3 years or 4 years?
First, I guess with related to the organic growth rate, you’ve seen what we’ve been able to grow in the prior year. We’ve talked in the past with launching the Enhance, Basics and Naturals lives that we would go after converting more wood. And we are seeing that that strategy is working at this point early into the launch of the product. So, there is no reason to expect that we would expect to see a lower number than what we’ve been doing before we had that product line. As it relates to a split of the costs, those are as I mentioned earlier, we’re not breaking out what that piece of the cost is between the material and other inefficiencies at this point.
Yes. The second part of the question was more, in 2019, clearly some of your distributor customer base are collecting inventory, which is kind of being [indiscernible] is sales from your standpoint, I suspect so. I guess, the question was how much of can you help us to estimate in 2019 with the net sales and residues from sort of building industry out there in the channel?
A very little inventory is being built in the channel. The material it’s getting out there is selling through at this point. So, the inventory build impact is minimal this year.
Yes, it will probably be the fourth quarter they start to build their inventories back to a more normal level.
And then as it relates to raw material cost inflation or deflation, how’s that playing out in the second quarter, in the second half of the year?
We continue to see some opportunity on recycled plastics. We see some other offsets that are in the marketplace on other raw materials. But overall, compared to what we saw last year, it’s much more muted this year.
Great. Thank you.
Thank you.
[Operator Instructions] Our next question comes from Alex Maroccia with Berenberg. Please go ahead.
Hi, guys. Good afternoon. Thanks for taking my question. You touched on increased marketing expense, really driving the SG&A higher this year versus last year. Can you just highlight some of the initiatives right now in marketing and the returns you’ve seen thus far?
We continue to focus on the major drivers within our marketing team. So online presence paid search is a key driver for us as well as some TV advertising, but also our investment we made last year in decks.com building our content for that website, which is driving organic traffic into decks.com and then onto trex.com. So we continue to invest in all of those marketing avenues and we’re able to track the analytics, each one of the investments that we make to ensure that it’s driving the consumers and driving the behavior that we’re looking for in the marketplace.
Okay, great. Thanks. And then the last one is, I’m just wondering about some of the current trends you’re seeing in wood conversion. Are the rates stronger at the top end or the bottom end of the market and do you have any updates on the current percentage of decking that is composites at the moment?
Well, the conversion from wood is stronger at the opening price point as well as the mid price point. The conversion at the top end is not something that has changed significantly year-over-year.
Okay, great. Thank you.
You’re welcome.
Our next question comes from Trey Grooms with Stephens. Please go ahead.
Hey, good afternoon, gentlemen.
Good afternoon.
Just a follow up on your comment, just a minute ago, Jim, I am trying to kind of put some things together with – you mentioned running at full capacity, kind of 3Q and 4Q, but then you’ve mentioned that in 4Q you expect maybe some of the channel feel to get back to more normal kind of seasonal patterns, if I heard you right. So help me kind of connect those two, is that kind of a implying that you’re going to have a little bit of inventory build on your own to prep for next year’s demand, or should the inventory kind of build at the distribution or in the channels should that still be somewhat elevated?
Well, we think that our distribution partners will continue to bring product in to their inventories in the fourth quarter to bring their stocking level up to what they deem is appropriate. Absent their efforts, we would continue to run at a higher level to build additional inventory, carrying costs in inventory is relatively minor in the scheme of things and we want to be ahead of this to ensure that we’re able to service our customers in appropriate manner for 2020.
Got it. Alright, that’s helpful. Again kind of just putting the dots together here, in the press release, I think it was said, double digit growth, top line growth or solid double digit top line growth in the back half and of course 3Q being up 25% and taking those other comments into consideration, the sell through into the channel is it – I guess the expectation that the need is still going to be that great to see something in the height I mean, I’ve just done a lot of quantified double digits especially on the – with such a large 3Q, it could be a wide, wide range.
It could be. We haven’t, obviously, we only get one quarter our guidance, but I think it’s fair to look at those numbers and assume that we’re going to be hitting numbers that are in excess of what we’ve averaged over the last several years on an annualized basis. So that’ll give you a better guidance for the fourth. We’re still working through the numbers, a lot will depend on how the weather holds out. We anticipate the weather is going to be pretty good through at least November. And we believe those distribution partners also will want to continue to build their inventories somewhat, so they are stocked and ready to go for the 2020 season.
Alright. It makes sense. Thanks a lot, Jim. Thanks for the color and good luck to you for the third quarter.
Thanks. I appreciate it.
This concludes our question-and-answer session. I would now like to turn the conference back over to Jim Cline for any closing remarks.
I’d like to thank everyone for participating in today’s call. We have a number of conferences coming up and meetings and we look forward to seeing you at those conferences and meeting. Thanks again. Good evening.
The conference has now concluded. Thank you for attending today’s presentation and you may now disconnect.