This management's discussion and analysis contains 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. All statements regarding our expected financial position and operating results, our business strategy, our financing plans, forecasted demographic and economic trends relating to our industry and similar matters are forward-looking statements. These statements can sometimes be identified by our use of forward-looking words such as "may," "will," "anticipate," "estimate," "expect," "intend" or similar expressions. We cannot promise you that our expectations in such forward-looking statements will turn out to be correct. Our actual results could be materially different from our expectations because of various factors, including the factors discussed under "Item 1A. Risk Factors." These statements are also 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 impact of seasonal and weather-related demand fluctuations on inventory levels in the distribution channel and sales of the Company's products; 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 relations expenses related to product quality; and the highly competitive markets in which the Company operates.
Trex Company, Inc.is the world's largest manufacturer of wood-alternative decking and railing products, which are marketed under the brand name Trex®. We offer a comprehensive set of aesthetically durable, low maintenance product offerings in the decking, railing, porch, fencing, trim and steel deck framing categories. We believe that the range and variety of our product offerings allow consumers to design much of their outdoor living space using Trex brand products. We have four principal decking products: Trex Transcend®, Trex Enhance®, TrexSelect®, and Trex Accents®; four railing products: Trex Transcend Railing, TrexDesigner Series Railing®, Trex Select Railing, and Trex Reveal® aluminum railing; a porch product, Trex Transcend Porch Flooring and Railing System; a steel deck framing system, Trex Elevations®; a fencing product, TrexSeclusions®; a deck lighting system, Trex DeckLighting™; and a cellular PVC outdoor trim product, TrexTrim™. In addition, we offer Trex Hideaway®, which is a hidden fastening system for specially grooved boards. On December 31, 2013, we discontinued the manufacture of Trex Accents and TrexDesigner Series Railing, which we do not believe will have a material impact on our results of operations or cash flow.
Highlights related to the fourth quarter and full year 2013 include:
• Net sales increased 38% in the fourth quarter of 2013 and 11% in the full
year of 2013 compared to the respective periods in 2012 due primarily to
an increase in sales volumes.
• We generated positive cash flow from operations and ended the year with no
outstanding indebtedness. • During 2013, we used cash on hand to repurchase
$25 millionof our
outstanding common stock under a stock repurchase program authorized by
the Board of Directors in
August 2013. • We recorded a $20 millionincrease to the warranty reserve in 2013 to settle future claims related to material produced prior to 2007 at our Nevadafacility that exhibits surface flaking. • We reduced a substantial portion of our valuation allowance on our deferred tax assets. Net Sales. Net sales consist of sales and freight, net of returns and discounts. The level of net sales is principally affected by sales volume and the prices paid for Trexproducts. Our branding and product differentiation strategy enables us to command premium prices over wood products. Our operating results have 20
Table of Contents
historically varied from quarter to quarter, in part due to seasonal trends in the demand for
Trex. We have historically experienced lower net sales during the fourth quarter because holidays and adverse weather conditions in certain regions reduce the level of home improvement and construction activity. Sales Incentives / Early Buy Program: As part of our normal business practice and consistent with industry practices, we have historically provided our distributors and dealers incentives to build inventory levels before the start of the prime deck-building season to ensure adequate availability of product to meet anticipated seasonal consumer demand and to enable production planning. These incentives, which together we reference as our "early buy program," include payment discounts and favorable payment terms. In addition, from time to time we may offer price discounts or volume rebates on specified products and other incentives based on increases in purchases as part of specific promotional programs. We launched our early buy program for the 2014 decking season in December 2013. The timing and terms of the 2014 program are generally consistent with the timing and terms of the 2013 program launched in December 2012. To qualify for early buy program incentives, customers must commit to the terms of the program which specify eligible products and quantities, order deadlines and available terms, discounts and rebates. Early Buy shipments in December 2013were higher than in December 2012due, in part, to additions to our distribution network, an increase in demand for our products and a revised pricing strategy. There are no product return rights granted to our distributors except those granted pursuant to the warranty provisions of our agreements with distributors. We generally do not extend the payment terms beyond those offered in the program. In addition, our products are not susceptible to rapid changes in technology that may cause them to become obsolete. The early buy program can have a significant impact on our sales, receivables and inventory levels. We have provided further discussion of our receivables and inventory in the liquidity and capital resources section. Gross Profit. Gross profit represents the difference between net sales and cost of sales. Cost of sales consists of raw materials costs, direct labor costs, manufacturing costs and freight. Raw materials costs generally include the costs to purchase and transport waste wood fiber, reclaimed polyethylene, or "PE material," and pigmentation for coloring Trexproducts. Direct labor costs include wages and benefits of personnel engaged in the manufacturing process. Manufacturing costs consist of costs of depreciation, utilities, maintenance supplies and repairs, indirect labor, including wages and benefits, and warehouse and equipment rental activities. Selling, General and Administrative Expenses. The largest component of selling, general and administrative expenses is personnel related costs, which include salaries, commissions, incentive compensation, and benefits of personnel engaged in sales and marketing, accounting, information technology, corporate operations, research and development, and other business functions. Another component of selling, general and administrative expenses is branding and other sales and marketing costs, which are used to build brand awareness of Trex. These costs consist primarily of advertising, merchandising, and other promotional costs. Other general and administrative expenses include professional fees, office occupancy costs attributable to the business functions previously referenced, and consumer relations expenses. As a percentage of net sales, selling, general and administrative expenses have varied from quarter to quarter due, in part, to the seasonality of our business.
Critical Accounting Estimates
Our significant accounting policies are described in Note 2 to our consolidated financial statements appearing elsewhere in this report. Our critical accounting estimates include the areas where we have made what we consider to be particularly difficult, subjective or complex judgments in making estimates, and where these estimates can significantly affect our financial results under different assumptions and conditions. We prepare our financial statements in conformity with accounting principles generally accepted in
the United States. As a result, we are required to make estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. Actual results could be different from these estimates. 21
Table of Contents
Inventories. We account for inventories at the lower of cost (last-in, first-out, or "LIFO") or market value. We believe that our current inventory of finished goods will be saleable in the ordinary course of business and, accordingly, have not established significant reserves for estimated slow moving products or obsolescence. At
December 31, 2013, the excess of the replacement cost of inventory over the LIFO value of inventory was approximately $24.5 million. Product Warranty. We warrant that our products will be free from material defects in workmanship and materials. This warranty generally extends for a period of 25 years for residential use and 10 years for commercial use. (With respect to TrexTrim™ and Trex Reveal® Railing, the warranty period is 25 years for both residential and commercial use.) With respect to our Transcend®, Enhance®, Select® and Universal Fascia product, we further warrant that the product will not fade in color more than a certain amount and will be resistant to permanent staining from food substances or mold (provided the stain is cleaned within seven days of appearance). This warranty extends for a period of 25 years for residential use and 10 years for commercial use. If there is a breach of such warranties, we have an obligation either to replace the defective product or refund the purchase price. Historically, we have not had material numbers of claims submitted or settled under the provisions of our product warranties, with the exception of claims related to material produced at our Nevadafacility prior to 2007 that exhibits surface flaking. We continue to receive and settle surface flaking claims and maintain a warranty reserve to provide for the settlement of these claims. In 2009, we agreed to a settlement of a class action lawsuit covering the surface defect, stipulating our responsibilities with regard to such claims. Estimating the warranty reserve for surface flaking claims requires management to estimate (1) the average cost to settle each claim and (2) the number of claims to be settled with payment, both of which are subject to variables that are difficult to estimate. The cost per claim varies due to a number of factors, including the size of affected decks, the type of replacement material used, the cost of production of replacement material and the method of claim settlement. Although the cost per claim does vary, it is less volatile and more predictable than the number of claims to be settled with payment, which is inherently uncertain. The key component driving our potential liability is the number of claims that will ultimately require payment. To estimate the number of future paid claims, we utilize actuarial techniques to quantify both the expected number of claims to be received and the percentage of those claims that will ultimately require payment. Estimates for both of these elements (number and percentage of claims that will ultimately require payment) are quantified using a range of assumptions derived from the recent claim count history and the identification of factors influencing the claim counts, including the downward trend in received claims due to the passage of time since production of the suspect material. For each of the various parameters used in the analysis, the assumed values in the actuarial valuation produce results that represent our best estimate for the ultimate number of claims to be settled with payment. A number of factors make estimates of the number of claims to be received inherently uncertain. We believe that production of the suspect material was confined to material produced from our Nevadafacility prior to 2007, but are unable to determine the amount of suspect material produced or the exact time it takes for surface flaking to become evident in the suspect material and materialize as a claim. Furthermore, the aforementioned 2009 class action settlement and related public notices led to a significant increase in claims received in 2009 and disrupted the claims data and settlement patterns. Lastly, we are not aware of any analogous industry data that might be referenced in predicting future claims to be received. The number of surface flaking claims received peaked in 2009 in conjunction with the class action settlement and related public notices and the trend of claims received began to decline significantly in 2010 and 2011, consistent with the our belief that the effect of the 2009 spike in claims was largely an acceleration of claims previously expected to be filed in future periods. As a result of the effects of the class action settlement and because the suspect material had not been produced since prior to 2007, we anticipated that the rate of decline in claims received would accelerate and the number of claims received would continue to decline significantly in 2012. 22
Table of Contents
We monitor surface flaking claims activity each quarter for indications that our estimate of the number of claims expected requires revision. Due to extensive use of decks during the summer outdoor season, variance to annual claims expectations is typically observed during the latter part of our fiscal year. During the third quarter of 2012, based on an analysis of additional claims activity, we observed that the actual rate of decline in claims received in 2012 would fall short of our anticipated rate of decline. As a result, we revised our estimate of the future claims to be received to reflect a rate of decline that incorporated levels experienced in 2012. Although the number of claims expected to be received continued to decline each year, the effect of reducing the anticipated rate of decline increased the total number of claims expected in future years. As a result of these changes in estimate, we recorded an increase to the warranty reserve of
$20 millionduring the three months ended September 30, 2012. During the third quarter of 2013, the number of claims received was significantly greater than our prior estimates. Although the number of claims received during the first nine months of 2013 remained lower than those received during the first nine months of 2012, the number of claims received during the third quarter of 2013 exceeded those received during the third quarter of 2012. This represented the first quarterly year-over-year increase in the number of claims received since the 2009 class action settlement was made public. We believe that this unexpected increase in claims was due primarily to a response to communications made by the Company in July 2013informing homeowners of potential hazards associated with decking products exhibiting surface flaking that are not timely replaced. These communications included a public press release and over 10,000 letters sent to homeowners that previously filed surface flaking claims. In addition to contributing to the increase in new claims received, these communications resulted in the reopening of a significant number of claims previously closed. Furthermore, although not directly related to the surface flaking issue, in August 2013, the United States District Court, Northern Districtof Californiagranted preliminary approval of a settlement agreement related to cases in which plaintiffs generally alleged certain defects in our products and alleged misrepresentations relating to mold growth. We believe that public notices made subsequent to the Court approval increased homeowner awareness of product-related issues and contributed to the increased number of surface flaking claims received during the third quarter of 2013. As a result of these public communications, we expect to experience elevated claims activity, both in new claims received and reopened claims, for the near future, after which we expect a return to previously-experienced rates of decline. However, the elevated claims activity resulted in a material increase in the expected number of claims to settle with payment. In addition to the increased number of expected claims to be settled with payment, we experienced an increase in the average cost to settle a claim during 2013. Analysis of claims data indicates that the increased cost per claim is driven primarily by an increase in the average size of settled claims, which we believe reflects a shift from partial deck replacements to full deck replacements. Also, our August 2013decision to discontinue production of the Accents® product, which is currently used as replacement material for surface flaking claims, necessitated a change in the average cost expectations due to the implications of transitioning to alternative replacement material. Due to the unfavorable claims and cost experience during the three months ended September 30, 2013, as described above, we recorded a $20 millionincrease to the warranty reserve. Our analysis is based on currently known facts and a number of assumptions. Projecting future events such as the number of claims to be received, the number of claims that will require payment and the average cost of claims could cause the actual warranty liabilities to be higher or lower than those projected which could materially affect our financial condition, results of operations or cash flow. We estimate that the number of claims received will decline over time. If the level of claims received does not diminish consistent with our expectations or if the cost to settle claims increases, it could result in additional increases to the warranty reserve and reduced earnings and cash flows in future periods. We estimate that a 10% change in the expected number of remaining claims to be settled with payment or the expected cost to settle claims may result in approximately a $4.1 millionchange in the warranty reserve. 23
Table of Contents
The following table details surface flaking claims activity related to our warranty: Year Ended December 31, 2013 2012 2011
Claims unresolved, beginning of period 4,073 4,878
4,689 Claims received (1) 4,256 4,807 5,662 Claims resolved (2) (4,080 ) (5,612 ) (5,473 )
Claims unresolved, end of period 4,249 4,073
Average cost per claim (3)
$ 2,265 $ 2,101 $ 1,869
(1) Claims received include new claims received or identified during the period.
(2) Claims resolved include all claims settled with or without payment and closed
during the period.
(3) Average cost per claim represents, for claims closed during the period, the
average settlement cost of claims closed with payment (excludes claims
settled without payment).
For additional information about product warranties, see Notes 2 and 12 to the consolidated financial statements appearing elsewhere in this report.
Contract Termination Costs. In anticipation of relocating our corporate headquarters, we entered into a lease agreement in 2005. We reconsidered and decided not to move our headquarters. The lease obligates us to lease 55,047 square feet of office space through
June 30, 2019. As of December 31, 2013, we have executed subleases for 41,701 square feet of the leased space and are currently marketing the remaining portion of the space to find a suitable tenant. We estimate that the present value of the estimated future sublease receipts, net of transaction costs, will be less than our remaining minimum lease payment obligations under our lease and have recorded a liability for the expected shortfall. During the three months ended September 30, 2013, a subtenant defaulted on its sublease payments. As a result we revised our estimate of sublease receipts and recorded a $1.1 millioncharge to selling, general and administrative expenses to increase our liability. To estimate future sublease receipts for the periods beyond the term of the existing subleases, we have assumed that the existing subleases will be renewed or new subleases will be executed at rates consistent with rental rates in the current subleases or estimated market rates. However, management cannot be certain that the timing of future subleases or the rental rates contained in future subleases will not differ from current estimates. Factors such as the availability of commercial office space, poor economic conditions and subtenant preferences will influence the terms achieved in future subleases. The inability to sublet the office space in the future or unfavorable changes to key management assumptions used in the estimate of the future sublease receipts may result in material charges to selling, general and administrative expenses in future periods. Income Taxes. We account for income taxes in accordance with ASC 740, "Income Taxes." Deferred tax assets and liabilities are recognized based on the difference between the financial statement basis and tax basis of assets and liabilities using enacted rates expected to be in effect during the year in which the differences reverse. In accordance with ASC 740, we assess the likelihood that our deferred tax assets will be realized. Deferred tax assets are reduced by a valuation allowance when, after considering all available positive and negative evidence, it is determined that it is more likely than not that some portion, or all, of the deferred tax asset will not be realized. As of December 31, 2012, we had a full valuation allowance recorded against our deferred tax assets. Our assessment gave significant weight to the negative evidence of our cumulative loss history in the three years ended December 31, 2012. As of December 31, 2013, we determined that we more likely than not will realize most of our deferred tax assets and, as a result, reversed a significant portion of our valuation allowance. The analysis performed to assess the need for a valuation allowance included an evaluation of the four possible sources of taxable income as identified in ASC 740, including the consideration of the positive evidence of our cumulative income history in the three years ended December 31, 2013. 24
Table of Contents
Based on this analysis, as well as due to the realization of certain deferred tax assets during 2013, we recorded a
$19.9 millionreduction of our valuation allowance during the year ended December 31, 2013, $10.9 millionof which was a direct result of our decision to exit a full valuation allowance. As of December 31, 2013, the remaining valuation allowance is $4.2 million, primarily related to certain state tax credits we estimate will expire before they are realized. We will analyze our position in subsequent reporting periods, considering all available positive and negative evidence, in determining the expected realization of our deferred tax assets. Stock-Based Compensation. Under the provisions of FASB ASC Topic 718, "Stock Compensation," we calculate the grant date fair value of share-based awards using the Black-Scholes valuation model for grants subsequent to the adoption of ASC 718. Determining the fair value of share-based awards is judgmental in nature and involves the use of significant estimates and assumptions, including the term of the share-based awards, risk-free interest rates over the vesting period, expected dividend rates, the price volatility of our shares and forfeiture rates of the awards. We base our fair value estimates on assumptions we believe to be reasonable but that are inherently uncertain. Actual future results may differ from those estimates.
Results of Operations
The following table shows, for the last three years, selected statement of comprehensive income data as a percentage of net sales:
Year Ended December 31, 2013 2012 2011 Net sales 100.0 % 100.0 % 100.0 % Cost of sales 71.2 72.5 76.5 Gross profit 28.8 27.5 23.5 Selling, general and administrative expenses 21.6 23.4 22.7 Income from operations 7.2 4.1 0.8 Interest expense, net 0.2 2.9 6.1 Income (loss) before income taxes 7.0 1.2 (5.3 ) Provision (benefit) for income taxes (3.1 ) 0.3 (1.0 ) Net income (loss) 10.1 % 0.9 % (4.3 %) 2013 Compared to 2012 Net Sales. Net sales in 2013 increased 11.4% to
$342.5 millionfrom $307.4 millionin 2012. The increase in net sales was due primarily to an 8% increase in sales volume and a 3% increase in the average price per unit in 2013 compared to 2012. We attribute the increase in sales volumes in 2013 compared to 2012 to the execution of growth strategies including increased market share from additions to our distribution network, the introduction of new product lines and a revised pricing strategy. The increase in average price per unit in 2013 was primarily driven by sales mix including an increased attachment rate on railing products. Gross Profit. Gross profit increased 16.6% to $98.6 millionin 2013 from $84.6 millionin 2012. Gross profit in 2013 and 2012 was adversely affected by $21.5 millionand $21.5 millionof non-operating charges, respectively. We recognized $20.0 millionand $21.5 millionof charges to increase the previously established warranty reserve in 2013 and 2012, respectively. In addition, in 2013, we recognized a $1.5 millioncharge related to market share expansion and a reset of prices for certain products as we transition our remaining products to the next generation product offering. Excluding the aforementioned charges in both 2013 and 2012, gross profit increased to $120.1 millionin 2013 compared to $106.1in 2012. Excluding the aforementioned charges in both 2013 and 2012, gross profit as a percentage of net sales, gross margin, increased by 40 basis 25
Table of Contents
points to 34.9% from 34.5% in 2012. The 2012 gross margin reflected
$4.5 millionof LIFO inventory liquidation income. The 2013 underlying gross margin at 34.9% was 185 basis points higher than 2012 excluding the LIFO inventory liquidation income. Key drivers to the favorable underlying gross margin for 2013 include lower sales related items, increased capacity utilization rates and continued manufacturing efficiencies. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $2.1 million, or 2.9%, to $74.0 millionin 2013 from $71.9 millionin 2012. The increase in selling, general and administrative expenses in 2013 compared to 2012 was attributable to various factors including a $1.2 milliondecrease in the benefits recognized from reductions in the provision for future contingent payments associated with the 2011 Iron Deck acquisition and a $0.9 millionincrease in legal and claims servicing costs primarily resulting from the mold growth class action lawsuit that was settled in December 2013and related public and homeowner communications. As a percentage of net sales, total selling, general and administrative expenses decreased to 21.6% in 2013 from 23.4% in 2012. Interest Expense. Net interest expense decreased 93.3% to $0.6 millionin 2013 compared to $8.9 millionin 2012. The decrease resulted from carrying lower debt levels at lower interest rates during 2013 compared to 2012. This was primarily driven by the repayment of the $91.9 millionprincipal balance on the 6.0% convertible notes on July 2, 2012. As a percentage of net sales, interest expense decreased to 0.2% in 2013 from 2.9% in 2012. Provision for Income Taxes. We recorded a benefit for income taxes of $10.5 millionin 2013 compared to an expense of $1.0 millionin 2012. The related effective tax rates were (43.9%) in 2013 and 27.1% in 2012. During 2013, our income tax benefit consisted of a reduction of a substantial portion of our valuation allowance on our deferred tax asset as well as statutory federal and state taxes, permanent book to tax differences, Federal tax credits, and other miscellaneous tax items. During 2012, our income tax expense consisted of cash taxes to various states where no net operating loss carry-forward existed to offset current year taxable income, unfavorable effect of permanent differences related to employee stock awards and increases in indefinite-lived deferred tax liabilities, primarily related to goodwill amortized for income taxes. Our effective tax rate for both years is substantially different than the statutory rate due to the effect of the valuation allowance we maintained against our net deferred tax assets. During the three months ended December 31, 2013, we determined it to be more likely than not that we will realize most of our deferred tax assets. During 2013, we recorded a $19.9 millionincome tax benefit resulting from a significant reversal of our valuation allowance, $10.9 millionof which was a direct result of our decision to exit a full valuation allowance. 2012 Compared to 2011 Net Sales. Net sales in 2012 increased 15.2% to $307.4 millionfrom $266.8 millionin 2011. The increase in net sales was due primarily to a 15% increase in sales volume in 2012 compared to 2011. We attribute the increase in sales volumes in 2012 compared to 2011 to various factors, including:
• Sales volumes in 2011 were depressed as a result of customers purchasing
product in late 2010 to avoid an announced 2011 Transcend price increase;
• Favorable weather conditions throughout 2012 compared to 2011 allowed for
a more favorable deck-building season, and;
• Execution of growth strategies including introduction of new product lines
and increased market share.
Gross Profit. Gross profit increased to
$84.6 millionin 2012 from $62.8 millionin 2011. Gross profit as a percentage of net sales increased to 27.5% in 2012 from 23.5% in 2011. Gross profit in 2012 was adversely affected by a $21.5 millionincrease to the warranty reserve. Gross profit in 2011 was adversely affected by a $10.0 millionincrease to the warranty reserve. Excluding the aforementioned charges, gross profit in 2012 was $106.1 million, a $33.3 millionincrease compared to 2011. Underlying gross margin in 2012 was 34.6%, a 7.3% 26
Table of Contents
increase compared to 2011. Our gross margin improvement was due to improved manufacturing efficiencies, a favorable product mix as we transition decking sales to our shelled products and a favorable inventory valuation adjustment related to our significant reduction in inventory. This was offset by start-up costs related to the introduction of our high performance shelled products. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased
$11.3 million, or 18.6%, to $71.9 millionin 2012 from $60.6 millionin 2011. The increase in selling, general and administrative expenses in 2012 was primarily related to a $9.6 millionincrease in personnel related expenses due to increased incentive compensation, sales commissions and severance costs. In 2012, we recorded a $1.9 millionloss on the disposal of equipment made obsolete by improvements in manufacturing technologies and a $1.5 millionexpense for costs associated with the mold and mildew class action lawsuit. These increases were partially offset by a $1.4 millionbenefit in 2012 due to a reduction in the provision for future contingent payments resulting from decreased near-term sales projections of steel deck framing systems. As a percentage of net sales, total selling, general and administrative expenses increased to 23.4% in 2012 from 22.7% in 2011. Interest Expense. Net interest expense decreased 45.3% to $8.9 millionin 2012 compared to $16.4 millionin 2011. The decrease was the result of a significant decrease in debt during 2012, primarily due to the repayment of the $91.9 millionprincipal balance on the convertible notes on July 2, 2012. As a percentage of net sales, interest expense decreased to 2.9% in 2012 from 6.1% in 2011. Provision for Income Taxes. We recorded an expense for income taxes of $1.0 millionin 2012 compared to a benefit of $2.6 millionin 2011. The related effective tax rates were 27.1% in 2012 and 18.4% in 2011. The effective tax rate for both years is substantially different than the statutory rate because of our full valuation allowance on our net deferred tax assets. As a result, our provision for income taxes and corresponding effective tax rate, are primarily a function of cash taxes paid to various jurisdictions, changes in indefinite-lived deferred tax liabilities and changes to liabilities associated with uncertain tax positions. The benefit recognized in 2011 was primarily related to the effects of favorably settled uncertain federal tax positions previously reserved under the provisions of ASC 740. The income tax expense recognized in 2012 was primarily related to cash taxes to various states where no net operating loss carry-forward is available to offset current year taxable income, unfavorable effect of permanent differences related to employee stock awards and increases in indefinite-lived deferred tax liabilities, primarily related to goodwill amortized for income taxes.
Liquidity and Capital Resources
We finance operations and growth primarily with cash flow from operations, borrowings under the credit facility and other loans, operating leases and normal trade credit terms from operating activities.
Sources and Uses of Cash. Net cash provided by operating activities totaled
$45.2 millionin 2013 compared to net cash provided by operating activities of $60.4 millionin 2012. The $15.2 millionyear-over-year reduction in cash provided by operating activities was primarily driven by increased inventory and accounts receivable balances, partially offset by an increase in net sales and earnings during 2013 compared to 2012. The increase in inventory balances at December 31, 2013was to support conversion to our next generation product offerings and additions to our distribution network. Accounts receivable balances increased to $37.3 millionat December 31, 2013compared to $26.5 millionat December 31, 2012due to increased sales in late 2013 primarily driven by additions to our distribution network, an increase in demand for our products and a revised pricing strategy. Substantially all of the accounts receivable balances at December 31, 2013were subject to the terms of our early buy program. We expect to collect all outstanding accounts receivable balances by May 2014. 27
Table of Contents
Net cash used in investing activities totaled
$12.7 millionin 2013 compared to cash used in investing activities of $7.5 millionin 2012. The increase is primarily attributable to an increase in capital expenditures in 2013 compared to 2012 due to a focus on new product launches and manufacturing efficiencies. Capital expenditures in 2013 consisted primarily of manufacturing equipment for process and productivity improvements, including retrofitting lines to produce new products. In 2012, net cash used in investing activities totaled $7.5 millioncompared to $9.4 millionin 2011. Net cash used in financing activities was $30.9 millionin 2013 compared to cash used in financing activities of $55.3 millionin 2012. The $24.4 millionimprovement in 2013 was due to the fact that, in 2012, we used cash on hand and $37.0 millionof restricted cash to fully repay the $91.9 millionprincipal balance on our convertibles notes. In 2013, we used cash on hand to repurchase $25.0 millionof our common stock. Net cash used in financing activities was $55.3 millionin 2012 compared to net cash used in financing activities of $47.2 millionin 2011. On February 19, 2014, our Board of Directors authorized an additional common stock repurchase program of up to $50 millionof our outstanding common stock. This authorization has no expiration date. Inventory in Distribution Channels. We sell our products through a tiered distribution system. We have approximately 20 distributors and two mass merchandisers to which we sell our products. These distributors in turn sell the products to approximately 3,100 dealers who in turn sell the products to the end users. Consistent with industry practices, to ensure adequate availability of product to meet anticipated seasonal consumer demand and to enable production planning, we have historically provided our distributors and dealers incentives to build inventory levels before the start of the prime deck-building season. These incentives include prompt payment discounts and favorable payment terms. In addition, from time to time, we may offer price discounts or volume rebates on specified products and other incentives based on increases in purchases as part of specific promotional programs. There are no product return rights granted to our distributors except those granted pursuant to the warranty provisions of our agreements with distributors. While we do not typically receive any information regarding inventory in the distribution channel from any dealers, we receive limited information from some but not all of our distributors regarding their inventory. Because few distributors provide us with any information regarding their inventory, we cannot definitively determine the level of inventory in the distribution channel at any time. Our sales in the fourth quarter of 2013 were higher than our sales in the fourth quarter of 2012. We believe that distributor inventory levels at December 31, 2013are comparable to distributor inventory levels at December 31, 2012. Significant changes in inventory levels in the distribution channel without a corresponding change in end-user demand could have an adverse effect on future sales. We seek to maintain favorable relationships with our distributors. However, on occasion, we may need to replace a distributor. Historically, we have had little difficulty replacing a distributor and have experienced little or no disruption to operations or liquidity. We believe that in the event we needed to replace a distributor, it would not have an adverse effect on our profitability or liquidity. Product Warranty. We continue to receive and settle claims related to material produced at our Nevadafacility prior to 2007 that exhibits surface flaking and regularly monitor the adequacy of the warranty reserve. During the year ended December 31, 2013, we paid approximately $8.2 millionto settle claims against the warranty reserve, which had a material adverse effect on cash flow from operations, and increased the warranty reserve an additional $20.0 million. We estimate that the number of claims received will decline over time. If the level of new claims received does not diminish consistent with our expectations, it could result in additional increases to the warranty reserve and reduced earnings and cash flow in future periods. Indebtedness. On January 6, 2012, we entered into an Amended and Restated Credit Agreement (the "Amended Credit Agreement") with BB&T, as a lender, Administrative Agent, Swing Line Lender, Letter of Credit Issuer and a Collateral Agent; Wells Fargo Capital Finance, LLC("Wells Fargo") as a lender and a Collateral Agent; and BB&T Capital Markets(" BB&T Capital"), as Lead Arranger to amend the Credit 28
Table of Contents
Agreement. BB&T and Wells Fargo are referenced herein as the "Lenders." These new agreements replace our previous revolver note, the swing advance note and the letter of credit facility, in their entireties and account for all of our debt capacity. No additional fees were due or owing as a result of the termination of the previous agreements. Under the Amended Credit Agreement, the Lenders agreed to provide us with one or more revolving loans in a collective maximum principal amount of
$100 million(the "Revolver Loans"). Included within the Revolver Loan limit are sublimits for a Letter of Credit Facility in an amount not to exceed $15 million(the "Letter of Credit Facility"); and Swing Advances in an aggregate principal amount at any time outstanding not to exceed $5 million(the "Swing Advance Loan"). The Revolver Loans, the Letter of Credit Facility and the Swing Advance Loan are collectively referred to herein as the "Loans." The Loans were obtained for the purpose of raising working capital and refinancing our existing indebtedness. The Revolver Loans, the Swing Advances and the Letter of Credit Facility provide us, in the aggregate, the ability to borrow a principal amount not to exceed $100 millionat any one time outstanding (the "Revolving Loan Limit") (subject to certain Borrowing Base requirements as described in the Amended Credit Agreement which include limits on Eligible Accounts and Inventory as described in the Amended Credit Agreement and any written agreement which may be executed from time to time by us and each of the Collateral Agents). We are not obligated to borrow any amount under the Revolving Loan Limit. Within the Revolving Loan Limit, we may borrow or repay at any time or from time to time while the Revolving Loans are in effect. Base Rate Advances (as defined in the Amended Credit Agreement) under the Revolver Loans and the Swing Advances accrue interest at the Base Rate plus the Applicable Margin (as defined in the Amended Credit Agreement) and Euro-Dollar Advances for the Revolver Loans and Swing Advances accrue interest at the Adjusted London InterBank Offered Rate plus the Applicable Margin (as defined in the Amended Credit Agreement). Repayment of all then outstanding principal, interest, fees and costs is due on January 9, 2015. The Letter of Credit Facility provides that upon our application, BB&T shall issue to our credit one or more letters of credit in the aggregate amount of up to $15 million, or such lesser amount as may be required by law. We shall reimburse BB&T for all amounts payable, including interest, under a Letter of Credit at the earlier of (i) the date set forth in the application or (ii) on business day after the payment under such Letter of Credit by BB&T. On February 26, 2013, we entered into a First Amendment ("First Amendment") to the Amended Credit Agreement dated as of January 6, 2012. Pursuant to the First Amendment, the Amended Credit Agreement was amended to temporarily increase the maximum amount of the Revolver Loans from $100 millionto $125 millionduring the period from February 26, 2013through and including June 30, 2013to meet seasonal cash requirements and reduce certain interest rate margins and costs. In conjunction with the First Amendment, the Revolver Notes executed by us to each of BB&T and Wells Fargo dated as of January 6, 2012were amended and restated. The maximum amount of the Revolver Loans reverted to $100 millionon July 1, 2013. On December 17, 2013, we entered into a Second Amendment ("Second Amendment") to the Amended Credit Agreement dated as of January 6, 2012, as amended by the First Amendment dated February 26, 2013(the "Credit Agreement"). Pursuant to the Second Amendment, the Credit Agreement was amended to temporarily increase the maximum amount of the Revolver Loans from $100 millionto $125 millionduring the period from January 1, 2014through and including June 30, 2014to meet seasonal cash requirements. No other material changes were made to the terms of the Credit Agreement. Amounts drawn under the Revolver Loans are subject to a borrowing base consisting of certain accounts receivables, inventories, machinery and equipment and real estate. At December 31, 2013, we had no outstanding borrowings under the Revolver Loans and additional available borrowing capacity of approximately $71.9 million. 29
Table of Contents
Compliance with Debt Covenants and Restrictions. Our ability to make scheduled principal and interest payments, borrow and repay amounts under any outstanding revolving credit facility and continue to comply with any loan covenants depends primarily on our ability to generate sufficient cash flow from operations. To remain in compliance with financial covenants in the Credit Agreement, we are required to maintain specified financial ratios based on levels of debt, capital, net worth, fixed charges, and earnings (excluding extraordinary gains and extraordinary non-cash losses) before interest, taxes, depreciation and amortization, all of which are subject to the risks of the business, some of which are discussed in this report under "Risk Factors." We were in compliance with all covenants contained in our Loans at
December 31, 2013. Under the Credit Agreement, the material financial covenants and restrictions are as follows:
(a) Minimum Consolidated Net Worth. We agreed that we will maintain
Consolidated Net Worth, measured as of the end of each
commencing with the
Fiscal Quarterended December 31, 2011, of not less than $85 million.
(b) Fixed Charge Coverage Ratio. We agreed that we will not permit the Fixed
Charge Coverage Ratio to be less than 1.15 to 1.0, measured as of the end
Fiscal Quarter, commencing with the Fiscal Quarterended December 31, 2011.
(c) Consolidated Debt to Consolidated EBITDA Ratio. We agreed that we will not
permit the Consolidated Debt to Consolidated EBITDA Ratio to exceed 3.5 to 1.0 measured as of the end of each
Fiscal Quarter(and in the case of Consolidated EBITDA, for the four-quarter period ending on such date)
after the date on which the Senior Subordinated Notes have been redeemed
Failure to comply with the financial covenants in our Credit Agreement could be considered a default of our repayment obligations and, among other remedies, could accelerate payment of any amounts outstanding under our Credit Agreement.
Contractual Obligations. The following tables show, as of
December 31, 2013, our contractual obligations and commercial commitments, which consist primarily of purchase commitments and operating leases (in thousands): Contractual Obligations Payments Due by Period Less than After Total 1 year 1-3 years 4-5 years 5 years Purchase commitments (1) 35,581 23,608 11,924 49 - Operating leases 44,272 6,803 11,651 10,620 15,198
Total contractual cash obligations
(1) Purchase commitments represent supply contracts with third-party
manufacturers and raw material vendors.
We do not have off-balance sheet financing arrangements other than operating leases.
Capital and Other Cash Requirements. We made capital expenditures of
$13.1 millionin 2013, $7.6 millionin 2012 and $7.4 millionin 2011, primarily related to new products and to make process and productivity improvements. We currently estimate that capital expenditures in 2014 will be approximately $15 million. Capital expenditures in 2014 are expected to be used primarily to support cost reduction initiatives, new product launches in current and adjacent categories and general business support. 30
Table of Contents
We believe that cash on hand, cash flow from operations and borrowings expected to be available under our revolving credit facility will provide sufficient funds to enable us to fund planned capital expenditures, make scheduled principal and interest payments, fund the warranty reserve, meet other cash requirements and maintain compliance with terms of our debt agreements for at least the next 12 months. We currently expect to fund future capital expenditures from operations and borrowings under the revolving credit facility. The actual amount and timing of future capital requirements may differ materially from our estimate depending on the demand for
Trexand new market developments and opportunities. Our ability to meet our cash needs during the next 12 months and thereafter could be adversely affected by various circumstances, including increases in raw materials and product replacement costs, quality control problems, higher than expected product warranty claims, service disruptions and lower than expected collections of accounts receivable. In addition, any failure to negotiate amendments to our existing debt agreements to resolve any future noncompliance with financial covenants could adversely affect our liquidity by reducing access to revolving credit borrowings needed primarily to fund seasonal borrowing needs. We may determine that it is necessary or desirable to obtain financing through bank borrowings or the issuance of debt or equity securities to address such contingencies or changes to our business plan. Debt financing would increase our level of indebtedness, while equity financing would dilute the ownership of our stockholders. There can be no assurance as to whether, or as to the terms on which, we would be able to obtain such financing, which would be restricted by covenants contained in our existing debt agreements.