News Column

TREX CO INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 5, 2014

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" in our Annual Report on Form 10-K for fiscal year 2013 filed with the Securities and Exchange Commission. 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.

Overview

General. 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 and 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 three principal decking products: Trex Transcend®, Trex Enhance®, and Trex Select®; three principal railing products: Trex Transcend 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, Trex Seclusions®; 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 Trex Designer Series Railing®, which we do not believe will have a material impact on our results of operations or cash flow.

Highlights related to the first quarter of 2014 include:

• Sales volumes in the quarter were suppressed primarily as a result of poor weather conditions, which delayed the start to the deck-building season. • During the quarter, the Board of Directors approved a two-for-one stock split, which will be in the form of a stock dividend to be distributed on May 7, 2014 to stockholders of record at the close of business on April 7, 2014.



Net Sales. Net sales consists 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 Trex products. Our branding and product differentiation strategy enables us to command premium prices over wood products. Our operating results have 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.

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We launched our early buy program for the 2014 decking season in December 2013. The timing and terms of the 2014 program were 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 2013 were higher than in December 2012 due, 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. 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 Trex products. 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.

Product Warranty. We continue to receive and settle claims related to material produced at our Nevada facility prior to 2007 that exhibits surface flaking and maintain a warranty reserve to provide for the settlement of these claims. We monitor surface flaking claims activity each quarter for indications that our estimates require revision. Due to extensive use of decks during the summer outdoor season, variances to annual claims expectations are typically more meaningful during the latter part of the fiscal year. Through the first quarter of 2014, the number of claims received was slightly lower than our expectations. Average cost per claim was lower than the 2013 quarter but higher than the cost expected for 2014. We expect the average cost per claim to decline throughout the year. At March 31, 2014, we believe that our warranty reserve is sufficient to cover future surface flaking obligations.

The following table details surface flaking claims activity related to our warranty: Three Months Ended March 31, 2014 2013 Claims unresolved, beginning of period 4,249 4,073 Claims received (1) 536 633 Claims resolved (2) (1,260 ) (1,396 ) Claims unresolved, end of period 3,525 3,310 Average cost per claim (3) $ 2,296$ 2,379



(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).

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.

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Results of Operations

The following table shows, for the three months ended March 31, 2014 and 2013, respectively, selected statement of comprehensive income data as a percentage of net sales: Three Months Ended March 31, 2014 2013 Net sales 100.0 % 100.0 % Cost of sales 62.1 61.2 Gross profit 37.9 38.8 Selling, general and administrative expenses 18.1 18.4 Income from operations 19.8 20.4 Interest expense, net 0.3 0.2 Income before income taxes 19.5 20.2 Provision for income taxes 7.3 0.2 Net income 12.2 % 20.0 %



Three Months Ended March 31, 2014 Compared With Three Months Ended March 31, 2013

Net Sales. Net sales in the quarter ended March 31, 2014 (the "2014 quarter") decreased 6.7% to $100.6 million from $107.9 million in the quarter ended March 31, 2013 (the "2013 quarter"). The decrease in net sales was due to a 5.6% decrease in sales volumes and a 1.2% decrease in the average price per unit. The decrease in sales volume was a result of unfavorable weather conditions in the 2014 quarter that delayed the start to the deck-building season and strong demand from both new and existing dealers in late 2013, which depressed the 2014 quarter sales volumes. The decrease in average price per unit in the 2014 quarter was primarily attributable to our revised pricing strategy implemented in the fourth quarter of 2013. This pricing strategy provides a more optimal pricing position for our high-performance products in the marketplace.

Gross Profit. Gross profit decreased 8.8% to $38.2 million in the 2014 quarter from $41.9 million in the 2013 quarter. Gross profit as a percentage of net sales, gross margin, decreased to 37.9% in the 2014 quarter from 38.8% in the 2013 quarter. The decrease in gross margin was primarily the result of the aforementioned revised pricing strategy, partially offset by favorable manufacturing efficiencies.

Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased $1.6 million, or 8.2% to $18.2 million in the 2014 quarter from $19.8 million in the 2013 quarter. The decrease was primarily driven by a $1.4 million reduction in branding expenses in the 2014 quarter due to the delayed start to the deck-building season and a $0.7 decrease in personnel related expenses. These were partially offset by a $0.6 million charge in the 2014 quarter related to our 2005 reconsidered corporate headquarters lease. As a percentage of net sales, total selling, general and administrative expenses decreased to 18.1% in the 2014 quarter from 18.4% in the 2013 quarter.

Interest Expense. Net interest expense increased $72 thousand, or 28.7% to $323 thousand in the 2014 quarter from $251 thousand in the 2013 quarter. This was driven by an increase in debt balances under the revolving credit facility in the 2014 quarter compared to the 2013 quarter. As a percentage of net sales, interest expense increased to 0.3% in the 2014 quarter from 0.2% in the 2013 quarter.

Provision for Income Taxes. The effective tax rate for the 2014 quarter and 2013 quarter was 37.3% and 0.9%, respectively, which resulted in expense of $7.3 million and $0.2 million for the respective quarters. The effective tax rate was substantially lower in the 2013 quarter due to the effect of the valuation allowance we maintained against our net deferred tax assets which substantially offset statutory income tax.

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Liquidity and Capital Resources

We finance operations and growth primarily with cash flow from operations, borrowings under our revolving credit facility, operating leases and normal trade credit terms from operating activities.

At March 31, 2014, we had $3.7 million of cash and cash equivalents.

Sources and Uses of Cash. Cash used in operating activities for the 2014 quarter was $82.0 million compared to $66.0 million for the 2013 quarter. Cash used in operating activities increased primarily due to unfavorable changes in cash flows related to inventory, accounts payable and reduced earnings, partially offset by a reduced investment in accounts receivable as compared to the 2013 quarter. Inventories increased $7.8 million in the 2014 quarter to support expected demand in the second quarter. Additionally, we used more cash to pay down accounts payable balances in the 2014 quarter primarily due to the timing of payments. As compared to the 2013 quarter, cash flow from operations was favorably affected in the 2014 quarter due to the timing of sales and associated changes in accounts receivable balances. Due primarily to additions to our distribution network and a revised pricing strategy, a greater portion of our pre-decking season sales took place in late 2013. Accordingly, a greater portion of the investment in accounts receivable occurred in late 2013, which created a favorable effect on the 2014 quarter as compared to the 2013 quarter. The accounts receivable balances at the end of both the 2014 and 2013 quarters were comparable. Significant increases in our accounts receivable balances during the first quarter of each year are typical as distributors purchase product ahead of the deck-building season. We expect to collect substantially all outstanding accounts receivable balances by the end of the second quarter of 2014.

Cash used in investing activities totaled $3.2 million in the 2014 quarter compared to cash used in investing activities of $1.8 million in the 2013 quarter. The key driver to the increase in the 2014 quarter reflects capital expenditures in support of new poly processing lines. Capital expenditures in the 2014 quarter also included continued retrofitting to our current production lines to support the manufacture of our high-performance product lines.

Cash provided by financing activities was $85.2 million in the 2014 quarter compared to $67.5 million in the 2013 quarter. The $17.7 million increase was primarily due to an increase in our net borrowing from the revolving credit facility, which was $80 million in the 2014 quarter compared to $67 million in the 2013 quarter. The borrowings during the 2014 and 2013 quarters were used to support our seasonal working capital needs and are generally substantially repaid during the subsequent quarter as accounts receivable balances are collected.

On February 19, 2014, the Company's Board of Directors authorized an additional common stock repurchase program of up to $50 million of the Company's outstanding common stock (the "February 2014 Stock Repurchase Program"). This authorization has no expiration date. During the three months ended March 31, 2014, the Company made no repurchases under the February 2014 Stock Repurchase Program.

Capital Requirements. Capital expenditures in the 2014 quarter totaled $3.2 million related to new poly processing lines and continued retrofitting to our current production lines to support the manufacture of our high-performance product lines. We currently estimate that our capital expenditures in 2014 will be approximately $15 million.

Indebtedness. At March 31, 2014, our indebtedness totaled $80 million, and the interest rate on our revolving credit facility was 1.9%.

On December 17, 2013, we amended our revolving credit facility to temporarily increase the maximum amount of the revolving loans from $100 million to $125 million during the period from January 1, 2014 through and including June 30, 2014 to meet seasonal cash requirements.

Our ability to borrow under our revolving credit facility is tied to a borrowing base that consists of certain accounts receivables, inventories, machinery and equipment and real estate. At March 31, 2014, we had $80 million of outstanding borrowings under the revolving credit facility and remaining available borrowing capacity of approximately $45 million.

Debt Covenants. To remain in compliance with covenants contained within our debt agreements, we must maintain specified financial ratios based on levels of debt, capital, net worth, fixed charges, and earnings before interest, taxes, depreciation and amortization. At March 31, 2014, we were in compliance with these covenants. Failure to comply with our loan covenants might cause our lenders to accelerate our repayment obligations under our credit facility, which may be declared payable immediately based on a default.

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We believe that cash on hand, cash from operations and borrowings expected to be available under our revolving credit facility will provide sufficient funds to fund planned capital expenditures, make scheduled principal and interest payments, fund warranty payments and meet other cash requirements. We currently expect to fund future capital expenditures from operations and financing activities. The actual amount and timing of future capital requirements may differ materially from our estimate depending on the demand for Trex and new market developments and opportunities.

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. The distributors in turn sell the products to approximately 3,100 dealers who in turn sell the products to end users. While we do not typically receive information regarding inventory in the distribution channel from dealers, we occasionally 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 channels at any time. We believe that distributor inventory levels as of March 31, 2014 are comparable to distributor inventory levels as of March 31, 2013. Significant changes in inventory levels in the distribution channel without a corresponding change in end-use demand could have an adverse effect on future sales.

Product Warranty. We continue to receive and settle claims related to material produced at our Nevada facility prior to 2007 that exhibits surface flaking, which has had a material adverse effect on cash flow from operations. We estimate that the number of claims received will continue to decline over time. If the level of new claims received does not decline consistent with our expectations, it could result in additional increases to the warranty reserve and reduced earnings and cash flow in future periods.


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Source: Edgar Glimpses