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Trex (NYSE:TREX)
Q1 2018 Earnings Conference Call
May. 7, 2018 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good evening, and welcome to the Trex Company first-quarter 2018 earnings conference call. All participants will be in a listen-only mode. [Operator instructions] I would now like to turn the conference over to Viktoriia Nakhla. Please go ahead.

Viktoriia Nakhla -- Investor Relations

Thank you all for joining us today. With us on the call are Jim Cline, president and chief executive officer, and Bryan Fairbanks, 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 closed containing financial results of the first quarter of 2018.

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?

William R. Gupp -- General Counsel and Secretary

Thank you, Viktoriia. Before we begin, let 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 law. The statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking. For a discussion of such risks and uncertainties, please see our most recent form 10-K and form 10-Q.

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 Jim Cline.

James E. Cline -- President and Chief Executive Officer

Thank you, Bill, and thank you all for participating in today's conference call. This was a strong quarter for Trex, representing our fifth consecutive quarter of record revenue and net income and a positive start to another growth year for the company. First quarter of 2018 sales results reflect the expected high single-digit growth in Trex residential products. In the December through March time period, we focus on stocking orders from our distributors and dealers adequate inventory is available in advance of the peak decking and railing season.

Our year-over-year residential organic demand for the first quarter and for the first four months of this year indicates a much stronger, low double-digit demand curve. Economic forecast support our expectations for continued progress in 2018. First, the repair and remodeling market is expected to grow at a high single-digit rate in 2018 and exterior property improvement, the subsector the most closely aligns with Trex residential is expected to capture 34% of the home improvement spending. At the same time, consumer confidence is at its highest level since 2004.

This index historically correlated well with Trex residential sales. From a company perspective, our data analytic show that the North American consumers been very active in the marketplace so far in 2018. Despite the long winter that has persisted in parts of the country, we're seeing record activity on our website, and our trade partners continue to report positive point of sale data. Also, with lumber pricing increasing, the Trex value proposition for decking railing has become even more attractive to consumers.

And it's not just a question of pricing. The quality of certain wood species is not as good as it was in the past. All of this underpins our conviction that the composite category will continue to gain share from wood. As the undisputed category leader, we believe the Trex is capturing more than its share of the conversion from wood.

This represents an actual return on the investments we have made in our targeted marketing programs that we roll out over three years ago. We also reported during the first quarter that Trex was honored with awards from the 2018 Builder Brand Use Study. For the 11th consecutive year, Trex was named as the Brand Most Used and the Brand Most Used in the past two years for composite PVC decking category. Trex also took the top position in quality category in this year's study.

Trex commercial products also had an improved first quarter and its performance was consistent with our expectations reflecting a solid backlog as well as new project wins. As you know, we are a leading provider in the domestic commercial railing market, which we estimate at approximately $1 billion. We continue to be the market share leader for all major stadium projects with about 85% of all major stadiums and arenas in North America. A good example of recently completed project is the Little Caesars Arena in Detroit, which is home to the NBA Pistons and the NHL Red Wings.

The project included over 18,000 feet of Trex commercial railing. The arena was designed to engage fans and features gondola-style seating that is suspended above the playing area, accompanied by several hundred feet of strong, secure glass track rail provided by Trex commercial products. Our involvement in a project of this scope can last for several years from planning to final installation. But we also built for refurbishment of college stadiums and smaller athletic venues like soccer and tennis stadiums that have a much shorter project cycle.

We are pleased with our first-quarter gross-margin performance as it was in line with our expectations for continued expansion of our residential and commercial gross margin. In residential, the drivers high gross margin were similar to the prior quarters, which Bryan will detail later. One of our major manufacturing cost-savings initiatives, which I mentioned last quarter, involves improvements to our production lines that will provide a step change in the manufacturing process of our deck boards. We began implementing the first phase of these manufacturing enhancements in the first quarter of 2018.

We will complete the retrofit to the remaining lines by the end of this year. In the first quarter, we utilized one of our production lines for a significant number of trials, and the results of those trials of the first phase were outstanding. When the first phase of this is completed and the fourth quarter of this year, available capacity will increase by at least 20%. More to come on this as the year progresses.

The commercial gross margin recovered from the fourth-quarter levels reflecting the roll-off of several legacy projects. We continue to make progress on margin improvement with the execution of a number of cost-reduction initiatives and improved acquisition of estimating and project management. We continue to be confident in our ability to drive margin improvement through the second half of this year. I will now turn the call over to Bryan Fairbanks, our chief financial officer, to provide further insight into our financial results for the period. Bryan?

Bryan H. Fairbanks -- Chief Financial Officer

Thank you, Jim. Good afternoon, everyone. We're pleased to report strong year-over-year comparisons driven by increased recognition of the Trex brand and operational performance. First quarter 2018 consolidated net sales amounted to $171 million, representing an 18% year-over-year increase, as higher volumes in Trex residential products drove 7% sales growth to $155 million.

We're also pleased with Trex commercial products' contribution of $16 million. Consolidated gross margin was 44.8%, compared to the 45% reported in the first quarter of 2017. The impact of the inclusion of lower margin Trex commercial products was almost completely offset by the strength in Trex residential, where gross margin expanded 260 basis points to 47.6%. This significant margin expansion was due mainly to material cost advantages and manufacturing cost savings, which together accounted for approximately 80% of the year-on-year improvement and higher capacity utilization, which represented 20% of the increase.

Trex continues to benefit from the use of low-cost raw material streams, which provides a significant cost advantage. Also, we're investing in R&D programs to develop processes that will allow us to use a greater variety of scrap material, including lower cost and harder-to-recycle sources. Trex commercial products gross margin at 17.7% for the first quarter improved from the fourth quarter 2017 as lower-margin legacy contracts began to roll off. As Jim mentioned earlier, we're confident in our ability to improve commercial gross margins this year.

The challenges we see in the commercial business are similar to the ones we faced at Trex a number of years ago. And our teams are working together to deliver margin improvement by the beginning of this year's third quarter. SG&A for the quarter totaled $29 million. Brand-related expenses that drive market share gains, the inclusion of Trex commercial products, and $1.2 million in noncash amortization of intangible expenses related to our recent acquisition resulted in a $5.7 million increase in SG&A.

This represented 16.9% of sales, compared to 16.1% of sales in the year-ago quarter. Exclusive of amortization expense, SG&A was 16.2% of sales for the quarter, 10 basis points above the comparable quarter in 2017. Net income amounted to $337 million, or $1.25 per diluted share, representing year-over-year increases of 33% and 32%, respectively, from $28 million, or $0.95 per diluted share reported in the last year's first quarter. This increase was partially attributed to timing related to a lower tax rate of 22%, which resulted from reduced federal statutory rate and benefits realized in the quarter on divesting of stock compensation.

With respect to capital allocation, in the first quarter, we invested in a number of fast-return projects that will result in future manufacturing cost savings, process improvements and other operating efficiencies. Additionally, we repurchased 50,000 shares of our outstanding common stock for a total outlay of $5 million as part of the share-buyback program authorized by the board of directors in February 2018. For financial modeling purposes, please note the following items; we expect consolidated incremental margin for the full-year 2018 to be approximately 45% to 50%. We project the improvement to be second-half weighted related to the manufacturing process enhancements noted by Jim and margin improvements in the Trex commercial projects (sic) segment.

Full-year capital spending is projected between $20 million and $25 million. SG&A is expected at approximately 17.5% of sales for the year. The remaining intangible expense related to the SC acquisition is approximately $1.7 million and will be fully amortized by the end of the third quarter. We expect the full-year tax rate for 2018 to be 25%.

As Jim noted, the board of directors approved a 2- for-1 stock split of the company's common shares in the form of a stock dividend to be distributed on June 18, 2018, to the shareholders of record at the close of business on May 23, 2018. Now I'll turn the call back to Jim for his closing remarks.

James E. Cline -- President and Chief Executive Officer

Thanks, Bryan. We're off to a solid start in 2018. The environment for consumer spending on home improvement and for outdoor living, in particular, remained strong, and we are seeing positive comparisons in Trex commercial. At the same time, we have begun to benefit from the cross-product development between our residential and commercial operations.

While we're seeing some increased costs in transportation, metals and certain other categories, we have clearly been able to more than offset these increases with cost-reduction initiatives and favorable capacity utilization. In the second quarter, we expect to report consolidated sales of $191 million. We anticipate that Trex residential sales will be $174 million and Trex commercial products will contribute $17 million. This will represent a year-on-year growth of 10% for residential and 21% on a consolidated basis.

Reflecting our positive long-term outlook, the board of directors has approved a 2-for-1 stock split to be distributed on June 18 to shareholders of record on May 23, 2018. Operator, I'd now like to open the call to questions.

Questions and Answers:

Operator

We will now begin the question-and-answer session. Our first question comes from Matt McCall with Seaport Global Securities. Please go ahead.

Matt McCall -- Seaport Global Securities -- Analyst

Thank you. Good afternoon, guys.

Bryan H. Fairbanks -- Chief Financial Officer

Good afternoon.

Matt McCall -- Seaport Global Securities -- Analyst

Bryan, first, thanks for the details around the drivers of the gross margin improvement. That was helpful. Maybe on that note, you'd originally talked about 45% gross contribution margin last year. You've inched that a little bit harder.

I was curious about which one of those markets has given you the comfort to take that range higher? Where is the incremental benefit coming from?

Bryan H. Fairbanks -- Chief Financial Officer

Yes, the guidance that we provided, consistent with what we talked about at year-end for the full calendar year 2018, we see very similar type benefits of what we've seen in the past couple of years. We'll still have strong operational savings from our cost initiative programs. We'll see utilization. The raw material benefits won't be driven as much through pricing.

We've talked in the past about gradual decline in pricing in the marketplace. But more so related to the efforts that we have from an internal perspective with R&D and operations to find different classes of material that can be used that may not be actively sought after today. So we'd expect that the categorization of those savings to fall roughly into the same buckets and not too different of amounts.

Matt McCall -- Seaport Global Securities -- Analyst

OK, OK. That's helpful. Jim, you talked about the expected step function and that the capacity you're going to open up later this year. And I know you're talking about some cost-efficiency efforts maybe.

Are they separate -- are the two separate? Or are we talking about kind of the same thing? What I'm getting at here, you talk about step function from a utilization perspective. What about from a margin perspective? What about from a revenue perspective? Are you going to be able to benefit on the top line from the debottlenecking you referenced?

James E. Cline -- President and Chief Executive Officer

Well, we've been able to service our customers within a two-week lead time in season. So it really doesn't expand our capabilities to handle more sales. It's really two things. It has a buffer on our capacity that is something that we need to pay attention to as we go forward.

This is the first of at least four phases that we've identified. So we see follow-on opportunities clearly beyond this first move. There will be cost reductions that we'll start to see in the second half of this year, but the full benefit of this first phase won't be recognized until 2019.

Matt McCall -- Seaport Global Securities -- Analyst

And are those cost reductions reflected in the new contribution margin outlook?

James E. Cline -- President and Chief Executive Officer

They are for 2018.

Matt McCall -- Seaport Global Securities -- Analyst

2018. OK. And then, I guess, the last question I had. You talked about the initial stocking period and how that's been encouraging.

You talked about a low double-digit demand curve. So want to make sure I understand what you're referencing there. I think you were up 7% in the quarter. But sounds like the incoming order rate might be higher than that.

And is there any indication -- I know we've talked in the past about some of the pricing actions that your competitors took. Any indication that's turning into incremental volume for Trex in the form of restocking or anything like that?

James E. Cline -- President and Chief Executive Officer

Yes. It's too early on any effect related to competitor pricing. But compared to the 7% we showed on sales to load the channel, clearly, the organic sales in the first quarter was substantially greater than that 7%. Also as we went into April, we again saw very strong organic demand that basically is much closer to that point-of-sale information that we like to track.

It is not unusual for us to start out with a lower percentage, because we do a very heavy load-up when the material is not really required so that we get it downstream so that we've got both the distributor and dealer with product on the ground ready to be able to respond to the demands of the consumer at the retail level.

Matt McCall -- Seaport Global Securities -- Analyst

OK. Thank you, Jim.

James E. Cline -- President and Chief Executive Officer

You're welcome.

Operator

Our next is from Alex Rygiel with B. Riley FBR. Please go ahead. [Silence] Hello, Alex, your line is live, you may proceed with your question, please.

Alex Rygiel -- B. Riley FBR -- Analyst

Thank you. Congratulations on a nice quarter, gentlemen.

James E. Cline -- President and Chief Executive Officer

Thank you.

Alex Rygiel -- B. Riley FBR -- Analyst

As it relates to lumber inflation, can you talk about how that affected your business? And have you seen pressure-treated lumber inflate as well?

James E. Cline -- President and Chief Executive Officer

Yes. What we're seeing is, with cedar and redwood in particular, prices have gone up considerably on both of those. Quality is not as good as what it has been in the past. And so we're extremely competitive now in both of those arenas.

We have not seen a movement on the pressure-treated of any significance. I think at some point we will see they have the same inflationary dynamics that affect them with regard to the raw lumber. And I think it's a matter of time before they will be looking at price increases to the marketplace.

Alex Rygiel -- B. Riley FBR -- Analyst

And as it relates to the commercial business, can you discuss the second-half outlook as it relates to the top line with regards to seasonality and the backlog and what kind of visibility it gives you?

Bryan H. Fairbanks -- Chief Financial Officer

Yes. So we do have a backlog that goes out between generally six to 18 months related to our projects. So we do have visibility that of when the projects and the revenue will be coming through on it. There is some seasonality to the business, not to the extent that we see in the decking and railing business.

But we are projecting that the business will grow in excess of what the residential segment will be growing on a full-year basis.

Alex Rygiel -- B. Riley FBR -- Analyst

Thank you,

Operator

Our next question is from Frank Camma with Sidoti and Company. Please go ahead.

Frank Faiella -- Sidoti & Company -- Analyst

Hey, guys. It's Frank Faiella on for Frank Camma. I have a question on the raw materials, but more so on the commercial side. Past calls, you've talked about the stainless steel and aluminum.

I was wondering if you could talk about some of your sourcing for those too.

Bryan H. Fairbanks -- Chief Financial Officer

Yes. So we have sourcing agreements with -- for both stainless steel and aluminum through a number of different suppliers. It's both within the residential as well as the commercial segment. We have seen some inflationary measures there with some of the recent tariffs.

There's also been some volatility in those markets as well. For the bids we put together, we do try to include enough provisions to be able to protect for the price increases as we go forward, or have clauses that allow for repricing as necessary. And it's something that we're aware of, and we monitor closely as we're estimating these projects. And having that direct information and on a timely basis is important, as we're preparing these estimates on projects that can range up to 18 months.

Frank Faiella -- Sidoti & Company -- Analyst

OK. And then just staying on the same subject. Last quarter, it sounded like on that commercial business, the -- I guess it was a little behind, but it was really just a timing thing. So I was just wondering if that's still the case or if you made up for [Inaudible] any of that timing of projects? Or if you could talk anything about that?

Bryan H. Fairbanks -- Chief Financial Officer

So it was just really the catch-up from the fourth quarter. We were a little bit below where we expected to be in the fourth quarter and came in a little bit higher in the first quarter of this year. As we said, these projects are due exactly when the revenue gets booked. It can't move from quarter to quarter.

We've got good visibility. But within a couple of million dollars, it can't move from quarter to quarter. So that was really the only dynamic that we saw in the first quarter.

Frank Faiella -- Sidoti & Company -- Analyst

Great. Thanks. That's all I have. Thank you.

Operator

Our next question comes from John Baugh with Stifel. Please go ahead.

John Baugh -- Stifel Financial Corp. -- Analyst

Thank you. My congrats as well on a terrific quarter. Jim, I was wondering, is the raw-material cost input -- are you still seeing a like-for-like decline in that? Or is that sort of flattened out? Or I guess, is all the benefit from being able to source, I guess, lower-quality, lower-cost waste streams?

James E. Cline -- President and Chief Executive Officer

You're referring to the poly, in particular, I think, right?

John Baugh -- Stifel Financial Corp. -- Analyst

Yes.

James E. Cline -- President and Chief Executive Officer

Yes. We really look at this in two ways. If you did a like-for-like in the poly, it seems to be a slightly weakening market. We have been very focused on trying to qualify new materials, as Trex has been very successful with this approach in the past.

But we're trying to qualify these new materials that basically nobody else wants. And what that means is, we can take materials that are lower-price and being able to use those, maybe 25% or even 50% of what our material costs would be at these lower-price items, that helps drive our overall cost profile to a lower level. And that's something we've always done. I think we're getting a little better at it.

And we've been pretty successful over the last 12 to 18 months, in particular.

John Baugh -- Stifel Financial Corp. -- Analyst

Right. And then the process improvements and capacity, is there any way to give us a sense for -- I know you don't want to give out your capacity utilization numbers. But I guess -- I'm just trying to figure out how this may or may not influence capital spending plans out in -- some period in the future in terms of being able to push that out? Or, put another way, when would -- would we might expect you have to meaningfully spend more capital to expand capacity to solve that problem for several years?

James E. Cline -- President and Chief Executive Officer

Yes. When we look out at our capacity requirements, we're basically going out three to four years and looking at our capacity requirements. Before this 20% improvement, we did not have a need for an additional building for the next three to four years. So this further pushes out the need for additional production facilities with this first phase.

And, again, I mentioned first phase. We do have four phases of this process that we've identified. And it's our belief that we can eventually push the requirements for an additional manufacturing facility out considerably further with the additional phases. As with anything, you take a low-hanging fruit first with the lowest capex spend and the best bang for your buck and that's what we've done for 2018.

It starts to get more expensive as you go into 2019, '20 and beyond. But at this point, we've -- we're basically doing the first phases straight at on. Second phase will be replace equipment that needs to be replaced anyway with better equipment that will enhance our throughput. So part of this would be replacement capital, but with additional throughput capabilities on the replacement side.

John Baugh -- Stifel Financial Corp. -- Analyst

Great. Last question. Can you give us any sense -- and maybe you need to look backwards at calendar '17 as opposed to the first four months of this year. But I'm trying to get a sense on the residential market.

If you're growing in that 10% area, how much of that, you think, is you're getting some share from wood versus maybe how you're doing versus your WPC competitors?

James E. Cline -- President and Chief Executive Officer

Yes. it's a tough number to come by. The overall market change, I think when we end up this year, I wouldn't be surprised to see the wood market lose about 1 point of share. That would be about $50 million.

Now that would be spread between us and other competitors. We believe, because of our campaign that we've been very active on, the customers that we have, we think that we pick up a greater percentage of that wood add. So I think the benefit there moves us certainly above the expected high single digit that -- growth that the market is expected for composite material.

John Baugh -- Stifel Financial Corp. -- Analyst

Great. Thanks for that color and congrats. Good luck.

James E. Cline -- President and Chief Executive Officer

Thank you.

Operator

[Operator instructions] Our next question is from Keith Hughes with SunTrust. Please go ahead.

Keith Huges -- SunTrust Robinson Humphrey -- Analyst

Thank you. You were giving a description of the step change of manufacturing. And the first phase this year with an add-on. Is there something in the first place? Does this increase production speed or does it -- lowering cost? Or is there something that you use less material with? I don't really understand what you mean an add-on.

Bryan H. Fairbanks -- Chief Financial Officer

Well, basically, it's a retrofit of the production equipment. So we're adding additional equipment and that gives us a better throughput profile, better quality than what we had before.

Keith Huges -- SunTrust Robinson Humphrey -- Analyst

OK. And your discussion earlier of double-digit or a pace for double-digit gains for the year, you had a phenomenal organic growth in the second half of last year. Are those tough comps going to slow down the rate at all? Or is that kind of irrelevant to what the year looks like?

James E. Cline -- President and Chief Executive Officer

Yes, it's difficult to say how this is going to fall. And I think other people on calls have brought this issue up. But part of the issue that every company is running into right now is transportation. And it tends to make the sales for everybody.

It's going to make the sales for everybody a little bit lumpy. Things that you expect will drop in the second quarter may end up dropping in the third quarter. We're playing heads-up ball on that. We've seen this impacting us, for example, in the first quarter, where we had several million dollars' worth of orders that were scheduled to be shipped out, couldn't get wheels under it because of transportation.

That problem is going to be worse in June. And so we're working to move orders so that we can do not have that bottleneck at the end of the quarter. So I think it ends up being a little bit different mix than what we expected at the beginning of the year and being driven more by transportation than consumer demand.

Keith Huges -- SunTrust Robinson Humphrey -- Analyst

All right. Thank you.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Jim Cline for any closing remarks.

James E. Cline -- President and Chief Executive Officer

Thank you. We do not publicly give credit often enough to one of our greatest competitive advantages, our people. Our ongoing success would not be possible without the best team in the business. We recently did an employee engagement survey related to Trex and looked at our overall results.

It indicated three dimensional strengths that were quality customer focus, clear and promising direction, and employee engagement. These were significantly above industry nor and underscores where our team has been so successful, not only with our operating results, but equally important, with our customers and consumers. To all of our employees, thank you for your support of the company. And to our shareholders, we thank you for your confidence in Trex.

Wish everybody to have a good evening. Thank you.

Operator

[Operator signoff]

Duration: 34 minutes

Call Participants:

Viktoriia Nakhla -- Investor Relations

William R. Gupp -- General Counsel and Secretary

James E. Cline -- President and Chief Executive Officer

Bryan H. Fairbanks -- Chief Financial Officer

Matt McCall -- Seaport Global Securities -- Analyst

Alex Rygiel -- B. Riley FBR -- Analyst

Frank Faiella -- Sidoti & Company -- Analyst

John Baugh -- Stifel Financial Corp. -- Analyst

Keith Huges -- SunTrust Robinson Humphrey -- Analyst

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