Trex (NYSE:TREX) is the world's largest manufacturer of high-performance wood alternative (composite) decking and railing, with a roughly 45% to 50% share of the composite deck market. 

The company, based in Winchester, Virginia, sells an environmentally friendly product and has a relatively low CEO-to-worker pay ratio. But is this sustainability-based company a high-ESG investment? Read on to find out how it scores on environmental, social, and governance factors as defined by The Motley Fool ESG Compounder Checklist

As a pioneer in composite decking, Trex demonstrates how a company can effectively set a new standard for the future of manufacturing and construction by selling an innovative green product. Traditionally, decks of all kinds were made with wood, but Trex has played a leading role in changing the game with its wood alternative.

Wood alternatives are beautiful (with colors similar to natural wood), last longer and require less maintenance, and are more environmentally friendly. Trex decks are made of 95% recycled material, including plastic film (like plastic bags) and wood fiber (like sawdust). Its railing products are generally made with 40% to 50% recycled content. Its proprietary shell technology prevents aging, fading, staining, splintering, rotting, and warping of decks, and the only maintenance needed is occasional cleaning with soap and water.

A Trex deck

A Trex deck. Image source: Trex.

Wood decks, on the other hand, require regular sanding and a new coat of sealer, stain, or paint -- sometimes annually.

Trex decks don't become a home for termites, so there is no chemical pest control needed. They are LEED (Leadership in Energy and Environmental Design) certified and come with a 25-year limited warranty against defects. And its high-performance decking products have an additional 25-year fade and stain limited warranty.

Trex's low-maintenance decks cost roughly two to five times more than wood, depending on the performance tier which ranges from low-cost to premium, but they last for decades and offer a lower total cost of ownership over their lifetime.

According to Trex, a 320-square-foot deck made of wood will cost about $600, and a similar-sized Trex entry-level product costs roughly $1,200. But over the 25-year lifetime of a wood deck, maintenance costs will total about $4,700 -- and that $4,700 does not assume the deck is replaced in 25 years. A fair number of wood decks, in fact, are replaced after 15 years, according to Trex CFO Bryan Fairbanks. So a Trex deck saves hassle and money over time!

For 12 years in a row, Trex has been recognized as No. 1 in "brand familiarity," "brand used most," and "brand used most in the past two years" for the composite/PVC decking category in the Builder Magazine annual Brand Use Study. It has also been recognized as the "greenest" decking brand from Green Builder Magazine for eight years in a row and won the 2016 Environmental Vendor of the Year award from Home Depot (NYSE:HD). And its decks look great: It has won the Best of Houzz Design award five years in a row, named for the home-renovation website that bestows it.

It's sold in 6,700 retail locations around the world, including Home Depot and Lowe's (NYSE:LOW), the two largest home improvement chains that cater to both do-it-yourselfers and professional builders. Trex also sells to wholesale distributors, which then sell the products to retail lumber outlets.

About 90% of its sales are to residential customers and 10% are commercial. The latter are railing systems and modular staging systems used at sports stadiums and performing arts venues. The company is less exposed to the highly cyclical new-home construction market, as 95% of residential business comes from repair and remodeling projects.

There's no doubt that the business model is based on sustainability. But one of the first things an ESG investor likes to see is a company's corporate social responsibility report. Trex published its first sustainability report in 2018, signaling that it will strengthen its ESG commitment even further. It is not uncommon for smaller companies to wait to publish a sustainability report until they are large enough to devote the resources to the effort. Perhaps in the next few years, Trex will take the next step toward appointing a chief sustainability officer to manage a fully staffed sustainability department.

Its first sustainability report builds a strong foundation and demonstrates its path forward. In future reports, many ESG investors would probably like to see the company comply with respected reporting standards, such as the first global standards for sustainability known as Global Reporting Initiative (GRI), and share more-detailed sustainability goals and track its progress against those goals.

Now, we'll score Trex using The Motley Fool's 10-question framework for ESG investing:

1. Does the company treat its employees well?

Yes. There are a lot of ways to examine this. One of the big ones is pay. The median salary of a Trex employee is $66,844 -- above the national average of $60,336. CEO James E. Cline makes 39.4 times the average employee's salary, which shows Trex executives believe their employees deserve to be paid well. The average CEO of an S&P 500 company earned 287 times more than their median employee in 2018, according to the AFL-CIO labor federation

Another way to examine how employees are treated is to look at company reviews on Trex has few reviews, but what's there is promising -- including 83% of the reviewers saying they would recommend working at Trex to a friend and 71% approving of the CEO. The company also responds to each review on Glassdoor, which shows a desire to be responsive to employees.

Finally, the average tenure of the executive officers is more than 12 years -- so clearly, there's a lot of upward mobility in the company. While we can't know exactly what goes on behind closed doors, Trex shows all the signs of finding and retaining top talent. 

2. Is the company a good steward of the environment?

Yes. Sustainability is built into the fiber of the company. Its main products are composite decks made out of recycled plastic and reclaimed wood fiber. Each 500-square-foot deck uses 140,000 plastic bags. Trex estimates that each year, it diverts and repurposes 500 million pounds of recycled plastic from landfills. It says it's "the largest recycler of discarded plastic shopping bags and waste polyethylene film in North America" and that it also uses recycled aluminum and steel in its manufacturing.

An independent third party performed a life-cycle analysis comparing a Trex deck with pressure-treated lumber and found that Trex decks produce 36% less greenhouse gas emissions, 47% less criteria air pollutants, 53% less smog, and 93% less ecological toxicity. And since its decks are a wood alternative, they contribute far less to deforestation than wood decks.

In addition to the fundamental attributes of the company promoting sustainability, Trex is committed to reducing its carbon footprint by using a closed-loop water system that saves 160 million gallons of water per year, and having bicoastal factories to reduce the costs and length of shipping. 

Areas for improvement: Because Trex decks are made of plastic, there's no end-of-life recycling option yet. Unfortunately, a solution to this challenge is likely years off and will probably involve collaboration from various organizations across the industry.

3. Does the company promote diversity and inclusion?

No. Every company has areas for improvement, and diversity and inclusion is Trex's. The board of directors has just one woman, and its named executive officers are all men. It doesn't disclose the makeup of its employee base. For ESG investors, it would be good to see these ratios improve in the future. More-diverse organizations make better decisions, which lead to increased profitability, value creation, and ultimately a more equitable world.

4. Does the company have ethical corporate governance principles?

Yes. It checks many of the boxes for good corporate governance, including a low CEO-to-worker pay ratio; stock ownership guidelines for officers and directors; no dual-class stock structure; separate chairman and CEO roles; and incentive compensation partly based on free cash flow (FCF), a key driver of long-term business value.

Areas for improvement: Some investors may want to see more diversity, annual election of directors, and an even higher stock-ownership guidelines for executives.

5. Do the company's business model and its investments promote ESG principles?

Yes. Trex literally turns trash into treasure! 

6. Does the company have a healthy balance sheet?

Yes. At the end of the first quarter in 2019, it had net debt of $27 million (not including its long-term operating leases of roughly $39 million). But historically, Trex has used debt seasonally. It typically has a net debt position in the first and second quarters for working capital purposes and to fund its Early Buy Program, and then shifts back to a net cash position in the third and fourth quarters. The Early Buy program allows the company to decrease seasonality in the business and ensure adequate inventory ahead of its busy season.

It's likely that Trex will end 2019 with net cash, as it has done in the past. The company is not averse to maintaining a net debt position, but it will only do so if it's sure that adding debt will lead to sustainably high returns. Even with this seasonal debt on the balance sheet, the debt-to-capital ratio (including operating leases) is only 18%, and its interest coverage ratio is very high.

7. Can the company generate organic revenue growth supported by long-term tailwinds?

Yes. From 2013 to 2018, Trex increased revenue at a five-year compound annual growth rate (CAGR) of 14.8%, and it was able to grow free cash flow at a CAGR of nearly 27% thanks to improved margins.

Revenue growth is nearly all organic, but it did acquire its commercial products division for $72 million in July 2017. Growth is supported by an industry tailwind: Consumers and investors are starting to favor companies and products with attractive ESG profiles -- giving priority to growing through sustainable business practices. Trex sells a green product that's good for the planet and good for business.

Home remodeling in the U.S. has historically grown at 5% annually, according to the Leading Indicator of Remodeling Activity released by the Joint Center for Housing Studies of Harvard University. It's also projected to grow more than 5% in 2019. And you could reasonably assume that home remodeling will grow at an annualized rate of 5% over the next 10 years as well, and that Trex will continue to take market share and grow its top line at roughly two times the industry rate.

The company has roughly 50% of the composite deck market, gaining a whopping 20% market share since 2010! It likely won't gain another 20 percentage points of market share over the next decade, but Trex is focused on taking share from wood, which is still the material used in 83% of decks. Every percentage point of market share captured from wood adds $50 million in sales for Trex, according to the company.

And consider that for many of us, our home is our largest financial asset and the place where we create some of our best memories. So people will always invest in their homes. Decks are not only fun, but they also add real value (a composite-deck addition generates a 69% return on investment for homeowners on average).

2018 survey from SunTrust Banks states: "The popularity of outdoor improvements remains strong. Projects such as decks, patios and landscaping rank at the top of the list for the fifth year in a row, with 43% of homeowners planning to transform their outdoor spaces, up 5 percent over last year." Furthermore, according to Trex, 34% of home improvement spending is dedicated to the home's exterior.

The company also has a long-term opportunity to grow outside the U.S., since it ships products to 45 countries. It focuses on countries with high GDP, high personal income, and a desire for outdoor living solutions. The largest markets outside the U.S. are mainland Europe, the U.K., Scandinavia, and Australia. It doesn't break out geographical sales, but currently generates less than 10% of sales from outside the U.S.

8. Can the business generate growing free cash flow (FCF) and sustain high returns on invested capital (ROIC)?

Yes. Using low-cost discarded materials for raw input isn't just good for the planet, it's also good for profitability, cash flow, and ROIC.

From 2013 to 2018, gross margins jumped to 43% from 29%, and operating margins increased to 25% from roughly 8%, according to S&P Global Market Intelligence. During the same time, its ROIC increased to 38% from about 16%, according to S&P. Over that duration, Trex generated average margins in FCF (cash flow from operations less capital expenditures) of roughly 13%, and average FCF to net income (a measure of earnings quality) of 0.93. A FCF conversion ratio of 100% (or higher) is typically ideal, but that 93% is still in the safe zone, especially considering Trex is ramping up investments into property, plant, and equipment to drive long-term organic growth.  

Trex was able to generate improving margins and return on capital because:

  • It is a vertically integrated ultra-low-cost manufacturer with operating leverage. Strong organic sales growth allowed it to leverage its fixed assets and improve operating margins.
  • It is skilled at removing costs through initiatives known as lean manufacturing or Six Sigma.
  • It can cut costs through its vast in-house recycling program. Nearly 100% of factory scrap is recycled back into the manufacturing process, reducing the raw materials it must purchase and boosting the gross margin line.
  • China's restriction on certain scrap plastic imports left more scrap for Trex to buy cheaply.

While it doesn't generate any meaningful recurring revenue because its decks last a minimum of 25 years, and it does not implement annual price increases, two factors which generally lead to high ROIC, it does have sustainable moats. Its first price increase since 2011 was in January 2019 on some decking products to offset higher costs for input, labor, and freight.

Trex generates exceptionally high ROIC because it sells a sustainable product manufactured in a sustainable way, and because of its multiple competitive advantages (the all-important "moat"). A strong brand; a very low-cost, energy-efficient, proprietary manufacturing system; the strongest distribution network in the industry; its commitment to innovation and growing sustainably; and management's skills with capital allocation will generate strong ROIC and growing free cash flows for a long time to come.

9. Is the management team focused on long-term profitable growth?

Yes. Leadership is clearly focused on profitable growth. It reports ROIC and FCF in its investor presentation, and incentive compensation is partly based on FCF. Trex is highly skilled at investing to remove costs from the manufacturing process.

CEO Cline said, "It's the cost-reduction initiatives which have been so great in the contribution of additional dollars to the bottom line." This management team excels at operation and capital allocation, it understands the drivers of business value, and it's laser-focused on balancing top- and bottom-line growth.

Trex does not pay a dividend. Its capital allocation priority is to reinvest in the business to sustain organic growth. After that, excess cash flow is used for acquisitions and opportunistic share repurchases.

The long-term growth investments should have ESG investors most excited. The company recently announced plans for a major capital expenditure expansion to increase capacity to meet higher-than-expected demand. Clearly, it's investing heavily to not only drive growth, but to keep up with it -- a strong indicator of product relevance, brand equity, and a long runway for profitable growth.

10. Does the company have a medium- or lower-risk profile?

Yes. Out of the roughly 20 risks (listed near the bottom at this link) that investors should examine each company for, Trex has only two or three, and those are not particularly worrisome, so it falls safely into the medium-risk category.

It does have a high degree of customer concentration. Two of its wholesale distributors accounted for more than 10% of 2018 sales. Its top 15 customers account for roughly 85% to 90% of total sales. This risk deserves highlighting, but the business model of selling through a handful of trusted distributors that share in Trex's success is one reason it can generate sustained profitable growth.

There's also some seasonality and cyclicality because results are tied to residential remodeling/home improvement activity and somewhat to new home construction. So consumers' financial health is a factor. In the U.S., unemployment is currently at record lows, and wages are rising. And home equity values are high, allowing households to tap into that equity to pay for home renovations while consumer confidence is relatively high and the economy strong.

But these macro indicators will eventually weaken, so the biggest short-to-intermediate risk is a slump in the housing market or a broader economic slowdown. For historical perspective, Trex generated a loss in 2009 to 2011, during the trough of the housing crisis -- the worst such crisis and economic recession since the Great Depression. But it did generate positive FCF from 2009 to 2011.

Its business is seasonal because most decks are built in the summer and spring. Weather also has a real effect on short-term results so inventory levels can be somewhat unpredictable, which makes forecasting sales and cash flows in the short term a bit of a challenge. Its commercial business is also lumpy from year to year because it partly depends on the construction of large (and costly) sports and performing arts venues.

The seasonality and cyclicality mean that investors should focus on full-year results and its long-term outlook, rather than any one quarter.

Trex gets a high score

Trex scores a 9 out of 10 on The Motley Fool's ESG Compounder Checklist. That's an "A" in our books, Fools. Anyone seeking a solid ESG stock idea -- one that furthers the greater good and serves its stakeholders well (including shareholders) -- should consider adding Trex to their watch list.

Check out other companies scored by The Motley Fool's ESG Compounder Checklist: 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.