Composite-decking company Trex (TREX 1.72%) is an underfollowed stock, and that's unfortunate since this company is nearly a 30-bagger over the last decade. For those who missed this incredible run, a top Trex competitor, The AZEK Company (AZEK 0.76%), just went public via an initial public offering in June. Could early Azek investors be rewarded as handsomely as early Trex investors were?
As we'll see, Trex isn't just doing business in an attractive industry, it's also a good business itself. It's creating meaningful shareholder value, and that might not be the case with Azek. Indeed, there's no reason to believe Trex can't keep delivering outsize shareholder returns despite how much it's already gone up.
Why alternative decking is an investable idea
Real estate company Redfin is tracking a rising trend. More people are exiting urban areas and moving to the country, where homes typically have more outdoor space, and outdoor decks are often considered a necessity. According to the American Institute of Architects Home Design Trends Survey, homeowners are increasingly interested in outdoor spaces, and they want options that are low maintenance and durable. Wood-decking alternatives address all these considerations.
The majority of decks in the U.S. are currently made of wood. According to data cited by Azek, 78% of decks built in the U.S. in 2019 were wood, down from 80% the year before. Therefore, the shift to alternative decking is happening, but there's a long way to go.
Because of this, Trex and Azek are competing with pressure-treated lumber more than they're competing with each other. Consider that full-year sales for Azek are up 42% from fiscal 2017 through the end of fiscal 2020 (ended Sept. 30). But this robust growth didn't come at Trex's expense. Trex's full-year sales increased by 32% from 2017 through the end of 2019. And through the first three quarters of 2020, net sales are up another 12% year over year. In short, both companies are growing, and can keep doing so without eating into each other's revenue.
The differences between Trex and Azek
Trex primarily manufactures decking, using wood and sawdust to mimic the look and feel of real wood. Azek has decking materials like this, too, but also has a broader portfolio including pavers, siding, and column wraps. Each requires a specific mix of ingredients.
Both Trex and Azek use recycled plastics in their products, which should be attractive to environmental, social, and governance (ESG) investors. But the types of plastics used and the composition of the boards differ.
Judging solely on these companies' income sheets, it appears Azek's "recipe" is either intrinsically more expensive or the company simply struggles to source its raw materials as economically as Trex. Either way, although it was a year-over-year improvement, Azek's gross profit margin was only 32% in fiscal 2020. For perspective, through the first three quarters of 2020, Trex's gross profit margin is far better at 41%. Unless Azek can somehow reduce its cost of goods sold, it will struggle to match Trex's profit potential.
Before you say that Azek should just raise its prices, consider that it's already more pricey than Trex. Its price tag may be justified considering it has longer warranties, but Azek will struggle to raise prices to improve profitability all the same. It needs to reduce costs.
Lastly, Azek's balance sheet isn't as good as Trex's. Trex has no debt. It's down to only $20 million in cash on the balance sheet at the moment, but it has over $250 million in accounts receivable that it expects to collect reasonably soon. By contrast, because of its struggles with profitability, Azek has $468 million in debt and only $215 million in cash.
That's not a deal-breaker necessarily. But Trex can focus cash flow entirely on growing its business and rewarding shareholders (for example, it's currently authorized to buy back around 7% of shares), whereas at least some of Azek's attention will be turned to servicing debt for the foreseeable future.
I'm sticking with a proven winner
Azek is working to improve profitability by opening new factories and planning better methods of collecting recycled materials. This may help in time. But for now, I'm content to watch this one from the sidelines and wait for profits to actually show marked improvement. If Azek can make progress, there'll be time to reevaluate and get in later.
Trex is a stock I'd still buy today. The company has spent $100 million so far this year to increase production by 70% to meet rising consumer demand. It hopes new capacity and product lines can reduce costs to better compete with pressure-treated lumber, which would provide plenty of growth over the next decade.