Alternative recycled decking (and now polyethylene pellet) manufacturer Trex Co. (NYSE:TREX) reported second-quarter earnings on Aug. 3, with the $136.8 million in sales better than management's $136 million guidance from last quarter and a 13% increase from last year. Better yet, the company reported earnings per share of $0.58, a strong 27% increase from last year. And in typical Wall Street fashion, the stock fell more than 14% since the results were slightly below analyst estimates of $137.5 million in sales and $0.60 EPS, as well as third-quarter guidance that puts sales roughly even with last year's results.
In other words, it appears Mr. Market is viewing Trex's business based on analyst expectations, and looking no further than next quarter's end, versus a long-term view of the prospects. Let's take a closer look at the company's earnings report, as well as some important things management talked about on the earnings call.
Perspective on the earnings miss and Q3 guidance
While it's hard to know whether coming up short for Wall Street's estimates for the second quarter or the company's own relatively muted guidance for Q3 played a bigger role in today's stock decline, it's important to consider both with proper context.
Trex surpassed management's guidance for sales of $136 million in the quarter, so its shortfall was more a product of analysts who did a poor job of estimating (that's fancy Wall Street lingo for "guessing") Trex's sales, and of course overestimating sales led to overestimating earnings. When a company misses an outsider's guess but meets its own guidance, you can't really call that a miss.
As to Q3's relatively weak guidance, it's a little more complicated and worth a closer look. To start, last year's Q3 was very strong, with nearly 30% growth from 2013. This unseasonably strong performance was largely driven by the heavy rains in the spring of 2014 that pushed a significant amount of business into the summer. On the recent earnings call, CFO (and soon to be CEO) Jim Cline said orders were up an astounding 44% in July 2014 largely because of spring weather, before moderating in August and September. He also said orders in the just-ended July were relatively flat, a strong performance against last year's huge 44% growth.
What about the pellet business?
Over the past year, investors have been looking forward to a new venture the company was working on, which we learned a few quarters back is the recycled polyethylene pellet business. The company has begun making and selling these pellets to companies that make plastic bags and film, and management set the expectation that sales would generate meaningful results in the second half of 2015.
So heading into the second half, the company's sales guidance didn't seem to reflect that there would be any gain in sales in the third quarter. Considering that Trex has invested in multiple new manufacturing lines and acquired more land adjacent to its Winchester, Va., manufacturing facility to expand, the market is expecting to see meaningful results, and sooner rather than later.
When pressed for more on this seeming lack of impact from the pellet business in the third-quarter forecast, soon-retiring CEO Ron Kaplan held firm, saying:
I can tell you that we expected to begin to move the needle within the second half of the year. So far -- the sales were immaterial in Q2. ... So I can just tell you in broad terms, our sales are exactly where we expect them to be. We're expecting them to start moving the needle in the second half of the year.
When asked about pricing, Kaplan stated that at this point, the focus has been more on quality and getting product in the hands of customers to ensure that it meets requirements, and not on "getting a few extra pennies a pound." He also reiterated that the operating margins produced from the pellet business would be essentially the same as the core decking business, since it adds almost no SG&A expense to the business.
Looking to what's next
In his prepared statement, Kaplan said the following:
Next, we have quietly assembled a team of over two dozen engineers, whose mission is to advance our technical lead in manufacturing efficiency and product innovations. This team is developing the next generation of composite decking and will propel us further into new industries. We are pleased with the progress of our R&D initiatives. This has been and will continue to be a value-added initiative.
In other words, the company isn't stopping just with the core decking, lighting, and just-getting-going pellet business. It's continuing to improve its current offerings while also developing new products where its core expertise can be leveraged. If the company is able to use its core strengths without taking an eye off the ball, it could find another market for growth.
Nailing it all together
According to management, alternative decking is growing at a mid-single-digit rate per year, largely by taking market share from traditional wood decking. Trex has grown even faster, taking market share from its competitors, and now commands more than 40% of the composite market. Just a year ago, the company held around 30%, and it says a 50% market share is a reasonable long-term goal, so it's not clear how much longer Trex can outgrow the industry -- at least domestically.
Looking ahead, it seems management is betting on being able to develop new products -- such as the pellets -- that leverage Trex's strengths while not taking resources away from its core decking business. If the company can indeed leverage these initiatives -- pellets are expected to be a $50 million or more business in two years -- then there could be a lot of upside in years ahead.
Whether it all pays off will only be answered over time, but Trex has proved to be able to innovate and grow. Apparently Mr. Market either isn't buying that -- or is just ignoring it.
Jason Hall owns shares of Trex. The Motley Fool recommends Trex. The Motley Fool owns shares of Trex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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