Chit Chat Stocks - Trex Company (TREX) with Jason Hall

Episode Date: April 21, 2022

Trex manufacturers wood-alternative composite decking. The company serves both residential and commercial clients. Trex uses recycled materials to build its composite decking. Listen as Brett and Ryan ask Jason questions about the company, its business model, and valuation. Enjoy the show! This episode is sponsored by Quartr, the new way of doing company research. Access conference calls, presentations, transcripts, and more for FREE on your mobile device. Download Quartr on the App Store here: https://apps.apple.com/us/app/quartr-investor-relations/id1552412128  Download Quartr on the Google Play Store here: https://play.google.com/store/apps/details?id=se.quartr.android Subscribe to 7investing with the code "Money" and get $100 off: https://7investing.com/subscribe/aff/4/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Interested in more of Jason's work? Follow him on Twitter here: https://twitter.com/llaHnosaJ?s=20&t=iwNO_15DkGBFP876DtfPNA Contact us: [e-mail]  Timestamps Trex | (4:00) Suppliers | (14:46) Housing Shortage | (31:26) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. This is our Thursday deep dive episode where we have on one guest, sometimes two guests, to discuss a single stock. We ask them a bunch of questions. It's typically a company they are an expert on. And today we have on Jason Hall and we talk Trex, which is a really fascinating company that a lot of households have probably dealt with in or have in their house, I guess, tangential to their house. It's composite decking, which Jason gets into a little bit. But did you have any highlights from the interview? Yeah, he's followed the company for a decade. It's a classic. Now, Jason's from the Motley Fool. So if you know, one of their big services is a rule breaker, the rule breaker service. And this

is kind of a classic rule breaker who try to disrupt the lumber decking industry. And now they're kind of turning into that rule maker who are, I don't know, continually gaining market share with lumber and his definition of a secular grower in a cyclical industry that has the best brand and the best management or good management i don't know if he just said they were the best management but really strong management that that's good capital allocators yeah that's a great pitch and it got me more interested in the business and maybe to put them on my watch list and follow them so i think anyone that listens you're well you may not come to the same conclusion but i think you will yeah great and jason is a good example of uh the benefits of a long

long-term investing uh because it doesn't always feel like a compounder we talked about this after this after we hit after we stopped recording but it doesn't always feel like a compounder when you first buy but after he's owned it for a decade it's been a wonderful compounder for him and they have that durable tailwind we don't need to pitch it too much but yeah yeah but uh before we get to that we uh have to talk about our sponsor and it's time to sound the alarms because it's about earnings season and that's a perfect segue into our sponsor quarter where they are the investor relations app all in one you've got conference calls conference call transcripts and uh presentations you can leave emojis or reactions to the conference call and this last quarter

i'm gonna start picking a favorite uh conference call that i've listened to through quarter The Restoration Hardware, I recommend. I know that one kind of blew up, but I recommend going in and listening to that one. You can see where the reactions are. It was a good one. And Quarter just makes it really seamless, really easy to listen to conference calls on the go. So go ahead, check them out. And it's Q-U-A-R-T-R. There's no E. They're 100% free. They're on iOS and Android. And you can also follow them on Twitter. They've got a great Twitter account, lots of memes. Yep. And when this is released, it'll be the heart of earnings season. I'm looking at the calendar right now for Thursday, April 21st. Danaher, I don't even know if they do conference calls, but Philip Morris International, AT&T, Snap, Intuitive Surgical. And the great thing about it is you're going to search those companies on quarter, whatever one you want. And it's almost like a podcast where you click and listen to it. It's way better than how you did it in the past. Exactly. But without further ado, let's get to the interview.

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Okay. Today we are welcomed by Jason Hall. He is a contributor at The Motley Fool. That is actually how I met him. And you may know him from Twitter. He's on there as well.

But today we're talking about Trex. And so this might not be a company a lot of people have heard of. They maybe have Trex products at their house, but don't know it. But how did you come across this company? I mean, there are a few things more exciting than a company that makes Fake wood decking, right guys? I do not find that. It's easy. It's everywhere. No, I'm kidding. So, believe it or not, and this actually probably will make complete sense, but I first learned about Trex before I was even working with The Fool. It was recommended in Rule Breakers, so David Gardner's service that David ran for a long time. And I believe it was Rick Minares pitched it to David, and it then came into the portfolio. So at the time, I was actually a member of Rule Breakers. So this is well over a decade ago when it first joined that portfolio.

And I started doing some research into the company and just immediately fell in love with it because of what they're doing and what they've built and the competitive advantages I think they've established. And then all of the tailwinds for the secular tailwinds, I think that are going to be really strong for what their business is. And you kind of just alluded to it there, but can you explain what Trex does? And then can you kind of go into more of what composite decking actually is? Yeah. So Trex, if you've been in a Home Depot or a Lowe's and you've looked at decking, you've seen the Trex product. And it's actually, it's by far the number one brand. It's kind of like Kleenex or Xerox in that it's become the term that represents the entire industry. And what composite decking is, is it's a drop-in replacement for lumber decking, which is typically cedar. In a lot of the country, it's cedar. You have other kinds of woods that are used too. Sometimes it'll just be pine that's pressure treated and then stained.

And why this material and why would you use this instead of using wood? So number one, wood's kind of a pain. You have to maintain it. You have to seal it, water seal it. Nobody just likes pine, plain white pine. So it's usually stained or painted some color. And you have to maintain that because people are walking on it. you're dragging stuff over it and it rains on it and all the things that happen to make it look

not good. And you have to do all those things basically every year to keep it, to make it last a decade or more. And of course you have to cut down trees to get it right. So, so maintaining natural resources is an issue, the environmental impact of all the chemicals, the time that you have to put into it right to to maintain it instead of just using it trex's material their decking is 95 percent um waste plastic and and scrap wood right so you think about um a lumber company or um a lumber mill or a forestry operation they have the tops of trees they have scrap wood that's left over you can only make so much particle board with that um the sawdust that comes out a lot of milling operations has almost no economic value for most of those

businesses. So they buy that material, that waste. And in some cases it's given to them if they pick it up, right? Just because getting it off the lot, getting it out of the way is valuable. And then the plastic part of it is one of the hardest plastics to recycle. It's polyethylene film. So we commonly think about grocery bags as that material, but their largest feedstock is actually pallet wrap. So if you've been in a warehouse and it's got the clear plastic wrapped around the big pallets and stuff to keep everything still, that is a massive source of feedstock for them. And one of the things that we've seen over the past, really the past five or six years, again, because that is a really hard to recycle material, right? A lot of like,

you think about water bottles and that kind of stuff, those sorts of plastics are easily recycled and turned into something else of value. With that polyethylene film, it's much more energy intensive to get something else out of it, right? China used to be a massive, and still is a pretty large recycler. They would take the junk from everywhere in the world, they send it over, and they try to make something out of it. And they changed that significantly a number of years ago. And that's been really good for Trex because it's increased their access to these waste materials is their feedstock. So they have a proprietary process where they take, again, it's about 95% of the, of the input is this, this waste scrap wood and this polyethylene film. And then the

other 5% are, are things like the colorant to make it look the color that it is and other materials, the binders and things that kind of hold it all together. And they have this proprietary process where they manufacture this, the decking. Um, most of it is comes with a 20, 25 year or longer warranty. Um, you don't have to stain it or treat it. I mean, you mop it, you blow it off with a blower, you sweep it. Um, and it, it's, it's a wonderful product for, for its, its life, which is multiple decades. Right. So what are the benefits as a homeowner? You don't have to mess with it every year. You know, you don't have to spend a weekend every spring making it usable before you can actually use it. Um, it takes waste that has little economic value, um, or

ability to repurpose in other ways and it brings it back in. Right. So it doesn't just end up in a landfill. Um, we think about, I'm a diver. So I think about this. One of the things that was really interesting to me about treks from the beginning is I've spent a lot of time in the water off of the California coast. And you see plastic everywhere, everywhere you go. And a lot of it is stuff that started out in a landfill or was supposed to go to a landfill, never made it, fell off the back of a truck, blew off the top of the landfill in the wind. Plastic, I mean, we've all seen plastic grocery bags in the gutters, right? So taking those things and getting them, keeping them out of the ocean was a big deal for me, right? It was a big emotional

trigger for me. And then thinking about helping businesses that are producing waste products, monetize those, or just take them out of their logistics stream. So it's, it's, it's great for their, the companies that are giving it that feedstock that it's sourcing from. So that's, I think that's really big is that it's better for, it's easier for consumers up front over the life of that product. And then it takes so many decades of, of keeping that app from going back into the waste stream. And whether you're focused on ESG as an investor, or you're just the average young person that's looking to buy a house and is being more thoughtful about your personal carbon footprint and your purchasing decisions and the implications on the environment,

Trex is just, it's a winning business from that perspective. So I think that's really, really, really exciting to me. Yeah. It sounds like it's a win-win perspective there. And I think we covered the pros for the consumer, but I want to hit on more of the costs compared to lumber. So say someone has a lumber deck or someone has a deck from Trex, what's going to cost more? And can you go through why one would cost more than the other if Trex is cheaper? Why so? Is it because of this recycled material? Because I think that kind of gets into maybe some of the unit economics of what Trex's business looks like? So Trex is going to be more expensive than wood, right? Right out of the box. Then the capital

outlay to buy the material per linear foot of material, you're going to pay more for Trex. And again, number one, it's a 25-year product versus a 10-year product for wood deck, right? So number one, it's going to last longer. But Trex also has different levels of product. They have different price tiers. And most of those price tiers are about the finish of the material, the colors, similarity to different wood textures and that kind of thing. Um, so the further you move up their food chain of product, the higher the price, the premium of the, of the price, um, which we've seen. So we've seen, you know, lumber prices, anybody that's followed anything related to inflation over the past, you know, year and a half, um, lumber prices are very, very high. come down but they're still up substantially um trex it's it's besides their feedstocks and labor you don't see the same sort of variability in their input costs versus um a decking producer that's making wood decking right so so that predictability is kind of nice um and they also Also their business is really tied to contractors that do decking.

So not just DIYers, a big portion of their business is their relationships with contractors. And they set pricing every year and that's their pricing. So this isn't a company that's going to turn around and try to gouge builders just because lumber prices have gone up and they can flex. They don't do that. That's not the way that they do business. what Trex has also laid out is, so yeah, you're going to pay more today, but now you don't have to buy that Thompson's water sealer every year. You don't need to stain it, right? You're not

going to have to replace it in 10 years. You're far less likely to have that one board right in front of your glass door that gets wet in the winter and you have to replace it after three years because it rotted, right? Because it's that one. Less likely for splinters. Yeah. Oh, dude, that's a bit, that's, that's, you got kids, that's, that's big. Or if you go barefoot a lot and yeah. Yeah. It's, it's a great, it's, so a lot of things now. The downside again is it is, it's a higher price. So you have to do a good job of telling the story that supports the total cost of ownership over the lifetime of that product. This episode is brought to you by La Quinta by Wyndham.

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Book your stay at LQ.com. Right. And you mentioned contractors. I want to get into more of the relationships between suppliers and customers. So they sell, obviously, to a lot of the home improvement stores, Home Depot and Lowe's. I think the number here that Ryan put down was 61% of sales come from the three largest customers. What is that relationship like? And can you speak more? Do the contractors that you mentioned all go to like a Home Depot or Lowe's or do they do any, does Trex do any sort of direct to, it's not direct to consumer, but direct to contractor sales? So one of the things that Trex has done really, really well is besides the Home Depot and Lowe's, there are a number of large regional building materials distributors that their businesses are focused on contractors. Right. Right. It's, we've all seen those lumber yards that are full of contractors that show up to get materials and maybe, you know, a quarter of their business is DIY customers, right. Versus the Lowe's and Home Depot, which, you know, I think with Lowe's it's like 75, 25 consumers versus pros. Right. Um, and even Home Depot, I think is more closer, closer to like 50, 50, but these guys are like 75 pros, 25, um, consumers. Right. So they do a lot of business with those as well. Um, which is, uh, and, and, and this is another advantage they have. And we'll talk about competition later is because they do have such broad distribution nationally. Um, they are positioned really, really well, um, for contractors, wherever contractors are. And that's allowed, that's allowed them to leverage an internal focus on not selling to the contractors, but providing the contractors with the skills to install their products, training them on it, providing perks and things for them to lead and to recommend the Trex product. um, like they do trainings for, for, for pros and they, they do, they do events for pros,

um, to get them certified on the Trex product. Um, and, and they've done a really, really good job with that. Is there any risk in having, uh, or maybe it's just a function of like selling a product like this, but is there any risk in having so much customer concentration with Home Depot and Lowe's? Do you see that as a potential risk at all? I don't. Again, I think that's just as much as anything, that's just a product of those two companies' size in this industry. And I could see a case where over the next decade, they continue to concentrate and to take more and more share. So I think having those strong relationships is probably far more important than it is any sort of a risk.

And then the other side of that is, again, for a company like Trex, if you're Home Depot or Lowe's, this is the best known, the most established, the highest reputation product in the industry. You can't not have it on your shelves. And then if you think about a company like Lowe's, which again, if you look at the national mix of sales, of building materials, all of the products that Lowe's carries in its store, the total addressable market is really 50-50 consumers pros. they're only 25% of their sales to pros. So if you have a regional distributor that you're competing against and your lows, and they have tracks and you don't have tracks and you're trying to grow your pro business, you're making it harder for yourself, right? So I think having

that established market leading position for tracks gives it some leverage with those national chains who who are the main i i imagine they have competitors who are they are the any of them public um and then what sort of advantages does trex have so probably the the the most well-known uh brand of this same product um competing product is is is timber tech um and also um azac and i they they're kind of rolling up those names um because they're they're part of azac which is publicly traded um but azac is a more diversified company they do a lot of other products too um so it's not really too pure plays um and it's only more recent that that timber tech brand was rolled in and it's become publicly available um it's a great product as well

Well, I think to me that the reason that I prefer Trex as an investment, if we talk about just the companies themselves, is if you look at Trex's economics, their unit economics, they are wonderful, wonderful. And they're already at a substantial scale. They're by far the largest in this category. More than half of sales in the US of this product are Trex. The real competitor is lumber, right? Wood decking still makes up well over 80%, probably 85% of linear feet of decking sold. Trex has a little more than 10%, right? So that's the real opportunity. And for a long time, Trex focused in their marketing on showing, well, here's why Trex is better than the other brands. They kind of glance at the other brands now in their marketing, but they really say, here's why we're better than Wood. They don't even consider the other company's competition. It's taking market share from lumber. Why would somebody that's building a deck today choose lumber?

Just cost? Or is there, maybe are they just not aware of Trex? I think it's largely just going to be cost. I really do. And a lot of it is going to be decided at the consumer level. You're a DIYer or you're hiring a contractor to do it. And it's a way to shave a little bit off the cost. But here's the thing, right? So underneath that Trex decking or that timber tech decking, you've still got lumber. You've still got the frame is still going to be made out of wood, right? Posts are going to be wood or steel or concrete. So there's still a wood cost that's going into it. And then if you're hiring a pro, the majority of your cost is probably going to be labor, right? You're going to pay more for labor than you are for the decking

or very close to the same amount, depending on how complex your job is. But then you also have think about maybe somebody that's flipping homes or they're a home builder and they're trying to manage their inputs. And selling, maybe they don't see the value of that incremental cost or maybe it's just they say, well, we're not going to be able to get a return on that additional cost. If it's going to cost me 20% more to build the deck with composite decking, am I going to be able to increase the selling price 30%, right? Can I make money on that, right? Or is it going to help me sell the property faster? And I think for most of those businesses, they just assume the answer is no. So they just stick with, again, it's about being

risk averse, right? And I think a lot of the, when the decks are happening in that way, there's just, there's no reason for them to, they don't see the value and they can't sell the value or they're not going to try to sell it. So they're not going to spend the incremental cost to do that. Has that, has the price difference between a lumber deck and Trex deck converged at all since lumber prices have gone up or has Trex? Yeah, definitely. Definitely has. Again, Trex has done a pretty good job of, of, of cost containment. Um, and they do increase their prices every year, right? They're not, they're not ignoring what's going on and not taking advantage of it. Um, but they set their

prices in the winter. Um, the, the buying season really kicks off late fall and through the winter and that's their build inventory build period before the building season kicks off in the spring and their seasonal sales really ramp up in, in, you know, late in the first quarter and then into the second quarter when the decking business, most decks are getting built, right? Heading into summertime and then through the summer, and then it slows down again in the fall and substantially slows in the winter. So they set those prices, right? And they've increased their prices, but lumber costs have come up a lot more than the prices that Trex has increased, right? So they've also, because of their increased scale and their operating efficiency,

They're just so good at making this material. They've done a good job of reducing their input costs, so they don't necessarily have to raise prices as much. A lot of the price raises, they're able to just put that, it's incremental margin on their bottom line. how usually i don't uh put too much emphasis on sort of the tam we're not i guess we're not a big tam podcast but yeah i'm not very familiar with this market at all so how big is sort of the market opportunity for trucks so i don't i don't have the exact exact numbers in front of me but again what we can use for this is we can use just the the market share it has versus what the market opportunity as a proxy. Trex generated about $1.2 billion in revenue last year, and they have about 11% of the market, roughly, of the decking market. Can I say, is that United States only or international?

That's the key, right? That's basically North America. They do have a material but not significantly meaningful part of their sales does come out of Europe, in the Middle East. So even if we're just talking about the U.S., this is a company that could easily, I think, easily double or even triple its revenue just by taking market share and by the natural increases in costs and revenues over the next 15 years. I think tripling the revenue in 15 years is absolutely within reason just in North America. Because there is so much opportunity to continue to grow here and just expand your market share. I think their approach has been really good to kind of stay focused on that. And then international growth at some point is going

to become a bigger focus probably over the next five or more years. And there is an enormous opportunity there as well. Can you give us just maybe some numbers on what the economics look like for Trex today? How much are they taking in in gross profit and maybe cashflow, I guess? I don't know if you have those numbers handy. I do. So one of the really cool things about Trex. And there's a little caveat to it too. So if you go back to say the late 20 teens, gross margins were above 40% pretty consistently. And they've come down a little bit. And the reason they came down as a company, Trex bought a company that makes railing for like stadiums and like baseball stadiums and entertainment venues. So like this really heavy duty commercial

railing. And the reason they did that is because it was a very low capital business that generates more cyclical revenues, but at really high cash margins. And it's a small part of the business, but from a gross margin perspective, it's lower. So that's kind of one of the reasons their margins have come down, but they're consistently getting margins in the high 30% range. And I think over time, they're going to be able to bring that back above a 40% gross margin, right? So you think about that as a manufacturer, that's pretty good, right? Particularly when you're competing against basically a commodity product like lumber. Now, what I really like is their ability to take that 38% gross margin they generated last year

and then turn it into operating margin. And trailing 12-month operating margin was almost 27%, percent, right? So comparing that to AZEK, and again, it's not an apples to apples comparison, AZEK's gross margins were 33%. Again, it's pretty good. But again, more typical of a manufacturer, operating margins were about 12%. Now again, Trex has consistently gotten 25% plus operating margins for years and years and years, right? So it's demonstrated its ability to do that. Now let's talk about cash margin, right? Cash margin of about 18% over the trailing 12 months. Again, that's roughly where it's been, you know, right, just a little bit below 20% cash margin for a long time, right? So the unit economics are just absolutely, absolutely

wonderful. Yeah, it's interesting that they're able to convert so much. And if I'm hearing those numbers correctly, they're converting so much of their gross profit to operating profit. Is that because they're basically just making the stuff and distributing it to Home Depot and Lowe's or is there some other cost in there? It seems to me that it's really just general administrative expenses, but I could be wrong. Yeah. They're just really good manufacturers. I mean, that's really the bottom line. They have a process that they've first started in the late 1990s and they've just got a really good process. Now, let me go back a little further. There's a part of the story that's important too. When I first started following the company and invested, Ron Kaplan was the CEO. He was brought in right at the beginning of the global financial crisis. He accepted the job, showed up, and his second day on the job, somebody told him they're about to run out of money. He's like, we're about to default.

right? Right. The company was literally about to go bankrupt and nobody did it. The housing cycle was collapsing or housing was collapsing. So the housing cycle, the timing for the housing crisis was, that was going to undermine so much of its opportunity. But the biggest thing was that the company was troubled when he took over and he knew that. Class action lawsuits were coming together. Their products were junk, issues with mildew, fading. They were not good products, right? It was a great idea. and they just lost all of their quality control and tried to expand really quickly in that first decade. And Ron Kaplan saved the company. He not only made some calls because of his connections

to get the capital in place to keep the business from defaulting on its debt, but put major focus on getting the products back to being the leading products in the industry as it was when the company was first founded, rebuilding its brand and establishing a great corporate culture. There have been four CEOs or three CEOs since Ron Kaplan took over. And the board of directors and each successive CEO, and these are all internal promotions, people that Ron Kaplan brought to the company and became part of that corporate culture, the company has continued to execute with incredible capital allocation, improving its process, continuing to build on its brand power to become the most recognized brand in this industry. And again, leveraging everything

that it does to continue to improve those unit economics. It's been a great story. Cox Panoramic Wi-Fi includes advanced security to help protect all your connected devices. You'll get real-time alerts. Oh, like this one. So you don't have to worry about malware. or when your kid downloads a song from a shady link. And now all your computer can play is Red color, red color, where are you? All blocked thanks to advanced security included with Cox Panoramic Wi-Fi.

Advanced security must be enabled in the Panoramic Wi-Fi app. Restrictions apply. You mentioned the housing cycle. That kind of inspired this question I have here. Is the housing shortage and the increase of millennial family formation, should that be a strong tailwind for Trex over the next decade?

Yeah, absolutely. Absolutely will. And I think even just looking at housing prices in general as an indicator for Trex, because when housing prices go up and it gets harder to buy the house you want, you spend money on the house you have, right? Right. And decking and a lot of these big outdoor investments, typically they're at the tail end of the spend for people. What are you going to do when you buy a house? You buy a fixer upper first. You do the kitchen and the bath. Right.

Those are the things you do first because it immediately improves the value and it also adds value to the things you use every day. Right. Outdoor living is further on the tail end of that. I do think as we see more of a shift to hybrid work and people using their homes more every day for different things, building a deck is a way to expand your living space in a very low cost way, right? I think all of those things are great tailwinds for Trex. What I would like to see Trex do is maybe establish some relationships with some of the bigger home builders to become a part of the way when people are choosing and building

a home to be more on the front side of that, not just people replacing decks or adding decks to existing properties. When I was looking at the 10K, if I'm not mistaken, they have more products too, right? It's not just decking, don't they have- That's the railings, right? Or is it other stuff? So they have decking, they have railing, they have lighting. They're rolling out these dividers, kind of portable dividers to be able to use to create more privacy. And again, they have the, the, the subsidiary business that does the commercial railing, um, for like, um, sorry, my mind just went blank, like for stadiums and large, um, event locales. Okay. And this could be, this might be a dumb question, but if they have an increasing amount of products, can they

go, and I don't, this isn't direct to consumer in the way that people would think like online or anything, but could they build their own stores like a Sherwin Williams type of deal? I'm kind I think of them as like Sherwin-Williams got big enough where, I don't know if they've always had stores, but you would think that it'd be fine for them to just be in Home Depot because that's where everyone's going already. But they seem to thrive with their own stores and other hardware companies have done that or home, whatever supply companies have done that. Do you think Trex could do that? Have they said anything about that or is it just really not in the picture? I would say never say never. But I think one of the challenges with that is using Sherwin-Williams

as an example, every house has paint, right? Not every house has decking. And my thoughts are that it's probably, it's, so here's one of the things I really like about Trex a lot is, again, this is a company that did $1.2 billion in revenue last year and has the ability to grow that by several multiples, I think, competing against wood decking. But the lumber companies, they make every stick of wood that goes into a house. Decking is just a part of it, right? Every house has walls, right? Every house has a frame. Every house has a roof. You have your joists for your flooring. This could be the sort of area where they're willing to seed market share, right? But it's still a big enough opportunity for a company like Trex to not face really, really stiff competition.

I think you start wanting to open stores. I don't know if this is a big enough business besides maybe it becomes part of their initiative to like feature their products, right? In certain markets, maybe you have these like showcase stores and then you do that. And then all of a sudden you start competing against Home Depot and Lowe's, right? And you put those really important relationships at risk.

And at the end of the day, I think it's far more important for Shrex to continue to cater to pros and have really good social media marketing and have a great website to make it really easy for people to go on their website and have three samples sent to your house so you can pick a color. And then when you do that, they send you an email and say, oh, hey, by the way, if you need help finding a pro to do it, we can help you. I think those are far smarter ways to spread awareness of its brand than opening

stores. And all of a sudden, the economics of operating stores is very, very different than being a really good manufacturer right yeah yeah you mentioned that they acquired that uh basically what is the railing company for the venues or the bigger stadiums and stuff like that is uh acquisition still in the cards do you think will that be a part of growth moving forward or has it just kind of been that one acquisition yeah i i i kind of feel like trex is again because this is an industry where, so if you think about its core decking business, it's by far the largest manufacturer. It has proprietary manufacturing to make the product that's different than the way Timber

Tech and the others manufacture their products. And it's hard to see an acquisition in that space that necessarily adds value, right? that would, besides just buying market share. And I don't think from, I've interviewed their current CEO and he is very much like their process and their corporate culture around capital allocation. These aren't a buy business kind of kind of guys, like buying market share kind of business. I don't think that's what they would do. But I absolutely think that if there were adjacent opportunities where they could get real per share cashflow value, particularly if it could help. So let's think about anything that's tied to housing and home improvement. Very

cyclical, right? What's going to happen when we see a recession, whether it's this year or five years from now, people are going to stop buying decking. It's inevitable. It's absolutely going to happen, that cycle is going to turn and Traxxas stock is going to fall a ton. And it's going to be a great opportunity for us to add to positions and to buy shares. And the business is going to be totally fine, right? Because they're well-capitalized, they're very well-run and they've done that rodeo enough times to know. So if they can find businesses that they can buy to help kind of act counter-cyclically, that also meet all of their thresholds for returns, then I think they absolutely could. I think they absolutely could.

What does the valuation look like today? And then what are your thoughts on, I guess, their capital allocation strategy? I know they have a buyback program, if I'm not mistaken. Yeah. So Trex is one of those stocks that's overvalued and basically always has been. Um, if you look at it, it very much is right. It's very, very much from that perspective trades for about 34 times, um, earnings, uh, trailing earnings right now. If you go back, I'm actually, I've got a chart open here. I'm just looking at it just to see. So you take out, you take out like the market crash period. So like March, 2020, and you look back, I don't think it has spent any meaningful amount of time trading for less than 30 times earnings

going back to 2014. It's just consistently trades for that multiple. What does growth look like for them? This is a business that will consistently grow. And again, depends on where things are in the cycle, will consistently grow like low-teens. We've seen 20 plus percent growth a lot over the past few years. I think a good expectation is 10% to low teens revenue growth over the next, I'll say, I'd go so far as to say 10 years, right? If you average it out over that period, I think it can consistently generate 10% to 15% revenue growth. And where it really pays off is operating leverage. We talked about that 38% gross margin that I think it can continue to grow. We talked about that 27%, 26%, 27% operating margin. I think this is exactly the kind of

business that 10% to 15% revenue growth can grow earnings 20%, 25% per period against the same period. And I think it can consistently do that. They've substantially increased their manufacturing capacity over the past five or 10 years, while actually reducing the number of manufacturing facilities they operate. They've added lines and they've just gotten faster and better at it. They've only recently expanded their actual geographic footprint because they've just stuffed all of their manufacturing facilities to the gills. So I think that's where this fits in there.

It's just like a real moneymaker business that can grow revenue at a pretty... Nice but modest compared to a lot of really high growth businesses, but really turn those economic wheels and drive per share earnings and cash flow growth that you would love to have is like just the foundation of a portfolio. Yeah. And you mentioned the new factory. Capital expenditures have been pretty high recently, at least that's what I was getting from reading on the conference call, the questions people are asking management. How does the CapEx stuff look for them? Have they guided any long term of how, I guess when I was looking, it seemed like they spend almost all of their operating cash flow on CapEx right now. I don't know if I ran numbers going back too far, but what do you think about that? But is there a period where we're going to see a big inflection in free cash flow, or is this kind of a one-time blip where CapEx is just elevated because of the new factory? I think it's a short-term thing. And by short-term, I mean a couple of years, right? Because we've seen – so they did a capacity expansion a few years ago, and they just – it was a mess, right? They had all kinds of problems.

At the same time, they had been developing some better processes. and like, so they tried to expand and also implement these processes at the same time. And it was a disaster, right? It was at a period when there was just massive demand too, and they couldn't meet the demand because they screwed up their manufacturing. And it took the better part of a year to kind of get back ahead of that because this is a seasonal business, right? If I can't buy Trex and I'm a home improvement guy and I have a book of customers, I'm going to go buy TimberTech, right? I have to build that deck. I have a business to run. So again, assuming everything goes smoothly and they've learned lessons, I think a couple

of years of elevated CapEx, and then we're really going to see free cash flow surge back up. I really think that's going to be the case. They've talked in the past about dividend and their response has always been, it's always on the table, but I don't think that they want to pay a dividend. I think they want to continue to find ways to grow. things like, again, that railing business that they bought. I think they would rather do those things than commit themselves to a dividend. I think they're more likely to continue to buy back

shares in terms of capital returns. When we see that free cash flow ramp up, I think that's probably the first thing they're going to do is really go aggressive about share buybacks. All right. Let's finish off with some risks here. Whenever someone talks about a company like this, housing, some manufacturing. Right now, everyone's thinking in their mind, energy and inflation. How does that type of stuff, shipping, how does that impact Trex? You mentioned a bit how they've been able to have some pricing power, but has that impacted them negatively at all? And maybe I'm thinking wrongly, does it impact them positively? Yeah. So this is a company that one of the advantages I think they do have against their competitors is the cost advantage side

because they're so good at manufacturing. We talked about the gross margin that they then turn into operating margin. I think that shows that cost advantage that they have. The risks to me, the biggest risk is that this is a cyclical, this is a growth company in a cyclical industry, right? So we're going to go through those periods of time where, um, when the consumer is feeling a pinch, um, stuff like the deck that you had planned to

build are the first things that, that, that come off the budget. Right. So, um, so this is again, it's like Harley Davidson, right? This is the, you don't buy a motorcycle if you can't make a car payment. So, um, so that's a reality for, for Trex. Um, I think it's important also to remember that because it is a seasonal business, there's a risk of management doesn't continue to do a good job managing the balance sheet, right? So they use a line of credit to try to be lean about how much cash they have on their balance sheet. So they tap that line of credit as they're getting into their build season, which their build season when they're spending more money is also when they're selling the least amount of decking, right? So there is a risk of management

not doing as well, continuing to focus on that capital allocation. Rising interest rates, that revolver is going to cost them more money. So that's going to weigh on their cost of capital. And the biggest thing to me is if their timing is really bad, they invest a lot, they take on more of that seasonal debt right before we see a turn in the economy that all of a sudden their business suffers. And instead of that double-digit growth, we go through one of those periods where sales are going to be down 20% in the second quarter because nobody's buying DEX. That's a material risk for the business that could take it some time to bounce back from. But I see them more than anything, I see those as being temporary risks and opportunities for investors who are

net buyers, right? When those opportunities come along, you buy more of the great companies, right? Yeah. Hopefully they've set themselves up better than in 2008. Sounds like from your thoughts on management, they definitely have. Not even close. Yeah. It's a different business. Yeah.

All right. Any more questions? I don't think so. Is there anything? Any other risks, I guess. I guess. Is there anything we forgot to ask about for Trex? Yeah.

One other risk real quick. I think there is some risks. Like the brand power is really important, reputational importance. So if, if, if, if there are, if we find out in a year or two, any of the changes they made to their products, they don't hold up. We go back to having like the mildew issues that we've had in the past or fading or any of those sorts of things. It undermines all of the work they've done over the past, past decade to completely turn that around. Um, I don't, I don't think that's going to happen, but I think that is just a risk to, to consider. Ryan, what were you?

Is there anything we didn't ask about for Trex that's like important to the investment thesis? I don't think so. I think we hit, I think we hit all the high notes and got and got pretty deep on the business. We had a lot of extra questions this time too. So that usually means that we're interested in it. So I think hopefully listeners are as well. It feels like they're going to have sort of just that the market tailwind or

it's just sort of a natural tailwind of people shifting. I imagine it's sort of, yeah, this is sort of a gradual shift that's going to happen towards composite decking. Does it feel a bit, and this might be a weird comparison, but it almost feels to me like semiconductors where you have the long-term durable multi-deck tailwind, but in between you can have these periods where it's not going to be like a software subscription business where it's just 10%, 10%, 10% growth. Cyclical industry with wonderful secular tailwinds.

sounded better than me. Yeah. That's it. All right. Perfect. Well, uh, for any listeners that want to keep up with you, Jason, where's the best place to find you? So you can find me on Twitter. Um, I'm at Jason Hall, but spell it backwards because there's another Jason Hall who's written movies and stuff. Um, so that's easy. That's, that's easy place to find me in the real world. Let me check it up and just make sure. Is it? Yep. It's Jason Hall backwards. If you're a Motley Fool subscriber interested in subscribing to the Motley Fool, you can find me on a lot of the live streams. We interact with members there too. So I'd love to see there. Helps pay my bills too, because people that pay to be Motley Fool

members, that's where my money comes from. So that's where you can find me. Perfect. All right. Well, I think that's going to do it. I should close out with the disclosure here. Brett and I are not financial advisors, so anything we say or discuss here on Chit Chat Money is not formal advice or recommendation. We are, however, general partners at Arch Capital, so clients may have positions in the securities discussed in this podcast. Thank you all for listening. We'll see you next time.