Is This Small-Cap Stock a Smart Way to Invest in the Housing Market?

As one of the best-performing stocks over the past decade, Trex (TREX 1.25%) has managed to fuel growth by converting wood decks to composite and convincing homeowners to invest in the Trex brand. But can Trex post another 800%+ gain over the next five years? In this episode of Industry Focus: Consumer Goods, join Motley Fool analysts Asit Sharma and Emily Flippen as they break down Trex's business and discuss its potential for long-term market-beating returns. 

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This video was recorded on June 1, 2021.

Emily Flippen: Welcome to Industry Focus. Today is Tuesday, June 1st, and I'm the host of this Consumer Goods episode, Emily Flippen. Today, I am joined by Motley Fool Senior Analyst Asit Sharma, as we take a look at the world's largest manufacturer of wood-alternative decking, Trex. Asit, happy June.

Asit Sharma: Emily, I feel like I have to one-up that. Is it already June? How about happy July? 

Flippen: Can you believe that it's already June? I genuinely woke up this morning and I was like, where did the first half of the year go?

Sharma: I know where it went. It's in the rearview mirror. That's all I know. But man, it was quick. 

Flippen: I actually got today's show idea from a listener. When you're taping last week, you had a question about Trex and about whether or not Trex was still a good investment, especially considering the price of lumber, which we had been talking about last week. I've picked my interest and now Trex is a great business for people who are members of The Motley Fool Rule Breakers subscription. They're already familiar with Trex or I hope they are because Trex's is David Gardner's 9th highest returning company on the Rule Breaker scorecard. It's outperformed the market by nearly 2,500% since David recommended it back in 2012. It's an outstanding company for investors alongside Motley Fool Rule Breakers. But really just in general, the wood alternative market has exploded since the Great Recession. Needless to say, I'm excited to chat about it today.

Sharma: Yes, Emily, this is a company that I think for many of us, it's not like your field of view. It's on the radar screen. But at the same time, it's been a smaller capitalization company. It's now a little bit bigger. Revenues are approaching the $1 billion mark. I think maybe it's in the foreground for many of us kudos to those who bought it when David recommended it in 2012, which is actually after, I think a period of rocky years. The company went public in 1999. I'm psyched to discuss this even more for me as someone who's not a shareholder, is to get to that point to figure out. Hopefully in this podcast, will I buy this today and hang onto this for another eight or nine year period?

Flippen: Yeah, that's a great question. I look forward to answering it. I think it's a fair assessment to say that it's unlikely Trex will see another 2,500% gain. I could be wrong, but it's already a $11 billion business, so it's already pretty large given its market opportunity. But I think a good question is, do we think Trex can steadily beat the market from here? Which would obviously not be 2,500%, but again, 10% CAGR for the next 10, 20 years. That's a good question and I'm not sure I have a really great answer. But I'm looking forward to hearing what your conclusion is.

Sharma: Yeah. I'll try as we go along not to get colored by what I think where your opinion is calling I should say. I got some thoughts. 

Flippen: Well, let's cover just Trex's business to start. I mentioned at the offset that it was the world's largest manufacturer of composite decking and railing products. When you're thinking about the business that Trex's in, anything that uses traditional wood, can really be replaced with Trex. A large part of their business, the vast majority of their business are residential decking markets; decking accessories, railing, fencing, replacing wood with their composite recycled material. But there's also a small portion of commercial sales. For architectural purposes, for staging, that sort of thing. It's maybe not the most exciting business from a standpoint of, I guess some of the businesses recover on consumer goods, but it certainly is a good business and an increasingly important business.

Sharma: Yeah, and I think too, it's a business that Trex has created by itself by coming up with an eco-friendly product. Now if you take a look at the market, it's a little bit wider. Other companies have come into the mix. We're not going to spend much time talking about competitors today. Maybe I will mention it or so as we go along. But I think that it's pretty interesting in just the idea. If you look back before 1998, there were not any major companies offering this type of composite, eco-friendly decking and railing product lines. I think in that sense, it's an exciting investment that you're investing in a pioneer that now is in the next stage of growth. At the same time, yeah, this is something that I think will try to parse out during the podcast. This is a commodity business in some ways, even though it's got a component of a niche that dis-competes with traditional lumber, it's still a commodity business, so we'll have to test that proposition as we go along as well.

Flippen: I like thinking about this business because when you think about their core consumer, which are people who are in residential areas, building, upgrading, renovating decks that exist on homes. It's interesting to think about the decision-making process that those people and more importantly, their contractors go through and make a decision to choose Trex over traditional wood. I do think there is a large part of the market that still prefers the look and the feel of traditional wood. At this point, the price point of traditional wood prior to 2021 and 2020 was actually really competitive. Wood costs on average $15-$30 a square foot. Trex costs on average $30-$45 a square foot. Even more expensive for the fancier Trex products. There is the obvious, I think decision-making that somebody would say, well, I'm just going to go traditional wood, it's cheaper, it's prettier to some people, it feels better. But when you actually look at the total cost of ownership, and when you think about the maintenance and the work that goes into maintaining a wood deck as well as the environmental cost, increasingly people are choosing to pay up for fake wood.

Sharma: I can't see that. I'm looking outside as we talk. Of course, if you are listening to the podcasts today, you can't see me looking out but mouthful members on live are watching me turn my head. Looking at my deck, which has had a higher cost of ownership than I thought when we bought our house some 12 years ago or maybe 15. My wife always knows the exact date. I don't know why I can't get this number straight, but we've sustained it. Emily, exactly. We've sanded it down. We've refinished it will stain. Probably we're on our third of these ventures. That tends to add up, not to mention that I'm not a handyman, so it takes me an inordinate amount of time to do the parts that I'm assigned to. My wife is so much more efficient with everything when it comes to things like handyman, handy person type preparations. But if I add up the cost, there's something that really comes to mind is I'm also thinking of all the hours that I put in and chasing the nails around your deck over the years having to replace sometimes a slat here and there, but also every summer having to hammer in all the nails because real wood, it does work, it does crack. It's just not something that you can set and forget. Although I should say, it does have a lovely feel to it, lovely color. I like the green pattern of my wood, but would I consider maybe replacing this deck? It's not so big and certainly after reading through the products in preparation for this episode, I saw some that didn't look that much different than one I have outside my window. I'm beginning to think, maybe I should consider this.

Flippen: Well, for people who are like myself, who may have an aggressive fear of splinters, I feel like the decision is really obvious. I hate walking on any real wood. I think our scar went too many times as a kid with some very deep splinters. But for people who don't have my particular peculiarities, if you actually look at the total cost of ownership, like you mentioned, Trex actually claims to be cheaper over the life of the deck. Trex products don't wreck, split, or get moisture damage, which is important for people who are living in temperate areas of the world. But you also don't have to worry about sand, paint, or recording. You don't worry about chemical treatments. Trex claims the last twice as long as traditional wood, so that makes it less likely to need to be replaced. A lot of what Trex does is trying to convince people not to necessarily build a new deck, but to your point, Asit, people like yourselves to replace their existing decks with Trex. To get to the point of your home ownership and maybe you're about that point. You mentioned that you bought the house 10-15 years ago. If you're looking out at your deck and it's getting old and you're getting to the point reoccur make a decision about upgrading or replacing, maybe you will choose to pay up a little bit more per square foot, thinking to yourself, OK, well, if I stay in this house for another 10 or 15 years, I'm not going to need to pay to replace this deck by the time I move out. That's where Trex really gets the majority of its markets.

Sharma: Yes, and the subliminal fear that you've just put in my head with the splinters. [laughs]. I'm going to be careful. I welcome my tech performer all the time. [laughs] Emily, you also were talking about, in the prep for this episode, the fact that this is a really environmentally friendly product. If you were talking about cost, the cost of lumber versus cost of a product, which has a higher price point. If you are the type who are into sustainable products, you're also thinking about environmental cost. I find this interesting. They use a composite, which is made of recycled wood. This recycled wood isn't the type of recycled wood I think of, it's like sawdust. They take sawdust and basically plastic film, the same type found in the plastic grocery bags at your local store. In fact, most of this is recycled grocery bags. This is polyethylene film. Not to be confused with polythene, for you older folks out there like myself, who remember the substance polythene. There was a great Beatles song, I think it was a John Lennon composition called Polythene Pam. I love that song. You combine these two materials and there you have this very strong, very durable, environmentally friendly product. It's made of recycled materials, it's going to last a long time, so that impact is less. This is something that has lent Trex a lot of brand power over time. This wouldn't be an episode of industry focus if we didn't talk about brand power, so I'll just mention at the outset here, we'll return to that.

Flippen: Yeah, that sounds good. What I think is interesting about Trex's strategy is, when I first started to research this business, I was under the assumption that Trex was in the business of trying to educate regular homeowners about the value of upgrading to a Trex stacks and deck, and that is true. I think there's always going to be an aspect of their business there. But actually, most of Trex's sales come from wholesale distributors. Trex is more actually more focused on emphasizing the importance and the value add of Trex products to professional contractors, remodelers, and home builders, than they are the average person who owns a home. That's because those professionals, and to quote Trex's management' here, "They're generally larger installations with professional craftsmanship where Trex retailers can generally provide sales personnel, trained in those products, contractor training, inventory commitments." So getting more wholesalers on board, getting them to carry those products and then selling them to contractors, getting contractors to pick up on the Trex products, allows them to make larger orders. 

When you think about the business here, there's always going to be an aspect that's personal, and you might be thinking about your own house, your own deck, or if you were to build a deck one day, the choices that you would make and that certainly is an aspect. But I think there's some pushing happening on the wholesale side, on the contractor side, on the professional side, that's important to not miss.

Sharma: Absolutely. This has to do with something you mentioned earlier, that Trex has a lot of its sales that emanate from remodels. This can be remodeling in the sense of replacing a deck, but they also have a part of their market for decks, which have never been attached to a home. People who buy a house and then decide that they've got this space, and they'd like to add that on, in both of those instances, if you're adding on a new deck, or you're doing a remodel, you most likely are working with a designer. If not a designer, you're working straight with a contractor. Those two professionals have all of their training from Trex. They give you the option when you're sitting down to talk about the renovation that you're going to do in your house. That is the point of knowledge that's really, I think, precise for Trex. If they have that contractor educated, they're more likely to make a sale. The brand power, of course, comes in with someone who recognizes Trex from hearing about it, or the tremendous word-of-mouth they have, understanding the product is eco-friendly, already being receptive to the pitch. But this has been a really successful model for them ever since they started the company in 1998.

Flippen: Let's talk about some of their financial performance here. I know that you just mentioned since they started the business in 1998, and if you look at the share price over the past five or so years, you are probably thinking this is always a really successful business. That was not necessarily the case.

Sharma: Sure. Trex went public in 1999 with a good amount of fanfare, and they had a really great financial model, very high gross margins, and high net profits. But immediately, it seems like after they went public, Trex ran into some initial growing pains. The first, I would say six or seven years, they were able to maintain their basic model, but profitability started to decrease a little bit as they were selling at more normal margin pressures. Then the Great Recession happened, so you had just a slump in consumer demand. But at the same time, Trex had a period where it had unusually high return, so it had a big warranty expense. Consumers weren't buying, they were having to take in all this return product. Their net profit margins, which had always been in the net-teens, plummeted and turned negative in 2008, 2009. They started having losses. Their gross margin, which when they introduced themselves to the public, was turning around 50%, that hit the mid-teens during the same period. It was already declining. This double whammy period, I think, was setting investors up at the time for maybe just this bleak outlook. But then right after the Great Recession, I think Trex saw this very gradual upward slope in both its gross margin and net margins. It never regained the healthiest profits that it had when it first went public because it's hard to replicate that when you're growing at scale and that's what Trex has done from going from a very small company to about $880 million in revenue last year. 

They finished 2020 with a gross margin of 39%, which is pretty decent. The thing that has really made the stock popular though, is this combination of controlling overhead expenses, which management is very good at, they're very disciplined, with a lot of top-line growth. Even before COVID-19, where Trex got this really big boost, it has shown evidence of being able to grow at scale. I was surprised, and I went back and looked at some old filings. Since 2012, they've been in fourth gear. I've talked here and there about my manual Mazda, which I don't want to get rid of. It's a Mazda 3 and I just love a stick shift, although I know I should convert to a more eco-friendly car, and a new car I've had this since 2007, but it's been paid off for years. I enjoy moving that stick around. I love fourth gear. Fourth gear says I've left the 30-35 mile-per-hour zone behind. I'm accelerating, I'm almost on the highway. I'm going to kick this into fifth gear. I think fourth gear is a great gear for businesses. It's not a gear where you're overheating. If you're not familiar with a stick shift, this is that higher gear when you hear people say, such and such as in a higher gear, they're talking about fourth gear and fifth gear. I don't know. This company has been in fourth gear for years and an impressive gear at that. I went back, as I said, to these old filings, since 2012. Emily, they've grown their top-line at a compounded annual growth rate of 14%, year after year. If you think about a growth rate that's in the mid-teens, it's really impressive for home improvement, do it yourself building industry. Of course, this is not a do-it-yourself product, but they've fallen within that industry. I was pretty impressed.

Flippen: Yeah. If listeners don't mind indulging a little bit of navel-gazing here about Trex's performance, we'll talk about what the next 10 years might look like. But I always like to think about what must have been going through David Gardner's mind in 2012 when he recommended Trex. I am a little nostalgic now that David has taken a step back from stock-picking at the Fool, but it wasn't an easy pick. When you look at how volatile I think that industry had been for a number of years leading up to the picking granted the years before 2012, were obviously improving as you mentioned. But when he looked back over the previous decades, since 1999, 1998, when the company got started, it was not an easy pick and I think there was a lot of skepticism about the potential and the reality for the decking market to move to what alternatives. It wasn't as clear as it was then as it is today, and I think what makes David such a great investor is that, and this kind of butcher, he's saying here, sets up his portfolio to be the best vision of the future. This is definitely a business that I think has a vision for the future, which really depends on the conversion of wood decks to alternative decks. It might seem like a small vision [laughs] relative to all the things I can change in the world. But I love the fact that this division that they've had for three decades now are starting to turn into real financial results and pre-COVID, this is still a great business, so that's worth reiterating is, this is not a COVID play, this is not a lumber price play, although we'll get to that in a minute. 

This is genuinely a business that has proven some operating scale, an operating leverage over the past few years. Excusing my nostalgic trip back there. The financial performance here is outstanding. I will say that when I think about some of the risks, I go back to that wholesaling and try to convince people just to stock Trex products. So much of their popularity depends upon the name-brand recognition. Now that people are aware of the world, alternative space competition is certainly heating up. One of the key risks that I think about with Trex just in general is the fact that 56% of their sales come from three main distributors. Presumably two of those are Lowe's and Home Depot, and you rightfully speculate that it's probably a third wholesaler that's making up the three main, I guess distributors there. Either way, that's a lot of concentration. If they were to lose some relationships with either of these players, or if those players were to somehow produce private brands of their own, that could be threatening to this business.

Sharma: I think it's a good risk to point out and we don't get the breakdown of consumer purchases versus, I'll call them pro-purchases. So Home Depot and Lowe's, they have a whole commercial business for small contractors. I would think that most of those sales are coming through those contractors. So that might be some insulation from that risk in that professionals who've been trained in the Trex product could simply purchase from another company. If, let's say Home Depot decided that we're going to offer a competing product, we don't want to feature Trex any longer. But given that such a huge part of their business comes from three of these two retailers and we think a third wholesaler, outside of Home Depot and Lowe's, Trex sales, almost exclusively to wholesalers. That is something that concerns me. Emily, one of the things that I was fascinated by, is that Trex has developed all these commercial lines and products off of really a single U.S. patent, at least as far as their residential product is concerned, they've got about five patents that deal with that commercial railings business that you mentioned. 

To me, this seems like something that's ripe for a little bit of attack by competitors. There are a few competitors, none that have the same type of composite offering that Trex has, every big player in this industry does it a little differently, they have one competitor that just does PVC decks and that is increasingly popular. They've got another one that incorporates bamboo. But I wonder how much of their product line going forward is still going to rest on that original formulation. They have some patents that are pending. But I just think that's a risk also, not a huge one and I don't want to blow that out of proportion. But it is very rare that you see a company which relies so heavily on its patented technology to not have patented a lot of the variance or very ideas that they have. But maybe those are coming in the next few years.

Flippen: Or maybe it is a challenging patent to get. They're aware that they're not going to be able to get such an all encompassing patent again, and that's the reason why they don't have anything patented beyond that one, which maybe is a bigger concern. One that I admittedly did not pick up on.

Sharma: But you did pick up on one that I think anyone who buys this company has to address and that is manufacturing utilization. Right now they're tapped out in their capacity. What's going on there?

Flippen: Yeah, manufacturing is a bit of a mess to put it lightly for Trex right now, which is the pandemic causing a bit of a surge in demand. But there's also a fire at one [laughs] of their manufacturing facilities over the last quarter, which certainly didn't help things. So right now they are at 100% capacity using all of their manufacturing facilities just to meet current demand. But they are in the process of building out more manufacturing throughout the United States right now, which is going to be important for capacity expansions. So right now, I believe they're producing only in Nevada and Virginia, and hopefully they'll continue to expand capacity in the future. I think that is a major concern because unlike something like Peloton, when we talk about manufacturing capacity, I think Peloton has proven that people will wait eight, 10 weeks to get a bike delivered to their house before they buy the nearest competitor. However, I think Trex right now is already competing for that up-sell when they can't immediately deliver. It's probably not a hard down so, for people just to be like, OK, well, I'm going with the wood or I'm going with the bamboo, whatever it may be. So many factors will be key to watch. 

It's important for them to expand out manufacturing. I think you should just be aware that the financial performance temporarily will be impacted, the margins will be impacted as they expand. I mean, they only have two manufacturing facilities right now, so building a third one is a pretty big undertaking for this business.

Sharma: That's true. Emily, any other risks before we talk really briefly about the latest earnings report and then speculate about the future?

Flippen: Really briefly, I will mention the seasonality that we see with Trex a bit. There's a lack of willingness to build, usually in the winter months, and then also whenever the weather is bad. Businesses like Trex are impacted by the storms and the crazy ice thing [laughs] I don't know what it's called, that happened in Texas over this past year, those sorts of things impact this business more so than others. I don't think it's a risk in the sense that I would let that keep me out of this business. I would just want to be sure that investors are aware that there's material slowdowns in this business because of things that are unpredictable, including seasonality and weather patterns.

Sharma: Awesome. Emily, this was very interesting, and we talked about that compounded annual growth rate of 14% over the last few years. But lately, Trex has been killing it. What has happened is the first quarter that they recently reported looks very, very strong to me.

Flippen: Yeah, a really strong quarter over this most recent report, which I believe was back at the beginning of May. Sales were up 23% year-over-year, which again, is great for business that's this mature, really driven by their residential segment. Despite the fact that there was margin compression, I did note that there was a fire at one of their manufacturing facilities, Trex doesn't expect some normalization. Gross margins fell from 45% to 39%. When they start increasing prices, which I believe are expected to happen in late August, it'll be interesting to see how those gross margins change. Hopefully, they take up to their historical average, but that will be critical to watch. It was still a great quarter, like I mentioned, demand for decking coming out of this pandemic and during this pandemic was above its historical norms.

Sharma: I noticed when I was flipping through the earnings, that strength is reflected in the other statements; the cash flow statement and the balance sheet. This brings me to a quick little side discretion. I shouldn't say discretion because I really exercise it. I meant to say digression. Let me digress here for just a bit, but it's related to what you're talking about, Emily, in the theme, I think of this whole episode so far. It even has something to do with David's foresight in picking this company. The company is very well-run, and you could see that in how all these profits fall out and what the company does with its profits. Their balance sheet is impressive because it's got virtually zero long-term debt any given quarter that you look at. I really like that Trex is the same basic capital structure today that it had when it went public in 1999. 

What I mean by that is they haven't really changed their balance sheet tremendously by, let's say, taking on a lot of debt to expand or having secondary share offerings to raise money for very rapid expansion. Basically, every quarter the company's operating cash flows exceed its reported net income. This is a type of cash conversion for those of you who are familiar with that metric using EBITDA. Forget about EBITDA for a second. If you just take a look at operating cash flow versus the net income that Trex puts on its books each quarter, you have more of those operating cash flows than you show bottom-line profits. What that means is essentially, they are always running at a bit of a cash surplus, but they use that surplus to expand capacity. While they probably could have chosen any number of ways to grow more quickly, let's say, by a whole bunch just go out and issue a lot of debt and then use that to have even bigger production footprint, they've been very disciplined. They've taken their time with these strong cash flows. It's so interesting. The first I've seen that they've hit the credit market's long-term, it's just actually a drawdown on their line of credit facility for $136 million this quarter that showed up on their balance sheet. That's still left $175 million worth of working capital on their books with no debt associated with it. Of course, they do have some lease expenses. But if there's a trade-off here that management has made, which is, I'll put it this way, we could grow more quickly or we could stretch our manufacturing capacity to sometimes hit 100%. 

If we have unforeseen events like that, the Texas ice thing, which Emily, this is the best description I have actually heard for what happened in Texas this year today. If we have stuff like that, so be it. We will catch up a little bit. We'll sacrifice some sales rather than try to go out and alter our capital structure. This discipline it's nice to see, and maybe it's a good setup for the next part of this podcast as we talk about what's going to happen next.

Flippen: Yeah. This is the part of the podcast I was looking for the most because we're trying to answer the question of, OK, well, that's great. All of that stuff happened in the past. What's going to happen over the next five to 10 years? I think the big question that's probably on people's mind, I will kick it off with this lumber prices. I have to admit when I was asked that question on Motley Fool Live last week about Trex, my immediate reaction was, well, this has to be a boon for Trex. Trex has always been more expensive than wood, as the price of wood goes up when people aren't looking to make that decision. Suddenly you're not being asked to shell out 50% or 60% more in order to get the better product. Because of the huge increases in lumber prices, there has been, I guess, a relative decrease in the price comparison between Trex and wood products. They appear more reasonably priced. Trex is only around 10% more expensive than wood right now, which is the lowest it's ever been. But interestingly enough, in the most recent quarter, management noted that they're actually seeing higher conversion across all of their product lines. It seems to imply that people aren't just upgrading from wood to the cheapest version of Trex because they're really price sensitive, that they're upgrading to Trex regardless of the cost. It's obviously a good thing. Once people realize that they can afford Trex, once they realize that wood is expensive now and they go to the alternative products, they don't just get the cheapest model of Trex, they pay up for the more expensive versions, the one that look and feel more like real wood, which to me says that maybe people and consumers aren't as price sensitive as they believe they are.

Sharma: Or maybe they're changing. That is so counter intuitive, but it's very nice to see, I'm sure if you're Trex. They announced their latest line called Enhance. I think it was late 2018, maybe it was early 2019, and it really sold beyond expectations. When we talked about Trex growing more quickly even before the pandemic, this was a driver of that. Before the pandemic, they offered this, I won't call it a cheaper line, but more of an entry-level product to attract new buyers, and it was taking off. But now you fast-forward where we're coming out of the pandemic and they're seeing this greater buying across all of their price points. I think this may have something to do with some more lifestyle changes that folks are making after COVID-19. It also has to do with other things we've been talking about on the podcasts lately. At least at the fact that millennials in some ways, some of them are stuck because growing percentage of millennials that are being tracked through so many different surveys, they want to move into homes, but the housing market is so hot right now and the supply of new homes is so dreadfully thin that those who are already in houses are staying put. They're spending more on those houses. I definitely see if you're thinking that you might want to move, but you just can't because surrounding home prices are so high, just spending more on renovations and upgrades. This is probably a longer-term tailwind than it looks today because you could think about lumber prices normalizing over the next year, and that's all long good. But there is this longer-term trend which has been in place since the Great Recession. We've been under-building versus demand for new residential construction since 2008. This is only in Trex's favor, if we are looking at that five to 10 year period.

Flippen: This was probably the biggest shock that I heard when pulling out what my expectations were for Trex over the next five to 10 years. In my mind right now I was thinking, OK, lumber prices are really high, benefiting Trex. We have under our belt, there needs to be demand for all of these new homes. What's expensive when people are building decks, that means that Trex wins. There's actually this interesting lag that happens for homebuilding. Again, management answered this question the most recent quarter from an analyst you asked it, which is essentially like, OK, well, as we build houses, I mean, surely all of these houses are going to have Trex decks on them. This is a great thing, and I'm over here getting really excited to buy more shares of Trex. But there's actually a 12-24 month lag between when a house is built versus when people actually add decks on. I guess I'm showing my ignorance here, not being a homeowner myself as houses are always built with decks. In fact, the majority of the time they are built without decks and the decks are added on later. It's good for long-term investors. I still think that this ends up being a benefit for Trex, but it's not an immediate benefit. If you see an uptick in homebuilding, which I'm not quite sure we've seen yet, especially with lumber prices. But over the next few years, if homebuilding ticks up, people expect that it's going to need to add on one, two more years before that ends up being results for Trex because that's how long people will take to build their decks.

Sharma: Yeah, Emily. I'm a homeowner, but I'm going to show my ignorance. I felt most new houses were built with decks too. [laughs] Maybe just because I live in the South, and it seems customary. But that was a surprising conversation in that conference call. But I think too, that's one that's a little more hard to track because there is that lag. You don't know as an investor because they don't break this out in any particular fashion. What part of that sales growth is due to lag from new housing construction. But what we do know is that homebuilders are racing to catch-up. Doesn't matter what the price of lumber is, that isn't slowing down the housing construction industry. It's only slowing it down in the supply chain aspect because we've seen that people are willing to pay up. The demand is high. Whatever that gives track, it's like greater percentage points on top of their core revenue.

Flippen: The other thing that's interesting to think about, which's, again, they don't break it out, but I would presume the bigger part of their business is just the deck upgrade cycle. Management talked a little bit about that in the most recent quarter. What did you take away from it, Asit?

Sharma: What I took away from it is just the sheer number of decks which I was totally ignorant of. Yes. The management team projects that there are existing 40-50 million decks in North America, and these each have only an average life of eight to ten years. Now, you can do what I didn't. You can try to keep it in good shape and I can promise you it'll last longer than that, but you have to put in work [laughs] if you don't want to buy a Trex product. They think that the average deck upgrade cycle, which includes repairs and upgrades, is going to play out over the next five to seven years. They think that they will get a preponderance of the upgrades. 

For me, this is about, again, brand power, and its brand power with the consumer who may ultimately be asking their contractor about Trex because they have such a tremendous word-of-mouth. It comes from that brand power with those pros, with those contractors who have now decades of experience with the product and have seen the company innovate. This is not an acquisitive company, so Trex has a track record of introducing new product lines every few years. I think that they will capitalize on that in the coming years, just as they offered to enhance, which we were talking about a few minutes ago. I think you'll see more of these lines come out and that's a key to capitalizing on this deck upgrade cycle, but it's a key to revenue growth in the future. If the company isn't going to add on a lot of intellectual property and new patents, what you have is, endless fascination [laughs] with new configurations, new products, and new finishes. Emily, you mentioned at the beginning of the show that their decks are becoming more and more realistic. Not to get too much into the way that their decks are constructed, but a Trex flat is finished on three sides basically. Within that strategy, you can finish the slot on all four sides, and some of their competitors do. But I think what that does, it makes the individual flat or railing more accessible and affordable to the customer and they take some of that profit because this is, after all, a product that has to compete with lumber so the price-points have to be within reason.

 I think they've been plowing that in for so many years into the finishes. That's a big part of this business. How to make it more realistic? How to expand the color lines which they've done year-after-year from these basic gray-mattered looking decks, which is what I remember when Trex first came out [laughs] as a product. To me, it wasn't the most aesthetically pleasing product but today looking back over all the product samples online when I was doing research for this episode, I realized that it is something that management is very keen to do. It's not necessarily changing the composition of the slot in the railing. It's really making it more pleasing and more natural to the customer to approximate a wood drain as closely as they can. I don't want to exaggerate here and say it's going to be a huge tail win but it could be if we think about that staggering number, 40-50 million decks, and new product lines they can aim at that market.

Flippen: Not to keep [...] numbers at people, but management did provide some interesting numbers in the most recent earnings report which you normally don't get. I feel it's always worthwhile to share them. One of the numbers they noted was that any 1% market share gain that they take away from wood that moves to Trex is another $50 million in sales for Trex or 5% increase in their current sales. Even just the marginal movement away from wood to Trex, you don't need every single deck owner for those 40-50 million North American decks to go to Trex in order to make this a good business. Very, very small marginal moves and market share between wood to wood alternatives, and in this case, Trex, actual results and really meaningful growth for Trex. It's interesting if I didn't quite realize how big the market is for decks, especially considering that Trex is really only in North America right now, but it made me feel a little bit better about the long-term opportunities here.

Sharma: But I absolutely hate it when a management team spouts out figures like that because then I just want to forget everything else and run out and buy the stock. [laughs] 1% of market share capture is going to result in these tens of millions [laughs] of dollars of sales for us. The rational investor aspect of my brain starts to dim down and maybe it's a good thing that the gut part of me says, you can just take a position. That's pretty persuasive but on the other hand, grabbing each percentage point, it's not as easy as it looks. I will say though with that track record of really fast revenue growth, I could see it happening as well.

Flippen: I'm curious. I'll give my thoughts after yours because I don't want to accidentally color your opinion, but when you think about Trex as an investment headed out over the next five years, let's say. Do you think this is a market beating stock?

Sharma: I think that one is fairly easy for me to answer. Let me back up and say, will the stock trade at a greater price than it does today in five years? I think it's got a really good chance to. As for, will it beat the market, I think that's easier to see than some other companies that I am looking at. My big basket of tech stocks that I study, I think those are at some inflated valuations, even though many of them have these great business models and great markets. I think Trex has both a reasonable valuation and these markets it can tap into. We haven't even talked about international markets, which I know you pointed out in our prep, Emily, that they've got in the international sales component, but it's so small that it's immaterial. They don't even call it the number in their annual reports. They just say we've got international sales. They don't have [laughs] international sales. I mean they do, but that's more of an opportunity for them. 

When I look at the plan to increase capacity, management answers to us, dinging them on that manufacturing capacity being tapped out is a 70% expansion of existing capacity. When they finish the work on their Virginia plant, between that and the Nevada facility, they'll be able to produce 70% more than they did it pre-COVID level, so 2019 levels. Management mentioned on the first quarter call that they're going to aim some of that at international revenue. Now, remember, they've got a totally U.S. manufacturing footprint, so that means they have to spend some time figuring out their logistics, freight, supply chains, as well as distribution partners, since that's their model, the wholesale partner model in places like Europe, Latin America, and Asia. But that's a wide open white space for this company. With the tailwinds that we've talked about, the fact that the company's got a track record of selling into demand, there's consistent demand and growing demand for the product. The fact that it has more than half of the eco-composites market in the U.S., because it created that market, I don't think any competitor really is going to give them too much trouble in the coming years. I think this has every potential to be a market beating stock. I love its balance sheet. There are risks, we talked about a few. I mean, these aren't all the risks that are inherent in this investment. But I would say this reminds me of companies that I really, really gravitate toward that have proven themselves very solid. They're big, they've scaled, and Trex isn't big, but it's big in its industry. They're just going to grow more. Autodesk is my recent favorite example. You've heard me rave about Autodesk. This is like that in this industry. But now that I have gone out of my way to color your opinion, which [laughs] I think was good to begin with, Emily. Do you think this will beat the market over the next five years?

Flippen: I don't know. Sometimes I feel like I do a lot of digging, and I come away with an answer that's really unsatisfactory, which is, I don't know. I'm scratching my head over this one, and a much easier question if you had asked me just a couple of years ago when Trex, I think, was trading at much more reasonable levels in terms of valuation. I'm a little bit worried about Trex. Let me first start off by saying, Trex is an amazing business. They have, to your point, about their financial performance, self-funded their own growth for decades led by a really smart management team that's prudent with their capital, clearly knows what they're doing. They're a great business that's doing something important in the world that has some very real tailwinds as homebuilding kicks up in the U.S. As it becomes less environmentally friendly and potentially less economical to build using wood. For all of those reasons, there's a lot to like about Trex, and I don't want to downplay that. I do find myself just a little bit nervous about how much bigger Trex can get. That's where I find myself nervous about beating the market over the long term because I think it implies $20 billion business, $30 billion business in the making of which I'm not positive Trex can get to without some major international expansion, which is really challenging when they're manufacturing solely in the United States, using a lot of recycled products which may be hard to source and access as they expand internationally. I'm also a little bit nervous about the cost of decks. I say that because Trex versus wood, I mean, that's only a small fraction of the actual costs that go into building a deck. 

The foundation, the structural support, the integrity, all of that stuff that has to be built up, that's the vast majority of the costs, not the actual raw materials themselves. So there ends up being a lot of other costs associated with Trex and with decks for that matter, but a lot with the Trex that aren't necessarily attached to just the price of the material itself. That alongside again, their need to build up manufacturing capacity. I think they are trading at a trailing price to earnings above 50. For a business that has not grown this quickly in a long time for which business may normalize over the next couple of years. For all those reasons, I think I actually come out of this research, maybe a little bit more nervous about being a shareholder than I was when I came in. I think if I was a shareholder, which I'm not for no reason other than I just never got around to it. I think if I was a shareholder, I'd feel happy owning this business and hopefully, enjoying the gains that I got over the prior years. I don't know what the next five years looked like. I genuinely feel like I could flip a coin right now. That could beat the market, trailed the market for the coin. That's how I feel. Is that bad? I'm thinking of a cop-out answer here?

Sharma: No. I think it's a very rational answer. We approach this from two different points of view because you're a shareholder, I'm not, so for me, I don't have maybe a slight subliminal pull in my head that's saying, is this going to maintain what it did? I'm parachuting in. What I'm looking at is a proven growth that is averaging. That's retail like 14%, 15%, so you need the revenue growth. If you're going to beat the market, you have to have a sustainable edge over S&P 500 growth. When I look at the S&P 500 over the next five years, do I think that the entire universe is going to grow at a 14% rate in terms of revenue, all the companies? I don't think they will. The other thing that I like about this, is that it's still a relatively small-capitalization stock. Everyone bear with me for a moment because I know, Emily, it's trading around $11 billion. Is that the market capitalization?

Flippen: Yes.

Sharma: Many of you may say, well, see that doesn't sound like a small cap to me. But the fact of the matter is in terms of market capitalization, companies like Apple, and Netflix, and Amazon, and Google [Alphabet] have punched out the definitions. They've punched out the whole universe of market capitalization. When you've got these mega-companies in the trillions, it really makes for all practical purposes, companies that are in the$12-$15 billion range still small caps. For those of you who are having trouble wrapping your head around this concept, take a look at some of the biggest small cap index funds. You will see as a rule, they include in their largest holdings companies that are $10 billion, $12 billion, $15 billion market capitalizations. If you buy that logic then it's also interesting that historically, 2,000 stocks, for example, have traded somewhere around 30 times forward earnings. Now, this company trades at a premium. Assembly said it's 50 times on a trailing basis. This is about 46 times, it's earnings on a forward basis. But that's not a huge premium to the universe that it's existed in for the last five to 10 years. 

As it gets into that mid-cap territory, sure, I see that there's going to be some margin compression there. But I don't think it's going to be as significant as some might think, because it's got this proven revenue growth component. I think there's enough in North America for it to sustain this type of growth. Emily's got a great point though. After the next five or 10 years, it will really need to hit that international expansion, if it's going to continue to grow at that rate. I say this with all the fearlessness of someone who doesn't own the stock. [laughs] Maybe my answer would be more cautious if I had enjoyed some gains and I had had that really emotional aspect of seeing the stock takeoff, which it has. As we talk, I am looking at the stock chart, which if you pull this up from just 2015 on, it's a pretty phenomenal gain in price. In fact, bear with me for just a moment everyone. Over the past year, the stock is up about 60% trailing 12 months, and it was up as high as 80%. I totally get that note of caution on your part. You probably will be very close to right in the longer run, which means maybe it's going to match the S&P 500 performance. We're just going to match the market in the next few years.

Flippen: Well, I tend to be wrong, and listening to you has reinvigorated my belief in this business. I look forward to seeing what it has for us over the next five years. But until those next five years. Asit, thank you as always for joining and providing your insights.

Sharma: Absolutely. Thanks as always for having me, Emily.

Flippen: Listeners, that does it for this episode of Industry Focus. If you have any questions, you can always shoot us an email at [email protected] or tweet at us @MFIndustryFocus. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for his work behind the screen today. For Asit Sharma, I'm Emily Flippen. Thanks for listening, and Fool on!