Right now, the biggest macro theme is probably the housing market. After prices accelerated in 2020 and 2021, we're now at a point where housing-related stock prices are selling off hard. The reason is rapidly rising mortgage rates and uncertainty regarding the course of the Federal Reserve. Risks are that the housing market and its participants will get hit by a wave of higher rates, high prices, slumping consumer sentiment, and additional uncertainty.
In this case, I want to discuss what might be a canary in the coal mine. The Trex Company, Inc. (NYSE:TREX) was one of America's hottest housing stocks due to its operations in wood and plastic composite products. Right now, the stock is off more than 50% from its all-time high. And yet, the stock still isn't "cheap." In this article, I am going to dive into this company and explain why it's a great stock to have on one's watchlist. It's the kind of company that flies as soon as rates start to fall.
So, without further ado, let's get to it!
Let's start from a rather obvious angle: the stock price slump. This $7.0 billion market cap industrial operating in the building products & equipment industry is currently down 55% year-to-date, which is roughly the total drawdown from the company's all-time high at $140 per share.
While this drawdown hurts, it's actually not that unique as TREX investors have been exposed to rather unpleasant selloffs a number of times in the past 10 years alone.
In this case, housing is once again in a tough spot as affordability has become a major issue. On top of sky-high home prices, (potential) home buyers are now encountering higher financing costs as the average 30-year fixed mortgage rate is now at 5.0%. That's up from less than 3% during the lows.
The Wall Street Journal had a great chart that shows the toxic mix of high home prices and higher interest rates (the graph below). 2020 affordability was lower than at any point in 2020 and 2021.
This is a quote from a different article highlighting how much of a burden this is on the average home buyer:
The increase can boost a homeowner’s monthly borrowing costs by hundreds of dollars when the cost of everything from gasoline to groceries is also jumping.
A 5% rate on a $300,000 loan would create a monthly payment of about $1,610, excluding taxes and insurance, according to LendingTree Inc., an online loan information site. At 3.04%, where the average mortgage rate stood a year ago, the monthly payment would be $1,271.
In other words, what we're seeing now is the market pricing in housing carnage. All the quality stocks are down including Home Depot (HD), which has lost 27% of its market cap on a year-to-date basis.
It's times like these that I work on a watchlist with stocks that I consider to be a good buy on weakness. The Trex Company is one of them. Here's why.
As I already briefly mentioned, TREX has a $7.0 billion market cap and it operates in the building products & equipment industry. Incorporated in 1998, the company has become the world's leading manufacturer of composite decking and railing products, which are sold under the Trex name and produced in the United States. Moreover, Trex is a leading national provider of custom-engineered railing and staging systems for the commercial and multi-family market, including sports stadiums and performing arts venues.
The company's decking products consist of a blend of 95% reclaimed wood fibers and recycled polyethylene film that provide an eco-friendly composite that lowers the need for maintenance and improves durability.
In this case, the company sells its products using wholesale and the two do-it-yourself stores, Home Depot and Lowe's (LOW).
The company's value proposition is actually quite good. Decking using Trex means no rotting, warps, or splinters, no need for seasonal painting or sealing, and no way for termites to do their thing.
Moreover, as of 2021, wood still had a 75% market share. Trex estimates that every 1% market share increase allows the company to boost annual sales by $80 million. In the case of Trex, the company estimates that its core market size is $8 billion with 38% of home improvement spending targeting the outdoors.
TREX reports 20% annual compounding growth in its residential segment versus 5% compounding growth in remodeling, which isn't bad either.
The graph below shows the company's annual revenues, EBITDA, EBITDA margins, as well as the growth rates for both revenue and EBITDA.
Between 2012 and 2024 (expected), we're dealing with the following growth rates (CAGR):
The company is also generating strong free cash flow despite rising capital expenditures. Bear in mind that free cash flow is basically operating cash flow minus capital expenditures. The company has accelerated CapEx due to higher demand for its products. This includes a third production site in Little Rock, Arkansas, where the company expects to start production in mid-2024. Construction starts this year. This year, the company is expected to do $122 million in free cash flow. Using the $7 billion market cap, we're dealing with an implied free cash flow yield of 1.7%. This number is expected to rise to $252 million or 3.6% once construction in Arkansas leads to both lower CapEx and higher sales.
You also may have seen in the chart above that the company has negative net debt. This means there's more cash than gross debt. Also known as positive net cash instead of negative net debt. It allows the company to engage in buybacks and invest in its company without having to deal with the burden of high debt.
The company has a fascinating stat based on buybacks. Since 2013, buybacks have been $350 million. The intrinsic value of these repurchases was $3.5 billion going into this year. It's lower now, but it shows that the company put buybacks to good use. Also, it shows how much value the stock price has generated for people despite regular and steep drawdowns as I briefly showed in this article.
Over the past 10 years, TREX has returned 1,410%. The S&P 500 has returned 287% including dividends. This difference is stunning as it includes a more than 50% sell-off.
So, what does this mean in terms of valuation?
Again, for that, we need the company's $7.0 billion market cap. We also need net debt. In this case, I'm going with $250 million in expected net cash (negative net debt) to price in higher free cash flow generation. This gives us an enterprise value of $6.75 billion. That's roughly 14.4x next year's EBITDA estimate of $470 million.
This valuation is still "lofty," even after a stock price decline of more than 50%. However, we're dealing with a company that's growing sales by double digits with even stronger EBITDA growth thanks to higher margins. This valuation is more than fair. If anything, the valuation last year was completely out of touch with reality.
The problem is that housing remains a big factor of uncertainty, which means I expect the stock to bottom in the $50-$60 range. However, I'm not yet turning bullish as I don't expect an easy rally to new highs - not until rates start to show meaningful weakness again.
So, here's how I would deal with TREX.
I'm very glad I found this stock. The Trex Company is more than just a provider of building products. While its business model is rather straightforward, the company is in a fantastic position to deliver outperforming capital gains on a long-term basis due to its position in a great niche market. Its decking and related products benefit from qualities that "traditional" wood products cannot compete with.
Prior to 2022, the stock was flying as investors were betting both on its products and a red-hot housing market. Now, we're dealing with (expected) housing weakness due to falling affordability and the risks of a recession that come with it.
While TREX is fairly valued at its current price, I expect a bottom between $50-$60 and an uptrend once rates start to weaken. For now, I remain neutral despite my bullish title.
The key takeaway is to keep a close eye on this company. If you're looking for housing exposure, look no further. I think TREX is in a great spot to outperform "anything" in its way during the next housing bull market.
(Dis)agree? Let me know in the comments!
This article was written by
Disclosure: I/we have a beneficial long position in the shares of HD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.