Heavily Shorted Trex Is Too Undervalued

| About: Trex Co. (TREX)

While efficient market disciples will cringe, those seeking alpha recognize there are opportunities to exploit. And, one of the favorite opportunities is finding a stock ready to move and undervalued.

In my most recent weekly screening of stocks for my institutional clients, Trex Company (NYSE:TREX) once again reared its head. The company, which makes plastic - err, wood-alternative - decking appears poised to move higher as home building trends improve.

In the most recent quarter, Trex posted top line growth of 20%, good enough to produce $0.58 cents in earnings per share and keep it on target to post full year EPS of $1.58.

Trex is a small company with rapidly improving sales growth.

It only has 16.8 million shares outstanding, of which 15.5 million are floating. At current prices just shy of $30 per share, it boasts a market cap of only $500 million. Unlike larger, highly institutionalized stocks, Trex is a niche player traveling under many funds radar.

But, that's likely to change as investors begin to put more credence behind the early stage recovery occurring in homebuilding.

In July, new home sales were 25.3% above last year. More importantly, months of inventory fell to 4.6, down from 6.7 a year ago. Months for sale were 8.7, down from 9.4 in July 2011.

Overall, June construction spending increased 7% from last year, with total private construction climbing 13.1% - more than offsetting a -3.7% drop in public spend. We'll get July numbers on September 4th.

And, while July year over year new housing permit growth was revised lower to 29.3% from 29.5%, permit growth remains an impressive number and bullish for related housing stocks.

Analysts are looking for a big bump in earnings next year.

The consensus among analysts is for Trex to post $2.20 per share in earnings in FY13, 39% above 2012's projected haul. This gives Trex a PE of 13.53, well below its 5 year PE range low of 19.

Given the discounted valuation, it would seem investors under appreciate the company's growth and margin potential.

In the past two quarters, the company has seen its cost of sales fall to 63.8%, down from 68.4% a year ago. It's selling, general and administrative expenses fell to 20.7% of sales, down from 23.1%. Last quarter, a 22% lift in volume provided enough scale to boost gross margin to 35.6% from 30% last year.

Investors also don't seem to appreciate the company's low debt status and the $3.25 per share the company has in cash and equivalents.

Instead, they remain too focused on last year's housing challenges than this year's recovery. All in, short sellers are sitting on 8.8 days of average volume equal to 14.5% of the float. They're betting any inventory build in the channel tied to pre-season incentives will remain stuck there.

This bet could end up costing shorts handily. Particularly, if results at big chains like Home Depot (NYSE:HD) prompt investors to think of Trex more like highly shorted Lumber Liquidators (NYSE:LL), which I wrote about in February here, and is up 37% this quarter.

As for how much running room Trex may offer investors, a simple back of napkin calculation shows the gains could be significant. Using its current 19 multiple against its forward estimate gives you a target price north of $41, which would be good for a 40% gain.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in LL over the next 72 hours. 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.

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