Bearish on Building Products
Featuring Bradley Safalow
Published on: August 15th, 2019 • Duration: 14 minutesBradley Safalow, founder of PAA Research, examines a highly regarded building-product stock, Trex. In this interview with Justine Underhill, Safalow cites increased competition and decreased market share as reasons for concern, and notes why strong growth for the overall industry is a risk to his thesis. He also reviews how traders can play the setup, and discusses just how low he sees share prices falling. Filmed on August 13, 2019.
JUSTINE UNDERHILL: Welcome to Real Vision's Trade Ideas. Today, we're sitting down with Brad Safalow of PAA Research. It's great to have you here.
BRADLEY SAFALOW: Thank you for having me. I'm excited.
JUSTINE UNDERHILL: And this is your first time on Real Vision's Trade Ideas. So could you give us a little bit of your background and what you do?
BRADLEY SAFALOW: Sure. So PAA research is a fundamental research firm that I founded about nine years ago now. And the idea, I previously worked at a hedge fund and before that, at JP Morgan as the lead sell side analyst, I wanted to bring an absolute return focused product, which means I generate not only longs but also short ideas, to the market that was backed by not only rigorous fundamental analysis, but a ton of primary research. So for your viewers, it's a hedge fund quality research product with no agenda, no investment banking conflicts, just get the idea right, let's generate high returns on investment ideas.
JUSTINE UNDERHILL: Great. Okay. So with that in mind, what idea do you have today?
BRADLEY SAFALOW: Today, we're going to focus on Trex, which is a composite decking manufacturer based in Virginia. The company's name is probably- if you have a deck, you've maybe have considered purchasing their products. They have gained a lot of share over the last several years due, in large part, to a number of factors but there's been a movement towards replacing wood decking with composite decking and if you're not familiar, composite decking is made of recycled plastic bags, bottles, other things combined with wood product to create what people hope is an experience that resembles wood and that will last a longer period of time.
Now, we have a bearish view on Trex, which the stock itself has done well over the last several years but our bearishness is based on the view that the company is now facing a huge increase in competition at a time when they're having significant manufacturing problems. So before we start on Trex, it's important to understand who they're competing with and how that's actually changed in a meaningful way the last two, three years. So the industry, if you go back to the last cycle, composite decking actually took about 24% of the linear feet installed in the United States of decking.
So one of the things that I think investors trip up on as they say, well, today, it's 18% to 20% of the decking industry is composite decking, the composite decking's lost share. And the point of this is that it is very expensive. So what's happened in the industry is that you have an influx of competitors and influx of competitors who are now trying to bring lower price product to market. So in the case of Trex, historically, they've had some competition, there's dozens of players out there.
But in the last few years, you've seen a lot of acquisition activity in this space where a company called Fiberon was acquired by Fortune Brands, Universal Forest Products, which is a big wood distributor across the country, acquired their own platform. And then you've had a couple other acquisitions that were made in the space. And now, instead of Trex really competing against a few other players that were not as well capitalized, they're competing against increasingly a swath of companies that have distribution across the country. So you have Fiberon, you have a brand called Decorators, which is owned by Universal Forest Products, you have TimberTech, which is owned by AZEK. And interestingly enough, at the start of this year, TimberTech launched its first ever advertising campaign, national TV advertising campaign and our research suggests that it gained a ton of consumer mindshare and broader backing from distributors.
So you look at Trex, which has had nice growth for a long period of time. Now, they're certainly facing competition from large, well-capitalized companies. And here's I think the most interesting part of Trex is that if you look across the building product space, most companies operate with gross margins around 23% to 25%. Trex has a 43% growth margin. Now, there are a number of factors that contribute to that. One is the pricing of the product, two is that they were running their manufacturing facilities at max utilization, and three is that they really have not faced a ton of competition.
So now, you have competition coming into the market, competition that's gaining distribution. And what's most interesting is that in the last three, four quarters, Trex suddenly has had major execution problems. So they've tried to roll out this new lower price product that they hope will accelerate adoption of composite decking that will cannibalize their gross margins unequivocally. So there's that dynamic. But separately, the management team has had a hard time getting the production right for these new products.
So what happened this spring is that they actually failed to deliver product to their dealers, to their distributors. So for the year, they've lost a ton of market share. Now, the decking orders come in, at least the initial orders for the spring summer selling season come in November, December. So as you look towards the fall, part of my thesis is that the company will lose share, because these competitors are now in the marketplace at the worst possible time for the company when they've actually failed to deliver.
So the market- when I said market, and the investment community views this stock, this company as this massive secular grower, the stock trades at nearly 30 times earnings. My view is that they're going to struggle with gross margin compression and slower sales growth as a result of competition.
JUSTINE UNDERHILL: So there's a lot of specifics with the Trex itself. But I want to talk a little bit about the sector overall, we recently had Jay Van Sciver on. He's the industrial sector head at Hedgeye, and he had this to say about the space.
JAY VAN SCIVER: So, you had a series of really unusual and exceptional events happen to the building products and construction material space. First, you had tax reform, tax reform, generally, major house and even the most optimistic view, less of a tax shelter a lot, fewer people are taking advantage of the tax benefits as afforded residential housing. Second, in 125 years, you've never had more rain than you had in the first half of 2019. So, I think it's a stat that people haven't quite internalized. But it was the wettest year in the period that note was measured over the last 12 months. They've been doing that for a long time since like 1895.
And the third thing is we had a spike of interest rates in the middle of 2018. And interest rates are now down. And we tend to see on average construction spending respond to lower interest rates with about a seven-month lag. So we should, as we enter 2020, at least on a relative basis have a better environment for residential construction, buildings, product suppliers, like Mohawk.
JUSTINE UNDERHILL: All right, so with mortgage rates declining, and with the weather possibly improving, do you think that could be something that could specifically buoy Trex?
BRADLEY SAFALOW: Sure. So I know in the case of Jay's arguments, he's talking about Mohawk, it's actually a stock I personally own and has been, as a firm, I published my portfolio holdings every quarter so my subscribers can see that but so much about Mohawk has to do with how they're dealing with LVT. And some of the manufacturing issues they've had. Certainly, lower rates will help them. Lower rates will help anyone in the broader construction space. I don't disagree with that.
The weather element, which is interesting, a lot of the building products companies have complained about them. Another company, Beacon Roofing, which is one of the largest roofing distributors in the US missed badly this most recent quarter, and they talked about the rain. So, there's no debating that better weather will help. And I would say that composite decking currently, because of the credit conditions, the category is growing at a low and double digit rate. And my checks with dealers suggest that through the spring and summer, they were- let's just say on average, expecting the teens, and then they just expect some slowing in the back half.
Certainly try to continue to benefit from that, my expectation is that relative to the share gains they've had up until this point, or really up until 2019, that they will start to show slower growth in the industry. And then again, from an earnings perspective, the margin dynamics for this company are about to change drastically. And so you have a scenario where I think the company's earnings could ultimately be 25% to 40% below where the street is. And in that scenario, I expect a massive re-rating of the stock going from, hey, we have this huge secular grower that has high margins, scary high margins for a building products company, and that you have some mean reversion in their margin profile and their growth rate. And that leads to what I think is a stock that's trading in the low 80s now can trade as low as $35.40.
JUSTINE UNDERHILL: Now, the stock over the course of the past year has seen some pretty choppy action. It recently released earnings and shot up out of that range that it was in, it shot up about 20%. Is that a concern here? And were you short the stock before earnings release?
BRADLEY SAFALOW: Sure. To your second question first, short the stock, we introduced it as a short idea in March of this year. My timing there wasn't exactly perfect. But we take a long-term view, most of the shorts that I'm looking at are two, three years in duration. As far as the action in the stock, the volatility is really surrounding the production issues that they've had about their Winchester plant and Nevada plants where, again, there is a big question whether the company can consistently execute on producing both their high-end traditional product, which is called Trex Transcend and this new lower price product called Trex Enhance, getting those lines up and running has create a lot of production problems.
They're also trying to do so many different things. They're launching new products, they're trying to increase capacity at their existing plans. And again, now, facing all sorts of different competition. So the volatility around the stock really has more to do with their execution issues, not so much with the broader industry trends.
JUSTINE UNDERHILL: So even though we saw bullish earnings outlook, you're still fairly bearish on the stock?
BRADLEY SAFALOW: Yeah, I should have spent a little more time talking about what actually happened with earnings. So, the company in the second quarter actually missed their gross margins or what they got it too. And they were offset that with some other. So I'd say the actual quality of their earnings was very low, the sales numbers not great. The reason why the stock traded up so much is that their guidance for the third and fourth quarter- they basically said, we have all these catch up sales to do. Because again, we weren't able to deliver product in the channel, inventories in the channel have been depleted to some level then there's been a drawdown and so we need to restock.
So what's really happened in totality is that earnings that should have been delivered in the second quarter been pushed to the third and fourth quarter so changing the seasonality of the business at least for this year. In my view is what happens next year is going to be a very different selling landscape for the company.
JUSTINE UNDERHILL: All right. So could you talk a little bit about your target price, and also where you would stop out of this?
BRADLEY SAFALOW: Sure. So, we expect the company's earnings to disappoint 2020-2021 as this competition dynamic takes hold, and I think the company will continue to struggle in some of these execution issues. So, we think the stock can trade to $36 is our official target, which is 15 times by 2020 earnings number. As far as being stopped out, from a stock price perspective, obviously everyone wants to manage risk. But I'm someone who's fundamentally focused in what's going on in the industry, it would have to be a change in the competitive dynamics, the company's ability to deliver incremental gross margin in excess of 45%, some other factor that would cause me to recalibrate how was thinking about the name. Not necessarily an absolute price.
JUSTINE UNDERHILL: Now, in terms of that, what do you see as being the biggest potential risk to this?
BRADLEY SAFALOW: This short thesis? I think we've touched on this several times, is that the category growth is very strong. And so, even a poorly run boat in a rising tide will still motor along. So that's what's happened for Trex this year, and certainly for the stock. So that, to me, is the biggest race is how long can overall demand and this shift from wood to composite decking- a lot of people view that as a secular trend. And there are people in the industry trying to lower the price of composite decking to draw that trend. But that's going to be the momentum for the business. You asked me about this earlier, about from a credit perspective, I don't think people are cognizant of how much these businesses are really reliant on all sorts of exogenous forms of credit. So, that is a really important dynamic and it doesn't get talked about enough around this company.
JUSTINE UNDERHILL: Great. Amazing. Thank you so much for joining us.
BRADLEY SAFALOW: Thank you for having me.
JUSTINE UNDERHILL: So Brad is bearish on Trex. Specifically, he likes shorting it at current levels, and sees downside risk as low as $36 over the next two years.
Just remember, this is a trade idea and not investment advice. Make sure to do your own research, consider your risk tolerance and invest accordingly. For Real Vision, I'm Justine Underhill.