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Why Trex Stock Squeezed the Housing Pessimists Tuesday

Motley Fool Staff, The Motley Fool

If you're wondering what Trex (NYSE: TREX) could have said in its second-quarter report to justify a 16% share price pop on Tuesday, you'll need to take a few steps back and look at the bigger picture. A certain segment of the investing world had been using the company's stock as a proxy bet on the housing market, and based on Trex's results -- and just as important, its outlook -- those folks bet wrong.

In this segment from the MarketFoolery podcast, host Chris Hill and MFAM Funds CIO Bryan Hinmon discuss what's happening at Trex -- its supply chain problems, which it appears to have put behind it, its aggressive guidance, and its healthy finances. They also talk about its investment thesis and why the stock may not be right for those who lack a strong stomach.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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This video was recorded on July 30, 2019.

Chris Hill: One of the biggest gainers on the New York Stock Exchange today is Trex Company. Shares of Trex are up 16% after second quarter results. This is the outdoor deck company, essentially. You tell me because this is a company you follow a lot more closely than I do, what is driving the stock today? Was the second quarter that much better than anyone thought it was going to be? Are they raising guidance?

Bryan Hinmon: You've got a couple of things at play here. First of all, there's about 15% short interest in shares of Trex. Many investors are using Trex as a way to bet against the housing cycle, to bet against the health of the consumer and spending on home projects. As you mentioned, Trex is a composite decking company. It's basically, you choose to build a deck, your choices are wood or Trex. They have no meaningful competition. Trex came out, earlier this year, they had launched some new products and actually had some supply problems, and they couldn't get enough product to market. Sales growth looks pretty muted right now, only 2% or 3% in the quarter. But they guided for 25% growth in Q3 and alluded to getting back to more normal growth rates for them over the next couple of years, which is low teens. The outlook they see for demand for what is now a pretty robust portfolio on the high, medium, and low levels of composite decking, they think that they are going to be able to accelerate market share. Stealing market share from wood, that's essentially the thesis here -- the composite holds up better, over the lifetime of the deck it is cheaper, and it's easier to maintain. They have painted a rosy picture. I think the shorts got caught betting against this company specifically, and a turn in consumer spending on the home. They got caught, and that's why you're seeing the pop here.

Hill: Shares are up as I mentioned. It's closing it on $80 a share. You look over the past year, it's been as high as $90, it's been as low as $50. The chart looks a little bit like a roller coaster. If someone is looking at Trex for the first time and thinking about, "This seems like a trend I can get behind, and I want a few shares for the next five, 10 years," is that the kind of volatility investors should expect? Or are the past 12 months something of an outlier?

Hinmon: I would expect it. This is, generally speaking, a high-budget purchase item of a one-off nature. There is no subscription element here that's going to smooth things out.

Hill: It's not Procter & Gamble, they're not selling laundry detergent.

Hinmon: No. This is not a fast-moving consumer good whatsoever. You're spending thousands of dollars to repair a deck. I would expect this volatility. However, this is a good business. The company notches 45% incremental gross margins, has really healthy profit margins, is cash flow generative, generates way more cash than they need, great returns on capital. The thesis here makes it seem as though there is a long runway for growth. You've got wood capturing 80% of the share. Trex claims to have a better mousetrap with no real clear No. 2. This is a good business. What you're ultimately betting on is that market share gain, and you're betting on the remodel nesting HGTV movement to continue. That spending really seems robust, even if housing continues to slow down. You saw numbers in Sherwin-Williams a week or two ago, paint sales continue to rise. There's volume there, but there's a lot of pricing there, too. People want to spend on making their homes better. Trex is a very pure way to express that thesis.

Bryan Hinmon, CFA has no position in any of the stocks mentioned. Chris Hill has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Trex. The Motley Fool recommends Sherwin-Williams. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com