Apple is a definitively high margin manufacturer. Everything about that company screams high margin.
The stuff feels expensive and (frankly) is expensive. But you are willing to pay for it because (a) it defines your identity and how you feel about yourself, (b) really does work pretty well and (c) has very good ways of keeping competition out - so you can't buy a true substitute.
On top of that Apple has software sales which (typically) are fatter margin than manufacturing.
Let's spell out just how high margin.
Here is Apple's 2017 second quarter results (link). Note these results are unaudited and in millions of dollars.
Reported sales were $52,896 million, Gross Profit was $20,591 million, and Operating Income was $14,097 million.
These are stunning numbers (especially because of their size) but lets spell them out as percentages...
Gross margin was 38.9 percent.
Operating margin was 26.7 percent.
Just stunning numbers.
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At Bronte we have the (justified) view that any manufacturing company with margins fatter than that needs some explaining.
So let me present you Trex Company.
Trex makes decking. Plastic decking. Outside many houses in middle America is timber deck often with a barbecue - or at least a grill - sitting at the end. This is a place for barbecue, socialising and - of course - beer.
The beer is very important.
The deck is also a frustration for owners because exposed to the weather the deck needs to be maintained regularly - and at a minimum oiled every year or so.
Sure the frustration can be offset by more beer. And I guess that makes it okay.
But these days you have an alternative - you can have fake timber decking. The fake timber is made of plastic and the sales pitch is that it looks just like timber but all you need to do for maintenance is sweep it.
Plastic decking is sold as a superior alternative to timber.
There are lots of suppliers. There is Trex Company, Fiberon, Azek and others. Beyond that Home Depot and Lowes have their own house brands (eg ChoiceDek available only at Lowes).
So with plenty of competition for a building product where most people will not know the brand names (and where the purchase is large and so you might wish to shop it) you would expect lowish margins.
But you would be wrong. The margins are stunning.
Here is the last quarterly result (link). This time the numbers are in thousands of dollars rather than millions...
Reported sales were $144,806 thousand, Gross Profit was $65,169 thousand, and Operating Income was $41,900 thousand.
Again we should spell them out as percentages...
Gross margin was 45.0 percent.
Operating margin was 28.9 percent.
Whoa - Trex Company - with lots of competition - is fatter margin than Apple.
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So what is happening here? How the hell does Trex do it?
There is your business puzzle for today.
And if you are a journalist with a middle-America beat there is a great story here for you. This one is just made for the USA Today or non-business mainstream media.
John
Disclosure: short a little Trex (which traded badly on these results).
This is not a death-grip short like say Home Capital Group. But it is a source of some amusement. I like puzzles like this.
38 comments:
They front loaded the quarter.
"2017 sales programs that provide incentives for our distributors and dealers to build inventory levels before the start of the prime deck-building seaon...
They front loaded the quarter.
"2017 sales programs that provide incentives for our distributors and dealers to build inventory levels before the start of the prime deck-building seaon...
Yeah I like a puzzle as well - only I am not good at them, nor is my core expertise in a manufacturing business.
Never the less I will get the ball rolling. I began with the non-PL hint regarding beer being important (you mentioned it a lot). Google didn't throw me any leads and I couldn't find any link between brewing by-produt and the trex raw material polyethylene.
This did get me to the understanding that much of he raw material is recycled and likely very low cost (maybe they are even paid to take it?). However I could find no indication that were paid to recycle (in effect a negative cost of raw material). However I did run across some hazy comment by CFO Brian Fairbanks quoted on Motley Fool that "In the past, the company has purchased far more used poly than it needed, selling the rest on the secondary market"
That is as far as I got, perhaps running down raw material stockpiles that they recognised as an expense previously?
Like I said I like a puzzle but I off in the weeds as far as my skill set goes. Looking forward to the real answer though. All the best Bruce.
Haven't looked any further than Accounts Recivable and already I'm wondering...
The company had a poor cashflow quarter, all cash and then some went into accts receivable. Similar to Q1 2016 but more pronounced this year.....it washed out (converted to cash) in q2 and q3 so we whall see what happens this year. Have not looked at business but could it be that the company is financing the decking to its customers, middle america? if so can they afford to pay it? perhaps the high margins have high rates of interest baked in....
Well, they bribe the installer channel.
my guess: main customers are contractors who pass through the cost (plus some % markup) and so have an incentive to pay higher prices.
my guess: trex's customers are mostly contractors who pass through the cost (plus markup) so they have an incentive to pay higher prices.
Rather than shorting TREX, maybe you should just go long AAPL. Or are you already? AAPL = the ultimate cash cow.
Isn't this as simple as they are cyclically over-earning? This isn't even the company's all-time high margins. In the years leading up to the housing bubble their margins were even higher.
Following the blow ups of the last major cycles EBIT margins declined enough to go negative.
Isn't this as simple as the company is cyclically over-earnings? These aren't even the company's all-time high margins. In the years leading up to the last housing bubble they were higher.
In the bust of the last two housing cycles EBIT margins declined enough to go negative.
Just by way of a hint, does the tricky accounting show up in the annual statement, or only in the quarter? Their annual margins are lower (though still damn good), and they freely acknowledge (at least in their filing) that a given quarter will be distorted by their very large customer incentives and financing of pre-orders before the busy season. But they note it tends to even out over the year. Good puzzle!
Perhaps their numbers are really high due to something about the industry that makes it cyclical (and perhaps partly due to raw material prices). For example, the company fared poorly in 2005-2012... that suggests some cyclicality to me.
2- Their accounting looks clean. They haven't been capitalizing more expenses (capex peaked at $50M in 2005). The estimated useful lives of their PP&E has gone down slightly... Machinery and equipment went from 11 years to 3-11 years.
3- They seem way too optimistic about the reliability/quality of their products. Their warranty reserves seem extremely low given their past issues. For 2006 and before, the company did not seem to have a warranty reserve at all (!!).
Buying back shares at such high prices is very aggressive.
4- Low insider ownership explains a lot in my opinion. These guys just want to sell their stock, which explains the silly buyback program.
And to top it off, decks seem to be going out of style, at least in our area (New Jersey). I see many more patios than decks being built. Lots of maintenance for decks, as you mention. I have a patio and a deck; I wish I had two patios. Plastic also weathers, although not as badly as real wood, and it gets hot enough that walking on it with bare feet is nearly impossible.
That said, if you mention man-made decking, the brand name that invariably comes to mind is Trex.
I was never comfortable investing in Trex for just that reason; there seemed to be little basis for them to make much money, long-term. That said (and I'm quite sure I'm missing the point here), it's obviously a cyclical biz. Current margins look extreme compared to historical, as they often to do in cyclical businesses, though I suspect you've found basis for more than a reversion to mean...
Also, I know a few people who work building/renovating homes and they use the term "Trex" generically for any synthetic decking. Having that kind of mind and market share (40%+ and growing for Trex, right?) may be a durable intangible asset, especially on jobs where labor cost probably exceeds materials cost.
That said, I'm missing something (or some things) and hope to find out what it is!
Price is set by comparison to the substitute product - redwood. That is the real competition. Plastic lumber is a small part of the market.
So you're shorting a growing company with very high margins. That seems to imply that you believe their margins come down but you have no idea why they earn high margins in the first place. Why do this?
that is quite the move in A/r and line of credit
Accounts receivable of $171m looks rather curious...
What percent of Trex's business is sold to individual homeowners, versus real estate developers/builders in 'green fields' suburbs? [greater returns to scale accrue to the latter]
I recently replaced the deck on my house, and was shocked at the price that Trex commands. Believing myself a savvy individual, I ordered samples from nearly everyone else and tried to source "manufactured" product elsewhere. I can say that Trex is (1) an awesome product and (2) seems to be better than the competitive products I reviewed. And therefore, it does seem to command a pretty high margin, though I agree that their margins are eye-watering. The brand has literally become a noun, like Jello or Tylenol, which suggests some brand power.
I have looked at a similar business (headquarter in Israel and sold to private equity last year).
The EBITDA margin of this company has risen from rose 12% to 20% in the last 2 years based on falling oil prices (the main raw material cost is a resin) not being passed on to consumers (and for the most part being retained by the manufacturer not the wholesaler or retailer). The increase was all from gross margin rising from 30% to 40%.
I believe there are only a few companies that make this kind of 'furniture' so competition may not be high, whilst the segment benefits from a switch from higher cost raw materials products to the resin based solutions (allowing prices to potentially be higher as the substitute product cost is the anchor). The mix of own brand and own label, product quality and local share could easily explain the mid 20% margin of Trex compared to the 20% of the business I looked at. Were resin prices to rise, expect margins to fall (and also potentially in the long term, although who knows what manufacturing and product composition changes could offset retail price pressure).
Hi John,
Fantastic blog and post. I'll have first crack.
Any chance you think it channel stuffing?
Accounts receivable jumped from $48m to $171m from YoY quarter ending March.
Their annual report also highlights their tiered distribution channel / systems and claims ignorance over inventory levels. I imagine not actually selling anything would keep sales costs down and margins up.
James
http://nasdaqomx.mobular.net/nasdaqomx/7/3527/5034/document_0/TERX_2016_Annual_Report-processed.pdf
Because few distributors provide us with any information regarding their inventory, we cannot definitively determine the level of inventory in the distribution channels at any time. We are not aware of significant changes in the levels of inventory in distribution channels at December 31, 2016 compared to inventory levels at December 31, 2015. Significant increases in inventory levels in the distribution channel without a corresponding change in end-user demand could have an adverse effect on future sales.
I think a lot of it has to do with the remodeling cycle in the US. 90%+ of TREX's sales are to for US resi remodeling. Remodeling activity is cyclical and current remodeling spend is at all time highs (well past the last cycle which was a huge housing bubble)... Normalized / mid-cycle margins are much lower
After a cursory glance at the 10Q it seems the treatment of warranty claims might be amenable to shenanigans. Beyond that inventory valuation is intriguing - 10Q shows LIFO inventory ~40% lower than FIFO as of 03/31. No idea what the comps look like for the other players but I suppose if you can pass inventory through COGS at 40% below cost that is one way to fatten margins. An interesting puzzle for sure.
So I have no comment on the financials, but I can tell you that Trex is (or at least was) the brand leader in the composite decking space.
This stuff all looks roughly the same, but brand does matter as a deck product that fails tends to fail catastrophically.
Also, Trex's dominance partly had to do with being an early player but also having an incredible installer base, ie they had tied up much of the deck installation industry with very aggressive incentives to installers who acted as their sales channel.
None of this explains the margins you point to, except that they may have achieved scale and brand recognition in their market and are not going after the low cost DIY market.
Hi John,
High accounts receivable!
It looks like they are only realising 50%-60% of their accounts receivable in the future as revenue. I suspect that the products are being sold but at a steep discount?
All this results in a really bad operating cash flow position. The company requires a line of credit to fund the cashflow shortfall.
Just to add to my first comment. I looked a bit more into the company and they sell decks to customers via a Loan scheme. This delays cash flow and bad debts are likely to increase. This is a form of "indirect" product discounting.
The dealers get a lot of support:
ie training, trade leads, marketing support...
However your clue was.....
"The beer is very important"
The incentives in addition to the above include entertainment
ie golf trips, fishing trips etc and of course beer !
Plenty of complaints about product quality on Consumer Affairs website (and elsewhere). Mold seems to be a recurring issue. Not sure if this is the right path, but may suggest management is stretching to save money on product costs that they can flow through to the bottom line.
not familiar with names, but are margins same or similar for competitors you mention or is Trex outlier in this field?
low cost position from recycled vs. virgin material from peers. Lower oil prices, Good distribution system vs. weak peers resulted in share gains and margin expansion. Lots of industrial companies with those type of margins
The dealers get a lot of support:
ie training, trade leads, marketing support...
However your clue was.....
"The beer is very important"
The incentives in addition to the above include entertainment
ie golf trips, fishing trips etc and of course beer !
Licensing revenue could be a factor - they license the Trex brand name to a number of companies that make complementary products. This would be revenue that has a 100% margin (or close to it). It's probably not the sole source of their high margins, but it likely gives them a boost.
It's all about the brand.
Trex's marketing is far beyond all other players in the industry. I'm on the management team at one of the largest retailers in the country for this product (we also carry the other leading brands of composite decking). Trex provides much more support to the retailer, as well as to the contractor, compared to any of the other brands.
Their product literature and website are superior to the competition. Homeowners that we encounter don't know what composite decking is, they just know they want a "Trex" deck. They are often shocked to learn how many other brands are available. Yet, almost always end up choosing Trex because they want the brand. It's the Kleenex of wood-alternative decking.
BBinc (Bruce?) at #3 seems to be closest to my thinking.
Trex make a great deal on their website of the recycling of plastics and sawdust into their boards.
So they say "the average 500-square foot composite Trex deck contains 140,000 recycled plastic bags! That makes us one of the largest plastic bag recyclers in the U.S."
Presumably, the margin arises since they have a great deal of power over one of their main inputs.
But, plastic bag bans seem to be gaining ground in the US, so I suppose those margins will come under pressure as supply tightens.
At the same time, it seems that per capita beer consumption is dropping in the US (as with elsewhere), so one of the use cases for decking is shifting, plus they've probably got close to peak sales growth if the stuff really is maintenance free.
So, limited scope for growth, margins likely to be under pressure, probably consolidation coming up.
The story is presumably that the environmental conscience of middle America created a great American business, then 20 years later, snuck up behind it and shot it in the head.
they are not recognizing accrued expenses (31m) to income, half of which is is sales, marketing and compensation related. Note 7 of 10Q.
John, firstly, I haven't delved much into this. But here is what confused/bothered me so far. I would really appreciate if you would let us know your thoughts.
1. It seems that a large portion of the recycled plastic/raw material is tied to their 35% ownership in Denplax. Weird enough, unless I am totally wrong here, a google search of Denplax doesn't yield much results. The link below is the closest i got to any info. Whoever owns the other 65%, why don't they come up with their own version / force Trex for more royalties? (just thinking out loud here)
http://translate.google.es/translate?hl=es&sl=es&tl=en&u=http%3A%2F%2Fwww.demplastic.es%2Fquienes.html
2. Trex recognizes revenue once product is shipped and under inventory, mentions that they have no information or control over inventory at the distributors. Channel Stuffing?
3. I did compare this to our Canadian equivalent, Fiberon by Goodfellow Inc. While I still have to do any work on it, Goodfellow has an operating loss and Gross Margins in and around 12-16%.
I will agree that it is a pretty decent business to be in but barring the early mover advantage, it seems like a commodity business to me.
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