This blog post is in reference to John Hempton’s post on Trex; the post points out that Trex’s operating margins are suspiciously high. I haven’t uncovered enough about Trex that would suggest to me that there is some form of egregious accounting fraud occurring. However, I can see how Trex’s margins can appear to be so high. This industry does not sell a commodity. Rather, the industry sells marketing hype and unproven technology.
Trex was one of the companies that pioneered the use of wood-plastic composites as decking material over 2 decades ago. Unfortunately, the composite materials did not live up to their fanfare and marketing hype (e.g. zero maintenance, lasts longer than wood, etc.). There have been issues with composite deck materials from virtually all manufacturers that have led to recalls, expensive warranty claims, and class action lawsuits. Some manufacturers have gone bankrupt and were not able to pay out all warranty claims, leaving homeowners holding the bag.
The current practice is for manufacturers to exclude known problems from their written warranties. These written warranties do not obligate them to stand behind their marketing hype.
(*Disclosure: No position.)
A primer on composite decking
A Nebraska company called “Star Craft Custom Builders” has put together an excellent handbook on composite decks. In particular, they have done an interesting lookback at Consumer Reports’ independent analysis of deck materials:
Consumer Reports® has been testing decking materials, including standard treated yellow pine, for a number of years for resistance to slipping, flexing, sagging, mildew, staining and color fading and scored each product on a scale of 1 to 100. Treated pine rated 67, and only two composite products rated above 67, and the best of these, CorrectDeck, scoring 73, is out of business. Consumer Reports® also rated GeoDeck a “Best Buy” just a few months before it was recalled nationally as being completely unsafe. The organization also still scores CorrectDeck its highest rated composite decking product although the company declared bankruptcy in 2009 and is out of business.
This is an industry where the “highest-quality” composite product was not commercially successful. Tough business.
If you really want to get into the nitty gritty details, you can read the textbook “Wood-Plastics Composites” by Anatole Klyosov. The Wiley website makes the first chapter public. The author worked as the vice president of R&D for Kadant Composites, which made Geodeck. Geodeck is the same product mentioned earlier that had a recall due to safety issues. Kadant Composites sold the operating business to another company and used the leftover cash to pay out warranty claims. Unfortunately that money ran out. Kadant Composites’ parent company -Kadant Inc (publicly traded as NYSE:KAI)- and the current owner of the Geodeck assets do not honour Kadant Composites’ warranty claims. To Kadant Composites’ credit, they were proactive in trying to clean up their mess and did not make homeowners resort to class action litigation.
Side Note: The textbook’s author Anatole Klyosov (personal website| archive.org) was one of the founders of the company that became Galectin Therapeutics (NASDAQ:GALT). He currently sits on the company’s advisory board. For whatever it’s worth, finance Twitter hates GALT… just do a search for $GALT among people you follow. The borrow is over 90% at the moment.
The road ahead
Going forward, I would expect many (though not all) of the problems to continue.
- Structural collapses should be reduced (and hopefully eliminated) now that manufacturers understand plastic oxidation problems. Adding antioxidants can combat plastic oxidation (see “Oxidation and Crumbling” on page 36 of Klyosov’s textbook- here’s a PDF link).
- Fading is a known issue. For the most part, the manufacturers’ written warranties specifically don’t cover this. Some of the latest high-end composite products are likely engineered with materials that protect against damage from ultraviolet light (which damages the appearance of the material), allowing the product to be more “fade resistant” than previous generation products. For example, Trex’s Transcend line is advertised as having higher fade “resistance”. Trex’s premium products come with a supplemental warranty for fading and stain resistance. However, the warranty is pretty bogus, e.g. it is extremely narrow in scope, requires the customers to pay for professional cleaning, and makes a distinction between stain-proof and stain-resistant. I would assume that the UV protection will taper off after several years just like the latest-generation coatings that can be applied to conventional decking.
- Mold and mildew are a known issue. For the most part, the manufacturers’ written warranties specifically mention this and don’t cover it.
- Durability of the material’s surface is a known issue. Manufacturers’ warranties generally do not cover “wear and tear”. Manufacturers recommend being gentle with high-pressure washers (e.g. keeping more distance between the nozzle of the washer and the deck).
- The manufacturing process will likely remain temperamental and inconsistent. According to this article in Eco Building Pulse, “roughly one-eighth of what’s produced gets rejected before it ever leaves the factory.” In practice, I doubt that the quality control process will always catch everything. One Twitter user posted a picture of their deck where some boards turned blue:
- Earlier generation product continues to be manufactured. To some degree, this is beneficial for homeowners who need to replace boards or to make decking additions. However, it is likely that old problems will persist. Note that Trex’s 2013 settlement (PDF) over mold and fading issues names Trex’s premium Transcend and Enhance product lines as products covered by the settlement- these product lines have not been discontinued.
If a homeowner desires an attractive, low-maintenance outdoor space, then there are proven building materials such as brick, stone, and tile. Ipe wood is also low maintenance if you allow it to fade to a silvery grey. I am not sure why any sane homeowner would want to take on the risks of unproven wood-plastic composites.
Are wood-plastic composites fundamentally flawed?
In general, we have a lot of knowledge about wood and plastics as building materials- they will not last when exposed to the elements. While plastics have been used in outdoors applications, we do know that ultraviolet light will damage them over time:
UV from sunlight will attack many plastics, resulting in discoloration and embrittlement. The rate of degradation depends on the UV stability of the polymer and the use of UV stabilizers, top layers, and/or coatings to protect the material. Lower latitudes, high temperature, and humidity can accelerate the weathering process.
I suspect that the latest generation of composite decking material will once again fail to solve fundamental problems with using wood and plastics in an outdoor setting.
Industry-wide bullshit warranties
Like its peers, Trex’s warranty covers very little. For its composite wood products, Trex’s 2017 Limited Warranty has some key gotchas:
- Durability: “ordinary wear and tear” is not covered. Presumably this includes scratches to the surface of the product. If the product is used in a commercial rather than a residential setting, the warranty expires in 10 years rather than 25.
- Mold and mildew: Not covered.
- Appearance: The following isn’t covered:
- “variations or changes in color of Trex products”
- “normal weathering (defined as exposure to sunlight, weather and atmosphere which will cause any colored surface to gradually fade, chalk, or accumulate dirt or stains)”
- “staining from foreign substances (such as dirt, grease, oil, etc.)”
- Trex will not pay the full costs of fixing the problems caused by their product. They will not cover labour, removal of old material, etc. This can be problematic for the homeowner since Trex can simply send the customer new replacement boards. If the same problem reappears in a few years, the labour + other replacement costs can be quite onerous for the homeowner.
Let’s take a look at the supplemental 2017 Limited Fade & Stain Warranty for Trex’s decking products.
- Durability: Exclusions include “any condition attributable to […] ordinary wear and tear”.
Trex won’t cover the product if you use metal shovels to remove snow: “Never use metal shovels or sharp-edged tools to remove snow and ice on the surface of the Product. If the surface of the Product is damaged or punctured, this warranty will be voided.”
- Requires professional cleaning (!!!): Trex requires the Purchaser to pay for professional cleaning before they are eligible for a warranty claim: “Purchaser must have the affected area of the deck professionally cleaned at Purchaser’s expense”.
- Declining coverage: After 10 years, the “percentage recovery” will start declining to 10%.
- Stain “resistant”, not strain-proof: Trex warrants that the product will be “resistant” to stains as long as the deck is cleaned within a week. “Trex does not warrant that the Product is stain-proof”. The warranty is also limited to certain things: food, beverage, and naturally occurring mold and mildew on the surface (as long as that material is cleaned within a week of first appearance). Of course, the issue with mold and mildew is that it often continually returns.
- Regular cleaning: As mentioned previously, the deck requires cleaning within a week. As well, “You should periodically clean your deck to remove dirt and pollen that can feed mold and mildew.”
- Fade resistant, not fade-proof: “No material is fade proof when exposed to years of UV exposure and the elements. The Product is designed to resist fading, and will not in any event fade by more than 5 Delta E (CIE) units.” To be fair, traditional wood has (more) issues with fading.
- Paint: Paint will void the (supplemental) warranty.
Typically, the homeowner buys a composite deck with the mistaken belief that:
- The deck will be close to maintenance-free. (The marketing departments imply this without actually claiming this.)
- The deck will hold its appearance for 25 years since the deck is backed by an “industry-leading” 25 year warranty. The deck is ‘supposed’ to require very little maintenance.
Such homeowners could be in for an expensive surprise if they have problems with their deck.
If you look online, there are many contractors that make bold claims about composite decking, e.g. that it is close to zero maintenance and ‘fully backed’ by a 25-year warranty. This is highly misleading. I believe that part of the problem is that contractors have incentives to shill for a particular manufacturer.
Some manufacturers will give incentives to contractors to promote their product, with incentives increasing with the volume of product purchased. For example, Fiberon provides cash “rebates” and marketing funds to contractors that generate high volumes of Fiberon purchases, as outlined in their partner program brochure. If you replace the word “rebate” with “kickback”, you can see how this practice might be problematic.
Trex’s webpage on its partner program does not mention cash rebates but does mention “marketing funds”.
Another incentive given to high-volume contractors are special labour warranties. In practice, manufacturers do occasionally make a homeowner whole when there is a manufacturing defect if the product was installed by one of their high-volume partners.
Trex’s marketing boasts of 95% recycled material: “an innovative blend of 95% recycled wood and plastic film—that’s almost the whole thing” (website | archive.org). This is not necessarily a good thing for the customer- recycled material is used because it is cheaper than new material as a consequence of lower quality. Trex recycles plastics to generate its raw material. Its recycling activities generates a lot of plastic that is too low quality for Trex to use. Trex has been open about trying to find good markets for the low-quality recycled plastic that it cannot use.
Klyosov’s textbook remarks that recycled plastics require more antioxidant additives on page 516:
If the incoming plastic is recycled, in which the initial antioxidant is largely (or completely) depleted, WPC deck boards made from such materials are doomed, if not loaded with a good amount of antioxidants.
I have no idea if recycled material is a problem in practice.
Trex’s warranty and litigation history highlights
Here are some class action lawsuits that Trex has settled so far:
- A 2004 settlement (see page 14 of the 10-K) covers New Jersey consumers for products sold by Trex over twelve years.
- The 2013 settlement (notice) covers certain Trex non-shelled wood-plastic composite decking, railing, and fencing products (“Trex Product”) purchased between August 1, 2004, and August 27, 2013 (the “Class Period”). This class action was about the appearance of the product due to mold and faking.
- The March 2010 settlement (notice) covers certain Trex decking and railing products (“Trex Product”) manufactured in Trex’s Fernley, Nevada plant between January 1, 2002 and December 31, 2007 are susceptible to Surface Flaking. This so-called “surface flaking” issue would eventually be hazardous as the board could break, leading to Trex issuing this 2013 press release (3 years later). It is somehow not a product recall.
It is slightly egregious that Trex has tried to avoid claims related to the “surface” flaking issue. It is sad that they forced homeowners to seek recourse via a class action lawsuit instead of proactively fixing a problem that they would have to fix anyways.
Warranty and litigation reserves
From what I can tell, the company did not have a warranty reserve at all in 2006. If you look at the 2007 10-K, you can see that the balance sheets do not show a “non-current accrued warranty” liability for 2006.
With the benefit of hindsight, we know that the company was manufacturing problematic product for years leading up to the end of 2006. Some of the 2002 and 2004 product would later result in 2 class action settlements. However, the company did not proactively reserve for warranty issues.
On previous conference calls, analysts have asked management whether its reserves were appropriate. Here is one exchange from the Q2 2010 call:
Eric Prouty – Canaccord (Analyst)
Great. Okay. And then, second, with the warranty reserve that you’ve taking for the past product, could you just talk about if you take Transcends, what are you reserving as a percent of revenue for some of the newer product lines with the extended warranty periods, et cetera, how are you accruing for warranties for some of these new product lines?
Jim Cline – Trex Company, Inc. (VP and CFO)
Well, number one, if you look at Trex’s experience in the past, the only issue of any significance they’ve had has been an issue– has been related to the surface flaking activities, outside of that–
Ron Kaplan – Trex Company, Inc. (President and CEO)
Surface flaking activities, 2003 to 2006 at the one Fernley plant.
Jim Cline – Trex Company, Inc. (VP and CFO)
Right. Right, sorry. And absent that, our claims are almost nonexistent on other products. And based on that, the accounting guidance would tell us that we would reserve based on the experience and expectations we have on that, so our reserves are minimal related to Transcend, as it is on the Accent-related products, produced outside of that Fernley window that we took the major reserve on.
Eric Prouty, Canaccord – Analyst 
Okay. Un– understood on that, great, thank you.
Since then, the warranty reserves have been repeatedly adjusted upwards. I would be surprised if Trex’s current warranty reserves turn out to be overly conservative.
Looking ahead, it seems to me that Trex will face the ire of some homeowners with defective decks. Since Trex has grow rapidly in the past several years, the company’s larger size (and therefore deeper pockets) will make it a little more attractive as a litigation target. Even if it wins its lawsuits (or settles them at attractive terms), it will have costs associated with defending itself against class actions and in providing customer service.
I don’t know if Trex is overearning due to the cyclical nature of the remodelling industry. There is a Value Investor’s Club writeup that lays out of the macro thesis.
Wrapping it up
For the most part, I find Trex’s business practices to be unsavoury. However, that does not necessarily make a great short thesis. US healthcare stocks for example have done quite well over the past two decades, despite engaging in questionable practices that occasionally kill patients (also known as murder). So I haven’t really made up my mind about this stock.
Trex’s mysteriously high margin: a business analysis problem for you… – John Hempton’s post on Trex.
“Wood-Plastics Composites” by Anatole Klyosov
Understanding composite decks by Star Craft Custom Builders
One contractor mentions that the protective “cap” on Fiberon’s composite wood has started coming off. It’s unclear to me whether the latest-generation of “capped” products will have issues with the adhesion of the protective cap with the core.