TREX CO INC 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following management discussion should be read in conjunction with the Trex Company, Inc. (Company, we or our) Annual Report on Form 10-K for the year ended December 31, 2019 filed with the U.S. Securities and Exchange Commission (SEC) and the condensed consolidated financial statements and notes thereto included in Part I, Item 1. “Financial Statements” of this quarterly report. NOTE ON FORWARD-LOOKING STATEMENTS This management’s discussion and analysis contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements regarding our expected financial position and operating results, our business strategy, our financing plans, forecasted demographic and economic trends relating to our industry and similar matters are forward-looking statements. These statements can sometimes be identified by our use of forward-looking words such as “may,” “will,” “anticipate,” “estimate,” “expect,” “intend” or similar expressions. We cannot promise you that our expectations in such forward-looking statements will turn out to be correct. Our actual results could be materially different from our expectations because of various factors, including the factors discussed under “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2019 filed with the SEC, and the factor discussed under “Item 1A. Risk Factors” in this quarterly report on form 10-Q. These statements are also subject to risks and uncertainties that could cause the Company’s actual operating results to differ materially. Such risks and uncertainties include, but are not limited to: the extent of market acceptance of the Company’s current and newly developed products; the costs associated with the development and launch of new products and the market acceptance of such new products; the sensitivity of the Company’s business to general economic conditions; the impact of seasonal and weather-related demand fluctuations on inventory levels in the distribution channel and sales of the Company’s products; the availability and cost of third-party transportation services for the Company’s products and raw materials; the Company’s ability to obtain raw materials, including scrap polyethylene, wood fiber, and other materials used in making our products, at acceptable prices; the Company’s ability to maintain product quality and product performance at an acceptable cost; the Company’s ability to increase throughput and capacity to adequately match supply with demand; the level of expenses associated with product replacement and consumer relations expenses related to product quality; the highly competitive markets in which the Company operates; cyber-attacks, security breaches or other security vulnerabilities; the impact of upcoming data privacy laws and the EU General Data Protection Regulation and the related actual or potential costs and consequences; and material adverse impacts from global public health pandemics, including the strain of coronavirus known as COVID-19. OVERVIEW COVID-19: Our results of operations are affected by economic conditions, including macroeconomic conditions and levels of business and consumer confidence. The COVID-19 pandemic has increased the level of volatility and uncertainty globally and has created economic disruption. We are actively managing our business to respond to this health crisis and will continue to evaluate the nature and extent of its impact. As of the date of this report, we have not experienced any material disruptions to our operations due to the COVID-19 pandemic. However, the pandemic remains an evolving situation due to the continuation of the outbreak and any future measures that may be taken to contain the spread of the virus. In addition, the extent and duration of the economic fallout from COVID-19 remains unclear. Our commitment to stakeholders is to take the appropriate actions to ensure the safety and well-being of our employees and partners, comply with any governmental orders relating to COVID-19, which may result in a period of disruption to our business, while at the same time leveraging our strengths and ensuring financial flexibility. As of June 30, 2020, our facilities continue to operate at output levels similar to those prior to the COVID-19 pandemic and we are following or exceeding all Centers for Disease Control and Prevention (CDC) and public officials’ guidelines. We have also adopted a business continuity plan and local emergency response plans at each location. We continue to take precautionary measures, make contingency plans and improve our response to the developing situation. We have assembled a cross-functional team whose chief charge is to oversee our efforts to ensure the health and safety of all employees and supply product to our customers. That team constantly monitors the latest CDC, Federal, state and other regulatory guidance, works to secure personal protective equipment, finds new ways to help mitigate risk, and identifies opportunities for us to exceed recommendations. 18 We have implemented preventative or protective actions at our facilities, our corporate headquarters and with field sales personnel. In order to mitigate the spread of the virus, we instructed our employees to practice social distancing. Efforts for social distancing included employees working from home, where possible, revising our production processes to allow for compliance with our social distancing efforts, suspending air travel and enabling technologies to allow employees to effectively perform their functions remotely. Our sales force worked from home and conducted training sessions with our channel partners by utilizing online audio and visual technologies. Late in the second quarter, our employees began transitioning back to the workplace and conducting customer visits on a voluntary basis. In addition, face masks and other protective equipment have been distributed to employees across all of our facilities, handwashing and hand sanitizing stations have been installed, and automated temperature scanners have been provided at the entrances to our manufacturing facilities and corporate office. We have installed air purifier systems for all enclosed areas in every one of our buildings. Our internal cleaning crew sanitizes an extensive checklist of high-touch items and areas across work facilities, and our facilities are cleaned repeatedly throughout each shift with CDC-recommended chemicals and disinfectants by internal and external groups. In addition, we fabricated face shields, donated the proceeds from decking sample sales to Feeding America, and supported the COVID-19 Relief Fund of our local United Way, supplementing our annual fund-raising campaign. Since we cannot predict the duration or scope of the pandemic, we cannot fully anticipate or reasonably estimate all the ways in which the current global health crisis and financial market conditions could adversely impact our business in the future. During the latter part of the first quarter and continuing into the first two months of the second quarter, some jurisdictions into which we sell had deemed the construction industry as non-essential and ordered the closure of those businesses. In addition, we experienced areas where the availability of our products was limited due to the closure of certain of our channel partners. However, during the latter part of the second quarter, jurisdictions began to lift their respective closure restrictions and certain of our channel partners that were closed reopened. As a result, the slowdown in net sales that we experienced early in the second quarter was offset by the pickup of those sales in the latter part of the quarter when jurisdictions began to lift their closure restrictions. As of June 30, 2020 we have no significant supply issues and maintain inventories of materials sourced from diversified geographies, allowing us to better tolerate short-term supply chain disruptions. In May 2020, we amended and restated our revolving credit agreement to provide us with an additional Revolving Line of Credit for Aggregate Revolving B Commitments in the amount of $100 million. The purpose of the additional $100 million is primarily to reduce risk, if necessary, associated with the COVID-19 pandemic should the Company need to secure additional capital to continue its strategy of accelerating the conversion of wood decking to Trex composite decking and expanding its addressable market. As of June 30, 2020, we had no outstanding indebtedness under our revolving credit facilities and $350 million in available borrowing capacity. As the impact of COVID-19 evolves, we will continue to evaluate our financial position and liquidity needs in light of future developments. Operations and Products: Trex Company, Inc. currently operates in two reportable segments: Trex Residential Products (Trex Residential) and Trex Commercial Products (Trex Commercial). The Company is focused on using renewable resources within both our Trex Residential and Trex Commercial segments. Trex Residential is the world’s largest manufacturer of high-performance composite decking and residential railing products, which are marketed under the brand name Trex ® and manufactured in the United States. We offer a comprehensive set of aesthetically appealing and durable, low-maintenance product offerings in the decking, residential railing, fencing, steel deck framing, and outdoor lighting categories. A majority of the products are eco-friendly and leverage recycled materials to the extent possible. Trex Residential decking is made in a proprietary process that combines reclaimed wood fibers and recycled polyethylene film, making Trex one of the largest recyclers of plastic film in North America. In addition to resisting fading and surface staining, Trex Residential products require no sanding and sealing, resist moisture damage, provide a splinter-free surface and do not require chemical treatment against rot or insect infestation. Combined, these aspects yield significant aesthetic advantages and lower maintenance than wood decking and railing and ultimately render Trex products less costly than wood over the life of the deck. Special characteristics (including resistance to splitting, the ability to bend, and ease and consistency of machining and finishing) facilitate installation, reduce contractor call-backs and afford consumers a wide range of design options. Trex Residential products are sold to distributors and home centers for final resale primarily to the residential market. Trex offers the following products through Trex Residential: Decking and Accessories Our principal decking products are Trex Transcend ® , Trex Select ® and Trex Enhance ® . Differentiating the Enhance collection is a scalloped profile that is lighter weight for easier handling and installation. Our high-performance, low-maintenance, eco-friendly composite decking products are comprised of a blend of 95 percent reclaimed wood fibers and recycled polyethylene film and feature a protective polymer shell for enhanced protection against fading, staining, mold and scratching. We also offer Trex Hideaway ® , a hidden fastening system for grooved boards, and Trex DeckLighting ™ , an outdoor lighting system. Trex DeckLighting is a line of energy-efficient LED dimmable deck lighting, which is designed for use on posts, floors and steps. The line includes a post cap light, deck rail light, riser light and a recessed deck light. 19 Railing Our residential railing products are Trex Transcend Railing, Trex Select Railing, Trex Enhance Railing and Trex Signature ® aluminum railing. Trex Transcend Railing, made from approximately 40 percent recycled content, is available in the colors of Trex Transcend decking and finishes that make it appropriate for use with Trex decking products as well as other decking materials, which we believe enhances the sales prospects of our railing products. Trex Select Railing, made from approximately 40 percent recycled content, is offered in a white finish and is ideal for consumers who desire a simple clean finished look for their deck. Trex Enhance, made from approximately 40 percent recycled content, is available in three colors and is offered through home improvement retailers in kits that contain the complete railing system. Trex Signature aluminum railing, made from a minimum of 50 percent recycled content, is available in three colors and designed for consumers who want a sleek, contemporary look. Fencing Our Trex Seclusions ® fencing product is offered through two specialty distributors. This product consists of structural posts, bottom rail, pickets, top rail and decorative post caps. Steel Deck Framing Our triple-coated steel deck framing system called Trex Elevations ® leverages the strength and dimensional stability of steel to create a flat surface for our decking. Trex Elevations provides consistency and reliability that wood does not and is fire resistant. Trex Commercial is a leading national provider of custom-engineered railing and staging systems. Trex Commercial Products designs and engineers custom solutions, which are prevalent in professional and collegiate sports facilities, commercial and high-rise applications, performing arts, sports, and event production and rentals. With a team of devoted engineers, and industry-leading reputation for quality and dedication to customer service, Trex Commercial markets to architects, specifiers, contractors, and building owners. Trex offers the following products through Trex Commercial: Architectural Railing Systems Our architectural railing systems are pre-engineered guardrails with options to accommodate styles ranging from classic and elegant wood top rail combined with sleek stainless components and glass infill, to modern and minimalist stainless cable and rod infill choices. Trex Commercial can also design, engineer and manufacture custom railing systems tailored to the customer’s specific material, style and finish. Many railing styles are achievable, including glass, mesh, perforated railing and cable railing. Aluminum Railing Systems Trex Signature ® aluminum railing collection, made from a minimum of 50 percent recycled content, combines superior styling with the unparalleled strength of aluminum – making it an ideal railing choice for a variety of commercial settings. Its straightforward, unobtrusive design features traditional balusters and contemporary vertical rods, and can be installed with continuously graspable rail options for added safety, comfort and functionality. Trex Signature is available in three colors – charcoal black, bronze and classic white – and is available in a variety of stock lengths. Staging Equipment and Accessories Our advanced modular, lightweight custom staging systems include portable platforms, orchestra shells, guardrails, stair units, barricades, camera platforms, VIP viewing decks, ADA infills, DJ booths, pool covers, and other custom applications. Our systems provide superior staging product solutions for facilities and venues with custom needs. Our modular stage equipment is designed to appear seamless, feel permanent, and maximize the functionality of the space. 20 Highlights for the three months ended June 30, 2020: • Increase in net sales of 6.9%, or $14.2 million, to $220.6 million for the three months ended June 30, 2020 compared to $206.5 million for the three months ended June 30, 2019. • Increase in gross profit of 10.7%, or $9.0 million, to $92.4 million for the three months ended June 30, 2020 compared to $83.4 million for the three months ended June 30, 2019. • Increase in net income to $47.2 million, or $0.81 per diluted share, for the three months ended June 30, 2020 compared to $35.7 million, or $0.61 per diluted share, for the three months ended June 30, 2019. • Capital expenditures of $39.9 million primarily to increase production capacity at the Trex Residential facilities in Virginia and Nevada and for general plan cost reduction initiatives and other production improvements. Net Sales . Net sales consist of sales and freight, net of discounts. The level of net sales is principally affected by sales volume and the prices paid for Trex products. Trex Residential operating results have historically varied from quarter to quarter. Seasonal, erratic or prolonged adverse weather conditions in certain geographic regions reduce the level of home and commercial improvement and residential and commercial construction and can shift demand for our products to a later period. As part of our normal business practice and consistent with industry practice, we have historically provided our distributors and dealers of our Trex Residential products incentives to build inventory levels before the start of the prime deck-building season to ensure adequate availability of our product to meet anticipated seasonal consumer demand and to enable production planning. These incentives include payment discounts, favorable payment terms, price discounts, or volume rebates on specified products and other incentives based on increases in purchases as part of specific promotional programs. The timing of our incentive programs can significantly impact sales, receivables and inventory levels during the offering period. However, the timing and terms of the majority of our programs are generally consistent from year to year. In addition, the operating results for Trex Commercial are driven by the timing of individual projects, which may vary each quarterly period. Gross Profit. Gross profit represents the difference between net sales and cost of sales. Cost of sales consists of raw material costs, direct labor costs, manufacturing costs, subcontract costs and freight. Raw material costs generally include the costs to purchase and transport reclaimed wood fiber, reclaimed polyethylene, pigmentation for coloring our products, and commodities used in the production of railing and staging. Direct labor costs include wages and benefits of personnel engaged in the manufacturing process. Manufacturing costs consist of costs of depreciation, utilities, maintenance supplies and repairs, indirect labor, including wages and benefits, and warehouse and equipment rental activities. Product Warranty. We warrant that our Trex Residential products will be free from material defects in workmanship and materials for warranty periods ranging from 10 years to 25 years, depending on the product and its use. If there is a breach of such warranties, we have an obligation either to replace the defective product or refund the purchase price. We also warrant our Trex Commercial products for periods ranging from 1 year to 3 years. We continue to receive and settle claims for decking products manufactured at our Nevada facility prior to 2007 that exhibit surface flaking and maintain a warranty reserve to provide for the settlement of these claims. We monitor surface flaking claims activity each quarter for indications that our estimates require revision. Typically, a majority of surface flaking claims received in a fiscal year are received during the summer outdoor season, which spans the second and third fiscal quarters. It has been our practice to utilize actuarial techniques during the third quarter, after a significant portion of all claims has been received for the fiscal year and variances to annual claims expectations are more meaningful. Our actuarial analysis is based on currently known facts and a number of assumptions. Projecting future events such as the number of claims to be received, the number of claims that will require payment and the average cost of claims could cause the actual warranty liabilities to be higher or lower than those projected, which could materially affect our financial condition, results of operations or cash flows. The number of incoming claims received in the six months ended June 30, 2020 was higher than the number of claims received in the six months ended June 30, 2019 and exceeded our expectations for the current year. Average settlement cost per claim experienced in the six months ended June 30, 2020 was considerably higher than the average settlement cost per claim experienced in the six months ended June 30, 2019, due to an increase in larger claims settled and changes in the mix of settlement methods that occurred in the second half of 2019, but was consistent with our expectations for the current year, and lower than that experienced for the full year ended December 31, 2019. We believe that our reserve at June 30, 2020 is sufficient to cover future surface flaking obligations. The following table details surface flaking claims activity related to our warranty: Six Months Ended June 30, 2020 2019 Claims open, beginning of period 1,724 2,021 Claims received (1) 782 700 Claims resolved (2) (572 ) (716 ) Claims open, end of period 1,934 2,005 Average cost per claim (3) $ 3,263 $ 2,992 21 (1) Claims received include new claims received or identified during the period. (2) Claims resolved include all claims settled with or without payment and closed during the period. (3) Average cost per claim represents the average settlement cost of claims closed with payment during the period. Selling, General and Administrative Expenses. The largest component of selling, general and administrative expenses is personnel related costs, which includes salaries, commissions, incentive compensation, and benefits of personnel engaged in sales and marketing, accounting, information technology, corporate operations, research and development, and other business functions. Another component of selling, general and administrative expenses is branding and other sales and marketing costs, which are used to build brand awareness. These costs consist primarily of advertising, merchandising, and other promotional costs. Other general and administrative expenses include professional fees, office occupancy costs attributable to the business functions previously referenced, and consumer relations expenses. As a percentage of net sales, selling, general and administrative expenses may vary from quarter to quarter due, in part, to the seasonality of our business. RESULTS OF OPERATIONS Below is our discussion and analysis of our operating results and material changes in our operating results for the three months ended June 30, 2020 (2020 quarter) compared to the three months ended June 30, 2019 (2019 quarter), and for the six months ended June 30, 2020 (2020 six-month period) compared to the six months ended June 30, 2019 (2019 six-month period). Three Months Ended June 30, 2020 Compared To The Three Months Ended June 30, 2019 Net Sales Three Months Ended June 30, $ Change % Change 2020 2019 (dollars in thousands) Total net sales $ 220,648 $ 206,453 $ 14,195 6.9 % Trex Residential net sales $ 208,877 $ 193,468 $ 15,409 8.0 % Trex Commercial net sales $ 11,771 $ 12,985 $ (1,214 ) (9.4 )% Total net sales increased by 6.9% in the 2020 quarter compared to the 2019 quarter reflecting an increase in Trex Residential net sales, offset by a small decrease in Trex Commercial net sales. The increase of 8.0% in Trex Residential net sales was primarily driven by volume growth of our residential decking and railing products, strong demand for our outdoor living products, a strong residential repair and remodeling sector and our initiatives to accelerate conversion from wood. The 9.4% decrease in Trex Commercial net sales during the 2020 quarter was due primarily to fewer large projects compared to the 2019 quarter. Gross Profit Three Months Ended June 30, $ Change % Change 2020 2019 (dollars in thousands) Cost of sales $ 128,243 $ 123,009 $ 5,234 4.3 % % of total net sales 58.1 % 59.6 % Gross profit $ 92,405 $ 83,444 $ 8,961 10.7 % Gross margin 41.9 % 40.4 % Gross profit as a percentage of net sales, gross margin, was 41.9% in the 2020 quarter compared to 40.4% in the 2019 quarter and reflects the increase in gross margin for Trex Residential and Trex Commercial to 42.5% and 30.7%, respectively, in the 2020 quarter compared to 41.7% and 21.4%, respectively, in the 2019 quarter. The increase in Trex Residential gross margin in the 2020 quarter compared to the 2019 quarter was primarily due to the non-recurrence of Enhance startup costs related to reduced throughput, equipment failures and other inefficiencies at Trex Residential manufacturing facilities in 2019. Also, a number of manufacturing lines were retrofitted to allow production of the reduced weight Enhance profile. We expect to be essentially at the original design target for Enhance by the end of the third quarter of 2020. The increase in Trex Residential gross margin was offset by startup costs associated with the expansion of capacity at our Nevada facility. The increase in gross margin at Trex Commercial was primarily due to non-recurrence of legacy low margin contracts coupled with a mix of higher margin contracts in the 2020 quarter, and initiatives aimed at improving project estimating, project management, and manufacturing cost savings initiatives. 22 Selling, General and Administrative Expenses Three Months Ended June 30, $ Change % Change 2020 2019 (dollars in thousands) Selling, general and administrative expenses $ 29,009 $ 35,705 $ (6,696 ) (18.8 )% % of total net sales 13.2 % 17.3 % The $6.7 million decrease in selling, general and administrative expenses in the 2020 quarter compared to the 2019 quarter resulted primarily from a decrease of $4.9 million in branding and advertising spend and a $2.0 million decrease in personnel related expenses. The decrease in personnel related expenses included a decrease in executive severance benefits compared to 2019, a decrease in meals and entertainment expenses and a reduction in medical claims, offset primarily by an increase in incentive compensation. Provision for Income Taxes Three Months Ended June 30, $ Change % Change 2020 2019 (dollars in thousands) Provision for income taxes $ 16,249 $ 12,030 $ 4,219 35.1 % Effective tax rate 25.6 % 25.2 % The effective tax rate for the 2020 quarter of 25.6% was relatively unchanged compared to the effective tax rate of 25.2% for the 2019 quarter. Net Income and Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) 1 (in thousands) Reconciliation of net income (GAAP) to EBITDA (non-GAAP): Three Months Ended June 30, 2020 Trex Residential Trex Commercial Total Net income $ 45,912 $ 1,306 $ 47,218 Interest income, net (71 ) — (71 ) Income tax expense 15,789 460 16,249 Depreciation and amortization 3,865 198 4,063 EBITDA $ 65,495 $ 1,964 $ 67,459 1 EBITDA represents net income before interest, income taxes, depreciation and amortization. EBITDA is not a measurement of financial performance under accounting principles generally accepted in the United States (GAAP). We have included data with respect to EBITDA because management believes it facilitates performance comparison between the Company and its competitors, and management evaluates the performance of its reportable segments using several measures, including EBITDA. Management considers EBITDA to be an important supplemental indicator of our core operating performance because it eliminates interest, income taxes, and depreciation and amortization charges to net income or loss. In relation to competitors, EBITDA eliminates differences among companies in capitalization and tax structures, capital investment cycles and ages of related assets. For these reasons, management believes that EBITDA provides important information regarding the operating performance of the Company and its reportable segments. 23 Three Months Ended June 30, 2019 Trex Residential Trex Commercial Total Net income $ 35,223 $ 487 $ 35,710 Interest expense (income), net 6 (7 ) (1 ) Income tax expense 11,866 164 12,030 Depreciation and amortization 3,258 141 3,399 EBITDA $ 50,353 $ 785 $ 51,138 Three Months Ended June 30, $ Change % Change 2020 2019 (dollars in thousands) Total EBITDA $ 67,459 $ 51,138 $ 16,321 31.9 % Trex Residential EBITDA $ 65,495 $ 50,353 $ 15,142 30.1 % Trex Commercial EBITDA $ 1,964 $ 785 $ 1,179 150.2 % Total EBITDA increased 31.9% to $67.5 million for the 2020 quarter compared to $51.1 million for the 2019 quarter. The increase was primarily driven by a 30.1% increase in Trex Residential EBITDA due to net sales and gross margin and by an increase in Trex Commercial EBITDA primarily related to an increase in gross margin. Six Months Ended June 30, 2020 Compared To The Six Months Ended June 30, 2019 Net Sales Six Months Ended June 30, $ Change % Change 2020 2019 (dollars in thousands) Total net sales $ 421,043 $ 386,024 $ 35,019 9.1 % Trex Residential net sales $ 395,751 $ 358,947 $ 36,804 10.3 % Trex Commercial net sales $ 25,292 $ 27,077 $ (1,785 ) (6.6 )% The 9.1% increase in total net sales in the 2020 six-month period compared to the 2019 six-month period was due primarily to volume growth at Trex Residential for both our legacy and new decking and residential railing products. The increase of 10.3% in Trex Residential net sales during the 2020 six-month period was primarily driven by volume growth, strong demand for our outdoor living products, a strong residential repair and remodeling sector and our initiatives to accelerate conversion from wood. The 6.6% decrease in Trex Commercial net sales during the 2020 six-month period was due primarily to fewer large projects compared to the 2019 six-month period. Gross Profit Six Months Ended June 30, $ Change % Change 2020 2019 (dollars in thousands) Cost of sales $ 238,941 $ 233,214 $ 5,727 2.5 % % of total net sales 56.8 % 60.4 % Gross profit $ 182,102 $ 152,810 $ 29,292 19.2 % Gross margin 43.3 % 39.6 % 24 Gross profit as a percentage of net sales, gross margin, was 43.3% in the 2020 six-month period compared to 39.6% in the 2019 six-month period. Gross margin for Trex Residential and Trex Commercial products in the 2020 six-month period were 44.0% and 32.3%, respectively, compared to 41.0% and 21.0%, respectively, in the 2019 six-month period. The increase in Trex Residential gross margin in the 2020 six-month period compared to the 2019 six-month period was primarily due to non-recurrence of Enhance startup costs related to reduced throughput, equipment failures and other inefficiencies at Trex Residential manufacturing facilities in 2019. Also, a number of manufacturing lines were retrofitted to allow production of the reduced weight Enhance profile. We expect to be essentially at the original design target for Enhance by the end of the third quarter of 2020. The increase in Trex Residential gross margin was offset by startup costs associated with the expansion of capacity at our Nevada facility. The increase in gross margin at Trex Commercial was primarily due to non-recurrence of legacy low margin contracts coupled with a mix of higher margin contracts in the 2020 quarter, and initiatives aimed at improving project estimating, project management, and manufacturing cost savings initiatives. Selling, General and Administrative Expenses Six Months Ended June 30, $ Change % Change 2020 2019 (dollars in thousands) Selling, general and administrative expenses $ 63,571 $ 65,872 $ (2,301 ) (3.5 )% % of total net sales 15.1 % 17.1 % The $2.3 million decrease in selling, general and administrative expenses in the 2020 six-month period compared to the 2019 six-month period resulted primarily from a decrease of $3.8 million in branding and advertising spend and a $1.4 million decrease in research and development expenses. The decreases were offset by a $1.3 million increase in personnel related expenses and an increase of $1.6 million in other operating expenses. Provision for Income Taxes Six Months Ended June 30, $ Change % Change 2020 2019 (dollars in thousands) Provision for income taxes $ 29,504 $ 19,730 $ 9,774 49.5 % Effective tax rate 24.8 % 22.7 % The effective tax rate for the 2020 six-month period increased by 2.1% compared to the effective tax rate for the 2019 six-month period primarily due to a current year decrease in excess tax benefits from the exercise of share-based payments and an increase in non-deductible executive compensation. Net Income and Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) 2 (in thousands) Reconciliation of net income (GAAP) to EBITDA (non-GAAP): Six Months Ended June 30, 2020 Trex Residential Trex Commercial Total Net income $ 86,932 $ 2,688 $ 89,620 Interest income, net (593 ) — (593 ) Income tax expense 28,577 927 29,504 Depreciation and amortization 7,529 386 7,915 EBITDA $ 122,445 $ 4,001 $ 126,446 2 EBITDA represents net income before interest, income taxes, depreciation and amortization. EBITDA is not a measurement of financial performance under accounting principles generally accepted in the United States (GAAP). We have included data with respect to EBITDA because management believes it facilitates performance comparison between the Company and its competitors, and management evaluates the performance of its reportable segments using several measures, including EBITDA. Management considers EBITDA to be an important supplemental indicator of our core operating performance because it eliminates interest, income taxes, and depreciation and amortization charges to net income or loss. In relation to competitors, EBITDA eliminates differences among companies in capitalization and tax structures, capital investment cycles and ages of related assets. For these reasons, management believes that EBITDA provides important information regarding the operating performance of the Company and its reportable segments. 25 Six Months Ended June 30, 2019 Trex Residential Trex Commercial Total Net income $ 66,478 $ 787 $ 67,265 Interest income, net (50 ) (7 ) (57 ) Income tax expense 19,466 264 19,730 Depreciation and amortization 6,525 268 6,793 EBITDA $ 92,419 $ 1,312 $ 93,731 Six Months Ended June 30, $ Change % Change 2020 2019 (dollars in thousands) Total EBITDA $ 126,446 $ 93,731 $ 32,715 34.9 % Trex Residential EBITDA $ 122,445 $ 92,419 $ 30,026 32.5 % Trex Commercial EBITDA $ 4,001 $ 1,312 $ 2,689 205.0 % Total EBITDA increased 34.9% to $126.4 million for the 2020 six-month period compared to $93.7 million for the 2019 six-month period. The increase was primarily driven by a 32.5% increase in Trex Residential EBITDA due to net sales and gross margin and by an increase in Trex Commercial EBITDA primarily related to an increase in gross margin. LIQUIDITY AND CAPITAL RESOURCES We finance operations and growth primarily with cash flows from operations, borrowings under our revolving credit facilities, operating leases and normal trade credit terms from operating activities. At June 30, 2020 we had $12.2 million of cash and cash equivalents. S ources and Uses of Cash. The following table summarizes our cash flows from operating, investing and financing activities (in thousands): Six Months Ended June 30, 2020 2019 Net cash (used in) provided by operating activities $ (32,332 ) $ 43,058 Net cash used in investing activities (60,467 ) (19,061 ) Net cash used in financing activities (43,797 ) (23,612 ) Net (decrease) increase in cash and cash equivalents $ (136,596 ) $ 385 Operating Activities Cash used in operations was $32.3 million during the 2020 six-month period compared to cash provided by operations of $43.1 million during the 2019 six-month period. The use of cash flows in operations was primarily due to higher working capital investment in accounts receivable as a result of the timing of sales within the period and related payment discounts offered to our Trex Residential decking and railing customers. The majority of the accounts receivable balance at June 30, 2020, will be collected in the third quarter. The decrease was primarily by offset increased net income, increase in accounts payable and the timing of payment for Federal income taxes. Investing Activities Capital expenditures in the 2020 six-month period were $62.6 million, consisting primarily of $52.6 million for capacity expansion at our Virginia and Nevada facilities and $8.8 million for general plant cost reduction initiatives and other production improvements. Financing Activities Net cash used in financing activities was $43.8 million in the 2020 six-month period primarily for repurchases of our common stock of $44.1 million. 26 Amendment of Restated Certificate of Incorporation. At the annual meeting of stockholders of the Company held on April 29, 2020, the Company’s stockholders approved an amendment of the Company’s Restated Certificate of Incorporation (Amendment), effective as of April 29, 2020. The Company’s Board of Directors unanimously approved the Amendment on February 19, 2020, subject to stockholder approval. The Amendment increases the number of shares of common stock, par value $0.01 per share, that the Company is authorized to issue from 120 million shares to 180 million shares. The Amendment was filed with the Delaware Secretary of State on April 29, 2020. Stock Repurchase Programs. On February 16, 2018, the Board of Directors adopted a stock repurchase program of up to 5.8 million shares of the Company’s outstanding common stock (Stock Repurchase Program). As of the June 30, 2020, the Company has repurchased 1.4 million shares of the Company’s outstanding common stock under the Stock Repurchase Program. Due to the volatility and uncertainty in the stock market associated with the COVID-19 pandemic, we suspended repurchases of our common stock under the Stock Repurchase Program on March 12, 2020. As of the date of this report, the Stock Repurchase Program remains in effect with repurchases suspended. However, we may determine to resume repurchases at any time. Stock Split. On July 29, 2020, the Company’s Board of Directors approved a two-for-one stock split of the Company’s common stock, par value, $0.01. The stock split will be in the form of a stock dividend to be distributed on September 14, 2020, to stockholders of record at the close of business on August 19, 2020. The condensed consolidated financial statements presented in this Form 10-Q appropriately do not reflect the effects of the stock split. Indebtedness. Our Fourth Amended and Restated Credit Agreement (Fourth Amended Credit Agreement) provides us with revolving loan capacity in a collective maximum principal amount of $250 million from January 1 through June 30 of each year, and a maximum principal amount of $200 million from July 1 through December 31 of each year throughout the term, which ends November 5, 2024. At June 30, 2020, we had no outstanding indebtedness under the revolving credit facilities and borrowing capacity under the facilities of $350 million, and $300 million from July 1, 2020 through December 31, 2020. On May 26, 2020, the Company entered into a First Amendment to the Original Credit Agreement (the First Amendment) to provide for an additional $100 million line of credit. The purpose of the additional $100 million line of credit is primarily to reduce risk associated with the COVID-19 pandemic should the Company need to secure additional capital to continue its strategy of accelerating the conversion of wood decking to Trex composite decking and expanding its addressable market. As a matter of convenience, the parties incorporated the amendments to the Original Credit Agreement made by the First Amendment into a new Fourth Amended and Restated Credit Agreement (New Credit Agreement). In the New Credit Agreement, the revolving commitments under the Original Credit Agreement are referred to as Revolving A Commitments and the new $100 million line of credit is referred to as Revolving B Commitments. In the New Credit Agreement, all of the material terms and conditions related to the original line of credit (Revolving A Commitments) remain unchanged from the Original Credit Agreement. The Company entered into the First Amendment, as borrower; Trex Commercial Products, Inc. (TCP), as guarantor; Bank of America, N.A. (BOA), as a Lender, Administrative Agent, Swing Line Lender and L/C Issuer; and certain other lenders including Wells Fargo Bank, N.A. (Wells Fargo), who is also Syndication Agent; Truist Bank (Truist); and Regions Bank (Regions) (each, a Lender and collectively, the Lenders), arranged by BofA Securities, Inc. as Sole Lead Arranger and Sole Bookrunner. The First Amendment further provides that the New Credit Agreement is amended and restated by changing Schedule 2.01 to add applicable Lender percentages related to the Revolving B Commitment for BOA of 47.5%, Wells Fargo of 28.0% and Regions of 24.5%. Compliance with Debt Covenants. Pursuant to the terms of the Fourth Amended Credit Agreement, the Company is subject to certain loan compliance covenants. The Company was in compliance with all covenants as of June 30, 2020. Failure to comply with the financial covenants could be considered a default of repayment obligations and, among other remedies, could accelerate payment of any amounts outstanding. We believe that cash on hand, cash from operations and borrowings expected to be available under our revolving credit facilities, as amended, will provide sufficient funds to fund planned capital expenditures, make scheduled principal and interest payments, fund warranty payments, and meet other cash requirements. We currently expect to fund future capital expenditures from operations and financing activities. The actual amount and timing of future capital requirements may differ materially from our estimate depending on the demand for Trex products and new market developments and opportunities. In addition, we believe our financial resources will allow us to manage the impact of the COVID-19 pandemic on the Company’s business operations for the foreseeable future. However, as the impact of COVID-19 evolves, we will continue to evaluate our financial position and liquidity needs in light of future developments. 27 Capital Requirements. In June 2019, we announced a new capital expenditure program to increase production capacity at our Trex Residential facilities in Virginia and Nevada. The new multi-year capital expenditure program is projected at approximately $200 million through 2021, and involves the construction of a new decking facility at the existing Virginia site and the installation of additional production lines at the Nevada site. The investment will allow us to increase production output for future projected growth related to our strategy of converting wood demand to Trex Residential wood-alternative composite decking. When completed these investments will increase our Trex Residential production capacity by approximately 70 percent. Our capital expenditure guidance for 2020 is $150 million to $170 million. In addition to the above, our capital allocation priorities include expenditures for internal growth opportunities, manufacturing cost reductions, upgrading equipment, and acquisitions which fit our long-term growth strategy as we continue to evaluate opportunities that would be a good strategic fit for Trex, and return of capital to shareholders. Inventory in Distribution Channels. We sell our Trex Residential decking and railing products through a tiered distribution system. We have over 50 distributors worldwide and two national retail merchandisers to which we sell our products. The distributors in turn sell the products to dealers and retail locations who in turn sell the products to end users. Significant increases in inventory levels in the distribution channel without a corresponding change in end-use demand could have an adverse effect on future sales. We cannot definitively determine the level of inventory in the distribution channels at any time. We are not aware of any significant increases in the levels of inventory in the distribution channels at June 30, 2020 compared to inventory levels at June 30, 2019. Seasonality . The operating results for Trex Residential have historically varied from quarter to quarter. Seasonal, erratic or prolonged adverse weather conditions in certain geographic regions reduce the level of home improvement and construction activity and can shift demand for its products to a later period. As part of its normal business practice and consistent with industry practice, Trex Residential has historically offered incentive programs to its distributors and dealers to build inventory levels before the start of the prime deck-building season in order to ensure adequate availability of its product to meet anticipated seasonal consumer demand. The seasonal effects are often offset by the positive effect of the incentive programs. The operating results for Trex Commercial have not historically varied from quarter to quarter as a result of seasonality. However, they are driven by the timing of individual projects, which may vary significantly each quarterly period.