TREX CO INC 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) 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.” 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; increasing inflation in the macro-economic environment; 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; material adverse impacts from global public health pandemics and geopolitical conflicts; and material adverse impacts related to labor shortages or increases in labor costs. OVERVIEW The following MD&A is intended to help the reader understand the operations and current business environment of the Company. The MD&A is provided as a supplement to — and should be read in conjunction with — our Consolidated Financial Statements and the accompanying notes thereto contained in “ Item 8. Financial Statements and Supplementary Data ” of this report. MD&A includes the following sections: • Our Business — a general description of our business, a brief overview of our reportable segments’ products, and operational and financial highlights for the twelve months ended December 31, 2022. • Critical Accounting Policies and Estimates — a discussion of accounting policies that require critical judgments and estimates. • Results of Operations — an analysis of our consolidated results of operations for 2022 and 2021 and year-to-year comparisons. An analysis of our consolidated results of operations for 2021 and 2020 and year-to-year comparisons between 2021 and 2020 can be found in MD&A in Part II, Item 7 of the Company’s Form 10-K for the year ended December 31, 2021. • Liquidity and Capital Resources — an analysis of cash flows, contractual obligations, and a discussion of our capital and other cash requirements. OUR BUSINESS General. The Company is the world’s largest manufacturer of high-performance, low-maintenance wood-alternative decking and residential railing and outdoor living products and accessories, marketed under the brand name Trex ® , with more than 30 years of product experience. A majority of our products are manufactured in a 25 Table of Contents proprietary process that combines reclaimed wood fibers and recycled polyethylene. The Company is focused on using renewable resources within our Trex Residential segment. Also, through December 30, 2022, the Company provided custom-engineered commercial railing and staging systems for the commercial and multi-family market, including sports stadiums and performing arts venues. During the three years in the period ended December 31, 2022, the Company operated in two reportable segments: Trex Residential Products (Trex Residential), the Company’s principal business based on net sales, and Trex Commercial Products (Trex Commercial). On December 30, 2022, we completed the sale of substantially all of the assets of our wholly-owned subsidiary and reportable segment, Trex Commercial. Outdoor living remains one of the fastest growing categories within the repair and remodel sector, and the strength of the Trex Residential brand coupled with our expanded manufacturing capacity, our key competitive advantages, help us to effectively unlock potential market share and drive long term growth. We continue to benefit from increasing consumer interest in our environmentally friendly, low maintenance product portfolio that transforms and enhances the outdoor living experience. We remain focused on ensuring the capacity to service our Trex Residential channel partners is aligned with both current demand and expected future growth. In October 2021, we announced plans to add a third U.S.-based Trex Residential manufacturing facility located in Little Rock, Arkansas, that will sit on approximately 300 acres of land. The development approach for the new campus will be modular and calibrated to demand trends for Trex Residential outdoor living products. Construction began in the second quarter of 2022, and in July 2022, we entered into a design-build agreement. As previously announced, we anticipate spending approximately $400 million on the facility and the budget for the design-build agreement is contained within this amount. Construction will be funded primarily through our ongoing cash generation or our line of credit. We continue to focus on cost reduction projects and identifying continuous improvement opportunities to enhance our margins. Specifically, our efforts are primarily centered on increased automation, modernization, enhanced energy efficiency and improvements to raw material processing. At the same time, we intend to expand our marketing campaigns, continue highlighting the advantages of Trex Residential decking over wood, as well as focusing on innovation and new product development to further strengthen our consumer brand and distribution advantages. These initiatives should help drive continued topline and profit growth and accelerated market share conversion. Trex Residential is the world’s largest manufacturer of wood-alternative composite decking and railing products marketed under the brand name Trex ® and manufactured in the United States. We offer a comprehensive set of aesthetically pleasing, high-performance, low maintenance, eco-friendly products in the decking, railing, fencing, cladding and outdoor lighting categories. We believe that the range and variety of our products allow consumers to design much of their outdoor living space using Trex brand products. We offer the following composite decking and railing products through Trex Residential: Decking and Accessories Trex Transcend ® Lineage ™ decking Trex Transcend ® decking Trex Signature ® decking Trex Select ® decking Trex Enhance ® decking Trex Hideaway ® hidden fastening system Trex DeckLighting ™ outdoor lighting system Railing Trex Transcend Railing Trex Select Railing Trex Signature ® aluminum railing Fencing Trex Seclusions ® fencing product 26 Table of Contents Trex Commercial offered modular and architectural railing and staging systems and solutions for the commercial and multifamily market, including sports stadiums and performing arts venues. Operational Highlights: Sale of Substantially All of the Assets of Trex Commercial Products, Inc. On December 30, 2022, we completed the sale of substantially all of the assets of our wholly-owned subsidiary and reportable segment, Trex Commercial, for net proceeds of $7.3 million. The divestiture of Trex Commercial reflects our decision to focus on driving the most profitable growth strategy for the Company and its shareholders through the execution of our outdoor living strategy. With the sale complete, we will dedicate our resources to accelerating conversion to composites from wood and further strengthen our leadership position in the outdoor living category. The divestiture did not represent a strategic shift with a major effect on the Company’s operations and financial results. As such, the results of operations of Trex Commercial are consolidated in the Company’s results of operations for the year ended December 31, 2022, through the date of sale. Refer to Note 17, Segment Information, for additional information on the Trex Commercial segment. Trex Residential New Product . On May 16, 2022, we announced the expansion of our premium Trex Residential decking line with the introduction of Transcend ® Lineage ™ . The new Transcend Lineage boards feature an elevated aesthetic with subtle, elegant graining, available in two new color options that expand the Transcend collection with nature-inspired tones and texturing that today’s homeowners are seeking. Like all Trex Residential decking, Lineage boards are made primarily from recycled and reclaimed content and engineered with a proprietary, high-traffic formulation and ultra-durable integrated shell. Transcend Lineage decking launched in mid-May and will be sold nationwide through Trex Residential dealers and major home centers. Production and sale of the new Transcend Lineage boards began in May 2022. Trex Residential Arkansas Manufacturing Facility . Construction began on the new Trex Residential manufacturing facility located in Arkansas in the second quarter 2022. The new campus will sit on approximately 300 acres of land and will address increased demand for Trex Residential outdoor living products. The development approach for the new campus will be modular and calibrated to demand trends for Trex Residential outdoor living products. In July 2022, the Company entered into a design-build agreement and, as previously announced, anticipates spending approximately $400 million on the facility. The budget for the design-build agreement is contained within this amount. Trex Residential NexTrex ® Grassroots Movement. In August 2022, Trex Residential launched its NexTrex Grassroots Movement to broaden its recycling initiative to enlist communities and organizations to partner in its robust recycling efforts. The initiative provides a turnkey framework for municipalities, universities, nonprofits and other qualifying businesses to serve as centralized drop-off locations for recycling polyethylene plastic film while earning funds for their organizations. Organizations approved for participation in the NexTrex program can earn funding by serving as drop-off locations where community members can recycle their discarded plastic film packaging. Each grassroots partner is equipped with a baler, which is housed on site for use in bundling and weighing recycled plastic material. Trex will pick up and transport the material to its manufacturing facilities in Virginia or Nevada, where it will begin its new life as high-performance Trex Residential composite decking. Trex Residential Earns Top Honors in Builder Brand Use Study. For the fourth time in the 15-year history of the Builder Brand Use Study, we earned top honors across all of the measured criteria for the Composite/PVC Decking category and outperformed all other brands in the Deck Railing category as well. The annual Builder Brand Use Study measures the attitudes of builders, developers, and contractors toward the products they recognize, use, and trust. The results of this year’s study are based on input from more than 850 building professionals who, for the 15th consecutive year, voted Trex #1 for “brand familiarity,” “brand used during the past two years,” and “brand used most” in the Composite/PVC Decking category. Trex also secured top honors for the same criteria in the Deck Railing category. Additionally, Trex received the highest score for “Product Quality” among the 27 composite and PVC decking brands included in the study. 27 Table of Contents Publication of 2021 Environmental, Social and Governance Report . On June 23, 2022, we published its 2021 Environmental, Social and Governance (ESG) report. The annual ESG report highlights how we are “Building a Better Tomorrow Together” through a broad spectrum of initiatives to address its most material ESG priorities. Highlights include: • Investing to reduce environmental impact and advance sustainability; • Prioritizing employee safety and career growth; • Nurturing a diverse, equitable and inclusive workplace; • Conducting business responsibly through strong governance and ethics; and • Adding value to the communities where we operate. Strategic Investments. During 2022, we made strategic investments to enhance the support of our Trex Residential brand and channel partners, including the debut of our new “We See It Too” marketing campaign. We also launched Trex Academy, an online multimedia content hub dedicated to helping the Trex Residential Do-It-Yourself customer bring their deck dreams to life by providing how-to content. Russian Invasion of Ukraine . The conflict between Russia and Ukraine has not directly affected our business and results of operations. We have no operations in Russia or Ukraine but continue to monitor the potential economic impact of the conflict on supply chains, commodity and fuel prices, and prices of raw materials. We cannot predict the impact of the continued conflict on the global economy, our industry or our business. Highlights and Financial Performance for the Twelve Months Ended December 31, 2022: Year Ended December 31, 2022 2021 $ Change % Change (000s omitted, except per share data) Net sales $ 1,106,043 $ 1,196,952 $ (90,909 ) (7.6 )% Gross profit $ 403,989 $ 460,504 $ (56,515 ) (12.3 )% Net income $ 184,626 $ 208,737 $ (24,111 ) (11.6 )% EBITDA $ 291,033 $ 311,322 $ (20,289 ) (6.5 )% Diluted earnings per share $ 1.65 $ 1.80 $ (0.15 ) (8.3 )% Capital expenditures . In 2022, we spent a total of $176.2 million on capital expenditures, primarily at our Trex Residential facilities, including $85.7 million related to construction of our Arkansas facility, $39.2 million related to general plant cost reduction initiatives at our Virginia and Nevada facilities, $19.1 million related to our new corporate office development, and $17.6 million for general support, safety and environmental initiatives. Repurchase of common shares . We repurchased 6.5 million shares of our outstanding common stock in 2022 under our Stock Repurchase Program. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our significant accounting policies are described in Note 2 to our Consolidated Financial Statements appearing elsewhere in this report. Our critical accounting estimates include the areas where we have made what we consider to be particularly difficult, subjective or complex judgments in making estimates, and where these estimates can significantly affect our financial results under different assumptions and conditions. We prepare our financial statements in conformity with accounting principles generally accepted in the United States. As a 28 Table of Contents result, we are required to make estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. Actual results could be different from these estimates. Product Warranty. We warrant that for the applicable warranty period our Trex Residential products, when properly installed, used and maintained, will be free from material defects in workmanship and materials and our decking, cladding, fascia and railing products will not split, splinter, rot or suffer structural damage from termites or fungal decay. Products sold on or after January 1, 2023: The warranty period for residential use is 50 years for Transcend ® decking, 35 years for Select ® decking and Universal Fascia, and 25 years for Enhance ® decking and Transcend, Select, Enhance and Signature ® railing. The warranty period for commercial use is 10 years, excluding Signature railing and Transcend cladding, which each have a warranty period of 25 years. We further warrant that Trex Transcend, Trex Enhance and Trex Select decking and cladding and Universal Fascia products will not fade in color from light and weathering exposure more than a certain amount and will be resistant to permanent staining from food and beverage substances or mold and mildew, provided the stain is cleaned within seven days of appearance, for the warranty period referred to above. If there is a breach of such warranties, we have an obligation either to replace the defective product or refund the purchase price. Products sold prior to January 1, 2023: The warranty period is 25 years for residential use and 10 years for commercial use. With respect to Trex Signature railing, the warranty period is 25 years for both residential and commercial use. We further warrant that Trex Transcend, Trex Enhance, Trex Select and Universal Fascia products will not fade in color more than a certain amount and will be resistant to permanent staining from food substances or mold, provided the stain is cleaned within seven days of appearance, for the warranty period referred to above. If there is a breach of such warranties, we have an obligation either to replace the defective product or refund the purchase price. We continue to receive and settle claims for Trex Residential 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. Estimating the warranty reserve for surface flaking claims requires management to estimate (1) the number of claims to be settled with payment and (2) the average cost to settle each claim. To estimate the number of surface flaking claims to be settled with payment, we utilize actuarial techniques to quantify both the expected number of claims to be received and the percentage of those claims that will ultimately require payment (collectively, elements). Estimates for these elements are quantified using a range of assumptions derived from claim count history and the identification of factors influencing the claim counts. The cost per claim varies due to a number of factors, including the size of affected decks, the availability and type of replacement material used, the cost of production of replacement material and the method of claim settlement. 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 year are received during the summer outdoor season, which spans the second and third quarters. It has been our practice to utilize the actuarial techniques discussed above 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. The number of incoming claims received in the year ended December 31, 2022 was significantly lower than the number of claims received in the year ended December 31, 2021, and lower than our expectations for 2022. Average cost per claim experienced in the year ended December 31, 2022 was significantly higher than that experienced in the year ended December 31, 2021, and higher than our expectations for 2022. The elevated average cost per claim experienced in the year ended December 31, 2022, was primarily the result of the closure of three large claims, which were considered in our estimation of the surface flaking reserve. We believe the reserve at December 31, 2022 is sufficient to cover future surface flaking obligations. 29 Table of Contents Our analysis is based on currently known facts and a number of assumptions, as discussed above, and current expectations. 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. We estimate that the annual number of claims received will continue to decline over time and that the average cost per claim will increase slightly, primarily due to inflation. If the level of claims received or average cost per claim differs materially from expectations, it could result in additional increases or decreases to the warranty reserve and a decrease or increase in earnings and cash flows in future periods. We estimate that a 10% change in the expected number of remaining claims to be settled with payment or the expected cost to settle claims may result in approximately a $1.6 million change in the surface flaking warranty reserve. The following table details surface flaking claims activity related to our residential product warranty: Year Ended December 31, 2022 2021 2020 Claims unresolved beginning of period 1,759 1,799 1,724 Claims received (1) 592 894 1,441 Claims resolved (2) (622 ) (934 ) (1,366 ) Claims unresolved end of period 1,729 1,759 1,799 Average cost per claim (3) $ 4,987 $ 3,519 $ 3,390 (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. For additional information about product warranties, see Notes 2 and 19 to the Consolidated Financial Statements appearing elsewhere in this report. Goodwill. We evaluate the recoverability of goodwill in accordance with Accounting Standard Codification (ASC) Topic 350, “ Intangibles—Goodwill and Other ,” annually or more frequently if an event occurs or circumstances change in the interim that would more likely than not reduce the fair value of the asset below its carrying amount. We evaluate the recoverability of goodwill at the reporting unit level. Through December 30, 2022 and during the two years ended December 31, 2021, we determined that the Company had three reporting units: a residential reporting unit in the Trex Residential reportable segment, and a commercial railing reporting unit and a staging reporting unit in the Trex Commercial reportable segment. We completed the sale of our wholly-owned subsidiary, Trex Commercial Products, Inc., on December 30, 2022. Trex Commercial Products, Inc. had been a reportable segment of the Company. Goodwill is considered impaired when the carrying amount of a reporting unit exceeds its fair value, and an impairment loss is recognized in an amount equal to that excess but limited to the total amount of goodwill allocated to that reporting unit. We first assess qualitative factors to determine if it is more likely than not that the fair value of the reporting unit is less than its carrying amount, including goodwill. Qualitative factors we consider include events and circumstances such as macroeconomic conditions, industry and market considerations, cost factors, overall financial performance, and other relevant Company-specific events. We evaluate, based on the weight of evidence, the significance of all identified events and circumstances in the context of determining whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Weighing the effect of various positive and negative factors is challenging and requires the use of significant judgment. The weight we place on each factor depends on certain conditions, including uncertainty about future events. If different conditions exist in future periods, future impairment charges could result. 30 Table of Contents If the qualitative assessment indicates that the carrying amount of the reporting unit exceeds its fair value, including goodwill, we are then required to perform a quantitative goodwill impairment test. The quantitative goodwill impairment test, used to identify both the existence of impairment and the amount of impairment loss, compares the fair value of a reporting unit with its carrying amount, including goodwill. The fair value of a reporting unit refers to the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date. If the carrying amount of a reporting unit is in excess of the estimated fair value of that reporting unit, a goodwill impairment charge is recognized in the amount by which the reporting unit’s carrying amount exceeds its fair value, but not to exceed the total goodwill assigned to the reporting unit. We measure the fair value of a reporting unit based on a combination of the Income Approach (i.e., the Discounted Cash Flow Method) and a Market Approach. The Discounted Cash Flow Method is a multiple period discounting model in which the fair value of the reporting units are determined by discounting the projected free cash flows using an appropriate discount rate and indicates the fair value of the reporting units based on the present value of the cash flows that the reporting unit is expected to generate in the future. Significant estimates in the Discounted Cash Flow Method include: the weighted average cost of capital (or discount rate); long-term rate of growth and profitability of the business (residual growth rate); and working capital effects. The Market Approach uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or a group of assets and liabilities, such as a business. Significant estimates in the Market Approach model may include identifying appropriate market multiples and assessing earnings before interest, income taxes, depreciation and amortization (EBITDA) in estimating the fair value of the reporting units. The use of different assumptions, estimates or judgements, including estimated future cash flows and the discount rate used to discount estimated cash flows to their net present value, could materially increase or decrease the fair value of the reporting unit and impact our assessment of any goodwill impairment charges. Also, if different conditions exist in future periods, future impairment charges could result. Revenue Recognition Trex Residential Products Trex Residential principally generates revenue from the manufacture and sale of its high-performance, low-maintenance, eco-friendly outdoor living products, consisting of composite decking and railing products, hidden fasteners, and a broad offering of outdoor living accessories. Substantially all of its revenues are from contracts with customers, which are individual customer purchase orders of short-term duration of less than one year. Trex Residential satisfies its performance obligations at a point in time. The shipment of each product is a separate performance obligation as the customer is able to derive benefit from each product shipped and no performance obligation remains after shipment. Upon shipment of the product, the customer obtains control over the distinct product and Trex Residential satisfies its performance obligation. Any performance obligation that remains unsatisfied at the end of a reporting period is part of a contract that has an original expected duration of one year or less. Any variable consideration related to the unsatisfied performance obligation is allocated wholly to the unsatisfied performance obligation and recognized when the product ships and the performance obligation is satisfied and is included in “Accrued expenses and other liabilities, Sales and marketing” in Note 8 to the Consolidated Financial Statements presented in this Form 10-K. Trex Residential may offer various sales incentive programs throughout the year. It estimates the amount of sales incentive to allocate to each performance obligation, or product shipped, based on direct sales to the customer. The estimate is updated each reporting period and any changes are allocated to the performance obligations on the same basis as at inception. Changes in estimate allocated to a previously satisfied performance obligation are recognized as a reduction of revenue in the period in which the change occurs under the cumulative catch-up method. Should estimates change or prove to have been incorrect, it could negatively affect our results of operations and financial condition. In addition to sales incentive programs, Trex Residential may offer payment discounts. It estimates the payment discount that it believes will be taken by the customer based on prior history using the most-likely-amount method of estimation. 31 Table of Contents Trex Commercial Products Trex Commercial generated revenue from the manufacture and sale of its custom, modular and architectural railing and staging systems. All of its revenues were from fixed-price contracts with customers. Trex Commercial contracts had a single performance obligation as the promise to transfer the individual goods or services was not separately identifiable from other promises in the contract and was, therefore, not distinct. Trex Commercial satisfied its performance obligation over time as work progressed because control was transferred continuously to its customers. Revenue and estimated profit were recognized over time based on the proportion of actual costs incurred to date relative to total estimated costs at completion to measure progress toward satisfying the performance obligation. Incurred costs represent work performed, which corresponds with, and thereby best depicts, the transfer of control to the customer. Incurred costs included all direct material, labor, subcontract and certain indirect costs. The Company reviewed and updated its estimates regularly and recognized adjustments in estimated profit on contracts under the cumulative catch-up method. Under this method, the impact of the adjustment on revenue and estimated profit to date on a contract is recognized in the period the adjustment is identified. If at any time the estimate of contract profitability indicated an anticipated loss on the contract, the Company recognized the total loss in the period it was identified. During the year ended December 31, 2022, no adjustment to any one contract was material to the Company’s Consolidated Financial Statements and no material impairment loss on any contract was recorded. RESULTS OF OPERATIONS General. Our results of operations are affected by a number of factors, including, but not limited to, the cost to manufacture and distribute products, cost of raw materials, inflation, interest rates, consumer spending and preferences, the impact of any supply chain disruptions, economic conditions, and any adverse effects from global health pandemics and geopolitical conflicts. Strong sales growth in the first and second quarters of 2022 reflected an increase in Trex Residential net sales driven by pricing actions taken in 2021 and 2022, volume growth that continued to reflect strong secular trends in the outdoor living category, continued execution of our wood-to-composite market strategy share conversion, and channel inventory build to support historically high growth rates. The channel inventory build was due in part to expected consumer demand consistent with what was seen in 2020 and 2021, but also was a consequence of improved product availability following more than two years of capacity constraints and product allocations. However, towards the end of June Trex Residential experienced a reduction in demand from its distribution partners, spurred by concerns over a potential easing in consumer demand due to rising interest rates, declining consumer sentiment and expectations of a general slowing in the economy. As a result, beginning in the third quarter Trex Residential’s channel partners met demand partially through inventory drawdown. The drawdown negatively impacted third and fourth quarter sales. In response to this changed environment, Trex Residential immediately took measures to better align its cost structure with current demand by decreasing production levels, right sizing the employee base, and focusing on cost efficiency programs. Net Sales. Net sales consist of sales and freight, net of returns and discounts. The level of net sales is principally affected by sales volume and the prices paid for Trex products. The operating results for Trex Residential have historically varied from quarter to quarter, often due to seasonal trends in the demand for outdoor living products. 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 practices, 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 to ensure adequate availability of its product to meet anticipated seasonal consumer demand and to enable production planning. These incentives include prompt payment discounts and 32 Table of Contents favorable payment terms. In addition, we offer 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 sales incentive programs can impact sales, receivables and inventory levels during the offering period. In addition, the operating results for Trex Commercial have not historically varied from quarter to quarter as a result of seasonality, but are driven by the timing of individual projects, which may vary significantly each period. Gross Profit. Gross profit represents the difference between net sales and cost of sales. Cost of sales consists of raw materials costs, direct labor costs, manufacturing costs, warranty costs, and freight. Raw materials costs generally include the costs to purchase and transport reclaimed wood fiber, scrap polyethylene and pigmentation for coloring Trex products. 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. Selling, General and Administrative Expenses. The largest component of selling, general and administrative expenses is personnel related costs, which include 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 of Trex. 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 have varied from quarter to quarter due, in part, to the seasonality of our business. Below we have included a discussion of our operating results and material changes in our operating results for the year ended December 31, 2022 compared to the year ended December 31, 2021. Year Ended December 31, 2022 Compared To Year Ended December 31, 2021 Net Sales Year Ended December 31, $ Change % Change 2022 2021 (dollars in thousands) Total net sales $ 1,106,043 $ 1,196,952 $ (90,909) (7.6 )% Trex Residential net sales $ 1,059,536 $ 1,139,266 $ (79,730) (7.0 )% Trex Commercial net sales $ 46,507 $ 57,686 $ (11,179) (19.4 )% Total net sales in 2022 decreased $90.9 million, or 7.6%, compared to total net sales in 2021, due to a decrease in Trex Residential and Trex Commercial net sales of $79.7 million and $11.2 million, respectively. The decrease in Trex Residential net sales was due primarily to an 18.2% reduction in volume, offset by a 13.6% increase in pricing, The decrease in Trex Residential volume was primarily due to a decline in demand beginning in the third quarter of 2022 as our distribution partners serviced demand requirements primarily through inventory drawdowns rather than reorders. The increase in pricing was due to price increases taken in 2021 and 2022 on certain products to address inflationary pressures across many key raw materials, labor and transportation. 33 Table of Contents Gross Profit Year Ended December 31, $ Change % Change 2022 2021 (dollars in thousands) Cost of sales $ 702,054 $ 736,448 $ (34,394) (4.7 )% % of total net sales 63.5 % 61.5 % Gross profit $ 403,989 $ 460,504 $ (56,515) (12.3 )% Gross margin 36.5 % 38.5 % Gross profit as a percentage of net sales, gross margin, was 36.5% in 2022 compared to 38.5% in 2021. Gross margin for Trex Residential and Trex Commercial in 2022 were 37.7% and 8.9%, respectively, compared to 39.3% and 22.0%, respectively, in 2021. Gross margin at Trex Residential was unfavorably impacted primarily by reduced production volume and inflationary pressures, offset by pricing realization increases on certain product lines, right sizing our employee base, and other actions to better align our cost structure with current demand. Selling, General and Administrative Expenses Year Ended December 31, $ Change % Change 2022 2021 (dollars in thousands) Selling, general and administrative expenses $ 141,831 $ 139,624 $ 2,207 1.6 % % of total net sales 12.8 % 11.7 % Selling, general and administrative expenses increased $2.2 million in 2022 compared to 2021 primarily resulting from a $12.6 million increase in branding and marketing expenses. The increase was offset by a $10.3 million decrease in personnel and personnel related expenses. Loss on Sale Year Ended December 31, $ Change % Change 2022 2021 (dollars in thousands) Loss on sale $ 15,423 $ — $ 15,423 N/A % of total net sales 1.4 % N/A On December 30, 2022, we completed the sale of substantially all of the assets of our wholly-owned subsidiary and reportable segment, Trex Commercial, for net proceeds of $7.3 million. The divestiture reflects our decision to focus on driving the most profitable growth strategy for the Company and its shareholders through the execution of our outdoor living strategy. With the sale complete, we will dedicate our resources to accelerating conversion to composites from wood and further strengthen our leadership position in the outdoor living category. The sale resulted in a loss on sale of $15.4 million and is reported in the Consolidated Statements of Comprehensive Income. Goodwill Impairment Loss Year Ended December 31, $ Change % Change 2022 2021 (dollars in thousands) Goodwill impairment loss $ — $ 54,245 $ (54,245 ) N/A % of total net sales N/A 4.5 % 34 Table of Contents During the fourth quarter of 2021, our annual goodwill impairment testing resulted in the recognition of an impairment charge to goodwill at our commercial railing reporting unit and our staging reporting unit within the Trex Commercial reportable segment of $42.5 million and $11.8 million, respectively. For fiscal year 2021, the Company determined that it was necessary to perform the goodwill impairment test for our railing and staging reporting units utilizing the quantitative assessment. We performed a quantitative assessment primarily due to a reduction in project commitments, which adversely impacted project backlog and forecasted net sales and EBITDA. The reduction in project commitments was influenced by a continued delay in new projects due to lingering uncertainty created in the commercial railing and staging markets by the COVID-19 virus. The delay in new projects, coupled with the Company’s successful fulfillment of its pre-pandemic projects, resulted in lower project backlog and reduced forecasted net sales and EBITDA, which became apparent in the fourth quarter of 2021. Gain on Insurance Proceeds Year Ended December 31, $ Change % Change 2022 2021 (dollars in thousands) Gain on insurance proceeds $ — $ 8,741 $ (8,741 ) N/A % of total net sales N/A 0.7 % In March 2021, an electrical fire occurred at one of our manufacturing buildings in our Virginia complex. No injuries occurred from the event. The building was temporarily off-line while damage to the building’s electrical systems was addressed. Our insurance covered repairs, incremental direct costs to serve our customers, and losses in operating income from the loss in net sales. During 2021, gains on insurance proceeds primarily related to the settlement from our insurance company of $6.8 million related to the fire at the Virginia facility. Provision for Income Taxes Year Ended December 31, $ Change % Change 2022 2021 (dollars in thousands) Provision for income taxes $ 62,212 $ 66,654 $ (4,442) (6.7)% Effective tax rate 25.2 % 24.2 % The effective tax rate for 2022 was 25.2% compared to the effective tax rate for 2021 of 24.2%. The increase in the effective tax rate was driven primarily by a reduction in excess tax benefits resulting from the vesting of outstanding share-based employee compensation. 35 Table of Contents Net Income and Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) 1 (dollars in thousands) Reconciliation of net income (GAAP) to EBITDA and EBITDA margin (non-GAAP): Year Ended December 31, 2022 Trex Residential Trex Commercial Total Net income (loss) $ 200,876 $ (16,250 ) $ 184,626 Interest income, net (103 ) — (103 ) Income tax expense (benefit) 67,313 (5,101 ) 62,212 Depreciation and amortization 43,173 1,125 44,298 EBITDA $ 311,259 $ (20,226 ) $ 291,033 Year Ended December 31, 2021 Trex Residential Trex Commercial Total Net income (loss) $ 247,059 $ (38,322 ) $ 208,737 Interest income, net (15 ) — (15 ) Income tax expense (benefit) 79,500 (12,846 ) 66,654 Depreciation and amortization 34,941 1,005 35,946 EBITDA $ 361,485 $ (50,163 ) $ 311,322 Year Ended December 31, $ Change % Change 2022 2021 (dollars in thousands) Total EBITDA $ 291,033 $ 311,322 $ (20,289 ) (6.5 )% Trex Residential EBITDA $ 311,259 $ 361,485 $ (50,226 ) (13.9 )% Trex Commercial EBITDA $ (20,226 ) $ (50,163 ) $ 29,937 59.7 % Total EBITDA decreased 6.5% to $291 million for 2022 compared to $311 million for 2021. The decrease was due to a $50.2 million decrease in Trex Residential EBITDA, primarily driven by a decrease in net sales and gross profit. The decrease was offset in part by an increase in EBITDA at Trex Commercial, which resulted primarily from a fourth quarter 2021 goodwill impairment charge of $54.2 million, offset by a fourth quarter 2022 loss on sale of $15.4 million. 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 the measures facilitate performance comparison between the Company and its competitors, and management evaluates the performance of its reportable segments using EBITDA. Management considers EBITDA to be important supplemental indicators of our core operating performance because the measures eliminate interest, income taxes, and depreciation and amortization charges to net income. In relation to its competitors, EBITDA eliminates differences among companies in capitalization and tax structures, capital investment cycles and ages of related assets, especially when comparing financial results to prior periods. For these reasons, management believes that EBITDA provide important information regarding the operating performance of the Company and its reportable segments. Non-GAAP measures are not meant to be considered superior to or a substitute for our GAAP results. 36 Table of Contents Year Ended December 31, 2021 Compared To Year Ended December 31, 2020 The Company hereby incorporates by reference the financial results from fiscal year 2020 and the comparison of financial results from fiscal year 2021 to fiscal year 2020 as set forth in the Company’s Management’s Discussion and Analysis of Financial Condition and Results of Operation in the Annual Report on Form 10-K for the year ended December 31, 2021 and filed with the U.S. Securities and Exchange Commission on February 28, 2022. LIQUIDITY AND CAPITAL RESOURCES We finance operations and growth primarily with cash flow from operations, borrowings, operating leases and normal trade credit terms from operating activities. S ources and Uses of Cash. The following table summarizes our cash flows from operating, investing and financing activities for the years ended December 31, 2022, 2021, and 2020 (in thousands): Year Ended December 31, 2022 2021 2020 Net cash provided by operating activities $ 216,220 $ 258,064 $ 187,294 Net cash used in investing activities (168,884 ) (158,039 ) (170,658 ) Net cash used in financing activities (176,064 ) (80,673 ) (43,768 ) Net (decrease) increase in cash and cash equivalents $ (128,728 ) $ 19,352 $ (27,132 ) Operating Activities Cash provided by operating activities in 2022 were primarily impacted by lower net sales and gross profit at Trex Residential, a loss on sale of Trex Commercial Products, Inc., and an increase in inventories, offset by an decrease in accounts receivable. Investing Activities In 2022, cash used in investing activities for capital expenditures was $176.2 million, primarily at our Trex Residential facilities, including $85.7 million related to construction of our Arkansas facility, $39.2 million related to general plant cost reduction initiatives at our Virginia and Nevada facilities, $19.1 million related to our new corporate office development, and $17.6 million for general support, safety and environmental initiatives. Cash provided by investing activities in 2022 included $7.3 million in proceeds from the sale of Trex Commercial. Financing Activities Net cash used in financing activities in 2022 consisted primarily of $398.4 million in repurchases of our common stock under our Stock Repurchase Program, offset by net borrowings under our revolving credit facility of $222 million. Stock Repurchase Program. On February 16, 2018, the Board of Directors adopted a stock repurchase program of up to 11.6 million shares of the Company’s outstanding common stock (Stock Repurchase Program). For the year ended December 31, 2022, the Company repurchased 6.5 million shares under the Stock Repurchase Program. 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 37 Table of Contents 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. 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. Indebtedness Prior to May 18, 2022. 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. 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. 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) remained unchanged from the Original Credit Agreement. The Company entered into the First Amendment, as borrower; Trex Commercial Products, Inc. (Trex Commercial), 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%, Well Fargo of 28.0% and Regions of 24.5%. The Company’s revolving credit facility executed November 5, 2019 was completely replaced by the Company’s revolving credit facility executed May 18, 2022. Indebtedness On and After May 18, 2022 . On May 18, 2022, the Company, as borrower; Trex Commercial Products, Inc. (Trex Commercial), as guarantor; Bank of America, N.A. (BOA), as a Lender, Administrative Agent, Swing Line Lender and L/C Issuer; Wells Fargo Bank, National Association (Wells Fargo), as lender and Syndication Agent; Regions Bank, PNC Bank, National Association, and TD Bank, N.A. (each, a Lender and collectively, the Lenders), arranged by BofA Securities, Inc. as Sole Lead Arranger and Sole Bookrunner, entered into a Credit Agreement (Credit Agreement) to amend and restate the Fourth Amended and Restated Credit Agreement dated as of November 5, 2019. Under the Credit Agreement, the Lenders agreed to provide the Company with one or more Revolving Loans in a collective maximum principal amount of $400,000,000 (Loan Limit) throughout the term, which ends May 18, 2027 (Term). Included within the Loan Limit are sublimits for a Letter of Credit facility in an amount not to exceed $60,000,000; and Swing Line Loans in an aggregate principal amount at any time outstanding not to exceed $20,000,000. The Revolving Loans, the Letter of Credit facility and the Swing Line Loans are for the purpose of raising working capital and supporting general business operations. 38 Table of Contents The Credit Agreement provides the Company, in the aggregate, the ability to borrow an amount up to the Loan Limit during the Term. The Company is not obligated to borrow any amount under the Loan Limit. Within the Loan Limit, the Company may borrow, repay and reborrow at any time or from time to time while the Notes are in effect. Base Rate Loans (as defined in the Credit Agreement) under the Revolving Loans and the Swing Line Loans accrue interest at the Base Rate plus the Applicable Rate (as defined in the Credit Agreement) and Term SOFR Loans for the Revolving Loans accrue interest at the rate per annum equal to the sum of Term SOFR for such interest period plus the Applicable Rate (as defined in the Credit Agreement). The Base Rate for any day is a fluctuating rate per annum equal to the highest of (a) the Federal Funds Rate plus 0.50%, (b) the rate of interest in effect for such day as publicly announced from time to time by BOA as its prime rate, and (c) the Term SOFR plus 1.0% subject to certain interest rate floors. Repayment of all then outstanding principal, interest, fees and costs is due at the end of the Term. The Company and BofA Securities, Inc. as a sustainability coordinator, are entitled to establish specified key performance indicators (KPIs) with respect to certain environmental, social and governance targets of the Company and its subsidiaries. The sustainability coordinator and the Company may amend the Credit Agreement for the purpose of incorporating the KPIs and other related provisions, unless the Lenders object to such amendment on or prior to the date that is ten business days after the date on which such amendment is posted for review by the Lenders. Based on the performance of the Company and its subsidiaries against the KPIs, certain adjustments (increase, decrease or no adjustment) to otherwise applicable pricing will be made; provided that the amount of such adjustments shall not exceed certain aggregate caps as in the definitive loan documentation. Under the terms of the Security and Pledge Agreement, the Company and Trex Commercial, subject to certain permitted encumbrances, as collateral security for the above-stated loans and all other present and future indebtedness of the Company owing to the Lenders grants to BOA, as Administrative Agent for the Lenders, a continuing security interest in certain collateral described and defined in the Security and Pledge Agreement but excluding the Excluded Property (as defined in the Security and Pledge Agreement). Indebtedness On and After December 22, 2022 . As of December 22, 2022, the Company entered into a First Amendment to the Credit Agreement (First Amendment) by and among the Company, as borrower, the guarantors party thereto; Bank of America, N.A. (BOA), as a Lender, Administrative Agent, Swing Line Lender and L/C Issuer; TD Bank, N.A. as lender and Syndication Agent; Regions Bank, PNC Bank, National Association, and Wells Fargo Bank, National Association (each, a Lender and collectively, the Lenders), arranged by BofA Securities, Inc. as Sole Lead Arranger and Sole Bookrunner, amending that certain Credit Agreement dated as of May 18, 2022, by and among the Company, as borrower, the guarantors party thereto, BOA, as a Lender, Administrative Agent, Swing Line Lender and L/C Issuer and the other lenders identified therein (as so amended, the “Credit Agreement”). As a part of the First Amendment, the Credit Agreement was amended and restated to provide for an additional Revolving B Loan (as hereinafter defined). Under the First Amendment, the Lenders agreed to provide the Company with a Revolving B Loan consisting of one or more revolving loans in a collective maximum principal amount of $150,000,000 (Revolving B Loan Limit) throughout the term, which ends December 22, 2024 (Revolving B Loan Term). Previously, under the Credit Agreement, there was no Revolving B Loan. The First Amendment also provided that TD Bank, N.A. would serve as Syndication Agent. As of December 22, 2022, the Credit Agreement was amended and restated to refer to this loan as the Revolving A Loan. The amended and restated Credit Agreement was made an Exhibit A to the First Amendment. All of the terms of the Credit Agreement apply to the Revolving B Loan. The Credit Agreement continues to include sublimits under the Revolving A Loan for a Letter of Credit facility in an amount not to exceed $60,000,000; and Swing Line Loans in an aggregate principal amount at any time outstanding not to exceed $20,000,000. The Revolving Loans, the Letter of Credit facility and the Swing Line Loans under Revolving A Loan are for the purpose of raising working capital and supporting general business operations. 39 Table of Contents The Notes provide the Company, in the aggregate, the ability to borrow an amount up to the Revolving A Loan Limit during the Revolving A Loan Term and Revolving B Loan Limit during the Revolving B Loan Term. The Company is not obligated to borrow any amount under the revolving loans. Within the respective loan limit, the Company may borrow, repay and reborrow at any time or from time to time while the Notes are in effect. With respect to Revolving B Loans, for any day, the rate per annum is a tiered pricing based upon the Consolidated Debt to Consolidated EBITDA Ratio. The applicable rate for Revolving B Loans that are Base Rate Loans range between1.20% and 2.15% and the applicable rate for Revolving B Loans that are Term SOFR/Term SOFR Daily Floating Rate range between 0.20% and 1.15%. At December 31, 2022, we had $222 million in outstanding borrowings under the revolving credit facility and borrowing capacity under the facility of $328 million. Compliance with Debt Covenants and Restrictions. Pursuant to the terms of the Credit Agreement, the Company, is subject to certain loan compliance covenants. The Company was in compliance with all covenants at December 31, 2022. 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. Contractual Obligations. Our contractual obligations consist primarily of purchase commitments and operating leases. Purchase obligations represent supply contracts with raw material vendors and service contracts for hauling raw materials. Open purchase orders written in the normal course of business for goods or services that are provided on demand have been excluded as the timing of which is not certain. As of December 31, 2022, we have purchase obligations under material supply contracts of $53 million for the year ending December 31, 2023, $26.1 million in 2024, $13.3 million in 2025, and $5.6 million in 2026. Please refer to Note 19 to the Consolidated Financial Statements in this filing for additional information on our purchase commitments. Operating leases represent office space, storage warehouses, manufacturing facilities and certain office and plant equipment under various operating leases, and include operating leases accounted for under Financial Accounting Standards Board Accounting Standards Codification Topic 842 and short-term leases. As of December 31, 2022, we have operating lease liabilities of $7.6 million for the year ending December 31, 2023, $20.7 million for the years 2024 through 2027 and $4.8 million thereafter. Please refer to Note 10 to the Consolidated Financial Statements in this filing for additional information on our operating leases. The Company believes that its cash on hand and cash generated through operating activities, both over the next 12 months and beyond the next 12 months, should be sufficient to cover purchase obligations and operating leases. Off-Balance Sheet Arrangements. We do not have off-balance sheet financing arrangements. Capital and Other Cash Requirements. In October 2021, we announced plans to add a third U.S.-based Trex Residential manufacturing facility located in Little Rock, Arkansas. The new campus will sit on approximately 300 acres of land and will address demand for Trex Residential outdoor living products. The development approach for the new campus will be modular and calibrated to demand trends for Trex Residential outdoor living products. Construction began on the new facility in the second quarter 2022, and in July 2022, the Company entered into a design-build agreement. As previously announced, the Company anticipates spending approximately $400 million on the facility and the budget for the design-build agreement is contained within this amount. Construction for the new facility will be funded primarily through the Company’s ongoing cash generation or its line of credit. Our capital expenditure guidance for 2023 is $130 million to $140 million. In addition to our capital expenditure program, our capital allocation priorities include expenditures for internal growth opportunities, 40 Table of Contents manufacturing cost reductions, upgrading equipment and support systems, 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. We believe that cash on hand, cash flows from operations and borrowings expected to be available under our revolving credit facility will provide sufficient funds to enable us to fund planned capital expenditures, make scheduled principal and interest payments, fund the warranty reserve, meet other cash requirements and maintain compliance with terms of our debt agreements for at least the next 12 months. We currently expect to fund future capital expenditures from operations and borrowings under the revolving credit facility. 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. Our ability to meet our cash needs during the next 12 months and thereafter could be adversely affected by various circumstances, including increases in the cost of raw materials and product replacement costs, quality control problems, higher than expected product warranty claims, service disruptions and lower than expected collections of accounts receivable. In addition, any failure to negotiate amendments to our existing debt agreements to resolve any future noncompliance with financial covenants could adversely affect our liquidity by reducing access to revolving credit borrowings needed primarily to fund seasonal borrowing needs. We may determine that it is necessary or desirable to obtain financing through bank borrowings or the issuance of debt or equity securities to address such contingencies or changes to our business plan. Debt financing would increase our level of indebtedness, while equity financing would dilute the ownership of our stockholders. There can be no assurance as to whether, or as to the terms on which, we would be able to obtain such financing, which would be restricted by covenants contained in our existing debt agreements.