This fall the East Coast was hit by hurricane Isabel. The storm struck us pretty hard at Fool HQ, in Alexandria, Virginia, but there, amidst the debris, the shuttered shops and the sandbags stood our town's 55,000-square-foot deck overlooking the Potomac River . It remained unmarked, unwarped and undamaged by moisture because it is not a traditional wooden deck. Less than two weeks later, it won the Governor's Award for Environmental Excellence in the state of Virginia .
The deck was manufactured by Trex Company (NYSE: TWP), my top pick in the November issue of Motley Fool Stock Advisor.
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Trex Company manufactures environmentally friendly decks, built out of equal parts waste wood and recycled plastic. Trex buys discarded wood fiber from lumber mills and recycled plastic bags from grocery stores nationwide and then heats, blends and cuts them into non-wood decking.
The cost of a Trex deck is as much as 20% higher than the chemically treated traditional wood buildouts, which account for more than 90% of all the decks in America today. So how has the company generated double-digit sales growth since its creation in 1996? Why would a consumer pay more to use Trex rather than install standard wooden outdoor flooring?
First, Trex decks require virtually no investment in staining or preserving them after their installation. The mixture of wood fiber and plastic provides flexibility and durability while demanding little maintenance. A conventional wood deck warps and cracks, splits and sends up splinters. Its owner has to invest in maintaining it with chemical coatings.
Second, Trex decks are gaining market share because the chemical treatments applied to wood are proving harmful to the environment and to humans. More than 90% of all lumber used in traditional wood decks has been chemically treated. This use of chromated copper arsenate (CCA) has resulted in heightened counts of arsenic in underlying groundwater and detection of that carcinogen in the bloodstream of children playing on the treated wood. EPA guidelines require the phasing out of CCA treatments by December 2003, which is helping fuel demand for Trex decks.
Finally, Trex has captured consumer and contractor enthusiasm because it is a handsome alternative that is relatively easy to construct. It doesn't look fake or cheap. I suspect most people walking across our deck in Alexandria , Virginia , think they're walking on lumber. Its attractive look is helping to make the Trex deck the platform of choice (pun intended) for more and more contractors across the country.
The Valuation
The business should generate north of $30 million in structural free cash flow for this fiscal year. Trex is buying back stock, and the business is generating returns on assets (ROA) north of 10%, and returns on equity (ROE) north of 20%. Very healthy. I am using my own projections of 20% annual growth over the next three years, and factoring in buybacks, which amounted to 2% of the company's stock over the past 12 months. When I blend these together, I generate a valuation over the next three years north of $1 billion -- a share price over $70, and just about a double for buyers of TWP today.
Trex Company is an innovative business trying to do things right for the world. In the years to come, the company may find additional applications of its composite wood and plastic that could generate unexpected growth. I believe this innovative company is generating sustainable profits out of a princely mission and will reward its owners with market-beating returns.
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