The AZEK Company Inc. (AZEK) Earnings Call Transcript & Summary

Okay. Good morning. I'm Matt Bouley, Barclays U.S. building products analyst. My pleasure to have the management team from AZEK here with us at the 38th Annual Barclays Industrial Select Conference. We have Jesse Singh, CEO; Ralph Nicoletti, CFO; Jon Skelly, SVP of Strategy; Eric Robinson; and Amanda Cimaglia from the ESG side as well from the AZEK management team. So I'm going to let Jesse take it off here in a moment with sort of a state of the union on AZEK and where everything stands today. But for everyone listening, please feel free to e-mail me questions. You should see my e-mail address up on the left side of the webcast if you don't have it. And also on the right side of the webcast, you're going to see the audience response questions. It's always much appreciated for investors to fill that out year after year. So with that, everyone, thank you for joining today, and I will let Jesse kick it off with those opening remarks. Please go ahead, sir.

Terrific. Thanks, Matt. Really appreciate it, and thank you all for being here. Let me just start by saying how excited we are by the market opportunity and the environment that we play in. We're in a unique position to be able to use recycled materials. In fact, we just announced at our earnings call our commitment to achieve 1 billion pounds of recycling. So we're just really excited by the fact that we're able to use recycled materials to create environmentally-friendly products that really beautify the exteriors of people's homes. As you take a look at our product categories, the vast majority of the company, it plays in the residential, repair and remodel space. And more specifically, within our Residential business, we've got an Exteriors business component that really created the exterior trim category -- a branded exterior trim category under the AZEK brand, and there's a number of great exteriors products there. And then on the outdoor living space, we've got the TimberTech brand in that particular business, and that brand continues to drive innovation in the marketplace on deck, rail and accessories and in other outdoor living products. And so as you step back and look at our journey, our results coming into the pandemic were 16% trailing 12 growth through March of 2020. We've obviously seen that momentum continue as people focus on their houses. And as we look at our leading indicators, as I highlighted on the call, we continue to see many of them, in fact, all of them that we track very, very green. And as a reminder, those indicators are not only short-term indicators, but they're also long-term indicators. Things like housing formation, as people move into new houses, they continue to focus for a multi-month and, in many cases, a multiyear journey on improving those houses. As you take a look at the focus on outdoor living, we see those trends continuing. As you take a look at the focus on wood conversion, we certainly see those trends continuing. And then our own internal execution metrics, we're really happy with our activity, both on the sales and marketing side, in terms of how we continue to move forward. And then on the margin front, and as we continue to focus there, when we went public, we talked about a 500 basis point target from a baseline -- or actually, a guidepost from a baseline of 2019. We made meaningful progress against that in 2020, and we feel really good about the opportunity there. And that opportunity is really driven hand-in-hand with our focus on sustainability. We have an opportunity to continue to use recycled products to improve our environmental footprint, as I mentioned earlier, the 1 billion pound target. But as we use more and more of those recycled products and as we go to lower and lower-value recycled materials, that gives us an opportunity to save money, and as important, reduce our carbon footprint. And so those initiatives are also very much on track. And so with that, Matt, just a very high-level overview of the company. And the last thing I'll just point out, through all of this, we view ourselves as the innovative leader in the marketplace. We continue to launch new products. We also launched earlier this week or late last week, our new Landmark decking line, which is another step in securing our position as really the leader and the innovator in the outdoor living space. Similarly, we've launched new products into our exterior space. So with that, Matt, I'll turn it over to you to see if you have any questions.

Wonderful. Thank you, sir, for that helpful overview. I think we touched on a lot there. So maybe we'll dive into some of the news hot off the presses from earnings last week. Obviously, you guys ended up reporting a quarter that was a little bit better than what the initial expectations were. You pre-announced that back in January. But you talked about sort of success with ramping some of the new capacity, and that's what I want to focus on. So you guys have outlined 3 phases of new capacity, with that second phase expected to come on this year. What we saw was a quicker-than-expected ramp with that phase 1 capacity. So my question is, when we think about that second phase of capacity come in line -- coming online, to what degree is that contemplated in the guide? And is there any reason why we shouldn't expect that second phase of capacity to come online quicker as we saw with that first phase?

Yes. Thanks for the question, Matt. And as you highlighted, in our first quarter, we brought our first phase of capacity online and made it more productive faster. And as you might imagine, when you're dealing with bringing new manufacturing online, you've got to set up the machines. You've got to tune them, and you've got to bring them up. And normally, when you do that, it's appropriate to assume start-up time and start-up timing. And in our case, the team did a, in the first quarter, a really, really nice job of executing and making our equipment more productive and making our entire factory more productive as they brought that new equipment online. As we look at the second quarter, our capacity really comes online, as we've highlighted, through the end of the third quarter. And so we're in the second quarter now. Between now and the end of the third quarter, we'll be bringing capacity online. And our guidance contemplates an appropriate assumption relative to how that capacity comes online in the second and third quarter, an assumption that we're confident we can achieve. There's always opportunity. And I think in our case, in particular, as we move into the tail end of the second quarter and third quarter to continue to execute and -- but we think our assumptions of how that capacity comes online is appropriate. There are a lot of variables, and we've got a terrific team that's, through a pandemic, bringing on additional capacity online while running and servicing our current customer base.

Got it. Okay. That's helpful. So maybe sticking with that topic, we're thinking a little bit longer term and not to get too far into the future. But when we think about composite decking being only roughly 20% of the industry today, and you see cases or arguments for that penetration to rise a few points, and you see arguments for that to get up to 1/3 or even 50% of the industry 1 day, and without really knowing what that number gets to, I think in any case, you're going to -- the idea is that there's likely going to have to be more capacity that comes on in this industry even beyond what you've laid out over the next year or so. So my question is just thinking longer term like that, what are some of the considerations on how you think about scaling this business to an industry that could potentially get a lot larger in size and how you think about the sort of return on capital of those type of investments?

Yes. Well, first off, let me start with your last point. We get a terrific return on capital and intangible assets with any investment we make relative to our organic investments in capital. Our paybacks are typically in a sub-3-year range relative to the payback on [ 8th ] and on the capital that we deploy. And so as we look at investments, obviously, investing in our own business, we believe, is a really, really good investment. As you pointed out, we -- the market has significantly more opportunity than we're tapping right now. And later on, we might get into some of the trends on the market. But to answer your question more specifically, the way we're deploying our phases, in particular, the last phase, where we're bringing up a new facility, that deployment will give us the opportunity at that site to continue to expand beyond the initial amount of equipment that we brought on board. And just as a reminder, our first 2 phases at about 40% capacity, the third phase, which will come online about a year from now, gives us a new roof and an additional 30% add. But that new roof has expansion capability, well beyond what we're adding. And so of course, we're thinking ahead. And we view an investment, in particular, in capital in our businesses is a really good investment.

Right. Okay. Understood. And helpful color there. And so jumping back down to the near term a little bit. You're guiding the second quarter sales growth, 13% to 15%; full year, 14% to 18% growth. I think you said on the call that some of that assumes channel replenishment. Curious if you could go over sort of where distributor inventories are today. And then just kind of based on where out-the-door or POS, whatever you want to call it, demand is running right now, do you think you'll have the production capabilities this year to actually replenish channel inventory? Or does there need to be kind of a matching of demand and ramping production?

Yes. I think just as a reminder, as you look at our fiscal first quarter, which is October, November, December, you would typically see a reduction of inventory in the channel. And then when we hit December, the beginning of a reinflation of that inventory, December, January, February, March. And that's typically the season within which -- because of generally low demand on a relative basis where we have an opportunity to rebuild inventory with our channel partners, and they would typically stage that inventory, to the point that by the end of March, from a days-on-hand standpoint would be at the higher end relative to our channel partners. And so then as you look at the flow, we've seen very consistent demand underlying through the -- through our first fiscal quarter coming into January. We expect that demand -- there's going to be a little bit of variation, obviously, day-to-day, week-to-week based on weather, but we expect that demand to continue through the quarter and continue into the season. And so as you look at that, with the production adds that we've had, we took a modest step in our fiscal first quarter at rebuilding some of the channel inventory, both at a dealer level and at a distributor level. We expect in this particular year, that rebuild in the channel will take place partially in the second quarter but probably more in the third quarter. And as you look at our capacity coming online, whatever we have guided, we will have capacity to deliver above that as we move through the year. And it's appropriate, obviously, to give ourselves some opportunity to continue to meet strong demand. And so to your question of where do we end up at the end of the year, we feel like we're in a really good supply position as we move through the season. But ultimately, how much inventory is in the channel is really going to be an outcome of the blend of what we're able to supply and underlying demand. But we certainly see our channel inventory getting healthier as we go through the year. And whether or not that's -- that we're totally full by the end of the year really remains to be seen based on the variables I just highlighted.

Got it. Okay. No, that's very helpful. So I want to touch on the margin side. But before we move into recycling, with the capacity coming online, it's been clear that you've been able to sort of more than absorb any start-up costs that have come along, but a lot of this capacity has been in existing facilities. So as you open this greenfield facility in the West next year, I think back a couple of years ago when you started rolling out recycling and all that, there might have been a little bit of margin pressure in the model. Should we -- as we think about modeling out next year, is there an expectation we should have to have a little bit more start-up costs, margin pressure as you roll on the new facility?

Matt, as we start the new facility, to your point, we would expect more start-up costs related to that. Obviously, that's all contemplated in our outlooks. And some of that, frankly, would start to impact even 2021 because we're going to start ramping up in the first 2 quarters of fiscal '22. So some of that even hits its '21, all contemplated in our thinking. But to your point, if you think about the puts and takes of our EBITDA margins going into '22, we have -- yes, we have start-up costs, which we would expect to be higher with the new facility, and we also will have some -- probably some carryover inflation just from the way material costs flow through. But having said that, we've taken pricing. We'll get the benefit of carryover pricing from the action we just recently took as well as a little bit from the one we took in. And we'll relook at pricing again, of course, as part of that overall look of '22. And we'll have continued productivity in both recycling benefits as well as continuous improvement areas, including procurement savings and things like that. And we'll lap public company costs, which are a big incremental cost in '21 that no longer become a headwind in '22. So when you put that all together, quarter-to-quarter, there'll be some lumpiness in '22 because of the way the costs flow, but we would expect over the arc of the year that we would be able to move up our EBITDA margins.

Got it. Okay. That's helpful color, Ralph. So maybe sticking to that point on the recycling side. Can you just kind of talk about where you are in that journey? I mean, you've highlighted that you're already at 100% recycled materials on the polyethylene side, but you're kind of still ramping the procurement of recycled materials on the PVC side. So can you just kind of outline where you're at on sourcing all that and then just kind of, even within polyethylene, sort of the outlook for getting better and better at it?

Sure. Just as a reminder, we have 3 phases relative to our recycle journey. One is the use of recycle. And as you pointed out, in our capped composite, we have 2 decking lines, which is actually one of the elements that differentiates us in the marketplace. The 2 technologies allow us to scale to a very premium -- a better performing product. So our capped composite product has a mix of recycle wood and recycle plastic, primarily polyethylene, as you point out. We're at 100% there. And on our capped PVC board, we're roughly at 50%. And so step 1 is the utilization of recycle. Step 2 is the vertical integration of recycle. Now these are all individual steps. They're not necessarily sequential. They're parallel. Step 2 is the in-housing of that recycle. And then step 3 is using lower and lower cost materials for recycle. So in the context we've used in the example, think the difference between a plastic bottle and a plastic bag. The economic value of a plastic bag is meaningfully less than the economic value of a plastic bottle. So where we are in the journey, specifically? On the PVC side, we continue to see opportunity to expand our percentage there, but we're in a really good spot right now. And so we've made a lot of moves. Relative to the in-housing side of it, obviously, volume is scaling for us. And so we continue to scale our capability to do PVC recycling. We just added our third polyethylene line that we highlighted as part of the earnings release. So we -- we're meeting a larger percentage of our own needs in-house. And then lastly, which is really, as you point out, the long tail on this journey, we have the capability and know-how to use lower and lower cost recycled materials. We have continued on that journey. Obviously, as you're adding capacity and as you're meeting demand, you phase that in. So as Ralph pointed out, we -- it gives us really good visibility from a cost standpoint. So as we're making changes, we're pretty confident about our ability to execute our cost-down programs. And so that last phase will continue for a long period of time. And it's really a mix of going to lower-cost formulations. Think of the more we get at things that go into landfills, the better our cost structure. And that's really a mix of sourcing and engineering. We've done a lot of the engineering work right now. And now it's just a matter of converting our machines over a period of time and building on our sourcing capability there, which we've been investing in over the last couple of years.

Got it. And so that is what I wanted to touch on, the sourcing capability, because I think the first thing you said, Jesse, was the goal to recyclability -- or to utilize 1 billion pounds of recycled materials, up from 400 million in this past year. And certainly, just the growth of the business will be part of getting you there, but it also sounds like increasing the sourcing capabilities within which you already do today is the other part of it. And you acquired Return Polymers, which I think did some of the way in terms of scaling up that PVC sourcing. Could -- so could you go into a little bit more on what else needs to be done to scale up the sourcing side? Does there need to be more M&A similar to Return Polymers? Or how does that all shape up?

Well, relative to your latter question, in any scenario, we have a proven ability to either build it ourselves or acquire it. And relative to anything we do, whether that's new products, capacity expansion, access to more recycle, we've built that muscle to go access the market and complete a deal if we need to. Relative to where we are in the journey, as you pointed out, Return Polymers was really the premier PVC recycler that's out there. And it's a terrific team, a great business. And it has the capability and capacity to really reach in to the broader economy, and we're definitely scaling that operation. And I think as importantly, it's given us the ability to engineer more specifically increased utilization of recycle. So we would fully expect to continue down that journey. And relative to 1 billion pounds, our -- some of the data we've seen is that in our types of plastics, there's over 50 billion pounds out there. So it's really just a matter of accessing it. And on the polyethylene side, we have been continuing to build that out. There is clearly more out there than any of us are accessing. We just announced earlier -- later in our last fiscal year a relationship with Berry. And that gives us access to their scrap. There'll be other relationships like that, that will give us secure sourcing there. So we feel really good about where we are on the journey. As you think about it, we went from 300 million to 400 million pounds in 1 year, and that's as we were scaling and prior to buying Return Polymers. So we're -- we feel very confident about our ability to continue to scale that.

Perfect. Okay. Thank you for that. So I guess sticking on the margin side. I think in the guide, you sort of outlined the pressures related to inflation in resins this year. Obviously, we just talked about how you're already -- a lot of your cost is coming from recycled resins. So my question is to what level of exposure do, I guess, you think you still have to the virgin side? Does your guide assume that recycled is also inflating to some type of material degree? And then just how does that timing work out with the price increases?

Yes. Let me take a quick answer, and then I'll have Ralph chime in relative to timing. Our guide assumes inflationary pressure relative to all the different variables that you have. So we feel very good that we've got really good visibility to what's happening out there, and we've taken appropriate actions such that from a margin perspective, we feel pretty confident about what we see and the actions we've taken. Ralph, if you want to just quickly talk about the timing.

Yes. So on the timing, to your question, the -- as we entered the year, we saw inflation -- we expected and saw inflation on both resins and wages, and we took some pricing to address that. And then with the more recent spike up in the early part of the calendar year here on resins, that led us to taking another increase. The increase is getting executed now. Not having any issue of getting it executed, but there is some timing lag, and it won't take full effect until the latter part of the third quarter. So -- but however, the resins will flow through the P&L at a higher cost in full through the third quarter and the fourth quarter. So timing-wise, there's some pressure on the third quarter margins just because the pricing hasn't fully matched up with the resin increases, and that will kind of correct itself as we move into the fourth quarter, and we protected the margins on the year to Jesse's point.

Got it. Okay. That's helpful. And then as we're almost coming up on time, I'm wondering if I could bring Amanda into the conversation, not to put you on the spot. But we talked a lot a bit about -- a lot about the recycling journey, but that's obviously only one portion of the sort of ESG side that you got -- that is core to your story. So since you've come on and joined AZEK, I'm wondering, however you want to address this question, but sort of outline your 1-, 3-, 5-year goals. What do you have kind of laid out for you in terms of your plan of expanding the kind of ESG side of the story?

Yes. Thanks, Matt. I really appreciate having the opportunity to participate today, and I'm just so delighted to be part of the AZEK company. And as we heard earlier, the sustainability and the business goals are very much interrelated and reinforce one another. And that is, in part, what attracted me to the AZEK company because AZEK is a company of a profile of what I hope all companies to be in the future, and that is one that acts with purpose today. And so we like to say that we think about the FULL-CIRCLE. So yes, it's about our recycling initiatives, but it's also about our people, our communities and engaging and inspiring others to really revolutionize our industry to create a more sustainable future. So in joining in this part of the corporate journey with AZEK, we've been formalizing our approach to ESG over the last several months and really formalizing things that were already implicitly happening within the organization. But now as a new public company, we've really taken that opportunity to shine some light on some of the initiatives that we already have in place like formalizing board oversight, formalizing an cross-functional ESG Steering Committee and really thinking about what our journey, as we said, I always like to describe ESG as a journey and not a destination, what do we hope to accomplish in the future. We've got a great foundation, but it's all about how can we continuously improve, how can we build more inclusive cultures and communities and engage and inspire and empower our employees to be part of our corporate purpose. So we're really excited with the recycling initiatives. We have our inaugural ESG report that we're going to launch here in the upcoming weeks that will have more details on our FULL-CIRCLE goals around products, people and planet. And we look forward to continuing to update you on our progress and our outlook on these very important and exciting initiatives for the company.

Wonderful.

Yes. And if I could...

Yes. Go ahead, Jesse.

Yes, just briefly add, first, we are really -- we're really excited to have Amanda onboard. And as we look at this, we certainly, just to reiterate, look at it as a journey. The 1 year is a terrific opportunity for us where we will have science-based targets. We -- those relate to different variables. But one in particular that, eventually, we'll start to highlight is our climate change goals, but we also have social goals and, obviously, governance goals. So the next year, as we look at it, is really making sure that we establish the foundation and set appropriate targets. Having said that, if you look out 3 to 5 years, we already know the steps we need to take to be able to make a positive impact. We gave you an example of one with 1 billion pounds, but there's other actions related to the initiatives that we're already on the journey on relative to the 3- and 5-year goals.

Wonderful. Well, that's going to be a great place to wrap it up. That was a quick 30 minutes. So Jesse, Ralph, Jon, Eric, Amanda, thank you to the entire AZEK team for joining today. Hopefully, next year, we'll be in Miami. And much appreciated, everyone.

Thanks, Matt.

Thanks, Matt.

Thank you, Matt.

Thanks, Matt.

Take care.