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

Hello again. Welcome to the AZEK presentation. I'm Ryan Merkel from William Blair's research department. Before we begin, I need to remind you that a complete list of disclosures and conflicts of interest is available on our website at williamblair.com. With us today is Jesse Singh, President and CEO; Ralph Nicoletti, CFO; and Jon Skelly, SVP, Strategy and Execution. By way of background, AZEK is a leading manufacturer of sustainable and low-maintenance outdoor living products with well-recognized brands. We're going to start off with Jesse giving a 5-minute overview, and then we'll dive into the Q&A. So Jesse, I'll turn it over to you.

Great. Thank you, Ryan, and great to be here with all of you today, albeit remotely. As Ryan mentioned, we are a sustainable building products company. We focus on the exteriors of houses. We have a very strong focus on ESG and sustainability. In addition to that, we participate in a number of secular trends that are really benefiting our growth. And first and foremost, we participate in the repair and remodel market. Within housing, we've got an extra focus and an increased focus on outdoor living and exteriors, but we're also benefiting from major trends as it comes to wood conversion. So in the markets that we play, a significant portion of those markets utilize wood, decking being a key example of that in addition to exteriors. So we have a market opportunity that's meaningfully larger than our current market situation. In addition to that, we're either #1 or #2 in the areas that we play. I mentioned earlier a couple of different aspects. Our Residential business, which is 85% of the business by revenue, 5% -- I'm sorry, 95% of the company's EBITDA is split in 2 different areas: one is deck rail and accessories, which is 62% of the company; and then the other aspect is our Exteriors business. We are leaders in both of those markets, and we tend to be the innovation leader. And so as you look at our portfolio and Deck, Rail & Accessories, we're good, better, best, but we also have a premium line. And we have 2 different technologies that really position us well to continue to benefit from all the trends that I just highlighted earlier. And then on the Exteriors side, within trim, specifically composite trim, we have the #1 and #2 brands there. And we are really well positioned with a stream of new product innovations. We recently released our inaugural ESG report. Within that report, it really highlights our focus on all of the important aspects. For us, it starts with recycle. Our largest raw material is recycled materials. And as part of our ESG disclosures, we've committed to using 1 billion pounds of recycle or we have an objective of using 1 billion pounds of recycle annually by 2026. Within that report, we also highlighted our current carbon footprint. And as an example, we continue to use recycle to lower our carbon footprint. And as an example, in 2019, we had carbon intensity, 9.2% lower on a basically carbon equivalent pounds per revenue sales. And we -- you'll see when you get to the report, genuine commitment to diversity and inclusion, we've got one of the most diverse management teams in building products, and we've also got an incredibly diverse Board. Last I'll leave you with is as you consider our business model, we are very focused on driving both differentiated growth and differentiated margins. The growth comes from playing in attractive markets that I talked about and also executing a clear strategy, which I'll highlight in a moment. And our margin structure really comes from a strong focus on our core strengths. And our key strengths include we are a branded player in the areas where we play. I talked about us being #1 or #2. We have a very strong focus on differentiated technology. Our products tend to be the most differentiated in the categories that they play. They have some element of either material science or R&D or manufacturing differentiation. On the decking side, in particular, it manifests itself as longer warranties and better visuals. We are an integrated manufacturer, and we see tremendous opportunity by increasing the use of recycled materials to not only positively impact the environment but also lower our cost structure. And we also play in markets where we've got incredibly sticky customers. So those are our core strengths. And the strategies that we operate from right now are really an accelerating focus on market conversion. That's converting from wood or other inferior materials to our types of products. We also drive growth through being focused on new products. We tend to launch a number of new products every year, most recently in the decking category. We launched an entirely new line of premium decking last year. We launched another line this year. So we continue to really focus on using new products to drive expansion. And we also see opportunity for us, in particular, in expanding our channel base. We have really nice penetration in the pro channel, and we are underpenetrated in the retail channels. And so we continue to see opportunity in terms of optimizing our position in channels. And then lastly, our growth strategy really is focused on improving the customer journey. And we continue to make investments in both sales and marketing and digital to make the consumer buying experience better, which ultimately will lead to better conversion and our own accelerated growth. So with that, Ryan, I can turn it over for any questions that might come up.

All right. Well, thanks for that, Jesse. That's great. Why don't we pick up on the wood conversion opportunity? So a two-part question. Why has the conversion accelerated recently? And then, a more important question, could it accelerate further from the 200 basis points that we've been seeing?

Yes. So as we look at the market, in general, the conversion has been occurring at roughly 1% a year for a number of different years. Starting about 2 years -- 2 to 3 years ago, we started seeing that conversion tick up. And as you pointed out, third-party sources, say, in 2020 -- 2019 to 2020, that conversion rate stepped up to 2% a year. And we believe it's at least that good this year. So if you look at the underlying drivers, we certainly believe that education, having the right product and being able to engage consumers is one of the primary drivers of conversion. So as retailers continue to market composite products, as pro channel -- as the pro channels continue to market composite products, as we continue to engage contractors, as we continue to market directly to consumers and, I think as important, as we have products that look, feel and last longer -- look, feel and aesthetically are as pleasing, if not more pleasing than wood, combined with much longer warranties, that also facilitates that education and that conversion. And then lastly, there are opening price point products that have closed the gap. We believe that's important insomuch as it gets people into the category. But what we also see is people are not buying just that opening price point product.

Got it. And then I want to ask about lumber. On the last call, you said that higher lumber prices is driving more consumer consideration of composite decking. Can you clarify what you mean by that?

Yes. So if you go -- if you take a look right now on a retail shelf, you would see wood prices. And they may moderate, but wood prices of wood decking being really similar to the opening price point composite. And what that does is it facilitates the consumer conversation that -- for them to consider that. I think, similarly, in the pro channel, if you're reaching out to a contractor and you're asking them for a quote on a wood deck, it becomes pretty obvious that you can get a composite deck near term. And then for us, on the Exteriors side where there's still a fair amount of wood and cedar used in some of our exterior applications up to 40% in our trim business. As those prices go up, it becomes much, much more beneficial for a contractor to consider a composite. And our experience is when contractors and consumers, once they start moving towards composite, they don't typically go back. And so the step-ups facilitate a engagement, but that engagement doesn't necessarily subside, in particular, with the pro, when those particular materials step back in price.

So a follow-up to that, if lumber prices stay high, how do you think about the trade-off of keeping your price similar to lumber and then seeing a faster conversion versus raising your price and actually charging for the value of your product?

Well, first and foremost, we always charge for the value of our products. So we don't -- we're not -- even in our opening price point, our intent was never to be at the exact same price as wood or similar to wood. And so for us, I think as we look at our value in the market, we've taken appropriate price actions relative to inflation. And it's really based on the value that our products provide. Our -- some of our largest-selling products are in the neighborhood of 4x the price of wood even at today's rates. And so that's really based on value, aesthetics, durability and just the quality of the product. And so for us, certainly, as I talked about, it can help with the conversation of discussion, but really, we're in the value capture gain much more so than trying to tie ourselves any single commodity.

Got it. Let's transition to the capacity expansion. So by the middle of '22, roughly, you will have increased your capacity 85% relative to 2019. And so my question is, will you go on the offensive more at that point? Because you have been in a shortage situation. Is there anything there to talk about?

Yes. I -- as you point out, our current situation right now, although we've been ramping up capacity, we feel good about the levels at which we are increasing our service to our customers. But when you're in a situation where you're allocating product, you've got to be really cautious on which customers you take on and how -- what kind of commitments you make. And it's really important for us that we continue to service the customer effectively and meet commitments. Certainly, as we continue to add more capacity, we have an opportunity to engage in a broader and continued expanded dialogue relative to potentially taking on new business. And certainly, that is a consideration with any additional capacity add. What I would say, though, is, in general, the conversion has been constrained. Wood conversion this year has been constrained because of the capacity in the industry. As we bring more capacity online, we believe that there's the potential for additional pent-up conversion opportunity that we just haven't been able to serve.

Good point. Okay. So a question from the audience here. In fiscal 2022, is there a chance you could fully sell out the new capacity that you bring on because demand is so strong?

I -- the -- first, I can't specifically talk about '22 in any guidance kind of a way. What I would say is we are bringing additional capacity online. That 15% is really an inserted small tranche of capacity that comes online before the end of the calendar year. And we're adding it because we think it would be helpful to the business and helpful to our service levels. The data points I can point you to is that what we've said is we're going to exit the year in a situation where we probably aren't going to be able to rebuild the inventory in the system. And so there'll be some natural pent-up demand relative to inventory replenishment in our channel as we enter next year. And we want to make sure that we continue to service the underlying demand that's there. So -- and I can't speak specifically to whether or not we could fill out the capacity that's there. But I do think that there's opportunity for growth, and that's why we're bringing capacity online.

Yes. Okay. Well said. So in my view, incremental margins in 2022 is the biggest question on the stock. I know you don't want to talk about '22. But just walk us through the puts and takes, and then any directional color that you can give on incremental margins would also be helpful.

Yes. I -- and Ralph, I can take this. And if you want to chime in, Ralph, our CFO, is with us also, Ralph Nicoletti. So first, exiting the year, we've talked about being more in balance between price and underlying inflation. So we're going to be exiting the year in a much better position. And then as you look at the puts and takes, right? So you have pricing that you've already passed on -- that we've already passed on. On top of that, we've got additional productivity programs that we've talked about in the past, those of you that have been around the story, the combination of recycle, continuous improvement. We're also going to get operating leverage off of some of the corporate SG&A, in particular, but SG&A, there's the potential opportunity for that, once again, depending on what we decide to invest. And so those are all -- and then the counter is at what level does inflation sustain, in particular, on raw material. Our last price increase was driven by really the shock to the system that we saw from the disruption in Texas. You would hope that some of that would subside, so that -- as we move in, in particular, the next calendar year, you could see some benefit there. And then we also have start-up costs of a new facility. So those are the puts and takes that our model has in it. And once again, I'll reaffirm, we feel really good about our productivity programs that we have ongoing, and those continue to deliver a benefit. And Ralph, I'll pause if there's any additional color that you think might be helpful there.

You hit the key ones. And we priced this year on a run rate basis, low double digits. So we're carrying in that low double-digit level of pricing in. And as Jesse mentioned, it remains to be seen how commodities level out or normalize over time.

Got it. Great. So a question from the audience here, what inning are you in to use more low-cost recycled plastic? How much longer will this be a tailwind to gross margins?

Yes. I'm trying to -- I'm debating whether I use a football analogy or a baseball analogy. But we're certainly in the first -- let's say, we're in the third inning of that discussion. Maybe we're in the fourth inning. We're in that range. We see -- probably close to the third. We see a lot of opportunity, really twofold. One is to obviously continue to use lower and lower cost of recycle. We talk a bit about polyethylene because it's common to what our known competitor is using. So we still have a tremendous opportunity to use more films and aspects there. But I think the part we probably don't talk about enough is on the PVC side. And we're just starting to get at lower and lower-cost sources of PVC. There's a lot of PVC that's landfilled right now, and I think that presents a really significant opportunity for the company. And we can -- we've owned return polymers for just over a year. We continue to invest pretty heavily in that business. They're going to see a step-up in their ability to process materials, and that really sets us up to continue to drive that side of the business, too. And we use a fair amount of virgin PVC. So hopefully, that gives you a context there, but we continue to make progress every day, both on the sourcing and the utilization of it. But as you're adding capacity, you have to stage it. And as such, we're not going to flip a switch. We're going to slowly implement these changes as we see fit, given the volumes that -- and capacity that we're adding.

That's helpful. Let's talk about the consumer journey, which you talked about in your opening remarks. I think, first, why don't you just talk about how you've improved it over the last couple of years? How does the customer find you and buy from you today?

Yes. So there's different aspects. And we've researched it. We continue to research it. So a consumer gets into an -- the deck-buying process, if I focus on decking, which is where the vast majority of our consumer interaction is, the deck-buying process, a consumer will -- the lead time can be 2 to 16 months. And that process involves an exploration phase where there's consideration. That consideration will include a digital exploration. It will include retail exploration where they'll walk around stores or pro yards. So there's an exploration phase. There's another phase where people start getting more into the decision-making phase, which is understanding the cost and understanding the options. And then there's a deployment phase, which is really raising their hands, saying, "I need help." So as you think about that overall journey, we've made investments in retail, we've made investments in the pro channel to make sure that we have better materials to support that journey. We've made a lot of investments in our digital platform, where, first, we're making sure we advertise and capture that consumer. We're relevant, but we're also capturing them in such a way that we've got structure right now digitally to help them through that journey. And then we've also made investments on the execution side. And that's doing a much better job of linking our leads to our contractors and also making sure that we make it easier and better to order samples. So long-winded way of saying we're investing in in-store. We're investing in digital. And we're investing in a call center expansion there. And I think as we talked about on the calls, the statistics are starting to show a much higher conversion rate from when people start the journey to when they engage us at the back end. And that's really the opportunity, right? And some of that's people guidance, and some of that's digital, and some of that's content. By the way, there -- we can continue to improve that, right? I still think our journey -- even though we've made improvements and we're as good as anybody in the industry, I believe that our journey still has huge opportunity to improve ahead of us. And we'll continue to make those investments.

Right. Why don't I ask an open-ended question about ESG? Just talk about how you think about it at AZEK.

Yes. Foundationally, for us, we have a core set of values. And if you happen to see our investor deck, we highlight [ that ]. And one of our core value against a core set of values is do the right thing. And I think that's really important because at a high level, many of us could work for other companies, right? Many of our new employees could work for other companies. And so the question ends up being, why are we here? And how do we make a difference in the jobs that we do? And so that's the overarching thought behind this of how do we make a difference in the world. And for us, making a difference in the world starts with our ability to consume an enormous amount of recycle. That has secondary benefits of lowering carbon footprint and also, of course, reducing single-use plastic in the waste stream. And it's just a -- there's just such a huge need in the world for more of the back end of the circle in the circular economy. And so it starts with do the right thing. We move to recycle. And then you start getting into some of the other aspects. We believe that it's -- we have a responsibility to participate and help mitigate the effects of climate change and mitigate any contribution that our products have to that. And so our products use energy and use resources to exist, how do we make sure we take the right steps to reduce that. And then on the social side, as I mentioned, we're a naturally diverse team, but we believe that we have a responsibility, once again, against our core values to absolutely do the right thing for employees. And then lastly, on the governance side, the ability to be transparent with shareholders is really, really important. 10% of my bonus and the rest of the management team's bonus is tied to ESG metrics and our measures. And it's really important that we also continue to migrate our governance to be world-class. And so hopefully, that gives you a perspective, but it's really around the core belief that this is how we make a difference in the world.

Great. Let's talk about contractors a little bit. What is your strategy to add more contractors?

Yes. We have -- we interact with roughly, at some level, about 50,000 contractors. We've got over 10,000 that are in our program in one form or another. We have a 200-person, give or take, sales force for the residential business. And a key -- those are direct sales. That's not -- those are our own and direct employees. And a key part of how we drive growth is contractor engagement and contractor development. So we do have a smaller group that's only responsible for that, a contractor development team, but we also have our broader sales force that is really responsible for driving that. And the virtual nature of what we're doing here has actually helped us in some ways because we have 3 different AZEK [ to use ] where we train employee -- I'm sorry, we train contractors and other channel partners. We've been able to scale that in a much bigger way because our most recent contractor training facility was fully digitally equipped. And so we're able to do Teams and Zooms calls with just a push of a button and do all that training. So we're fortunate that we just built a new center, and that was technology-enabled, which also allows us to accelerate that. So long-winded way of saying, on the ground, in every local geography, continuing to work and expand our position as people want to move into the space and facilitating that movement.

Got it. A question from the audience here. How does pricing work in the decking industry? Is there a list price that everyone pays? Or do you offer volume discounts?

So in general, there is a list price that everyone pays. So that's probably the most fundamental aspect, and that is the primary driver of price across the industry. Now there are variations, right? So if you buy truckloads, if you're a large dealer and you buy truckloads, you'll get some form of truckload discount. If you are either -- any of our channel partners have modest incentives that are built in as part of the stack. So the way to think about all that discount structure, either volume-based or growth-based or whatever the incentives happen to be, that entire -- and plus there's an incentive to buy earlier in the season, that gives us an ability to plan our operations. So it's an efficiency play for us where people commit to a certain amount. That entire stack ends up being in the neighborhood of 5% to 6% for the business. And so when I say it's primarily a list price business, the entire stack of all the incentives is in the kind of mid-single-digit range. But in effect -- but -- and then the question is, at a consumer, we are pricing against different tiers of product attributes and quality. So good, better, best premium. In general, you try to stay within a range there.

Right. Okay. Just 1, 2 minutes left. I want to end on product technology, material science. Talk about how you're different. And do you have patents? Or is this trade secrets?

We've got a number of patents on our products, and we also have a number of trade secrets on our products. So let me just start there. So the core difference in technology is we have multiple technologies that we are basic in. There's cap composite, which is similar to our competitor on the decking side and most of our competitors on the decking side. In addition to that, we've got cap polymer, which is a totally different material set. And in both of those, we have invested pretty heavily in our visuals and our ability to get certain looks and patterns and durability on the surface of the board. And that's what allows us to have extended warranties. So we've got a lot -- we've got a different technology and a pretty heavy investment in capping technology, and we continue to invest in that technology. And then on the Exteriors side, we have -- we've also invested in multiple technologies where we created the category for foam PVC and a branded application for trim. We've since built upon that technology, the ability to use recycled materials, the ability to mix materials and get different either aesthetic looks or different performance aspects. The other thing we have is the ability to integrate functionality. And so as we step back and we look at our capability, we're basic in multiple material sets. And we're really good at surface technology, and we've got 20 years of data, in many cases, that allow us to put the 50-year warranty on a number of our products.

Unfortunately, we're out of time. I wish we had more time. But thanks, everyone, for joining today. We appreciate it. And thanks, Jesse and the AZEK team. Appreciate your time.

Appreciate it. Thank you.

Talk to everyone later.