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

Good afternoon, everyone. I'm Matt Bouley, Barclays U.S. homebuilding and building products analyst. Thank you all for being here in person. We're just excited to be back down here after 2 long years. So thank you all for making the effort to be here in person, and thank you to the AZEK team for making the effort to be here in person as well. So we have Pete Clifford, CFO; Jon Skelly, SVP of Customer Experience here. So we're going to start with sort of a simple sort of opening remarks here from Pete and Jon. If you guys wouldn't mind, with the QR codes in front of you, feel free to answer some of the survey questions we have about how you feel about the company, and we're going to go ahead and circle that data back to you, back to the company as well. But that's enough for me. So thank you very much for being here. Please go ahead, sir.

Yes. So I am Pete Clifford, CFO of AZEK.

I'm Jon Skelly, SVP of Customer Experience, and what that means is, everything that's customer facing for AZEK in terms of our sales teams, customer service teams, product team. So I'll just spend a couple of minutes, a quick refresher on the AZEK company. So we are one of the industry-leading providers of sustainable, beautiful, low-maintenance building products. So our largest line of business is our Composite Decking Rail & Accessories business, followed by our Exteriors business, things such as trim and siding products, and then we also have a small Commercial business, about 10% of the revenue. We are a sustainable manufacturer. We differentiate ourselves by creating the most beautiful, highest esthetic building products that replaced wood on the outside of homes, and the sustainability is driven by anywhere from 50% to 85% of our products. The raw material is recycled waste, the recycled plastics that we use inside the product. We are a branded player. It's really important to who we are. The consumers and contractors choose us because of the strength of our brand, and the quality of our products, the length of our warranties and our overall performance, how we stand behind the customers. Sales and marketing is really important to who we are. We spend all of our time downstream in the marketplace, generating demand at the contractor level and at the dealer level with a large sales force. And we supplement that with world-class digital marketing and traditional marketing as well. A lot of moats around the business. It's a -- we have a scale business that we've generated over a 20- to 30-year history of standing behind those contractors when they use our products. It's put us in a very defensible position in terms of our brand preference and our technology. We view ourselves as the innovation leader. We regularly introduce more beautiful new products in the marketplace than any of our competitors. It's a key differentiator for us. We use our technology to create the most life-like look of the material. And so when you compare our product to any type of wood, you're going to see a very similar look and feel, except instead with ours, you're going to have no maintenance, no splintering. You're not going to have to stand or stain or maintain a product. We're going to offer warranty from anywhere from 25 to 50 years on the product. So it's a core, core differentiator that we are. And we operate in a really dynamic market space with very long tailwinds. If you look at the decking industry, for example, 75% of deck still built today are built out of wood. And so our opportunity to convert -- and we've been accelerating that conversion by replacing inferior wood products with our beautiful, long-lasting sustainable products with a very long runway in terms of our future conversion opportunity to convert that wood into our types of materials. So I'll kind of stop there, Matt, if that's...

Wonderful. No. Plenty -- thank you for that and plenty of areas to jump off of. So before I get into the nitty-gritty, just one high-level question on sort of your overall growth algorithm. I think you've said publicly, as you just mentioned, penetration that 50% could be the number. And I don't want to put words into your mouth, but 50% penetration potentially of composite decks over time. So kind of bridge us from now until then, what does the annual volume growth algorithm look like from AZEK's perspective?

Sure. So I mean, I think the core of our business, the core driver is really repair and remodel spend. And so if you look at what we correlate to and what's the sort of market driver behind the business, it's going to be the overall health and market growth of the repair and remodel sector. So that's kind of the base. That's kind of the foundation. And then on top of that, then we start to look at things like conversion. What you saw historically is somewhere around 0.5% of conversion from wood to our type of material. You've seen an acceleration in that to closer to 1%. During the pandemic, it even got a little bit faster, but we think a sustainable rate of conversion for the business is somewhere around 0.5% to 1% per year, which would translate into a couple of points of growth. So if you look at our base repair and remodel, growth of anywhere from -- on a historical basis, 3% to 5% conversion on top of that. And on top of that, we add our initiatives, and those are new product introductions, that's our downstream sales and marketing initiatives, expansion of our share in retail. That's the additional sort of initiative build of the growth stack. Add it all together and we view this business as a long-term sort of compounder, a long-term sort of 8% to 10% growth business. If you look over 2 years, 5 years, 10 years, we've actually outpaced that with our Residential business, it's a consistent double-digit growth business.

Got it. So that's very helpful. So then, I guess, to zoom into the near term, the near-term question, but the implications are longer term around growth. It'd be helpful if you could sort of educate everyone what you meant by kind of sell-through demand. I believe the comment on the Q1 call that fell through modestly that you're adding inventory into the channel. And in a market that is relatively sensitive, if -- one might interpret that to mean demand is slowing. So why is that not the case? And sort of what did you mean by kind of sell-through and inventory management?

Sure. So if you look -- if you wind back to last year, so if you kind of break it into halves, the first half of the year, we could not [indiscernible] we did not have enough capacity nor did the competition to meet all the underlying demands that existed in the marketplace. Then we started to get more capacity to come online, and that gave us the -- put us in a position where now we can meet demand and we could also start to get the channel a little bit healthier. And so we shared in prior conference calls, we had the opportunity in 3Q of last year and into 4Q to start to get the channel healthy. And why that's important is that builds confidence amongst our contractors, our dealers and our distributors about our ability to meet supply. And once they had the confidence and once they started to see inventory levels improve, that put us in a position where we start to return to a more seasonal pattern. So our Q1, which is October, November, December, that's typically going in a winter where you see dealers and distributors start to wean down their inventory a little bit. And then we have our winter buy program, which is where we're positioning inventory for the next year, and so we start to build inventory and start to take orders over the coming year. And so what the comment was, Matt, was that as people started to draw down the inventory, we still saw some moderate sell-through growth. And then if you look at our guidance for the next quarter, now that we've -- what we've done is we've sort of balanced the supply and demand environment to where we've gotten the channel healthy. And so going forward, the demand that you're going to see is roughly sell-through equal to sell-to, right? So we're now back in a position where a lot of the inventory noise goes away, and it's just a real demand environment. And so if you look at our guidance that we shared for this next quarter, that's going to be market demand, not any sort of channel fill or infill that you might have seen.

No. That's very helpful color, exactly what we're looking for. And so you mentioned the winter buy program, and I think it kind of makes sense to think this in context of where you are from a capacity perspective and where competitors are from a capacity perspective. What does this success with the winter buy program sort of mean for your ability to continue to basically take share, whether it's new dealers or a wallet share, as you think about the rest of this year or even beyond?

Yes, so what you're doing during going in the winter months is, you're positioning yourself for the next year and beyond. And so typically, what you see your dealers do is, they're making choices in terms of which products do I want to stock to make available to contractors and consumers, so it's important. And so -- and what they're doing is, basically, they're giving you a preorder for inventory that they're going to buy over time throughout the season. So what we did and what gave us encouragement was we had very broad participation amongst the winter buy, and we expanded positions within existing dealers, and then we gained new positions and new dealers. And essentially, to boil it down, if you're a store owner, if you're a shop owner or a dealer, your salespeople in there are going to sell what you have on the shelf, first and foremost, because you've made a commitment, you've bought some inventory, you want to sell through that inventory. And so by gaining that shelf position, there's an incentive, obviously, for the dealer to sell it. And then what we do is we complement it with the sales and marketing activities, as we talked about earlier. So our sales team is spending 99% of their time downstream with contractors, generating the pull-through demand, making sure those contractors are using our products, installing our products that pulls through the dealer. Once the dealer receives the transactions and they see, okay, this brand really means something, contractors are asking for it, that solidifies the relationship for many, many years to come. So you get your foot in the door with the shelf position, and then you grow it by pulling through that demand. That creates sustained growth of the business year after year after year. And then we use all of our marketing capabilities, digital marketing, traditional marketing to grow our consumer awareness, and then you want to start to have consumers come in to those dealers and ask for the product by brand. So it's that combination of sort of downstream sales generation focus that pulls through the demand, but you have to have the position. If you have the position of the dealer, then you have the starting point for where you can pull through the demand, and then you also have more locations for consumers to come into and see the product and buy the product.

That, coupled with the capacity work that we've done in the last couple of quarters and continue this year for the next -- throughout the balance of the calendar year, it really positions us as well to be able to maintain our lead times as low as possible. And obviously, if the season is stronger, we feel like from the marketplace, we're the one OEM out there that's really positioned to outperform from a capacity perspective.

Yes. No, and thank you for bringing that up because while we're on the growth topic, I think you've publicly alluded to the guide for growth in 2022, embedding roughly high single-digits volume growth. But clearly, there is a big chunk of capacity set to come online in the middle of this year, and you're already -- you have the new capacity that you brought on last year. So kind of what's embedded from the new capacity coming online in terms of how you're thinking about growth over these next few quarters?

Yes. So to support our guidance, we've got enough capacity coming online through this quarter to basically serve fiscal '22 with the balance of everything that's coming on through the end of the calendar year. We should be able to get through fiscal '23 as well as pretty deep into '24 before we would likely need to look at building out the other half of our Boise facility. So in the near term here, we feel like we really have everything we need to win and exceed at least through the remainder of this year and well into next year as well.

Got it. So maybe shift gears to the margin side. You've had a public target for 500 basis points of EBITDA margin expansion going back to the IPO. Obviously, 2021 was what it was from a price/cost perspective. Can you kind of bridge us within that 500 basis points, recycling your own, what you call, AIMS operating system leverage, how should we think about kind of the components to that 500 basis points of margin expansion?

Yes. Yes. So we are still doubling down on sort of that 27.5% as you get out to 2025, 2026 in terms of quality of earnings. We obviously made progress for pre-pandemic, got about almost 100 basis points of improvement. When you think about the levers, it really is a portfolio of actions in terms of how you get to the 500 basis points. And certainly, recycling is probably the biggest lever that's out there. We think of the recycling opportunity in kind of 3 elements. The first one is obviously just increasing recycled content in our products. That's mostly a PVC statement as it relates to both decking and trim. The second one is really not increasing the percentage, per se, on our cap composite product, but kind of moving to lower-grade, lower-cost recycling materials. So right now, about half of our recycled content on the capped composite is, call it, high density, which is higher cost; and the other half is low density. So you could think of the opportunity as how do we get closer to 100% on low density. And then the third element in there is any chance that we can get to in-house some of that conversion opportunity, obviously, is also additive from a cost-out perspective. So think of that as still sort of the biggest lever out of the 500 basis points, but followed by several other opportunities that are not insignificant. So second one is kind of sourcing savings. So like a lot of companies, just over $1 billion, there are opportunities for us to mature how we procure. And we think that there's meaningful opportunity for us to buy smarter and bring in sourcing savings via that lever. Third one is critical when we think about some of the capacity actions that we've taken over the last year is getting ourselves back closer to that, call it, optimal 80% to 85% utilization. And at that kind of strike zone, it allows us to run our plants in a meaningfully different way. There's a lot less over time. You can do preventive maintenance in a very different way. And then the third bucket is really around sort of that volume leverage that, ultimately, if we're targeting 10% volume growth a year, the way we think about our cost structure from a COGS perspective is it's approximately 70% material, 20%, I would call, variable conversion costs and 10% is kind of fixed overhead. So that 10% fixed overhead has obviously given us some leverage and just plant productivity off of that. And then to a lesser degree, we've kind of said, look, internally, we aspire in most years, probably not every year, but most years, we're able to get some modest SG&A leverage as we grow, again, 10%. Internally, our mantra has been how do we get headcount to only increase by half of the volume growth, and that allows us to still be opportunistic and spend on some initiatives but still drive basic leverage from an SG&A perspective every year.

So that's fantastic color. I guess the one additional component to that would be price/cost. You've given us color on the level of pricing that's been taken in 2021. And I think we can do some math around how much inflation you, therefore, faced from a dollar basis. Just how do we think about that? I mean PVC prices have sort of flattened. Polyethylene maybe came down and gave us a bit of a head fake, we'll see. But just what's kind of the magnitude of price/cost that is sitting out there if you were to see some level of deflation?

Yes. So as we kind of had provide perspective on full year '21, I'm rounding, but it was approximately 10% price and similar pricing kind of dynamic into this year. We kind of signaled it last year. We really only covered dollars, not the rate from an inflation perspective. And our guidance for this year kind of implied that we would not cover rate until the third quarter. You can kind of do the math that we had anywhere from $150 million to $180 million of inflation from commodities over the last kind of, call it, 20 to 24 months as you think about the full fiscal year '22. So obviously, you don't have to believe a thesis of a massive unwind of the $180 million for it to be very impactful to our gross margins, right, that $1.4 billion in revenue. Every $14 million that, that $180 million recedes is 100 basis points of quality of earnings for us. So separate from our other levers that we had articulated on the 500 basis points, we absolutely see a structural margin change opportunity as some of the key commodities start to recede. Right now, PVC, yes, it's flattened. It's still more than double what PVC pricing was 18 months ago. So I can't certainly predict the quarter when it's going to come down, but to think that PVC is going to stay at historic highs forever is not logical that we would hope and expect that some of that starts to recede more meaningfully either in the fourth quarter of '22. If not, certainly, in '23.

No, that's very helpful color. Maybe we can go back to the capacity side of things, but it's an investor question I get often sort of the competitive angle amongst large amounts of capacity are being added in this industry, although it's occurring at different times. And I think over prior years, we have not seen cases where utilization margins are necessarily dependent on utilization. But I'm curious, just given the significant amount of capacity that's now going to come online in the next couple of years and a couple of different competitors...

Yes, Jon, I can [indiscernible] I think in one sense, as you think about the long term, I think it's a validation of the opportunity that we see and our competitors see from wood conversion, what the natural growth rates are in this space. To me, that's an optimistic signal that people see that and are investing ahead of the curve, not afterwards. In the short to medium term, I mean, the industry has had excess capacity for many years prior to the pandemic, and you didn't see any dysfunctional pricing or irrational behavior. And then I just think lastly, I use the term discrete. We say modular, but each line is discrete in our plants, and there really isn't a disincentive for us to keep running machines and making boards to just get it done and sell it at a cheaper price, as we talked about our cost structure being 70% material, which is 100% variable, and then 20% as sort of variable conversion cost is far better for our industry historically. And we think it remains unchanged to just simply not run lines that you don't need the capacity on at a given time. And again, we've been in a situation where we've had almost 0 slack capacity at least within our business the last few years. It's really, really difficult to run our business when you have 0 slack capacity in your plants. So when we talk about recycle, one of the key ingredients for us getting that work done is getting access to production extrusion lines to do the formulation validation work. And those are examples of when we have excess capacity or why you need excess capacity to run your business actually in a more cost-effective manner. One of the best examples I can give you.

Yes. So -- and that's -- I wanted to follow up exactly on that point, which is recycling amidst all this. So you mentioned within the 500 basis points that expanding use of recycled materials is clearly, I think -- and basically, you said it was the #1 component of that as you listed them. And you're doing this at the same time that you're expanding capacity. So it begs the question of the ability to source all this recycled material. How do you continue to increase that mix while you're outright adding capacity at the same time? So what are some of the things you're doing to kind of boost that recycle?

Yes. So look, we've continued to invest both organically as well as inorganically in recycling capabilities, and you'll see us continue to do that. So last quarter, as an example, we announced the acquisition of a regional PVC recycler in the Midwest, which, obviously, we can either build those recycle streams ourselves organically or at times, we can choose to buy it. In this case, we chose to buy it. I think we kind of signaled that it increased our capacity in terms of stream and capability by about 20% on PVC with that acquisition. So again, I kind of think of things in a simple sense of kind of swim lanes, we've got to source it. We have to convert it. We have to do the formulation work, and then we have to get it deployed in manufacturing. So those are the ways that we kind of run our business and hold ourselves accountable to our -- are we making the advancements in each one of those capability streams. And again, we've kind of continued to do that both organically as well as inorganically.

Yes. I mean nothing has changed as far as the opportunity. And as we get to those desired utilization rates, the team will simply have more time to spend on accelerating our efforts around recycling.

And so on PVC specifically and recycling because that's clearly a product that is not typically recycled, right, so part of your efforts are expanding usage of recycled PVC for a product that is less recycled. So maybe that acquisition of recycling was part of it, but my question is about the cost differential. So if I'm looking at HDPE virgin versus recycled and PVC virgin versus a nascent recycled market, how does that kind of play out where you guys are really one of very few companies that are actually going after recycled PD? How does that play out from a cost perspective?

Yes. So in a lot of ways, we're sort of making or building out the PVC market. The way we think about it, I'll call it, normal times, not the super inflation that we've had over the last year that in a normal market, we should save basically about 50%. The cost of a recycled pound is about half of a virgin pound on the PVC side. That spread gets a little wider when you see so much inflation on the virgin as we have in the last 18 months, but we think, over the long haul, we see a path to saving about half the cost as we look forward on a pound of PVC.

That's a meaningful number. So I have questions on the portfolio, but I want to check out the audience and see if anyone wanted to ask questions to the team while they're here. Okay. So the portfolio, I don't want to ask too many questions at once, but you did the StruXure acquisition. So really like -- and then you have the Commercial business, right? So on the one hand, you're adding an adjacency on the Residential side. On the other hand, people asked about where Commercial fits kind of in the portfolio. So as you think about the AZEK portfolio over several years, how do you kind of envision this coming together? Will there be more Residential? And how does Commercial kind of fit into the long-term plans?

Yes. I would say, the long-term growth engine of the business is going to continue to be Residential, and that's where we're going to deploy capital. StruXure makes sense for lots of different reasons in terms of it being a very strong complement to our existing channel and also just additive to anywhere where we can participate in wood conversion as most pergolas today are kind of wood, shifting to or participating in that wood conversion tailwind to growth. As far as the Commercial business, look, what I would say right now is we're experiencing a pretty strong year this year and a tough year 2 years back, but a lot of the end markets that were impacted by COVID are really starting our rebound, so whether it's semiconductor to marine, even the graphics space has really rebounded. So what I would say in the short term is that we see a really healthy backlog. We see really strong order rates, and this year, at least through the third quarter, we see a business that's positioned to win within that space. And as far as long-term answer, we're a public company. We commit every year to looking at the portfolio and seeing what fits and what doesn't. And it's an area of business that we'll continue to look at and see where it fits in -- from a possible disposition perspective.

Matt, on the StruXure acquisition, in particular, the -- it all comes from a customer angle. And to give the story is, that contractor who's installing that deck already has captive audience, right? It's that homeowner. And 10 years ago, maybe it was just building the deck. Now it's building an outdoor space. And so that contractor is going to spend probably a couple of weeks laying the foundation, building the substructure and putting the deck. If they can then sell to that consumer, would you like a pergola, and that's going to take them maybe a day, 1.5 days to install. And they're going to have a labor margin and a product margin associated with it. Part of the vision of what we're trying to do outside the home is this, how do we help that contractor be more successful and make more money by not just doing the deck anymore. I am now also using these other beautiful sustainable products to complement the overall outdoor space. It increases the project size for the contractor and increases our revenue opportunity, and it's all on strategy in terms of wood conversion, material conversion outside the home.

Got it. No, that's very helpful color. So I think even post the StruXure acquisition, your leverage is down to 1.4. Correct me if I'm wrong.

Yes.

But at a certain point, an investor constant question is, when does a buyback become a realistic option? I know your recent IPO, so that's -- it would be quick, I guess, would be one way to put it, but at the same time, the balance sheet is what it is, right? And you have sponsors that own the stock. So how are you guys thinking about either broader capital allocation and specifically, share repurchase over time?

Yes. What I would say is as a public company, we're supposed to be having those conversations every year with our Board about capital allocation. And what I would say is, you could be rest assured with the volatility in our space or our sector, we're doing the work and having those conversations right now. We look out, obviously, with the cash generation that we expect from the business with the growth that we see, with the margin expansion, even fully supporting organic growth investments to CapEx to even putting aside money for M&A. And if we wanted to maintain a 2 to 2.5x kind of capital structure from a net debt perspective, we have some unallocated capital. And again, we're having those conversations right now with our Board.

Well, I think that's a great place to finish. It's always a very quick 30 minutes. So Pete Clifford, Jon Skelly from AZEK, thank you both for joining us, and thank you all for making the effort to be here in person. It's much appreciated, and great to see you all.

Thank you.

Thank you.