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

Good morning. Thanks for joining us today on the second day of our 15th Annual JPMorgan Homebuilding and Building Products Conference. My name is Mike Rehaut. I'm the senior analyst covering the homebuilders and building products teams for JPMorgan, and we're excited to kick off day 2 with The AZEK company. We have CEO, Jesse Singh; and CFO, Pete Clifford. Jesse will be presenting some slides. This is a 35-minute session. There will be plenty of time for some questions though from myself as well as the audience. [Operator Instructions] Without any further ado, I'll turn over to Jesse and thanks again for participating.

Great. Thank you for having me this morning. As Michael pointed out, I'm Jesse Singh, the CEO of The AZEK company. I have been in the role coming out 6 years. For those of you that have the slides, I will just click through briefly a few of the points. If you start on Slide 3, it's really a slide on who we are, and we're focused on being innovative manufacture beautiful, low maintenance and environmentally sustainable outdoor living products. And I think the one key point that we continue to highlight, although I'll move away from it for much of this is we're committed to making a lasting impact. And the way we do that is through the use of recycled materials. Our purpose is to revolutionize outdoor living in the broader sense and to create a more sustainable future. And we are a values-driven company with our core value being always do the right thing. If you move to the next page, Slide 4, over 30 years through a combination of organic development and acquisition, we've developed what we believe is an industry-leading portfolio, and it's really built on 2 key platforms that are synergistic with each other. Our outdoor living platform includes decking, rail, ports, lighting, and most recently, pergolas, smart pergolas through our structure acquisition. So the way to think of it is we have the floor, we've got rail, we have the wall with our exteriors business and now with Pergolas, we have a very smart overhead protective component. So if you take a look at our outdoor living products, combined with our leading exteriors products, that are made up of column wraps, trim, niche siding and cladding products. These 2 operate with enormous synergy. And you can actually see that in the picture that we've highlighted there where you see the decking, you see the white accents that are there, that are all made out of our exteriors products. You see the rail. You see the trim on the side of the house. You also see our siding product and you see our column wraps. And we continue to see tremendous opportunity on the outside of homes, really built by our diverse and synergistic product portfolio. If you believe or if you move to Slide 5, we built this business over 30 years and have a leading presence primarily focused across U.S. And Canada. We believe we've got an industry-leading sales force with 200 direct salespeople. We manufacture in the U.S., and we have very much a North American focus with 99% of our business here. We're focused on consistent margin growth and overall expansion combined with consistent growth. You can see that in our historic numbers where we've seen nice margin progression over the years. The other key component is we've been a consistent grower. Our growth rate prior to the pandemic was 16% trailing 12 March of 2020 earlier. So we had consistent growth coming into the pandemic. If you move to Page 6. We believe we've developed a resistant business that's really well positioned for sustainable growth. You can take a look at our history, and it's also built for sustainable margin expansion. We play in growing markets to benefit from material conversion, combined with structural growth in the markets that we play in both exteriors and outdoor living, we are the innovation leader. We developed the most new products. We have the most diverse technologies and we also have the most advanced portfolios. We don't rely on one growth lever or one in market expansion lever. We take a portfolio approach to both. Our business is built on a model that leverages recycle to drive both margin expansion and increased sustainability for every pound of recycle that we use, we say 50% or more than a virgin pound. And I think, as importantly, it also reduces our carbon footprint by up to 80%. And we've got a stated objective of using 1 billion pounds annually of recycled materials by the end of 2026. Our 10-year CAGR for the residential business, which makes up 90% of our business is 18%. And that's really built by a combination of market growth, organic development and very selective acquisitions that are additive in terms of building out the portfolio. As you can see from the right side, our long-term sales target, and we guided this when we came out as an IPO in June of 2020, and we've consistently held to it is double-digit residential sales growth and an aggregate sales growth for the company of 8% to 10%. And our long-term adjusted EBITDA growth is 10% to 14%. More specifically, relative to EBITDA, we came out at 22.5%. And in 2019 -- and we guided to a 500 basis point margin expansion, and I'll get into some of the specifics that drive that. If you move to Page 7, our core markets have consistently grown and are poised for sustainable and durable growth. We've got the combination of a boomer generation staying in their houses, millennials becoming homeowners, and outdoor living is one of the key trends for each of those generations. There's a large installed base of decking 56 million decks, half of them are beyond their useful life. Our core markets all tend to grow above the traditional R&R rate, and it's really driven by this increased consumer focus combined with material conversion. And I'll say -- make a comment on that. In addition to the core markets in which we operate, we access and we have access to adjacencies. And I think this is a key differentiating point for us. If you look at our growth of 18% over the years, it's our ability to continue to access adjacencies. What we have now in our core at some point in the past, was an adjacency. And we continue to grow. And every year that goes by, we access more and more of these adjacencies. We believe that we have an opportunity to continually expand our addressable market, and we've launched products against that. Specifically, if you take a look at structure, if you would have seen this chart a year ago, it would have been $9 billion in the core and $11 billion in adjacencies with the acquisition of structure, we've been able to add an additional $1 billion into what's now in our core. If you move on to the next page, there is -- Page 8. There is significant opportunity that we see in terms of wood conversion. If you take a look at our blended markets that we play in on the residential side, combined, there is 64% of the markets are wood today. And as an example, in decking, every 1 percentage point of conversion we have in decking adds 3 to 5 percentage points of growth in the market. And our proprietary research suggests -- so if you take a look at decking specifically, it's 25% non-wood and 75% wood. We've done proprietary research that shows that of that 75% that's currently wood, 2 -- 1/3 of them are clearly focused on price. 2/3 are focused on the right value proposition. That's the right look, that's the right sustainability story and 1/3 of them are already leaning composite, and it's a matter of educating them and letting them know that we have the right aesthetics so that they can have a very natural look on the outside. We have similar opportunities in the other areas that we plan. If you go to Slide 9, it really highlights our business model. As mentioned earlier, we play in markets that have powerful tailwinds. We drive attractive markets, and we see our margins, and we see terrific opportunity to really expand those margins. And it's really driven by our core strengths. We are a branded player with integrated manufacturing and the more we integrate, including moving downstream into recycle, to higher our margins. We have differentiated material science that's a competitive advantage. And we've got incredibly strong customer connections. And let me just make a comment there. Our business in the residential side has been built out over 20 years. We deal with millions of consumers, and we're one of the few players that has consistently marketed to consumers. They sell or they buy from tens of thousands of fragmented contractors that buy from thousands of dealers that are, in many cases, family shops across the country that deal with an exclusive distribution network. It is extremely difficult to enter this market at scale and to continue to build out not only those relationships, but the business model associated with that. We operate with a clear and focused strategy, market conversion, product innovation, channel expansion, improving the consumer journey and selective M&A on the growth side. And then on the margin side, we've got some key elements, primarily driven by recycling and our continuous improvement. If you take a look at Slide 10, it really highlights some of what I'm talking about relative to execution against our strategy. This is just our new product launches for 2022. We have a model where we launch new products every year. You can see that we've launched products in our core with decking products and rail. You can also see that we're accessing some of these adjacencies. Our most recent captivate prefinished siding and trim is a way for us to start to access a different part of the market with prefinished products. And then our structure acquisition is not only growing in their core, but they've launched a product called Cabana X, which is more of a price point product that allows more and more people and I think more specifically, our dealer base and our contractor base to access smart pergolas on the outside of houses. If you move to the next slide, just to summarize what we've talked about, we've guided to double-digit growth. If you take a look at how that -- and that's Slide 11, if you take a look at how that stack lines up, it's typically mid-single-digit growth for the repair and remodel market. On top of that, we see opportunities for conversion, wood conversion in outdoor living. One comment you might make, and we haven't updated these numbers is 2% to 3% is probably under where we've been now. And then add to that, we believe, through our initiatives and new products and adjacencies, we can add an additional 2 to 3 points of growth. At our Investor Day, we might give a little bit broader guidance here. But you should think of this as, in general, the stack that helps us arrive to the growth side. And then the next page, Slide 12, gets you to the margin stack. We continue to be confident in our ability to drive 500 basis points of EBITDA margin conversion. When we originally did this slide, it was really driven by our continuous improvement, and you can see our track record there, recycles expansion being the predominant element there and then some modest SG&A leverage. We have made significant progress over the last 2 years in a number of these areas, but it's really been masked in the short term by a price raw material by increasing raw materials where we've had to offset it with price. Once that normalizes, and we expect to see that as we exit the fiscal year, normalize being we've taken enough price to offset raw materials, and there's always a lag in doing that. Once we stabilize on that element, we expect to see progress -- meaningful progress, again -- against this margin expansion commitment. With that, I'll just highlight the next slide to me is one of my favorite slides. I just put it in there. It really shows you how we take garbage, whether that be plastic bags, post-consumer, post-industrial or post-industrial and post-construction PVC, and we convert it into beautiful products. And fundamentally, I think that's what excites us about the model and why we're so excited by combined with the terrific growth opportunity we see in the marketplace. So with that, I'll summarize. There's one other summary slide, but I'll turn it back over to you, Michael.

Great. Thanks, Jesse. A lot to go over there in a short period of time, but I think really helpful information as always. I'm going to -- as I said, I'm going to ask a few questions. There's also the ability to convey some -- relay some reason questions from the audience. We've already gotten a couple. Maybe just to start off, though, even going off the path of the questions that I've prepared, and I think it's probably the question that I get every day as we alluded to before this session started in our preroom session is just -- I was hoping you could comment on some of the volatility in the stock price over the last couple of months. Certainly, yourselves and your closest public competitor tracks have been trading very similarly. So in a lot of sense, it's not as much company-specific. But wanted to get your sense of what's driving the stock volatility, some of the challenged stock price so far this year? What are the investor concerns? And how do you think about those concerns?

Yes. I mean, first, just to reiterate, for us, we were private for 4 years. And we really focused on value creation and building a great business. In times like this, we're focused on value creation and building a great business. And so independent of what's happening in the market, we see tremendous opportunity. And in fact, we announced a buyback, and you'll see some of our senior level folks have stepped in including ourselves and our Board members to continue to accumulate as possible just because we view the long term as terrific. If you just look at the macro, right, there's a risk-off that we certainly are playing into kind of that first tranche for volatility started to relate to a concern on interest rates. And I think one of the things you're going to hear from almost every player in the marketplace is interest rates don't have the impact that people are concerned with, and that was kind of a component of all of us taking a step back. The combination of interest rates affecting growth companies and the combination of interest rates, idiosyncratically affecting players that play in the housing market. I think the second component is most recently, I think people are -- folks that are investing right now, the major funds, AIMS that might be on here. Some of what we hear is just a general concern that there's a recession coming. And so -- and you have this dichotomy of us continuing to see strong, solid demand, lapping some really strong quarters and there being a general concern of what happens in a downturn. And so without getting too specific, I think it to us feels like a risk-off moment in time, and that may present opportunity. But more specifically, that risk-off starts to get to at a macro thematic level, have we seen the signs and what would happen to the business if there were to be a downturn. So that's kind of number one. I think for us, specifically, we have seen a huge run-up in raw materials, as we said on the call, $220 million plus of raw material inflation. We've been able to offset all of that. But the problem in offsetting it, and we saw another tranche go up soon after the war is there's a lag, right? And so for us, specifically, I think people are waiting to see that margin expansion story that I just talked about manifest itself through the P&L. And so if you step back, that would mean that there might be a wait-and-see aspect to whether or not that margin progression that we are so confident in because of the actions we've taken materializes. So at a high level, I think that those are kind of the macro components. I would just say, for us, we feel really good about how we're exiting the quarter and exiting the year relative to a few things, right? Our ability to sustain and get back on track on margin expansion. And then knowing the actions we've taken. And I think number two, if you look at the resiliency of the market, what we know about what's happened in previous downturns combined with the tool set that we have and our pricing power in the marketplace, we feel really good about our ability to perform and outperform in any kind of macro scenario as we move forward.

Great. Well, thank you for that, Jesse. I appreciate it. Kind of actually on those last comments about feeling good where you are and exiting the quarter kind of led me into my original first question, which was around sales guidance for the back half of the year. You're expecting sales growth of 17% to 19% in the third quarter, which implies about 4% -- I'm sorry, 6% for the fourth quarter, if you use the midpoint of the full year and the third quarter guidance, and that's despite channel infill estimated to be slightly lower in the fourth quarter of last year versus the third quarter. So I was just curious what's driving that lower growth outlook? Is it simply conservatism? Are there other things going on there? Is it timing or seasonality throughout the year? And because certainly that's given all the strength that we've seen a little bit on the lower end, end of the year.

Yes. Look, I think you hit it well. First, if you take a look at the quarter that we're in currently, we're lapping a 50% growth quarter. And within that, we clearly added inventory to the system. So once again, to reiterate, in 2020, we had strong growth, we drew down inventory in the network. In 2021, as capacity came online, our service improved. We were able to better position the inventory that was needed in the market. So we're lapping 2 meaningful inventory fill quarters. The second component is, I would say, we're being appropriately conservative, right? And so not only are we lapping those quarters, we recognize that our service levels are improving and interest rates are higher. And that combination would potentially have our channel partners not only not reinflate their inventory, but knowing that we have good service. They may use that as an opportunity to manage their own working capital, right? And so if you look at the underlying demand, our assumption right now and what we can see is that we've got solid underlying demand. A lot of these nuances are really lapping huge quarters and the combination of -- you're right, Q4 is near the end of the season. And unlike the previous couple of years, there might be some consideration by our channel partners of the right inventory to have coming into the area. And then relative to margin there, Pete, I don't know if you've got any additional comments. Pete Clifford is CFO. And by the way, in a previous life, he was CFO and COO and President at Cantel Medical. So Pete, I'll let you make a quick couple of comments there.

Yes. Just quickly on the fourth quarter step-up, the way you kind of want to think about the progression from 3Q to 4Q is look, I've got all of the inflation in the third quarter and really only about a 1.5 months' worth of price. Obviously, if you included about $15 million plus of price in the third quarter, you'd be taking revenue to almost $400 million and $95 million on the midpoint. So when you look at that sequential step up, it starts to make a lot more sense than in the fourth quarter. We get our full pricing impacted as well as we expect a meaningful step up on our structure acquisition in terms of their quality of earnings. We expect it to accelerate from 1Q to 2Q or I'm sorry, from our fiscal 2Q to 3Q and then again pretty meaningfully from 3Q to 4Q.

Great. That's helpful. Maybe just on the topic of growth to stick there for a moment. Jesse, you referenced your long-term growth algorithm of 8% to 10% consolidated. I think the step-ups that were more for the residential segment kind of got you to 8% to 12%. And you gave the components there. Have any of those growth drivers changed at all over the last 12 months? You kind of referenced outdoor shift, maybe that component being a little conservative relative to what you've seen. Clearly, you've -- the industry has significantly exceeded that over the last couple of years, and you've had a 2% -- roughly a 2% shift from wood to composites and each percent is 4 points of growth for the composite industry. So I was curious if you want to talk about that a little bit. And if you see a little bit of upside in the near term or given the current backdrop, let's stick with a more conservative approach.

Well, I -- first, I think it's a good question. I think our numbers on conversion are conservative. They're really based on the 1 percentage point number. And there's -- we also are using that across the whole company. I think the growth stack is really what we believe makes this part of our industry resilient, right? So as you've pointed out, I think our focus right now. And if you did the stack, you would say it's 6% to 8% above market, depending on how you look at it. I think our focus would be to get that closer to 8% to 10% above market. And as we looked at the last year or so, our competitors say that conversion is it has gone up to 2%. We haven't seen the data enough to kind of draw a perfect conclusion there. What we know is coming into the pandemic, it was 1.5%. We believe it's realistic to consider it too. And that, for us, is one of the key drivers that will allow us to power through any kind of any kind of an economy, right? So I would look at that stack right now is hedged and modestly conservative. But we've got to execute against that. We've got to continue to drive conversion. The one thing I'll say about conversion is there's a bit of a network effect, right? So my brother-in-law put in a deck a couple of years ago, and it happened -- of course, it was a TimberTech deck and 9 -- I think probably now 10 of his neighbors put in a TimberTech deck, right? And so this is one of those categories where the more the activity there is in the category, the more likelihood of conversion, especially when people see how good a TimberTech deck looks, right, and it kind of breaks their notion. So those are variables that give us optimism. We're also going to be realistic as we look at projections and committing to a future growth rate.

Okay. No, that's fair enough. I want to switch to margins for a moment. We have about, I want to say here, 8 minutes left, and we have a couple of questions. So I'm only going to ask a couple more questions and then pass along some of the questions from the audience. But the margin story is very important, obviously. You talked about the 500 bps of EBITDA off of fiscal '19. The margins after achieving about that 100-bp expansion in fiscal '20, they're on track to roughly be flat over the next couple of years. So I was hoping -- you alluded to the price mix catch up, I was hoping if you could give me a rough quantification of what that might be. And then also the -- to break down the material benefit, the recycling benefit as you continuously shift more and more, you alluded to the 1 billion pounds. I think you've also talked about moving to 60% recycled in some of your core products. What that means also from a margin perspective?

Pete, I'll take this just very briefly. We said on the call, we're going to exit -- we expect to exit the year with $30 million to $40 million of got to catch up. So that -- the way to think of it is enormous raw material inflation historic, right? And despite that, at some level, you would look at it and say it's pretty remarkable given that we have exposure to PVC and PVC has more than doubled that we've been able to offset that and kind of be flattish, as you said, over the last couple of years. That price raw exit is $30 million to $40 million as we move into '23. I think the second component I would throw out is that effectively, at a high level, think of it as every couple of percentage points of recycle expansion across the company, gets you something like 50 basis points. Now we haven't -- I'm just giving you a directional number. That's why I'm not letting the CFO speak. But it's kind of directionally in that area. And we've also got another component where if we go at a higher cost recycle to lower cost, we get another 50% benefit, right? So postindustrial PVC versus post-construction PVC is a meaningful difference in price, right? Because one is landfilled, the other one, albeit very competitive, can be used in other places.

So that -- so I appreciate that, and I'm not going to hold you to the exact 50 bps, as you said, but just directionally to make I'm understanding that right.

Pete, any additional commentary to that?

Yes. I just -- the pathway is still the same, right? Jay said, on the recycling piece, it's as simple as, look, we have an opportunity to go from 50% high density, 50% low density to 100% low density on our cap composite. Every pound of low density is about 50% savings. And then our PVC decking, as we've talked about previously, we're at about 55%. We don't think entitlements anywhere near that. We like to think it's probably well above 70%. So it's still a significant opportunity. Sourcing savings are real. We've got lots of opportunities like lots of companies to look at plant operations over the inefficiency of COVID in the last 2 years through continuous improvement. Even though our fixed cost base is minimal, there's still real opportunities, obviously, when you're growing double digit on a volume basis to get manufacturing fixed cost leverage as well as, look, we think most years, we can still get modest SG&A leverage.

Right. And so just the PVC going from 50% up. You said every couple of points is directionally -- and again, I'm using your words and I'm not going to hold you to that 50 basis points. Okay. That's very helpful.

And that's a combination of both the polyethylene opportunity on recycling PVC.

Okay. So it's a combination of both going from high density to low density and the...

Recycling in general, we feel like is at least a 50 basis points expansion opportunity each year.

A couple of points, is that what you said?

50 basis points.

At least 50 bps every year. Yes. I mean part of what we need to expose hopefully, we can find a way to do it in the investor meeting is, we made progress. Arguably, we're probably 100 basis points of progress recently, and -- but it's being masked by this kind of price raw think about it, right? You've got $220 million versus 100 basis points, which is $12 million, right? So the magnitude of the delta of the price raws is kind of eclipsing the progress we've made on recycle.

Right. And I think we almost certainly plan on our Investor Day giving people a lot more clarity on sort of cadence and the impact. So what kind of margin expansion should you expect from us every year.

Right. That will be helpful. A question from the audience. On the R&R side, how do you think about the breakout between what is "fix and flip investment" compared to owner-occupied consumers doing renovations. I'm sorry -- additionally, how would the slowdown in cash out refis impact the end consumer?

So just very quickly, we tend to skew on a wealthy demographic. And in general, our focus is not flippers, right? So we -- for us, there's a small percentage of the market that's that right now. I know it gets some press like Phoenix or whatever, right? But in general, it's homeowners making a decision. And in general, if you look right now, we're at -- 90% is paying out of cash, at least what industry data says, right? So a very small percentage, 10% to 15% might be doing HELOC. Now it's difficult to get at those numbers. This is industry numbers for a couple of years ago. So our purchases tend to be in the $15,000 kind of and up range. So for a lot of folks, that's cash or some modest financing.

Okay. Great. Also I have a question -- the one here is you're exposed to a single 2-step distributor that's about 25% of your sales. What do you need to do to be able to diversify away from that? And maybe just more broadly, I would add on to that channel expansion because one of the goals you've had is to get a little bit more into the home centers. And so perhaps you can kind of address both of those questions as they're kind of linked.

Yes. So number one, our focus -- so think about, we sell to a 2-step distributor and that 2-step distributor fulfills and delivers to a dealer. And that dealer can either be retail or it can be a pro dealer. Our focus of the 200-person sales force is on that dealer network. The specific channel partner that we have, Parkside, the distributor, you reference is a reference is a partner in delivering the product. We have dual distribution in every geography that we play in. And so Parkside is a terrific partner. We're a meaningful part of their business. They're private. But in general, our focus is on the dealer network and gaining share there. and partnering to have the product delivered. So I know it's called out in our materials. But in general, you should think of our -- the breadth of our exposure with our partners being a fulfillment arm, specifically to the retail channel, DIY, 3 years ago, 4 years ago, it was 5% of our business. It's now 10% of our business. We continue to partner with channel partners, including them to expand our business, and we believe that will and will continue to be accretive to our growth as we continue to focus and service all of our customers better. And we, as you mentioned, are meaningfully underpenetrated in that particular channel, and we'll continue to work with that channel to expand our position and give our customers options that are going there to be able to buy our products.

One -- I'm going to throw in one last one. I know that we're a minute over, but I'm going to take a host privilege here. The -- because you mentioned expanding with retail. But obviously, you've gone through a significant capacity expansion and not only to address the fact that maybe you've been sold out in some ways over the last year or 2, but further opportunities going forward. With that capacity now fully -- I believe almost it's on track, let's say, I believe, over the next couple of quarters can be fully locked and loaded. Are there new partnerships or new areas that you feel like you're able to go to that we should expect to hear about over the next 12 months, be it an expanded partnership with one of the major home centers or in a certain new res channel, things of that order?

Yes. I think it's -- first, we have been capacity constrained for coming on 3 years. And our objective was to -- given our low fixed cost, so our manufacturing is modular. So we had -- if we have excess capacity, we can shut it down and not have a meaningful impact on the P&L. So the optionality of having extra capacity to allow us an earlier than anybody else, right? People are breaking ground now. Our facility is up and running. And so that optionality for us was really important for the elements that you talked about, right, which is it gives us an opportunity to engage customers and improve their service levels, and it gives us an opportunity to continue to expand our product portfolio. We believe that will have a benefit in the market. Anything specific, obviously, wouldn't be appropriate to talk about. But we believe having that capacity gives us an opportunity to continue to expand and engage the market. I highlighted on the last quarterly call, not just on the one prior, that we picked up some modest incremental shelf space within our pro dealers and certainly our capacity both on the exterior side with trim combined with decking was extremely helpful in showing our customers that we could give them a terrific value proposition of the best products and the best service and capacity is a key component of that.

Great. Well, we'll cut it off there. Thank you so much, Jesse, and Pete. Really appreciate your participation in the conference. It was great to see you, and I think we hit on a lot of important points. We will cut it off here. Again, thanks so much, and we'll see you soon.

Great. Take care.