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

Okay. Well, welcome, everybody, and thank you for joining us today. My name is John Lovallo. I'm the senior U.S. homebuilding and building products analyst here at UBS. We are very excited to have AZEK with us today. We have Pete Clifford, who's SVP and CFO; and Chris Russell, who's VP and Head of Corporate Development. So thank you guys for joining us.

Great. It's good to be here.

Yes. Thanks for having us.

All right. Maybe we'll start off with a question that we get all the time, and it's really just sort of on inventories through the channel and through the different regions. How would you kind of characterize the state of things?

Yes. I would say, over the last couple of quarters, days-on-hand inventory with our channel partners has settled back to sort of pre-pandemic days on hand as well, I would argue, on the bulk of our portfolio. Our lead times are now kind of back to pre-pandemic as well.

Got it. Okay. And when we think about the pandemic and we think about one of the big concerns out there being pull-forward demand, how do you guys kind of characterize that? I mean if we think about what trend growth has been over the last 20 years and what pricing did, how do you kind of frame that?

Yes. Our 10-year CAGR, coming into the pandemic, was about 18% and about 5 or 6 points of that was M&A. So from a traditional volume perspective, because we had really very little price over that 10-year period, is kind of low double digit. And as we look at the last 3 years and we peel back sort of the price to inflation and we peel back sort of the channel inventory noise, it feels like we got maybe 3 to 4 points of tailwind over the last 3 years. And the way we think about that 3 or 4 points, it's kind of hard to parse it, but included in there would obviously be the tailwind but also any acceleration in conversion as well as any kind of share pickup over the last couple of years.

Okay. That makes sense. How do you think of trend growth as we move forward here if we think about market conversion, pricing, because to your point, historically, there hasn't been as much pricing? How do you kind of bucket trend growth?

Yes. I mean I parse it into sort of 2 pieces. There's our kind of, I'll say, longer-term guide and then there's sort of the aspiration of what are we really trying to drive the teams towards. So I'll start with the guide. Historically, we've articulated consistently that we view our Residential business as sort of a growth stack of kind of mid-single-digits for R&R. And I think the 10- to 20-year CAGR kind of supports that well, followed with a couple of points of growth from conversion. And just a footnote for folks who aren't familiar with the space, 1 point of conversion from wood to composite at this point in the journey is actually translates to about 3 or 4 points of growth for the industry. So again, conversion for us is a couple of points, and then we've usually stacked on top of that a couple of points for commercial initiatives. And we've historically let pricing out of that guide. So that's kind of our math on how do we get to -- why we think we can consistently deliver about 10% organic growth on the Residential business aspirationally. Certainly, there's times like now where R&R is above sort of mid-single-digits. Obviously, we feel like we control some of our own destiny in terms of accelerating conversion. So it's pretty well known at least over the last couple of years. It feels like conversion has been closer to 2 than 1 historical pattern. So obviously, we'd like to get closer to 2 and the 6% to 8% growth that comes with that. And we'd like to think that we could do 3 to 4 with commercial initiatives. And then obviously, pricing and M&A are all additive to that. But that's the aspiration of why not try and continue the legacy 18% CAGR.

Got it. Okay. That's helpful. And in your conversations with channel partners and just from what you're seeing, how would you characterize demand today?

I think that everybody is trying to get as close to the end consumer and purchaser as possible. So we're not alone in terms of our desire that we do a monthly survey with the contractors in our channel. And I would say the feedback from contractors has been pretty consistent over the last 3 or 4 months, that backlogs for work are still at kind of really elevated levels, similar to last year. I think that contractors like lots of folks in lots of different industries, probably now have to -- where their sales had more often than they did in the last 2 or 3 years, where it was sort of in an environment of kind of order taking. So it's kind of back to selling. But everything that we hear from our channel partners downstream is that demand is fairly robust for the season.

So that's encouraging. And when we think about AZEK versus the 2 other main competitors out there, the product is all really good. So if we were to think about holding 3 pieces of board, what do you think, in your mind, differentiates your board from the competitors?

Yes. I think, first and foremost, from a platform material perspective, we're unique in the sense that about half of our Decking business is capped composite and half is the capped polymer or PVC product line. Obviously, we think with -- PVC is an important part of our premium category. So we truly believe that PVC is a differentiator from an aesthetics perspective. We think we have the most natural-looking product that mimics the natural beauty of wood. Obviously, our product on the PVC side is a lot lighter. It's cooler to the touch. It's easier to use. So from a material platform perspective, we think we're different. And then I'd just add, in general, I think sometimes people miss the portfolio being a bit different from our competitors that obviously, we are significant in Deck, Rail & Accessories, but we also have a view of the world with Exteriors that's a bit broader from a portfolio perspective. We're interested in anything that's in the front yard, the backyard, on the outside of the house that participates in that wood conversion story, that has obvious channel synergies with our business or brings us vertical capability like on the recycling side and has a profit and organic growth profile that's accretive to our business. Those are the things that we get really excited about.

Okay. Makes sense. When I take a step back and I think about the industry in general, the characteristics are pretty attractive. I mean margins -- EBITDA margins, 30% plus; turns on capital, call it 40%. Generally speaking, when there's "excess returns", it introduces more competition. Why do you think that hasn't happened? And what are kind of the big strategic advantages that you guys have?

Yes. I think first and foremost, since 70% of the industry on the decking side goes through sort of the pro channel, the moat around the pro channel for those that are already in it and doing well is pretty significant. So kind of first and foremost, the relationships with both the dealers and the contractors, in many cases, they're 20-plus years. They've built their business and their reputation on the products that they're selling. So the reality is having a superior product, having dependable lead times, a reliable warranty that you stand behind, the fact that we have 200-plus folks that are in downstream sales and marketing that are helping them drive and grow their business is a pretty powerful moat around that part of the business. And as you think about, let's just say, low-cost kind of competitors trying to move in, as we've articulated pretty broadly, 70% of our cost of goods sold is material, and conversion cost is obviously 30%. But of that 30%, what we would view as kind of direct labor is very low. So anybody who's trying to make product cheaply overseas, the labor arbitrage is pretty minimal. And obviously, with freight costs where they are today, it's really, really difficult for people to make the economics work from exporting materials to -- our product to the United States.

That's a good summary. Okay. And again, from an industry standpoint, 24%, 25% composite market share, I think you guys laid out kind of a longer-term goal of getting to 50%. Just curious, if you could put a broad time line around when you think that's possible. And what could sort of derail that, in your mind?

Yes. Look, I'd start with the 25% of the market that has converted to composites of the 75% that's remaining. Our studies and our work has kind of shown that about 1/3 of that 75% is fairly rigid and price-driven. The other 50%, candidly, is open to a conversation on composites. So we view it probably even more a bit ambitiously than just the 50%, but how to get the market to be 3x the size of what it is today. We feel strongly that the keys to conversion really center on aesthetics and -- versus price. And I think, in my mind, the things that could derail the industry is candidly product out there that doesn't mimic the natural beauty of wood, either poor quality, more poor introductions to the category. And I think if you look at our strategic goals and actions, they align really closely around a lot of those to make sure we're staying in front, from an innovation perspective, in launching the most new products to making sure that we actually have product availability, so having the right amount of capacity to seize growth opportunities. And we're putting an enormous amount of effort into making sure that we improve our own customer journey, so that we're making sure we're getting people introduced to the category the right way, so that we can accelerate more of that 50% and the middle of it is open to composites.

And maybe sticking with that acceleration, the industry, historically, has converted at about 1%.

Yes.

We got to 2% last year, which is obviously a very big move. Is that sustainable, in your mind?

I do. I think -- I would argue, being somewhat new to the space or the industry here at 7 or 8 months in, I've seen this before, where you have one OEM that's sort of selling the conversion story and when you can suddenly put a second OEM of significance and kind of leaning into the same story. It's actually a good thing for the entire industry. So I think the competition that we have with our large competitor is actually only making the industry better, and it should only continue to accelerate conversion as we look forward.

Yes. Okay. That makes sense. If we think about pricing historically, we touched on this before, but it hasn't -- the composite decking industry and ancillary products, there hasn't been an industry where there's been tremendous pricing power. Curious what your thoughts on that. Is it really just maintaining a spread to wood? What has been kind of the dynamics historically? And how do you kind of see things as we move forward? Do you think that this kind of recent move-up in pricing power, if you will, is going to -- is there more room to move up if material pressures increase? How are you just kind of thinking about pricing in general?

Yes. I mean there were times in the past where we frequently tied to that question, get questions around capacity and excess capacity or capacity coming online in the industry and will [ not ] drive any dysfunction. But candidly, there's been many instances over the last 20 years where there's been excess capacity and various times where there could have been price pressure and there hasn't been. So good or bad, our view is price givebacks have really never happened in the industry. I get it that the inflation that we've seen in the last 18 months is pretty unique. But I still think that pricing, as it stands on the decking side, we feel pretty comfortable that, that can be maintained. As we think about deflation, a possible deflationary environment next year in '23, obviously, that's an opportunity for us that with our PVC exposure in the last 18 months, we've had a lot of work to do to offset inflation dollars with price dollars and now eventually rate. But we should be one of the benefactors if we see commodities start to roll over next year.

Okay. And then maybe along those same lines, historically, you mentioned there's been excess capacity, there is a fear out there from the folks that we talk to that the industry is heading back in that direction. Everyone is sort of adding more capacity. How do you kind of see this playing out, given the demand environment that we have today?

Yes. I think it goes back to the conversation about that 50% of the market that's open to composites. And I think the investments that you're seeing the industry more broadly make is just a reflection in the confidence in the ability to reach that and that market and triple the size of the space. So I think everybody has learned a bit of a lesson over the last few years, where almost everybody in the industry had a massive capacity crunch and actually couldn't serve the marketplace. So I think there's a desire to want to stay modestly ahead to be able to, again, seize kind of growth opportunities. As I think about our own business, I think we have the ability to rightsize or moderate our CapEx spend at times. We've said directionally, our guide is kind of 5% to 7% of sales for CapEx spending, but about half of that is maintenance. And obviously, in choppier markets, we do have the ability to kind of pace our CapEx to be primarily maintenance. So as it relates to our Boise facility, we've kind of said, look, our first lines are up and running here last month. But I think we also hold the flexibility to pace out the further lines that we'll commission to sort of better match demand over the next kind of 3 quarters or so.

So one of the things that you guys have talked about is the capacity, to your point, being sort of modular, and then that makes a lot of sense. When that capacity is in place, though, and up and running, how easy is it to sort of gravitate you on and off?

It's discrete, right? At the end of the day, we can either turn lines on or off, and we have the ability to pull the variable resources directly from those. So it's back to our conversation that we view, from a cost of goods sold perspective, about 90% of our COGS is variable and about 10% is fixed. And so we -- there is not a disincentive at all for us to run machines just to run machines. If we don't have demand, we don't run them. And frankly, after having 2 years of no capacity right now, having the excess capacity is incredibly helpful as we're grinding our way through sort of the recycle expansion that you need machine time and capacity to do that recycle formulation work. So it's been incredibly valuable for us already to kind of get back to a position where we're not at 100% utilization on machinery.

What is sort of optimal capacity utilization?

Yes. I think in this business, if you're above 85%, that's actually not a good thing, and that would probably surprise people. So I think kind of an optimum kind of target is probably about 75% because at the end of the day, a lot of the equipment that we need, tends to have 9- to 12-month lead times. So if you're at 85% and you're finally making a call to order something, you can find yourself if demand picks up in a pretty unenviable spot of being closer to 100% than the 85%. So it's -- 75% is the right capacity to not only make the right capital deployment decisions, but it's also what you really need to do the recycle work as well as kind of maintenance.

Okay. And when we think about the new capacity that's being brought online, how different is it from the legacy capacity? How much more efficient -- anything you can comment on that?

Yes. I think that's one of the things that has been a real pleasant surprise, just in general, as I know when the team announced the capacity expansions almost 2 years ago, what they didn't talk about that we've seen a lot of improvement is just in the existing fleet, and we use the term OEE, it's just basically your machine efficiency. And so we've seen a lot of efficiency on our legacy portfolio of gear as well as the new machines. So what I would say is what we put into Boise that might help is, it's pretty balanced in terms of the mix of machines and lines that we put in about half PVC and about half capped composite.

Got you. Okay. And maybe just switching gears for a moment and moving to the Commercial business, thinking about Vycom and Scranton, how do you guys view the Commercial business in general, from a high level? I mean, is this an opportunity for you to sort of leverage fixed cost? Or is there a real growth opportunity? And how core is this to your overall business?

Yes. So for us, the core of the business is clearly Residential. That's where we're deploying capital and that's where we'll continue to deploy capital. That said, the Commercial side of the business has been going really well. There's been a lot of efforts over the last 1.5 years to kind of get that business back to the profile that we believe it should be at, and that's closer to a 20% EBITDA sort of the ambition there. But right now, year-to-date, that business is doing exceptionally well. We've got about 50% revenue growth through the first half of the year. And if I remember right, EBITDA is up about 90%. We're getting closer to 20% EBITDA. The backlog, it's probably our longest-cycle business. So what we can see in the backlog is really encouraging and the markets that Commercial supports, whether it be semicon to marine, to graphics, it has all been pretty robust this year.

Any markets that are clearly lagging?

On that side of the business, there really hasn't been much that's -- there hasn't been -- really, really strong.

Okay. And when we think about Scranton specifically and think about back-to-school and back-to-office, and I'm kind of focusing on bathroom partitions and things that are -- have the sanitary nature. Have you seen an uptick in demand for antimicrobial-type features in your product?

Modestly. I think the biggest thing I would say in terms of the schools business is, the team has done a lot of good work over the pandemic to get our lead times about as short as they've been in many years. And so I think what I hear from our Commercial teams is that our manufacturing capabilities and lead times are actually allowing us to win more business and actually hold more price because we have the ability to quick ship.

Got it. I'm just going to pause for a second to see if anyone in the audience has any questions. Okay. We'll keep going on here. The -- let's talk about the big-box retail business and sort of your strategy there, one of your competitors. It's a big part of what they do. You guys are more focused on the traditional channel. Where do you see big box kind of shaken out as a percentage of your business? And kind of how important is that to you guys?

Yes. So certainly, look, as we've said, about 10% of our business is retail and 90% is pro channel. So we are actually kind of peers, in essence, on the pro channel side. The difference between our largest competitor is largely on the retail side. We're under-indexed. I think when Jesse joined the business, it was actually less. It was about 5% of business. So there's been a concerted effort over the last couple of years to ready ourselves and position ourselves that we do think that we can do more opportunistically in retail. I don't know that the aspiration is necessarily to match the share of 30%. But certainly, there's an opportunity to smartly do more than the 10% that we do today. And look, I think some of the investments that we made, i.e., Boise, are important things that we had to do to position ourselves to participate hopefully in the future.

Makes sense. And maybe in terms of the overall recycling effort, if we think about -- I mean, there's still a small delta in the Residential margin between you and your largest competitor. And it seems like maybe that's a function of the recycling ability. Let's just talk about the strategy of getting that sort of ramped up to the levels that you guys are thinking about.

Yes. So you could kind of parse the recycle opportunities kind of into 3 buckets. So on our capped composite product line in Decking. Today, we pretty much use almost 100% recycled content in that product. The asterisks or our opportunity is that we use about 50% high density and 50% low density. So our opportunity is actually to move to [ 100% ] low density, which is obviously a cheaper form of recycled resin. One pound of LD is about half the cost of HD. So that's kind of one bucket. Second one is kind of our capped polymer or PVC product line, which has got recycled PVC as well as virgin on the inside, wrapped with a virgin cap around it. And so we've got about 55% is kind of. [Audio Gap] The consistent execution on PVC and the inside of those boards. Our next milestone, it's not entitlement, but our next milestone is kind of 70% in ramping that up. And similarly, today, a pound of recycled PVC. [Audip Gap] is about half of the cost as well of a virgin PVC product. And so there, we're sort of tackling kind of both things. One is, we're developing or have been developing this PVC supply chain of recycle, which we think kind of differentiates us. There's not many folks doing that and then, obviously, the machine work and formulation work. So -- and then the third kind of last recycling opportunity is really around our trim business. And so our Exteriors business uses exclusively PVC. And what's different or unique about trim versus Decking is kind of two things. So one is, products on the trim side are not capped. So obviously, it's easier on the Decking side to put more recycled content in the middle of the board because we cap it with a virgin cap. So the uncapped, what matters there is the fact that if it is a non-painted PVC application for trim, you need to be able to source really pristine, pure-white recycled product to be able to move up the recycled percent. So it is absolutely an ambition on the sourcing and recycle side to look at either building those relationships or acquiring other recycled assets that have access to that recycled pure-way content. So on that side of the business, we're at about 10% recycle, so it's much lower. Our next milestone is kind of 40%.

So is that the biggest sort of challenge with PVC relative to other resins? It's just the pureness of the input that you need?

[ Ruling ] mostly on the trim side as it relates to our Decking side. We can use just about any kind of almost landfill-type PVC in our Decking product. We kind of think of it most simplistically on the recycle side as you got to source it, you got to convert it, which is size reduced, get it to a pellet. You got to do the engineering work for the formulation and then you got to deploy it in manufacturing, right? It's got to get blended into the machine.

Okay. And as you guys continue to ramp the recycling effort, I mean, is there just a rule of thumb or a ballpark way to think about how accretive that could be to margin as you ramp?

I think we're going to try and make that a little bit more transparent next week with our Investor Day to kind of help people kind of monetize and provide a bit of cadence around how they should think about the annual impact to recycle.

Let's front-run the Investor Day. Okay. That makes perfect sense. Let's talk about M&A...

But let's just go back on your point. I mean, the recycling assets that we can acquire are unbelievably great returns for the business. We're typically only spending single-digit millions to acquire businesses that really give us access to millions of pounds. And when you again go back and sort of say that 1 pound of recycled PVC is half the cost of virgin, those are probably some of our best returns right now as any time we can go out and find a great recycling partner. Those are really great investments for us.

So if we think about M&A, I mean, should we sort of think about that being the strategy heading -- looking at some of the recycling? Or are there -- should we think about maybe that in combination with other products that you can add on...

Yes, it's definitely -- Chris can speak to this as well. Just look, we are -- there's the left-hand side that's looking for clear adjacencies, again, back to -- if it's in the backyard, the front yard or on the outside of the house, plays in the material conversion story, fits in our channel, has the kind of growth characteristics that are not dilutive to our Residential business, has margins, let's call it, at least in the mid-teens that we feel like it can bring up to AZEK-like levels pretty quickly. Those are assets that we would be interested, and StruXure is a great example of that. And then on the right-hand side is sort of that vertical manufacturing capability. And for us, that usually means recycled. So we will definitely -- we played in both of those, and we'll continue to play in both of those.

Got you. Okay. Let me just check to see if there's any questions from the audience before I move on. All right. One of the building product companies, non-decking building product companies, just acquired a smaller composite decking company, called [indiscernible]. Can you talk about where the differences are between what [indiscernible] does and you guys do? And are assets like that potentially also of interest to you?

Yes. I mean, we're familiar with the company. It's a good company. It's a fiberglass-driven material platform that they use to make their product. In our mind, we've admired it but looked at it basically as a niche marine product application that's done very well in the Southeast, but it's not classically a decking product.

Got you. Okay. All right. And if we think about capital allocation, I mean you guys have been very clear that reinvesting in the business is a top priority. If we think about what's going on in the stock market today and -- does that change the way you think about priorities? I mean, could you become more aggressive on buybacks or things of that nature? How should we think about that?

Yes. Look, I think we were trying to send a signal more forcefully with the ASR and sort of being in the market aggressively and actively as soon as we announced the share repurchase program. I think you'll see us be moderated in the sense that, look, we've set that up for multiple years, and we think we will continue to buy pretty consistently throughout that timeline. I guess, to answer the question, would we somehow go to take on additional leverage just to do a larger buyback in year 1? I don't think so. We feel like the right capital structure kind of has us at about 2x to 2.5x kind of net debt from debt-to-EBITDA's perspective. So I would say, we might flex up to the higher end of that, opportunistically. But you wouldn't see us go above that just because of the stock price.

Okay. And here's kind of a tough one to answer, I think, we're kind of scratching our heads on it as well. When you think about your business, you think about market. What's being missed in terms of your overall business versus the stock price, I guess?

Yes. I still think it gets back to folks that aren't familiar with our space. We don't help ourselves when we talk about 1 point of conversion because it tends to -- people automatically think that's 1 point of growth and don't understand the concept that when you go from 25% to 26% share of composites, it's actually 3 to 4 points of growth for the entire industry. So to me, that's probably one of the most misunderstood things. Second one would probably be just around PVC. And the reality is when I joined the company, it's probably the thing that got me the most excited about AZEK's prospects, the aesthetics that came with the product in my mind were superior. But the fact that as a small public company doing their IPO in the first 18 months, to see inflation on a specific commodity type that your best proxy doesn't have, I think, has caused people to miss the strategic differentiation that I think PVC brings to the table for AZEK versus its competitors.

Maybe the point in interest rates as well, right? There's a notion out there that people are taking out HELOCs to do these types of projects and potentially could be impacted by higher interest rates in the future. And the reality is, the research suggests that around 10% of projects are financed with HELOCs, right? So kind of very durable from that perspective. But I think it's been many of those things, John, and then just the fact that we're kind of a new issuer with a few secondaries, being high growth doesn't help, being high multiples doesn't help, all those things.

Okay. That's very clear. I think we'll see if there's anything from the audience. And if not, we're about out of time anyway. So to see if there's any quick ones left. All right. Well, guys, this has been great. Appreciate it.

Appreciate it.

Appreciate it. Fantastic.