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

Welcome. Good morning. This is the AZEK presentation. Before we begin, I need to remind you that a complete list of disclosures or conflicts of interest is available on our website. I'm Ryan Merkel. I'm responsible for Building Products coverage at William Blair. With us speaking today is Jesse Singh, President and CEO. Thank you, Jesse, for being here. For a bit of background, AZEK is a leading manufacturer of wood alternative outdoor living products that are sustainable in maintenance. The industry is currently benefiting from wood conversion and consumers investing in the backyard. With that, let me turn it over to Jesse.

Great. Thank you, Ryan. Good morning. I'm -- since we've got a lot of different folks in here. I'll start with a bit of a high-level overview on the company. Give you a sense of what we do and then I'll dive specifically into a few strategies. First and foremost, our focus is really around beautification low maintenance and sustainability focused on outdoor living. And our focus is really on revolutionizing outdoor living and building a more sustainable future. So what does that mean specifically? We are focused on using recycled materials to replace wood on the outside of homes. And as I'll show you a little bit of data and as is in our investor deck, there is still an enormous amount of wood on the outside of homes. It is not a great material. You have to paint it, you have to stain it. You have to maintain it, And it doesn't look right over a period of time. The most pronounced application of that is Deck, Rail & Accessories. The advantage we have as a company is we do that not only in that category, where we are the innovation leader, but we also do that in the other parts of the exterior of the home. And I'll show you that in a moment. We are a values-driven company. We've been around for 30 years. 20 years of that, we have been focused on this particular category. So very specifically, over those 20 years, we've built 2 platforms that focus on the exterior of the house. First is outdoor living under the TimberTech brand. It's decking, it's rail, it's accessories. There happens to be another public company that does a similar thing. In addition to that, we most recently added Smart pergolas. So think of it as the floor, and now we have the ceiling. In addition to that, though, we also have what we define as exteriors. It's a category we created. We branded relative to the trim side, in the late '90s under the AZEK brand. It starts with Trim and it has since expanded into other accessories on the outside of the house. So if you take a look at this picture, this is a good representation of the combination of both businesses. There, you'll see rail, you'll see decking. But on top of that, what you also see is white. And that white is our trim product. So on a lot of decking projects, you will also see white trim. You will see white fascia, you will see white accents, that falls into the exteriors category. In addition, if you take a look at the columns, those columns are wrapped with our exteriors products. If you take a look at the windows the white around the windows, the accent is our trim products. In addition, you will also see, if you kind of zoom in here, shingles. Shingles is a niche product within the siding area. We also now produce shingles that have the capability of being painted. So this really highlights that over the last 20 years or so, we have built up this business with 2 key platforms. Outdoor Living for the residential business is about 2/3 of our business. Exteriors is about 1/3 of our business. One of the -- so as you take a look then at what makes us different. So on the Deck, Rail & Accessories side, we have 2 platforms. We operate with something called cap composite, which is what is traditional in the industry. That's a cap around wood and plastic traditionally recycle. We also have something called A cap polymer. In our case, it's the legacy of having the AZEK technology. It is cap PVC we are uniquely positioned with that product. So first, on the Deck, Rail & Accessories side, we have 2 products -- product lines, right? That unique differentiation on the capped polymer side is it's lighter and it's cooler and you can inherently get better aesthetics related to looking like exotic hardwoods, Ipe, mahogany, et cetera. It is also because it is PVC-based, has some inherent flame retardant properties to it. So that is one differentiation. Differentiation, number two, on the cap -- I'm sorry, cap composite side is we have an ability to get unique visuals. We have developed proprietary technology and manufacturing capability that allows us to get the most lifelike visuals in the marketplace. As we move to exteriors and rail, we are focused on developing productive solutions. These solutions allow contractors to increase their productivity. So as we look at our exteriors market, we sell Trim, but we also sell products that are increasing contractor productivity. Why is that? We have the capability of integrating components into one shape. So as you think about that specifically, right, think about the corner of a house, right? The corner of a house, if you're making it with traditional products or wood alternatives, it's basically just 2 pieces put together and then sealed. We actually have things like an integrated corner, right? And we happen to have an example of that here, if you're in the breakout room with us, but it's 20 feet high and it integrates all the functionality of a corner. And you can slide the siding right behind it without having to seal it. So it's those kind of components that make us -- that are a key part of our differentiation. Relative to just a little bit on the financial background, you can find most of this on our investor deck. We have built this over, as I mentioned, over 20 years, you can see the financial performance. And more specifically, we have built an industry-leading sales force. We have 200 direct sellers that are our employees in addition to our channel position. We have built out an extremely broad pro dealer network. We have built out an exclusive distribution network over that period of time. And we are U.S. and Canada focused. It's not that we don't sell internationally, but the predominant amount of our revenue is domestic. I used to work at a global company that had 65% of their sales outside the U.S. Prior to this job, there is a distinct advantage in being focused in geographies within North America and specifically U.S. and Canada. And I think most of you have seen the benefit of that as you look at other investments that are now trying to explain or everyone is trying to explain away what's happening in Western Europe every 2 or 3 years, right? This happens to be a different circumstance. But we see the event -- it's not that we won't take advantage of some of that upside opportunity, but we see huge advantages in being a U.S.-focused both manufacturer and seller U.S. and Canada focus. So the macro, right? Number one, we play in growing markets that have a benefit of material conversion. We focus on innovation. Our patent portfolio, give or take, is 10x the patent portfolio of some of our competitors, right? We are constantly launching new products. Every year that goes by, we are always in the process even during the pandemic of launching new product platforms. We've reinvented our entire decking platform. 60% of the products we sell in decking, for example, were launched in the last 5 years. So we are constantly focused on upgrading and innovating. We take a portfolio approach to growth. I'll show you some examples of that in a moment. We also take a portfolio approach to margin expansion. So if you roll all that up, over the last 10 years, including acquisitions, we've grown at a CAGR in our residential business of 18%. Next week, we'll disclose specifically what of that is acquisitions, but think of it as kind of mid-single digits. So organically, we have consistently grown over the last decade. Our long-term guidance and long-term target for the business is 8% to 10% growth, 10% to 14% EBITDA expansion. I'm sorry, a 10% to 14% EBITDA growth. So what that rolls up to specifically is roughly double-digit growth in our residential business and 500 basis points of margin expansion off a base of 2019. That specifically gets you to 27.5% EBITDA margin. So that's what we have guided as our focus moving forward. The last thing I'll highlight is sustainability is literally at the core of what we do. It is within our products. We use 56% of our extruded raw material right now is recycled or repurposed materials. That will continue to expand. It's integrated both in our sustainability story, our carbon footprint story, but it's also integrated relative to our margin expansion story. Just a couple of slides on our markets. One of the aspects of the company over the last 20 years is we will continue to add products to expand our TAM, right? So when I showed this slide last year, it was $9 billion in the core and $11 billion or $12 billion in adjacencies with the addition of the Pergola platform, we have moved some of that adjacency in the core. You should think of our focus as constantly accessing our core, which we love and expanding our position there, but always adding select adjacencies that fit what we've talked about. The other thing I'll just highlight in the core base here, is that part of our core is the existing deck base, right? The existing installed deck base, right? And we're roughly, give or take, there's 60 million installed decks, about 50% of them are beyond their useful life. It is a consistent driver of engagement for us on that side of the business. There's a similar stat relative to trim. There's a lot of homes that were built over the last 10, 15 years. Prior to the global financial crisis, those homes all now have rotting trim or trend that needs to be replaced. So part of what we access is that large installed base. As I highlighted earlier, it's really about wood replacement. That's actually the same project. The wood that was treated well. It was maintained, but never quite look right -- never quite looked right. And then what it was replaced with on the right, it will look like that for 50 years, right? And so it's not just the maintenance part of it, it is the look and feel. And I think we've talked about Historically, we've been converting about 1 to 2 points a year of that wood. We're roughly in the neighborhood of 25% of the market for decking is converted from wood to our types of composite. Every 1 point of conversion, you just do the math, right, 25%, you're adding 1 more point. Every 1 point of conversion roughly adds 3 to 4 points of growth. And so as we look at the structure of the market and the benefits we get in the categories that we play, we basically stack what the underlying market growth is, and that conversion adds 3 to 4 points, if you're at 1%, double that, if you're at 2% conversion. We believe, based on data, and we'll share some of that at our Investor Day that we -- the next milestone for conversion for us is around 50%. It doesn't mean it's the last milestone. It's just the logical aspect that we should be able to go after. One of the key aspects for conversion as we look at the data is people want -- there are plenty of people that have money and want the right kinds of products outside. The challenge has been educating them on what our products look like and the fact that they don't look plasticy. So the next challenge we have in terms of conversion is education of the market. I know for those of us in the industry, it seems like everyone should know about composite decking and the benefits and our specific TimberTech decking, but there is a large base of consumers that don't understand the benefits relative to the visual benefits of what's out there. So part of what we focus on as we look to drive conversion is the aesthetics of the product and the education around the sustainability of it. Price, as you look at those demographics is not in the top 5. It has to be within the range of a budget, but they're not looking to optimize price. They're looking to optimize the look. And that really comes out of the fact that give or take, 25% of the cost of a job, in total, 20% to 25% is our deck boards, right? The vast majority of it, you've got to build in any way, think of building a house. This is the flooring, right? So you're going to have to build that structure, whether it's wood, whether that's a low-cost composite or our types of products. And so there's a huge education opportunity here to drive conversion. Now just how -- what is the model under which we operate against that attractive exterior segment. First, obviously, we play in attractive markets, I just talked about that. Part of how we drive differentiated margins is the combination of a few things. Number one, we're a branded player. TimberTech is a tremendous brand, in particular, at the Pro, and we target our brand activities for those that are in the journey, right? Number two, as you look at AZEK, if you ask around and many of you do before you make investments, you will find that the vast majority of contractors and architects understand AZEK. Now we need to educate them on our new products, continue to sell the value proposition. But the brand is incredibly powerful when you look at the exteriors of the business -- at the exteriors portfolio in general. We operate with integrated manufacturing. One of the benefits we have is we blend our own PVC. We buy raw PVC, but we do all the blending in-house. We continue to look -- that's an example. We continue to look for ways to integrate manufacturing, and we manufacture in the U.S. One way to integrate into your raw material stream is to actually source recycle and use that as your raw material stream, right? So our focus on integrated manufacturing is a part of our margin story. Third is differentiated technology. When you have something different, you're able to charge more for it. If you look at how we sit in the decking category, think of it as good, better, best premium because of our TimberTech AZEK technology, we have the ability to charge more than the rest of the market. That is really based on our material technology. And last is our customer connection. So think of it as we've been in the market for 20 years, we sell to millions of consumers. We're one of the few companies that actually markets and engages directly with those consumers. They buy from tens of thousands of contractors. There is no key leverage point in this industry. You have to engage each contractor where they live, right? So we've done that over 20 years, and then they buy through an exclusive, or they buy through a pro dealer network or a retail network. It's thousands and thousands of locations. Once again, with the exception maybe of the retail side of the business, there isn't really a central point in that. You've got to engage each of those dealers. We have built that out. And if you think about it through the view of a contractor, this is a, as I mentioned, 20%, 25% of their total job. They want to work with suppliers that they know will back the product. Saving 5 or 6 percentage points on 20% of the job and creating liability for themselves, the biggest risk a contractor has is having to go back out and fix something, right? We've got a strategy of engagement. We back our contractors up with warranties, and we are always there. It is a huge benefit and a huge barrier entry for anyone else trying to come in. So our strategy -- we operate with a focused strategy, as I talked about, market conversion, product innovation. We launched products that secure our core, but we're always launching products that allow us to access an adjacency multichannel expansion. We continue to see opportunity to expand into different channels and other channels. Historically, for us, the retail side of the business is about 1/3 of the market on the deck, rail and accessory side. It is -- historically, when I got here 6 years ago, it was about 5% of our business, it's now 10% of our business. And every year that goes by, we get an incremental accretive benefit from the engagement of that channel, but we see other opportunities and other types of channels the consumer journey, engaging with both the brand and making the buying process easier and then strategic M&A. We will always focus on M&A that's additive to our value proposition. We've got a strong track record of that, and we continue to expect to do that. And then as we look at margin, I highlighted 500 basis points, that's made up of really 2 main components on the gross margin line, our expansion of the use of recycle. For every pound of recycled PVC we use, it's give or take, 50% cost savings for every pound of low density we use versus high-density polyethylene because we do use 100% recycle in the core of our boards. The more we think of milk jugs as high density, think of plastic bags as low density. The more we use plastic bags, the more cost savings we get similarly, right? So those are 2 elements where we are still early in the journey as an example. With decking last year, we were using a PVC decking, we were only using 40% recycle. As we exited '21, we were using 50% recycle in the core of the Board. we've guided that we would expect as we enter '23 to use 60% recycle. So there's a tremendous opportunity there. Layer on top of that our focus on continuous improvement. The chart I showed earlier showed a nice margin progression coming into the pandemic. A lot of that came out of our AIMS program, which think of it as basic blocking and tackling and Lean Six Sigma. And then add to that, the 500 basis points includes some SG&A leverage. A couple of examples of new products just this year. Once again expanding the core, accessing an adjacency, continuing to build out our adjacencies through the acquisition of structure. And then as we take a look at our growth rate, we've guided to give or take, double digits. The way you should think of that as we stack on top of repair and remodel. And we -- if you just do the math on this, you're basically stacking 6 percentage points plus on top of underlying repair and remodel growth. And then similarly, on the margin side, we have an opportunity to continue to expand. I'll make one quick comment as we've gone through the last 18 months, we have been executing against our margin expansion program. We have had meaningful raw material inflation to the order of -- we said on the last call, $250 million. We have been able to offset that from a price standpoint, but there is a lag on realizing the margin against that. So think of it as we typically have a 1- to 2-quarter lag. We have fully offset all of our raw material at close to the peak. From a price standpoint, we have pricing power in the marketplace. We have a lot of value in what we sell to our consumers. What we have said is, as we look into fiscal '23, we will get the benefit of that pricing as it finally takes place against the extended raw material inflation. I'll leave you with this chart, which is in effect what I started with, we take garbage. And these are actually 2 of our recycle streams, pictures from our recycling facility, bags and just a whole bunch of scrap PVC, and we turn it into beautiful outdoor living products. So with that, I think we've got a few minutes for a couple of questions from Ryan.

So Jesse, I'm asking 3 questions everybody talk about the health of the consumer, talk about inflation, it's still rising? Or is it peaking? And then talk about supply chain, how is product flowing?

Yes. So hopefully, this is on. Let me start with supply chain. We've -- obviously, we were constrained through the back half of '20, back half, both calendar and fiscal '20 for us. Through much of '21 -- through the first half of '21 -- since really give or take, the summer of '21. We have had capacity to be able to fully service the market. So we have -- from a supply chain standpoint, we've been able to operate kind of unimpeded. We did have capacity constraints till about, give or take, 6 to 9 months ago. And so we've -- we're back to a more -- much more normalized production on the supply chain. Once again, it has to do with our relationships with our suppliers our aggressive stance and how we source. That then gets to inflation. We were well positioned. It may seem odd to talk about this. But the Texas freeze disrupted the plastics market, in particular, the PVC market. So really since that freeze, there have been elevated levels of raw material costs in particular, PVC and polyethylene. We saw that peak at the beginning of this quarter. We have now seen that stabilize. And there's commercially or there's publicly available data relative to the pricing of these 2 raw materials. And basically, the way I would describe it, as we sit -- as we said on the last call, is it's stabilizing to having some modest moderation expected in the future. Now we've got a -- we've dealt with that in the past. We're kind of priced for a lack of moderation. But right now, we see that stabilizing and if anything, in certain pockets, flattish and predicting some modest pullback, so stable. The consumer side of the fence, we do surveys with our contractors every month before the last earnings call. They have similar backlogs. If you try to call a contractor right now, you're still going to have a difficult time engaging them. Their backlog, 8 to 10 weeks. We tend to skew in a more premium consumer. Think of it as you have to own a house. And then number two, we tend to skew more premium in that consumer. I think what we see there broadly is their health is fine. In certain pockets, kind of the froth has come out, I'll give you an example, Long Island, right? So for 2 years, the Hamptons whatever they could do to either buy a house or upgrade the houses that they were in, there was a frenzy to do that. That has clearly moderated. On the other hand, there's a huge backlog of projects across much of the country. That needs to have stuff access and built that backlog continues to go. So I think as we see it, I would describe it as steady and more normalized from a consumer demand standpoint. Of course, we're aware of the macro. The key metric we tend to look at is our backlogs, what's happening in terms of our web activity and what's happening in terms of equity value for our consumers because that's the measure against which they typically will look at large ticket R&R.

Perfect. Thanks for that Jesse. The other question, wood conversion. You showed a chart where you said 50% was the logical place where conversion would go. Why is 50% the right number? What is that based on?

I think it's the logical next tranche that we're going after. I think when you look at research. So I'm giving you a very high numbers, we're going to parse this more specifically next week. But think of it as 75% of the market is wood, give or take, 25% or so, maybe a little bit more, is focused on cost, right? The price of the board, I'm going to go with the lowest cost option. Some of that's DIY, some of that is just cost conscious consumers, right? So of that 75%, about 1/3 focus on cost conscious, right? There's another, give or take, 2/3 -- 1/2 to 2/3 of what's left that is focused on other attributes. They either leaning composite, and we need to show them our product to get them over the hump. So that they realize it's not a fisher-price deck. It actually looks like real wood. And -- or there's another component that's leaning wood for sustainability reasons or other reasons, we need to educate them, right? So as we look at it, almost half the wood market is our next tranche of target because they self acknowledge that they need to be educated. And once they're educated, there's a higher probability of conversion. So that's how we look at it. It's not to say we couldn't convert the whole market or it's not to say the endpoint is 75% or higher, whatever that happens to be, we're just focused on that value-added consumer that will recognize the benefit and pay what we think is an appropriate price without purely price shopping.

Yes. Okay. In the minute we have left, one of the big questions I'm getting on AZEK, is it's a COVID winner. There was pull-forward demand. What's the rebuttal to that, Jesse?

10-year track record of kind of mid-teens growth. If you look -- and we'll provide a little bit more granularity, as I mentioned next week, and I keep apologize for that. I just can't show the slides until it becomes public. But the way to think of it is if you take out price and certain other things, give or take, we've had 3% to 5% incremental growth over the last 2 years over a kind of a historical norm. As we look at that, that's really driven by 2 components. One is the increase in R&R, which is a few percentage points of that, and then the increase in conversion. Against that backdrop, our contractors have been capacity constrained, and we have been capacity constrained, right? So there's been a natural governor of what we've been able to fulfill in demand. But if you look at it in aggregate, it's not a huge number. And it can easily be explained by that combination. As we look moving forward, we've got a focus on driving wood conversion and the self-help story that we have on margin to continue to drive growth into the future.

Perfect. We're out of time. Thanks everyone.

Great. Thank you, appreciate it.