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

Great to be here this morning. Just a very quick overview on the company. We're focused on outdoor living products. For us specifically, that means deck rail and accessories and exteriors products. Exteriors products, if you take a look at a home, it's really the accent around siding. And our core value proposition is taking recycled materials, recycled PVC, recycled polyethylene, converting them into these types of sustainable, long-lasting outdoor living products. As you take a look at why a consumer would buy us, we have 30- to 50-year warranties on most of our products, part of our secret sauce is our ability to have products that are -- that look almost indistinguishable from wood and have a very natural look. And obviously, that look will look the same for 30 to 50 years, which is a key value proposition in the market. If you think about our historic growth trend over a 10-year period, give or take, we've grown 18% CAGR. We have grown pre-pandemic. We've grown through the pandemic. And we fully expect that the trends that have been driving this business will continue. And then as you step back and you look at the trends that are driving this business, it is a material conversion. We've got our own analog to digital conversion that we're going through. The market in many of our spaces used to be predominantly wood. And in decking, for example, we have converted about 25% of that market from wood to our types of materials that leaves a very long runway. And so that is a key element to our growth. And then for us specifically, we have initiatives that layer on top of that. We are the new product innovator in the industry. We are always adding adjacencies. We've done a couple of acquisitions in the last year that solidify our portfolio. The company has been built by constantly expanding. And there are certain areas where we are we continue to see opportunity to expand channels. So our growth proposition, as we've laid it out is really to layer 5 to 7 points on top of underlying repair and remodel growth, that's our growth proposition. And then on the margin side, one of the great benefits of using recycled materials is a pound of recycle is [indiscernible] and a pound of lower-cost recycle is typically 50% and in some cases, less than one pound of virgin material. So we've got a lot of self-help relative to the margin front. So if you roll all that out, that kind of rolls into -- we view ourselves as a double-digit grower and below that, we view that we have an opportunity to expand margins, EBITDA margins by about 100 basis points a year. And we do have a target of 2027 to be at 27.5% EBITDA margin. So with that, I'll turn it over.

Great. So I guess just starting off, I think, in terms of the general view, I think people will often think about Azek and we'll think about sort of decking in terms of just being it's known, but then also involved in terms of the sort of rail and trim to it and then exterior. When you think about sort of the different elements and sort of the -- what the market could end up being over time, how you size that and just think about sort of potential for it -- how should we think about as you go into [indiscernible], are there other adjacencies? How do you think about just where Azek can be over time?

Yes. I'll start and please chime in. So if you take a look at the way we've defined our core markets, which as you pointed out, is deck rail and accessories and exteriors, our core markets right now are -- we estimate to be about $14 billion. And within their decking, for example, would be about $5 billion. And rail is about $3 billion exteriors. Our core exteriors business is about $4 billion. And the opportunity there, if you think about your -- when you use our types of products, you are in effect building an outdoor room. And when you build an outdoor room and the cost of square footage right now is incredibly expensive for new build. In some cases, it's over $1,000 a square foot. And if you think about building an outdoor room, it can be 25% of that or lower, right? A really good outdoor deck with a pergola and everything around it might be $100 a square foot, might be $150 so as you consider that $14 billion of opportunity, think of it as decking as the flooring, rail as kind of the safety element and our exteriors business as the wall and then the smart pergolas we have is really just an opportunity to create overhead, shade and protection from the elements. Now layer on top of that, we have adjacencies of about $10 billion that start to relate to products we don't currently have in the portfolio or are new in the portfolio. A couple of small examples of that really relate to things like niche siding where we have some higher-end products that are there for wood replacement and furniture. We make our own furniture. We launched that recently. And once again, these are niche plays for us, and they're just kind of additive to that outdoor living space.

Yes. And I'd just add anything that is in the space that participates in a material conversion story as well as has natural synergies with our channel is of particular interest to us.

Got it. And I guess wondering sort of if we think big picture now, sort of everyone is wondering about housing, trends are taking place, whether it's new construction, repair and remodel, wondering so just thinking about Azek and both exposure, but also when we've gone through prior housing downturns. How has it been for Azek and how do you see the cycle there?

Yes. I'll start at a high level. I'll let Pete talk about maybe the specifics of the global financial crisis. But -- so about 15% of our business is new construction, and the remaining 85% is either commercial or primarily repair and remodel. So I think one thing to consider the cycle that we're going through, if you look at the data, certainly you would expect the data is showing that new housing starts are down, that sector is certainly under pressure. And so as you look at the macro, that will recover when it recovers. And then typically, in any scenario, repair and remodel is much, much more resilient, right? It is really dependent on people wanting to continue to expand their living space and improve their homes. So in almost any economic scenario, you would typically see repair and remodel, weathering any kind of economic macro on a much more stable basis. And so for us, since we play there, we historically have seen a dampening in any cycle. And I think the data right now would show that there continues to be good spend in the repair and remodel space, we may see -- as we talked about on our earnings call, there are expectations of somewhat of a slowdown, which we have now incorporated into our planning assumptions. But the macro is very much intact. So if you look at the macro on housing and repair and remodel in particular, you've got multiple generations now, right, the baby boomer generation, the Gen X generation, which isn't that much smaller and then the millennial generation, all now competing for a place to live as millennials have their second child, which kind of drives the activity. And so you basically have a shortage of livable space. That really puts us in a position where we're bullish on the market and then more people want to build the outdoor space. And then Pete, on the specific.

Yes, specifically on -- in the great recession back in 2008, 2009, kind of peak to trough revenue dropped about 15% and quality of earnings dropped about 500 basis points temporarily. On the rebound, the following year coming out of the recession, recovered about 760 basis points. And one of the key dynamics to that is obviously PVC is an important input cost for us. The strongest correlation of PVC pricing is actually construction spend. So naturally, as there is a pullback in construction, we actually get to tend to be pretty resilient on the margin profile as we tend to see resin prices start to recede with construction spend lowering.

Great. And in terms of outdoor living, we've seen a trend certainly, not just for the past couple of years, but prior to that, in terms of more spending more time spent outside and that theme. How do you think about that and concerns that there was some pull forward in demand? What do you think about the overall issue and your take.

Yes. As you pointed out, the trend -- I started 6.5 years ago and one of the reasons coming into this job that I got so excited about it was the combination of the macro demographic trend I talked about, the material conversion, but also this focus on what people are defining as outdoor living. And the reality is people no longer want lawn chairs on grass. They want the ability to use outdoor space as a place where they can eat and work and everything else, right? That focus has really been there. We have AIA data, the architect industry data that says that focus has been, gosh, I want to say, 7 or 8 years now, it's been the #1 area of focus for remodeling spend, right? So that focus has been there. We expect it to continue to be there. It's something that kind of transcends all the generations that are involved. As we look specifically at what occurred during the pandemic we certainly had elevated levels of focus in that area. But there was also a general constraint, right? The constraint really was around contractors and our own ability to supply. So if you look at our unit volumes, they were up above the historical average. So think of double-digit historical average. Maybe our unit volumes got to 20%. We believe within '22, as we've gone through inventory corrections in the channel and a modest unit slowdown through most of '22 that we have gotten a lot of that, let's call it, heightened growth out of the system. And so as we sit now, as we ended '22, our unit volume compared to 2019 would be up about 30%, give or take. Now our sales volume is up closer to 60% or even higher because of acquisitions, pricing and mix and certain other things. But if you just look at the unit volume being up 30% from 2019 is pretty consistent with the historical average. So a long-winded way of saying we believe that with the correction we had in channel inventory, we're now to the point where we're back to a normalized volume level. So now as we look at '23 million we believe that we're operating under a normal year, which will be potentially impacted by a macro but we're now back to kind of the baseline. So some of the kind of the excess, if you will, has left the system, and now we're back to our standard contractors doing work and having really good backlogs.

Got it. And then in terms of -- you talked about in your initial remarks talking about sort of the thoughts on margin improvement over time. Wondering about that and how that fits in terms of the overall environment here, what -- and how that works given sort of some headwind.

Yes, I'll start with that. So I think at the end of the day, in our Investor Day back in June, we laid out a pretty clear road map around how we're thinking about the margin expansion opportunity in front of us and how we've got a portfolio of actions to meet or exceed the 27.5%. But for us, it kind of starts with kind of a core pillar is recycling. And we laid out sort of the pieces or let's call it, the next phase of recycling in terms of increasing PVC content in our decking business and our Trim business, and making a more forceful shift to more low density within our cap composite line. That basket is worth about 350 basis points of margin expansion over time just to get to that next phase. It's not necessarily an entitlement. We think we can go further than that. And then we've got about 200 basis points of what I'll call product configuration opportunities, whether it's either just the design of our product itself or the formulation opportunities for the cap that we use around our product. And then, call it, just good old-fashioned continuous improvement in how we run our plants, how we think about conversion cost opportunities, scrap and then lastly, we feel like with the growth profile of the business, we can still invest in the ways that we need to but still get modest SG&A leverage most years. So I think, again, in the Investor Day, we called out the cadence that people should think about is about 100 basis points of improvement each year. But we had a list of and still have a list that's much more than the 450 basis points incrementally that we need to deliver, and we feel really good about it. And I'll just make one other point on recycling in general. Recycling is obviously really important to that story. And as Jesse said, it's about half of the cost of a virgin pound. But we also like to say it's one of our best buffers against inflation. It's one of our best buffers against product availability when you have hurricanes and disrupt the supply chain issues. And then obviously, from a sustainability perspective, it's hugely important to us.

Just kind of just if I could briefly add to what Pete said. As you take a look, just -- if you look at calendar fiscal '22, we've had a lot of these programs that we've been executing. But the challenge we've had within '22 is and really starting in '21 with the freeze, we've had 18 months of raw material inflation that we have been pricing against, but that pricing has lagged the raw material inflation. So if you just look at let's say, calendar '22 for us, what you would see is good growth and not as strong an EBITDA growth. As we move into '23, we're finally to the point where our price has -- with some of the step backs in raw material, our price is now beneficial relative to raw material. And whatever margin compression we might have had in '22 or over the last 18 months, logically is starting to unwind. And so if you just step back, that's $220 million of inflation we talked about on the raw material side. As that unwinds, that presents an opportunity for us to have a benefit and also for some of the programs that Pete was just talking to, to really start to flow through to the bottom line. And that's a bit of why we're confident in our ability to manage through the back half of '23 is because we're finally starting to see the benefit of a lot of those programs as it flows to the balance sheet.

I guess wondering along these lines in terms you talked about that. So there's the cost coming down where you sort of endured this $220 million there. How -- as you think about do envision then being able to hold price in an environment where we do have a tougher macro. And as you think about sort of margins going forward, how important -- how necessary is sort of being able to hold the line on price environment of easing volume to achieve that.

Pete, do you want to take that?

Yes. I think our confidence, especially on our -- the biggest part of our business is the deck railing and accessories business. And I think we feel supremely confident that the history of the of the space is that list prices don't look backwards. So we feel completely comfortable in the rational behavior of the industry. On the exterior side, we expect there'll be some modest program activities probably in '23 and then on our commercial side of the business, I think the traditional pricing patterns will remain intact, that we should do a very good job of managing price in 2023.

And I guess related to that, we've seen capacity coming on in the industry here as of late and sort of still to come and there's a fear that with that capacity and sort of pressure on demand that, that impacts pricing. But a lot of the capacity is modular, how does that -- has the production sale sort of impact your thoughts on pricing versus volume and what you expect for the industry here for Azek and the industry overall?

Yes. Look, I mean, we price to value. Capacity is not part of the equation. Ultimately, as you talked about, the modularity of our manufacturing look for our businesses, each extrusion line is discrete. If we don't have work for it, we can turn it off and actually remove the variable headcount resources that are tied to it. So there's not really a disincentive in our industry to run a machine just to run it. If the load isn't there, we don't run it, we take the cost out. And so it's not really a factor in our pricing.

And I would just add -- if you take a look at deck rail and accessories, right, the people choose the product because of how it looks and the value it provides. So we've got a good, better, best premium offering. And as we talked earlier about wood conversion, people are converting because that's the product that they want or the look that they want or the feel that they want. So in general, we don't use price as a lever for generating market demand. The demand is the demand and it's our job to fulfill it the best way we can. And by having better products that happen to cost more, we're actually, if anything, kind of pulling the market up. And if you think about the logic and the structural aspect of that in the market, there's only 2 of us that market to consumers in a big way, and there's millions of consumers. We've got tens of thousands of contractors and thousands of retail and pro channel outlets, right? To win, you've got to be present in all of that. So there's not an easy -- the structure of the market, especially on a product that's warranted for 30 to 50 years doesn't naturally lend itself to price being a variable that can easily disrupt that process.

Got it. And then in terms of the replacement of wood in terms of taking share over time, I think seen stats of sort of 60 [indiscernible] with decks and [indiscernible] beyond useful life and need to be replaced. And so when you think about that in terms of just what then should be coming in terms of demand of that [30 million ] in an environment where there's a hiccup, I guess, is the view that, that essentially becomes just pent-up demand for so if it's not '23, it's the 24 or 25. How do you think about sort of the -- what we then see over time?

Yes. I mean it's a good question relative to ebbs and flows. I think if you go back to the underlying growth stack, we see a benefit from wood conversion, and we see a benefit from this large base of existing decks, right? So that sits out there. We believe that one point of conversion a year, one point of conversion a year leads to 4 percentage points of growth above the underlying wood deck market. And if you look backwards, that equation 1% to 1.5% has held. So if you look at the lineal feet of wood decking versus the lineal feet of our types of products, what you would see is we're always selling more and more lineal feet and we're always outgrowing wood decks. We view that as an opportunity in any market in the global financial crisis, I didn't happen to be here, but the team that was here indicated that some of our most premium products actually took off during that cycle, right? So we were able to drive wood conversion during that deep economic downturn in 2009 of some of our more premium products. We view it as an arc of, call it, double-digit growth. And so your point is a good one, which is if we don't have a year of double-digit growth for whatever reason, the demand is still there, right? And the demographics and the conversion and the need to replace is still there. So yes, I mean, if we still believe on the double-digit growth on an annualized basis. And so that means if it doesn't occur in a year we should have an opportunity to catch that back up.

And I guess then in terms you're talking about in terms of premium products and such, given the cost of replacing a deck or an overall project like that. And the fact, that largely, these are paid out of pocket, how do you think about sort of the affluent of the end consumer and what that means to an environment where the consumer maybe pinched to some extent, but given the affluence, is there beyond sort of discretionary purchases, is there some benefit that you may see here given that those consumers have the resources?

Yes, the macro, I think as we look at it is there's a lot of reasons for people to buy our product and replace either what's not working or use it to expand their square footage, right? And in general, our demographic has the means to do that. Think of it as you're expanding outdoor living. It's $20,000 $50,000, $60,000, $70,000, and we've got people that are spending $0.5 million also but think of it in the range of a car. So people have the financial means to do it, and there's multi-generations, there's pent-up demand there's people that have moved in their houses. That's on one side. And the counter to that is, call it, consumer sentiment and how people feel about their wealth. I don't know that I'm -- that we or we are good enough to predict that equation. Certainly, if there's a macro slowdown that affects people's perception of their wealth that has the potential to impact that equation. But we do tend to skew more -- I mean first, we go to homeowners. So that's kind of the first cut of who's buying our product. And so by definition, homeowners have more wealth than not homeowners, in many cases, and then you layer on top of that, that we tend to skew with a more mature, more settled demographic. Our research would say give or take, a big chunk of, I don't want to say the exact number, but a good size of our customer base is people like us, right? And what I mean by that is people that have owned their -- they've owned a home, they had a deck. This is not their first home. This is not their first time dealing with the issues related to wood and they're doing a remodel, and they just want it to be right, right? And so that demographic tends to be wealthier and tends to have better homes. And so there's always going to be a push pull, but we tend to play in the more affluent demographic and by virtue that tends to be at least what history has shown us may be different this time, it tends to be more resilient in economic cycles.

I call them the folks that don't like to paint, maintain or stain.

All right. I guess wondering you talked about sort of the increased use of recycled materials before and sort of going and sort of making the beautiful deck out of that. Where are you in terms of recycled content. We're able to increase that, I think, this past year, where do you think that, that can go over time in terms of goals for 5 years from now, what percentage of materials will be recycled.

Yes, I'll start with that. So on the PVC side, I think what's interesting or attractive about the opportunity for us, both on TRIM and the PVC deck side is it's really kind of more iteration than it is innovation. So we just exited this past year at about 60% recycled content for our PVC decking business. And I think when we started the year, it was about 54% to 56%. So it's not a 50-yard pass on the PVC side. It's just incremental, continuous gains each year. So we haven't published necessarily with the percentage for 2023. But you can think of it as probably making another 4% to 5% kind of improvement in terms of content on the decking side, and then really, our next ambition on the cap composite side is our opportunity is to continue to shift to even lower cost recycled material today, all of our content really other than the cap on cap composite is recycled materials already, but we use about half high density and half low density, and our next ambition is to get to about 75% low density versus high density. And again, in that scenario, it's about half the cost of a pound each time we can shift to low density versus high density.

So if you think about the macro arc, right, we're at about 56% material usage, that's recycled material. So of our raw materials that we buy for extrusion, 56% of that is repurposed or recycled materials that we're using, which is an incredibly high percent, right? I used to run an office products business actually posted many years ago, and you would kind of fight to get to 25% or 30% recycled content, right? So as a company, we're at 56%. We believe we can get into the 60s. And -- but that takes some work. You need to make sure you have the right sources. And in our case, every day that goes by, we're vertically integrating. So we do our own recycling on polyethylene. We do our own recycling on PVC. We're the largest vertically integrated PVC recycler in the U.S., at least we believe we are. We've made a few different acquisitions there. And so we have a lot of supply and capability to recycle PVC. You've got to be able to know how to introduce it into the product, which is also technical know-how. And so that combination of sourcing engineering it, using it and scaling it, we've already proven out it where we are now. And it's -- it will give us enormous flexibility as we continue to increase higher and higher percentages of recycled, right? Because it's a huge competitive advantage.

And now we're getting close to the end here. I wonder if there are questions from the audience. Anyone wants to ask or have a few more, but okay. I guess just to continue that. I think there's been -- how do you think there's been enough noise out there based on sort of inventory trends and sort of how that can influence results for a quarter and such. But as you think about sort of underlying consumer demand sell-through any thoughts in terms of what you're seeing there that sort of gives a better read on the overall market relative to sort of what's influenced by inventory.

Pete, given the time, I'll answer. Go ahead, either way.

Yes. No, I mean, I think we've seen a lot of stability over the last 2 or 3 months. And what we see as a general rule on the sell-through perspective is we've remained positive on a dollar basis and modestly negative on a unit volume basis, call it, low to mid-single digits.

Great. I think then we're close to the end of time here. If there's -- we can wrap it up. Anything else you want to say in closing?

I would just say I appreciate the questions on the strategic side of what we're trying to do. We're -- we laid out some objectives in June. We're incredibly confident in our ability to execute against those objectives. And we're -- as we move into some time of uncertainty, macro uncertainty, the natural hedge we have is our cost reduction and our capability to use raw materials that will naturally normalize as we go through the tail end of the economic cycle. And so -- so we're really, really confident about our ability to navigate through an uncertain time, especially given the way the company is built. So with that, I appreciate it.

Thanks very much.

Yes. Thank you.